The German federal government has set itself the goal of strengthening Germany as a fund location. To this end, the German federal government passed the government draft (in German) on the Fund Location Act (FLA, in Germany referred to as FoStoG) on 20 January 2021. Existing barriers are to be dismantled and Germany is to be made more competitive as a financial centre without lowering the existing level of protection. We consider the legal policy endeavour to promote Germany as a fund location to be welcomed. Unfortunately, the FLA falls short of the needs of startups in some important points and does not offer legal certainty for fund managers and investors.
The key points of the government draft on the FLA are as follows:
- VAT exemption for the management of venture capital funds
- Tax incentives for employee stock ownership plans
- Adjustments to the German Investment Code
– Pre-marketing regulation
– Requirements and consequences of a marketing de-notification
– Further product options
I. VAT exemption for the management of venture capital funds
For years, the VAT on the management of German venture capital and private equity funds has been perceived as a material disadvantage for Germany as a fund location. Since the funds are not entitled to deduct input tax, the VAT makes the fund investment more expensive for investors by the same amount. The current VAT obligation in Germany for the management of venture capital and private equity funds has been a thorn in the eye of many participants for a long time, as it seems to be incompatible with European legal requirements, which suggest that these funds should be exempt from VAT.
The German federal government's goal, already stated in the former ministerial draft on the FLA, to extend the VAT exemption at least to the management of 'venture capital funds' has therefore caused quite a stir in the industry. The law, however, so far lacks a definition as to which funds are actually to be covered. The limitation of this tax privilege solely to the management of venture capital funds is subject to considerable concerns under EU law, as the privileged treatment of a (partial) asset class could constitute impermissible state aid.
It is hence all the more remarkable that the German federal government in its new government draft upholds the VAT exemption for the management of venture capital funds without changes.
Our view: The extension of the VAT exemption is to be welcomed without reservation. The lack of a definition or catalogue of criteria for determining a 'venture capital fund' should be viewed critically, as the scope of the planned VAT exemption remains unclear. Instead of referring to the term 'venture capital fund', a general reference to the regulatory status of the fund manager (authorisation or registration under the German Investment Code and/or as a EuVECA manager) would be appropriate and would be in line with regulations that also apply in other EU member states. Irrespective of this, each fund manager should take precautions to cope with the potential change of status of the management company for VAT purposes without any hiccups.
II. Tax incentives for employee stock ownership plans
The planned introduction of Section 19a German Income Tax Act also remained unchanged in the government draft. According to it, it is to be avoided that wages are already taxable at the time of the transfer of the shares to an employee. Taxation only takes place at a later point in time, usually at the time of the sale; at the latest after ten years or in the case of a change of employer. The advantage of avoiding this 'dry income' is to also apply in favour of employees of SMEs (less than 250 employees, annual turnover not exceeding 50 million euros or annual balance sheet total not exceeding 43 million euros). The foundation of the enterprises must not be more than ten years ago.
Our view: For a detailed analysis of the planned new regulations, we refer to our previous briefing on the ministerial draft and our video contribution (German only) at the German Private Equity and Venture Capital Association (BVK) on this subject. We welcome the tax incentives for employee stock ownership plans, but consider the approach of limiting the incentives to pure equity shares with full shareholder rights to be misguided. The change of employer as a possible taxation point is detrimental to innovation and the 10-year limit is also too short; an extension to 15 years would be desirable.
III. Amendments to the German Investment Code
1. Pre-marketing regulationIn implementation of Directive (EU) 2019/1160 with regard to the cross-border distribution of collective investment undertakings, the FLA will for the first time introduce a definition of pre-marketing as well as related conditions and ongoing obligations in the German Investment Code. The background to this is that the definition of pre-marketing and the conditions under which it is permitted vary widely from one member state to another in those member states where it is allowed.
'Pre-marketing' in this context is - to put it simply - the provision of information about an alternative investment fund (AIF) which has not yet been established or for which no marketing notification has yet been made to potential investors with the aim of determining whether there is interest in subscribing (so-called 'testing the waters'). Pre-marketing is thus to be distinguished from the actual marketing of the AIF and the requirements applicable to marketing.
a) How far does the pre-marketing definition extend?It follows from the definition that pre-marketing originates directly from the AIFM or on its behalf. According to the wording, group companies of the AIFM would therefore be classified as third parties and can thus only be involved in pre-marketing under the restrictions outlined below.
Pre-marketing covers both professional and semi-professional investors under the German Investment Code who are domiciled in the EU or the EEA. If the initiative to acquire units of a fund is made by the potential investor (so-called reverse solicitation), this is neither considered marketing nor pre-marketing.
The explanatory notes to the FLA state that the mere advertising of one's own capabilities by an AIFM is to be considered separately from the advertising of a specific investment fund and does not lead to the exclusion of reverse solicitation. This clarification is important.
b) What are the limitations of pre-marketing?The concept of pre-marketing under the new draft section 306b of the German Investment Code provides that investors cannot subscribe to units or shares of an AIF during pre-marketing. Accordingly, it is not permitted to issue subscription forms or similar documents in draft or final form to potential investors at this stage. Offering documents shall not contain information sufficient to allow investors to take an investment decision; moreover, they must be marked as draft. This is a good development as the former ministerial draft on the FLA was stricter with regard to the scope of information as to when subscription maturity exists and was in contradiction to the requirements under European law.
A further restriction concerns the scope of application of reverse solicitation. If an investor subscribes for units or shares in an AIF which is mentioned in the course of pre-marketing or is registered as a result of the pre-marketing within 18 months after the start of the pre-marketing, the subscription is to be considered as marketing, so that no reverse solicitation is possible. In our opinion, it is unclear whether this restriction applies to all investors of a member state in which the pre-marketing was commenced or only to those investors who were approached in the course of the pre-marketing. In our view, the latter is more convincing, also in view of the systematics of the draft FLA.
Finally, as an ongoing obligation to pre-marketing, a German AIFM must notify BaFin within two weeks of commencing pre-marketing and provide certain information. This notification obligation also applies to non-EU AIFMs with regard to their pre-marketing in Germany.
c) Which cooperation partners can be used for pre-marketing?The new draft section 306b of the German Investment Code provides that only a limited group of regulated companies may be involved as third parties in the provision of pre-marketing.
Investment firms, tied agents, credit institutions, UCITS management companies and AIFMs that are authorised are covered. It therefore does not matter whether pre-marketing actually is a regulated investment service. What is problematic is the fact the government draft for the first time introduces the restriction that investment firms and tied agents have to be domiciled in Germany. Such restriction is not provided for in the EU directive. The restriction is inappropriate and might also be inadmissible in view of the active European freedom to provide services.
d) Are sub-threshold AIFMs covered by the pre-marketing restrictions?Sub-threshold AIFMs should not be covered by the restrictions and ongoing obligations of the new draft Section 306b of the German Investment Code, because the provisions of the German Investment Code governing sub-threshold AIFMs do not refer to it. Furthermore, it would be contradictory to, on the one hand, allow pre-marketing by sub-threshold AIFMs themselves, but, on the other hand, when cooperating with third parties, sub-threshold AIFMs would only be allowed to collaborate with those AIFMs that hold a full AIFMD license.
e) Our viewThe regulation of pre-marketing stems from an EU directive and was therefore foreseeable. The extension of the restrictions to non-EU AIFMs is consistent insofar as EU AIFMs should not be disadvantaged in any way compared to non-EU AIFMs. This requirement is, in fact, laid down in the EU directive itself. Sub-threshold AIFMs should be exempted from the prerequisites and ongoing obligations for pre-marketing. Although the government draft remedies technical deficiencies of the pre-marketing regulation in some places, it at the same time creates a restriction of the permitted circle of 'third parties', which will hopefully be loosened up in the further legislative process.
2. Requirements and consequences of a marketing de-notification
Currently there are no consistent rules for the de-notification of marketing of units or shares of a UCITS or an AIF.In implementation of EU legal requirements, the FLA now contains regulations on the de-notification of cross-border marketing of EU UCITS as well as non-EU and EU AIFs
. Purely domestic cases as well as the de-notification of units or shares in AIFs managed by a sub-threshold EU-AIFM remain unaffected.
In the case of closed-ended AIFs (such as PE & VC funds)
, this means above all that the intention of de-notification has to be made public by means of a publicly available medium and that any contractual distribution agreements have to be modified or terminated accordingly in order to prevent any further offering or placement of the fund units or shares. Non-EU AIFMs must notify BaFin of the de-notification and provide evidence that the above requirements have been met. EU AIFMs must notify their home member state regulator of the de-notification of marketing in Germany. Information obligations vis-à-vis investors who remain invested after a marketing de-notification will, however, remain.
The marketing de-notification will be combined with a ban on pre-marketing following the de-notification
. For a period
of 36 months
from the de-notification date, AIFMs may not engage in any pre-marketing of units or shares of the AIF referred to in the de-notification or in respect of similar investment strategies or investment ideas.
This pre-marketing ban would disproportionately affect non-EU AIFMs
with regard to marketing under Art. 42 AIFMD or Sec. 330 of the German Investment Code, respectively. While EU AIFMs continue to be subject to the AIFMD regulations even after the de-notification, this does not apply to non-EU AIFMs in the aforementioned scope of application. Consequently, they would have to weigh up whether to accept a three-year pre-marketing ban in order not to have to continue to comply with the requirements of Art. 42 AIFMD or Sec. 330 of the German Investment Code despite an unsuccessful marketing.Our view
: The requirements for EU AIFMs are essentially determined by the EU directive. However, these should not be applicable to non-EU AIFMs to the extent now foreseen in the government draft. Non-EU AIFMs are subject to regulation in their home country. Therefore, in the absence of marketing success, they have a legitimate interest to terminate the additional regulation according to Art. 42 AIFMD or Sec. 330 of German Investment Code. They should have the opportunity to test an adjusted investment strategy within the scope of a renewed pre-marketing. If this pre-marketing is successful, it is followed by a marketing and the regulation according to Art. 42 AIFMD or Sec. 330 of the German Investment Code takes effect. There is hence no regulatory gap which would need to be addressed here.3. Further product options
a) Closed-ended domestic special AIFs as contractual investment funds (Sondervermögen)According to the government draft, closed-ended domestic special AIFs will in the future also be allowed to be set up as contractual investment funds (Sondervermögen). This would be completely new territory for the German venture capital and private equity industry, as fund managers and investors have so far grown accustomed to the typical GmbH & Co. KG structure.
The attractiveness of this new product for the area of venture capital and private equity can only be assessed in an overall assessment of the legal and tax framework. Regulated investors are required to align their participation in a contractual investment fund with an investment strategy in the area of venture capital and private equity with the increasingly changing banking and insurance regulatory requirements.
Our view: There is no recognisable justification for previous restrictions, which is why we welcome the expansion of the product range. Especially in the European and international context, contractual investment funds are definitely used. For German investors, contractual investment funds are currently less attractive due to taxation under the German Investment Tax Act.
b) Closed-ended master-feeder structuresThe new regulations would also seek to introduce closed-ended master-feeder structures for public AIFs, which were previously not permitted. This would make Germany more flexible as a fund location and would offer fund managers more design options and investors more choice of possible products. Special AIFs may not be involved in these closed-ended master-feeder structures.
Our view: The product acceptance remains to be seen; a broad need for this structure is rather not recognisable at first glance.
c) Open infrastructure contractual investment fundsThe FLA also intends to enable open infrastructure contractual investment funds, as is already possible in other fund locations.
According to the explanatory notes to the FLA, the introduction of the infrastructure contractual investment fund serves to create a suitable fund vehicle for small investors to invest in infrastructure project companies. This would enable investors to participate in infrastructure projects. Due to their structure as open-ended public investment funds that invest primarily in highly illiquid assets, namely infrastructure project companies, infrastructure contractual investment funds are structurally particularly close to real estate contractual investment funds.
Our view: The market acceptance of open-ended infrastructure contractual investment funds remains to be seen with regard to the maturity mismatch of an illiquid investment in an open-ended retail fund structure.
Finally, the FLA intends to make further changes to the German Investment Code in order to reduce bureaucracy and to digitise supervision. Numerous written form requirements are to be abolished, which will ultimately save investors costs.
Unfortunately, however, and contrary to this concept, a semi-professional investor with a minimum investment amount of 200,000 euros still has to provide a written risk confirmation statement to the fund manager. Digital equivalents should, in our view, be sufficient in every respect for a semi-professional (!) investor; in any case, it should at least suffice if the investor provides a digital copy of the signed risk confirmation statement. The government draft has not remedied this despite corresponding criticism expressed by industry groups.
From April 2023 onwards, communication with BaFin shall take place electronically as a matter of principle. The supervised entities and other persons named in the new draft section 7b of the German Investment Code will be obliged to use the electronic communication procedure provided by BaFin for the aforementioned forms of communication and procedures. The electronic communication shall already begin with the application for permission or registration as an AIFM. This electronic communication procedure shall be used to transmit information and documents to BaFin within the scope of the aforementioned applications.
There will, however, also be introduced an obligation to check the digital inbox every five calendar days.
Our view: The progressive efforts to reduce bureaucracy are to be welcomed. Electronic communication with BaFin enables a more efficient exchange of information and contributes to cost reduction. Instead of a regular check of incoming mail, however, an automatic notification of receipt would be desirable. Digitisation efforts should also not stop at individual written form requirements.
The government draft will now be forwarded to the German Federal Council. The German Federal Council is entitled to comment within six weeks. The German federal government would then present its view in a counterstatement. The draft will subsequently be submitted to the German parliament together with the statement and the counterstatement. It remains to be seen whether the FLA will be passed in the German parliament before the upcoming election in September 2021.
The planned tax changes to the VAT exemption for the management fee and the promotion of employee stock ownership plans are to apply as early as 1 July 2021. Retroactive entry into force is not possible for VAT. The other changes are to come into force on 2 August 2021, with the exception of electronic communication with BaFin, which is not to be possible until 1 April 2023.