Recent Developments in Germany for Closely-Held Businesses and Private Clients

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1 Recent Developments in Germany for Closely-Held Businesses and Private Clients Inheritance Tax Reform of 2016 / New Cultural Property Act in 2016 / Taxation of Trusts, Settlors and Beneficiaries / Exit Tax / Sec. 50i ITA by Dr. Manfred Reich A. Inheritance Tax Reform of 2016 The German Federal Constitutional Court ruled on December 17, 2014 that the relief model for business property that granted tax relief of 85% or 100% of the value of acquired business assets was unconstitutional. The court gave the legislature until June 30, 2016 to amend the relief model for business assets and stated that the unconstitutional provisions will apply until the new provisions take effect. The coalition s agreement was published on June 21, 2016 and the German parliament gave its approval on June 24, 2016 (BT-Drs. 18/8911). But the representatives of the German federal states rejected the coalition s agreement on July 8, 2016 and demanded further amendments to the proposed relief models. As the amendment deadline of June 30, 2016 was not met, the German Federal Constitutional Court stated on July 14, 2016 that it will discuss an additional decision if the reform process is not finished by the end of September. The representatives of the German federal states and representatives of the German parliament tried to find an agreement on September 8, 2016 but failed. They discuss the so-called flat tax model again (no relief and tax rate e.g. 11%). The next meeting will be on September 21, Now the reform process has been under way for more than 20 months and is still not completed. The relief models for business assets are relevant in cases of unlimited, limited or extended limited gift or inheritance tax liability in Germany. The unlimited inheritance or gift tax liability applies especially if the deceased/donor or the heir/legatee/donee has a residence or habitual abode in Germany or is a German who left Germany for not more than five years (ten years FGS_DOC: _2.docx

2 12 September 2016, page 2 of 13 Germany/US). The limited inheritance and gift tax liability is applicable if a person who lives abroad has, for example, an interest in a German partnership with business assets or holds a share of at least 10% (alone or with other closely related persons) in a corporation. The extended limited inheritance and gift tax liability can be relevant for Germans who had unlimited income tax liability for at least five years of the last ten years before leaving Germany. Therefore, the relief models are highly relevant even for people who do not live in Germany. The coalition s agreement published on June 21, 2016 is not expected to be changed significantly in the further reform process unless the so-called flat tax model (no relief and tax rate e.g. 11%) will be preferred and implemented. Two relief models are proposed for persons subject to taxation on the transfer of business assets. According to the standard exemption, 85% of the value of the business assets is not subject to tax. To avoid subsequent taxation, the recipient has to continue to operate the acquired business for a five-year retention period and has to maintain at least 80% of the business s payroll (wage regulation). The second exemption applies to 100% of the value of the business assets. Here, the retention period is seven years and 100% of the business s payroll must be maintained. A heated debate has arisen on whether there has to be a further requirement to opt for the second exemption. In general, all taxable business assets (including the assets of a GmbH & Co. KG) as well as shares in corporate enterprises (shareholdings of more than 25%, alone or with others within a pooling agreement) will profit from the preferential tax treatment. The extent to which interests or shares in holding companies should be excluded from the preferential tax treatment is a subject of great debate. In its agreement published on June 21, 2016, the coalition decided not to implement the proposed holding provisions. According to the decision of the German Federal Constitutional Court, management assets are subject to tax and therefore have to be separated from the preferential business assets. The management assets will be fully taxable at the regular rate insofar as the value of these assets exceeds 10% of the acquired company s assets. In general, the provisions to identify the management assets (catalogue of management assets) are not expected to change significantly in the reform process. However, in the future, the management assets will be calculated and totaled at the group company level (consolidated appraisal of management assets). Therefore, all management assets in the company and its subsidiaries will be taken into consideration and have to be valued.

3 12 September 2016, page 3 of 13 The relief of 85% or 100% can no longer be claimed independently of the value of the acquired business assets. The German Federal Constitutional Court required the extent of the relief to be limited. A particularly complex tax system applies if the value of the acquired business assets exceeds EUR 26 million (all acquired business assets of the deceased/donor within a ten-year period have to be taken into account). According to the ablation model, the relief is reduced by 1% for each EUR 750,000 that exceeds EUR 26 million. Above EUR 90 million, the relief of 85% or 100% for business assets can no longer be claimed. If the value of the acquired assets exceeds EUR 90 million or the transferee opts not to use the ablation model, he can only apply for an examination of the need for relief (Verschonungsbedarfsprüfung). The transferee is not required to use privileged business assets, but he has to use 50% of the value of all other assets that he already owns or that he acquires within a ten-year period to pay the regular rate on the privileged business assets. Furthermore, he has to use 50% of the value of the management assets that he already owns or acquires within a ten-year period also to pay the regular rate for business assets. The total rate for acquired assets that do not qualify as privileged business assets can be 80% or more. This makes the tax planning complicated for entrepreneurs if the value of the privileged business assets exceeds EUR 26 million. Finally, a special tax relief of maximum 30% is planned for family companies. The requirements in the articles of association that have to be fulfilled (for example limitation on disposal and on distributions or withdrawals) are widely disputed. According to the coalition s agreement published on June 21, 2016, the provisions in the articles of association have to be incorporated two years before the relevant transfer and have to remain unchanged and regarded for the subsequent 20 years. Family companies are therefore advised to examine their articles of association and amend them if their provisions do not meet the special requirements of tax relief for family companies.

4 12 September 2016, page 4 of 13 B. New Cultural Property Protection Act in 2016 The reform of the law on the protection of cultural property in Germany became effective on August 6, 2016 (Federal Law Gazette Part I, 1914). As a result, cultural protection legislation in Germany was harmonized and merged into a single act. During the reform process there was uproar on the German art scene: artists, collectors and art dealers alike criticized the proposed legislation and export restrictions. Collectors, art dealers and German artists such as Georg Baselitz removed their works from German museums and took them abroad. But this did not prevent the implementation of special export restrictions for cultural property. According to the new legislation, an export permit is mandatory for works that exceed certain age and value thresholds. For example, paintings that are older than 75 years and worth more than EUR 300,000 require special permission to be exported and sold outside Germany. The corresponding thresholds for exports and sales of paintings outside the EU are 50 years and EUR 150,000. The competent Germany authority has the power to decide whether a work is so important for German culture that it can be classified as German national cultural property, in which case it may not be exported at all. It was e.g. discussed controversially if a Andy Warhol can be qualified as German national cultural property (discussion in respect of the Portigon collection). If the export takes place without official authorization it is illegal. In this case, the German authorities can retrospectively classify the exported cultural good as national cultural property and can enforce its reversion to Germany. In the future it will therefore be very important for art sellers to be able to prove that cultural goods exceeding the thresholds were exported before August 6, 2016 or authorized by the competent authority to be exported after that date. Purchasers of German cultural property are strongly recommended to request evidence of the authorization before signing the purchase agreement. Cultural goods that were exported before August 6, 2016 were legally exported at that time. Furthermore, there is a risk that the cultural goods are classified as German national cultural property if they are imported for exhibition in German museums on/after August 6, 2016, for example. In such a case it is very important that the collector receives a certificate or similar

5 12 September 2016, page 5 of 13 from the competent German authority beforehand that the work will be returned and can be exported after the exhibition has ended (Bescheinigung freien Geleits). The special export restrictions e.g. do not apply to cultural goods by artists who are still alive (such as Gerhard Richter and Georg Baselitz). Furthermore, collectors who store their important German cultural goods abroad will now need to review their estate planning to receive the special German inheritance and gift tax relief for cultural property after a relevant transfer. The cultural goods have to be exhibited in museums in the EU/EEA (not in UK after Brexit) and in Germany only with consent from the competent German authority that the work in question will be returned to storage abroad after the exhibition in a German museum has ended. Additionally, the German Federal Tax Court published a decision on May 12, 2016 (Federal Tax Court of May 12, 2016, DStR 2016, 1804) that is good news for art collectors because it makes it easier to receive the special inheritance and gift tax relief.

6 12 September 2016, page 6 of 13 C. Taxation of Trusts, Settlors and Beneficiaries I. Corporate tax liability of a trust/foreign family foundation The concept of a trust is unknown in German civil law. Nevertheless, trusts and foreign family foundations can have their place of management for tax purposes in Germany. Then, unlimited corporate tax liability applies and in general, the worldwide income is taxable in Germany. 1. According to Sec. 1(1) no. 5 of the German Corporate Income Tax Act (CITA Körperschaftsteuergesetz), the trust has to qualify as a separate pool of assets. In general, a discretionary irrevocable trust that is no longer controlled by the settlor (segregation of property) and independently generates income is such a separate pool of assets (Federal Tax Court of February 2, 1994, Federal Tax Gazette Part II 1994, 727; Federal Tax Court of November 5, 1992, Federal Tax Gazette Part II 1993, 388). The family foundation is expressly named in Sec. 1(1) no. 5 CITA. Note: The trustee/family foundation can also act as a fiduciary on behalf of the settlor/beneficiaries (Treuhandverhältnis). This is the case if he/it is subject to strict guidelines imposed by the settlor and the settlor/beneficiaries are empowered to terminate the fiduciary agreement at any time (Federal Ministry of Finance of February 3, 2004, DStR 2004, 1387; Federal Tax Court of June 28, 2007, Federal Tax Gazette Part II, 669). Then, the trustee/family foundation acts only as an asset manager; the assets and its income are directly attributed to the settlor/beneficiaries. No gift tax is triggered by the transfer to the trustee/family foundation and vice versa (e.g. grantor trust, Federal Tax Court of September 27, 2012, Federal Tax Gazette Part II 2013, 84). Sec. 15 of the German Foreign Tax Act (FTA Außensteuergesetz) does not apply. 2. The trust/family foundation has its place of management in Germany if its representatives run the business and make the important decisions there. But the place of management can also be in the country in which other persons who have significant influence on the decisions have their (business) address. Therefore, also the

7 12 September 2016, page 7 of 13 protector or other persons who have significant influence should not have their (business) address in Germany. Note: In practice, if residents of Germany have significant influence on the trustee/family foundation, it often does not qualify as a separate pool of assets. The trustee/family foundation often acts only as a fiduciary on behalf of the settlor/beneficiaries. 3. If the trust/family foundation has its place of management outside Germany, limited corporate income tax liability applies so that only German-sourced income can be taxed in Germany (Sec. 2 CITA, Sec. 49 ITA). II. Taxation of Settlor and Beneficiaries 1. Settlor/beneficiaries subject to tax a. Tax residence and its beginning An individual is a tax resident (with unlimited tax liability) in Germany if he acquires a residence (Wohnsitz) or habitual abode (gewöhnlicher Aufenthalt) in Germany. The terms residence and habitual abode are defined in Secs. 8 and 9 of the German General Tax Code (GTC Abgabenordnung). An intention to acquire a tax residence or a habitual abode in Germany is not necessary. (1) Residence in Germany A person is deemed to have his or her residence at the place where he or she occupies a living accommodation in a manner suggesting that he or she maintains and uses such accommodation. The unlimited tax liability begins at the moment the individual has a residence in Germany. For example, residence in Germany can be established if over a period of years a house is used for four to six weeks twice a year (Federal Tax Court of November 23, 1988, Federal Tax Gazette Part II 1989, 182).

8 12 September 2016, page 8 of 13 (2) Habitual abode in Germany A person has his or her habitual abode at a place where he or she resides in circumstances suggesting that he or she stays at such place or in such area permanently. If a person stays in the country for more than six months, the habitual abode is determined with reference to when the stay begins. b. If the person is a tax resident in Germany, the main tax consequences are: Unlimited tax liability: For income-tax purposes, an individual who is a tax resident in Germany is taxed on his worldwide income. For inheritance and gift tax purposes, a deceased person, donor, heir, legatee or donee who is a tax resident in Germany has unlimited tax liability or Germans who left Germany for not more than five years (ten years Germany/US). If the person is not a tax resident in Germany, only an (extended) limited tax liability applies concerning German-sourced income and German-based assets (Secs. 2 and 4 FTA, Sec. 49 ITA, Sec. 2 (1) no. 3 of the German Inheritance and Gift Tax Act (IGTA Erbschaftsteuer- und Schenkungsteuergesetz), Sec. 121 of the German Valuation Act). Filing status and disclosure obligations: An individual with unlimited tax liability has to file a tax return. A person who becomes a tax resident in Germany has special disclosure obligations, for example if he is involved in foreign companies, foundations or trusts (Sec. 138 GTC, Sec. 17 FTA). The person has the option to voluntarily disclose false or incomplete tax returns to the tax authorities (Sec. 371 GTC).

9 12 September 2016, page 9 of 13 c. Using double taxation treaties to resolve issues of dual residence: (1) Income tax: Germany has more than 100 double taxation treaties (DTTs) with other countries. (2) Gift and inheritance tax: Germany current has DTTs with the USA, France, Greece, Sweden, Denmark and Switzerland (in general, the Swiss DTT applies only for inheritance tax). If no DTT exists, the national rule of crediting foreign taxes has to be checked (Sec. 21 IGTA). (3) The treaties can prevent German tax residence status (Ansässigkeit) and double taxation (crediting taxes/tax exemptions) in cases of dual residence. 2. Taxation of settlors/beneficiaries a. Gift/inheritance tax The IGTA contains specific provisions on the creation, distribution and dissolution of trusts and family foundations. These provisions apply if the settlor and/or the beneficiaries are German tax residents. Article 12(1) DTT- USA for inheritance and gift tax purposes states that, principle, both states reserve the right to apply their respective rules governing the recognition of a taxable event with respect to transfers of property to and from trusts/family foundations. b. Income tax A settlor who is a German tax resident is subject to tax on the income of the trust/family foundation he or she created in accordance with Sec. 15 FTA. In principle, the income is attributed to the settlor/beneficiaries if the trust/family foundation has its registered office and place of management

10 12 September 2016, page 10 of 13 abroad but qualifies as a trust/family foundation (50% of the property/income of the separate pool of assets is for the benefit of the settlor and family members, Sec. 15(2) and (4) FTA). Sec. 15 FTA is a treaty override. The DDTs cannot prevent the attribution of the income of the family foundation/trust (Sec. 20(1) FTA). The German Federal Constitutional Court decided on December 15, 2015 that treaty overrides are constitutional (Federal Constitutional Court of December 15, 2015, DStR 2016, 359). Furthermore, Art. 1(6) DTT-USA for income tax stipulates that Germany can apply the German CFC rules (Sec. 15 FTA), but it is a matter of debate as to whether Sec. 15 FTA applies if an election in accordance with Art. 12 DTT-USA for gift and inheritance tax was made. According to Sec. 20(1) no. 9 of the German Income Tax Act (ITA Einkommensteuergesetz), the flat tax system can apply for distributions of the trust/family foundation (25% plus solidarity surcharge and, if applicable, church tax). In the past, according to case law the application of Sec. 20(1) no. 9 ITA was refused if the distributed income was already taxed in accordance with Sec. 15 FTA (income attributed to the settlor/beneficiaries; Federal Tax Court of February 2, 1994, Federal Tax Gazette Part II 1994, 727). Section 15(11) FTA, implemented in 2013, expressly excludes the double taxation of distributed income that was previously taxed in accordance with Sec. 15(1) FTA. Section 20(1) no. 9 ITA applies if Sec. 15 FTA is not applicable (e.g. the separate pool of assets has its registered office or place of management in an EU/EEA member state). Additionally, Sec. 20(1) no. 9 ITA can apply for distributions of the trust capital. Trusts that are resident in third countries cannot refund distributions out of the tax contribution account within the meaning of Sec. 27 CITA (steuerliches Einlagenkonto). This is a matter of debate, and new case law is expected. An important question is whether a gift tax on the distribution is triggered in addition. The Federal Tax Court has serious doubts on whether, additionally

11 12 September 2016, page 11 of 13 to the income tax within the meaning of Sec. 20(1) no. 9 ITA, a gift tax can be imposed on the distribution of a foreign family foundation (Federal Tax Court of July 21, 2014, BFH/NV 2014, 1554). Furthermore, it is debated in German literature whether the new Sec. 15(11) FTA also excludes gift tax. Neither is it completely clear whether the settlor is an interim beneficiary (Zwischenberechtigter) within the meaning of Sec. 7(1) no. 9 IGTA (Federal Tax Court of September 27, 2012, Federal Tax Gazette Part II 2013, 84 for grantor trust). New case law is expected. If the trustee/family foundation acts as a fiduciary on behalf of the settlor/beneficiaries, the income is attributed to the settlor/beneficiaries and has to be declared in his/their income tax return. No gift tax applies for transfers between settlor and trustee/family foundation or vice versa.

12 12 September 2016, page 12 of 13 D. Exit Tax / Sec. 50i ITA I. Sec. 6 FTA exit tax An individual who has been a tax resident of Germany for at least ten years and who terminates his German residence while he holds a stake in a domestic or foreign corporation covered by Sec. 17 ITA, i.e., who holds or has held within the five years preceding the termination a share interest of 1% or more, will be deemed to have realized a capital gain in the amount by which the fair market value of the share interest at the time the individual terminates his German residence exceeds the individual s cost basis in the shares, as if the individual had sold or otherwise disposed of the share interest (Sec. 6(1) FTA). Other circumstances can also trigger the exit tax, e.g. the share interest is donated or bequeathed to a person who does not have unlimited tax liability in Germany; or an individual keeps his German residence and takes residence in another county and under the DTT has his single tax residence (Ansässigkeit) in the other state. It is also discussed in Germany whether the amendment of a DTT can trigger exit tax if the German right to tax is ruled out or restricted due to the amendment. If the individual is a resident of an EU/EEA Member State and moves his residence to another EU/EEA Member State, the exit tax can be deferred until, for example, the shares are actually sold subject to compliance with annual reporting requirements (by January 31, address and ownership; otherwise, the tax deferral can be revoked) and other criteria. II. Sec. 4(1) sentence 3, 50i ITA exit tax/capital gains tax German exit tax can also be triggered if, for example, a limited partner of a German GmbH & Co. KG that does not qualify under Art. 7 DTT terminates his German residence.

13 12 September 2016, page 13 of 13 Section 50i ITA can also trigger capital gains tax if shares in a German GmbH & Co. KG are donated or bequeathed to foreign and/or German tax residents. Section 50i ITA can also apply if such a partnership is transformed. The Federal Ministry of Finance published a decree on December 21, 2015 in which German tax authorities state their interpretation of this provision especially which requirements have to be fulfilled to prevent a taxation (Federal Ministry of Finance of December 21, 2015, Federal Tax Gazette Part I 2016, 7). Dr. Manfred Reich Lawyer, Certified Inheritance Lawyer, Tax Advisor Associated Partner Flick Gocke Schaumburg Partnerschaft mbb MesseTurm, Friedrich-Ebert-Anlage Frankfurt/Main Germany manfred.reich@fgs.de