Case law – A family foundation taxed twice on the same event?

The assets of a family foundation are subject to inheritance tax, by class of beneficiary (including grand-nephews/nieces at the rate of 25%). Subsequent distribution from the foundation to the great-niece subject to income tax.

1. Facts

A family foundation, created under the laws of Panama, which had not been declared during the founder's lifetime, was subject to a tax assessment by the Geneva Cantonal Tax Administration ("AFC-GE"), based on a voluntary disclosure. For the period prior to her death, it is treated by tax transparency insofar as the founder is the primary beneficiary. To this extent, the Foundation's assets are subject to inheritance tax. In accordance with the foundation's articles of association, the foundation becomes irrevocable after the founder's death.

The assets of the Foundation amount to CHF 3,197,864. Of this sum, CHF 2,857,864 are allocated to nine grand-nephews-nieces of the founder, as second beneficiaries (i.e. CHF 317,540 per nephew/niece). These allocations are treated as bequests by the AFC-GE.

Inheritance tax is calculated on these bequests at the rate of 24.9%, applicable to grand-nephews-nieces. Under the Articles of Association, however, beneficiaries must wait until the age of 30 before they can benefit from the distribution.

At the age of 30, one of the grand-nieces of the deceased, a resident of Geneva (the "Appellant"), requested that the sum of CHF 317,540 due to her be made available. The AFC-GE considers that this constitutes taxable income and subjects it to income tax.

The Appellant disputes the fact for the distribution to be subject first to inheritance tax and then to income tax. She argues that assets acquired as part of an inheritance does not constitute taxable income. Therefore, only the accumulated income and increases in value since the death should be taxed as income, but not the total amount of the distribution.

The Appellant also alleges an infringement of the prohibition on dual methods. There is a dualism of methods when a tax authority considers an entity (such as a foundation) to be transparent by invoking tax avoidance to infer a certain tax treatment (such as inheritance tax at certain point in time), and then as opaque subsequently, this time by invoking the legal reality, to be able to modify the tax treatment to its sole advantage (such as income tax at another point in time).

According to the AFC-GE, it is the moment when the foundation becomes irrevocable and loses its status as a tax-transparent entity that triggers inheritance tax. From that moment, the assets are held by the foundation, which has become irrevocable and opaque, so that any distribution as from the death, based on its statutory obligations, represents taxable income for the beneficiary.

2. Law

The Geneva Court of Justice ("CJ") first states that an increase in assets must in principle be considered as income unless the increase in assets results notably from an inheritance or a gift. The one is exclusive of the other.

Free distributions made by a family foundation to its beneficiaries represent taxable income, since foundations are legal entities. Thus, distributions from a foundation are alike income from shareholdings. Therefore, distributions, although made for no consideration, cannot be treated as gifts if the foundation is obliged to make them by virtue of its statutory obligations. The animus donandi, i.e. the will to give, is then lacking. In the case in question, the family foundation was obliged by its articles of association to pay to each grand-nephew-niece who had reached the age of 30 their share of 1/9th.

Regarding the Appellant's main argument, according to which the amount she received from the foundation at the age of 30 had already been subject to inheritance tax, the CJ held that the inheritance tax was levied on the heirs, of which the Appellant, as legatee, was not a member. The inheritance tax levied, which allegedly encumbered the assets of the heirs, did not concern her.

Finally, the principle of dual methods prohibits a tax authority, when invoking tax evasion, from choosing between the economic reality of a factual situation and the legal reality of the same complex of facts, in order to satisfy its own interests. However, the CJ considers that this principle is not applicable in the present case since both the taxpayers (heirs vs. legatees) and the taxes (inheritance tax vs. income tax) are not the same.

3. Comments

In the CJ's view, the family foundation is a legal entity and, as such, the capital it receives at the founder's death devolves to it and not to the beneficiaries. The assets, although viewed from the perspective of tax transparency for the purposes of inheritance tax, belong irrevocably to the foundation immediately after death.

From a tax perspective, we find this approach dubious since the tax transparency accepted by the CJ should have resulted in the transfer of the assets to all the beneficiaries, for tax purposes. In our view, it is inconsistent to take advantage of tax transparency before death, to subject the assets to inheritance tax according to the classes of all beneficiaries concerned, and then to consider that the assets are devolved to the foundation, which has become opaque after death.

We believe that either the foundation is the beneficiary of the assets at the time of death because of its opacity, or it is transparent, and the assets are deemed to belong to the deceased founder for tax purposes. In the latter case, the tax authorities must analyze the economic objective that the founder actually wanted to achieve and apply the resulting tax consequences.

According to the first hypothesis (tax opacity), the legal reality prevails at the time of death and the foundation is the beneficiary of its assets, as death does not result in any devolution subject to inheritance tax. Subsequent distributions to beneficiaries may be treated as taxable income.

Under the second hypothesis (tax transparency), subject to the tax avoidance principles, the economic reality prevails and the foundation is not the owner of the assets, but instead the founder. After submission to inheritance tax, the beneficiaries, in turn, must be considered as post-mortem beneficiaries/owners. The obligation imposed on the foundation to consider the age of the beneficiaries before any actual payment is made should, in our opinion, be assimilated to a testamentary charge which does not call into question the post-mortem tax attribution of the assets to the beneficiaries. Subject to the principle of the difference on the increase in value of the assets, the amount made available at the age of 30 is incorrectly subject to income tax. The distribution, already acquired at the time of the founder's death, should have also been considered as a wealth taxable asset for the Appellant.

To this extent, the prohibition on dualism of methods is, in our view, undermined, with tax transparency being first invoked for the levying of inheritance tax, followed by tax opacity for the levying of the income tax (although this approach is approved by some legal writers). To apply tax transparency of the foundation, the CJ should have ruled on the economic reality that the founder wanted to achieve by setting up the family foundation (a measure for estate planning and for sharing her wealth among her grand-nephews-nieces, deferring a payment to the age of 30, etc.), and thus, assimilate the legal structure either to a trust or even to a testament subject to a testamentary charge.

In addition, the potentially very high cumulative tax burden (inheritance tax plus income tax) resulting from the practice of the AFC-GE also poses a problem as regards the principle of the Appellant's ability to pay taxes (so-called "tax paying capacity" principle).

Finally, the question of whether or not the Appellant personally bore the inheritance tax on the distribution to her is not clearly addressed in the judgment of the CJ. Nor is it clear whether or not the Appellant declared her share in the foundation for wealth tax purposes.

This ruling has been appealed to the Swiss Federal Court. The case will thus be followed up.