2.4.1 The ability-to-pay-taxes justification (the theory of value)

The ability-to-pay-taxes justification, which is based on the theory of value, serves as the first, albeit not primary in my view, justification of death taxation. This justification is often discussed in parallel with the windfall justification (which is examined in the next section). Under the ability-to-pay-taxes justification, the mortis causa transfer of property increases the beneficiaries’ financial capacity and, thus, their ability-to-pay-taxes. Therefore, any abolition of death taxation will create an “unjustifiable leak in taxation” as Tipke notes.1 However, Ydema and Vording are of the view that it seems unreasonable for the states to levy death taxes based on the ability-to-pay-taxes justification. In their view, if it is argued that an inheritance constitutes taxable income for the beneficiary, any deviation from the normal rules of income taxation (author: as in the case of inheritance and estate taxes) would require another justification than the ability-to-pay-taxes one.2 On the contrary, West regarded the ability-to-pay taxes justification as a justification of death taxation but he considered that the increase of the beneficiaries’ ability-to-pay-taxes should not always be taken for granted. He noted that it is not true in every case that the inheritance of property indicates a real increase of tax-paying ability.3 In that regard, West drew a distinction between transfers of property to close family members, on the one hand, and to distant relatives (or even to independent adult children), on the other. Regarding the former transfers, he noted – quoting Adam Smith – that the death of the head of the family may have a positive or a negative influence on the ability-to-pay-taxes of the rest of the family members: “If the deceased’s income was from property and not from labour, the death of the head of the family will make little difference in the family income. In the case of passive income (e.g. interest), the economic situation of the family improves as the necessary expenditure diminishes by the death of a family member.4 If, however, the deceased’s income was wholly from labour, the increase of the beneficiaries’ ability-to-pay-taxes should not be taken for granted if the deceased was the only working member of the family.”5 Concerning transfers of property to collateral relatives, West noted that “[w]here property goes to collateral relatives, or even to self-supporting adult children, there is a distinct increase of tax-paying ability.”6

Irrespective of the above, I observe that the ability-to-pay-taxes justification may justify the imposition of death taxes at progressive tax rates depending only on the size of the estate. On the contrary, it does not seem to be able to justify progression based on the kinship between the parties involved which is an important element of most death tax laws. Therefore, the ability-to-pay taxes justification should not be considered the main justification of death taxation.7

Furthermore, in the literature, the ability-to-pay-taxes justification has been associated with the assessment of the personal nexus at the level of the deceased. More specifically, taxation based on the deceased’s personal nexus with the state gives rise to the following logical gap if considered in the light of the beneficiaries’ ability-to-pay-taxes, as shown by the two examples below.

In the first example, the deceased B was a resident of State A at the time of his death. His beneficiary A is also a resident of State A. He inherits property located in State B. State A levies inheritance taxes (as a type of death tax) based on the deceased’s personal nexus (residence) and an objective nexus. As a result, beneficiary A has to pay tax in State A following the mortis causa transfer of the deceased’s property that is located in State B (because the personal nexus with the deceased is satisfied).

In the second example, the deceased B was residing in State B at the time of his death. The deceased’s beneficiary A is a resident in State A. The deceased’s property is located in State B (i.e. the state of the deceased’s residence). State A levies inheritance taxes based on the deceased’s personal nexus (residence) and an objective nexus. In such a case, State A may not seek to tax the property inherited by beneficiary A as neither the personal nexus nor the objective nexus is satisfied: the deceased was not a resident of State A at the time of his death and the inherited property is not located in the territory of State A. However, one could argue that from State A’s perspective, the ability-to-pay-taxes of beneficiary A in both examples increases following the mortis causa transfer of property. As a result, State A should treat them equally (as in the case of income taxation).

Because of this logical gap, it has been argued that the starting point of death taxation should be the beneficiary’s and not the deceased’s personal nexus with the state as being more in line with the ability-to-pay-taxes justification. More specifically, the supporters of the transition of the starting point of taxation from the deceased to the beneficiary invokes the personalisation of inheritance taxes argument mentioned in the previous section. In their view, the states already consider the situation of the beneficiaries through the increased exemption thresholds and the broadening of the subjective tax exemptions.8

Concerning this point, Sonneveldt (2016) noted that a distinction should be made between estate taxes and acquisition-based taxes such as inheritance taxes. In his view, an estate tax focuses on the increase in the deceased’s property during his lifetime. Thus, the starting point of estate taxation shall be the deceased’s personal link with the state concerned, as estate taxation focuses on the deceased’s estate and not on the individual acquisitions. The same should apply in the case of mortis causa capital gains taxation.9 On the other hand, in the event of acquisition-based taxes, such as inheritance taxes, Sonneveldt (2016) noted that it is arguable to take as the starting point of taxation the beneficiaries’ personal nexus with a state in light of their ability-to-pay taxes. The same should also apply, in his view, in the case of mortis causa income taxes.10

Nevertheless, the transition of the starting point of taxation from the deceased to the beneficiary may not be an easy task. Sonneveldt (2014) observed that worldwide taxation determined by the beneficiary’s residence might not be easily applicable considering the limited control mechanisms that a state may have concerning the foreign property. Furthermore, he argued that a possible transition of the starting point of taxation would affect the OECD IHTMTC, which has been drafted based on the deceased’s fiscal domicile (see section 5.1.1). Finally, most inheritance tax legislation has to be amended as it takes the deceased’s personal nexus with their territory as the starting point of taxation.11

The discussion on the transition of the starting point of taxation from the deceased to the beneficiary falls outside the scope of this study, which focuses solely on the problems of cross-border inheritance and gift taxation. It is true, however, that the assessment of the personal link at two different persons by two states can often result in double taxation of the cross-border inheritance and donation as discussed in the next chapter.