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German controlled foreign corporation (CFC) reporting and alternative investment funds in light of ATAD 2

Alternative Universe

Tax Reporting for Alternative Investment Funds

Alternative investment funds (AIF’s) are facing more and more challenges to fulfill all tax reporting requirements for their investors in the different distribution countries. New regulations like ATAD 2 and DAC6 as well as recent tax measures in response to COVID 19 will also bring significant changes on the tax reporting for the AIF fund industry. This article is the first of a series, which will give you details on the tax reporting requirements for alternative investment funds in different countries.

On 10 December 2019, the Federal Ministry of Finance published the first draft bill on the law implementing the Anti-Tax Avoidance Directive (ATAD Implementation Law—ATADUmsG) in Germany. It also includes a reform of the German foreign tax law (GFTA). This update provides new requirements regarding shareholder control relationships, which would significantly change CFC reporting for the alternative investment fund industry.

Currently, CFC rules apply if a foreign corporation is controlled by German shareholders (i.e., they own more than 50% of the shares or voting rights)—the domestic control approach. However, to comply with ATAD 2’s new participation requirement, shares directly or indirectly owned by parties related to a German shareholder would also have to be taken into account—a shareholder-based approach.

In principle, taxable shareholders of an intermediate company are subject to CFC taxation if they—directly or indirectly—control the intermediate company, either alone or together with persons who are related parties (partnerships can also be closely related). According to these new rules, the related parties do not have to be subject to unlimited German tax liability for the shareholder-based approach, which means that foreign investor participation must also be considered when analyzing German CFC rules.

This approach also affects the multi-tier taxation concept, especially for alternative investment funds. Both direct and indirect participations must now be considered. Indirect participations (e.g., due to multi-tier structures) will no longer lead to an upstream allocation to the intermediate company if an upstream additional taxation has already happened at a sub-company level e.g., due to foreign CFC rules. However, this requires new efforts to request information from underlying companies and a deeper knowledge of foreign tax laws.

Intermediate companies within the scope of the GFTA are all foreign corporations, associations of persons or assets that fall within the scope of the corporation tax law. Under the German investment tax act (GITA), foreign investment funds are considered assets under the German corporate tax act. This means that all foreign investment funds that fall within the scope of the GITA initially meet the formal requirements to qualify as an intermediate company as per the GFTA.

For those funds that fall within the scope of the GITA, there is no additional taxation because the GITA continues to supersede the GFTA. What is new, however, is that the GITA and GFTA must both be applied if the taxpayer holds more than 50%, provided that the intermediate company generates more than a third of its income from its business with the taxpayer or related parties. Investment funds that do not fall within the scope of the GITA can either qualify as intermediate companies (e.g., holding companies in the legal form of a corporation) or be considered for control purposes (AIF in the legal form of a partnership).

Even if ATAD determines income based on a so-called list (or catalog) of activities that generate a passive income, the German tax law will still base its CFC-income qualification on a catalog of active income activities. Meaning if the activity is not defined as active, it is considered passive and subject to CFC rules. What is new is that passive income will now also include dividend income from corporations for holdings that are less than 10% (free float dividends). The accrued profit calculation method is now the only accepted way to determine the income that is deemed to be received by German investors.

Due to this new CFC taxation concept, the fund industry is once again faced with an enormous challenge. In-depth tax knowledge is required to calculate the amount to be added, and reviewing the new GFTA ownership structure will be an enormous obstacle to overcome.

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