The current German fund tax regime in principle distinguishes between domestic (hedge) funds and foreign (hedge) funds, the latter being treated as "white" (= registered), "gray" (= tax compliant) or "black" (= unregistered) funds.

Under the new German tax regime, the category of "gray" funds will disappear and only "white" and "black" funds will remain. The good news is that the discrimination of investors in foreign funds will be abolished and they will enjoy equal tax treatment with investors in domestic funds.

The bad news, however, is that this will only apply to investors in "white" funds. Investors in "black" funds, i.e. funds (including fund of hedge funds) not complying with very detailed reporting requirements (to be delivered in the German language) will still be subjected to an almost unchanged penalty taxation regime.

Worthwhile mentioning is that this does not only apply to foreign but also to domestic funds not complying with the rigid reporting requirements. They will also qualify as a "black" fund and its investors will be subjected to the penalty taxation.

The past has shown that fund of funds, not only fund of hedge funds, in Germany usually could not comply even with the existing reporting requirements which will be yet tightened by the new law.

For the hedge fund companies which intend to enter the German market from abroad or who are thinking of setting up hedge funds in Germany, the new taxation regime consequently is not too favorable. With the best of efforts, foreign single manager hedge funds might be capable of meeting the reporting requirements. For foreign funds of hedge funds, however, it will be virtually impossible to fulfil the reporting obligations (such as the determination of tax-exempt and foreign-source income in a distribution and information in respect of retained earnings to investors).

Consequently, investors in foreign funds of hedge funds will still face the penalty taxation regime for "black" funds. This also means that funds of hedge funds still need to be marketed as structured products.

This article was contributed by Munich-based HVB Alternatives. A more detailed analysis of the proposed changes of the two draft bills issued on July 8, 2003 by the German Ministry of Finance and dealing - inter alia - with the future regulatory and tax regime of hedge funds in Germany will be issued by HVB Alternatives in due course.