New Opportunities for Hedge Funds in Germany
By Ralf Eckert, Hans-Joachim Schreiber and Christian Gebhardt (McDermott Munich)
A German Investment Act and Investment Tax Act came in into effect in early 2004. These acts establish guidelines for investment funds in Germany, the marketing of funds andoffshore investment funds in Germany and regulate tax consequences for funds and investors. For the first time in Germany, the law will allow hedge funds to be established and distributed in Germany. Before 2004 it was virtually impossible to setup and distribute hedge funds in Germany, because typical hedge fund features such as short-sales or leverage were prohibited for registered investment funds by law.In addition, unregulated hedge funds were subject to a punitive tax regime and, thus, nearly impossible to market.
According to the Investment Act, single hedge funds may now be set up either in the form of an investment stock corporation (also with variable capital) or as a separate fund of a financial investment management company. Both alternatives require permission from the Bundesanstalt für Finanzdienstleitungsaufsicht (BaFin), Germany’s central supervisory authority for the financial services industry. Hedge funds need to comply with various requirements and restrictions set out in the Investment Act. In particular, eachsingle hedge fund requires significant initial equity capital as well as managers with specific investment fund expertise. Hedge funds must comply with various reporting duties and may undertake short-sales, use leverage and freely decide in principle, how to invest their monies. However, they may not invest in real estate and only to a certain extent in non-listed private companies. This is in order to prevent venture capital/private equity funds being labelled as hedge funds. Furthermore, single hedge funds have to involve depository banks or prime brokers to custody the funds’ estate. Finally, the funds’ articles of association or, as the case may be, its contractual relationship with investors, requires a further license to be issued by the BaFin.
The Investment Act does prevent single hedge funds from being publicly marketed. However, they may be distributed by way of a private placement and, in this context,single hedge funds may not only be offered to institutional investors but also toindividuals. Inregards to marketing and distribution, offshoresingle hedge funds are subject to the same legal regime as German single hedge funds and may only be distributed via private placement. In addition, all single hedge funds have to comply with the provisions of the Investment Tax Actin order to preventa punitive tax regime. The marketing and distribution of any single hedge fund requires a specific license from the BaFin.
Under the Investment Act, a fund of hedge funds may be established as an investment stock corporation (also with variable capital) or as a specific estate of a financial investment management company. Both alternatives require permission from the BaFin.A fund of hedge funds must not invest in one single underlying hedge fund but has to invest in various underlying single hedge funds, which should not be managed by the same fund manager or setup by the same management company. The underlying single hedge fundsare not necessarily subject to a supervisory authority in the European Unionas long their country of origin reasonably cooperates with the BaFin (as of today the Cook Islands, Egypt, Guatemala, Indonesia, Myanmar, Nauru, Nigeria, Philippines and the Ukraine are deemed not to be cooperative in this sense). In addition, short-sales and leverage are not permitted for the fund of hedge funds but are only permitted for the underlying single hedge funds. Contrary to the single hedge funds, domestic funds of hedge funds may also be publicly marketed and distributed once the fund and it’s estate have been permitted to be set-up by the BaFin. The same applies to foreign funds of hedge funds provided that they have received a specific authorization to be publicly distributed in Germany by the BaFin. In this case, they may even be distributed by institutions which do not carry a specific license to do so. In case of public marketing, each fund of hedge funds needs to produce and provide any potential investor with a very detailed sales prospectus, whereas the distribution via private placement does not require a sales prospectus by law. This difference, however, should be negligible, as even in case of a private placement a sales prospectus should be produced for the purpose of liability reduction.
The Investment Tax Act states German shareholders of investment fund shares will be treated as if the shareholder directly participates in the investments of the fund. As a consequence of this pass-through concept, capital gains, for instance, which would be tax free if achieved by a German shareholder through the direct sale of a certain asset shall also be tax free even if the certain asset is an investment of the fund and was sold by the fund.Income generated on a fund level of a German fund is tax exempt as regards to the fund itself.
This rather favorable taxation for shareholders of a hedge fund only applies if the hedge fund meets certain disclosure requirements. There are two kinds of disclosure requirements: the hedge fund has to list all sources of its income. This list has to be sent to the respective shareholders in order to enable the filing of their tax returns in Germany based on the information provided. Furthermore, the list has to be published in the electronic Federal Gazette. The second disclosure requirement a hedge fund has to fulfill is the publication of an annual report in the electronic Federal Gazette that describes the activity of the fund and contains all important information that will enable the shareholders to form a view of the activities and results of the fund. This obligation gives rise to concern that this kind of proprietary information might result in the disclosure of the wholefund’sstrategy. As a consequence of a non-disclosure as described above the investors in hedge funds are subject to a severe punitive tax regime. Investors in a fund of hedge funds will also be subject to this regime insofar as the underlying single hedge funds do not fulfill their disclosure obligations as described above. It is therefore expected that the hedge fund industry will establish hedge funds which are specifically tailored to meet the disclosure requirements of the Investment Tax Act and thus should be able to attract German investors. In addition, if such hedge funds are established offshore, certain regulatory aspects of the Investment Act do not apply.
For the first time in German history, the new German Investment Act allowsthe settingup of localsingle hedge funds and theirdistribution via private placement. Offshoresingle hedge funds may also be distributed via private placement. However, certain specific licenses issued by the BaFin need to be obtained up front. In addition, funds of hedge funds may be setup in Germany and all funds ofhedge funds may be publicly distributed upon receipt of specific licensesfromthe BaFin. From a regulatory point of view, the German Investment Act may be regarded as being quite liberal. However, the future success of hedge funds in Germany will depend on how these funds are able to comply with the rather rigid requirements of the Investment Tax Act and whether they are willing to publicly display certain internal investment strategies.
Ralf Eckert is a partner, resident in McDermott, Will & Emery`s Munich office. He practices in the areas of corporate and tax law, and his work focuses on advising on German and internationalcross-border M&A transactions. His experience encompasses all fields of German and international tax law. He can be reached at +49 89 12712 101 or via e-mail at reckert mwe.com.
Hans-Joachim Schreiber is a partner in the Corporate Department, resident in McDermott, Will & Emery’s Munich office. He focuses his practice on mergers and acquisitions, listed stock corporations, corporate restructurings, corporate governance and venture capital as well as general corporate matters. He can be reached at +49 89 12712 270 or via e-mail at hschreiber mwe.com.
Christian Gebhardt is an associate, resident in McDermott, Will & Emery`s Munich office. He practices in the areas of tax and corporate law with a particular focus on Germanand international M&A transactions. His practice emphasizes all aspects of Germanand international estate planning as well as tax-exempt charitable organizations. He can be reached at +49 89 12712 103 or via e-mail at cgebhardt mwe.com.