The German Investment Modernisation Act
(the Investmentmodernisierungsgesetz) became effective on 1 January 2004. The legislation regulates investment funds in the Investment Act (Investmentgesetz) and all tax aspects in the Investment Tax Act (Investmentsteuergesetz). Its effect is to overhaul Germany’s investment fund and tax regimes and to implement the UCITS III Directives of the Council of the EU.
The new legislation provides, inter alia, for the establishment of hedge funds in Germany, facilitates the public distribution of interests in foreign hedge funds under conditions comparable to those of German hedge funds and modernizes the rules governing investment stock corporations.
Although these changes enabled by the new law have been discussed in many legal publications, the law’s effects on private equity funds and venture capital funds have had hardly any mention. This article considers the impact of the new law on such funds.
In the explanations to the first draft of the new law (dated August 2003) it was anticipated that private equity funds and venture capital funds would be not covered by the new legislation.
In general, they were not supposed to fall into the scope of application of either the Investment Act or the Investment Tax Act. It was intended to isolate private equity funds and venture capital funds from the new law’s scope and by that to abolish the risk of being subject to a punitive taxation (Strafbesteuerung) pursuant to the provisions of the former German Foreign Investment Act for investors who invest in an unregistered non-German private equity fund.
This intention to clarify the legal environment for such funds, however, was overruled in the final draft of the new law (dated November 2003) which was accepted and came into force at the beginning of this year. The previous ambiguity remains in place and accordingly the applicability of the new Investment Act and the Investment Tax Act has to be reviewed carefully in the context of private equity funds/venture capital funds.
The Investment Act is specifically applicable to both private placements and public offerings of investment funds in Germany. However, the vast majority of provisions of the Investment Act relate only to public offerings and in practice there should be a limited effect on private placements. By contrast, the Investment Tax Act applies equally to both private placements and public offerings.

Investments in private equity funds set up in Germany In this scenario German or non-German investors invest in private equity funds or venture capital funds which are been established in Germany. The Investment Act (and as a consequence the Investment Tax Act) is only applicable to investment funds (Sondervermögen) organised by a specific type of German investment management company (Kapitalanlagegesellschaft) and to investment stock corporations.
Private equity funds in Germany are commonly organised in the legal form of a limited partnership (Kommanditgesellschaft) or a corporate entity which are not deemed investment funds. Hence, the Investment Act and the Investment Tax Act are generally not applicable to such funds.
The gains resulting from private equity investments continue to be subject to the usual taxation according to German tax law. Thus, the new Investment Act or the Investment Tax Act have no effect on German private equity funds or venture capital funds.

Investments in non-German private equity funds by non-German investors Where the private equity fund or venture capital fund is established outside Germany and the investors of the fund are also non-German, the only link to Germany is the fact that the private equity fund or the venture capital fund might invest its assets in Germany.
Under these circumstances, the Investment Act is not applicable as long as the fund does not offer its investment to German investors. Similarly, for the non-German investors the potential applicability of the Investment Act is not material. Special provisions with respect to a potential limited liability
for tax of a foreign investor in Germany have to be considered.

Investments in non-German private equity funds by German investors If non-German private equity funds or venture capital funds wanted to attract German investors for their investment as well, they would have to offer shares in Germany. As a result, German investors would be investing in private equity or venture capital funds abroad. Under these circumstances the Investment Act’s and Investment Tax Act’s applicability might be relevant for investors in Germany as well as for the private equity funds/venture capital funds abroad.
The law expressly applies to foreign investment shares (ausländische Investmentanteile). Whether the investment in a non-German private equity fund/venture capital fund (which may or may not invest in Germany) is considered a foreign investment share depends, inter alia, on the assets in which the private equity fund invests.

For example, an interest in a private equity fund/venture capital fund that invests solely in non-security equity will, in principle, not be considered a foreign investment share. Hence, the public offering in Germany and the taxation of the gains arising from such investment in the private equity fund will not have to be in accordance with the Investment Act or the Investment Tax Act.
The profits derived by the investor will be taxed under general German income tax principles if no German or foreign investment fund is given. In contrast, the new law is applicable if the fund’s portfolio consists, inter alia, of securities. However, by implementing management control over the portfolio companies the applicability of the new law can sometimes be avoided.
If the investment in the private equity fund is considered a foreign investment share, such private equity funds will have to structure their investments in accordance with the Investment Act regarding a public offering, in particular provisions regarding the distribution of such investment fund units.
Under these provisions, the private equity fund will need to comply with several requirements. The fund has to notify the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or BaFin) of its intention to publicly distribute its fund units in Germany. It has to appoint a German representative and at least one German paying agent. It also has to fulfil additional prospectus content requirements and is prohibited from using a short-form prospectus. In addition, the contractual terms or articles of incorporation must meet certain minimum requirements (eg, the right of investors to call for redemption). For example, in the case of a US private equity fund the fund would be required to entitle investors to sell their investment back to such private equity fund at any time. It might prove a major obstacle for US private equity funds to comply with the requirement.

Taxation
Under the German Investment Tax Act, German investment funds are exempt from German corporate income tax and trade tax.
Based on the condition that certain tax reporting requirements are met, German investors enjoy favourable tax treatment of certain types of income derived from their investment units that is similar to the tax treatment of a direct investment. The tax reporting requirements demand a statement in which all relevant types of fund income is specified as required in the Investment Tax Act.
If, however, the aforementioned tax reporting requirements have not been met, eg, reporting of the amount of the distributed income or the amount of withholding tax on the distributed income was omitted, a penalty tax becomes due at the level of the German investor.
By law, the tax basis of the German investor with respect to its income will be deemed to consist of the distributions of fund income received plus 70% of the increase of the redemption price of the investment unit in the calendar year, but at least 6% of the last quoted redemption price of the investment unit in the calendar year. The penalty tax becomes due irrespective of the receipt of liquidity by the investors and so economically constitutes a taxation of capital.
After the amendments to the first draft of the Investment Modernisation Act, the legal environment for private equity funds and venture capital funds remains unchanged. The opportunity to clarify the tax environment in Germany for German investors that invest in non-German private equity funds and venture capital funds established abroad has not been taken.
Kai-Uwe Steck is head of Dewey Ballantine’s German desk in London and of the German investment management team in Frankfurt. Julia Launhard is a senior associate based in the firm’s London office

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