Global Tax Alert | 2 December 2013
German Federal Fiscal Court rules on S corporation treaty protection under 2006 German-US tax treaty
On 30 October 2013, the German Federal Fiscal Court published a ruling regarding the treaty protection of a US S corporation under the 2006 protocol of the German-US tax treaty (treaty). The court ruled that the S corporation is a “body corporate,” which was entitled to the 5% dividend withholding tax rate under Article 10(2)(a) of the treaty.
A US corporation which elected to be taxed pursuant to the rules of Subchapter “S” of the US Internal Revenue Code (S corporation) owned a 50% interest in a German corporation and received in the year 2008 German dividend income. The German distributing company withheld German withholding tax (WHT) at the then applicable rate of 21.1%. The S corporation applied for refund of the WHT on the basis of the 5% WHT granted to a 10% or greater shareholder which qualifies as a “company” under the treaty (Article 10(2)(a)). German tax authorities granted the refund only on the basis of the 15% rate available to “all other” shareholders pursuant Article 10(2)(b).
The 5% rate was rejected by German tax authorities based on the argument that the S corp is not a resident person under the treaty, as it is not a taxable entity in the US because its income is taxed in the hands of its shareholders. Other than Article 4(1) of the 1998 treaty regarding the residency status of partnerships, Article 1(7) of the 2006 protocol (the treaty article dealing with income received through hybrid entities) should not confer on the S corporation residency status.
The S corporation litigated its case, but the lower tax court sided with the tax authorities when reviewing the case.
Federal Fiscal Court Decision
Upon appeal, the German Federal Fiscal Court overruled the tax court and decided in favor of the S corporation.1 In its very detailed and complex reasoning, the court held that an S corporation qualifies for German purposes as a “body corporate” under Article 10(2) and 3(1)(e) of the treaty. Since its income is taxed in the hands of its shareholders, it must be, as a consequence of Article 1(7) of the treaty also be treated as a person resident in the US. From a German perspective, the S corporation should qualify also as the beneficial owner of the dividend. As a result, the Federal Fiscal Court held, it follows that the S corp is, as a 50% shareholder, entitled to the lower 5% WHT rate pursuant to Article 10(2)(a) of the treaty.
In the current case, the S corporation was only a 50% shareholder, and thus the Court did not have to decide whether an S corporation is also entitled to the 0% WHT rate for dividends from certain 80% and greater shareholdings. However, in a side comment, the Court referred to the application of the new Section 50d (1) S. 11 German Income Tax Act (ITA). This new statute, which applies to distributions made after 30 June 2013, is in principle modelled after Article 1(7) treaty, but includes more extensive language. The court did not explicitly comment on whether or not Section 50d (1) S. 11 ITA would deny an S corp now the benefits of the lower treaty rates reserved for qualifying companies. Due to procedural reasons, the Court did not also decide whether the S corporation would be entitled to a refund of the WHT on the basis of the so called “free movement of capital“doctrine under EU law. Although it is still open as to whether or not shareholders from non EU jurisdictions could benefit from such claims, the Court noted that such claims may possibly have merits.
The decision should have consequences beyond the sphere of S corporation taxation, as its reasoning should in principle also apply to other US hybrid entities, which are owned by qualifying US resident taxpayers and which in turn own shares in German corporations, such as a US LLC which qualifies as a corporation under German entity classification rules. However, it is currently unclear, whether German tax authorities will apply the Court case on distributions made after 30 June 2013, in light of the new Section 50d (1) S. 11 ITA.
US shareholders of German corporations with relevant ownership structures (S corp, LLC qualifying as a corporation for German tax purposes) should thus review withholding tax refund claims for their eligibility to the lower rates of Article 10 (2)(a) and (3) of the treaty, or, potentially, under the “free movement of capital” doctrine under EU law. The latter refund claims must be filed with the competent local German tax office, and not with the office which is processing treaty refund claims (which is the German Federal Central Tax Office in Bonn). Those claims may be also subject to a more favorable statute of limitation period and could encompass also prior years for which a treaty refund was already filed. Potential refund filers should evaluate the relevance of the coming end of the year 2013 on the statute of limitation for any claims.
1. BFH I R 48/12, judgment dated 26 June 2013.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP, German Tax Desk, New York
- • Jorg Menger
+1 212 773 5250
- • Thomas Eckhardt
+1 212 773 8265
- • Thomas Schmitz
+1 212 773 6379
- • Theresa Seitner
+1 212 773 0635
- • Simone Guter
+1 212 773 7043
- • Daniela Ahrling
+1 212 773 4752
EYG no. CM4002