Abolition of tax income equalization will ‘hit fund industry very hard’

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The abolition of the tax income equalization procedure in Germany, effective January next year, ‘will hit the fund industry very hard and will cause considerably greater expense to fund management companies’, warned Carina Berberich, head of investment management and tax at Hamburg-based fund manager IntReal, a unit of Warburg-HIH Invest Real Estate.

Income equalization is an investment law instrument by which the unit price and the earnings per unit are kept constant despite continuous investor fluctuation in open-ended funds. Tax income equalization will be scrapped under the new law. As a result, spezialfonds will have to calculate the earnings share of a distribution individually for every single investor moving ahead – taking into account the exact dates on which an investment begins and ends. In addition, other tax figures will also have to be calculated for individual investors.

‘Distinguishing between specific investors in this way is extremely labour-intensive and will be a major challenge to the respective accounting systems,’ said Michael Schneider, managing director of IntReal International Real Estate.

Under the new tax regime, spezialfonds will be subject to taxation at the fund level, as of January next year, ‘if they bill themselves as ‘intransparent’ investment funds, like public funds’, said Schneider.

Currently, such funds are taxed at the investor rather than the fund level – or so-called tax transparency. Not all funds will be affected by the new law, though, according to Berberich, who noted that pension funds won’t be taxed at the fund level and ‘the gains at investor level are generally tax-free anyway’. As such, pension funds will continue to benefit under both regimes as they have done in the past. This also applies to churches and charitable trusts.

For insurance companies, in particular, it is important to only invest in funds with transparent taxation, otherwise there is the threat of taxation at the fund level, which cannot be credited or reimbursed at the investor level. As returning to special investment fund status has been ruled out, benefits still possible in connection with trade tax today could be extremely risky for investment funds, according to IntReal.

‘We very much welcome the fact that lawmakers have preserved the option of tax transparency for special AIFs,’ said Schneider. ‘The special investment fund regime (tax transparency) will nearly always be first choice for income from German properties held by a German fund. However, this will entail greater expense for a series of investment limits.’

That means there will be challenges for the fund management company, said Berberich, particularly when it comes to the restriction on ‘active business management’.

‘Property funds generate income from renting and leasing, and are therefore essentially pure play asset managers,’ she said. ‘However, a small share of their income can come from active business management.’ If this income accounts for more than 5% of a fund’s total income, the fund is disqualified from the transparent regime and, as an investment fund, this income becomes subject to trade tax. ‘More comprehensive risk controlling than before is, therefore, needed here. The difficulty for fund managers lies in monitoring the 5% ceiling over the entire life cycle of the fund. Both rental income – the main component of total income – and income from active business management can fluctuate over time,’ she explained.

A further consequence of the amendment that will mean more work for fund initiators and management companies is the adjustment of investment conditions. These have to be amended for all special AIFs, regardless of which tax regime they fall under. Also, under the new taxation, ‘the fund manager of a transparent special fund will have to calculate the applicable tax every time an investor buys or redeems a share, which is really time consuming for us’, Berberich said.

IntReal manages 112 real estate funds with around €16.6b of AUM as of end-September, around 80% of which are pooled, thereby containing different types of institutional investor. ‘As of next year, we estimate that up to 80% of our funds will remain tax ‘transparent’ investment funds that are taxed at the investor level,’ Schneider said. ‘There is a lot of pressure on funds because the yields are low, so we can’t really increase the fund costs to cover the cost of the work relating to new taxation. We will have to bear that cost ourselves.’

Despite the new tax regime coming into effect next year, there are still a lot of questions that the Ministry of Finance needs to answer, according to Berberich. ‘They were supposed to answer in September but now it seems we won’t know until the end of next year. One of the most pressing questions is how the income and costs of the fund will be divided over the shares. Some investors, who are taxable in Germany, could profit from the new tax regime. However, the KVGs, such as ourselves, don’t like it because of all the extra work it will entail.’