Self-directed Individual Retirement Account
von Peter Scheller
There are various situations where an expatriate who relocates to Germany would benefit from a “tax cover” to avoid undesirable tax consequences. One way to avoid unwanted tax implications is the transfer of property which generates respective income to a German or a foreign company. However, this transfer often results in tax consequences at a later stage which may be considered not to be beneficial and so it must only be done after proper research. Another tax planning tool might be the transfer of respective property into a pension plan.
The following scenarios are often seen as problematic by expatriates who relocate to Germany:
- The expatriate owns a large portfolio of capital investments such as stocks and shares, investment funds or cryptocurrency. After relocating to Germany, income such as dividends, interest or capital gains will be subject to German income tax at a flat rate of 25% plus the solidarity surplus charge (combined tax rate of 26.375%). For taxation in Germany, it is irrelevant whether the stocks and shares, funds etc. are foreign or held at foreign banks or financial institutes. Foreign taxes can only be credited against the German income tax at a limited rate.
- The expatriate is a shareholder of a foreign company or a partner of a foreign partnership. The foreign business entity is profitable and represents a substantial value. The expatriate plans to sell shares in the company or the partnership interests. This is often the case if a financial investor, an employee or another third party becomes a shareholder or partner. Often a corporate restructuring is necessary in order to integrate the new partner in an optimal way. Transactions such as selling business entities or parts of them, and corporate restructuring, can result in a heavy tax burden in Germany.
- The expatriate is beneficiary of a trust. The taxation of trusts in Germany is very unfavourable. Payments to a beneficiary who is tax resident in Germany can be subject to German income and/or gift tax. Under certain circumstances the beneficiary is confronted by a double taxation scenario. In addition to this, unfavourable tax classes and tax rates may be applicable.
- The expatriate who relocates to Germany is a famous artist and will get high royalties in the future. He or she does not need these payments for everyday living but plans to build up a financial backbone for retirement purposes. The artist wants to pay as little tax as possible in order to build up the biggest possible pension.
In cases like this it can be advisable to transfer the relevant assets or rights into a pension plan. If the expatriate is a US citizen an Individual Retirement Arrangement (IRA) may be a suitable solution. This can be trust or custodial based (Individual Retirement Account) or insurance based (Individual Retirement Annuity). Often the account holder of an IRA wants to reserve the full control of investments within the plan to himself. This self-directed IRA (SDIRA) includes the power of the account holder to invest in anything IRA rules allow. The SDIRA has to be held with a custodian who is not allowed to give any advice on investment decisions. Within a SDIRA a wider range of asset classes are allowed than in a normal IRA. The holder is for example allowed to invest in real estate, private company stock, trust deeds, venture capital etc. However, there are certain investments which are not allowed, for example life insurances, S Corporation stocks or collectibles. The account holder has to make sure that he or she only invests in allowed assets because a violation of investment rules will result in the taxable distribution plus penalty. A SDIRA can either be a traditional or Roth IRA.
If the holder of a SDIRA is relocating to Germany it has to be determined whether the respective IRA can provide a suitable cover. For normal IRAs there is no doubt. Number 16 a) of the protocol to the Double Taxation Convention between Germany and the United States of America (DTC USA) explicitly states that Individual Retirement Accounts and Individual Retirement Annuities are “pension plans” for the purpose of Article 18A DTC USA. Article 18A (1) DTC USA states that income earned by the pension plan may only be taxed as income when, and to the extent that it is paid to, or for the benefit of, an individual who is tax resident in Germany. This does not apply to transfers to another pension plan. In simple terms this means that income which is earned by or within a US-pension plan cannot be taxed as long as no money or other assets are not withdrawn by the account holder. So, a regular IRA provides the wanted cover.
However, it has to be determined whether the cover is also provided by a SDIRA in Germany. The problem may be that German tax authorities do not classify a SDIRA as a pension plan but as an artificial tax planning tool. The latter could be seen as a fictitious transaction which would not provide the respective cover. If this is the case the income within the SDIRA would directly be taxed at the level appropriate to the account holder. The situation would be the same as if the account holder held assets in person and received the income directly. The SDIRA would be ignored for tax purposes. There are no publications by the German tax authorities nor rulings of German fiscal courts on this matter. However, there are other incidences which might give an indication as to how German tax authorities might classify a SDIRA:
(1) Liechtenstein life insurance policies
German tax payers used Liechtenstein life insurance policies to cover capital investments from German income taxation. The idea is to transfer assets into a life insurance policy in order to avoid the immediate taxation. Liechtenstein policies are chosen because Liechtenstein’s law allows a much wider range of asset classes to be held in a life insurance policy than German law. In addition to that, the protection in the event of death is usually very limited (e.g. 101% of the value of assets in the policy). Payments to the beneficiary of a life insurance will be taxed at the moment the money is withdrawn. Taxed will be the difference between the payments out of the policy and contributions paid into the policy which are connected to the withdrawals. If the beneficiary is sixty years of age or more and the agreed term of the policy was longer than 12 years only half of the difference is taxed.
Obviously German tax authorities did not like this kind of tax planning using tools which defer the taxation of income. Therefore, in the year 2009 the German income tax law was altered. The above mentioned rules relating to the deferred taxation of income of a life insurance policy are not applicable if the policy qualifies as an “asset managed insurance policy”. The following conditions have to be met to classify a life insurance contract as an “asset managed insurance policy”:
- The arrangement is aimed at the administration of a capital stock assembled especially for the contract in question. This is not the case if the capital stock is composed of publicity traded investment fund shares or shares tracking benchmark indices.
- The policy holder or beneficiary of the policy has the direct or indirect possibility of determining the selling of assets and the reinvestment thereafter-
A SDIRA fulfils most of above mentioned conditions. The plan is set up to hold special assets only on behalf of the account holder. The allowed asset classes of a SDIRA is very wide. The plan is self-managed and therefore the account holder has the full control over selling of assets and reinvestments thereafter. However, in general a SDIRA is set up as an account. The German provisions do not apply to Individual Retirement Accounts because they are not insurance policies. However, the provision might be applicable to Individual Retirement Annuities under certain circumstances.
The tax treatment of trusts in Germany is rather complicated. However, in this respect it is only of importance if the trust is considered to be transparent or in transparent. If a trust is classified as transparent the trust’s income and assets are attributed to the beneficiary directly. A trust is transparent if the settlor or the beneficiary is free to make his or her decisions in relation to all legal and effective issues of the trust. This is especially the case if the following applies:
- The settlor is able to reclaim transferred assets.
- The settlor or beneficiary is able to control all relevant decisions in relation to investment policies, payments to beneficiaries etc.
- The settlor or beneficiary is free to cancel the contract with the custodian/trustee or replace him or her at any time.
The provisions in regard to trusts are not directly applicable to a SDIRA. However, they might give an indication whether general German tax rules are applicable. This could be the case if the account holder could be seen as the economic owner of the SDIRA’s assets despite the fact that he or she is not the legal owner of those assets. If the account holder of the SDIRA has far reaching rights in regard to investment policies, selling of assets and timing of withdrawals then he or she could be considered to be the economic owner of the SDIRA’s assets.
(3) SDIRA as a transparent arrangement
However, there are arguments which may mean that a SDIRA cannot be seen as a transparent arrangement.
- An IRA is a contractual arrangement which shall provide an individual with financial resources when reaching retirement age. US tax law therefore allows penalty-free withdrawals before retirement age of 59 ½ years only in certain cases, such as first-time home purchase, educational expenses, medical expenses or in case of disability. The intention to provide tax advantages to account holders in the USA is similar to tax advantages contained in certain old-age instruments in Germany. Individuals are able to save for retirement. As in the USA these instruments are not treated as being tax transparent in Germany (with the exception of the above mentioned “asset managed insurance policy”). That the legal framework differs in both countries should not be of significance.
- A SDIRA is legally an IRA (§ 408 IRC). Germany accepted in No. 16 a) of the protocol to the DTC USA that Individual Retirement Accounts and Individual Retirement Annuities are pension plans which qualify for the provisions of Article 18A DTC USA. Although Article 18A DTC USA is applicable to company pension schemes the mention of IRAs in the protocol can only be interpreted as confirming that a private IRA of any kind must be classified as a pension plan. The qualification of a SDIRA as a transparent arrangement would contradict its purpose as an instrument to provide a financial cover for retirement.
Since a SDIRA is a special form of a US-IRA it has to be classified as a pension plan. If it is set up as an Individual Retirement Account it should provide in Germany a cover for income generated by the SDIRA. A taxation of its beneficiary who is tax resident in Germany shall only be take place if funds of the plan are distributed.
However, since there are no statements from the German tax authorities or rulings of German fiscal courts in this respect there is no doubt that a legal uncertainty remains. German tax authorities might classify a SDIRA as a transparent entity if it is obviously set up to avoid German taxation. If it is a tax-saving tool it has to be reported to the German tax authorities.
The transfer of business property, private company stock or partnership interests might be considered as a taxable event. It could be seen by German tax authorities a “fictitious” selling of shares, partnership interests or business property. This might especially be the case if the transaction of transferring the shares, interests or property results in an exclusion or limitation of the taxation rights of German tax authorities.
Whether this is a serious financial issue to be considered depends on various facts such as the:
- Fair market value of the shares, interests in partnerships or property
- Acquisition costs of the shares, interests in partnerships or property
- State where the company or a permanent establishment which holds the property is situated
In general, it is less risky in regard to potential German tax implications to set up the IRA and transfer the shares, interests in partnerships or business property before relocating to Germany.
Author: Peter Scheller, Steuerberater, Master pf International Taxation
- capital investments
- private company stock
- self-directed individual retirement account