Investment in German real estate has increased significantly, in part because the German market is perceived as less inflated than others. In response to such demand and to offer an internationally recognized investment vehicle, on Nov. 2, 2006, the German government issued a draft bill for the introduction of German real estate investment trusts (G-REITs) (expected to take effect retroactively, as of Jan. 1, 2007).
A G-REIT must have the legal form of an Aktiengesellschaft, a stock corporation. Its statutory capital must be at least 15 million. All shares must have voting rights and may be issued only if the issue price is fully paid in.
The activities of a G-REIT are limited to acquiring, owning and managing (including renting activities and related services) domestic or foreign real estate or certain real estate rights. The G-REIT may own interests in real estate management companies and holding partnerships. It must not be considered a real estate dealer (i.e., its gross proceeds from the sale of immovable property within a five-year period must not exceed 50% of the average assets of immovable property within the same period).
To obtain G-REIT status, the corporation’s registered and head offices must be in Germany and listed on a stock exchange in either a European Union (EU) country or a member of the European Economic Area. The listing must occur within three years after register-ing as a pre-G-REIT with the Federal Agency for Taxes. No shareholder may hold 10% or more of the shares.
At least 75% of a G-REIT’s assets must consist of immovable property (after distribution of profits and reserves), and at least 75% of its income must come from rental or leasing activities and from the sale of immovable property. A G-REIT must return 90% of its distributable profits to shareholders. The G-REIT’s articles of association may provide for debt financing, but only for up to 60% of the company’s assets and only at market rates.
G-REITs have to prepare (group) accounts in accordance with the German Commercial Code and International Financial Reporting Standards (IFRS). For instance, the amount of distributable profits is determined under the German Commercial Code. To maximize distributable profits, G-REITs are generally required to apply straight-line depreciation of 2% per year. On the other hand, the G-REIT is allowed to allocate half of its capital gains resulting from the sale of immovable property to reserves, thus reducing distributable profits. These reserves must be dissolved at the end of the second year following the year of allocation.
A G-REIT must also determine its profits under IFRS accounting standards, to provide a “true and fair view” of its financial situation and to allow for better comparability on an international level. Independent auditors have to certify the G-REIT’s financial statements and its compliance with various qualification requirements under the G-REIT statute (e.g., for assets and distributions).
A G-REIT that complies with the above criteria is generally exempt from German corporation income and trade taxes. This exemption at the company level is available even if one or more shareholders actually hold 10% or more of the shares. Special rules apply to a G-REIT that fails to meet one or more of the criteria. For instance, if less than 75% of a G-REIT’s assets consist of immovable property at the end of the business year, the authorities may assess a penalty of 1%–3% of the value of the assets in excess of the 75% threshold. If less than 75% of the G-REIT’s income results from rental, leasing or sale activities, the penalty is between 10% and 20% of the income below the 75% threshold. Likewise, if the G-REIT fails to distribute the full 90% of its distributable profits, the difference between the amount actually distributed and the statutory 90% is subject to a penalty of between 20% and 30%.
When any of these criteria is not met for three consecutive years, the financial authorities shall deprive the G-REIT of its tax exemption.
Taxation of Nonresident Shareholders
Dividends paid by a G-REIT to a nonresident shareholder are generally subject to a dividend withholding tax at a total rate of 26.375%. However, the current U.S.-Germany income tax treaty (as well as the not-yet-ratified 2006 protocol) provides for a reduced withholding tax of 15%; see Convention Between the United States of America and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and to Certain Other Taxes, signed Aug. 29, 1989, and Protocol Amending the Convention Between the United States of America and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and to Certain Other Taxes signed on 29th August 1989, signed June 1, 2006. Further rate reductions are possible under the treaty for 10%-or-more shareholders. But, as noted earlier, the maximum direct shareholding is limited to less than 10% under the G-REIT statute, to ensure that G-REIT profit distributions to nonresident shareholders will not become eligible for these privileged treaty (or comparable EU Directive) benefits.
Capital gains from a disposition of
G-REIT shares (including dispositions by
nonresidents) are generally subject to German taxation if the shareholder holds at least 1% of the G-REIT’s share capital. Although many German treaties eliminate that liability, the U.S.-German tax treaty is a notable exception. Art. 13(2)(b) of that treaty provides that shares of real estate holding companies are immovable property; thus, any gain on the sale of such shares can be taxed in the country of incorporation. Moreover, the German government is considering abolishing the capital gain exemption for long-term shareholders owning less than 1%, in which case, all U.S. investors would ultimately have to pay capital gain tax in Germany when they sell G-REIT shares.
Tax Considerations for U.S. Investors
The potential German capital gain tax liability on disposition of G-REIT shares is only one of several concerns for U.S. investors. Are:
- G-REIT dividends qualified dividends under Sec. 1(h)(11)?
- German taxes imposed on dividends and capital gains creditable?
- G-REITs subject to the passive foreign investment company (PFIC) regime?
Qualified dividends: The first question appears relatively straightforward. Qualified dividends (currently taxed at a 15% maximum rate) include those from a foreign corporation, if the corporation’s country of residence has a comprehensive tax treaty with the U.S. and the corporation is eligible for benefits under that treaty (qualified foreign corporation). Because a G-REIT is a publicly traded entity, it should be a “qualified person” under the U.S.-German treaty’s limitation-on-benefits provision (Art. 28) and, thus, a qualified foreign corporation for Sec. 1(h)(11) purposes.
FTCs: Under Sec. 904(a), foreign tax credits (FTCs) are essentially limited to foreign taxes imposed on foreign-source income. Withholding taxes on dividends paid by the G-REIT are thus creditable against a U.S. investor’s taxable income (subject to the statutory limits), as the dividend income should generally be from foreign sources; see Sec. 862(a)(2), which refers to the payer country as the source country.
However, a U.S. resident’s gain from the sale of a foreign corporation’s stock is generally U.S.-source income under the residual rule in Sec. 865(a). Double taxation of such gains can nevertheless be avoided. Sec. 865(h)(2)(A) allows a taxpayer to elect to treat certain gains from foreign stock sales as foreign-source income if a tax treaty provides that such gain is sourced in the foreign country. As indicated, Art. 13(2)(b) of the U.S.-German tax treaty gives the right to tax gain on the sale of shares of a real estate holding company to the country in which the real property is situated (in the case of a G-REIT, that would be Germany).
Thus, it is crucial that U.S. investors in a G-REIT actively elect the application of the Sec. 865(h) sourcing rule on disposition of their G-REIT shares. U.S. taxpayers may not credit the German tax against U.S. tax imposed on any other foreign income, because the FTC limit rules apply separately to such treaty-sourced gain; see Sec. 865(h)(1)(B). When taxpayers elect Sec. 865(h) sourcing in accordance with the treaty, they should further disclose this position by filing Form 8833, Treaty-Based Return Position Disclosure.
PFIC rules: Perhaps the most un-pleasant implications for a U.S. investor in a G-REIT could arise from the PFIC regime. Under Sec. 1297(a), a PFIC is any foreign corporation (regardless of the extent of U.S. ownership) in which (1) 75% or more of the corporation’s gross income for the tax year is passive income or (2) the average percentage of assets held by the corporation during the tax year that produce passive income or are held for the production of passive income is at least 50%. Passive income is determined by reference to “foreign personal holding company income” (FPHCI), as defined in Sec. 954(c). If a G-REIT were to qualify as a PFIC, depending on whether certain elections are made, a U.S. shareholder could be taxed currently (qualified electing fund), on excess distributions (plus interest charges) or on the annual share appreciation (mark-to-market election). These alternatives would ultimately result in ordinary income (as opposed to capital gain or qualified dividend income).
A G-REIT will likely earn predominantly rental income (as it will own predominantly assets that produce such income). The corporation would then risk being classified as a PFIC, because rental income is generally considered FPHCI under Sec. 954(c)(1)(A). However, Sec. 954(c)(2) includes an exception for rents derived in an active business.
Regulations provide for various instances in which rents will be deemed derived in the active conduct of a trade or business, two of which could potentially apply to a G-REIT. First, under Regs. Sec. 1.954-2(c)(1)(ii), rental income is deemed active business income if it is derived from the leasing of real property, “with respect to which the lessor, through its own officers or staff of employees, regularly performs active and substantial management and operational functions while the property is leased.” Second, under Regs. Sec. 1.954-2(c)(1)(iv), the active-income exception applies to property that is leased as a result of the performance of marketing functions by such lessor if the lessor, through its own officers or staff of employees located in a foreign country, maintains and operates an organization in such country that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from the leasing of such property.
It is anticipated that G-REITs will typically form management subsidiaries that should perform the management (and perhaps the marketing) functions outlined in the regulations. But the requirement that the G-REIT’s “own officers or staff” perform the management services would likely render this insufficient to meet the active-business test. Regs. Sec. 1.954-2(c)(3), Example (3), illustrates that the engagement of a real estate management firm does not create an active rental business. However, if the management company is wholly owned by the G-REIT, the latter could make a check-the-box election to treat the subsidiary (presumably a Gesellschaft mit beschränkter Haftung (GmbH)) as a disregarded entity for U.S. tax purposes. The GmbH’s management activities could be attributable to the G-REIT, which would, in turn, be viewed (from a U.S. perspective) as actively managing the properties. PFIC classification could thus be avoided.