Germany Christian Birkholz Baker

Using Trusts in Family Wealth Planning Wednesday March 21, 2007

Overview
Basic legal considerations
Testamentary trust
Intervivos trust
The trust in German Income Tax Law
The trust in German Inheritance/Gift Tax Law
Income versus inheritance/gift tax effects
Summary

“ The Trust, the unknown being”

A trust is an unknown being in Germany
German civil law does not acknowledge the trust as a legal tool
As a result a trust is an “unknown being” in the day-to-day practice

Comparable structures (“translation” into German legal structure)
Fiduciary relationship versus trust
Fiduciary relationship is restricted to the escrow holder ( Treuhänder ) as a person
In contrast, the trust is, as a basic principle, not restricted to the trustee
Basically, the fiduciary relationship allows instructions etc. to a large extent
Fiduciary relationship is neglected for tax purposes, as the grantor ( Treugeber ) is the economic owner of the assets for tax purposes

Trust versus Foundation
Both legal forms establish a specific kind of separated assets
The foundation itself is the holder of the assets
In contrast the trust itself is not the holder of assets, but the trustee
Trust itself has no legal capacity, but the foundation
Other German related legal forms
Preliminary heritage ( Vor- und Nacherbschaft )
Usufruct ( Nießbrauch )
Execution/administration of a will ( Testamentsvollstreckung )
Last will with specific conditions ( Testamentsauflage )

Testamentary trust
A German citizen is not entitled to set up a testamentary trust via testament nor may he/she dispose by last will such a formation

Testamentary trust
Why is that?
A trust lacks legal capacity according to German law
Germany did not sign the Hague Convention of July 1, 1985
Basic German provision for succession law requires law of the state, the decedent is a citizen of
Therefore a German citizen may only use acknowledged legal instruments for his/her testament planning
Result a testamentary trust of a German citizen is invalid (!)
Exemption
Real estate situated in common law countries
German international private law allows a split of legal status regarding real estate

Testamentary trust
Summary
A German citizen may not set up a testamentary trust regarding e.g. securities, shares in corporations, cash etc., as such a testamentary trust would be invalid
Real estate situated outside of Germany may be subject to a testamentary trust

Intervivos trust
The foundation of an invervivos trust is possible according to German civil law
Foundation of an intervivos trust is not subject to law of succession, but subject to law of obligations ( Schuldrecht )
German civil law differs between the law of obligations and the law of property ( Sachenrecht ). The transfer of legal title of assets usually requires effectiveness of both sides.
The foundation of an intervivos trust is possible according to German law of obligations

Intervivos trust
What about law of property?
According to law of property the transfer of legal title is based on the law where the assets are located
As German civil law does not acknowledge the trust as a legal entity, the transfer of e.g. legal title to a trust is invalid, as far as assets are concerned, which are situated in Germany

Intervivos trust
Further issue: the transfer of assets (situated in Germany) which are subject to registration
Can a trust be the legal owner of a real estate in Germany (legal ownership requires registration in the real estate register)?
Can a trust hold a participation in a limited partnership (limited partner is required to be registered in the trade register)?

Intervivos trust
Summary
A German citizen may set up an intervivos trust regarding assets which are situated in Germany
A German citizen may not set up an intervivos trust regarding assets which are situated outside of Germany
Both, a testamentary and an intervivos trust only work regarding assets situated outside of Germany

Intervivos trust
Example
Mr. Müller is a German citizen and wants to set up a trust in order to avoid forced heirship rules. For this purpose he sets up a trust and transfers his entire German situated real estate to the trust. Was he successful in avoiding the forced heirship rules?
The actual transfer of title in the real estate is legally valid only to the extent German law of property ( Sachenrecht ) has been followed
Furthermore German law of property requires the registration of the acquirer of the real estate who should be registered as legal owner of the real estate in the real estate register?

Intervivos trust
The transfer of German real estate to the trust is invalid. Mr. Müller was not successful in avoiding forced heirship rules.

What kind of income may trigger German income tax effects?
Income from investment activities, such as interest income, dividends, capital gains etc.
Rental income etc.
only income from assets which are situated outside of Germany (due to the legal restrictions)

Who is the tax entity, the trust, the settlor or the beneficiaries?
If German legal law does not recognize the trust as a legal instrument, German tax law could follow and deny the effectiveness of the transfer of assets to a trust
German tax law differs between legal law ownership and economic ownership in the underlying assets
It depends on the individual trust structure if the transfer of assets to a trust is acknowledged by tax law
Economic ownership of settlor can be assumed in case of fully revocable trust

As a general rule, a trust is acknowledged as a specific legal estate and qualifies as an entity for tax purposes

What is required to acknowledge a trust as “own” legal estate
The assets which have been transferred to the trust must have left economic ownership of the settlor
Trust as a separate legal estate requires a specific economic independence of the trust
Extensive rights of settlor to give instructions to the trust may result in economic ownership of settlor
Same is true if the administration of assets by the trust is predominantly in the interest of settlor (in such a case fiduciary relationship according to German law)
Lack of legal capacity is of no further relevance for the acknowledgement of a trust for German tax purposes (Federal Tax Court, Decision of June 23, 1992 and February 2, 1994)

§ 15 Foreign Tax Act ( AStG )
§ 15 AStG deals predominantly with the taxation of so called “family foundations”
§ 15 AStG is an anti-avoidance provision which provides a deemed income allocation to the founder/settlor and/or the beneficiaries
§ 15 AStG also applies to trusts
Any income of a trust will be allocated to the founders/beneficiaries, even if there is no actual “distribution” of income to those persons
§ 15 AStG is subject to supervision by the European Commission, European Commission opened a breach of contract procedure against Germany because § 15 AStG seems to discriminate foreign foundations/trusts
A suspension of this provision by Germany within Europe would not necessarily comprise trusts located in countries outside the EU such as in the US

Example:
Mr. Berger, who is a German citizen but who has been living for more than five years in the US sets up a US trust. Beneficiaries are his family members B, C and D. B will acquire the entire assets in case of dissolution of the trust. C and D are entitled to ongoing benefits.
Alternative a): C and D are not family members of Mr. Berger
Alternative b): B is not a family member of Mr. Berger
Alternative c): B and C are not family members of Mr. Berger

In the basic alternative B is entitled to receive the entire assets. The trust is a family trust. Any income of the trust is allocated to B, C and D.
According to alternative a) again only B is entitled to receive the entire assets. The trust qualifies again as a family trust.
According to alternative b) the entitlement of C and D is decisive for the qualification of the trust as a family trust.
According to alternative c) the trust does not qualify as a family trust.

According to § 15 AStG any income of a family foundation with place of management/registered office outside of Germany is allocated to the individuals as far as they are subject to unlimited tax liability
Family foundation is described as a foundation where the founder, his relatives and/or their descendants are entitled to more than half of the benefits of the foundation/trust

Legal consequence of § 15 AStG
Deemed income allocation liquidity of taxpayer required !!!
Shielding effect does not occur
Foreign taxes are creditable in Germany

“ Regular” German income tax effects
If the beneficiaries are entitled to regular payouts by the trust, they may also be liable to regular German income tax (as far as they are domiciled in Germany)
§ 15 AStG is the prevailing provision towards the “regular” income tax provisions

The trust in German Inheritance/ Gift Tax Law
Legal status prior to March 4, 1999
The transfer of assets to a trust is not subject to inheritance/gift tax
Neither the trust nor the beneficiaries inherit any assets
Only upon actual distribution of funds to the beneficiaries inheritance/gift tax is due
Considerable deferral effects could have been achieved

Current legal status
Foundation of a trust
The transfer of assets to a trust is subject to inheritance/gift tax
All subsequent transfers of assets are subject to inheritance/gift tax
The trust itself and the settlor (if settlor is resident in Germany) are liable for taxes
Tax class III. applies the most detrimental tax class
Tax class III. varies between 17 % and 50 %
Tax class I. varies between 7 % and 30 %

The trust in German Inheritance/ Gift Tax Law 50 % 30 % more than 25,565,000 47 % 27 % 25,565,000 41 % 23 % 12,783,000 35 % 19 % 5,113,000 29 % 15 % 512,000 Tax class III Tax class I Value of assets including EUR

Distributions of a trust
The distributions of a trust to a beneficiary are subject to inheritance/gift tax
Taxation only upon actual distribution (no deemed allocation of distributions for inheritance/gift tax purposes)
Tax class goes by the relationship between settlor and beneficiary

Dissolution of a trust
Dissolution of a trust and subsequent distribution of funds is again subject to inheritance/gift tax
Same tax class applies as in case of distribution, that is to say relation between settlor and beneficiary is decisive

Income tax versus inheritance/gift tax effects
§ 15 AStG deemed income allocation and tax liability
Actual distributions are subject to inheritance/gift tax
Double taxation with income tax and inheritance/gift tax
No tax credit between these to types of taxation !!!

Summary
Foundation of a trust is subject to strong civil law restrictions
Trust is subject to a rather detrimental tax treatment
Deemed income allocation according to § 15 AStG
Detrimental tax class applies in case of setting up a trust (up to 50 %)
Double taxation based on income tax and inheritance/gift tax liability
Trusts are not a preferred planning tool for German tax purposes

Contact
Christian Birkholz
Rechtsanwalt/Steuerberater
Baker & McKenzie
Partnerschaft von Rechtsanwälten,
Wirtschaftsprüfern, Steuerberatern
und Solicitors
Friedrichstraße 79-80
10117 Berlin
Tel.: +49 (0) 30 – 203 87-720
Fax: +49 (0) 30 – 203 87-699
E-Mail: [email_address]

Germany Christian Birkholz Baker

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