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10. March 2022 | Significance and taxation of foreign trusts: gift tax and inheritance tax (this contribution)

A trust is a legal relationship in which assets are transferred to a person which it is to manage or use for certain beneficiary persons under the rules of the trust deed. Trusts are regularly used in other countries, especially in the USA, as a means of succession planning. In Germany, on the other hand, the legal institute of the trust does not exist under civil law. In addition, beneficiaries of foreign trusts who live in Germany can incur high tax burdens. We explain the gift tax consequences of a US trust for German-based beneficiaries and provide tips on how to optimize the trust under tax consideration. The income tax consequences of a US trust, on the other hand, we explained in one of our other contributions.

A trust is a legal relationship in which assets are transferred to a person, so-called administrator. This administrator must manage or use the assets for certain beneficiary persons in accordance with the rules of the trust deed. The trust is therefore similar to a trust relationship. Accordingly, not the trust itself is the owner of the property, but the administrator, who is bound according to the trust deed. However, it is not necessary that the creator of the trust is a different person than the beneficiary. A trust can be established both by death and among the living. It may also be revocable or irrevocable. The latter always occurs when the builder dies. If, on the other hand, the trust is revocable, its creator can retrieve the assets at any time or change the trust deed.

The persons acting in a trust have different names. The Remainderman is the person who receives the assets in the event of dissolution of the trust. The beneficiary is called “beneficiaries”, the builder “Settalor” and the administrator “Trustee”. Often there is also a protector who has a supervisory function.

1.3.1. Trust prevents trials

In the USA, the establishment of a trust is usually interesting because it can prevent the procedure for the appointment of an administrator or executor in the case of inheritance, so-called probate procedure. This Probate procedure serves to settle the decedent’s estate, pay the tax incurred and return the surplus to the heirs. However, the disadvantage of this process is its duration and the associated costs. The latter prevents a trust. If this is established during his lifetime, the trust settles the estate. Ultimately, the establishment of a trust therefore has no tax reasons, but is characterized by practical considerations.

1.3.2. Grants Trust

In a Grantors Trust, the builder is the same person as the beneficiary and the administrator. Accordingly, the trust consists of only one person.

1.2.3. Discretionary Trust

The Discretionary Trust is characterized by the fact that the administrator, the beneficiary and the builder are different. In these cases, the administrator has a wide discretion over the use of the proceeds and the management of the assets.

Nevertheless, a trust causes certain problems in German law. On the one hand, German civil law does not recognize a trust as a legal institution. On the other hand, there are high tax consequences for beneficiaries of a foreign trust who live in Germany. Therefore, a trust is regularly unattractive and requires careful documentation. In the following, we discuss the gift tax consequences and provide tips on how to optimize a trust under tax consideration.

The transfer of assets to the trust can have gift tax relevance if a person resident in Germany transfers the assets to the foreign trust. For the time being, however, a spatial/personal connection point is required to fulfill the taxation status. If the builder is subject to unlimited taxation in Germany, Germany taxes all world assets and thus also the transfer of assets to a foreign trust. According to § 2 (1) no. 1 letter b ErbStG, this also applies if a German citizen moves away from Germany and transfers his assets to a trust within the following five years. In all these cases, one must therefore consider a German taxation of the transfer of assets to the trust.

The double taxation agreement between the USA and Germany provides in Article 4 paragraph 3 a special arrangement for this personal connecting point. Therefore, in the case of dual residence, the nationality is decisive, so that this state may tax. Requirements are that the builder is a national of one state without having been one of the other, but has his residence in both states. In the other contracting state – i.e. in this one without nationality – the duration of residence may not be 10 years. Consequently, the US has the right to tax within the first 10 years of residence of a US citizen in Germany. Germany, on the other hand, cannot tax.

Inheritance tax and gift tax on the transfer of property is incurred in the case of § 7 (1) no. 8 sentence 2 ErbStG. Accordingly, the transfer is taxable if the trust constitutes assets under foreign law whose purpose is to bind assets.

3.2.1. Foreign exchange foreign exchange

The trust would therefore first have to represent an asset. A wealth is present when the assets of the builder have finally transferred to the trust. It is therefore crucial to whom the assets are economically attributable. Consequently, the property is imputable to the builder if the administrator, like a trustee, is strictly bound by the instructions of the builder and the builder can revoke the transfer of property at any time without any objective reason. Then the taxation of § 7 (1) no. 8 sentence 2 ErbStG does not apply. If the property is attributable to the trust, however, there is an independent asset. Here you must therefore check in individual cases how the trust deed is designed and the design based on the criteria for allocation.

3.2.2. Commitment of external assets

Furthermore, the purpose of the asset must be directed to the tie-up of assets. Therefore, if the trust is to regulate the estate of the builder after his death and dissolve in a timely manner after the succession, there is no binding of third-party assets. On the contrary, a commitment of assets can only be assumed if the trust manager manages the assets in the interest of the subsequent beneficiaries and transfers them in the context of a longer-term succession. Decisive are therefore in particular the duration of the asset management and the revocability.

The transfer of assets by an unrestrictedly taxable creator of a trust leads to gift tax in tax class III. The tax class privilege of § 15 (1) sentence 1 EStG applies only to domestic foundations. The application of tax class III is unfavourable, since on the one hand a tax rate of 30 § or 50% applies, but only an allowance of 20 000 euros applies. Therefore, in the case of the establishment of a trust, you must safely exclude that the builder is taxable without restriction or that the taxation of § 7 (1) number 8 sentence 2 ErbStG applies. Otherwise, there is a serious tax trap.

In summary, it can therefore be said that the transfer of the assets to the trust is subject to gift tax under the conditions of § 7 (1) no. 8 sentence 2 ErbStG. Then the tax class III is applied.

Distributions from foreign trusts are subject to taxation with gift tax in accordance with § 7 (1) no. 9 sentence 2 ErbStG. The acquisition of an intermediate beneficiary is accordingly considered a gift among living people. However, it is questionable who is intermediary in this sense and whether beneficiaries of a trust are included.

The wording suggests that any person who receives something from a trust is subject to gift tax for the entire distribution. However, this is problematic if, at the same time, there are taxable income from capital assets according to § 20 (1) no. 9 second sentence of the EStG. Then there is double taxation with income tax and gift tax. Therefore, the taxation of § 7 (1) no. 9 second sentence ErbStG must be interpreted restrictively. Therefore, only the intermediate beneficiary who has legal jurisdiction over the assets of the trust independently of a specific distribution decision is. In other words, only the intermediate beneficiary who has a specific right to the distribution is.

Therefore, in the case of a trust under the gift tax, a distinction must be made according to whether the beneficiaries have a specific right to the distribution or whether the administrator can decide on a reversal depending on discretion. Consequently, the trustee deed must specify whether the administrator has discretion in order to provide clarity on gift taxation.

Also the dissolution of a trust by transfer of assets to beneficiaries resident in Germany is subject to gift tax according to § 7 (1) no. 9 sentence 2 ErbStG. However, once again, it is necessary that the purpose of the trust is aimed at the commitment of assets. Therefore, the above criteria are to be applied. Consequently, the winding-up cannot be taxable if the entity was not actually and legally free to dispose of the assets during its existence.

In addition, the tax class privilege of § 15 paragraph 2 sentence 1, 2 ErbStG applies. Accordingly, taxation is based on the relationship between the creator of the trust and the remotest beneficiary.

Of course, the builder himself can also be a beneficiary. The return of assets is therefore taxable according to § 7 (1) no. 9 sentence 2 ErbStG if the builder is a national or receives domestic assets. In this case, however, the tax class privilege cannot be applied. Rather, the tax class III applies.

The right of the beneficiary is initially only a right of entitlement. In fact, no assets have been transferred. Therefore, the acquisition of such a position does not yet lead to a taxable inheritance tax event or gift tax event.

According to § 20 (1) sentence 2 ErbStG, when a trust is established, the trust itself is the acquirer and therefore the taxpayer. The installer may be called upon as a joint debtor in addition to the assets.

If you are a beneficiary of a trust, you have a special right to apply within the framework of German taxation. If a transfer of assets to a trust under German inheritance and gift tax law does not lead to taxation at the time of the transfer, the beneficiary may, within five years of the transfer, demand that he be used for German tax (including income tax) as if a taxable transaction had taken place at the time of the transfer. Accordingly, it is assumed that the beneficiary had a taxable operation at the time of the transfer of the assets to the trust. Accordingly, the crediting of US taxes triggered by the transfer of assets to the trust is also possible. The application therefore makes sense if US taxes have been incurred, which are then eligible.

The prerequisite is that the transfer in Germany did not lead to taxation under German inheritance tax law and gift tax law. This occurs if the builder of the trust was not taxable in the country. For example, if an American builder transfers assets to a US trust. The beneficiary must be resident in Germany and the application must be made within five years of the transfer to the trust.

The application causes the assets to be held directly by the beneficiary. Subsequent distributions or additional taxation are therefore no longer eligible. Therefore, in the case of distributions from the trust, a taxation according to § 7 (1) no. 9 sentence 2 ErbStG is excluded.