The German securities lending market is weeks away from the introduction of a new tax on dividend income that may drive participants out the market

For most people, the new year brings hope and a sense of opportunity and optimism. For Germany, 1 January 2018 brings the German Investment Tax Act (GITA 2018), which, among other things, will introduce the taxation of manufactured dividends and lending fees on German equities.

The rule has been described as murky, inconsistent and unnecessary—and industry leaders fear the worst about its negative effects on the market.

The Manufactured Dividend Rule renders securities lending and repo income subject to a 15 percent German taxation in the hands of a lender and repo seller, respectively, when such lender or repo seller is an investment fund.

The reform essentially modifies the taxation on investment income by creating two distinct tax regimes for non-tax transparent investment funds on the one hand, and transparent special funds, on the other.

The category of ‘investment funds’ includes UCITS funds, alternative investment funds, hedge funds and single investor funds, and these are the ones that will be hit hardest by GITA 2018.

Under the new regulation, German-sourced income, including revenue from securities lending and repo, are taxable at 15 percent withholding tax for non-resident funds, while some 15 percent corporate tax will also be imposed on German resident funds. Payment of the withholding tax on German-sourced dividends by non-German resident funds discharges the corporate tax at fund level, in order to ensure no double taxation takes place.

Primarily, these investment funds and their investors will be subject to tax. Fund level taxation will take place for the first time either in the form of corporate tax, or withholding tax. The key indicator is where the fund is domiciled.

Fran Garritt, director of securities lending and market risk at the Risk Management Association, offers further insights on the German tax law. He says: “GITA 2018 will treat manufactured dividend payments, repo interest and related fee income as German-sourced participation income, subject to potential German withholding tax if the payments are associated with a securities lending or repo transaction involving in-scope German securities.”

Securities lending on the radar

The German market regulator is committed to putting a stop to dividend stripping and boosting compliance with EU laws on anti-discrimination. This will lead to equal treatment for German-domiciled and foreign funds on German-sourced income.

Local authorities have been strengthening tax regulation in securities lending in recent years. Ali Kazimi, managing director of London-based tax advisory firm Hansuke, explains: “The aim of the authorities is to stop abuse on trades between foreign and German resident shareholders around the dividend date of the shares.”

The first step was to tax cum/ex transactions, followed by a levy imposed on cum/cum transactions this summer, according to Kazimi.
He adds: “The third piece of the jigsaw is to tax manufactured payments and lending fees that have a German origin. Now, all of these, including fund taxation and anti-tax avoidance packages have come together under the new framework.”

Insecurity and liquidity challenges around GITA

As Germany aims to impose heavier taxes on securities finance moving forward, the industry raises fears of liquidity disruption in the German market.

As another concerned industry representative, the International Securities Lending Association (ISLA) submitted a letter on 5 December to the German Ministry of Finance asking for further clarification and expressing industry concerns around GITA.

ISLA explains: “Due to a lack of clear understanding across the industry, lenders may determine that the risk of lending securities is no longer low and therefore will withdraw from the market, rather than accept a higher level of risk or uncertainty.”

“A number of members have indicated that they may have to cease securities lending activity in German equities mid-December in order for positions to be fully returned by borrowers before 1 January 2018. It should be noted that a wholesale withdrawal of liquidity over the typically lightly-traded Christmas period, could have an unpredictable and outsized impact on equity markets.”

Garritt also warns that, in such an investment climate, most lenders and their agents may stop lending German securities. If a number of foreign investors decide to withdraw their supply from the market, there will be a negative impact on liquidity.

Garritt adds: “In fact, we are already seeing a number of agents and their clients decide to stop lending their German equities altogether, in preparation for the 1 January 2018 effective date.”

“The liquidity challenge could be exacerbated around the holidays,” Garritt adds. “Since the rule goes into effect on 1 January 2018, some institutions may decide to cease securities lending activity in German equity markets by mid-December in order to close out positions by the start date of the rule.”

According to Garritt, the shortage of liquidity can affect the German market severely, “as volumes are typically low during this time period”. Similarly, Kazimi predicts that 30 percent of the liquidity could be taken out from the German market as a result of the uncertainty around new regulation.

While Germany will likely remain a significant player in the financial market, demand could wane for German securities in the face of uncertainty and ever-stricter regulation.

Deutsche Boerse’s Michael Port examines GITA 2018 from a German perspective

How is the taxation on income changing?

Among other amendments, the main changes of the German investment tax reform are in the taxation on fund level. In the case that the lender is an investment fund which is subject to the new German Investment Tax Act 2018 (GITA 2018), a fundamental change of the tax regime is to be considered. Chapter six of GITA 2018 foresees a withholding tax:

  • On income from German shareholdings

  • On payments on securities financing transactions (SFT) in German equities (for example, lending fees)

  • On income from property

  • On other income that is subject to limited tax liability

This withholding tax compensates further tax obligations on the level of investors. Additionally, there is less complexity in the declaration of the earnings figures from a tax perspective.

What tax requirements will be set out for resident and non-resident investors as of 1 January 2018?

In the case that the lender is an investment fund that is subject to the GITA 2018, the borrower will be obliged to deduct the withholding tax on payments in the context of a securities lending transaction, such as the lending fee. These rules are valid for both German and foreign investors.

How should investors and asset managers prepare?

If it has not already been done, they should contact their tax advisor. In addition, ISLA is also working on this topic.

Which investment funds will be in scope?

The affected funds are outlined in chapter one of the GITA 2018, which refers to chapter one of the German Investment Code (Kapitalanlagegesetzbuch).
Where will GITA 2018 not be applicable?

The investment tax act is only applicable in the case that an investment fund is involved. In all cases where no investment fund is involved in the SFTs the GITA 2018 won’t be applicable. For example, in the case that a foreign bank is borrowing German equities from a German bank.

Can you explain the difference between an investment fund and a special investment fund?

To be qualified as a special investment fund for tax purposes, various requirements have to be fulfilled by the funds. The investment terms and criteria are listed in chapter 26 of GITA 2018. They include the provisions that:

  • The fund is limited to 100 investors

  • No private investors are allowed

  • The fund is not subject to German trade tax

Public investment funds only need to fulfill the criteria of chapter one GITA 2018.

Is it possible to change from an investment fund to special investment fund?

Only in the case that the special investment fund no longer fulfills the requirements of chapter 26 of GITA 2018, can a special investment fund be changed into an investment fund.

Will there be any punitive measures if market participants react too late? Or will transitional rules be implemented?

The new investment tax rules come in force on 1 January 2018. There are no transitional rules in place.

All questions have been answered with a main focus on securities lending transactions. Please be aware that the answers represent Deutsche Boerse’s interpretation of the new rules, especially in the cases that are still in discussion. These responses are not to be construed as tax advice.

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