Germany: Re-shaping the German investment fund market

The biggest economy in Europe is heavily targeted by international asset managers. However, although more than 5,000 foreign funds are registered for public marketing, the overall market share is still relatively small. The reasons for that are manifold and could be much better understood by distinguishing the retail from the institutional market. In the retail space, investors have still a strong but unrealistic expectation regarding the state pension system and nearly any German retail bank owns significant asset management businesses. Institutional investors are keen to invest in German domiciled institutional funds (Spezial-Sondervermögen). Although Sondervermögen are not fully in line with the UCIT-directive, they provide a great assurance in terms of investor protection. There is also a great amount of flexibility to influence the fund management and favourably accounting treatments. Despite of the facts outlined above there are serious discussions to change the tax environment covering investment, hedge and open real estate funds.

Table 1 illustrates the status quo of the German investment fund market.

In total the German investment fund market is worth €1.5 trillion ($1.87 trillion). €688.482 billion net assets are administrated in the mutual fund market (43.89%) while the institutional fund market manages €880.579,6 billion (56.11%). The institutional fund market is strongly dominated by German investment companies holding €856.487,3 billion (97.26%) whereas in the mutual fund market the stake of foreign investment funds is €281.665,9 billion (40.89%) compared to €407.176,1 billion (59.11%) net assets in German investment funds.

Equity funds [€228.684,7 billion (33.20%)], bond funds [€185.379,8 billion (26.91%)], multi-asset funds [€118.840,70 billion (17.25%)] and real estate funds [€85.071,40 billion (12.35%)] administrate the biggest stake in the German mutual fund market.

Germany is obviously difficult to capture for foreign asset managers and the proposed changes of the tax environment could also change it in certain aspects.

Under the Investment Tax Act, foreign and domestic funds are seen as transparent vehicles as long as certain criteria are met. Transparent in this respect means a favourable tax treatment for investors, often even more attractive than an equal direct investment. In simple math, the transparent system creates one level playing field.

Distributions and deemed distributions are to be calculated due to a high sophisticated set of rules but normally only once a year. Based on the duration of the calculation of the net asset value of the funds, three different tax figures are to be calculated and published. Compared with the reporting for funds in the other European countries it is seen as over-complex.

The proposed rules would lead to a radical change due to a decrease of complexity which is seldom enough in Germany. Based on the concept on the table, retail products are to be taxed in a very simple way. Any distribution is taxable without any exception. The tax figures correlating with the net asset calculation of the funds would be abolished. The calculation of the deemed distribution income would follow the logic in Table 2.

From a technical standpoint, the proposed rules could represent one of the few tax reforms which would effectively lead to decrease in complexity what is great news. However, the reform is also to be evaluated from a product perspective.

The proposed rules would exclude hedge funds from the Investment Tax Act. This would mean to apply the ordinary taxation rules for direct investments or partnerships. In both cases it would be even more difficult to distribute shares of hedge funds into the German market as the tax treatment would be less attractive and the administrative burden for hedge fund managers is likely to be duplicated.

Exchange Traded Funds (ETFs) were the investment product of the last two years as they were underrepresented in institutional portfolios. The proposed changes would not only stop this trend but also cancel it. The proposed rules would abolish the transparent system with its many beneficial treatments. Thus, any distribution and capital gain due to the disposal of fund shares would be fully taxable for institutional investors. In practice, this could make a massive difference in terms of the after tax return. The following example illustrates the potential impact. A German domestic institutional investor is invested in a physically replicating Euro Stoxx 50. Under the transparent system the effective tax rate is around 3% where under the proposed rules 25% is due. Of course, this example represents the worst possible outcome of the reform but it illustrates that retail products in the institutional space are then outdated.

The abolishment of the existing transparent systems applies not only for ETFs but for all retail products. It is obvious that institutional investors are likely to sell foreign retail products. It is fair to say that German domestic retail products would also not provide a different tax result. The question is what institutional investors do to buy those strategies they found in the retail space previously? Basically, two situations look most realistic. Rather than purchasing unattractive retail products, direct investments could become more common. Even more realistic, the Spezial-Sondervermögen is used as a wrapper for the former retail strategies.

For private investors investment funds as such are only one out of a kind of products. Traditionally, life insurance products and ordinary savings accounts are the biggest competitors of investment funds. Active private investors prefer structured notes, also known as certificates. Due to the very complicated calculation of the various tax bases relevant for any distribution and deemed distribution, it is hard to predict what the reaction of the wider retail market will be. However, it is plausible to take the view that short term reactions will not be significant where well informed private investors may prefer structured notes even more than in the past.

The timeline for the proposed changes is not explicitly outlined in the proposal, but due to the latest developments, any significant change in 2012 should not be realistic anymore. Due to the fact of the election of the lower house of the German parliament in 2013, this could even mean that significant changes are to be expected not before 2014. However, there is a proven track record of the German law maker to introduce new laws in the week before Christmas – every year.

Biography
		Markus Hammer PwC Tel: +49 69 9585 6259 Email: markus.hammer@de.pwc.com Markus is a tax partner in Frankfurt and the asset management tax & legal leader at PwC Germany. He has also been on short-term secondments to New York and Hong Kong/Beijing. Markus is known for his innovative articles and is a regular speaker at conferences on asset management issues. He has experience in: Collective investments, investment funds, hedge funds, private equity funds, real estate funds and special funds. He also focuses on operational tax issues for financial services clients.