Exit tax on (special) investment fund units held as private assets – What fund investors need to know from 1 January 2025

Background

German tax law has provided for an exit taxation regime for decades. It applies to natural persons who have been resident in Germany for a total of at least seven of the last twelve years and who hold an interest in a German or foreign corporation within the meaning of section 17 of the German Income Tax Act (EStG) (i.e. participation quota of at least 1% at any time in the last five years). Their relocation from Germany is treated as a deemed disposal of their concerned shareholding and thus results in the taxation of the hidden reserves in the shares in accordance with the partial-taxation regime (Teileinkünfteverfahren) (i.e. an effective tax rate of approx. 28%).

The exit taxation may not only be triggered by the actual relocation of an individual from Germany, but also by the relocation of the centre of vital interests to a foreign jurisdiction while maintaining a German residence, as well as by the gratuitous transfer of the shares to individuals not tax resident in Germany (see our blog post from 29 April 2021). In practice, exit taxation is particularly challenging in the case of high hidden reserves and tied assets, as liquidity must be procured to pay the tax. Against this backdrop, exit tax often proves to be an obstacle to leaving Germany.

Exit tax currently does, however, not apply to units in investment trusts within the meaning of the German Investment Tax Act (InvStG). These can be investment trusts in the legal form of corporations (e.g. the Luxembourg SA SICAV, Irish ICAV, German Investment-AG) or in contractual form (e.g. the Luxembourg FCP, German asset pool). The legislator originally made this decision deliberately because by introducing the advance lump sum taxation (for investment funds within the meaning of Chapter 2 of the German Investment Tax Act, “Chapter 2 Funds”) and deemed distribution taxation (special investment funds within the meaning of Chapter 3 of the German Investment Tax Act, “Chapter 3 Funds”), a permanent or long-term tax-free accumulation of profits at fund level was circumvented.

Exit taxation for fund units starts from 1 January 2025

With the German Annual Tax Act 2024, the legislator extends the German exit taxation regime with effect from 1 January 2025 also to relocations of individuals holding certain (special) investment fund units and gratuitous transfers of such units to foreign resident individuals.

The corresponding new rules will be included in the German Investment Tax Act and are essentially based on the already existing exit taxation pursuant to section 6 of the German Foreign Tax Act (AStG). In accordance with the different tax regimes, separate regimes will be introduced for Chapter 2 Funds (section 19 of the German Investment Tax Act) and Chapter 3 Funds (section 49 para. 5 of the German Investment Tax Act).

The legislator aims to close (supposed) tax loopholes with these new rules. According to the explanatory memorandum to the German Tax Act 2024, the legislator has cases in mind in which shareholdings of (still) low value are “contributed” into an investment fund within the meaning of the German Investment Tax Act (which generally triggers German tax on the hidden reserves in such shares) with the fund investor later subsequently relocation from Germany without triggering exit tax.

The new rules apply to (i) natural persons who (ii) have been subject to unlimited tax liability in Germany for at least seven of the last twelve years and (iii) hold (special) investment units as part of their private assets for tax purposes. In the case of Chapter 3 Funds, the participation of private investors is an absolute exception. Natural persons who hold (special) investment units as business assets are not covered by the scope of application of sections 19 and 49 of the German Investment Tax Act. For them, a relocation from Germany may generally (only) trigger exit tax if the fund units are subsequently no longer attributable to a German permanent establishment (of section 4(1) sent. 3 et seq. of the German Income Tax Act).

The new rules apply to units in Chapter 2 Funds and Chapter 3 Funds whether or not they were established under German or foreign law and regardless of the custody account in which they are held. This also affects popular investment products such as exchange-traded funds. Furthermore, in addition to (regulated) investment funds within the meaning of the German Investment Code (KAGB) or the AIFM Directive, deemed investment funds pursuant to section 1(2) sent. 3 of the German Investment Tax Act (such as the Luxembourg SPF) are also covered. As the new rules do not require an investment in a corporation but in a (special) investment fund (unlike section 6 of the Foreign Tax Act), they also cover investment funds established as special assets and not only in the legal form of corporations. For investment funds in the legal form of partnerships, however, exit tax does generally not apply (with the exception of UCITS partnerships). However, a relocation from Germany holding such fund units may result in a taxation of hidden reserves pursuant to the exit regime for business assets (section 4(1) sent. 3 of the German Income Tax Act), in cases where such partnerships are considered asset-administrating for German tax purposes, however, German exit tax may apply on a look-through basis for shares or fund units held indirectly.

However, the legislator aims that the German exit taxation for fund units does not cover each and any investors in investment funds but only “important cases”. In light of this, units in Chapter 2 Funds may only be subjected to exit taxation if the individual (i) either held at least 1% of the investment fund at some point in the last five years or (ii) had acquisition costs of at least EUR 500,000 for the units in a specific investment fund. By setting this acquisition cost threshold, the legislator is actually placing fund investors in a worse position than “normal” investors for which there are no valid arguments. By contrast, the value of the units (e.g. derived from the stock price or redemption price) at the time of the relocation from Germany is generally irrelevant for the (non-)application of German exit taxation. Private investors who have invested EUR 500,000 or more in an investment fund and are planning to relocate from Germany should therefore diversify accordingly at an early stage. The legal situation is even more complex for investors in Chapter 3 Funds: These are subject to exit taxation regardless of their participation quota or acquisition costs, as the German legislator generally assumes that any such cases are “important” and respective investors have “at least a de facto influence on the business activities” of the fund. The latter is not convincing because the AIFM is independent from a regulatory point of view in terms of portfolio and risk management (principle of external management).

As with section 6 of the German Foreign Tax Relations Act, the exit tax is triggered by a termination of the unlimited tax liability in Germany, any other exclusion or restriction of the German right of taxation (e.g. if the centre of vital interests is transferred to another DTA state) or a gratuitous transfer of the units to a foreign tax resident. However, exit tax only arises if a notional capital gain is realised; in the case of losses (i.e. if, in simple terms, the share value on the “exit date” is below the acquisition costs), no exit tax is therefore incurred. If exit tax is triggered, this must be stated in the investor’s income tax return; there is no requirement to withhold and pay withholding tax.

The provisions in section 6 of the German Foreign Tax Relations Act on temporary relocation, pro rata deferral of incurred exit tax and taxpayer’s obligations to cooperate and provide evidence apply accordingly. Thus, according to the future legal situation, exit tax to be paid on (special) units in investment funds can only be deferred in instalments over a period of seven years upon application and, in the opinion of the tax authorities, generally only in return for the provision of collateral. Exceptionally, full deferral without payment in instalments is possible if the taxpayer returns to Germany within seven (or a maximum of twelve) years (or if the individual which gratuitously has acquired ownership of the units establishes German tax liability). In all deferral cases, the taxpayer must fulfil annual obligations to provide evidence, and certain events after the relocation (sale of units, distributions corresponding to more than 25% of the unit value at the time of departure, etc.) can lead to the exit tax becoming due immediately.

Conclusion

By introducing exit taxation on units in (special) investment units, the legislator is further restricting the freedom of movement of natural persons. From 2025 onwards, relocations or cross-border gifts and inheritances may result in unwanted capital gains taxation not only for shares in corporations within the meaning of section 17 of the German Income Tax Act, but also for fund units. Fund investors should therefore review their portfolio for corresponding risks at an early stage and diversify or restructure as necessary. This is relevant not only for planned departures from Germany, but also for unplanned bequests to heirs resident abroad or possibly even legatees.