New exit tax rules for investment shares

The Annual Tax Act 2024 shall extend how an asset’s increase in value is taxed under Sec. 6 of Germany’s Foreign Tax Act (the Außensteuergesetz). One of its key measures is the extension of exit tax provisions to include certain cases, such as investment shares and shares in special investment funds under Germany’s Investment Tax Act (the Investmentsteuergesetz). Entered into the draft bill and adopted by the Bundestag (Germany’s Federal Parliament) on 18 October 2024, it is likely to receive approval from the Bundesrat (Germany’s Federal Council) in November.

Closing tax loopholes 

The legal amendment was introduced by the Bundesrat and supplemented by the Finance Committee in its proposed resolution in the Annual Tax Act. Its goal is to provide greater legal certainty and close tax loopholes. Shares held by private individuals in an investment fund or special investment fund with the legal form of a ‘special fund’ (Sondervermögen) are not subject to exit taxation for shares in corporations (under Sec. 6(1) of the Foreign Tax Act in conjunction with Sec. 17(1) of the Income Tax Act (the Einkommensteuergesetz)). This is because shares in a ‘special fund’ are not classified as ‘shares’ under Sec. 17 of the Income Tax Act. Therefore, if an investor moves abroad, the hidden reserves included the fund shares do not trigger exit taxation. For investment fund shares or special investment funds in the legal form of a corporation, moreover, it remained uncertain whether they are covered by the German exit tax regime or not.

According to the explanatory memorandum to the law, cases have been identified where this had sometimes been used to avoid capital gains tax from an investment fund by relocating abroad. It is believed that holdings in start-up companies were sometimes transferred into funds at an early stage to avoid capital gains tax when relocating abroad at a later date. These ‘tax loopholes’ have come to light thanks to disclosures connected to cross-border tax arrangements in accordance with Secs. 138d et seq. of Germany’s General Tax Code (the Abgabenordnung) (see also the EU’s Directive for Administrative Cooperation, commonly called “DAC6”). In order to prevent such uncertainties and avoidance schemes, the Annual Tax Act draft sets out two changes to the Investment Tax Act. These essentially replicate the provision of Sec. 6 of the Foreign Tax Act and adapt them to the special features of investment tax law, while also tightening them.

Amendments to the Investment Tax Act 

A paragraph is to be added to both Secs. 19 and 49 of the Investment Tax Act, which subjects shares in investment funds or special investment funds held by private individuals to exit tax. This includes both shares in domestic and foreign funds, regardless of whether they are held in domestic or foreign security accounts. In this respect, the key criteria mean that a natural person meets the conditions for unlimited tax liability under Sec. 6(2) of the Foreign Tax Act. Further, they also mean he or she holds the relevant (special) investment shares directly or indirectly (e.g. through a private asset management partnership) as part of their private assets.

These shares are deemed to have been sold (“deemed disposal”), based on Sec. 6(1) sentence 1 of the Foreign Tax Act, if the unlimited tax liability ends if:

• the domicile or habitual abode no longer exists in Germany,
• the investment shares are transferred free of charge to a person with limited tax liability,
• or if the Federal Republic of Germany’s right to tax is limited or excluded for other reasons.

Threshold values for ‘severe’ cases

The legal amendment does not, however, seek to cover all cases. Instead, it targets only ‘severe’ cases involving a level of holdings comparable to that defined in Sec. 17 of the Income Tax Act. Section 19(3) of the updated Investment Tax Act should therefore contain two different thresholds: The increase in value of the shares will be taxed only if at least one percent of the issued investment shares in an investment fund were held during the five years prior to the deemed disposal. However, exit taxation is also intended to apply as an alternative if there is no participation of at least 1 percent, but the acquisition costs per share amounted to at least EUR 500,000. This is a first in exit taxation. However, several holdings in different investment funds are not added together. No thresholds are planned for the case of Sec. 49(5) of the updated Investment Tax Act, as it is generally assumed that private individuals’ holdings in special investment funds are significant cases. Thus, exit taxation for investment shares goes beyond the exit taxation for holdings in companies under Sec. 6 of the Foreign Tax Act in conjunction with Sec. 17 of the Income Tax Act. The legislature justifies this. It states that investment funds could potentially have more untaxed hidden reserves because they are only subject to corporate income tax on a small portion of their income, whereas corporations are subject to corporate income tax on all of their net income.

Consequences for practice 

Following the planned legal amendment, the provisions regarding the origin, loss, maturity, notification and cooperation obligations, but in particular the deferral and return provisions and their restrictions, will also apply to shares in investment funds or special investment funds with reference to Sec. 6(2) to (5) of the Foreign Tax Act.

The aim of the legislature is to ensure that hidden reserves are taxed and that tax evasion is prevented. However, the new regulations have an excessive effect and include a large number of cases that are not abusive. The question of EU conformity also arises here. In particular, the link to acquisition costs as an alternative to a minimum holding leads to an additional fiscal tightening of the system of exit tax. The Annual Tax Act therefore represents a severe restriction of flexibility on an international level. Investors in investment funds or special investment funds should therefore seek legal and tax advice for cross-border situations in good time if they want to avoid costly surprises.