Germany proposes investment fund reform

The German Ministry of Finance is proposing changes to its investment fund formation and fund taxation laws to attract foreign investment funds and managers, including those from the alternative asset industries.

As part of plans to introduce the European Union’s UCITS (Undertakings for Collective Investment in Transferable Securities) Directives II and III, which are required to be implemented in each EU state by February 2004, the German Ministry of Finance has announced plans to harmonise and modernise fund investment and tax legislation which are currently separately regulated.


The Investment Modernisation Act (Investmentmodernisierungsgesetz) sets out plans for the reform of Germany’s dated public investment law and fund taxation laws, which are currently separately regulated. The new legislation aims to tax German and non-German funds in an equal manner, although it is proposed that the transparent tax treatment of funds will be maintained.


Present German laws applicable to the offer and sale of European funds to the public in Germany tightly restrict the kinds of funds and the types of assets in which it is possible to invest. Currently, only EU funds investing in transferable securities can benefit from the EU passporting regime in Germany. Recognising that these restrictions inhibit the ability of German funds to be sold in the EU and limit the kinds of funds that can be publicly sold in Germany under UCITS II, the exposure draft replaces the present system.


The new legislation also sets out reforms to the laws on third party provision of fund management services. The new law will permit outsourcing by German investment management companies (KAGs) of various functions performed for funds including outsourcing for discretionary investment management.


“The current law on outsourcing made it uncertain as to whether managers were entitled to outsource services to external management,” explains Patricia Volhard, a partner at international law firm Debevoise & Plimpton. “Under the new law, EU-based third-party providers of discretionary investment management services are able to offer services although they must be licensed in their home country to provide such services.”


The purpose of the reforms is to put Germany on a par with countries such as Luxembourg, the UK and Ireland, Europe’s leading investment fund centres and to stem the further flow of fund business away from Germany. The new legislation would permit the formation of public “umbrella funds”, enabling firms to apply for one license under which can be incorporated different investment guidelines. “This was previously forbidden by German law, meaning that investors were prevented from switching from one structure to another,” adds Volhard. “The new structure, in line with those in Ireland and Luxembourg, will make this easier.”


Typical German or non-German private equity and venture capital funds will not be covered by the new legislation.  Funds holding private equity investments will only fall within the scope of the new legislation if private equity investments make up less than 30 per cent of the total fund assets. The Investment Tax Act will also not apply to private equity funds. This will improve the current position of private equity funds under the German Foreign Investment Act where they risk being subject to penalty taxation.


The greatest impact of the reforms could be felt in the hedge fund industry, which for the first time will have a regulatory framework under German law. “Changes to the hedge fund laws are more liberal than expected, although there are still some restrictions,” said Volhard. “For example, private investors will only be able to invest in hedge fund-of-funds.”


In a statement, European law firm Macfarlanes said: “The proposed reforms are encouraging and demonstrate that the German government is keen to promote private equity and venture capital investment in Germany. For private equity or venture capital funds established in the UK and raising finance from investors in Germany, the new law should eliminate the need to set up a parallel German limited partnership (a KG).”


“Presently, German limited partnerships are often set up in parallel with the UK limited partnership. The parallel German vehicle allows German tax-resident investors to invest alongside (effectively through) the Fund without falling foul of the Foreign Investment Act tax rules which would otherwise characterize the units in the Fund as foreign investment units leading to adverse tax consequences for the investors. The proposed changes (if enacted) will allow German investors to participate directly in the Fund, thus saving administrative time and cost for fund managers.”


Under German parliamentary procedure, the Exposure Draft was released to the public at the beginning of July. It will be considered by both houses of the German Parliament in September for enactment later in the year.