By Anthony Diosdi
Foreign investors generally have the same goal of minimizing their tax liabilities from their U.S. real estate and other U.S. investments, as do their U.S. counterparts, although their objective is complicated by the very fact that they are not domiciled in the U.S. The U.S. has a special estate and gift tax regime that is applicable to foreign investors that are not domiciled in the U.S. Sometimes, with proper planning, foreign investors can avoid U.S. estate and gift taxes. This article discusses the special provisions of the U.S.- Germany estate and gift tax treaty foreign investors should consider when planning to avoid or mitigate U.S. estate and gift taxes.
An Overview of the Estate and Gift Tax
U.S. Federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest or inheritance. During an individual’s lifetime, his transfer tax takes the form of a gift tax. For gift tax purposes, a gift is defined as the transfer of property for less than adequate and full consideration in money or money’s worth, other than a transfer in the “ordinary course of business.” No U.S. gift tax would be owed on a gift to a beneficiary until the gifts made to the beneficiary in a calendar year exceed an applicable exclusion amount for that year ($17,000 for calendar year 2023). Upon an individual’s death, the tax takes the form of an estate tax. The tax is measured against a tax base that includes all the assets owned at death.
The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or gift. A unified credit is available to minimize the impact of the transfer tax. The unified credit gives a set dollar amount that an individual can gift during their lifetime and pass on to beneficiaries before a gift or estate taxes apply. U.S. citizens and resident individuals are permitted a unified credit that exempts $12.92 million (for the 2023 calendar year) from the estate tax. This means that U.S. citizens and residents can pass $12.92 million to their heirs without being assessed a gift or estate tax. The unified credit is significantly smaller for foreign individuals that are not domiciled in the U.S. The current unified credit for non-domiciliaries is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. In addition to its smaller size, the unified credit available to non-U.S. citizens and non-U.S. domiciliaries cannot be used to reduce their U.S. gift tax. The credit can only be used by their estates upon their deaths to reduce U.S. estate tax. See IRC Section 2505(a).
There are also significant differences as to how the estate and gift tax is calculated for individuals domiciled in the U.S. compared to individuals not domiciled in the U.S. The worldwide estate of a decedent is subject to U.S. estate tax only if the individual was either a U.S. citizen or resident at the time of death. See IRC Sections 2001(a) and 2031(a). In contrast, the estate of an individual not domiciled in the U.S. is subject to estate tax solely on his or her U.S. situs assets. Similarly, all property gifted by a U.S. citizen or domiciliary is subject to U.S. gift tax regardless of where the property is situated. However, in the case of a donor who is neither a U.S. person nor a U.S. domiciliary, only gifts of real property or tangible personal property situated in the U.S. are subject to U.S. gift tax.
Determining Domicile for U.S. Estate and Gift Tax
Because individuals domiciled in the U.S. are permitted a unified credit of $12.92 million, for most U.S. citizens, the estate and gift tax is not an issue. This situation is different for foreign persons who are not domiciled in the U.S. Instead of a unified credit that would shelter up to $12.92 million in lifetime gifts, individuals not domiciled in the U.S. are only provided a credit equivalent to an exemption of just $60,000 against the estate tax. Given the differences in the way the U.S. estate and gift tax is calculated, it is crucial to understand when an individual can be classified as being domiciled in the United States. An individual is presumed to have a foreign domicile until such domicile is shown to have changed to the United States. A person acquires a U.S. domicile by living here, potentially even for a brief period of time, with no definite present intention of leaving. To be domiciled in the U.S. for estate and gift tax purposes, an individual must physically present in the U.S. coupled with the intent to remain in the U.S. indefinitely or permanently. For U.S. estate and gift tax purposes, an individual can only be domiciled in one country. The term “domicile” for estate and gift tax purposes should not be confused with the terms “resident” or “residence” used in the income tax context. A foreign investor may be characterized as a resident of the U.S. for income tax purposes through either the green card test or substantial presence test. Just because a foreign person is classified as a U.S. resident for U.S. federal income tax purposes, does not mean the individual is domiciled in the U.S. for estate and gift tax purposes.
How the Estate Tax and Gift Tax is Computed for a Decedent Not Domiciled in the U.S.
The estate tax for a decedent that was not domiciled in the U.S. is only assessed on its gross estate. The gross estate is made up of property or assets situated in one of the U.S. states or the District of Columbia at the time of death. This is often referred to as U.S. situs assets or property. The gross estate is composed of revocable transfers, transfers taking effect on death, transfers, with a retained life interest or (to a limited extent) transfers within three years of death are includible in the U.S. gross estate if the subject property was U.S. situs property at either the time of the transfer or the time of death. In the case of corporate stock, the stock of a U.S. corporation is U.S. situs and stock of a foreign corporation is foreign situs, regardless of place of management or location of stock certificates.
The rules for determining gift tax for an individual not domiciled in the U.S. differ from the estate tax. As a general rule, the gift tax applies only if transfers of tangible property (real property and tangible personal property, including currency) are physically located in the United States at the time of the gift. The gift tax does not apply to intangible property such as stock in U.S. or foreign corporations even though such property is includible in the U.S. gross estate for federal estate tax purposes. Since the gift tax is not assessed on the transfer of securities, non-domiciliaries often transfer securities to heirs prior to death for planning purposes.
Introduction to U.S.- Germany Estate and Gift Tax Treaty
The United States imposes its estate tax on estates of individuals who were U.S. citizens or U.S. domiciliaries at the time of their death, and on assets of nondomicilies where the assets are situated in the United States at the time of their death. The United States imposes its gift tax on gifts made by U.S. citizens and U.S. domiciliaries regardless of where the property which is the subject of the gift is located, and also on gifts made by nondomiciliaries where the property which is the subject of the gift is tangible property in the United States at the time of the gift.
Germany imposes an inheritance tax on property transferred at death where either the heir or decedent has a residence or customary place of abode in Germany. Germany also imposes a tax on gifts where either the donor or donee has a residence or customary place of abode in Germany. Otherwise, Germany will only impose its inheritance or gift tax when the subject property is located in Germany.
Since each country has its own definition of domicile in that country, it is possible that the definition of domicile, it is possible that the definition of domicile in the two countries could overlap resulting in double taxation. This could result in double estate and gift taxation. The U.S.- Germany estate and gift tax treaty was enacted to avoid double taxation.
Elimination of Double Taxation
The U.S.- Germany treaty is designed to alleviate double taxation on gifts and estates of U.S. citizens and domiciliaries and German domiciliaries in some situations by allowing only one country to impose its tax and in others by allowing both countries to impose a tax but requiring one of the countries to allow a credit against its tax for the taxes paid to the other country.
In most situations, the treaty allows the country of domicile to assert primary tax jurisdiction. However, the situs country is given priority taxation in the case of real property, tangible personal property, and business assets which are located in that country.
Estate, Gift, and Taxes Covered
The treaty applies to estates of decedents who were domiciled in Germany at the time of their death and to estates that are subject to tax in the United States because the decedent was a citizen or domiciliary of the United States at the time of his death. With respect to gifts, the treaty applies to gifts made while the donor was a domiciliary of Germany and to gifts which are subject to tax in the United States because the donor was a citizen or domiciliary of the United States when the gift was made. Generation-skipping transfers which are subject to tax in the United States because the transferor was a U.S. citizen or domiciliary are also covered. The U.S.- Germany estate and gift tax treaty applies to the U.S. estate, gift, and generation skipping tax.
The treaty also applies to any German inheritance or gift tax that is imposed on the transfer of property that is transferred at death or by gift.
Below, this article will discuss select provisions of the U.S.- Germany estate and gift tax treaty.
The concept of domicile is important under the treaty because the country of domicile has, under the treaty, primary tax jurisdiction on all property other than the property subject to situs taxation. Under the Internal Revenue Code, an individual is considered a domiciliary of the United States for purposes of the federal estate and gift tax if the person was residing in the United States and had the intent to remain in the United States indefinitely. A person is a domiciliary of Germany if he has his domicile abode in Germany or if he is deemed to be subject to unlimited tax liability for purposes of the German inheritance or gift tax.
To provide relief from double taxation where the individual is considered domiciled in both countries under their domestic laws, the treaty provides a series of rules designed to establish a single country of domicile for the individual for purposes of the taxes covered by the treaty. The country so selected will then have the primary tax jurisdiction with respect to the worldwide estate of the decedent or his worldwide gifts, other than with respect to real property, business assets of tangible property situated in the other country.
In determining the domicile of an individual under the treaty, each country will first determine whether the individual is considered a domiciliary under its law. If the individual is a domiciliary of only one country then that will be the individual’s country of domicile for purposes of the treaty. However, if the person is determined to be a domiciliary of both countries the treaty provides a series of rules by which an exclusive domicile for the individuals will be determined.
Under the first of these rules, if the individual is a citizen of one country and not a citizen of the other country and has not been domiciled in that other country for more than ten years, then the individual will be considered a domicile of the country of his citizenship. If a dual domicile problem still remains after application of these rules, the treaty provides four additional rules to determine domicile. The rules (applied in the order presented) provide that the individual will be considered domiciled in the country (1) in which he had a permanent home available to him; (2) in which his personal and economic relations were the closest (center of vital interests); (3) in which he had a habitual abode, or (4) in which he was a citizen. In cases where an individual’s domicile cannot be determined by these tests, then the competent authorities of the countries can be utilized to determine domicile for purposes of taxation.
The Taxation of Property
Under Articles 5, 6, and 7 of the U.S.- Germany estate and gift tax treaty, immovable (real) property is one of three properties over which the situs country has primary tax jurisdiction rather than the country of domicile. The other two are assets of a permanent establishment or fixed base. Under these articles, domiciliaries of Germany who own U.S. real property could be subject to the U.S. estate or gift tax on the value of the U.S. situs property. Many foreign investors utilize planning techniques to avoid the U.S. estate and gift tax. One such planning option is to contribute U.S. real property to a corporation, limited liability company, or partnership to avoid U.S. transfer taxes.
Under Article 9 of the U.S.- Germany estate and gift tax treaty, Germany likely only has the ability to tax tangible personal property located in the U.S. of German domiciliaries such as personal property, U.S. debt obligations, and corporate stock. Thus, the traditional planning methods could potentially be utilized with the U.S.-German estate and gift treaty. However, Article 8 of the treaty provides that partnership interests where a partnership has either business property in the U.S. or “immovable property” such as real estate in the U.S. could be subject to U.S. estate and gift taxation. As a result, an interest in limited liability company or partnerships which comprises U.S. situs real property may be subject to U.S. estate and gift tax. In light of Article 8, extreme caution is recommended for any tax advisor that utilizes the planning techniques discussed above for German domiciliaries.
Claiming a Treaty Position to Reduce or Eliminate the U.S. Estate Tax
The taxation of non-U.S. domiciliaries can be harsher than that of U.S. domiciliaries. Non-U.S. domiciliaries are subject to estate tax on their U.S. situs assets and are not allowed an exemption of only $60,000. The treaty provides a pro rata unified credit to the estate of an individual domiciled in Germany (who is not a U.S. citizen) for purposes of computing the U.S. estate tax. The pro rata portion is based upon the ratio that the German resident’s gross estate situated in the United States at the time of his death bears to his worldwide gross estate. Below, please see Example 1 which discusses how pro rata unified credit is computed.
Let’s assume a husband and wife were domiciled in Germany. They decided to acquire U.S. real estate in the resort town of Park City, Utah. Husband died when the U.S. real property had a fair market value of $5,000,000. Let’s assume that the Park City real estate was the only asset the couple held on the date of the husband’s death.
The executor of the deceased German domiciliary husband may utilize the U.S.-German estate, gift, and generation skipping tax treaty reduce the estate’s exposure to the U.S. estate tax.Under the U.S.-German estate, gift, and generation-skipping tax treaty, for purposes of determining the estate tax, “the taxable base is to the extent by its value (after taking into consideration any applicable deductions) exceeds 50% of the value of all property.”
Under Article 10, Paragraph 4 of the U.S. – German estate and gift tax treaty, for purposes of determining the U.S. estate tax for the estate of the deceased German husband, 50% of the value of the property passed to the surviving spouse is not subject to the U.S. estate tax (this will be discussed in more detail below). In determining the estate tax imposed by the United States, Article 10, Paragraph 5 provides that if a decedent was domiciled in Germany at the time of the decedent’s death, the estate tax shall be allowed a unified credit equal to the greater of: a) the amount that bears the same ratio to the credit allowed to the estate of the citizen of the United States as to the value of the part of the decedent’s gross estate that at the time of the decedent’s death is situated in the United States bears to the value of the decedent’s entire gross estate wherever situated; or b) the unified credit allowed to the estate of a nonresident not a citizen of the United States. Under Article 10, Paragraph 5 of the treaty, the estate of the husband is allowed a unified credit of $12.92 million against the estate tax.
The estates of individuals not domiciled in the United States are generally not entitled to a marital deduction for U.S. estate tax purposes. Marital deductions refers to exceptions to gift and estate taxes for transfers made to spouses. Almost all property qualifies for this deduction and there is no limit. The deduction does not avoid transfer taxes completely, but rather, the spouse receiving the property must pay the eventual estate taxes. The marital deduction for non-U.S. citizens is limited to an annual exclusion of $175,000 for the 2023 calendar year.
The U.S.- Germany estate and gift tax treaty allows a marital deduction in connection with transfers satisfying each of five conditions. Where a surviving spouse is not a U.S. citizen, the treaty allows an estate to elect a limited U.S. estate tax marital deduction for property that would qualify for the marital deduction if the surviving spouse had been a U.S. citizen, provided that the following conditions are met: (1) at the time of the decedent’s death, the decedent was domiciled in either Germany or the United States; (2) the decedent’s domiciled in either Germany or the United States; (3) if both the decedent and the decedent’s surviving spouse were domiciled in the United States at the time of the decedent’s death, one or both was a citizen of Germany; and (4) the executor of the decedent’s estate irrevocably waives the benefits of any other estate tax marital deduction that would be allowed under the Internal Revenue Code. Under the wording of the United States-German estate, gift, and generation-skipping tax treaty, the estate would then be subject to U.S. tax in the lower amount of a) the figure determined using the marital deduction; or b) that generally imposed upon nonresident aliens under U.S. law. In general, the treaty provides the following benefits to foreign investors that are residents of Germany:
1. The estate of a German domiciliary may claim a proportion of U.S. estate unified credit based upon the respective values of the decedent’s U.S. gross estate and his worldwide gross estate.
2. An estate of a German domiciliary is entitled to a marital deduction equal to the value of any “qualified property” passing to the decedent’s surviving spouse so long as such amount would qualify for the U.S. estate marital deduction if the surviving spouse were a U.S. citizen and all applicable elections were properly made, providing that: a) At the time of the decedent’s death, both the decedent and the surviving spouse were domiciled in either the U.S. or Germany; b) If the decedent and the surviving spouse were at the time both U.S. domiciliaries and one or both of them were German citizens; and c) The executor of the decedent’s estate elects to use the marital deduction treaty benefits and irrevocably waives the right to make a qualified domestic trust or (“QDOT”) election on behalf of the estate.
To illustrate how the marital deduction is applied, the Treasury Department has provided a number of examples in the Treasury Department’s Technical Explanation to the protocol governing estate tax in the United States-German estate, gift, and generation-skipping tax treaty illustrates the operation of the pro rata unified credit and marital deduction. The examples provided by the Treasury Department provide as follows: for purposes of these examples, presume that: 1) H (the decedent) and W (his surviving spouse) are German citizen residents in Germany at the time of the decedent’s death; 2) H died in 2016, when the Section 2010 unified credit was $2,125,800 and the related applicable exclusion amount was $5,450,000; 3) the conditions set forth in the Protocol are satisfied; 4) no deductions are available under the Internal Revenue Code in comparing the U.S. estate tax liability.
(i) H has U.S. real property worth $10,000,000, all of which he bequeaths to W. The remainder of H’s estate consists of $10,000,000 of German situs property.
(ii) Pursuant to the existing marital deduction provision of the Germany Treaty [Article 10(4), as modified by the Germany Protocol], the U.S. gross estate equals $5,000,000 [the amount by which the $10,000,000 of U.S. real estate bequeathed to W exceeds $5,000,000 (50 percent of the total value of U.S. property taxable by the United States under the Germany Treaty)]. H’s worldwide gross estate equals $15,000,000 ($5,000,000 plus $10,000,000 of German situs property).
(iii) The $5,000,000 U.S. gross estate is reduced by the $2,500,000 marital deduction of Germany Treaty Article 10(6), resulting in a $2,500,000 U.S. taxable estate. The tentative tax on the taxable estate equals $945,800. H’s estate would also be entitled to the pro rata unified credit allowed by Germany Treaty Article 10(5) of $708,600 [$2,125,800 (the full 2016 unified credit) x $5,000,000/$15,000,000 (the $5,000,000 U.S. gross estate divided by the $15,000,000 worldwide gross estate)]. Thus, the total U.S. estate liability is approximately $237,200 ($945,800 – $708,600 = $237,200).
(i) The facts are the same as in Example 1 except that H bequests $1,000,000 of his real property to W and $9,000,000 of his real property to C, H’s child.
(ii) The $9,000,000 of U.S. real property bequeathed to C is included in H’s U.S. gross estate. Pursuant to the U.S.-Germany Treaty Article 10(4), none of the U.S. real property bequeathed to W is included in the gross estate because such property would be included only to the extent its value (i.e., $1,000,000) exceeded 50 percent of the $10,000,000 total U.S. situs property taxable under the applicable provisions of the Germany Treaty. H’s worldwide gross estate equals $19,000,000 ($9,000,000 plus $10,000,000 of German situs property).
(iii) Because none of the U.S. situs property bequeathed to W is included in the U.S. gross estate, the property is not “qualifying property,” and therefore no marital deduction is allowed with respect to that property under Germany Tax Treaty Article 10(6). The tentative tax on the $9,000,000 gross estate equals $3,545,800. H’s estate would also be entitled to the pro rata unified credit allowed by Germany Treaty Article 10(5), which equals approximately [$2,125,800 (the full 2016 unified credit), multiplied by a fraction equal to the $9,000,000 U.S. gross estate over the $19,000,000 worldwide gross estate. Thus, the total U.S. estate tax liability is $2,538,843 ($3,545,800- $1,006,957).
If an individual nondomiciliary or decedent that was not domiciled in the U.S. would like to take a treaty position, this treaty position must be disclosed on Form 8833 which must be attached to either a U.S. estate or gift tax return.
This article is intended to acquaint readers with some of the principal U.S. estate and gift tax considerations that can come into play when investors who are not U.S. citizens or residents invest in a business or real estate in the United States. This area is relatively complex and is constantly evolving with Congress entertaining new tax laws, the IRS issuing new regulations and interpretations and courts rendering new rulings in this area. As a result, it is crucial that non-U.S. investors consult with a qualified international tax attorney when planning to invest in a U.S. business or real estate. This is to ensure that the proposed investment is appropriate given the investor’s tax circumstances and that no developments have arisen in the area that can impact the investment’s tax objectives. With careful, individualized planning, non-U.S. investors may be able to substantially reduce the U.S. estate and gift tax consequences of their U.S. investments that affect not only themselves but their heirs and beneficiaries as well.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.