How are hedge fund profits taxed?

Taxation of hedge funds: Still many questions unanswered

Foreign hedge funds are offered in a variety of forms:

  • as a direct investment,
  • as profit participation certificates from Austrian corporations,
  • as structured products,
  • and in future also as a domestic fund of funds within the framework of § 20 a InvFG (according to the InvFG amendment 2003).

The tax consequences for the investor depend on the structure of the form of participation. The following statements assume that the investor is a natural person who holds the investment instrument in question as private assets.

The tax consequences in detail:

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A. Participation in a foreign hedge fund

Participations in foreign hedge funds can be offered as direct participation. Foreign hedge funds can - in individual cases - be approved for public distribution as foreign investment funds in accordance with Section II InvFG. Otherwise, investors can acquire the foreign fund shares by way of a private placement.

From a tax point of view, the term foreign investment fund is defined in Section 42 (1) InvFG. According to this, a foreign investment fund is deemed to be "... regardless of the legal form, any property subject to foreign law that is invested in accordance with the law, the articles of association or actual practice according to the principles of risk diversification."

The legal form is irrelevant for the foreign investment fund. Co-ownership funds, trust structures, corporations, partnership structures or “managed accounts” can therefore fall under the term foreign investment fund. It is also not necessary that the Austrian investment regulations and limits of the InvFG are complied with. It is decisive that the capital employed is invested according to the principle of risk diversification. Accordingly, foreign hedge funds can fall under Section 42 InvFG, even if a comparable investment in a domestic investment fund would be inadmissible.

The investor is taxed on the basis of the actual distributions as well as the distribution-equivalent income. Income equivalent to distribution is fictitious distributions from the investment fund. The taxation time (inflow fiction) is to be assumed no later than 4 months after the end of the fund financial year. The extent to which the income of foreign investment funds is taxed depends on the tax qualifications of the funds. Up to the BBG 2003, three fund categories had to be distinguished:

White funds are foreign investment funds that are approved for public distribution in Germany and whose distribution-equivalent income is evidenced by a domestic tax representative. As is the case with domestic investment funds, only 20% of capital gains generated by white foreign funds are recorded (with the exception of capital gains from debt securities).

Gray funds are not approved for public distribution in Germany, but have a tax representative who can prove the distribution-equivalent income. For gray foreign investment funds, 100% of capital gains were taxable.

Black funds are not approved for public distribution in Germany and have no tax representative. In the case of black funds, the distribution-equivalent income is calculated on the basis of a flat rate (at least 10% of the last redemption value).

Since the BBG 2003, the “gray” fund category has been abolished. If a foreign investment fund has a tax representative in Germany, the fund is considered “white”. In this case, the capital gains achieved at the level of the investment fund - as with domestic investment funds - are only recorded to a limited extent: 20% of the capital gains (excluding capital gains from debt securities) are subject to taxation at 25% for a natural person in the private assets. All other income is also subject to final taxation.

A special feature of foreign investment funds is the security tax. Foreign investment funds that are held in a domestic custody account are subject to a security tax of 1.5% annually, unless the investor can prove to the custodian bank that the investor is taxable.

B. Hedge funds as profit participation rights

In Austrian hedge fund practice, investments in hedge funds are often structured in the form of profit participation rights in Austrian corporations. In this case, an Austrian corporation issues participation certificates similar to bonds, the performance of which depends on one or more hedge funds.

Regardless of whether the referenced hedge funds qualify as investment funds within the meaning of Section 42 InvFG, the participation certificates do not meet the requirements of Section 42 InvFG. Because they are not subject to foreign law. In addition, it should be noted that there can be no “double allocation” of foreign fund units. Even if the underlying hedge funds qualify as foreign investment funds within the meaning of Section 42 InvFG, the beneficial owner and object of income tax attribution is the corporation issuing profit participation certificates. Although the participation certificate holders participate economically in the performance of the relevant hedge fund shares, they generally have no rights of disposition or administration with regard to the hedge fund shares. The profit participation certificates therefore do not qualify as participation in a foreign investment fund within the meaning of Section 42 InvFG.

In terms of income tax, the relevant participation certificates are usually structured as participation rights similar to obligations. In accordance with longstanding administrative practice, the tax treatment of the investor depended on whether a capital guarantee was provided. Only in the case of a capital guarantee (in the sense of a minimum stratification of at least 20%) was a debt security to be accepted for tax purposes, the income of which was subject to capital gains tax and subject to final taxation. This administrative practice was called into question by a ruling by the highest court (VwGH November 26, 2002, 99/15/0159). According to the VwGH, income from debt securities is subject to capital gains tax and is subject to final taxation regardless of a capital guarantee.

The legislature of the BBG 2003 reacted to the tax uncertainty and created a transitional regulation. According to this, income from investments, the interest rate of which only depends on the performance of an (existing or artificially created) securities index or comparable index, is not considered income subject to capital gains tax if the following conditions are met:

a. the investments were issued before March 1, 2004 and
b. A capital repayment of no more than 20% of the capital invested in the issue is factually or legally guaranteed.

The wording of the transitional provision is based on a “securities index” or “comparable index”. In this context - from the point of view of the tax authorities - it has not yet been clarified whether profit participation certificates relating to a specific hedge fund are to be qualified as "index-dependent". However, this question decides whether or not to apply the specified transitional provision. If the transitional provision comes into effect, the previous administrative practice will be "continued". According to this, income from non-guaranteed bond-like profit participation certificates is regarded as capital gains that are only subject to tax liability for natural persons if they are realized within the speculation period. If, on the other hand, the transitional provision does not apply, all income must be classified as income from capital assets that is subject to capital gains tax and subject to final taxation.

C. Other structured products

In the case of certificates that relate to one or more hedge funds, the preliminary question for foreign issuers is whether a certificate is given for tax purposes or whether there is a participation in a foreign investment fund. In this regard, financial management practice has stipulated in the InvF guidelines that a certificate is only available if it relates to a sufficiently diversified hedge fund index (which includes all strategies).

If a certificate in the tax sense (and not a foreign investment fund) is to be assumed, the question arises - as is the case with bond-like participation certificates - whether the income qualifies as income subject to capital gains tax and final taxation or as capital gains. Here, too, it depends on the applicability of the transitional provision.

D. Domestic investment funds according to § 20a InvFG

The 2003 amendment to the Investment Fund Act allows for the first time the approval of domestic funds of funds that also invest in foreign hedge funds. There are no special regulations for the taxation of Section 20a investment funds. This means that - as with other domestic securities funds within the meaning of Section 20 InvFG - the principle of transparency is applied. The taxation of the investor therefore depends on the securities or funds in which the § 20a investment fund invests. If the § 20a investment fund is designed as a real fund of funds, the tax consequences of the investor are based on the underlying foreign hedge fund. As a rule, these will be “white” foreign investment funds.

E. Overall assessment of the tax framework according to the BBG 2003

According to the BBG 2003, "white" investment funds and participation certificates / certificates that are issued after 1.3.2004 differ in the following key points:

Scope of taxation: Capital gains made by white foreign investment funds are only subject to limited taxation. In the case of natural persons, only 20% of the capital gains in question are recorded and taxed at a tax rate of 25%. This results in a tax burden of around 5%. In the case of profit participation certificates and other structured products issued after March 1, 2004, the entire income is subject to capital gains tax and final taxation.

Time of taxation: In the case of foreign investment fund units, the investor is taxed on an ongoing basis, ie in accordance with the (at least annual) distribution-equivalent income. In the case of participation certificates and other structured products, taxation is based on the inflow principle, ie at the time the certificate is sold or redeemed.

Taxation technique: The distribution-equivalent income from foreign investment funds is recorded in an assessment process. In the case of profit participation certificates and certificates, taxation is carried out - in the case of a coupon paying agent in Germany (custodian) - by way of capital gains tax and final taxation, ie practically automatically.

Security tax: Safeguard tax can only apply to foreign funds.

In summary, the following can be stated: In the case of foreign investment funds, there is a taxation on the basis of fictitious distributions, which are to be declared as part of an assessment procedure. In contrast to this, profit participation certificates continue to offer tax deferral effects because taxation is only linked to the actual inflow (at the time of sale or redemption). The taxation will be linked here to the capital gains tax, which has a final inventory effect. The tax base can be lower for foreign investment funds, but the taxation technique for participation certificates is much more "convenient". The topic of security taxation does not arise in the case of profit participation certificates either.

Dr. Sabine Kirchmayr is a partner at Leitner + Leitner,
email: [email protected]

Guest comments are written by recognized financial market experts whose opinions do not have to agree with those of the editorial team.   

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