Although the Federal Constitutional Court (BVerfG) granted the legislator a deferment period of approx. 1 ½ years (30 June 2016) in December 2014, the legislator failed to reach an agreement in due time. Only after the BVerfG threatened further measures after 30 September 2016, the legislative procedure was moved forward. On 21 September 2016, an agreement was reached in the Mediation Committee, the German Bundestag adopted the new law as early as 29 September 2016, and the German Bundesrat approved of it on 14 October 2016. It is the 3rd reform of the inheritance tax act in 20 years (1995 / 1996, 2008 / 2009 and 2016). Each reform was required because the BVerfG found the existing inheritance tax act to be unconstitutional. What was this reform about? Although the BVerfG considered it generally constitutional to spare business assets at 100% in its decision in 2014, the BVerfG rejected three aspects of the existing law:
- non-operating assets, i.e. so-called (harmful) administrative assets, must not be privileged;
- the wage bill control must be extended, i.e. it must not only be applied to companies with more than 20 employees; and
- a needs test is required for so-called large acquisitions.
How has the legislator met these requirements of the BVerfG?
I. Modifications to the administrative assets
1. According to the previous regulation, the entire business assets, i.e. including the administrative assets, were included in the exemption (85% or 100%) if the administrative assets accounted for less than 50% of the entire business assets. The “all or nothing principle” applied. This principle has now been abandoned. The administrative assets must be taxed to full extent in the future. This is a significant deterioration of the revision. It means that the administrative assets must be excluded from the eligible assets and separately valued in the future. 2. Furthermore, the legislator tightened the determination and/or definition of what constitutes administrative assets. a) So far, administrative assets essentially included:
- Properties let out to third parties; and
- Financial resources (securities accounts, bank balances above the exemption limit).
In the future, so-called luxury goods are also excluded from the exemption from the outset (such as yachts, art collections, hunting lodges, etc.). b) Regarding the financial resources, a basic amount of 20% related to the business assets has been non-harmful so far, i.e. the liquidity has not been regarded as harmful administrative assets to this extent. This limit was reduced to 15% referred to the business assets. c) An exception was introduced for properties let out to third parties: If and to the extent the property is let out to external third parties, but this happens for the purpose of selling the company’s own products, the property is not deemed to be included by the harmful administrative assets (e.g. property of a brewery let out to a restaurant owner who is obliged to purchase beer). d) The rules for group companies were seriously tightened. So far, harmful administrative assets of subsidiaries have not had an impact on the parent company (cascade effects). In the future, the administrative assets of subsidiaries, sub-subsidiaries, etc. will be projected to the principal company, which can cause a considerable increase of the harmful administrative assets. 3. In order to prevent misuse due to the organisation of Cash-GmbHs and commercially characterised partnerships, a regulation was introduced stating that the administrative assets must not exceed 90% of the eligible business assets. If this limit is exceeded, the remaining up to 10% of the business assets are also excluded from exemption. Another much tighter regulation stipulates that full exemption (100%) may only be claimed if the administrative assets amount to less than 20% of the business assets (before debt netting). Otherwise, only the regular exemption (85%) comes into consideration.
II. Extension of the wage bill control
While, according to the old law, all companies who employed less than 20 employees were excluded from the obligation to maintain the wage bill (5 years and/or 7 years), this regulation had to be changed due to the decision made by the BverfG. In view of the fact that the vast majority of the small and medium-sized enterprises has less than 20 employees, it was not constitutional in the BverfG’s opinion that only a minority of companies was affected by the wage bill control. The legislator now decided that only companies with less than 5 employees shall be excluded from the obligation to maintain the wage bill. However, reduced retention periods shall apply to companies with 5 to 10 employees and 11 to 15 employees, and the previous retention periods (5 years with regular exemption and 7 years with full exemption) shall apply only to companies with more than 15 employees.
III. Revisions to the extent of exemption
1. In this regard, the legislator introduced a value reduction for eligible family companies. If the shareholders’ agreement includes limitations for the shareholders, namely A withdrawal and distribution limit to a maximum of 37.5% of the profit after tax; A limitation of the successive entitlement to close relatives and fellow shareholders; and The grant of compensation below the fair market value of the participating interest; the value of the participating interest is reduced to the extent the compensation under company law is below the fair market value; however, by no more than 30%. However, this relief is considerably complicated by the fact that a grace period of 20 years is introduced for the (final) claim of this value deduction. If e.g. more than 37.5% of the profits after tax is distributed or withdrawn in one year within these 20 years, this value deduction will not come into effect. 2. Moreover, the legislator had already introduced the aforementioned stricter regulation that full exemption may only be an option if the harmful administrative assets amount to less than 20% of the business assets (before debt consolidation).
IV. Needs test for large acquisitions
According to the new law, the application of the regular exemption (85%) and the full exemption (100%) is limited to such cases where the value of the inherited share does not exceed EUR 26 million. If the value of EUR 26 million is exceeded, there are two options: 1. If the so-called “Abschmelzungsmodell” is applied, the exemption reduction is reduced by respectively 1% per EUR 750,000.00 by which the value of the tax-exempted assets exceeds the amount of EUR 26 million. This has the consequence that there is no more exemption as from a value limit of EUR 90 million. 2. If the so-called “Erlassmodell” is applied, an exemption needs test is performed. The heir / donee must then explain and, where required, prove that no sufficient assets are available to him/her in order to pay the inheritance tax. In doing so, he/she must use respectively 50% of the following values: The private assets acquired jointly with the share; The non-exempted administrative assets; The previously available private assets or business assets (including the administrative assets). It is of particular importance to note that the availability of assets to be used does not mean that such assets are actually fungible and realisable. The law does not take into account either that an income tax burden may accrue in addition to the inheritance tax if the heir / donee liquidates such available assets.
V. Revision of the company valuation under inheritance tax law
In the last inheritance tax reform in 2009, the legislator introduced a new method to assess companies due to an objection raised by the BverfG. According to this new method, a simplified German income approach (so-called Ertragswertverfahren) was used in which the average yield of the company was capitalised with a base interest rate from the long-term returns obtainable from bonds issued by public authorities and a fixed surcharge of 4.5%. Therefore, a base interest rate of 3.43% and a surcharge of 4.5% in 2011 resulted in a capitalisation factor of 12.61% (100 : (3.43 + 4.53%)). Due to the decline of the base interest rates for long-term achievable yields of bonds issued by public authorities, the capitalisation factor amounted to 17.857 in 2016 (100 : (1.1 + 4.5)). Such a capitalisation factor considerably exceeded the capitalisation factors paid in the free market. Therefore, the company values under inheritance tax law considerably exceeded the fair market values that could be achieved in the market. The legislator has now determined a general capitalisation factor of 13.75%. At the same time, the Ministry of Finance was permitted, with the Bundesrat’s consent, to adjust the capitalisation factor in the future if the interest rate structure data change. This regulation will cause that the company values under inheritance tax law decrease by approx. 25%. Even if a capitalisation factor of 13.75 is still very high compared to the prices paid in the market, this relief is most welcome.
VI. Summary
In a final assessment, it can be noted that the legislator has met the requirements of the BverfG with the new formulation of the law in a way that repeated unconstitutionality need not be feared. However, in my opinion, it is correctly pointed out in legal literature that this extent of stricter regulations was not a mandatory requirement. Furthermore, it must be pointed out that the application of the new law has become much more complex and difficult. This concerns both the fiscal authorities and particularly the tax citizens and their advisers who want and need to plan a gift and/or succession also in consideration of the tax burden.