The German Federal Tax Court clarified that distributions from foreign trusts to beneficiaries resident in Germany are subject to German gift taxation, but did not address the possible imposition of both gift and income tax on such distributions. There remain substantial tax risks when using a trust as an estate-planning tool when the beneficiary is resident in Germany.
In a recently published ruling, the German Federal Tax Court dealt with U.S. trusts and gift tax on trust distributions. The court of last resort with jurisdiction over tax matters clarified that distributions from foreign trusts to all beneficiaries resident in Germany are subject to German gift taxation (Bundesfinanzhof, September 27, 2012, II R 45/10). However, the decision did not clarify how this gift taxation relates to income tax on trust distributions. Therefore, using a trust as an estate-planning tool bears significant tax risks when the beneficiary is resident in Germany.
Because the common law trust is foreign to German civil law, there are only a few federal court rulings pertaining to trusts. German tax rules, on the other hand, are strict and may have a punitive effect, since the German legislative body seems to be highly suspicious about trusts, although they are commonly used in estate planning for U.S. assets.
Link to Germany
Settlors and beneficiaries of a trust should pay special attention to tax consequences in Germany if either the settlor or any beneficiary is resident or has his or her habitual abode in Germany. U.S. and multinational families may have children, grandchildren or other relatives residing in Germany who are or may become beneficiaries of a trust. In addition, Germans who emigrated to the United States and want to pass on U.S. property to the next generation by using a trust must be careful. They may be still be linked to Germany if they regularly use a second home in Germany or stay in Germany for longer than six months a year without interruption. A common situation is that the senior generation of the family is no longer subject to tax in Germany, but their children or grandchildren have become resident in Germany as a result of working in the family business.
German Gift Taxation of Trusts
Using a trust for estate planning can trigger German gift tax in different situations:
- A German tax resident who is setting up a trust may face German gift taxation, because Germany imposes gift tax on transfers to a trust qualifying as such under the German Inheritance and Gift Tax Act (Erbschaftsteuergesetz). This is true for irrevocable and discretionary trusts if the settlor loses control of his or her assets by transfer to the trust.
- During the existence of a trust, distributions to beneficiaries who are tax resident in Germany and qualify as an “intermediate” beneficiary (Zwischenberechtigter) under the German Inheritance and Gift Tax Act are subject to German gift taxation.
- On termination of a trust, Germany imposes gift tax on all distributions of assets if the beneficiary is tax resident in Germany.
Clarifications by the German Federal Tax Court
In the case at hand, the German Federal Tax Court clarified that any person who receives a trust distribution during the existence of a trust qualifies as a so-called “intermediate” beneficiary, and therefore all distributions to beneficiaries who are tax resident in Germany are subject to German gift tax. German tax authorities have long taken this view. However, some commentators questioned whether a beneficiary who is entitled to distributions from the trust upon termination qualifies as an “intermediate” beneficiary. In contrast to its broad interpretation, the court stated that a settlor who becomes a beneficiary of his or her own trust after some time might not qualify as an “intermediate” beneficiary. The court also pointed out that distributions during the existence of a trust cover both principal and income.
Avoidance of German Gift Tax
German gift tax can be avoided in some cases by cutting off any link to Germany. The settlor or a beneficiary may give up his or her residence or habitual abode in Germany, or the trust deed could provide that a beneficiary’s entitlement to benefit from the trust (during its existence and upon termination) is suspended as long as he or she resides in Germany. For German citizens, merely moving away will not suffice immediately. According to a special rule in connection with the double taxation treaty between Germany and the United States on estate tax, a citizen of Germany may still be deemed to be gift tax resident in Germany for 10 more years after giving up his or her residence in Germany.
Income Tax Aspects
Because the court decision focuses on gift tax only, it does not address the possible imposition of both gift and income tax. There is also a significant risk of double taxation with gift tax and income tax, because trust distributions may qualify as taxable income of a beneficiary who is tax resident in Germany. But even if there is no distribution of trust assets, the mere entitlement of the settlor or a beneficiary may result in German income taxation. Under a special rule in the German Foreign Tax Act (Außensteuergesetz), the income of a trust can be attributed to an individual residing in Germany and therefore be subject to German income tax.