Taxation of US-Trusts under German law
This article provides a brief introduction to the taxation of US-trusts under German tax law.
Trusts are a fundamental component of traditional estate planning in common law jurisdictions. Yet, they are virtually unknown in German Civil law. 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 describes the legal framework applicable to common law trusts and provides recommendations for the avoidance of tax traps associated with German tax law.
Trusts in German Civil Law
Trusts are virtually unknown in German Civil law. Accordingly, it is not possible to transfer assets located in Germany to a trust whether during the lifetime of the Grantor or upon death). However, such a transfer does not necessarily have to be without effect. The trust may be interpreted as a German legal instrument which has similar effects, e.g. a foundation (Stiftung), durable execution of the estate (Dauertestamentsvollstreckung) or subsequent heirship (Vor- und Nacherbschaft).
Taxation of Trust under the German Inheritance Tax Act
General Concept of German Inheritance and Gift Tax
German inheritance and gift tax law is codified in the German Inheritance and Gift tax Act (hereafter “Inheritance Tax Act”). Additionally, other German tax laws, such as the General Revenue Code (Abgabenordnung, hereinafter AO) and the Foreign Tax Act (Außensteuergesetz, hereinafter AStG) contain relevant provisions. Contrary to U.S. federal estate tax, German inheritance taxes do not tax the estate itself, but instead the acquisition of each beneficiary is taxed. Tax free exemptions are granted per capita. Tax rate and tax free exemptions depend on the familial relationship between the deceased and the beneficiary. As there is no familial relation between a trust (deemed to be a legal entity) and the grantor/trustee/beneficiary, one may assume that the least favorable tax classification is applicable. However, there are certain provisions that prevent this tax adverse scenario with respect to trust distributions (see below).
Trust as deemed legal entities under the German Inheritance and Gift Tax Act.
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. Following the introduction of regulations drafted to target tax avoidance in 1999, the German government enacted provisions that provided for the taxation of transfers to a trusts, unless the trustee is, from a German perspective, a mere agent of the Grantor or the trust is merely used as shell as the Grantor retains all rights (e.g. most grantor trusts / grantor interested trust). Thus, if the Grantor has the right to the following, the trust will not be deemed a legal entity and any transfer to the trust will not be taxed:
- To change 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).
Should the Grantor lose the requisite control of the trust assets (e.g. following the creation of the trust through death) and the (successor) Trustee holds the trust assets in favor of a beneficiary without being obliged to distribute the trust assets to the beneficiaries without delay (like an executor or administrator), German inheritance tax is triggered (see decision of the German Federal Fiscal Court dated 27th September 2012, file number II R 45/10). 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 only applies to non-transparent trusts.
Tax liability in Germany
Of course, when there is no nexus to Germany, any transfer of assets (outside of Germany) to a trust or distribution will not be subject to German taxation. However, it should be noted that Germany taxes the worldwide acquisition upon death. Further, any lifetime gift, if either the beneficiary or the deceased/donor has a residence in Germany at the time of his death, is subject to taxation.
An individual is a German resident if he or she has either a permanent home (§ 8 German General Tax Code) or a habitual abode (§ 9 German General Tax Code) in Germany. A “permanent home” does not necessarily have to be the principal home of the individual. A taxpayer has a permanent home in Germany if he possesses a home in Germany under circumstances from which it can be assumed that he will keep this home and use it.
The German Federal Fiscal Court has ruled that even a stay of several weeks may meet these requirements if it is on a regular basis for several years. Thus, in many cases, persons who own property in Germany are unexpectedly subject to taxation in Germany with respect to German inheritance and gift taxes.
If the German – American Convention for the Avoidance of Double Taxation with respect to taxes on estates, inheritances, and gifts is applicable, the fiscal domicile is deemed to be in the State in which his personal and economic relations are closest if the person had more than one home in the meaning of the Convention. Additionally, a U.S.-citizen moving to Germany is deemed to be for another 10 years to be domiciled in the U.S. Thus, in relation to the U.S., the risk of having a nexus to Germany is far lower.
Taxation of the creation of a trust, management of the trust and distributions to beneficiaries
If the trust is deemed a legal entity for tax purposes (not tax transparent) and there is a nexus to Germany, the transfer, management and distributions of the trust may have tax consequences in Germany.
Taxation of Asset Transfers to Inter Vivos Trusts
Pursuant to § 7 Section 1 Lit. 8, Sentence 2 of the German Inheritance Tax Act, transfers of assets to a trust, that is deemed a legal entity for tax purposes, trigger German gift tax. There is a nexus to Germany, if either the Grantor or the Trustee is domiciled in Germany at the time of the transfer as defined by the German-American Double-Taxation Agreement. If only the beneficiary is domiciled in Germany, no German gift tax is triggered by the mere fact of transferring the assets to the trust.
Example One: Grantor A, U.S. citizen, without a residence/habitual abode in Germany, transfers € 500,000 into an irrevocable living trust 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 least favorable tax class III, which provides for a minimal € 20.000 tax-free allowance and tax rates from 30% to 50%.
Example Two: Grantor A transfers € 500,000 to an AB Trust, which is managed by a person fiscally domiciled in Germany. Upon transfer of the assets to the trust, a tax base of € 480,000 would be found resulting in a tax assessment of € 144,000. Calculations: Taxes payable at transfer: Transfer to the Trust = Taxable acquisition of the trust: €500,000 Tax allowance under § 16 German inheritance tax Act: - €20,000 Tax Base: €480,000 Application of tax rate according to § 19 German inheritance tax Act (x 0.3) = Tax Due: € 144,000
Taxation of a trust upon death
If a non-tax-transparent trust is created upon the death of the grantor and the trust has a nexus to Germany, German inheritance tax is triggered. § 3 Section 2 lit 2 German Inheritance and Gift Tax Act. There is a nexus to Germany, if either the Grantor or the Trustee is domiciled in Germany at the time of the creation of the trust. If only the beneficiary is domiciled in Germany, no German gift tax is triggered by the mere fact of transferring the assets to the trust. If the successor trustee shall without delay distribute the trust assets to the beneficiaries, the trust is tax transparent and the death of the grantor has no tax consequences in Germany.
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 of the German Inheritance and Gift Tax Act. The applicable tax class is determined by the familial relationship between the Grantor and the beneficiary (see § 15 Section 2 Sentence 2 of the German Inheritance and Gift Tax Act). Any distribution within the 10 years preceding the final distribution is added to the taxable acquisition for the calculation of the tax (see § 14 of the German Inheritance Gift Tax Act).
Example Three: In 2001, Grantor A transfers €500,000 to an AB trust (tax consequences, see Example two). The trustee is T, a professional trust manager residing in Germany. Under the terms of the trust instrument T is free to administer the trust assets. The income of the trust (€100,000) is distributed to the A`s son B during the lifetime of A. Upon the death of A the trust assets are distributed to A´s son, B (beneficiary). Final distribution (€500,000) + Distributions to B in the last 10 years (€100,000) = Total taxable acquisition: € 600,000. Tax base after deduction of tax allowance (€400,000) = € 200,000
Tax due (see tax table): € 22,000
Total Tax due (Transfer of assets to the trust + Tax an distribution): € 166,000
Taxation of Distributions during the existence of the Trust
Distributions during the existence of the trust are subject to German gift tax under § 7 Section 1 Lit. 9 Sentence 2 of the German Inheritance Tax Act (see decision of the German Federal Fiscal Court dated 27th September 2012, file number II R 45/10). Unfortunately, the German Federal Fiscal Court has not clarified in his decision dated 27th September 2012 (file number II R 45/10) if this excludes German income taxation. However, an inference can be made from previous decisions of the German Federal Fiscal court that if the distribution is subject to German gift tax, no income tax is payable on capital distributions.
As in the case of taxation of the final distribution of trust assets, the tax class is determined by the familial relationship between the Grantor and the beneficiary (see § 15 Section 2 Sentence 2 of the German Inheritance Tax Act).
Income Tax Assessment
As the German tax authorities do not recognize a trust as a legal entity for income tax purposes, the trust is not subject to income taxation under German tax law. While the trust as an entity may not be subject to taxation, the income will be attributed to a Grantor with a fiscal domicile in Germany who will be subject to income taxation. The taxation imposed on the Grantor is irrespective of whether the income is reinvested or distributed to the Grantor or the beneficiaries. If the Grantor has no fiscal domicile in Germany, the income of a “family trust” is attributed to the taxable income of the beneficiaries with fiscal domicile in Germany regardless if any payments are made to the beneficiaries. See § 15 German Foreign Tax Act. A trust is a “family trust” in the meaning of German tax law, if the Grantor, his close relatives or their offspring are beneficiaries of at least 50 % of the trust assets. The taxation imposed on the beneficiary is irrespective of whether the income is reinvested or distributed to the beneficiary.
Please note: Distributions during the existence of the trust are subject to German gift tax, Accordingly, some German lawyers have opined that there is a risk of double Taxation. Regardless, previous decisions of the Federal Fiscal Court indicate that the gift tax generally overides any Obligation to pay income tax.
§ 15 German Foreign Tax Act is not applicable if the Grantor does not lose control of the transferred assets (see above). In this case, the trust assets and the income of the trust will be attributed to the Grantor. § 15 German Foreign Tax Act is also not applicable, if the trust is managed in the EC or EEC.
- If the Grantor has a fiscal domicile in Germany it is advantageous to avoid the creation of a trust that is deemed to be a legal entity under German tax law.
- A trustee who has a fiscal domicile in Germany should not be named if the trust is deemed to be a legal entity under German tax law.
- If one of the beneficiaries has a German tax domicile, but may want to leave Germany in the future, the creation of a trust that is not transparent under German law should be considered. The beneficiary may avoid taxation of trust distributions by moving out of Germany.
- If more than one family member lives in Germany, consider making distributions to each of them individually as the tax free amount is granted per capita.
- If there is more than one generation living in Germany, consider skipping one generation. There is no generation skipping tax in Germany.
- Do not transfer German assets to a trust. Trusts are not recognized by German civil law.
- If the beneficiaries are minors or there is any other reason to retain rights in the estate, use German legal instruments that are similar to a trust in replacement of a trust.
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