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 of assets 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.

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 (Erbschafts- und Schenkungsteuergesetz). Additionally, other German tax laws, such as the German General Fiscal Code (Abgabenordnung) and the German Valuation Act (Bewertungsgesetz) 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 any gift (Schenkung) and any other inter vivos transfer irrespective of the situs of the transferred asset if either the donor or the donee was a German tax resident (Inländer) 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 to the acquisition of each beneficiary. Consequently, tax-free exemptions are granted per capita and the tax rate depends on 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

Historical Background

Prior to 1999, transfers of assets to trusts were not taxed by the Inheritance Tax Act. Similar to German Civil Law, the German Inheritance and Gift Tax Act (ErbStG) did not recognize trusts as legal entities. the German government enacted tax provisions applicable to transfers to certain trusts.

Law

The law does not explicitly use the term "trust". Instead, it uses the term "foreign pool of assets with the purpose to bind assets". 

Foreign Pool of Assets

While the wording of the law is broad, it is well settled that a trust is not a foreign pool of assets (Vermögensmasse ausländischen Rechts) if the  grantor remains the (economic) owner of the assets transferred to the trust, because he is the sole trustee and remains in (complete) control of the trust assets.

Example: A transfers assets to himself as sole trustee of a revocable trust and retains comprehensive rights, in particular the right to change/amend or revoke the trust. Under the terms of the trust, he is the sole beneficiary and upon his death the assets shall pass to his son S. 

If the person in this example retains comprehensive rights, but is not the (sole) trustee, the trust should still not be characterized as a "foreign pool of assets" if it is comparable to a fiduciary arrangement (Treuhandverhältnis).

Similarly, a trust is not a foreign pool of assets, 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 pool of assets for German inheritance and gift tax purposes. 

It should be noted that the characterization by German tax authorities may change if the grantor dies or relinquishes retained rights.

In light of the issues discussed above, trusts established in the U.S. in which the grantor does not maintain all rights including the right to revoke shall be deemed  a "foreign pool of assets". Irrevocable trusts by their nature require the Grantor to relinquish the right to revoke and would be deemed a “foreign pool of assets.”

Binding of Assets

The term and the law governing a foreign pool of assets is only relevant for inheritance and gift tax purposes if the purpose of the transfer is purpose is to bind assets. This is generally the case if, under the terms of the trust, the trustee holds the trust assets for a considerable time in favor of a beneficiary without being obligated to distribute the trust assets to the beneficiaries without delay (like an executor or administrator).

Trust as a Legal Entity

All trusts that qualify as a pool of assets, are, for inheritance and gift tax purposes, treated as a legal entity. The entity shall be deemed a German tax resident, if its registered office (Sitz) or place of effective management (Ort der Geschäftsleitung) is situated in Germany. See § 2(1) d) ErbStG. As a German tax resident, the foreign pool of assets would be liable for German inheritance taxes. See § 20(1)(2) ErbStG 

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 discussion solely applies to non-transparent trusts.

Taxation of Asset Transfers to Inter Vivos Trusts

Pursuant to § 7(1) Nr. 8, S. 2 ErbStG, inter vivos transfers of assets to  non-transparent trusts are subject to German gift tax (Schenkungsteuer).

Please note: If neither the grantor nor the non-transparent trust is a German tax resident (Inländer), only the transfer of German domestic property (Inlandsvermögen) is subject to assets to the trust. See § 2 ErbStG

An asset transfer from a non-transparent trust 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%.

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 non-transparent trust is subject to German inheritance tax (Erbschaftsteuer) under § 3(2) Nr.  2 ErbStG and the transfer is taxed in tax class III. 

Please note: If the successor trustee shall without delay distribute the trust assets outright to a German resident beneficiary, the trust is tax transparent and, from a German perspective, the beneficiary`s acquisition and not the transfer to the trust will be subject to German inheritance tax.

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 Federal Fiscal Court 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 consequence, distributions from a trust may be not subject to German gift tax, if the trustee’s 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, transferred $500,000 to an irrevocable trust. The trustee is T, a professional trust manager without a residence (Wohnsitz) in Germany.  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 by the non-transparent 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 Trusts under the Germany-U.S. Estate and Gift Tax Treaty

Treaty does not preclude Germany from applying special Rules for Trusts

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.

Treaty Benefits 

However, the Treaty precludes Germany in many situations from taxing transfers to a trust or from a trust, in particular if the grantor`s and the trustee`s fiscal domicile is in the U.S. 

Example: Grantor A is a U.S. citizen with a fiscal domicile in the U.S. transfers € 500,000 into an irrevocable living trust with a U.S. corporate trustee, who holds the assets for a beneficiary with a fiscal domicile in Germany. As the grantor`s fiscal domicile is in the U.S., Germany may only tax the transfer if the trust is deemed a legal entity which is fiscally domiciled in Germany. As the trustee clearly has no fiscal domicile in Germany, Germany may not tax the transfer despite the fact that the beneficiary is a German tax resident. 

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 being 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 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. There are significant issues with this opinion and practitioners and scholars have opined that it conflicts with the clear wording of the Treaty, would result in double taxation, and there is no justification for double taxation.

Thus, any decision rendered pursuant to the Ministry’s analysis should be ripe for appeal. 

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