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Coronavirus - (Real Estate) investment funds in the Corona crisis: Liquidity risks through regulatory and tax provisions - Germany

  • Germany
  • Tax planning and consultancy

12-04-2020

No support in the Corona crisis...

The measures already initiated by the German Federal Government and the EU Commission to support and secure liquidity in the Corona crisis are focused on the industries directly affected by Corona/ COVID 19. They are intended to help these companies to meet their current obligations, in particular to pay their leases. However, the current package of measures will only (temporarily) solve the existing liquidity issues for some of the companies:

... due to the lack of immediate involvement of investment funds...

The tenant’s solvency issues may also give rise to considerable liquidity issues for institutional landlords, which largely comprise alternative investment fund managers (AIFM) and their open-ended and closed-end real estate investment funds or real estate companies, insurance companies and pension funds, in particular due to

| an increased risk of losing lease payments due to the segment focus of the real estate portfolio, e.g. on shopping centres or hotels or a high quota of retail properties

| an increased risk that within the scope of the eligible external funding of the properties, contractually agreed requirements (covenants) cannot be met, which could in principle lead to the maturity of the loan or the disposal of the property;

| no possibility of deferral of current ancillary costs (e.g. the - recently increased - property tax, electricity, water), as these are essential for maintaining the use of the property;

| no possibility of deferral of costs for the management of the property, which also arise irrespective of vacancy or loss of lease payments, e.g. fees for property management, facility management, asset management, accounting, tax returns.

...with massive restrictions imposed by investment (tax) law and other risks!

Due to the applicable investment law and investment tax provisions for investment funds, the liquidity problem may considerably aggravate:

1. Limited capacities for taking up new loans

German real estate investment funds may only hold liquidity and take up loans within defined limits. Given the persistently low level of interest rates in the past years, the admissible leverage thresholds are likely to be largely exhausted. As things stand at present, the corona credit programmes provided would not work for real estate investment funds, if they were at all entitled to receive such loans, because this would increase the risk of actively infringe the investment limits.

2. Impairment of real estate

Due to the anticipated longer-term shortfalls in lease payments, especially in the case of real estate portfolios with a high proportion of tenants from the sectors directly affected by Corona, a decrease in the value of the real estate portfolio is also to be expected - this could possibly result in passive infringements of investment limits for the maximum liquidity permitted for the real estate investment fund.

3. No Corona tax relief

The use of corona tax relief measures is likely to have no effect on real estate investment funds, as it will be difficult for real estate investment funds to prove that they - unlike their tenants - are directly and not immaterially affected by the Corona crisis.

4. But: Risk of loss of tax privileges or tax-transparent status

In addition to these considerable restrictions for real estate investment funds to achieve an increase of liquidity, the infringement of investment limits under investment law can have an adverse effect on the investment tax treatment, too; in particular the infringement of the limits can lead to a loss of the status as a special investment fund within the meaning of sec. 26 of the German Investment Tax Act (Investmentsteuergesetz, InvStG) - and the real estate investment fund would then irreversibly fall into the non-transparent taxation regime applicable to (public/retail) investment funds.

5. Risk of violating investor interests

The loss of the transparent tax status could ultimately - depending on the agreement with the investors - possibly entail consequences for the AIFM from the failure to safeguard investor interests.

Temporary admissible passive infringements of limits under investment tax law...

After the German Federal Financial Supervisory Authority BaFin has already indicated to the associations that passive infringements of the respective supervisory regulations as a result of the corona pandemic would be regarded acceptable (see BaFin homepage), the German Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) has joined in accordingly for tax purposes.

...currently apply only to fund qualification...

The German Investment Tax Act stipulates that granting of certain tax benefits or legal consequences depends on an investment fund not "significantly infringing the fund rules". The fund rules are the constituting contractual agreement between AIFM and investors to set up an investment fund in accordance with the German Investment Act (KAGB). However, in addition hereto, the fund rules generally include all relevant provisions as required by investment tax law, such as a minimum of more than 50% of the investment fund’s assets in qualifying assets (e.g. more than 50% in securities to qualify as a securities investment fund or more than 50% in directly and indirectly held properties to qualify as a real estate fund). Depending on the type of investment fund, the investor may then benefit from different tax exemption applicable to his investment income from the investment fund, e.g. 60% tax-exemption for income from a real estate fund owning predominantly domestic real estate.

According to the statements in the Federal Ministry of Finance’s guideline dated 21 May 2019 related to the interpretation of InvStG rules (BStBl. I p. 527), an investment fund may lose its tax qualification as a security, mixed or real estate fund, if it would no longer invest more than 50% in eligible asset and therefore materially breach the fund rules. Whether an infringement is "material" should depend on the overall circumstances of the individual case, such as, among other things, the degree of negligence of the AIFM when the infringement occurred, the duration of the infringement or the value of the infringement in relation to the total value of the fund assets. In particular, no material breach shall be assumed in case of a passive infringement of limits, which may occur, among other things, due to changes in the value of the assets held, provided that the investment fund takes possible and reasonable measures immediately after becoming aware of the infringement to restore the required proportion of the respective assets.

As a simplification rule, the German Federal Ministry of Finance has stipulated that, in principle, no material breach is to be assumed if a securities fund, mixed fund or real estate fund falls below the eligible asset limits on a total of up to 20 single or consecutive banking days in a financial year (20-business day limit).

It has to be noted that the eligible asset investment limits may not be complied with when a new investment fund is launched or wound up.

...but not with special investment fund status

To qualify as a tax-transparent special investment fund (for institutional investors) , German investment tax rules require that the special investment fund does not "materially infringe the investment regulations" according to sec. 26 InvStG (note that the investment regulation as defined under tax rules are in general derived from the fund rules). This involves, among other things, compliance with the requirement to invest at least 90% of the portfolio investments in certain eligible assets or the restriction on taking up short-term loans to a maximum of 30 % of the value of the investment fund. If the requirements of sec. 26 InvStG are not met, the special investment fund is no longer subject to the transparent taxation regime and thus becomes taxable as an opaque investment fund. Interpretations of the Federal Ministry of Finance related to sec. 26 InvStG have, however, not yet been officially published.

Only Temporary Relief granted by Federal Ministry of Finance on 9 April 2020

The Federal Ministry of Finance states in a letter (in German) to the associations dated 9 April 2020, that within the period between 1 March 2020 and 30 April 2020

| a passive border infringement does not constitute a material breach of the investment requirements and does not count towards the 20-business day limit; and

| a passive infringement of the limits for a special investment fund would not be considered a material infringement of the investment provisions of sec. 26 InvStG.

Recommendations

So what are possible measures to increase liquidity in the short term?

| Depending on the number of investors, special investment funds may consider amending the fund rules to increase the investment limits in line with the applicable provisions under investment law or investment tax law.

| Furthermore, it should be reviewed whether and to what extent the real estate investment fund accounting still leaves room for interpretation to retain liquidity in the investment fund to compensate for expected future losses over and above the permissible maintenance reserves under investment law provisions. This should take into account compliance with requirements for the minimum liquidity in the event of (expected) devaluations of the real estate portfolio.

| In the case of real estate investment funds, it might also be worth considering to convert particularly affected properties (e.g. shopping centres, hotels) to a limited liability company (GmbH), in which both from an accounting and tax perspective it is possible to retain profits.

Conclusion: There is only temporary relief

In principle, the German Federal Ministry of Finance’s simplification regulations are to be welcomed and give a little more flexibility, especially for fully invested investment funds with a fiscal year-end of 31 March or 30 April. However, it is to be assumed that the full impact of the Corona crisis, particularly in case of real estate investment funds, will not become apparent until a subsequent date or even not until the next financial year - when the losses can no longer be absorbed by profits from the pre-Corona period.

The far-reaching restriction of the possibility to form provisions in the case of fully distributing investment funds will further aggravate the liquidity issues.

Depending on the future developments during the COVID 19 pandemic, it can be assumed that further transitional regulations under supervisory law as well as investment tax law will be necessary to overcome the tense liquidity situation in this exceptional situation.