Update on Tax, Investment Funds and Real Estate Law – The VAT Exemption for Alternative Investment Funds Is Coming Soon

Management services for alternative investment funds (AIFs) will be free from value-added tax (VAT) starting in 2024. This is good news for Germany as a fund location because there will finally be alignment with the more favorable VAT regulations currently in place for European fund locations, such as Luxembourg. There are important changes at the intersection of tax law, investment funds and real estate law, so AIFs, , alternative investment fund managers (AIFMs), investment advisors and landlords should start preparing now before the changes take effect on January 1, 2024.

BACKGROUND

• According to the current legal landscape, management services for (i) Undertakings for Collective Investment in Transferable Securities Directive 2009/65/EC (UCITS) within the meaning of Section 1, Paragraph 2 of the of the “Capital Investment Code (Kapitalanlagegesetzbuch) (KAGB), (ii) AIFs in comparison to those within the meaning of Section 1, Paragraph 3 of the KAGB and (iii) venture capital funds are exempt from VAT (Section 4, Paragraph 8(h) of the Umsatzsteuergesetz (UStG)).
• For AIFs within the meaning of Section 1, Paragraph 3 of the KAGB, this means that, because of the restrictive interpretation of a comparable AIF by the tax authorities (See Section 4.8.13, Paragraph 8 of the German VAT guidelines), management services provided by the AIFM to an AIF are generally subject to VAT.
• Because of their passive investment, AIFs are typically not entrepreneurs within the meaning of VAT law. As a result, the VAT on management services is not deductible as input tax by the AIF and therefore leads to definitive costs at the fund level. These are charged either to the investors or the fund managers.
• The cost aspect was often cited as a disadvantage for Germany as a fund location. In neighboring European countries, particularly Luxembourg, management services for AIFs are generally exempt from VAT.
• •The extension of the VAT exemption through the German Fund Location Act (BGBl. 2021 I, 1498) as it relates to venture capital funds was seen as a step in the right direction. However, this also came with delimitation difficulties that lead to legal uncertainty in the practical application.

NEW VAT EXEMPTION FOR AIFS

• As part of the German Financing for the Future Act (BGBl. I 2023, No. 354), the VAT exemption is now being introduced to AIFs for management services. AIFs and venture capital funds that are “comparable to a UCITS” will be abolished, and a general VAT exemption will be introduced for AIFs. The aim of the new regulation is to create a level playing field between Germany and other European jurisdictions (See BT-Drs. 20/8292, p. 133).
• The regulation is mandatory, so the VAT exemption cannot be waived.
• In terms of timing, the new regulation will apply starting January 1, 2024.

EFFECTS IN PRACTICE

THE TAX PERSPECTIVE

• Once the new regulation takes effect, AIFs will receive relevant administrative services from AIFMs as VAT-exempt input transactions. This means that input taxes can no longer be deducted at the fund level.
• For AIFMs, the new regulation should lead to an increase in VAT-exempt output transactions. (Services provided to an AIF must be examined to determine whether they fall under the VAT exemption.) That increase is relevant for an AIFM’s ability to deduct input tax. Input services directly attributable to administrative services are completely excluded from input tax deductions. For general costs, the input tax deduction is only granted in accordance with the individual input tax key (i.e., the share of output services subject to VAT in the total output services).
• Under certain conditions, the VAT exemption also applies to management services provided indirectly to an AIF (e.g., certain services provided by an investment advisor in the case of outsourcing who provides advisory services for an AIF to its AIFM.)
• In the event of advisory services for a foreign fund to its foreign AIFM (e.g., Luxembourg’s fund structure), the same principles apply. Certain other services for an entrepreneur will be VAT-exempt because of the place of performance abroad. However, the VAT exemption on administrative services leads to a (partial) exclusion of an input VAT deduction at the level of the domestic investment advisor if the place of performance is hypothetically in Germany (Section 15, Paragraph 2, Clause 1, Number 2 of the UStG).
• The output services provided and the impact on the input tax key should be analyzed from the perspective of AIFMs and investment advisors.
• At the AIFM or investment advisor level, the invoices must also be adjusted for the changed VAT treatment. An incorrect VAT statement (Section 14c, Paragraph 1 of the UStG) will result in paying the incorrectly stated VAT. There is no input tax deduction for an incorrectly stated VAT. If necessary, invoices must be adjusted to show the corrected VAT.

THE INVESTMENT FUND PERSPECTIVE

• The new regulation applies to regulated AIFs within the meaning of Section 1, Paragraph 3 of the KAGB and is irrespective of asset classes. It also extends to include relevant management services, like portfolio management and risk management services. Other activities, such as custody, are not included.
• The elimination of the VAT burden will cause a reduction in costs at the AIF level, which will increase the investment return. Individual remuneration agreements regarding VAT must be reviewed.
• At the other end of cost reduction at the fund level, there is a reduction in the input tax deduction at the AIFM or investment advisor level, i.e., a definitive cost burden due to a nondeductible VAT on input sales (e.g., advisory services). (For further additional costs, see the real estate perspective below).
• In the event of existing structures, the fund documentation should be reviewed for any necessary adjustments. For new structures that still need to be set up, fund initiators and AIFMs or fund advisors should take the impact of VAT into account commercially.

THE REAL ESTATE PERSPECTIVE

• When it comes to rented offices of the AIFM or the investment advisor, these rental agreements may not be subject to VAT from the landlord’s perspective (the so-called VAT option). For the VAT option to be effective, the tenant must generate at least 95% of its sales subject to VAT. The landlord has an interest in letting subject to VAT if there are current input tax adjustment periods for the property existent and the increase of the VAT-exempt letting may trigger input VAT adjustments for the landlord or a pro rata refusal to deduct current input VAT.  (the so-called input tax damage).
• The elimination of the VAT option means that the rent will be owed without VAT in future (i.e., VAT-free). However, depending on the provision in the rental agreement, the tenant may be obliged to compensate the landlord for any input tax loss incurred.
• In the invoice issued to settle the rental agreement (usually in the form of a long-term rental invoice), the VAT statement must be adjusted, if necessary, to avoid liability for an incorrect tax statement (Section 14c, Paragraph 1 of the UStG).
• Existing lease agreements with AIFMs and investment advisors should be reviewed from the tenant’s and landlord’s perspective for relevance, potential information and compensation obligations as well as adjustment options.