Germany: Possible Tightening of German Inheritance/Gift Taxation

Last Updated: 14 February 2005

Article by Ralf Eckert, M. Read Moore, Dirk Pohl and Richard Schmidt

Arrange Inheritance Now

Inheritance and gift tax

It is no longer a question of whether the German tax practice will be reformed, rather a question of when and how the reform will take place. Entrepreneurs as well as wealthy private equity investors in certain asset classes should react quickly in order to save as much money as possible. Following are, some important questions with answers about inheritance and gift tax planning which are addressed in respect of indicated legislative changes.

Introduction

The judges of the German Supreme Tax Court (BFH) in Munich appeared before the public with their decision in early 2002. The German chief financial judges consider pivotal points of existing taxation practice for estates and gifts as unconstitutional. The Federal Constitutional Court (BVerfG), located in Karlsruhe, has been concerned with this issued on the grounds of the BFH since then.

It is not exactly clear when the paving decision on the taxation of estates and gifts can be expected from Karlsruhe. Some experts had expected a decision last year, many think it will be this year and some expect it in 2006.

Entrepreneurs are acting swiftly

It is clear that a decision will be made in the near future, and that presumably nothing will remain as it was with the taxation of estates and bestowals in Germany. Wealthy individuals and in particular entrepreneurs should not watch and wait until Karlsruhe or politics makes the decisions. In fact, there is still time to use the numerous benefits within the existing tax legislation. This applies in particular for the transfer of real estate and company assets, which has a distinct advantage compared to cash and savings in bank accounts or securities. Caution should, however, be taken with overhasty decision making, as Company succession is not just a case of saving on taxes. Maintaining the company and securing funds for old age are just as important.

Suggestions for the reform are already drafted
The Karlsruhe judges are expected to follow their colleagues in Munich in most aspects in declaring the current taxation practice incompatible with the German constitution. Then it would be politics turn – and that can happen quickly. Since the middle of last year the Federal Council of Germany has a "Draft of a legislative reform for estate taxation" on ice. Behind this is an initiative of the state government of Schleswig-Holstein led by the Social democratic Governor, Mrs. Heide Simonis. It is quite possible that this draft – which presses, in particular, for a higher assessment of real estate – or a different suggestion could be passed through the German Federal Council and Federal Parliament very quickly after a constitutional decision in Karlsruhe.

Clever investors and company chiefs should not get themselves involved in the timing of Vabanque game (which can be compared to roulette). As such the following consideration need to be factored in.

Can politics change tax laws retrospectively after the court decision?

Currently, it isn’t to be anticipated that the legislator will intervene and retrospectively tighten tax regulations on those gifts and bequeathed assets already fully and effectively implemented before a decision by the Federal Constitutional Court (BVerfG). However, even this is not completely certain. It would not be the first time that the legislator has brought forward the rules of the timing for the application of new tax tightening regulations. Timely action will thus preclude nasty surprises in the future.

How can the actual taxation practice even be unconstitutional?
The BFH is of the opinion that the regulations for the determination of the tax base on company assets, the shares in limited liability corporations and real property holdings including land forestry assets are inconsistent with the right of equality.

The momentarily prevailing law on the taxation of estates violates, in the opinion of the BFH, the imperativeness of realistic value relation of these assets compared to other assets, which are to be valued at their fair market value. The BFH also distances itself from the additional privileging of company assets by means of tax exempt amounts and value reductions. According to the current practice, heirs or donees of company assets can assert a further tax exempt amount of €225,000 when these are transferred. Furthermore, when certain requirements are met, the value of these business assets can be reduced by a stately 35% with only this reduced value being then subject to taxation (additional 35%-evaluation discount).

Who should take action now?

Action is often already called for if an individual with children has substantially more than €200,000 worth of assets, if the joint assets of a husband and wife exceed a value of €300.000, if a company’s assets exceed €500,000 or if company succession or the closing down of operations is pending. The economic, entrepreneurial and family orientated goals should, however, be considered to the fore by company succession and the transfer of assets. The optimal tax solution can only then subsequently be considered.

How the use of the personal tax exempt amounts can be optimised?

Gifts/bestowals to spouses up to an amount of €307,000 respectively and to children up to an amount of €205,000 respectively are tax exempt. These tax exempt amounts can be reused fully after 10 years have elapsed. Children are entitled to use the tax exempt amount for each parent so that equally made gifts from both parents up to the amount of €410,000 are tax exempt. The chief attraction is that the use of the double tax exempt amount for children can be achieved by a series of gifts even if only one parent should originally be the owner of the entire assets. The parent owning the assets initially bestows each child to the maximal tax exempt (€205,000) and in addition his or her spouse to the maximal tax exempt amount for spouses (€307,000) of these assets. The spouse then bestows/gives this to the children after an appropriate period of time.

What the bestowal of company assets achieve

The transfer of domestic company assets enjoys a definite advantage thanks to the €225,000 tax exempt amount and the 35 % value reduction. The tax exempt amount of €225,000 can only be used every ten years, but the 35% reduction may be used for every transfer because there is no regulation for a blocking period.

A further privilege for inheritance tax on company assets results from the fact that company economic goods are assumed at their tax balance-sheet value instead of their market value. Due to the lack of consideration of hidden reserves, the tax-balance sheets values do not directly reflect the actual increase in value. Companies to profit from this are those with high investment and amortization volumes as well as those with high revenues. Furthermore, the valuation of the liabilities of the company assets at face value compared to the assets side of the balance sheet leads to an over compensation of the liabilities side, which additionally reduces the value of the company assets being transferred.

In light of this it could be wise not only to transfer existing business assets to the legal successor or legal successors by means of bestowal duly, but also to convert private held assets into business assets. The standard models for this are the contribution of the private assets (including e.g. monetary assets) into a limited partnership (KG) or a limited partnership with a limited liability company as general partner (GmbH & Co. KG). In this way privileged company assets can be generated and the respective company shares can be transferred in one’s lifetime, which leads to valuation advantages and can mean savings on inheritance and gift tax of up to 50%.

The transfer or creation of business assets for the purpose of transfer quite often leads to – besides the valuation advantage - the additional reduction of the progressive scaled tax base. This means that doubled tax savings are possible in one move.

What should be done with real estate?

It is also often advisable to bestow real estate before the tightening of the Inheritance tax laws. According to the current rules of valuation of developed real estate, estimates of merely 50% of the actual value can be achieved.

The special valuation advantages for real estate can be combined with the possibilities available for company assets or for shares in non-listed corporations. An established instrument for the transfer of real estate assets, which one has personally leased to a third party, to company assets relevant for tax is the contribution of the properties into a characteristically commercial GmbH & Co.KG. The valuation advantages for the company assets can then be called upon for the transfer of the limited partnership (KG) shares. An alternative that can be considered for real estate that one uses themselves is to invest the real estate in a limited liability company (GmbH) instead of using the GmbH & Co.KG model.

The advantages of an indirect bestowal of property offer

An additional tax saving alternative for real estate is the indirect bestowal of property. The basis of this alternative is that the real estate is not directly transferred from the donor rather that the donee receives monetary funds to either purchase or build a precisely defined building. In this case it is not the face value of the received monies which is subject to tax, but the significantly lower value of the (partial) property. Important requirements for the acknowledgement for taxation purposes are that the donor must want to procure a certain property or building for the donee. Furthermore, the donor must demonstrably promise the earmarked monies before purchase or the beginning of construction of the building/real estate. In addition, the tax authorities are of the opinion that the bestowed monies must amount to more than 10% of the total purchase or construction costs. It is of particular importance for the tax authorities that the financing approval for the property/building is signed and dated and that the transfer of the funds is documented.

General

The tax saving strategies described always require a diligent individual consultation and advice from a tax specialist. The tax planning of company or individual succession is only practicable with expert advice. The implementation of alleged standard models, the bestowal of a single valuable object or the bank transfer of large sums of money to, for example, spouse bank accounts, should also not be made without competent advice from specialists.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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