Related Practices

• International Business
• Tax

On November 5, 1999 the United States Senate approved the Protocol executed on December 14, 1998 (the "Protocol") amending the United States-Germany Estate, Inheritance and Gift Tax Convention (the "Treaty"). The final step in making the Protocol's changes effective is the exchange of instruments of ratification between the United States and Germany, which is expected to occur shortly.

The Protocol makes five changes to the Treaty. Two changes are more or less administrative and warrant little comment. Three changes, however, are substantive and should have a significant impact on estate and gift tax planning for individuals eligible for benefits under the Treaty. As discussed in detail below, the three substantive changes contained in the Protocol are: (i) an extension of time during which an individual can be domiciled in either the United States or Germany before becoming subject to its gift and/or estate taxing jurisdiction; (ii) a unified credit against U.S. estate taxes based on the value of a decedent's assets located in the United States, and (iii) a limited estate tax marital deduction for small estates.

Domicile Provisions
The Treaty contains certain "tiebreaker rules" designed to determine which country can tax an individual who is a taxable resident of both the United States and Germany. These tiebreaker rules provide that (i) an individual is a resident of the country where he has a permanent home, (ii) if the individual has a permanent home in both (or neither) country, then he shall be a resident of the country where he has his center of vital interest, (iii) if the center of vital interest cannot be determined, then he shall be a resident of the country where he has an habitual abode, and (iv) if the individual has an habitual abode in both (or neither) country, then he shall be a resident of the country where he is a citizen.

The current Treaty contains an exception to the tiebreaker rules designed to limit a country's right to tax an individual's gifts, inheritances and estate where that individual has not been a resident in the country for a significant period of time. The Treaty provides that regardless of the result under the tiebreaker rules, an individual's general liability for gift, inheritance and estate taxation will be in the country where such individual is a citizen if the individual: (i) is a citizen of either the United States or Germany, (ii) is considered a taxable resident of both countries under their internal laws, and (iii) is domiciled in the country where he/she is not a citizen for less than five years.

The Protocol extends the five year period noted above to ten years. Consistent with the Treaty, the change to the domicile rule applies only to the general right to impose estate and gift taxes, not to individual items such as real estate which is taxed in the country where it is situated.

The Pro Rata Unified Credit
The United States provides its citizens and residents with a credit against gift and/or estate tax (the "Unified Credit") equal to, on a cumulative basis, $220,500 in 2000, an amount that will shelter $675,000 of assets. Non-residents subject to U.S. gift and/or estate taxes are provided with a $13,000 Unified Credit, an amount that will shelter only $60,000 of assets. Under the Protocol, non-U.S. citizens domiciled in Germany are afforded a Unified Credit equal to the greater of (i) the Unified Credit available to non-residents (currently $13,000) or (ii) a pro rata portion of the Unified Credit available to U.S. citizens and residents (currently $220,500). To ascertain the Unified Credit available under the Protocol, an individual domiciled in Germany would calculate her pro rata portion of the Unified Credit available to U.S. citizens and residents by multiplying the Unified Credit ($220,500) by the quotient obtained by dividing the value of her gross United States estate by the value of her gross worldwide (including U.S.) estate.

For example, assume that a non-U.S. citizen domiciled in Germany died in 2000 with a U.S. gross estate valued at $700,000 and a worldwide gross estate valued at $2,700,000. The executor of the individual's estate could now claim a Unified Credit of $57,109 ($220,500 x [$700,000/$2,700,0001) against the estate's U.S. tax liability.

Marital Deduction
Under domestic U.S. tax law, citizens and residents transferring property upon death to a spouse who is a U.S. citizen can claim an unlimited marital deduction against estate tax. The marital deduction does not apply, however, where the surviving spouse is not a U.S. citizen.

Under the Protocol, a U.S. estate with a non-U.S. citizen surviving spouse can elect, if it meets certain requirements, to utilize a limited marital deduction for property that would have qualified for the marital deduction had the surviving spouse been a U.S. citizen. To qualify: (i) the decedent and the surviving spouse, at the time of death, must have been domiciled in either the United States or Germany, (ii) the qualified property must pass, within the meaning of domestic U.S. law, to the surviving spouse, and (iii) the executor must irrevocably waive the benefits of any other estate tax marital deduction permitted under the United States Internal Revenue Code. Where both the decedent and the surviving spouse were domiciled in the United States at the time of death, the Protocol also requires that either or both must be a German citizen.

Estates that qualify for and elect to use the limited marital deduction will be entitled to, in addition to the above-described Unified Credit, a U.S. marital deduction equal to the lesser of (i) the value of the qualified property passing to the surviving spouse, or (ii) the value of the decedent's property sheltered by the Unified Credit ($675,000 in 2000).

For example: husband ("H") and wife ("W") are citizens of and domiciled in Germany. H dies in 2000 with U.S. real property valued at $2,000,000 and German-situs; assets valued at $3,000,000. H leaves the U.S. real property to W. Since under the Treaty the United States may only tax a decedent's transfer of property to a surviving spouse to the extent that the value of the transferred asset(s) exceeds 50% of the value of all of the decedent's property located in the United States, H's gross U.S. estate will equal $1,000,000 (the amount by which the $2,000,000 exceeds 50% of the total value of H's U.S. property) and his gross worldwide estate will equal $4,000,000 (the $1,000,000 U.S. gross estate and the German assets valued at $3,000,000). Under the Protocol, H's gross U.S. estate is reduced by a $675,000 marital deduction - in essence a second "marital deduction" in light of the 50% rule - (since the value of H's property sheltered by the Unified Credit, $675,000, is less than the value of the qualified property transferred -$2,000,000). Thus, H's U.S. estate is $325,000, which would be subject to a tentative tax of approximately $96,000 but further reduced under the pro rata Unified Credit rules of Protocol to approximately $41,000 ($220,500 x [$1,000,000/$4,000,000]).

Conclusion
If the administrative requirements needed to make the Protocol effective (i.e. the exchange of instruments of ratification) proceed as expected, the Treaty will soon include the changes noted herein. With the exception of those administrative rules not discussed herein, the changes set forth in the Protocol are intended to provide beneficial estate and/or gift taxation in the United States and Germany. For the most part, the Protocol achieves this objective (especially for smaller estates) by, among other things, allowing a decedent's estate two marital deductions (the old 50% marital deduction and the new limited marital deduction) and permitting a decedent's executor to offset any U.S. estate with the more equitable pro rata Unified Credit.

For more information, please contact djamieson@cohenlaw.com.