On 14. October 2016 the members of the Arbitration Committee of the Federal Parliament (Bundestag) and the Federal Assembly (Bundesrat) have reached a compromise on the inheritance and gift tax reform for the inheritance of business enterprises. All business assets, including interest in a commercial GmbH & Co KG as well as qualified shares in corporate enterprises shall continue to be eligible for preferential inheritance/gift tax treatment.
Already in 2014 the Federal Constitutional Court has declared that the existing rules for the beneficial inheritance-gift-tax treatment of business heirs are too generous to be constitutional. The Court called on the Government to introduce new rules by June, 30 2016. However, an agreement between the two houses proved to be difficult to achieve. The Bundesrat called for the establishment of an arbitration committee. This committee has reached a compromise in October 2016, which has been confirmed by both the Bundestag und Bundesrat.
The reform rules will affect all transfers by death or by gift from 1. July 2016, if either the decedent/donor or the heir/donee is domiciled in Germany or if the transfer comprises German eligible assets, such as business assets or shares in German corporations.
The Basic Relief of 85 % and the Optional relief of 100 % remain almost unchanged
The two main relief models for the transfer of eligible business assets remain intact and the taxpayer (heir or donee) in cases where the transferred eligible assets do not exceed EUR 26 million can chose between the 85 % regular relief, where 85 % of the value of business assets are excluded and the 100 % optional relief, where 100 % of the value of business assets is excluded. Both relief measures are still tied to the preservation of jobs and wages and the continuation of the business for 5 years with respect to the basic relief and for seven years with respect to the optional relief after the transfer.
However, the test for the preservation of jobs and wages for the respective relieves has been substantially tightened. Whereas under the existing rules the wage test only has to be satisfied with enterprises of more than 20 employees under the new rules the payroll regulations have to be applied, if the enterprise has 6 employees. Utilizing the basic relief of 85 % the acquirer has to maintain 50 % of the aggregate payroll for 5 years, if there are no more than 10 employees, 60 % of the payroll, if there are no more than 15 employees and 80 %, if there are more employees. In utilizing the optional relief the respective quota increases to 71 %, 81 % and 100 %.
Furthermore the optional relief of 100 % will only be granted in the future, if less than 20 % of the business assets compromise harmful administrative assets (such as, e.g. real property leased to third parties, shareholding of 25 % or less , works of art etc.) This ratio of administrative assets to business assets is calculated on the basis of the respective fair market value.
Adjustments to valuation
Another renewal has been made concerning the valuation of business assets. The determination of the value of the enterprise still requires the application of the so-called simplified capitalized earning method. The Bundestag und Bundesrat have agreed on a fixed capitalization factor of 13.75 (instead of the currently factor 17.86). With this new fixed capitalization factor the parties anticipate to reach a more realistic value for the business assets involved, even though some are of the opinion that this factor would still lead to a value which cannot be achieved in a real sale of the business enterprise. The Federal Ministry of Finance has the right to adjust the fixed capitalization factor according to the interest rate structure.
Management property/Administrative assets
In the reform the existing rules have been substantially changed with respect to the treatment of administrative assets. Under the existing rules administrative assets were included in the tax benefits, if the value of the administrative assets did not exceed 50 % of the value of the business assets. According to the new rule only administrative assets up to the value of 10 % of the total company assets (so-called “contamination clause” (“Schmutzklausel”) can enjoy the preferential tax treatment. Otherwise, administrative assets will be subject to the full inheritance/gift tax. Thus, if the administrative assets exceed 10 % of the total business assets, they are fully taxable at the regular rate. In extreme cases where the value of administrative assets equals 90 % of the value of the company, the remaining 10 % privileged business assets is excluded from all relief. As a result of this new rule the succession of business enterprises will be subject to a higher burden of inheritance tax in the future, due to the taxation of so called “harmful” administrative assets.
The property items included in the harmful administrative assets are determined on the basis of an almost completely unchanged catalog. “Harmful” administrative assets are basically leisure and luxury assets such as precious stones and metals, works of art, stamp collections, yachts, gliders, unless the trading, processing or leasing of these assets are not the main purpose of the respective business. Also included are real estate rented to third parties and shareholdings in corporations of less than 25 %.
Not included in administrative assets are real estate that are rented to third parties, but used for the purposes of marketing the company’s own products (e.g. brewery restaurants or gas stations). In addition real estate properties rented to third parties that are held in a so-called cooperative company are also not included, if the number of apartment units exceeds 300.
To further put a stop to the revival of so called “cash GmbHs” the new rules provide that the allowance for preferential inheritance tax treatment of financing amounts is limited to 15 % of the fair market value of the business assets and only then, if the main business purpose is trading or a profession or is connected to land and forestry business. Any other financing amounts are considered “harmful” administrative assets subject to full inheritance/gift tax at regular rates.
Special tax relief for family enterprises
A new rule has been introduced with respect to the inheritance of family enterprises. Specific eligible business assets of family enterprises with specific restrictive clauses contained in the Article of Association are subject to an advance deduction of up to 30 %. This reduction might be applied even before the Basic Relief of 85 % and the Optional Relief of 100 %. The advance deduction is subject to three restrictions to be contained in the Article of Association and which relate to the right to draw profits, the right to transfer a business interest and the right to exit the business. Thus, for example the drawings or distributions of profits must be limited to a maximum of 37.5 % of the profits after deduction of the income tax attributable to the relevant profit shares or distribution. The right to dispose an interest in the partnership or the corporation is limited to members of the same entity, to relatives or to family trusts. This new special relief is a significant alleviation for family enterprises. However, the above mentioned restrictions must have been incorporated in the Articles of Association already two years before the relevant transfer and still in place and exercised up to 20 years after the transfer. If one of the restrictions is not met within the 20 year period, the benefit will be become retrospectively invalid.
Acquisitions of business over Euro 26 Million
The key change of the reform probably relates to large eligible assets. The inheritance or gift of businesses with a value of more than Euro 26 million are less favored under the new rule. The new rules provides here for two alternative models. The taxpayer can either choose between the stepped decreasing relief (a) and a partial tax exemption (b) if an appropriate means test is met. According to the decreased relief model the advanced up to 30 % valuation reduction for business assets is decreased by 1 % for each EUR 750,000 above the threshold of EUR 26 million (with the result that there is no reduction for favored assets with a value of EUR 90 million). The alternative of the partial exemption relief requires that the taxpayer demonstrates that he is not able to settle the inheritance tax debt by using his own estate or the transferred assets. This means that the relief for large fortunes can only be justified if it is determined, based on a separate examination that the accrued inheritance/gift tax can only be paid out of or by selling business assets subject to preferential tax treatment. An exemption from the inheritance tax will be considered upon request to the extent that 50 % of the acquirer’s own assets and the transferred assets are not sufficient to settle the tax obligation.
These rules call for the structure to reduce the transferred value of EUR 26 million per acquisition. It can be expected that family trusts will be used more frequently in order to reduce the threshold amounts, or that business enterprises are transferred to young children with no other assets in order to meet the “assessment of need for relief” requirement for the partial tax exemption.
Deferment of payment
The new rules also provide for the deferment of inheritance tax payment for up to 7 years. However, the deferment is free of interest only for the first year. From the second year on the deferment is subject to a 6 % interest per year.
The amendment leaves many things unchanged related to the tax privilege of business assets. Small and medium sized enterprises should in the future make some adjustments, if necessary and possible, to reduce the value of “harmful” administrative assets, which are under the new rules only privileged, if they constitute less than 10 % of the total value of business assets. In cases where small or medium sized enterprises opt for the Basic Relief of 85 % or for the Optional Relief of 100 % they have to take into account the new job-wage requirements for these respective relieves. The big change certainly is for large business fortunes. Taxpayers with large business enterprises should definitely plan in time succession structures to ensure that the value per acquisition remains below the EUR 26 million threshold so that at least the 30 % advance deduction for family business are secured. If a split of the value cannot be reached, structures should be found as to meet the “assessment of need relief” requirement for big fortunes. Furthermore, the reduction of the capitalization factor to determine the valuation of business enterprises is a positive development and could lead to more realistic values, on which the inheritance/gift tax is ultimately based. To be welcome is the up to 30 % advance deduction for family enterprises, which still constitute a very high percentage of German companies. Here the Articles of Association need to be examined in order to make sure that the above mentioned required restrictive clauses are met.