We will experience the biggest wealth transfer in history within the next three decades since Baby Boomers will leave trillions to Generation X and Millennials. A part of this money will flow into the taxman's pockets.
Wealth taxes and gift, inheritance, and estate taxes on the transfer of wealth are controversially discussed around the globe. We won't join the discussion here but focus instead on some practical implications of international estate taxes.
The complexity of international estate planning
International estate planning is demanding: you have to consider applicable laws, your and the beneficiaries' residence, the location of assets that form part of the estate, formal requirements, procedures, the right tools for estate planning, and finally, estate taxes.
In particular, in cross-border scenarios with beneficiaries of your estate plan resident in different countries and your assets abroad, you face the risk of double taxation.
We know from experience that a structured approach helps to iron out some difficulties in estate tax planning. That's why, in this post, we outline the key steps that are the groundwork for international estate planning strategies to reduce estate taxes.
The starting point
Many countries claim jurisdiction over the estate based on the deceased's last residence, habitual residence, or domicile. And with that, they will apply inheritance and estate taxes, not always both, if that's a consolation.
Sometimes a domicile is assumed due to birth and the parents' domicile and residence in a given country. The deceased may have left the country decades before death, unaware of such domicile, and still estate tax may apply.
There's no globally unified residence or domicile definition, and it may also trigger inheritance tax for beneficiaries. Some countries tax based on nationality, and the USA is one of them.
Their taxman, the IRS, explains the concept as simple and straightforward as this: "If you are a US citizen or resident alien, the rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether you are in the United States or abroad. Your worldwide income is subject to US income tax, regardless of where you reside."
Differences between estate taxes and inheritance taxes
All of these intertwined rules and taxation systems can lead to double taxation in cross-border scenarios. Where to start with estate tax planning? Unless you live in a country with no estate taxes, your place of residence or domicile is the first jurisdiction to assess.
Three types of taxation are relevant in this context: inheritance tax occurs on transfers of value in a death event, and the recipient usually is owing payment. An estate tax is due on the estate itself and paid out of the estate. And finally, the gift tax applies to transfers between living individuals.
This post will use the term estate taxes for both estate and inheritance taxes to reduce complexity.
International estate taxes case study
Since the above is already confusing, let's assess a cross-border case of concrete tax application. Suppose you are a Swiss national and live with your family in Switzerland, you own real estate in Germany, and you hold a substantial amount of US shares in your portfolio with a Swiss wealth manager.
Switzerland's estate taxes
In Switzerland, the cantons levy gift and estate taxes. They do this based on the personal (unlimited) or economic (limited) tax liability of the taxpayer. That means that you either have your primary tax domicile in Switzerland since you stay there with the intention of permanent residence or a specific economic tie due to gainful activities or enforceable rights in Switzerland.
Your global income will be subject to tax in Switzerland with unlimited tax liability, while limited tax liability is restricted to local income and specific local assets.
A voluntary transfer of wealth during your lifetime without compensation will be subject to gift tax. The gift tax is intended to supplement the estate tax in order, among other things, to prevent the avoidance of the estate tax by making a gift during one's lifetime. Therefore, the taxation of inter vivos transfers of assets is based on the same principles as the taxation of the inflow of assets upon death.
After your lifetime, the canton of your domicile will levy estate taxes on the occasion of the transfer of assets because of death. In general, the recipients of an inheritance or gift, i.e., a natural person or legal entity, are liable to pay estate taxes.
Since the recipient is taxed, considering the individual case and tax burden depends on the transferor and recipient's relationship. However, the recipient's residence is irrelevant for the tax liability, and thus also residents of a foreign country can become subject to estate taxes in Switzerland and are obliged to notify the tax authorities of taxable events.
Tax evasion is subject to penalties up to three times the amount of evaded taxes.
Estate tax exemptions
Here is some good news: transfers to the (surviving) spouse and direct descendants are exempt from gift and estate taxes in most cantons. Other family members benefit from reduced tax rates and reduced progression depending on the value.
The Swiss tax system protects transfers within the family and the unity of its wealth. There are also opportunities for local tax planning: the canton Schwyz does not levy gift and estate taxes at all, and the canton of Lucerne is only taxing gifts within the last five years before a person's death.
However, having assets in different cantons adds complexity since they will want to apply estate taxes. Still, inter-cantonal double taxation is explicitly prohibited by the Swiss Federal Constitution, and there are clear tax allocation rules.
Switzerland offers an attractive tax planning environment, and if the beneficiaries of your estate plans are also Swiss residents, the planning exercise should be straightforward.
You can also discuss details with tax authorities and have the common understanding confirmed in a binding tax ruling to ensure clarity and predictability. So far, so good, but what happens to your assets abroad?
Estate taxes in Germany
Since part of your estate, namely real estate, is located in Germany, the German taxman may want to tax. Again, the concepts of unlimited and limited tax liability trigger taxation of either global or local wealth transfers.
To keep things simple, let's assume that Germany also considers you a Swiss resident with limited tax liability due to the real estate in their territory. Thus, only the real estate would be subject to German estate taxes.
The German tax system provides general exemption thresholds of EUR 500'000 for spouses, EUR 400'000 for children, and EUR 200'000 for grandchildren. However, those are reduced in cases of limited personal tax liability in Germany.
Since there are exemptions for family homes subject to specific conditions for surviving spouses and children, you may still avoid German estate taxes.
Before we get lost in German taxation details, Switzerland and Germany have an essential agreement for cross-border estate taxes.
Double Taxation Agreement on Estate and Inheritance Taxes
The treaty aims to avoid double taxation and provides a ruleset for collision scenarios where both countries, according to local law, may have the right to tax.
As a general rule, the state of residence of the deceased has the exclusive right to tax. A tax residence is established by a permanent home.
If there is a domicile in both countries, the tax residence is deemed to be found in the country with which closer personal and economic relations exist.
If this cannot be determined, the habitual abode is used to determine the tax residence. If this is also not possible, nationality shall be decisive.
If none of these criteria leads to an allocation, the tax authorities settle the issue by mutual agreement.
However, there are specific exceptions. The state of its location will tax immovable properties, and thus German estate taxes will be levied on your real estate.
The beneficiaries can deduct debts that are economically related to real estate. If Swiss estate taxes were due, the German real estate would be exempt from Swiss taxation, although it is still relevant for calculating the Swiss tax progression rate.
The treaty is not applicable for gift taxes, and unilateral tax reliefs for foreign taxes would be needed to avoid double taxation.
Estate taxes in the US
Here the IRS tells us: "Deceased nonresidents who were not American citizens are subject to US estate taxes for their US-situated assets. US-situated assets include American real estate, tangible personal property, and securities of US companies. A nonresident's stock holdings in American companies are subject to estate taxation even though the nonresident held the certificates abroad or registered the certificates in a nominee name."
In other words, even if you hold US shares in a Swiss bank account, they become subject to US estate tax with a rate of up to 40% and an exemption of USD 60'000.
Convention to avoid Double Taxation
The US and Switzerland back in 1951 signed the Convention to avoid Double Taxation concerning Inheritance and Estate Taxation.
To benefit from the treaty, the worldwide estate needs to be disclosed to the IRS, not everyone's cup of tea. Furthermore, disclosure occurs at the fair market value, which is not straightforward for corporations and real estate and not needed for Swiss estate tax purposes in our case.
If disclosure and evaluation are not an issue, the treaty will provide a proportional application of a higher exemption threshold. Your estate would thus benefit from a percentage of the exemption threshold for US persons corresponding to the proportion of US situated assets of the entire estate.
Since the exemption threshold at the date of this writing is USD 11,7 million per individual, the treaty application can significantly reduce US estate taxes.
However, if a Swiss canton also applies estate tax, there would be no obligation to grant a tax credit for paid US estate taxes. Thus one can not entirely exclude double taxation.
Like any other foreign asset, it is advisable to consider US estate tax exposure in your estate planning well ahead since the entire process may become cumbersome and costly for your estate plan's beneficiaries.
Absence of an estate tax treaty
Next to the two treaties above, Switzerland has inheritance and estate tax agreements with Denmark, Finland, France, UK, Northern Ireland, Netherlands, Norway, Austria, and Sweden.
They are based on the residence principle, and the decedent's last residence state will tax all worldwide assets. The exception is real estate and movable assets of permanent establishments, which are taxed in the state where they are located.
Some cantons such as Zurich have entered into additional tax treaties regarding estate taxes with foreign countries, but gift taxes remain excluded.
Without an estate tax treaty, things in cross-border scenarios can become expensive. Two countries may tax on different ties or apply other taxation criteria that can lead to double taxation. In the absence of a treaty, cantonal rules may only provide limited relief from double taxation, although a Swiss Federal Supreme Court decision precludes double taxation of foreign real estate.
To sum up on international estate taxes
We kept our case study simple to highlight the most imminent estate tax issues in international estate planning. You should follow a structured approach that considers your and the beneficiaries' domicile, residence, and nationality.
The importance of tax residency
Tax residency is a serious issue to consider in cross-border scenarios, and for estate taxes, you should obtain clarity on it during your lifetime. Your assets' assessment should further clarify estate tax exposure according to the asset class and location.
If there is a risk of double taxation, applicable treaties, and in their absence, unilateral double taxation relief should be analyzed. You should then further consider local and foreign procedures to capture your estate planning environment.
Estate planning tools
We recommend evaluating the above steps based on your individual estate planning options and tools. Wills, trusts, foundations, life insurance policies, and other estate planning tools must be carefully analyzed in cross-border scenarios to enable predictable and consistent results.
Rarely are they treated the same way by two tax authorities and thus require a thorough international tax assessment for estate planning strategies to reduce estate taxes.
Regular stress testing
Since there are many moving parts, regular stress testing is essential to ensure that your plans stay within defined parameters. Don't forget to include liquidity planning to settle estate taxes levied on illiquid assets.
Finally, tax policymakers worldwide are aware of the upcoming wealth transfer and may want to secure their wallet share by amending their estate tax laws.
For example, the Biden administration has recently announced tax proposals that would significantly impact US estate tax planning. There is currently no clarity on whether and how the proposed changes may be implemented, causing further uncertainty.
This shows that you cannot plan for everything. However, you should have greater peace of mind with a thorough assessment, a clear planning strategy, and ongoing monitoring.
FREQUENTLY ASKED QUESTIONS
What are the tax challenges in international estate planning?
International estate planning presents many challenges due to the interplay of various factors. These include the laws applicable in different jurisdictions, the residence status of the beneficiaries, the location of the assets that form part of the estate, and the formal requirements and procedures that must be followed.
One of the most significant challenges is the risk of double taxation, especially in cross-border scenarios where beneficiaries reside in different countries and assets are located abroad.
A structured approach is necessary to navigate these complexities and devise strategies to reduce estate taxes.
This involves a thorough understanding of the tax laws in each relevant jurisdiction, careful planning, and regular review of the estate plan to ensure it remains effective and compliant with the changing laws.
What's the difference between estate taxes and inheritance taxes?
Estate taxes and inheritance taxes are two distinct types of taxes that can apply when wealth is transferred after someone's death.
An estate tax is levied on the total value of a deceased person's money and property and is paid out of the decedent's assets before the distribution to the beneficiaries.
On the other hand, inheritance tax is imposed on the value of individual bequests received by the beneficiaries after the owner's death. The tax rate and exemptions often depend on the relationship between the deceased and the beneficiary.
In cross-border scenarios, both types of taxes can lead to double taxation, where the same asset is taxed in two different jurisdictions. This complexity underscores the importance of careful estate planning.
How can one navigate international estate taxes?
Navigating international estate taxes requires a comprehensive understanding of the tax laws in each country where you have assets or beneficiaries. Tax residency is a crucial factor that can significantly impact how your estate is taxed.
Some countries tax based on the deceased's last residence, habitual residence, or domicile, while others may tax based on nationality.
Double taxation agreements between countries can provide relief by preventing the same wealth from being taxed twice. However, these agreements vary and may not cover all types of taxes.
Regular stress testing of your estate plan is also crucial to ensure that it remains effective under different scenarios and changes in tax laws.
This involves reviewing your estate plan periodically and making necessary adjustments to stay within defined parameters and comply with the current laws.