Written By: Anka Hakert, Esq.
American trusts are created for several purposes as asset protection, privacy, tax avoidance and wills planning. Trusts are therefore very popular as an instrument for estate planning. All too frequent it is hereby overlooked that in case there is a nexus to Germany, German tax may be levied.
In principle American trusts are unknown to German civil law. However, with the purpose to stop tax avoidance by transferring assets to a foreign trust the German legislator implemented some regulations which take several actions concerning foreign estate like American trusts under taxation. As it is laid down in Section 3 Para 2 (1) and Section 7 Para 1 (8) and (9) German Estate Tax Act the provision of a trust and all the distributions to beneficiaries are laid down under estate tax or gift tax (both types are regulated in the German Estate Tax Act and are handled similar). Precondition of the taxation is that there is a nexus to Germany. Such a nexus exists in case the settlor, the trustee or the beneficiary has his residency in Germany or is a German citizen with residency abroad up to five years. However, these new regulations keep several open questions which haven’t yet been answered neither by the courts nor the tax authorities.
In many cases with nexus to Germany the beneficiary resides in Germany. Even if the settlor’s residency is in the US and the trust is an American one with all real estate located in the US, as soon as the beneficiary takes up residency in Germany he may be affected by German taxation although he is an American citizen. Principally the American-German Estate and Inheritance Tax Treaty refers the place of taxation to the country where the testator or donor has its primary residence. But pursuant to Art. 11 of that treaty Germany has reserved its right to levy estate tax from the heir regardless where the settlor’s residency is.
As it is laid down in Section 7 Para 1 (9) in conjunction with Section 9 Para 1 (2) German Estate Tax Act, in principle all distributions during the existence of the trust and the final distribution of all the principal to the beneficiary is subject to German gift tax or estate tax at the time of the distribution. If the beneficiary achieves an irrevocable expectant right on all principal and distributions upon the settlor’s death the question may arise, whether this expectant right will already cause German estate tax. There is a regulation laid down in Section 15 Para 1 German Foreign Transaction Tax Act, which ascribes principal and income to beneficiaries for taxation purposes in case they have an expectant right on it. But this principle doesn’t apply for estate tax (Section 15 Para 1(2) German Foreign Transaction Tax Act), so for estate tax or gift tax purposes the expectant right is of no significance. Estate tax will only be levied in case of actual inflow.
But all this depends on the trust category. Even though the main structure of trusts is similar there are many varying types depending on the characteristics and the purpose of the trust. The German Estate Tax Act on the other hand takes only trusts under taxation whose purpose is the tying up of assets. This German specification of the trust has to be taken under examination in every individual case as it depends not only on the American category as a revocable or an irrevocable trust. A trust with the purpose of tying up assets may not be assumed in case the trust is revocable, terminable without any requirements, the trustee is bound to the instructions of the settlor and the settlor has a significant influence to investment decisions. But it is highly controversial, when the purpose of a trust is the tying up of assets, and this aspect should therefore be taken under examination carefully. Only in case the trust is one with tied-up assets, German estate tax will be levied from the beneficiary not before the time of the distribution. If the trust is not one with tied-up assets the beneficiary receives the assets right upon the settlor’s death and be levied with estate tax immediately. So, first of all the German category of the trust has to be resolved by an expert under consideration of current judicial decisions.
If the beneficiary hasn’t yet resided in Germany for ten years, Art. 4 Para 3 American-German Estate and Inheritance Tax Treaty would eventually eliminate estate tax at all. According to the letter of that regulation estate tax will not be levied in case the decedent (with residency in Germany upon his death) has stayed in Germany for not longer than ten years. It is controversial if this provision is applicable to the heir, too, although this point of view might be vindicated with good reason. But one should not trust on it without obtaining expert advice for one’s individual case.
In case estate tax was levied, in principle the heir would get some tax credit in Germany for estate tax paid in USA. Pursuant to Art. 11 Para 3 lit. b American-German Estate and Inheritance Tax Treaty principally the tax credit method would be applied, so that Federal estate taxes paid in the USA would be deducted from the German estate tax (for estate tax of member states Art. 11 Para. 4 DBA-E USA is applicable). But the American estate tax situation should be examined carefully. The tax deduct could be different in individual cases, for example if the US gave some tax breaks.
In view of the extensive implication and the not distinct legal consequences in all cases, the legal classification of the trust category and the tax effects also considering the American-German Estate and Inheritance Tax Treaty should be taken under examination in good time to have an early opportunity for changes in estate and gift tax planning. To avoid any German tax effects the time of residence in Germany has to be kept in mind with regard to Art. 4 Para 3 American-German Estate and Inheritance Tax Treaty. But no decision should be taken without having recourse to legal advice before.
In cases where the settlor’s residency is in Germany principally the creation and provision of a trust is taken under German taxation pursuant to Section 3 Para 2 (1) and Section 7 Para 1 (8) German Estate Tax Act. This provision also presupposes that the trust is one with tied-up assets. On contrary to the case mentioned above (where the nexus to Germany is the beneficiary’s residence) Art. 4 Para 3 American-German Estate and Inheritance Tax Treaty will exclude estate tax if the settlor with American citizenship resides in Germany up to ten years. Anyhow, to assess the tax situation properly and to avoid any risk, settlors with residence in Germany should obtain early expert advice.
Despite of the settlor’s and beneficiary’s residence, the residence of the trustee has to be taken under consideration, too. If the trustee’s residence is in Germany the tax authority could consider the management of the trust as situated in Germany. In case the settlor with residence in the US founds a trust or provides an already existing trust with further assets this could be levied with gift tax pursuant to Section 7 Para 1 (8) German Estate Tax Act. Additionally it may not be overlooked that even if neither the settlor’s, the trustee’s nor the beneficiary’s residency is in Germany, assets situated in Germany could be subject to German taxation (limited tax liability). Pursuant to Section 2 Para 1 (3) German Estate Tax Act and Art. 5 Para 1 American-German Estate and Inheritance Tax Treaty real estate in Germany could be subject to German taxation. Tax credit might be given by the American tax authority pursuant to Art. 11 American-German Estate and Inheritance Tax Treaty.
Despite of estate and gift tax the income tax situation has to be taken under consideration. Usually assets are held in the trust which produces income such as from renting out or leasing real estate or income from savings and capital investments. In case the settlor with residence in Germany has significant influence to investment decisions the income may be attributed to the settlor with the consequence of income taxation even if there are no distributions. But even without significant influence by the settlor income tax may be levied if the management of the trust is considered in Germany because of the trustee’s residence there. Despite of influence on investment decisions the income tax situation depends also on the question whether the trust is a so-called family trust. A trust will be considered as a family trust if the settlor, his relatives or their children are beneficiaries to more than half of the income or estate. Pursuant to Section 15 German Foreign Transaction Tax Act in this case the income will be attributed either to the settlor or the beneficiary with residency in Germany.
According to all the tax consequences mentioned above the will and estate planning will have to contemplate German taxation if there is a nexus to Germany. The taxation of trusts in Germany is highly controversial in many points and the risk of being levied with German tax should not be evaluated without considering individual aspects. In cases with an expected nexus to Germany early expert advice is highly recommended.