German Federal Fiscal Court: A legacy of German Real Estate is not subject to limited inheritance tax liability

The Federal Fiscal Court (Bundesfinanzhof) has held, that the legacy (Vermächtnis) of a domestic property (Inlandsvermögen) is not subject to limited inheritance tax liability (beschränkte Erbschaftsteuerpflicht). See Judgement of the Federal Fiscal Court dated 23. November 2022 - II R 37/19.

Excerpts from the  judgment

"2. If a claim to the transfer of a domestic real property is acquired by way of a bequest and if the prerequisites for unlimited tax liability pursuant to § 2 (1) No. 1 or No. 2 ErbStG are not met, this claim to payment in kind is not subject to limited tax liability pursuant to § 2 (1) No. 3 Sentence 1 ErbStG.

a) § 2 (1) No. 3 ErbStG also includes an acquisition by bequest within the meaning of Sec. 1 (1) No. 1 in conjunction with  § 3, Subsection 1, No. 1, Alternative 2, Inheritance Tax Act. The provision presupposes - like § 2, Subsection 1, No. 1 and No. 2, ErbStG, which contain a direct reference to § 1, Subsection 1, ErbStG - a taxable transaction within the meaning of § 1, Subsection 1, ErbStG. The phrase "in all other cases" refers to cases that are not already covered by § 2, Subsection 1, Nos. 1 and 2, ErbStG, i.e., cases in which there is no unlimited tax liability. This does not imply a restriction to certain taxation situations.

b) The object of the accrual of assets within the meaning of § 2.1 No. 3 Inheritance Tax Act by bequest, which creates a claim to the transfer of a co-ownership share in a domestic plot of land, is not the proportionate domestic plot of land, but rather the claim in kind to the creation of co-ownership in this plot of land. This claim is neither domestic real property within the meaning of § 121 No. 2 BewG (…) nor is the claim to be assigned to one of the other categories listed exhaustively in § 121 BewG.aa) Pursuant to § 1939 BGB, a legacy exists if the testator bestows a pecuniary benefit on another without appointing him or her as heir. Pursuant to § 2174 of the Civil Code, a bequest gives rise to a claim by the beneficiary against the heir for performance of the bequeathed object. Under German law, the bequest does not pass in rem of its own accord, but only establishes a right of claim against the person to whom it is made (so-called "legatee of the estate"; (…). The claim to a legacy under the law of obligations is then to be fulfilled in rem. In the case of land, this is done by transferring ownership of the land to the legatee and entering it in the land register (§§ 873, 925 of the Civil Code and §§ 20, 29 of the Land Register Code; see Grüneberg/Weidlich, loc.cit., § 2174 margin no. 4).

bb) Pursuant to § 2.1 No. 3 Sentence 1 of the Inheritance Tax Act, the limited tax liability applies to the accrual of assets consisting of domestic assets within the meaning of § 121 Bewertungsgesetz (BewG). Pursuant to § 121 No. 2 BewG, this includes domestic real property. This must be the object of the acquisition. A mere claim under the law of obligations to the transfer of domestic real property as the object of the acquisition is not sufficient.

cc) An extended interpretation of § 121 BewG to include legacies aimed at the transfer of domestic real property is out of the question. The formulations selected in § 121 BewG are conclusive. In no. 7 and no. 8 of § 121 BewG, only the claims defined in more detail therein are regarded as domestic assets. For § 121 no. 7 FL, it is a prerequisite that the claim is secured, among other things, by domestic real estate. § 121 No. 8 FL only covers certain claims under commercial law and also requires that the debtor has a domicile, habitual residence, registered office or management in Germany. A claim to the transfer of a co-ownership share in real property, on the other hand, is not mentioned in § 121 BewG.

dd) An interpretation contrary to the clear wording of § 2 (1) No. 3 Sentence 1 ErbStG in conjunction with § 121 No. 2 BewG§ 121 No. 2 BewG would only be possible in the absence of an intention of the legislator confirming the literal interpretation if a sensible application of the law required the deviation, i.e. the literal interpretation led to a result contrary to the meaning which the legislator could not have intended (cf. BFH judgment of 20 August 1985 - VII R 182/82BFHE 144, 465BStBl II 1985, 716, under II.2.b). However, such an exceptional case does not exist. In the case of a claim for payment in kind for the transfer of a co-ownership share in Germany obtained by bequest, the domestic reference is significantly weakened in comparison to the acquisition of ownership ipso iure - as in the case of inheritance under German law. In contrast to the acquisition of ownership of domestic real property, for example, by inheritance, the acquisition of a claim to the transfer of ownership of domestic real property at the time of acquisition does not ensure that the acquirer will ultimately also receive ownership of the domestic real property. In such cases, it is also conceivable that the claim for transfer of ownership will remain and the transfer of ownership will never be executed. Therefore, an interpretation other than the one made in accordance with the wording is neither teleologically nor systematically indicated. If the legislator also wanted to regard a claim to transfer of ownership of real property in Germany as domestic real property, this would have to be expressed unambiguously in the wording of § 121 BewG.

ee) A link under inheritance tax law to the real property located in Germany is also not required because under foreign legal systems a legacy can have direct effect in rem (so-called vindication legacy; cf. on a legacy under Colombian law Federal Court of Justice judgment in NJW 1995, 58, under III.). In Germany, in 2013, the year of the testator's death, such a legacy was to be treated under civil law as a legatee of damnation pursuant to section 2174 of the Civil Code (see Federal Court of Justice judgment in NJW 1995, 58, under III.).

(...)
 

ff) This interpretation of § 2 (1) No. 3 Sentence 1 ErbStG in conjunction with § 121 No. 2 BewG§ 121 No. 2 BewG does not conflict with the BFH ruling of 06.05.2021 - II R 34/18 (BFHE 272, 521). There, unlike in the case in dispute, it was not the question of the limited tax liability that was to be assessed, but rather the valuation of the claim to the surrender of the granted object acquired by way of a power of attorney in kind. With regard to the acquisition, the Senate expressly states that the object of the acquisition is the claim under the law of obligations against the heir. In the case of the so-called bequest in kind, it is the claim to the surrender of the object granted by way of bequest, but not the object itself. Only for the valuation of the claim for the purposes of inheritance tax does it correspond to established Senate case law that the claim to the surrender of an object is to be valued according to the tax value of the object granted by way of bequest (BFH ruling in BFHE 272, 521, margin no. 22, with further references).

Analysis

The Court’s decision and analysis surprised many practitioners. The Court’s ruling suggests that it may be possible for a testator, who is not German tax resident (Inländer)  and who have real property located in Germany, to transfer such property by Will free of German inheritance tax to a beneficiary who is not German tax resident (Inländer), if this is done by way of a bequest (Vermächtnis). This structure does not appear to constitute an abusive tax scheme (Missbrauch von rechtlichen Gestaltungsmöglichkeiten) in the meaning of § 41 AO,  as this section does not address all tax planning structures. In addition, there are often factual and practical justifications for engaging in such estate planning. 

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