Taxing German beneficiaries

Introduction

The authors first gave an overview of Germany’s legal treatment and taxation of trusts in the September 2020 edition of the Trust Quarterly Review.^[2] At the time, a German Federal Fiscal Court (the Court) decision had provided clarity on the gift tax treatment of distributions from foreign (non‑German) foundations to German beneficiaries. In the decision of 25 June 2021, the Court applied the same principles to trusts.

The treatment of a trust in the German legal system

Although some countries of Continental Europe recognise trusts and have even enacted trust laws, it is not a traditional instrument of the civil‑law system of Europe. The Continental European law tradition has developed other legal forms to achieve similar results as with a trust; in particular, certain structures in inheritance law (e.g., bequests, usufructs, etc.) and foundations. However, the legal basis of these structures is not comparable with a trust. Therefore, the German civil‑law system has to find its own answer to the question of how to treat a trust. This answer remains quite unsatisfactory: since the German civil‑law system does not acknowledge the trust, it does not exist as such. Any trust arrangement has to be reinterpreted as the native German legal institution that comes closest to the intended effect of the trust in the individual case. In particular, this can be:

• the institute of pre‑ and post‑inheritance;
• a usufruct;
• a suspended or temporary inheritance; or
• the permanent execution of the will.

Since the trust is not acknowledged by the civil‑law system in Germany, it cannot be entered into a public register, such as the commercial register or the land register, with the result that its ability to acquire assets in Germany is limited.

Legal type comparison of a trust

For German income, inheritance and gift tax purposes, the trust, like other foreign legal forms, must be classified based on a comparison with native German legal forms or instruments, according to a so‑called legal type comparison (Rechtstypenvergleich), in order to make it manageable for the German tax system. In particular, a trust may be treated as an independent property fund (selbständige Vermögensmasse) similar to a corporate entity (non‑transparent or opaque) or as a partnership or fiduciary arrangement (transparent). Specific legal regulations for the classification of a trust do not exist and indications of the tax administration are sparse. Tax practitioners essentially draw on case law, according to which the legal type comparison of a trust must be determined in each individual case on the basis of the structure of the trust relationship.^[3] The trust deed, a last will of the settlor and any ‘letter of wishes’ or similar provided by the settlor in the course of the settlement of the trust are used. Actual circumstances must also be taken into account. Of particular relevance is the question of who can dispose of the assets and income of the trust, who is in charge of the management of the trust’s assets and who is actually exercising it.^[4] This view has been confirmed in two recently published decisions.^[5] In any case, the overall circumstances of the individual case must be examined.

If the characteristics of the trust are comparable to a German corporate entity, such as a foundation, it is treated as an independent property fund for tax purposes and is non‑transparent with regard to the German taxation of any individual, in particular the settlor or the beneficiaries. This is particularly the case where the settlor has transferred the assets to the trustee in such a way that the trust fund is legally and factually irrevocably and completely separated from the settlor and the beneficiaries. In this case, the trust itself can be subject to German tax. This non‑transparency should apply to most irrevocable discretionary trusts where the trustee is free to dispose of the trust’s assets within the scope of their reasonable discretion.

If the trust is comparable to a German partnership or fiduciary arrangement, it is transparent from a German tax point of view. This is the case if the settlor can continue to dispose of the assets transferred to the trust; for example, if they can arrange for a transfer back to themselves or they reserve essential rights of instruction to the trustee. In addition, if the settlor or a beneficiary can exchange the trustee at any time, a transparent trust is regularly assumed. Most revocable trusts should be seen as transparent.

A transparent trust is ignored for German tax purposes. The assets and income are still attributed to the settlor for tax purposes. The settlor will continue to pay income tax on the trust’s income. In individual cases, a direct allocation to the beneficiaries of the trust may be assumed. This is the case, for example, if the settlor does not hold the rights of instruction over the trustee but a beneficiary does. Transfers from the settlor to the trustee are then considered direct transfers to the beneficiary, which may be subject to gift tax, provided that the settlor and/or beneficiary is subject to unlimited tax liability in Germany,^[6] i.e., a German tax resident. German unlimited tax liability is given where the residence (Wohnsitz) or habitual abode (gewöhnlicher Aufenthalt) of a person is in Germany. In this case, the German beneficiary is subject to income tax on the current income of the trust.

The following will only describe the German tax consequences of a non‑transparent trust. For ease of reading, the term ‘trust’ will mean the non‑transparent trust. Further, the scope will be limited to the German taxation of the beneficiary and will not look at the lifecycle of a trust as a whole.

Tax treatment of trust distributions in Germany

Distributions from trusts can be subject to German income tax and gift tax at the level of the beneficiary.

Income tax regularly applies to current or one‑off distributions of trusts to German tax‑resident beneficiaries, in accordance with s.20(1), no.9, of the German Income Tax Act (Einkommensteuergesetz, the EStG), taxed as investment income. The tax rate is 25 per cent plus a solidarity surcharge, i.e., a total of 26.4 per cent and, if applicable, church tax.^[7],[8] Details on the applicability of this provision are disputed, as the wording is unclear, in particular with regard to any required legal position of the beneficiary in relation to the trust.^[9]

Gift tax may apply to distributions under the provisions of two separate sections of the German Inheritance and Gift Tax Act (Erbschaft und Schenkungsteuergesetz, the ErbStG), s.7(1), no.1, of the ErbStG (gratuitous transfer inter vivos) or s.7(1), no.9, sentence 2, alternative 2, of the ErbStG (acquisition upon dissolution of a foreign law fund or acquisition by an interim beneficiary).

For gift tax purposes, a gift is defined as a gratuitous transfer inter vivos, insofar as the donee is enriched by it at the expense of the donor, under s.7(1), no.1, of the ErbStG. The donor must objectively and willingly enrich the recipient without any consideration.^[10] It is therefore necessary for the donor to be aware of the fact that the transfer is without any obligation and without legal connection with a consideration or a common purpose (gratuitousness).^[11] Distributions in conformity with a trust deed lack the subjective characteristic of gratuitousness and should, therefore, not qualify as gifts in accordance with s.7(1), no.1, of the ErbStG, even though this has not yet been expressly decided for trusts.^[12]

Although the distribution to a German beneficiary upon dissolution of the trust is always subject to gift tax, it was unclear when a current distribution (during the existence of the trust) was made to an ‘interim beneficiary’ (Zwischenberechtigter) within the meaning of s.7(1), no.9 of the ErbStG. In the decision of 3 July 2019,^[13] the Court ruled that only a person who has a legal right in rem or based on obligation to the distribution from a foreign foundation is an interim beneficiary within the provision of s.7(1), no.9 of the ErbStG, and that this should not be the case when a person receives a distribution on the basis of the discretionary decision of a third party, such as, in the Court’s case, the board of a foundation. This represented a major change since, prior to this, the Court and the German tax authorities had argued that every beneficiary who receives distributions by a foreign foundation during its existence shall be regarded as an interim beneficiary within the meaning of s.7(1), no.9 of the ErbStG.^[14] However, even though the wording of the decision suggested that it could also be applied to distributions from a trust to German beneficiaries, this was, until now, not entirely clear.^[15]

Add‑back taxation under the ASTG

In addition to income and gift tax on distributions from trusts, the add‑back taxation under s.15 of the Foreign Relations Tax Act (Außensteuergesetz, the AStG) may result in a direct attribution of a trust’s income to the German tax‑resident settlor or beneficiary.

The add‑back taxation is a controlled foreign company (CFC) taxation that applies to foreign foundations and trusts if the majority of their beneficiaries are the founder, their relatives and their descendants (a Family Trust).^[16] The income of a Family Trust is attributed to the settlor if they are a German tax resident, otherwise to the German tax‑resident beneficiaries according to their share in assets or income.^[17] This is regardless of any actual distributions of a Family Trust to the beneficiaries. ^[18] As a result, a Family Trust loses its shielding effect for income tax purposes. The settlor and then the beneficiary are then taxed on the trust’s income, according to the rules that would apply if the income were received directly by the German tax‑resident settlor or beneficiary (without the trust).^[19] Foreign taxes paid by the trust (or, in certain cases, the grantor)^[20] on its income will generally be credited.^[21] The German tax‑resident settlor or beneficiary is the taxable person and is obliged to file the respective tax return.

In cases where the trust holds shares in a corporate entity,^[22] generally only its dividend distributions will be taxable on the trust and, via the add‑back taxation, also the German tax‑resident settlor or beneficiary. However, the regular German CFC taxation may lead to an attribution of passive, low‑taxed income to the trust, independent of a distribution. ^[23]

Since the add‑back taxation is triggered independently of actual distributions, liquidity disadvantages arise from such tax payments, unless the income so taxed is distributed. The distribution is then, in general, free of income tax so that, in this regard, double taxation should not arise.

In addition, the add‑back taxation leads to a significant tax compliance burden for the German beneficiary, since the trust’s income must be determined following German tax rules. In practice, the tax base can therefore significantly differ from the income calculated in the trust’s jurisdiction.

One of the major issues with regard to the application of this add‑back taxation is the lack of clarity surrounding under which circumstances individuals shall be regarded as beneficiaries within the meaning of s.15(2) of the AStG (Bezugsberechtigte oder Anfallsberechtigte, translated as current beneficiaries or remaindermen). The current stated view of the German Federal Ministry of Finance on this subject is vague and so entails significant uncertainties for taxpayers and tax practitioners.^[24]

For family foundations or trusts with management or a legal seat in an EU/EEA Member State, such as Cyprus, Ireland, Liechtenstein or Malta, there is an exception to the add‑back taxation under the EU’s fundamental freedoms. This requires, inter alia, that the settlor and beneficiaries are legally and factually irrevocably and completely deprived of the assets transferred to the trust.^[25] In other words, it must be demonstrated that it is a non‑transparent foundation/trust in which neither the founder/settlor nor the beneficiaries can exert decisive influence on the foundation’s/trust’s assets or determine its use.

Landmark decision of 25 June 2021

In its decision of 25 June 2021,^[26] the Court had to decide under which circumstances distributions from a trust to a German tax resident would be subject to gift tax. By publishing the decision in the German Federal Tax Gazette, the German tax authorities have decided to apply the decision beyond the individual case, if comparable.

Facts of the case

The decision was based on a case in which a US trust made distributions to a beneficiary who was tax resident in Germany. The trust had been irrevocably established by the deceased husband of the beneficiary and it was intended to distribute the trust’s net income on a quarterly basis. The trustees were in charge of the management of the trust’s assets, of which they could freely dispose. Neither the deceased husband nor the beneficiary could affect the trustee’s decisions on the management of the trust’s assets.

From a German tax point of view, the Family Trust (as defined above) qualified as non‑transparent and a trust, so the add‑back taxation applied and the German beneficiary was subject to income tax on the trust’s income, independent of actual distributions. Further, the trust reported the quarterly payments to the beneficiary to the competent German gift tax office as a distribution received by an interim beneficiary, under s.7(1), no.9 of the ErbStG. The tax office assessed gift tax accumulating the quarterly distributions on the basis of the (beneficial) tax class I and an allowance of EUR500,000.

Subsequently, the beneficiary raised an objection against the gift tax assessment, which was rejected by the tax office. The beneficiary based their action against the rejection, in particular, on the inadmissibility of double taxation of the same fact pattern (lebenssachverhalt); that is, income from a trust with income tax (add‑back taxation), as well as gift tax.

The decision

The view of the German tax authorities in this case was that income and gift tax may apply in parallel. This view is highly controversial as it may lead to double taxation and an excessive tax burden on the distributions, which amounted to more than 50 per cent in this case.^[27]

In the first instance to the Court’s decision of 25 June 2021, the Tax Court of Munich (the Lower Court) ruled on 15 May 2019 that the beneficiary should be regarded as an interim beneficiary and, therefore, the distributions to the beneficiary were subject to gift tax.^[28] The Lower Court argued that every beneficiary who receives distributions from the assets of a trust during its existence should be regarded as an interim beneficiary. Further, it considered double taxation of the same fact pattern with income and gift tax admissible.^[29]

In the decision of 25 July 2021, the Court ruled, by way of derogation from the Lower Court, that the view taken by the Lower Court contradicted the decision of the Court of 3 July 2019.^[30] According to this, only beneficiaries of a foreign foundation with a legal right in rem or based on obligation to the distribution should be regarded as an interim beneficiary. The Court now expressly clarified that these principles also apply to distributions of a trust, since both trusts and foreign foundations qualify as Vermögensmassen under s.7(1), no.9 of the ErbStG. Moreover, in the Court’s view, there are no reasons for treating trusts differently to foreign foundations. Since, in the opinion of the Court, the Lower Court had not sufficiently assessed whether the beneficiary should be regarded as an interim beneficiary based on the principles of the decision of 3 July 2019, the Lower Court would have to re‑examine this in a second legal process.^[31]

The Court also commented at great length on the duty of the Lower Court to determine under the foreign law applicable to the trust, under which legal conditions a beneficiary of the trust is entitled to a legal right over the assets and/or income of the trust, which cannot be easily withdrawn.

In a scenario where the Lower Court came to the conclusion that the beneficiary should not be regarded as an interim beneficiary and that the distributions of the trust would therefore not be subject to gift tax under s.7(1), no.9 of the ErbStG, the Court indicated that the Lower Court would have to decide whether the distributions constituted a gratuitous transfer inter vivos,^[32] and should be subject to gift tax. The Court did not comment on this any further, so one can assume that the principles laid down for foreign foundations in the decision of 3 July 2019 will apply, as described above. The facts of the case do not indicate that this provision might be relevant for a decision of the case.

In a scenario where the Lower Court came to the conclusion that the beneficiary should be regarded as an interim beneficiary and that the distributions of the trust would therefore be subject to gift tax under the provision of s.7(1), no.9 of the ErbStG in the second legal process, the Court commented on the admissibility of trust distributions being subject to double taxation with income tax as well as gift tax, as follows.

First, the Court pointed out that, contrary to the arguments of the beneficiary, there was no taxation of the same fact pattern in the present case since income taxation under the add‑back taxation rules, in contrast to gift taxation, takes place independently of actual distributions. Further, the Court expressed no doubts on the admissibility of the taxation of the same fact pattern with income and gift tax. Doubts on the admissibility of the taxation of the same fact pattern with income and gift tax expressed by the Court in the past,^[33] on the other hand, were only due to the legal characteristics of the preliminary proceedings in the case subject to the decision.

Finally, the Court did not explicitly comment on the compatibility of the taxation of distributions from a trust with the free movement of capital under the EU’s Charter of Fundamental Rights. This would need to be decided by the Lower Court in the second legal process.

Structuring ideas

Considering the hitherto existing risk of double taxation of a trust’s distributions to German tax‑resident beneficiaries with German income and gift tax, the non‑transparent trust was usually not considered in German estate planning (except where settlor and beneficiary are outside of Germany and German‑situs assets were transferred). However, a non‑transparent trust can bring significant tax advantages for German beneficiaries. Transfers of assets to the trust by a non‑German tax‑resident settlor are not subject to German gift tax, except for certain German‑situs assets.^[34] In addition, such assets will be excluded from the German beneficiary’s estate and German exit tax will not apply in cases where the beneficiary relocates, to name only some advantages. Therefore, a trust may be seen as an alternative to a foreign foundation.

Considering the increased legal certainty after the decision of 25 June 2021 on the gift tax side, the trust and estate practitioner may have additional options. This requires structuring the trust deed in line with the Court’s decision: the German beneficiary can neither have a legal right in rem nor based on obligation, according to German legal understanding, to distributions from the trust, based on the trust deed and the law in the jurisdiction of the trust. This must be carefully planned and reviewed on a case‑by‑case basis. The impact of the law in the trust’s jurisdiction will be especially difficult to assess. In any event, a request for a binding ruling from the responsible German tax office is usually recommended, ^[35] both to receive legal certainty and to ensure that the trust is considered non‑transparent in Germany.

With regard to the add‑back taxation, which applies to Family Trusts with a German settlor or beneficiary, practitioners are still facing significant legal uncertainties. This is especially due to the vagueness of the terms Bezugsberechtigte and Anfallsberechtigte, expressions that determine for which beneficiaries or remaindermen the rules apply.^[36] Nevertheless, the following routes could be considered to make use of trusts for German settlors or beneficiaries.

One approach to avoid the application of the add‑back taxation is the statutory exception to the add‑back taxation for trusts with management or their legal seat in an EU/EEA Member State, such as Cyprus, Ireland, Liechtenstein or Malta. See above for the requirements. For an existing trust outside the EU/EEA, the transfer of management (trustee) or legal seat may lead to complex exit tax issues in the previous jurisdiction of the trust and must be carefully planned.

If the add‑back taxation cannot be avoided, transferring the ‘right kind of assets’ to the trust can mitigate its effect. This could, in a best‑case scenario, avoid any attribution of income to the German tax‑resident settlor or beneficiary or at least reduce complexity in German tax compliance. In an existing trust with several beneficiaries, of which the German beneficiaries are only one, a separation of such assets by splitting up the trust may be a solution.

One might also consider transferring assets that do not regularly generate income, as determined under German income determination rules, such as life insurance or zero bonds. In that case, there would not be a regular income attribution to the German beneficiary. Further, it can be argued that the add‑back taxation may not apply to such income, which would not be taxable in Germany under a double‑taxation treaty (DTT), in cases where the beneficiary had generated the income directly (without the trust).^[37] The commonly cited example for this is non‑German real estate income, which is exempt from German tax under most German DTTs. The tax authorities’ view on this is not clear.

Finally, if the trust holds shares in a corporate entity that is not considered a CFC under the regular German CFC taxation, this entity may block its income from being taxed at the level of the trust and the trust’s beneficiary until it is actually distributed. In a nutshell, this requires that the corporate entity has no low‑taxed (effectively less than 25 per cent) and passive income.^[38] The corporate entity could, for example, be engaged in an active business.

Conclusion

The Court’s decision of 25 June 2021 increases legal certainty that current distributions from trusts to German tax‑resident beneficiaries will not be subject to German gift tax. This requires that the German beneficiary has neither a legal right in rem nor based on obligation to distributions from the trust.

On the other hand, the Court has also made clear to the disadvantage of the taxpayer that there are no doubts on the admissibility of double taxation of trust distributions with income and gift tax. This should not only be relevant for distributions during the existence of a trust where a beneficiary has a right to a distribution but also for distributions upon the dissolution of a trust.

The decision of 25 June 2021 should allow trust and estate practitioners to consider additional tax‑structuring options for German beneficiaries. However, the add‑back taxation will limit the investment options of the trust.