Finance & Investment Briefing - The German KG Model

Finance & Investment Briefing July 2012 Contents Overview Structure Taxation Financial Supervision and Further Regulation Contact The German KG Model 01 Overview 02 In the 1970’s the German KG model was established to raise private equity 02 as a form of finance for projects. To raise the necessary funds initiators set 04 up a legal entity and placed the equity among individuals as private investors. The investors realised tax benefits mainly from book losses 06 exceeding their investment amount plus an annual dividend payment as return on investment. Since then, the German KG model has significantly increased the volume and value of its transactions. In 2007 fundraising in the KG model market exceeded €10bn equity. In the following years of the economic crisis the fundraising dropped to approx. €5bn per annum. Last year the amount of equity from private and institutional investors totalled up to €5.85bn. Furthermore, the asset classes KG financing covered expanded into several types of assets: ships, real estate, aviation, private equity, renewable energy, natural resources, infrastructure, containers, life insurance policies, films and other media rights, etc. The main objective of the German KG model is asset financing by individuals participating in single purpose companies which are organized in the legal form of a German limited partnership (i.e. Kommanditgesellschaft, hereinafter ʺKGʺ). Most significantly, the structure has no special corporate legislation attached to it on set up. The legal entity form of the KG was in general established at the beginning of the last century and is the most common legal entity form in the German “Mittelstand”. The general concept of the KG is understood and accepted by private investors, financing banks, business partners and other stakeholders. The legal environment for such funds has changed dramatically, especially with respect to the applicable tax law and the financial supervision of funds prospectuses for the equity placement. wfw.com 02 FINANCE & INVESTMENT BRIEFING Structure The KG has one general partner and one or several limited partners. In the majority of cases, the general partner of a German KG is a limited company (i.e. Gesellschaft mit beschränkter Haftung, hereinafter GmbH ). The limited partners may be participating in the KG directly or via a trustee. Often the KG has an advisory board representing the investorsʹ interests by monitoring the management of the general partner. The establishment of a GmbH as general partner limits the overall exposure of the investment to the raised equity of the limited partners plus the equity of the GmbH (minimum equity amounts to €25,000). In such cases investors participate in a so‑called GmbH & Co. KG. For private investors, as limited partners of the KG, the risk for each investor is generally limited to the amount of his single investment. Each private investor participates in the profit and loss of the KG in proportion to his equity stake compared with the total equity. The purchase of the assets acquired by the KG is partly financed by the equity provided by the investors and partly leveraged by bank loans. The KG receives income from lending real estate, containers or planes, time chartering ships, making use of media rights or insurance policies or receiving income from the sale of electricity. The KG is liquidated after the assets have been sold. Depending on the risk profile the KG may invest in single assets or groups of assets or may be organised as fund of funds investing in other KG s. The investment of the limited partners is bound until liquidation (closed‑end fund). Taxation 1. General issues With the exception of VAT and German trade tax, which is directly imposed on a KG in case it carries on a trade or business, a KG is tax transparent. Thus, the individual partners are the taxable entities rather than the KG itself. At the KG level, taxable income is uniformly and separately determined by the tax authority in whose district the management of the KG is domiciled. The trade tax burden of the KG depends on the local levy rate of the district in which the KG is domiciled and may vary between 7% and 19% of the income. Taxation at the level of the investor is applied at the individual rate of income tax. Since January 1, 2007 the maximum rate of income tax for German taxpayers has been 45% plus solidarity surcharge of 5.5% of the assessed income tax plus, if applicable, church tax. Where income generated by the asset is subject to income taxation in a foreign country with which Germany has concluded a double taxation agreement (e.g. by foreign real estate or by a foreign renewable energy project), such income is typically tax exempt in Germany. Thus, the German investor may benefit from lower tax rates in the country where the asset is located. 2. Tax deductibility of preliminary business expenses According to the 5th Building Owner Decree (see decree of the Federal Ministry of Finance dated October 20, 2003), all preliminary expenses (e.g. equity placement provisions, marketing costs, advisorsʹ charges) incurred at the level of a fund are not immediately tax deductible. Instead, they will be considered as incidental acquisition costs of the assets owned by the fund – if the fund constitutes a so‑called buyer fund without any real FINANCE & INVESTMENT BRIEFING 03 possibility for investors to exert influence, as is generally the case. Depreciation of such expenses is applicable to the actual period of use for the investment. 3. Tax rules regarding the use of losses In the past, tax authorities and legislators restricted the amount of loss creation for investment schemes such as the KG model. The initiators of closed‑end funds reacted each time, changing their business models in order to generate an attractive overall internal rate of return for the investors. The Tax Deferral Schemes Act (Gesetz zur Beschraenkung der Verlustverrechnung im Zusammenhang mit Steuerstundungsmodellen) adopted new rules designed to limit the usage of losses generated by certain tax deferral schemes (see Section 15b of the German Income Tax Act (Einkommensteuergesetz, hereinafter “EStG”)). According to this legislation, a “tax deferral scheme” is a standardised tax structure designed to generate tax benefits for taxpayers in the form of losses. The rule only allows such losses to be offset against income generated in later tax years from the same source. The law applies to all German KG models, especially media funds, shipping funds, and movie funds. This regulation applies to any “Tax Deferral Models” in which the taxpayer enroled after November 10, 2005. Since then, the initiators have developed high yield funds (“Renditefonds”) which use the losses for tax free distributions to the investors in the first years of their investment. Other projects are structured on a pure profit base, i.e. without any calculated losses. 4. Shipping funds ‑ German tonnage tax system The main attraction of the German KG model for shipping funds lies with the benefits available under the German tonnage tax regime. Here, enterprises and individuals with seagoing vessels have the opportunity to be taxed on the basis of a deemed profit related to the shipʹs tonnage instead of the actual operating results. The basis for the calculation of the deemed profit is an amount per net ton of the ships in operation. According to the German tonnage tax system the profit earned is fixed at a certain amount and is much lower than the average profit calculated on the basis of the regular rules of determination of the taxable profit. All profits including capital gains as well as losses from the shipping business are covered by this lump‑sum profit. The lump‑sum profit is the tax basis for trade tax and income tax of all investors. Effectively the lump‑sum allows a nearly tax free income from shipping business for investors. In order to qualify for the application of the German tonnage tax system the following requirements must be fulfilled: > operation of merchant ships in international traffic (see (a)); > qualifying presence in Germany (see (b)); > irrevocable application (see (c)). a. Operation of merchant ships in international traffic Merchant ships are operated in international traffic, if owned or chartered (self equipped) seagoing vessels are predominantly registered during the business year in a German ship register (it is not necessary to fly the German flag) and vessels are mainly used for transportation of goods or passengers with or between foreign ports, within foreign ports or between a foreign port and the High Seas during more Watson, Farley & Williams July 2012 04 FINANCE & INVESTMENT BRIEFING than half of their total operating time. Other qualifying ship types are vessels used for towage, salvage or exploration. For cruise ships an individual tax ruling is necessary. b. Qualifying presence in Germany The requirement for a qualifying presence in Germany is that the management of the business establishment must be located in Germany and that the shipping company undertakes almost all of its strategic and commercial ship management services from Germany. c. Irrevocable application The switch to the German tonnage tax system is optional (the application is irrevocable). The application has to be filed in the business year during which the ship is built or bought (commission) with effect from the beginning of the respective business year. Losses can neither be balanced nor set off. Otherwise, companies can only opt ten years later. The election is binding for a period of ten years. The law explicitly expands the tonnage tax regime to rime charter vessels in case the above mentioned requirements are met and the ship management is performed by the charter operator in Germany. An existing fleet of vessels under the tonnage tax regime can be expanded by vessels chartered in from another ship owner. In case the chartered vessels are not registered in Germany, a certain ratio of foreign registered vessels to German registered vessels must not be exceeded. However income from bare‑boat charter does not qualify for the tonnage tax regime. The German tonnage tax regime is based on the European guidelines for state aid to maritime transport which are currently under review by the European Commission. Financial Supervision and Further regulation In the past, no financial supervisory regulation was applicable to offering or brokering KG investments, because closed‑end funds are structured as company participations. The obligation to obtain approval for investment models from the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht ‑ known as “BaFin“) radically changed the preconditions for the placement of closed‑end funds in 2005. Since July 1, 2005, BaFin examines the prospectuses issued for investments in German closed‑ end fund KGs. The financial supervision has recently been strengthened further: Since June 1, 2012, closed‑end fund participations are now treated like other financial instruments. Offerors of participations in closed‑end funds must, as a matter of principle, publish a sales prospectus. Exemptions exist for certain types of closed‑end funds such as club funds (not more than 20 investors) or high investment funds (minimum investment of €200,000 per investor). Approval by BaFin is required for publication of the prospectus which, in turn, is a condition for selling the investments. The BaFin investigation period is 20 business days. BaFin will grant its approval if the prospectus contains all details required under the Investment Act (Vermögensanlagegesetz) and if it is comprehensible and consistent. The prospectus may have to be updated during the public offering period. The prospectus is the key basis for liability if it is not correct or if it does not contain all material information which is needed for an informed investment decision. In addition to the prospectus, offerors must publish an investment information sheet (Vermögensanlagen‑Informationsblatt) containing key information on the investment 05 FINANCE & INVESTMENT BRIEFING on a maximum of three pages. Like the prospectus, the investment information sheet may have to be updated during the public offering period. The information sheet can also be a basis for liability if it is wrong or misleading or not in line with the prospectus. Sales and brokerage of closed‑end fund participations by banks and certain other types of brokers is subject to the general regulations and obligations of the Securities Trading Act (Wertpapierhandelsgesetz). Brokers whose activities are limited to advising on and brokering investment products other than securities are exempt from the Securities Trading Act. However, for these “free brokers”, comparable regulations shall come into force as of January 1, 2013. Under certain circumstances and for certain investments additional licenses will be required under the German Banking Act (Kreditwesengesetz), in addition to BaFin’s approval of the prospectus. In particular this may apply if the relevant closed‑end fund investment involves securities. Further regulation for closed‑end funds is planned to be announced in 2013, when the EU Directive on Alternative Investment Fund Managers (AIFM) is set to be implemented. Currently, the EU Commission is still working on details of regulation regarding the required implementation measures, with the assistance of the European Securities and Markets Authority (ESMA). The AIFM Directive and the implementation legislation shall be applicable to the managers of closed‑end funds. Please be aware that this briefing is designed only to summarise key information relating to the German KG model. It should not be relied upon without taking further advice. If you have any questions about issues raised in this briefing, or any other finance and investment law matter, please get in touch with your regular contact at Watson, Farley & Williams. Contact Gerrit Bartsch Partner Hamburg gbartsch@wfw.com +49 40 80 80 3440 Germany Am Kaiserkai 69 20457 Hamburg Germany Tel: +49 40 80 80 3440 Fax: +49 40 80 80 344 10 Thierschplatz 6 80538 Munich Germany Tel: +49 89 237086 0 Fax: +49 89 237086 222 All references to ‘Watson, Farley & Williams’ and ‘the firm’ in this brochure mean Watson, Farley & Williams LLP and/or its affiliated undertakings. Any reference to a ‘partner’ means a member of Watson, Farley & Williams LLP, or a member of or partner in an affiliated undertaking of either of them, or an employee or consultant with equivalent standing and qualification. This brochure is produced by Watson, Farley & Williams. It provides a summary of the legal issues, but is not intended to give specific legal advice. The situation described may not apply to your circumstances. If you require advice or have questions or comments on its subject, please speak to your usual contact at Watson, Farley & Williams. 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