At the beginning of 2004, Germany enacted a new investment fund regime allowing for the first time the setting-up and marketing of hedge funds including funds of hedge funds to German private and institutional investors.
Market sources say eight hedge funds and funds of hedge funds (FoHFs) were licensed with Germany's Financial Services Supervisory Authority (BaFin) in the first half of 2004, and total investor inflows reached about €500m.
A further increase of German investor demand for hedge fund products could result from pending change of investment rules for German insurance companies.
This newsletter provides an overview of the possibilities to market offshore hedge funds not domiciled in an EU member state.
The old regime
Until the end of 2003, most offshore hedge funds where covered by Foreign Investment Act provisions, apart from derivatives funds.
As a consequence of the applicability of the Foreign Investment Act, any marketing by public distribution in Germany required prior registration with BaFin. A private placement did not trigger such a requirement.
Due to their legal structure and investment policy (especially leverage and short sales), registering offshore hedge funds with BaFin was more or less impossible.
Some offshore hedge funds listed on a German stock exchange to create a tax optimised status for German investors, but could not be marketed by public distribution in Germany.
Unless they had nominated a German tax representative and been able to provide details of their taxable profits, offshore hedge funds, which were neither registered for public distribution nor listed on a German exchange were subject to a form of "penalty tax" with German investors taxed on a "fictitious" income even if the fund made no distributions. Consequently, "direct offerings" of offshore hedge funds did not occur.
Nevertheless, German retail and institutional investors invested €10bn in structured hedge fund products, predominantly certificates, notes linked to performance of certain hedge fund indices.
After the Investmentmodernisierungsgesetz, passed by Germany's Parliament in November 2003, Foreign Investment Act provisions have been replaced by a new regulatory framework for offshore funds, set out in the Investmentgesetz and by a new tax framework set out in the Investmentsteuergesetz.
The Investment Act provides specific rules governing hedge funds and funds of hedge funds, for the first time allowing establishment of such funds as "regulated investment vehicles" in Germany and for public marketing of foreign hedge funds and FoHFs in Germany. This also has a positive impact on marketing offshore hedge funds and FoHFs.
As a matter of principle marketing single manager hedge funds - both German and other EEA-domiciled single-manager hedge funds and offshore funds - by public distribution in Germany is not permissible.
However, private placement of single-manager hedge funds, including offshore funds to institutional and retail investors, is permissible and does not require prior registration of these funds with BaFin. Derivatives funds are now also subject to the these rules.
Unfortunately, the Investment Act provides no specific rules allowing clear distinction between public distribution and private placement of funds. A definition is only available for a public distribution, deemed in the case of:
• public offering, that is, offering of shares or units in a fund to an unlimited number of addressees by personal contact, mailing or media advertising, irrespective of success of such offering;
• public advertising, that is, any kind of measure aimed at influencing others in the context of sales promotion for a fund; or
• distribution in a similar manner, measures which, from an economic perspective, are comparable to a public offering or public advertising in the aforementioned sense.
Historically BaFin has always applied a wide interpretation to the term "public distribution".
Marketing activities were only deemed "private" when a predefined group of persons with whom the provider already had contact before the offering was addressed, and in which the provider selected certain persons as recipients for activity.
However, there exist no specific private placement rules, which would limit scope of a private placement to a specific number of addressees or to any qualified investor addressees by requiring minimum investment or available net wealth, and therefore provide greater clarity and safety.
The financial industry is urging BaFin to release a guidance note on this issue. There are also no definitive guidelines on use of the internet to promote funds in Germany.
According to current regulatory practice, the question whether any form of internet marketing is subject to German regulatory supervision is determined by circumstances of the activity, especially:
• use of German for promotion unless content is clearly aiming at investors in other German speaking countries;
• use of German law as governing law for any contractual relationships with addressees;
• use of German contact details;
• distribution of unsolicited emails to recipients in Germany; and
• possibility of downloading information and sales material in German.
Operating a website with secure access only granted to a limited number of persons with whom the operator already maintains a business relationship should principally not be viewed as public marketing triggering licensing or registration requirements.
Regulatory issues in the context of internet promotion can be avoided if products are only promoted on an "abstract" basis without details about specific products and without providing information necessary to subscribe.
Marketing offshore FoHFs in Germany by public distribution is permissible once they are registered with BaFin. Private placement in Germany within limitations set out above can always be made without such registration. Key requirements for registering offshore FoHFs are:
The fund's investment strategy must be comparable to the standard provided for German FoHFs by Investment Act provisions. Such a standard includes, inter alia, that:
• the fund hold no more than 49% its assets in cash deposits and money market instruments;
• it may not invest over 20% of its assets in the same target fund;
• it may not employ leverage or short sales and may only invest in derivatives for currency hedging;
• it may not invest in more than two target funds with the same issuer or manager;
• it may not invest in target funds which invest in other hedge funds.
• it must be subject to effective public regulation in its domicile country, requiring the fund and its service providers be subject to specific regulatory oversight established to protect fund investors' interests, and which is comparable to the one established for German funds under the Investment Act.
The regulator of the fund's domicile country must be prepared to co-operate with BaFin satisfactorily and confirm this in writing with BaFin unless the foreign regulator and BaFin have agreed on a MoU. Until today no such MoU exists for leading offshore jurisdictions.
Additional requirements for registering offshore hedge funds are expected to be set out in an information paper for registering foreign FoHFs, which BaFin has announced but not yet released.
The registration process may take some time, whereas FoHFS domiciled within the EEA may benefit from a more established registration process. Consequently the only non-German FoHFs that have been registered with the BaFin so far have been products from EEA countries, especially Luxembourg.
Offshore hedge funds and FoHFS with only a "limited focus" on Germany and which will only be marketed to a limited number of investors - for example, institutional and HNWIs by private placement - can still enter the German market without selling restrictions since they need not undergo BaFin's registration process.
Before marketing offshore hedge funds in Germany, however, one should carefully examine whether the envisaged promotion is deemed a private placement.
Public distribution of non-German funds without registration is treated as a regulatory offence incurring fines up to €100,000.
In private placements, there must be compliance with general risk disclosure rules applying to soliciting investment opportunities.
Such rules apply to the fund's promoter and fund itself. It is always advisable to have a prospectus available for potential investors to address liability issues and demonstrate adequate information has been provided to investors about potential investment and tax risks.
This may be written in English only, but liability risks may be triggered if German investors argue they have not been properly informed on risks from not understanding the prospectus.
Private placement of non-registered offshore hedge funds and FoHFs in Germany can only be made by regulated sales agents, for example German banks or financial services institutions.
new tax framework
Germany's Investment Tax Act provides, in general, for equal tax treatment of distributed proceeds and other deemed income from domestic and foreign hedge funds, irrespective of whether or not the funds are publicly distributed.
Taxation of German hedge fund investors in general depends on whether the funds and, in cases of FoHFs also target funds, can provide detailed German tax reporting of earnings.
For these purposes, the Investment Tax Act differentiates between three "categories" of hedge funds:
Transparent funds calculating earnings applying the German income tax rules, fulfilling specific reporting requirements set out in the Investment Tax Act and providing investors with German breakdown of distributed and retained earnings, including, inter alia:
• tax-exempt capital gains from securities and derivatives trades;
• capital gains from shares and dividends taxable in accordance with so-called half-income system (Halbeinkünfteverfahren);
• amount of "accumulated deemed distributed income";
• portion of distribution giving rise to an entitlement for a tax credit or refund of withholding tax;
• amount of withholding tax to be credited or refunded; and
• amount of foreign tax attributable to proceeds, which may be credited, deducted or deemed to be paid.
To be accepted as "transparent", an offshore fund must publish these income details in German Electronic Federal Bulletin upon each distribution and, in case of a fund retaining earnings, within four months following the fund's fiscal year's end.
The amount of "accumulated deemed distributed income" must be published at each redemption date.
Relevant figures must be calculated pursuant to German tax law and, in compliance with German tax law, be certified by qualified tax professionals. They must be published together with the fund's annual report, unless the fund is not obliged to do so in Germany, for example, if it is not publicly distributed.
On request by the Federal Tax Agency the fund must, within three months, provide proof of accuracy of published income details. Certified translations into German may be requested.
Investors in transparent offshore hedge funds are subject to regular tax. Private individuals will, in general, be taxed as if invested directly in assets held by the fund. However, individual investors' income derived from certain financial derivatives transactions, fund capital gains from disposing shares and other securities including short selling are tax exempt, irrespective whether distributed or retained.
The tax exemption for capital gains and certain financial derivatives transactions is important for hedge funds short selling and leveraging through derivatives. The exemption would not apply to investments by institutional investors.
Investors in semi-transparent funds not fulfilling certain of the described reporting requirements, especially regarding tax benefits (for example, relating to tax-exempt capital gains and foreign tax credits) will not benefit from tax benefits described above and are therefore fully taxable on all income.
German investors in offshore funds not providing any of the required income details are subject to penalty tax levied on higher of (i) all actual distributions the fund makes plus 70% of the increase between first and last redemption price of the relevant calendar year, or (ii) 6% of redemption price on the calendar year's last business day. However, the 'penalty' tax rules will not be applied to offshore hedge funds established as institutional funds (Spezialfonds), that is funds not having more than 30 investors, all institutions.
Nominating a German tax representative or a fund registration or listing in Germany is no longer required to avoid "penalty" tax rules.
Gains or losses from redemption or sale of fund units held in a trade or business or by an institutional investor will be included in the respective taxable income.
Gain or loss attributable to a share or certain other participations held by the investment fund when redeeming or selling, so-called share profit (Aktiengewinn) will be taxed at the investor level as if he had sold the relevant shares and therefore taxed in accordance with the so-called semi-income system (Halbeinkünfteverfahren).
Share-profit rules will only be applicable if the fund calculates and publishes - together with redemption price - on each valuation date the NAV positive or negative percentage rate that can be allocated to such share profit.
The above, however, does not apply to private individual investors not holding the fund's shares in a trade or business.
For FoHFs, the same principles apply both to the FoHFs and target funds. Consequently, for German investors, such FoHFs will be particularly attractive if they predominantly invest in target funds complying with German tax reporting requirements.
If the target fund does not comply with the calculation and publication requirements all proceeds derived from such a target fund will be subject to penalty tax at the level of the German investor in the FoHFs.
Such failure does not "infect" the FoHFs' whole income with income of other target funds fulfilling information obligations taxed at German investor level.
Offshore hedge funds can attract new business in Germany if marketed by private placement only, and calculate and publish their taxable income in accordance with Investment Tax Act specific disclosure rules.
Offshore FoHFs might also enter Germany's retail market by public distribution. It may be reasonable for offshore hedge funds to incur costs of implementing a German tax accounting and reporting system, allowing compliance with tax rules.
As an alternative to "regulated" hedge funds and FoHFs, structured products including index-linked bonds and derivatives may also be used as hedge fund products.
author: hans stamm, clifford chance
A partner in the Munich office of Clifford Chance since 2000, Hans Stamm works predominantly in the areas of tax structured finance, capital markets, private funds and international tax law; has advised on several private funds offerings including hedge funds, private equity funds, and repackagings of alternative investments, including index-linked funds. He has advised investment banks on the tax and capital markets law aspects of cross-border financial instruments - including hybrid financial instruments - and has structured several cross-border leasing and media financing funds. He has advised on repackaging structures for alternative investments, on index-linked bonds for hedge funds and on structuring and setting up of German real estate funds of funds. For further information phone +49 89 21632 8800 or email [email protected]
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