Change in the taxation regime for investment funds and investors

Income tax treatment of investment funds and their investors

For income taxation purposes, domestic investment funds are treated under current tax law (Sect. 6(1) of the Investment Tax Act (“Investmentsteuergesetz”)) as special-purpose vehicles pursuant to Sect. 1(1) No. 5 of the Corporate Income Tax Act. They are subject to resident corporate income taxation on their worldwide income. Foreign investment funds, on the other hand, are considered special-purpose vehicles pursuant to Sect. 2 No. 1 of the Corporate Income Tax Act and are subject to non-resident corporate income taxation on their domestic income. This describes the core of the “non-transparent” taxation that has been applied to investment funds since 2018. This is also clear from the structure of the Investment Tax Act itself – Section 1 of Chapter 2 deals with the “taxation of investment funds,” while Section 2 deals with the “taxation of investors in investment funds.”

However, compared to other corporations with resident tax liability, Section 6(2) of the Investment Tax Act imposes restrictions on the determination of income. Investment funds are essentially subject to corporation tax only on domestic investment income, domestic real estate income, and other domestic income (Section 6(3), (4), (5) of the Investment Tax Act). Section 8b of the Corporate Income Tax Act (the German participation exemption) is disallowed at the fund level (Section 6(6) of the Investment Tax Act).

As a second component of the non-transparent (“opaque”) taxation system, investors generate income from capital assets in accordance with Sect. 20(1) No. 3, 3a of the Income Tax Act. This consists of the following components (Sect. 16(1) of the Investment Tax Act):

1. Distributions from the investment fund pursuant to Sect. 2(11) of the Investment Tax Act,
2. an advance lump sum (“Vorabpauschale”) pursuant to Sect. 18 of the Investment Tax Act, and
3. gains from the sale of investment fund units pursuant to Sect. 19 of the Investment Tax Act.

In order to mitigate the problem of “economic double taxation,” investors are granted “partial exemptions” from taxation (Sect. 20 of the Investment Tax Act), depending on the nature of “their” investment fund. A good overview of the applicable rates can be found in the corresponding circular by the German Federal Tax Authority dated May 21, 2019 (Federal Tax Gazette I 2019, p. 527), section 20.5. Since investment funds are usually exempt from trade tax (Sect. 2(3) of the Trade Tax Act; Sect. 15 of the Investment Tax Act), the rates are applied in full for income tax and corporation tax, but only at 50 % for trade tax (Sect. 20(5) of the Investment Tax Act).

This regime also applies to corresponding losses and expenses (Sect. 21 of the Investment Tax Act). In accordance with the legal principle of Sect. 3c of the Income Tax Act, corresponding reductions in the investor's income may not be deducted when determining income to the same percentage extent as a partial exemption applies to the income (Sect. 21 sent. 1 of the Investment Tax Act).

Transition of individual regimes under the Investment Tax Act

Over the last 20 years, the Investment Tax Act has undergone several “regime changes.” First, the taxability of income from capital assets (Sect. 20 of the Income Tax Act) was extended by the transition to the flat-rate withholding tax (“Abgeltungsteuer”; Sect. 32d of the Income Tax Act) at the turn of the years 2008/2009. Second, the regime of non-transparent taxation described above was introduced at the turn of the years 2017/2018.

Sect. 56 of the Investment Tax Act contains the appropriate instruments for dealing with these changes: 

• According to Sect. 56(6) of the Investment Tax Act, fund units acquired before January 1, 2009 outside of business assets are “grandfathered old fund units”.
• Other fund units were deemed to have been sold at the end of December 31, 2017, and acquired at the beginning of January 1, 2018, pursuant to Sect. 56(2) of the Investment Tax Act.

But what if this fictitious acquisition resulted in a profit? This profit was not to be recognized immediately on December 31, 2017, but was (under Sect. 56(3) of the Investment Tax Act) only to be “taken into account at the time when the old fund unit is actually sold.”

Particular frictions arose when a profit had been generated by December 31, 2017, but a loss (Sect. 2(14) of the Investment Tax Act) was incurred up to the date of sale due to the fictitiously increased, “new”, stepped-up acquisition costs. The tax authorities only wanted to recognize this loss within the limits of the partial exemption under Sect. 20 of the Investment Tax Act (for the standpoint of the tax authorities, see circular by the Bavarian tax authorities dated June 2, 2022). A fully taxed profit was then offset by a loss that was only partially recognized, triggered by a fictitious sale.

The German Federal Fiscal Court has now issued a solution to this question in several rulings dated November 25, 2025 (file numbers VIII R 15/22, VIII R 22/23, VIII R 31/23) – in particular with regard to the “ability to pay principle” that governs German income tax law: According to this, the partial exemption should not apply if a loss stemming from a disposal determined from January 1, 2018 – i.e. under the new law – is “based on the fact that the notional acquisition costs as of January 1, 2018 exceed the historical acquisition costs of the sold fund units.” Existing fund units acquired before January 1, 2009, are exempted on the basis of grandfathering.

Regime change requires tax advice

Changes in income tax regimes are notoriously difficult to manage. In some cases, the old regime is simply continued for “old cases” (“grandfathering”; Sect 52(28) sent. 11 of the Income Tax Act), as is the case with the flat-rate withholding tax (Sect. 32d of the Income Tax Act). 

In some cases, it is also transferred to the new regime by increasing the acquisition costs or restricting the new regime to newly generated profits – as was the case with the introduction of non-resident tax liability for “real estate-rich” cases in Sect. 49(1) No. 2 lit. e sublit. cc of the Income Tax Act in the 2018 Annual Tax Act (“Jahressteuergesetz 2018”). This extended tax liability for non-residents was introduced “gently” by Sect. 52(45a) sent. 1 of the Income Tax Act, in that it was “to be applied for the first time to profits from the sale of shares” where “the sale took place after December 31, 2018.” In addition, it only applies “insofar as the profits are based on changes in value that occurred after December 31, 2018.”

In the case of the Investment Tax Act, which concerns a truly mass procedure, the legislature has made two significant changes in the last two decades. The German Federal Tax Court cases at hand show a special constellation for which a “solomonic” solution has now been found – neither the plaintiff nor the defendant has ultimately prevailed completely.