Foreign family foundations and trusts: German Federal Fiscal Court strengthens the tax position of German resident settlors and beneficiaries

Background

Under certain conditions, German resident settlors or beneficiaries of a foreign family foundation or common law trust may be subject to the so-called German attribution taxation (Zurechnungsbesteuerung) under the Foreign Tax Act (Außensteuergesetz) (Section 15 Foreign Tax Act). In simple terms, the income of a foreign family foundation or trust is attributed to the settlors living in Germany or, if there is no German resident settlor (any more), to the German resident beneficiaries as deemed own income and taxed at their respective level – regardless of whether the foundation or trust distributes its income or not.

This attribution taxation is intended to prevent income from being generated via foreign family foundations or trusts with little or no taxation at foundation or trust level. The Foreign Tax Act also provides for a similar concept for low-taxed foreign corporations generating so-called passive income, albeit with different requirements and legal consequences (Sections 7 et seq. Foreign Tax Act).

The application of this attribution taxation requires that the foundation/trust is a family foundation/trust. This is the case if the settlor, his relatives and their descendants are entitled to more than 50% of ongoing distributions (Bezugsberechtigung) or corpus distributions (Anfallsberechtigung) (Section 15 (2) Foreign Tax Act). The concepts of entitlement to ongoing distributions or corpus distributions are not defined by law. The German tax authorities interpret these broadly: an entitlement to ongoing distributions (Bezugsberechtigung) is assumed if a person receives or will receive pecuniary benefits in accordance with the foundation statutes or can be expected to do so. An entitlement to corpus distributions (Anfallsberechtigung) is assumed if a person can legally demand or actually cause the foundation/trust assets to be transferred to him in the event of the dissolution or termination of the foundation/trust. The German tax authorities do not require the settlor or beneficiary to have a legal entitlement to any of this, but at least a so-called secured legal position – which means that mere ‘beneficiaries by chance’, where an actual distribution is speculative, are not covered.

Escape clause (Section 15 (6) Foreign Tax Act)

The law provides an exception to CFC taxation in the form of the so-called escape clause (Section 15 (6) Foreign Tax Act). According to this clause, foundation or trust income is not attributed to a German resident settlor or beneficiary under three cumulative conditions - namely if:

1. the family foundation or trust has its registered office or place of management in the EU or EEA,
2. the settlor and the beneficiaries are legally and actually deprived of the power of disposal over the assets of the foundation (or trust) and
3. there is a sufficient exchange of information between Germany and the country in which the family foundation or trust is registered office or managed from.

For German beneficiaries of a family foundation or trust located in a neighboring EU/EEA country, this escape clause is important in many cases, especially if the entitlement to ongoing or corpus distributions cannot be denied with legal certainty. In these cases, the escape clause helps in any case if the (investment management) activities for the foundation are carried out independently of the settlor and the beneficiaries and the settlor and beneficiaries cannot assert any (re)transfer claims. A sufficient exchange of information can be assumed in many cases on the basis of the EU Mutual Assistance Directive, applicable double taxation agreements (DTA) that provide a so-called large information exchange clause (e.g. Art. 26 DTA-USA, Art. 27 DTA-UK or Art. 26 DTA-Canada) or separate agreements (e.g. TIEA-Liechtenstein).

However, the wording of the escape clause expressly only covers family foundations and trusts that either have their registered office or place of management in an EU or EEA member state. If the registered office and place of management are in a so-called third country (i.e., outside of the EU and EEA), the wording of the escape clause does not apply. In German expert literature, this has already been predominantly assessed as contrary to EU law.

Interpretation by the Federal Fiscal Court in line with European law

The Federal Fiscal Court has now ruled that the limitation of the escape clause to EU/EEA cases is contrary to EU law. By extension of its wording, the escape clause does apply to all foreign family foundations or trusts for which the other two above-mentioned requirements of Section 15 (6) Foreign Tax Act are met.

The decision of the Federal Fiscal Court was based on the following simplified facts:

• A settlor had established a family foundation under Swiss law. The beneficiaries were relatives of the settlor who were exclusively resident in Germany for tax purposes.
• According to the foundation statutes, these beneficiaries could only receive distributions in certain situations of need, which the foundation board had to decide on at its own discretion. The beneficiaries had no enforceable claim.
• If the foundation is dissolved, its assets should generally be allocated and distributed to the beneficiaries.
• The German tax office affirmed both an entitlement to ongoing distributions as well corpus distributions and denied the application of the escape clause for the benefit of the German resident beneficiaries. The settlor had died in the meantime.

Like the lower court, the Federal Fiscal Court affirmed the beneficiaries' entitlement to corpus distributions. It left open the question of whether the beneficiaries were also entitled to receive the ongoing distributions (which the lower court rejected).

However, the Federal Fiscal Court ultimately denied the application of attribution taxation by applying the escape clause beyond its wording and ignoring the statutory restriction to EU/EEA foundations ‘to prevent a breach of EU law’:

• The attribution taxation constitutes a restriction on the EU right of free movement of capital, which also applies to third countries (Art. 63 TFEU), because it can deter a potential settlor from setting up a foundation in a third country due to its disadvantageous consequences.
• This restriction is also not justified. In particular, the legislator cannot invoke compelling reasons in the public interest. It is true that the prevention of tax avoidance through artificial arrangements is recognized as a justifying compelling reason. However, even in these cases, the taxpayer must always have the right and the opportunity to provide evidence to the contrary. The escape clause falls short in this respect, as it excludes family foundations and trusts with their registered office and place of management in a third country.
• The primacy of application of EU law therefore requires that the element contrary to European law (i.e. the requirement of having a registered office or place of management in an EU/EEA state) be omitted by way of a reduction in the scope of application.

The Federal Fiscal Court’s additional explanations on the interpretation of the second element of the escape clause mentioned above (deprival of the power of disposal over the foundation's or trust’s assets) are also helpful: According to the Court, this depends solely on civil law standards, i.e. that settlors or beneficiaries cannot effect the (re-)transfer of the foundation's assets if civil law standards are applied. Economic standards and indirect possibilities of exerting influence, such as the right to dismiss members of the foundation's or trust’s governing body, are irrelevant. The latter contradicts the previously published opinion of the German tax authorities in the Foreign Tax Act Circular.

Relevance in practice

The decision is of great importance in practice. In future, settlors and beneficiaries of family foundations and trusts that would generally be subject to attribution taxation (Section 15 Foreign Tax Act) will be able to invoke the escape clause, irrespective of the law under which the foundation or trust was established or where the place of management is located.

This is important, for example, in cases where German resident beneficiaries are to be classified as having an entitlement to ongoing or corpus distributions. In individual cases, it may be possible to exclude an entitlement to ongoing distributions if an independent governing body of the foundation or trust decides on the timing and amount of any such distributions on a discretionary basis. However, settlors typically want to determine the beneficiary of the foundation or trust assets in advance in the event of dissolution and not leave this to the discretion of a third party (so that in these cases, an entitlement to corpus distributions can generally be assumed). Depending on the individual case, such ‘affected’ beneficiaries can now provide evidence that they have been permanently deprived of the foundation or trust assets – with the result that attribution taxation can be successfully navigated for them despite their entitlement to ongoing or corpus distributions. According to the Federal Fiscal Court ruling, as explained above, only civil law standards are decisive for this. However, even in such cases, any potential German notification and filing obligations (Section 138 (2) AO; Section 18 (3), (4) AStG) should be monitored.

The legislator is now called upon to adapt the wording of Section 15 (6) Foreign Tax Act to the interpretation of the Federal Fiscal Court in line with European law. In order to have legal certainty until the law is amended, a corresponding clarification by the German tax authorities or publication of the ruling in the Federal Tax Gazette would be desirable. It remains to be seen how the German tax authorities will position themselves on this