Inheritance Tax Reform - Initial Practical Experience

Ever­ything re­mains the same?

On Oc­to­ber 14, 2016, the tough struggle to ad­apt in­heri­tance and gift tax law to the judg­ments of the Fe­deral Con­sti­tu­tio­nal Court came to an end. At first glance, the chan­ges brought about by the re­form do not sound all that dra­ma­tic. Busi­ness as­sets that are eli­gi­ble for pri­vi­le­ges un­der in­heri­tance tax law will re­main as they are. Law­ma­kers are also sti­cking with a – slightly mo­di­fied – list of ad­mi­nis­tra­tive as­sets.

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Chan­ges in the ru­les for ad­mi­nis­tra­tive as­sets

Howe­ver, a more de­tai­led ex­ami­na­tion re­ve­als that the chan­ges are ac­tually more ex­ten­sive and af­fect small and large en­ter­pri­ses in equal mea­sure. Why is this? Law­ma­kers ma­na­ged to change the ru­les for ad­mi­nis­tra­tive as­sets. Whe­reas in the past ad­mi­nis­tra­tive as­sets were in­clu­ded in the tax be­ne­fits un­der in­heri­tance tax law as long as their va­lue did not ex­ceed 50% of the va­lue of the busi­ness as­sets, they are now sub­ject to full in­heri­tance/gift tax – aside from a one-time “con­ta­mi­na­tion surch­arge” of 10%.

This re­sults in a hig­her in­heri­tance tax bur­den for all com­pany suc­ces­si­ons af­fec­ted. It has eli­mi­na­ted the lee­way that was pos­si­ble un­der the exis­ting ru­les. The most im­port­ant goals now are to create tax-pri­vi­le­ged as­sets and avoid ad­mi­nis­tra­tive as­sets. In group struc­tures, mo­ni­to­ring this and also kee­ping an eye on it du­ring the year on a con­so­li­da­ted ba­sis will be a huge chal­lenge.

Fur­ther­more, a 90% cap for ad­mi­nis­tra­tive as­sets has been in­tro­du­ced for the first time as an ad­di­tio­nal pre­re­qui­site for uti­liza­tion of any tax re­lief ru­les in the case of gra­tui­tous busi­ness trans­fers. In prac­tice, this re­pres­ents a fur­ther obst­acle to ob­tai­ning re­lief. If an en­ter­prise does not pass the 90% test, all of the eli­gi­ble as­sets will be ex­clu­ded from the re­lief. In spe­ci­fic ca­ses, it may be ex­pe­dient to re­clas­sify non-tax-pri­vi­le­ged ad­mi­nis­tra­tive as­sets as per­so­nal pro­perty to be able to ap­ply the re­lief ru­les for tax-pri­vi­le­ged as­sets. En­ter­pri­ses with si­gni­fi­cant fi­nan­cial re­sour­ces and debts may also be af­fec­ted by these ru­les be­cause there are no pro­vi­si­ons for off­set­ting. Con­se­quently, a com­pany may quickly ex­ceed the 90% li­mit. In this re­spect, the le­gis­la­tor at­temp­ted in an in­con­sis­tent and con­sti­tu­tio­nally ques­tio­nable man­ner to pre­vent abuse of law. Howe­ver, in the pro­cess, it un­for­tuna­tely en­lar­ged the group of af­fec­ted com­pa­nies un­duly.

In the case of in­heri­tance, though not gifts, ad­mi­nis­tra­tive as­sets can be re­tro­spec­tively re­clas­si­fied as tax-pri­vi­le­ged as­sets if, and only if, the cri­te­ria in the “in­vest­ment clause” are met. For this, the ad­mi­nis­tra­tive as­sets must be in­ves­ted in items of pro­perty wi­thin the eli­gi­ble as­sets ac­qui­red by the testa­tor wi­thin two years of the tax be­com­ing char­ge­able in ac­cor­dance with a plan pre­viously drawn up by the testa­tor. The pro­blem here is that the exis­tence of this in­vest­ment clause will fail in many ca­ses owing to le­gal and de facto obst­acles be­cause in prac­tice it will be dif­fi­cult to fur­nish evi­dence that the pro­perty was ac­qui­red in line with a plan that had been drawn up in ad­vance by the testa­tor.

Tax re­lief re­sul­ting from ad­just­ments to va­lua­tion

Even though the new tax ru­les for ad­mi­nis­tra­tive as­sets are li­kely to cause a hig­her tax bur­den in the main, some tax re­lief is ex­pec­ted to be pro­vi­ded th­rough ad­just­ments to the va­lua­tion of the en­ter­prise. This al­re­ady ap­plies with re­troac­tive ef­fect from Ja­nu­ary 1, 2016. If this is achie­ved using the sim­pli­fied in­come ap­proach, the now sta­tutory ca­pi­ta­liza­tion fac­tor tends to pro­duce lo­wer aver­age va­lues to be used for the ta­xa­tion.  

Trans­fer of busi­ness as­sets be­low the th­res­hold for large eli­gi­ble as­sets

Ge­ne­rally spea­king, busi­ness as­sets will con­ti­nue to be­ne­fit from the gran­ting of ba­sic re­lief of 85% (re­gu­lar re­lief) and the de­duc­tible amount of EUR 150,000 or op­tio­nal re­lief of 100%, i.e. com­plete ex­emp­tion from ta­xes. In each case, the tax­payer is re­qui­red to com­ply with the re­ten­tion pe­riods and mi­ni­mum pay­roll re­gu­la­ti­ons. The pre­vious ex­cep­tion to the mi­ni­mum pay­roll for mi­cro­en­ter­pri­ses has been mo­di­fied and now ap­plies only to busi­nes­ses with fe­wer than five em­ployees. Lo­wer mi­ni­mum pay­roll li­mits ap­ply in­cre­men­tally to busi­nes­ses with up to 15 em­ployees.

Howe­ver, neit­her re­gu­lar nor op­tio­nal re­lief is ap­plica­ble if the as­sets are what are known as ‘large eli­gi­ble as­sets’. This con­cerns ac­qui­si­ti­ons of tax-pri­vi­le­ged as­sets with a va­lue of more than EUR 26 mil­lion. The goal must the­re­fore be to make use of this ac­qui­si­tion th­res­hold on mul­ti­ple oc­ca­si­ons and for mul­ti­ple peo­ple. For this it is us­eful – as in the case of pro­perty as­set suc­ces­sion – to think in ten-year pe­riods. As the ac­qui­si­tion th­res­hold is ap­plica­ble per per­son, it is ad­visa­ble to di­vide the ac­qui­si­tion among se­veral peo­ple. The en­ter­prise can, for ex­am­ple, be trans­fer­red not just to one child but to se­veral child­ren if this ma­kes sense from a busi­ness per­spec­tive. The ge­ne­ra­tion leap can be ta­ken al­ter­na­tively or cu­mu­la­tively. It is also im­port­ant to con­sider this in par­ti­cu­lar when dra­wing up the last will and tes­ta­ment for the busi­ness ow­ner’s re­mai­ning equity in­vest­ment due to the risk of ag­gre­ga­tion wi­thin a ten-year pe­riod with ac­qui­si­ti­ons prior to July 1, 2016. Other trans­fe­rees that could be con­side­red in­clude a fa­mily foun­da­tion or a non-pro­fit foun­da­tion; re­lief for the lat­ter is not cap­ped at EUR 26 mil­lion.

Mo­re­over, in view of the amount of the ac­qui­si­tion th­res­hold, the com­pany va­lua­tion will also play a more im­port­ant role than in the past. It is ad­visa­ble to make use of ti­mes of eco­no­mic cri­sis for trans­fers by gift be­cause the en­ter­prise va­lue is then lo­wer; in other words, a lar­ger per­cen­tage of the en­ter­prise or the equity in­vest­ment can be trans­fer­red be­fore the EUR 26 mil­lion ac­qui­si­tion th­res­hold is re­ached.  

Com­pa­nies and en­ter­pri­ses for which the ac­qui­si­tion th­res­hold is not ex­cee­ded be­cause the equity in­vest­ments are spread among a large num­ber of share­hol­ders or suc­ces­sors the­re­fore only need to ad­apt their suc­ces­sion con­cepts to the new le­gal si­tua­tion selec­tively.

Re­lief for fa­mily-ow­ned busi­nes­ses

Fa­mily-ow­ned busi­nes­ses will be gran­ted fur­ther re­lief th­rough an ad­vance de­duc­tion of up to 30% of the equity in­vest­ment’s fair mar­ket va­lue. This ad­vance de­duc­tion re­du­ces the va­lue of the tax-pri­vi­le­ged as­sets prior to ap­pli­ca­tion of the re­gu­lar re­lief of 85%. If the tax­payer choo­ses op­tio­nal re­lief, the ad­vance de­duc­tion be­co­mes ir­re­le­vant. Ne­vert­he­less, the ad­vance de­duc­tion may be in­te­res­ting if the va­lue of the tax-pri­vi­le­ged busi­ness as­sets is close to the EUR 26 mil­lion ac­qui­si­tion th­res­hold for large ac­qui­si­tion as­sets and can be re­du­ced to be­low this th­res­hold as a re­sult.

Howe­ver, the ad­vance de­duc­tion can only be ap­plied if the com­pany’s con­ti­nued exis­tence can be en­su­red th­rough the pro­vi­sion of li­mi­ta­ti­ons in the share­hol­der agree­ment on wi­th­dra­wals, se­ver­ance pay­ments, and dis­po­sal. The li­mi­ta­ti­ons on dis­po­sal must exist two years be­fore and 20 years af­ter the ac­qui­si­tion. These dis­pro­por­tio­na­tely strin­gent re­qui­re­ments are li­kely to be dif­fi­cult to meet in prac­tice. Whe­ther the re­lief is prac­tica­ble re­mains to be seen. What is more, cri­ti­cism is al­re­ady being voiced that the ad­vance de­duc­tion is not con­sti­tu­tio­nal.

To keep all op­ti­ons open no­nethe­less, the re­qui­re­ments for the ad­vance de­duc­tion should pre­fe­ra­bly be met. At a la­ter point in time, the tax­payer can al­ways opt out of this ad­di­tio­nal re­lief to be ap­plied wi­thout re­quest by de­li­be­ra­tely vio­la­ting the li­mi­ta­ti­ons on wi­th­dra­wals or dis­tri­bu­ti­ons. This may be the case, for ex­am­ple, once the en­ter­prise va­lue has been fi­nally and ab­so­lu­tely as­cer­tai­ned and the tax risk can the­re­fore be de­ter­mi­ned, but the en­ter­prise does not wish to be bound to the sub­se­quent 20-year pe­riod.  

In light of this si­tua­tion, on ac­count of the two-year waiting pe­riod, fa­mily-run en­ter­pri­ses should re­view their share­hol­der agree­ments or ar­ti­cles of as­so­cia­tion promptly and make any ne­cessary mo­di­fi­ca­ti­ons in line with the new law. It is also ad­visa­ble to make a re­fe­rence to the ad­vance de­duc­tion in the share­hol­der agree­ment, for ex­am­ple in the sec­tion on the terms for amen­ding the share­hol­der agree­ment. Other­wise, there is a risk that no­body will re­mem­ber this spe­cial re­lief dis­count at a la­ter date, lea­ding to the ad­vance de­duc­tion being un­in­ten­tio­nally drop­ped with re­troac­tive ef­fect.  

Si­gni­fi­cant tigh­te­ning-up of large eli­gi­ble as­sets

When tax-pri­vi­le­ged as­sets with a va­lue in ex­cess of EUR 26 mil­lion are ac­qui­red, ap­pli­ca­tion of an ab­la­tion mo­del can be re­ques­ted. In this mo­del, the hig­her the ac­qui­si­tion, the lo­wer the amount of re­lief gran­ted. There is no lon­ger any re­duc­tion for tax-pri­vi­le­ged as­sets at around EUR 90 mil­lion. Like the nor­mal ba­sic re­lief, this re­du­ced ba­sic re­lief also re­qui­res the tax­payer to com­ply with the re­le­vant mi­ni­mum pay­roll and main­ten­ance re­gu­la­ti­ons.

Al­ter­na­tively, ac­qui­rers of large busi­ness as­sets can ap­ply for me­ans tes­ting. In this case, the ac­qui­rer will be ex­emp­ted from pay­ing all or a por­tion of the in­heri­tance tax if the tax to be paid on the ac­qui­si­tion ex­ceeds half of the ac­qui­rer’s non-tax-pri­vi­le­ged as­sets, i.e., in­clu­ding the ac­qui­rer’s per­so­nal pro­perty. And if that was not enough, as­sets that will not be tax-pri­vi­le­ged in the fu­ture which are trans­fer­red to the ac­qui­rer by de­ath or by gift wi­thin the fol­lo­wing ten years must also be fac­to­red into the cal­cu­la­tion of avail­able as­sets. Here, too, the stric­ter re­qui­re­ments re­la­ting to the main­ten­ance pe­riod and the mi­ni­mum pay­roll for op­tio­nal re­lief must be com­plied with. This im­po­ses a si­gni­fi­cant ad­di­tio­nal bur­den on both the tax aut­ho­ri­ties and the ac­qui­rer, com­bi­ned with pos­si­ble back ta­xa­tion of the ori­gi­nal ac­qui­si­tion.

As a re­sult, the tax bur­den on the ad­mi­nis­tra­tive as­sets or per­so­nal pro­perty may be 80% or more, de­pen­ding on which tax bra­cket the tax­payer is in. It should also be re­mem­be­red that where the tax­payer only ac­qui­res a cer­tain quota of the as­sets, the tax-pri­vi­le­ged as­sets can be clas­si­fied re­pea­tedly as avail­able as­sets. Owing to this ex­tre­mely high tax bur­den, each large busi­ness ow­ner should im­ple­ment in­heri­tance tax plan­ning to make pro­vi­sion for their de­mise.

The ob­jec­tive at a com­pany le­vel must be to create aba­te­ment re­qui­re­ments that are as com­pre­hen­sive as pos­si­ble, i.e., to ge­ne­rate tax-pri­vi­le­ged as­sets (ad­mi­nis­tra­tive as­sets: ma­xi­mum of 10%). Ide­ally, this has the ad­van­tage that the tax aba­te­ment can re­ach the ma­xi­mum al­lo­wance, no ad­mi­nis­tra­tive as­sets need to be used to pay ta­xes, and the op­ti­mi­zed over­all pa­ckage can be trans­fer­red to the de­si­red suc­ces­sor, in other words it does not need to be trans­fer­red to dif­fe­rent ac­qui­rers. Fur­ther­more, more weight should be gi­ven to the tax-pri­vi­le­ged as­sets and less to per­so­nal pro­perty. Ano­ther op­tion is to have the avail­able per­so­nal pro­perty trans­fer­red to ano­ther in­di­vi­dual in the event of de­ath. The ideal trans­fe­ree is the spouse or ci­vil part­ner if this per­son is en­tit­led to a spe­cial tax al­lo­wance in the amount of the ac­tual or no­tio­nal claim to di­vi­sion of com­mu­nity pro­perty. The aim of this is for the very va­luable com­pany stake that ex­clu­si­vely com­pri­ses tax-pri­vi­le­ged as­sets to be trans­fer­red to an ac­qui­rer. This ac­qui­rer has no (more) avail­able as­sets, ha­ving trans­fer­red their own as­sets to their child­ren, for ex­am­ple, prior to the ac­qui­si­tion. In cer­tain cir­cum­stan­ces, ano­ther ideal ac­qui­rer for in­heri­tance tax pur­po­ses could be a fa­mily foun­da­tion set up for the pur­pose of in­cor­po­ra­ting the com­pany stake. In an ideal sce­na­rio, this foun­da­tion can ap­ply for the full tax aba­te­ment in con­nec­tion with the me­ans tes­ting for the re­lief as it has no other as­sets.

A new era is the­re­fore be­gin­ning for in­heri­tance tax plan­ning at large en­ter­pri­ses. This must start si­mul­ta­neo­usly with the testa­tor/do­nor, at en­ter­prise le­vel, and with the ac­qui­rer. The grace pe­riods must also be mo­ni­to­red clo­sely to achieve the best pos­si­ble tax re­sult. Here, the Fe­deral Mi­nis­try of Fi­nance ap­pears to hold the view that not only the ac­qui­si­ti­ons from July 1, 2016, but also ac­qui­si­ti­ons un­der the old in­heri­tance tax law must be tal­lied up for che­cking whe­ther the EUR 26 mil­lion ac­qui­si­tion th­res­hold has been re­ached. As a re­sult, there is a risk that trans­ferors will also get caught up in the highly com­plex re­lief re­gime for large ac­qui­si­ti­ons – so­me­thing they didn’t ex­pect gi­ven the an­ti­ci­pa­ted com­pany suc­ces­sion im­ple­men­ted in the past.

In prac­tice, par­ti­cu­lar at­ten­tion will have to be paid to whe­ther the me­ans test or the ab­la­tion mo­del is cho­sen for a large ac­qui­si­tion. Ap­pli­ca­ti­ons must be made for both of these forms of tax re­lief. Howe­ver, a re­quest to ap­ply the ab­la­tion mo­del is ir­re­vo­ca­ble and ru­les out an ap­pli­ca­tion for me­ans tes­ting for the same ac­qui­si­tion. Pro­blems arise in the in­ter­play of both ap­pli­ca­ti­ons if a fur­ther ac­qui­si­tion, be it by gift or by in­heri­tance, is made wi­thin the ten-year pe­riod. Then, the ag­gre­ga­tion can lead to the ori­gi­nally ex­pec­ted ba­sic re­lief being lo­wer and pro­ving to be eco­no­mi­cally di­sad­van­ta­ge­ous in hind­sight.

De­fer­ral of pay­ment now only per­mis­si­ble to a les­ser ex­tent

If, in the event of an ac­qui­si­tion on ac­count of de­ath, in­heri­tance tax is re­qui­red to be paid out of the per­so­nal pro­perty, there is an op­tion to de­fer pay­ment. Howe­ver, this has been re­stric­ted un­der the re­form and is now li­mited to just se­ven years. The de­fer­ral is in­te­rest- and re­pay­ment-free for the first year. Star­ting in the se­cond year, in­te­rest of 6% is char­ged and an­nual re­pay­ments of one-sixth of the amount must be made each year. The op­tion of de­fer­ral ends when the heir trans­fers sta­kes in the en­ter­prise to third par­ties.

Con­clu­sion

While the in­heri­tance tax re­form ap­pears at first glance to be the “mi­ni­mal in­ter­ven­tion” in exis­ting law that was in­iti­ally pro­pa­ga­ted, a clo­ser look re­ve­als a large num­ber of tax pit­falls that must be ta­ken into ac­count when plan­ning a com­pany suc­ces­sion. In any case, any tax bur­den on an en­ter­prise to be trans­fer­red af­ter the re­form of in­heri­tance tax must be re­cal­cu­la­ted. Other­wise, the change in the ta­xa­tion of ad­mi­nis­tra­tive as­sets in par­ti­cu­lar may lead to nasty sur­pri­ses for many.

In the fi­nal ana­ly­sis, each busi­ness ow­ner needs an in­heri­tance tax plan that is tailo­red to their spe­ci­fic si­tua­tion. Thin­king in long-term trans­fer cy­cles and in­cor­po­ra­ting the per­so­nal pro­perty of all par­ties and dis­tri­bu­ting this among the fa­mily mem­bers up to in­te­gra­ting fa­mily foun­da­ti­ons and the next ge­ne­ra­tion of heirs but one are new chal­len­ges ari­sing from the re­form of the law. Where pos­si­ble, tax-pri­vi­le­ged and non-tax-pri­vi­le­ged as­sets should be se­pa­ra­ted in the long term, both le­gally and com­mer­ci­ally, and trans­fer­red se­pa­ra­tely. On ac­count of the caps im­po­sed, large as­sets should be trans­fer­red by gift early on. Brin­ging gifts for­ward to an early age for do­nors and donees ne­ces­si­ta­tes re­thin­king the ar­ran­ge­ment of the fa­mily’s as­sets and the ru­les of the game (fa­mily go­ver­nance). Le­gal in­de­pen­dence in the form of foun­da­ti­ons is also li­kely to be­come an in­cre­asin­gly via­ble plan­ning op­tion. In ad­di­tion, in­come tax con­side­ra­ti­ons must be in­cor­po­ra­ted into the or­ga­niza­tion of do­na­tion and trans­fer pro­ces­ses.