Investment Tax Act (InvStG)

Basics and importance

The Investment Tax Act was completely restructured by the fundamental reform on January 1, 2018 and regulates the taxation of investment funds and their investors in Germany. The new regulations led to a paradigm shift in investment taxation by replacing the previous transparent taxation system with a non-transparent system with pre-taxation at fund level. The reform aimed to reduce the increasing complexity of investment taxation and simplify administrative practice, while at the same time ensuring conformity with European law. The law makes a fundamental distinction between mutual investment funds, which are aimed at the general public, and special investment funds, which are reserved exclusively for institutional investors. The tax treatment of investment income was newly regulated by the introduction of a flat-rate partial exemption for equity and real estate funds, which is intended to avoid economic double taxation. The international dimension of investment tax law is becoming increasingly important, particularly due to the requirements of the AIFM Directive and cross-border fund investments. The complexity of the regulations requires an intensive examination of the tax consequences of different investment strategies and fund structures. The practical implementation of the regulations presents both fund companies and investors with considerable administrative challenges. The tax treatment of investment funds has a significant impact on the investment decisions of institutional and private investors. The ongoing digitalization of the financial markets and new forms of investment require continuous adaptation of the legal framework. The importance of the law is reflected in fund assets under management of several trillion euros in Germany.

Taxation system and fund level

The basic system of the Investment Tax Act is based on separate taxation at fund and investor level, whereby investment funds have been treated as independent taxable entities since 2018. The investment fund’s corporation tax liability extends to certain domestic income, in particular dividends from German shares and real estate income, which are subject to a tax rate of 15%. Foreign income generally remains tax-free at fund level, which is intended to avoid double taxation in an international context. Taxation is independent of the fund’s distribution policy, which represents a considerable simplification compared to the previous system. The fund companies must keep comprehensive records of the tax composition of the fund assets and carry out regular status assessments. The tax treatment of different asset classes and financial instruments requires careful examination and documentation by the fund company. The determination of taxable income follows complex calculation rules that require precise knowledge of the tax regulations. Taxation at fund level is modified by various exemption regulations for certain tax-exempt investors. Compliance with the tax regulations is monitored by regular audits by the tax authorities. The technical implementation of the taxation regulations requires efficient IT systems and qualified personnel. The international dimension of fund taxation is characterized by numerous double taxation agreements and EU legal requirements. In practice, the complexity of the regulations often leads to questions of interpretation and legal uncertainty.

Taxation at investor level

The taxation of investment income at investor level follows a two-tier system that distinguishes between current distributions and gains from the sale of fund units. For private investors, distributions from an investment fund are generally subject to flat-rate withholding tax at a flat rate of 25% plus solidarity surcharge, whereby the partial exemption rates for different fund types must be taken into account. The amount of the partial exemption depends on the fund’s investment strategy and is 30 percent for equity funds, 15 percent for mixed funds and 60 percent for real estate funds or 80 percent for predominantly foreign real estate investments. The advance lump sum as a special form of minimum taxation is calculated annually on the basis of the prime rate and is intended to ensure appropriate taxation even for accumulating funds. Business investors must pay tax on investment income in accordance with the general tax regulations, whereby the partial income procedure or the corporate income tax box privilege may apply. The tax treatment of special investment funds is subject to special regulations that enable largely transparent taxation and take into account the specific requirements of institutional investors. The determination of taxable income requires careful documentation and calculation by the custodian institutions. The offsetting of foreign withholding taxes is subject to complex regulations and often involves considerable administrative effort in practice. The tax optimization of fund investments requires careful planning, taking into account the investor’s individual tax situation. The increasing internationalization of fund investments places particular demands on tax compliance and documentation. The complexity of the taxation rules requires intensive advice for investors from tax experts.

Special investment funds

The regulations for special investment funds were fundamentally revised as part of the investment tax reform, although the previous transparent taxation system was largely retained. The strict investment regulations for special investment funds include, in particular, the restriction of the group of investors to a maximum of 100 institutional investors as well as specific requirements for assets and investment limits. The tax transparency option enables investors to take advantage of the tax characteristics of fund income as they would with a direct investment, which is particularly important for pension funds, insurance companies and other institutional investors. The daily calculation and attribution of income places high demands on the technical infrastructure and reporting of fund companies. The exercise of the various taxation options must be carefully documented and agreed with the investors, whereby the decisions must be made uniformly for all investors. The tax treatment of foreign special investment funds requires a particularly careful examination of the qualification requirements and cross-border tax consequences. The requirements for risk management and compliance systems are particularly high for special investment funds, as breaches of the investment regulations can lead to the loss of tax status. Cooperation between the fund company, depositary and investor must function smoothly in order to meet the tax requirements. The increasing regulation of the fund market through European requirements also influences the tax structure of special investment funds. The digitalization of processes and the automation of reporting are becoming increasingly important. The complexity of the regulations requires intensive coordination between all parties involved and regular staff training. The ongoing monitoring of investment criteria and taxation requirements is a key challenge.

Special forms of investment and structures

The tax treatment of exchange traded funds (ETFs) follows the general provisions of the German Investment Tax Act, although the special structure of this form of investment poses specific challenges in terms of tax reporting. The taxation of funds of funds and target funds requires a multi-level consideration of the partial exemption rates and investment limits, whereby the review of the individual target fund investments places special demands on tax reporting. The tax treatment of hedge funds and other alternative investment funds has been significantly tightened by the reform, in particular through the restriction of loss offsetting and the stricter obligations to provide evidence. The design of real estate investment trusts (REITs) and other real estate-related forms of investment must take into account the special tax requirements for real estate funds, with the increased partial exemption rates representing an important design aspect. The integration of ESG criteria (environmental, social, governance) into the investment strategy is becoming increasingly important and requires careful coordination with the tax requirements. The use of derivatives and other complex financial instruments in the fund portfolio must take into account the tax implications, whereby the qualification of income often causes difficulties. The cross-border structuring of investment funds requires intensive coordination between the jurisdictions involved and the consideration of different tax regimes. The development of new forms of investment and financial instruments poses continuous challenges for investment tax law in terms of legal classification and tax treatment. The tax optimization of fund structures must take into account the various investor interests and at the same time meet compliance requirements. The increasing importance of sustainability in capital investment is leading to new requirements for the tax structuring of investment funds. The digitalization of the financial markets and the development of tokenized fund units require adjustments to tax regulations. The complexity of the structuring options requires intensive coordination between fund management, tax advisors and supervisory authorities.

Reporting and verification obligations

The extensive reporting and verification requirements of the Investment Tax Act pose considerable administrative challenges for both fund companies and custodians when it comes to practical implementation. The daily determination and publication of the tax assessment bases requires highly developed IT systems and standardized processes that must ensure error-free processing of the tax-relevant data. The tax bases must be determined separately for each investment fund and published in the Federal Gazette, whereby the complexity is further increased by different unit classes and currency calculations. The documentation of the partial exemption rates and their review requires continuous monitoring of the investment strategies and portfolio compositions by the fund companies. The reporting obligations to the Federal Central Tax Office have been considerably extended by the reform and now also include detailed information on the tax characteristics of the investment funds. The preparation and transmission of tax certificates for investors must comply with the strict formal requirements of the tax authorities and contain all relevant tax information. The cross-border dimension of the fund investment requires additional evidence and reports within the framework of the international exchange of information and the various withholding tax procedures. The implementation of an effective tax compliance management system has become essential for fund companies in order to be able to meet the various tax requirements. Coordination between the fund company, depositary and custodians must function smoothly in order to ensure the correct tax treatment of investment income. The increasing digitalization of reporting processes requires continuous investment in technical infrastructure and staff training. In practice, the complexity of the reporting obligations often leads to questions of interpretation and the need for coordination with the tax authorities. The error-prone nature of the processes requires extensive control mechanisms and regular reviews of the reporting chains.

Future prospects and development trends

The future of investment tax law will be significantly influenced by the ongoing digitalization of the financial markets and the development of new forms of investment, with the tax treatment of tokenized fund units and digital assets posing a particular challenge. The increasing importance of sustainable investments and ESG-compliant investment strategies is likely to lead to a further development of tax regulations, possibly through the introduction of specific partial exemption rates for sustainable investment funds. The European integration of capital markets and the harmonization of fund regulation will exert increased pressure on national investment tax law to adapt, particularly with regard to cross-border comparability and competitiveness. The ongoing automation of tax processes and the development of standardized interfaces will lead to more efficient processing of reporting and verification obligations, but will also require considerable investment in the technical infrastructure. The increasing complexity of financial products and investment strategies will make it necessary to continuously adapt the tax regulations, while maintaining a balance between practicability and tax fairness. The international dimension of fund taxation is becoming increasingly important due to the global networking of financial markets, which requires greater coordination of tax systems and an intensified exchange of information. The further development of tax compliance requirements will lead to a further professionalization of fund management and possibly accelerate the consolidation of the fund industry. The integration of artificial intelligence into the tax management and monitoring of investment funds could lead to more efficient control and better risk identification. The importance of the tax design of fund structures will continue to grow in light of increasing regulation and transparency requirements. The development of new forms of investment and distribution channels will pose continuous challenges for investment tax law in terms of legal classification and tax treatment. The ongoing globalization of the capital markets will require further harmonization of the tax treatment of investment funds. The future viability of investment tax law will largely depend on its ability to keep pace with the dynamic developments in the financial markets.