Global Tax Alert | 19 February 2014

German Federal Fiscal Court holds treaty override unconstitutional

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In a decision published on 12 February 2014 (BFH 11 December 2013, I R 4/13), the German Federal Fiscal Court (BFH) held that the treaty override by domestic German tax legislation was unconstitutional. Once again the BFH submitted the question to the German Federal Constitutional Court as to whether German tax legislation violates the German constitution with a treaty override.

According to the facts of the case, a German limited partnership (GmbH & Co. KG – “KG”) paid interest to an Italian resident who also owned an interest in the KG itself. Citing a 2008/2009 amendment of the German Income Tax Act (Section 50d (10) ITA), the German tax authorities reclassified the interest income as German business income of the partnership and claimed German taxation of the interest under the business income Article 7 (1) and the permanent establishment Article 5 of the German/Italian tax treaty (the Treaty), thus consequently denying Italy the right to tax the interest pursuant the interest Article 11 (1) of the Treaty.

Pursuant to Section 15 (1) No. 2 ITA, interest paid to a partner of a German business partnership is re-characterized as (partnership) business income and taxed accordingly in the hands of the partner. Section 50d (10) ITA 2009 upholds this principle also in the treaty context by defining such income as business income for purposes of the application of a tax treaty. Section 50d (10) ITA 2009 was introduced to override prior case law of the BFH which held that interest paid to a treaty resident partner cannot be taxed in Germany because of the interest article of the treaty. The statute is applicable with retroactive force on all open cases.

In its decision the BFH argues that this unilateral reclassification of remunerations which generally fall under a (specialty) article of a treaty (such as royalty or interest payments in an OECD model type double tax treaty - DTT) as (deemed) business profits is indeed an override of those provisions. In the opinion of the BFH, overriding bilateral treaty provisions that have been negotiated between two contracting states to allocate the right to tax constitutes an unconstitutional breach of international law.

Consequently, the BFH has asked the German Constitutional Court to decide on the issue. The upcoming decision by the Federal Constitutional Court, which would be its first one on this topic, could impact a large number of other provisions in German tax law currently unilaterally overriding the provisions of DTTs.

Note: In 2012 the BFH already submitted the question as to whether a treaty override is in line with the German constitution to the Federal Constitutional Court (decision dated 10 January 2012, I R 66/09). The specific case relates to the taxation of cross-border employment income and the overriding of the respective provision in the former DTT with Turkey.

Irrespective of the question of constitutionality, the BFH sheds further light on how the court interprets the German legislator's attempts to unilaterally reclassify royalty or interest payments as (deemed) business profits. To recapitulate, in the case at issue a partner resident in Italy granted a loan to a German partnership. According to the BFH, the loan could not be attributed to any other permanent establishment (PE) of the Italian partner, and the mere administration of loans could not constitute a PE of the partner. An attribution of the loan to a German PE imparted through the presence of the partnership itself was also denied by the court, since the loan could not be treated as an asset from the perspective of the partnership. It was only the unilateral reclassification of the interest payments as business income according to Article 7 (1) of the DTT with Italy allowed German taxation of the interest.

In contrast to earlier case law from the nineties, the BFH is now of the opinion that such a treaty override can only be justified under national law where mandated by a significant issue of national interest, and no other less-infringing measure was available. Here, the court pointed to the possibility that Germany could terminate a tax treaty upon short notice, if an unacceptable loss of German tax revenue was to be feared. Interestingly, the court also allocated in a side comment little weight to the OECD partnership report for the interpretation of the German/Italian tax treaty, as it represented “only the majority opinion of various tax authorities in the OECD tax committee” which should be neither authoritative nor binding for national courts when interpreting a specific double tax treaty.

Note: The provision in Section 50d para. 10 ITA was introduced in 2008 with retroactive effect. Also, the 2013 amendment of the provision became applicable retroactively. In the opinion of the BFH (I R 4/13) the retroactive introduction of both the original provision and its amendment are a breach of the German constitution in itself.

For additional information with respect to this Alert, please contact the following:

Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft, Munich
  • Christian Ehlermann
    +49 89 14331 16653
Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft, Stuttgart
  • Daniel Zöller
    +49 711 9881 28504
Ernst & Young LLP, German Tax Desk, New York
  • Thomas Eckhardt
    +1 212 773 8265

EYG no. CM4185