Taxation of U.S.-Trusts under the German Inheritance and Gift Tax Act

Taxation of U.S.-Trusts under the German Inheritance and Gift Tax Act

Following the introduction of regulations drafted to target tax avoidance in 1999, the German government enacted tax provisions applicable to transfers to certain trusts. This article provides a brief introduction to the impact that such regulations have on U.S.-trusts with a nexus to Germany and discusses practices that could avoid the tax traps associated with German tax law.

Trusts in German Civil Law

Trusts are virtually unknown in German Civil law and German real property law does not allow for the transfer of assets located in Germany to a trust. However, a transfer to a trust does not necessarily have to be without effect. For example, a testamentary trust may be interpreted as a German legal instrument which has similar effects. For example, a U.S. trust may be interpreted as a durable execution of the estate (Dauertestamentsvollstreckung), subsequent heirship (Vor- und Nacherbschaft), usufruct (Nießbrauch) or a combination thereof.

Applicable Tax Laws

The taxation of estates and gifts in Germany is codified in the German Inheritance and Gift Tax Act (ErbSt). Additionally, other German tax laws, such as the German General Fiscal Code (AO) and the Valuation Act (BewG) contain relevant provisions. Finally, the Germany-U.S. Estate and Gift Tax Treaty (Treaty) may be applicable. 

Introduction to the German Inheritance and Gift Tax Act

Germany imposes German inheritance tax (Erbschaftsteuer) on all worldwide transfers mortis causae, if either the beneficiary or the deceased is a German tax resident (Inländer) at the time of his death (§ 2 ErbStG).

German gift tax (Schenkungsteuer) is imposed on all inter vivos transfers (e.g. gifts), irrespective of the situs of the transferred asset, if either the donor or the donee was a German tax resident at the time of the transfer.

The transfer of German domestic property (Inlandsvermögen) is subject to German gift or inheritance tax irrespective of the tax residence of the transferor or transferee. 

Contrary to U.S. federal estate tax, German inheritance tax (Erbschaftsteuer) does not attach to the estate itself, but instead the acquisition of each beneficiary. Consequently, tax-free exemptions are granted per capita and the tax rate depends of the value of the acquisition  of the beneficiary and not the total value of the estate. 

Transfers upon death or inter vivos between the same persons within 10 years are aggregated and the tax is (re-) calculated based on the aggregated taxable acquisition. See § 14 ErbStG

The applicable tax rates and the tax-free exemptions are dependent on the familial relationship between the deceased and the beneficiary.

For more information on the calculation of the German inheritance tax please see our article “The German Inheritance Tax and for more information on German gift tax please see our article German Gift Tax

Trusts as (deemed) Legal Entities for Inheritance and Gift Tax Purposes

Prior to 1999, transfers of assets to trusts were not taxed by the Inheritance Tax Act. Similar to German Civil Law, the Inheritance Tax Act did not recognize trusts as legal entities.

In 1999, the German government enacted provisions that provided for the taxation of transfer of assets to a foreign pool of assets (Vermögensmasse ausländischen Rechts), if such pool of assets shall hold such assets for a considerable time period in favor of a beneficiary without being obliged to distribute the trust assets to the beneficiaries without delay (like an executor or administrator). Such a pool of assets is, for inheritance and gift tax purposes, treated as a legal entity. 

While the wording of the law is broad, it is well settled that a trust is not a "deemed legal entity" and the grantor remains the (economic) owner of the assets transferred to the trust under § 39 para 2 S. 2 AO, if he remains in (complete) control of the trust assets. The grantor remains in control of the trust assets, if he retained the following rights: 

  • To change/amend the trust document at any time;
  • To revoke the trust at any time; and
  • To give the trustee instructions with respect to the management of the trust assets and the distribution to the beneficiaries (or he is the trustee himself).

The same is true, if the beneficiary of the trust is in complete control of the trust. 

Example: A and B create a joint trust. Upon the death of A, two sub-trusts are created: The survivor`s trust and the decedent`s trust. Under the terms of the trust, B may change/amend or revoke sub-trust B or distribute the total income and principle to herself. B is the economic owner of the trust assets and the trust is not a deemed legal entity for German inheritance and gift tax purposes. 

If the grantor dies or relinquishes such rights retained, the trust may become a deemed legal entity. 

In light of the issues discussed above, the majority of U.S. trusts in which the grantor does not retain all rights (e.g. most grantor trusts) and that are not mereley shells qualify as such "Foreign pool of assets".

All trusts that are not deemed to be legal entities under German tax law are referred to as “transparent trusts” hereinafter. If not explicitly stated otherwise, the following solely applies to non-transparent trusts

Taxation Right of Germany under the Germany-U.S. Estate and Gift Tax Treaty

Pursuant to Art. 12 para 1 of the Germany-U.S. Estate and Gift Tax Treaty, the Treaty does not preclude Germany from applying its domestic tax rules governing the recognition of a taxable event, with respect to transfers of property to a trust. However, the Treaty precludes Germany in many situations from taxing transfers to a trust or distributions to a beneficiary. 

Example: Grantor A, U.S. citizen, moves to Germany in 2015 and transfers U.S. financial assets and U.S. real property into an irrevocable living trust. Despite the fact that the grantor is a German tax resident (Inländer) under German domestic law, his fiscal domicile under the Treaty is not in Germany. As a consequence, Germany may only tax the transfer to the irrevocable trust if the trustee`s fiscal domicile is in Germany. 

Election Right under the Germany-U.S. Estate and Gift Tax Treaty

Pursuant to Art. 12 (3) of the Treaty, the beneficiary of a trust may elect to be subject to all German taxation (including income taxation) "as if a taxable transfer had occurred to him at the time of such transfer and not to the trust" provided that

  • the transfer to the trust did not trigger German inheritance or gift tax and
  • the election is made within five years after the transfer to the trust. 

This election right may be used to enable a beneficiary to credit U.S. federal estate tax paid against German gift tax imposed on trust distributions to a German resident beneficiary. 

However, this will not necessarily prevent the German resident beneficiary from beeing taxed upon the distribution from the trust: On March 6th 2019, the Ministry of Finance of Brandenburg has published a regulation on the taxation of distributions from a U.S. trust to an individual with a fiscal domicile in Germany subsequent to making use of the right under Art. 12 (3) of the Treaty. Pursuant to this regulation, such distributions are subject to German gift tax under § 7 (1) Nr. 9, S 2 ErbStG. We disagree with this opinion as

  • it conflicts with the clear wording of the Treaty,
  • would result in double taxation, and
  • there is no justification for double taxation.

Any decision rendered pursuant to the Ministry’s analysis should be subject to appeal. 

Taxation of Asset Transfers to Inter Vivos Trusts

Pursuant to § 7(1) Nr. 8, S. 2 ErbStG, inter vivos transfers of assets to a non-transparent trust is subject to German gift tax (Schenkungsteuer). Germany may tax such transfer under Germany-U.S. Estate and Gift Tax Treaty if either the grantor or the trustee has a fiscal domicile in Germany at the time of making the transfer  If only the beneficiary is domiciled in Germany, no German gift tax is triggered by the mere fact of transferring the (non German) assets to the trust.

Example: Grantor A is a U.S. citizen, without a fiscal domicile in Germany, transfers € 500,000 into an irrevocable living trust (with a U.S. corporate trustee) and does not retain any rights with respect to the trust assets. The trustee is fiscally domiciled in the U.S. Despite the fact that the beneficiary resides in Germany, the transfer is not taxable in Germany.

If the transfer is taxable in Germany (because the grantor or the trustee has a fiscal domicile in Germany), the asset transfer is subject to the least favorable tax class III as there is no familial relationship between the transferor and the trust. Accordingly, the transfer simply receives a minimal tax-free exemption of € 20.000 and is subject to an initial tax rate of 30%.

Example: If, in the above example, grantor A`s fiscal domicile at the time of the transfer is in Germany, the transfer would be taxable at a rate of 30 % and the tax free-amount would only be € 20.000. 

Taxation of a Trust upon Death of the Grantor

If a non-tax-transparent trust is created upon the death of the grantor or a transparent trust becomes  non-transparent, the transfer to the trust (as deemed legal entity for German Inheritance and Gift Tax purposes) is subject to German inheritance tax under § 3(2) Nr.  2 ErbStG.

Please note: If the successor trustee shall without delay distribute the trust assets to a German resident beneficiary, the trust is tax transparent and the death of the grantor will trigger German inheritance tax. 

However, if the Germany-U.S. Inheritance and Gift Tax Treaty is applicable, Germany may not tax such transfer if neither grantor nor the trustee has a fiscal domicile in Germany and no German inheritance or gift tax will be imposed on a German resident beneficiary until he receives a distribution from the trust. 

Taxation of Distributions during the Existence of the Trust

Pursuant to § 7 (1) Nr. 9, S 2 ErbStG Germany taxes the transfer during the existence of a non-transparent trust to a intermediary beneficiary (Zwischenberechtigter). 

In its decision dated 27th September 2012,  II R 45/10 the Federal Fiscal Court Bundesfinanzhof) held that any person who receives trust distributions during the existence of a trust is such intermediary beneficiary.

However, in its decision dated July 3, 2019, II R 6/16 the Bundesfinanzhof held that distributions from a non transparent trust can only be subject to German gift tax if the beneficiary has “rights to the assets and/or income of the trust independently of a distribution decision of the trustee.” The substantive decision states that an "abstract-general right to the distribution" or an "interest in the capital and/or income that cannot easily be withdrawn" may qualify as a  “right” in this meaning. As a consquence, distributions from a trust may be not subject to German gift tax, if the trustees discretion is broad. 

As there is no familial relationship between the trust (as deemed legal entity) and the beneficiary, one may think that the unfavorable tax class III applies to the taxation of distributions from a trust. However, § 15 para 2 Sentence 2 ErbStG states that the tax class is determined by the familial relationship between the grantor and the beneficiary. 

Example: In 2015, grantor A, transfers €500,000 to an irrevocable trust. The trustee is T, a professional trust manager with a fiscal domicile in the U.S..  T distributes €500,000 to A`s son, B. The distribution is taxed in the favorable tax class I (tax-free exemption: € 400,000, initial tax rate: 7 %).

Any distribution from the trust within the 10 years preceding the final distribution is added to the taxable acquisition for the calculation of the tax. See § 14 ErbStG.

Taxation of Final Distribution (Dissolution of Trust)

The final distribution of trust assets to beneficiaries is subject to German gift tax under § 7 Section 1 lit. 9 Sentence 2 ErbStG. The applicable tax class is determined by the familial relationship between the Grantor and the beneficiary (see § 15 Section 2 Sentence 2 ErbStG). Any distribution within the 10 years preceding the final distribution is added to the taxable acquisition for the calculation of the tax. See § 14 ErbStG.

 

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