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.
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.
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.