Investment Funds in Focus New German exit tax A trap for investors

The draft Annual Tax Act 2024 (Jahressteuergesetz 2024) passed the German Federal Parliament (Bundestag) on October 18, 2024, and is set to be approved by the German Federal Council (Bundesrat) in November. A key aspect of the draft is its extension of exit taxation to (special) investment fund shares, marking a significant development.

Current Legal Framework

To date, investment fund shares are not considered shares under Sec. 17 of the German Income Tax Act (Einkommensteuergesetz, “EStG”) and therefore do not fall under the exit tax as defined in Sec. 6 of the German Foreign Tax Act (Außensteuergesetz, “AStG”).

Changes Under the Annual Tax Act 2024

The German Investment Tax Act (Investmentsteuergesetz, “InvStG”) will now be expanded to include provisions equivalent to the exit tax rules under Sec. 6 AStG.

If a taxpayer holds shares in an investment fund as private assets, unrealized gains on these shares will become taxable upon relocation from Germany. For the exit tax to apply, the taxpayer must have held (directly or indirectly) at least 1% of the issued investment fund shares within the past five years prior to relocation, or the acquisition costs for the relevant shares must total at least EUR 500,000. This assessment applies per investment product, which is particularly relevant for ETFs. The legislator aims to capture only substantial cases comparable to those under Sec. 17 EStG.

The exit tax results in a tax on "dry income," as it does not involve a liquidity-generating sale.

The same rules will apply to shares in special investment funds (regulated by the third chapter of the InvStG, “Chapter Three Funds”), but no materiality threshold will apply here; private investors with special investment fund shares are generally assumed to hold a significant stake.

The application of the new regulation will not depend on whether the shares are in a domestic or foreign fund, nor on whether the shares are held in a domestic or foreign securities account.

The regulation will apply to relocations after December 31, 2024. The provisions in Sec. 6 (2-5) AStG for deferring tax claims and returning to unlimited tax liability will apply correspondingly.

Objective

The legislative change was initiated by the Federal Council and addresses certain cross-border tax arrangements reported under Sec. 138d et seqq. of the Fiscal Code of Germany (Abgabenordnung, “AO”)  ("DAC 6"). It appears to be the first, or at least most notable, case where the legislator has acted based on DAC 6 reporting to counter tax planning strategies. The goal is to prevent schemes in which investors set up private investment funds to acquire shares in corporations and potentially carry gains abroad tax-free. Additionally, cases have emerged where startup shares are placed in investment funds at an early stage to avoid capital gains taxation upon later relocation abroad.

Criticism

Criticism quickly emerged, particularly regarding the application of the EUR 500,000 acquisition cost threshold per investment product. In practice, this threshold could lead to effects that go far beyond the legislative intent.

Outlook

The new regulation signals the legislator’s intent to actively counter tax avoidance schemes. However, the expansion of the exit tax could have far-reaching effects, potentially affecting cases that do not constitute tax avoidance. Due to substantial market gains over the past decade, investors should pay close attention to this new regulation. Many funds likely contain significant unrealized gains that previously would have remained untaxed upon relocation.

Investors in (emerging) companies who have used the aforementioned structuring strategy and placed their shares in investment funds could also be negatively affected by the new regulation.

Taxpayers should carefully review their tax situation and potential implications arising from these changes before planning any move abroad.

Authored by Vanessa Rinus, and Heiko Gemmel.