by Dr. Dietrich Ostertun, KPMG Hamburg, and Frank Heidemann, KPMG Mannheim
For editorial cut-off date, disclaimer, and notice of copyright see end of this article.
1. FTC rules inheritance and gift tax unconstitutional
On 14 August 2002, the German Federal Tax Court (FTC) released the text of a decision that has attracted great attention and may have far-reaching impact on German inheritance and gift tax law (ruling of 22 May 2002 – IIR 61/99 – DStR 2002, 1438). In this decision, the FTC takes the position that both the Inheritance and Gift Tax Law and the Valuation Law are partially unconstitutional. The court accordingly referred the issue of the constitutionality of the relevant provisions to the Federal Constitutional Court for resolution.
This article provides an analytical summary of the FTC ruling (sec. 2), discusses the decision's potential inheritance and gift tax impact (sec. 3), and outlines tax planning actions that can be taken to preserve existing tax advantages (sec. 4).
2. Summary and analysis of the FTC ruling
The case before the FTC involved a decedent who had purchased a condominium, but died before title was transferred to her in the German land records register. The issue before the court was the standard by which to value the inheritance for tax purposes: either under the rules governing condominiums, which generally yield a result that is only 50% of fair market value, or at full fair market value under the general valuation rule because the decedent had not yet acquired title to the condominium at the time of death.
The FTC resolved this issue in accordance with prior case law and held that a mere right to receive title to real property should be valued at fair market value. However, instead of stopping there, Germany's highest tax court used the case as an opportunity to examine the justification for disparities in the rules governing the valuation of property for inheritance and gift tax purposes under applicable law (Inheritance and Gift Tax Law in conjunction with the Valuation Law).
The FTC came to the conclusion that these disparities violate the principle of equality in Article 3 of the German constitution. The court's attention focused on the fact that the Inheritance and Gift Tax Law applies uniform tax rates to a tax base determined using different rules depending on the type of property being valued. Business property, farming and forestry property, improved real estate, and unlisted shares in corporations are valued at less than fair market value under the current law. These types of property enter the tax base at roughly 10% to 65% of their fair market value. Moreover, a special exemption, a valuation deduction, and a tax rate cap further reduce the inheritance and gift tax on these categories of privileged property. The preferential treatment is heightened by allowance of a full deduction for liabilities related to undervalued property. The court also criticised the lack of recapture provisions for cases in which real estate and farming and forestry property enjoys preferential inheritance and gift tax treatment, only to be sold shortly after the taxable event. The court disapprovingly noted that non-business property such as securities and homes can also benefit from the aforementioned preferences if contributed to the proper form of business association, even though such property is not productive in the sense of contributing to the economic welfare of the society as a whole.
All in all, the ruling may be seen as a frontal assault on numerous common inheritance and gift tax planning structures, the future of which will now be decided by Germany's highest court. The ruling has major significance for all individuals subject to German gift and inheritance tax who expect to convey or take property gratuitously or by inheritance in the foreseeable future.
3. Proceedings before the Federal Constitutional Court
Since the Federal Tax Court lacks subject matter jurisdiction to rule on the constitutionality of German tax law, it referred the constitutional issues to the Federal Constitutional Court (FCC). Various outcomes are conceivable:
- The FCC can reject the referral on procedural or substantive grounds, sending the case back to the FTC, where the condominium in question would be valued at fair market value. The Inheritance and Gift Tax Law and the Valuation Law would then remain entirely intact.
- On the other hand, if the FCC concludes that the referral is procedurally admissible and that the laws in question are indeed unconstitutional in part, it can either hold that the specific norms in question are void, or merely determine that they conflict with the constitution.
- A holding that the norms in question are void would invalidate them ab initio. Nullification would generally relate back to 1 January 1996, when a fundamental revision of the Inheritance and Gift Tax Law and the Valuation Law took effect. However, final tax assessments based on the void provisions could no longer be modified. Where assessments are still pending or have not yet become final (e.g. because the assessments are provisional), tax would have to be assessed or re-assessed, in principle without regard to the unconstitutional norms. However, a consensus exists that assessments issued on a provisional basis may only be amended in the taxpayer's favor – not to his or her detriment – in light of the need to protect justified reliance on the law. All inheritance and gift tax assessments issued subsequent to the all-state tax directive of 6 December 2001 have been provisional in nature.
- The Federal Constitutional Court could also merely determine that the affected provisions conflict with the constitution and set a deadline for the legislature to take remedial action. The FCC has often followed this approach in the past when it has ruled tax laws unconstitutional. This was in particular the court's approach in its June 1995 ruling that the Inheritance and Gift Tax Law, the Net Worth Tax Law, and the Valuation Tax Law then in force were partially unconstitutional. It thus appears likely that the FCC would again give the legislature the opportunity to bring the tax laws into line with the constitution if the court were to confirm the constitutional breach identified by the FTC. In this event, the Inheritance and Gift Tax Law would remain in effect until the legislature takes action or the deadline expires. All taxable events occurring in this period would remain subject to the law currently in effect. The unconstitutional "old" law would cease to have force and effect when the deadline expires, at the latest. If the legislature wished to continue collecting inheritance and gift tax, it would have to enact revised provisions.
4. Planning possibilities
It is not possible to predict with certainty how the Federal Constitutional Court will rule. In the interim, taxable events will continue to occur as property passes by inheritance and inter vivos conveyances. Complete legal certainty as to the tax consequences will not exist. One should note, however, that the FCC has already issued one ruling holding the Inheritance and Gift Tax Law to be unconstitutional because of different valuation of different forms of property (ruling of 22 June 1995 – see German News no. 2/1995 p. 13 = Article 25). The valuation disparities were not completely eliminated in the revised 1996 law now before the court. There are thus strong indications that the FCC will hold at least some of the disparities underscored by the FTC to be unconstitutional. However, there is also good reason to believe that, in such event, the current law would still remain in force for a transition period, as this solution would avoid the loss of tax revenue by the treasury and give the legislature time to devise a more equitable form of inheritance and gift taxation for the future. It is therefore reasonable to assume:
1. that some of the inequalities in inheritance and gift taxation criticised by the FTC are unconstitutional and
2. that a transition period – like that in 1995 – is probable.
Taxpayers must, however, decide for themselves what result to anticipate from the Federal Constitutional Court and structure their personal tax planning accordingly. The same applies for a decision to delay inter vivos conveyances until the FCC's ruling is known or to accelerate such conveyances in an attempt to lock in the benefit of tax preferences currently in effect.
The following suggestions may aid taxpayers in reaching their individual decision.
- As a basic matter, an inheritance and gift tax expert should analyze each taxpayer's specific situation and discuss it with the taxpayer. A determination should be made whether a major property transfer will be necessary in the taxpayer's family in the foreseeable future, for instance, in connection with a generational change in a family business. Or perhaps there are plans for significant inter vivos transfers of other assets to a younger generation. If so, thought should be given as to how the transferor can retain some control over the assets and perhaps continue to enjoy the income they yield. In such cases, it is advisable to have an expert assess the valuation and tax treatment of the assets in question under current law and address the threats posed depending on the tenor of the FCC's ultimate decision. Such analysis and discussion with an expert can facilitate personal decisions to initiate or postpone a contemplated conveyance.
- Taxpayers who share our expectation that the FCC will abolish certain tax preferences subject to a transition period in which they will continue to apply should in principle take action to utilise the tax advantages of current law before this period expires. After analysis of the associated opportunities and risks in conjunction with tax counsel, conversions of assets into business property, improved real estate, farm and forestry property, or shares in non-listed corporations can be considered and conceptualized. It may also make sense to transfer non-business property to a GmbH or a to limited partnership with a corporate general partner as a step preparatory to a subsequent conveyance. However, one should bear in mind that such "asset management companies" also pose specific risks in the event that the FCC's ruling is not as anticipated. Estate planning decisions should in general be the product of careful consideration from multiple perspectives and frequently require protracted planning. While this is no reason to rush to set the process in motion, it is likewise inadvisable to put such decisions off indefinitely. The danger of postponing action until it is too late is especially pronounced where there is a need to use inter vivos conveyances to transfer assets to a younger generation.
- If inheritance or gift tax has already accrued, one should note that the tax authorities were instructed by the directive of 6 December 2001 to issue assessment notices that are provisional in their entirety so as to permit modification of the assessments in accordance with the ultimate decision of the Federal Constitutional Court. If an administrative or judicial appeal is pending, thought should be given to staying or suspending proceedings. This can be advantageous if the Inheritance and Gift Tax Law or the Valuation Law is declared partially void. A request to stay collection of tax is also a possibility, but should be carefully considered in light of the interest potentially payable in this event. The best strategy in each individual case should be worked out in consultation with tax counsel in light of the complicated procedural law.
- As a general matter, steps should be taken to ensure assessment of inheritance and gift tax so as to be able to claim the good faith reliance protection of §176 AO (Tax Procedure Act). This can shield taxpayers from revised assessment of higher taxes based on the decision of the Federal Constitutional Court. One should also take action to obtain zero assessments for gifts that do not exceed the exemption amounts and hence trigger no tax.
It took the Federal Constitutional Court almost four years to decide the comparable 1995 case. How long it will take the court to decide the matter now before it is, however, just as difficult to predict as the ultimate outcome. Considering the 1995 case, it seems unlikely that a decision will be rendered until 2004 at the earliest. However, for tax planning purposes this does not mean that the tax preferences in question will with certainty remain available until 2004. Like the decisions of the FCC, legislative action is also frequently unforeseeable. Legislative reform of the Inheritance and Gift Tax Law and the Valuation Law is a distinct possibility once the parliamentary elections on 22 September 2002 are over. Proposals have repeatedly been voiced that would drastically increase inheritance and gift taxes. These have so far been deferred, possibly as a matter of election campaign tactics. The reform proposals may well be revived after the national elections at the initiative of the German states as a means to improve their chronic budget problems.
KPMG Germany would be pleased to assist individuals in clarifying inheritance and gift tax issues and devising a tax strategy for passing ownership of family businesses or other assets to the next generation.
Editorial cut-off date: 31 August 2002
Disclaimer and notice of copyright
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