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In article no. 79, we reported on a decision by the Federal Tax Court (since published in BStBl II 1997, 657 - 9 April 1997) concerning the calculation of creditable foreign withholding tax on dividends earned by a German insurance company. The stockholdings involved were too small to qualify for the participation exemption.

The tax authorities sought to allocate a pro rata share of certain domestic (German) expenses to the dividends received. The foreign tax credit is limited to the German tax owing with respect to the income from the foreign country in question (per country limitation). The amount of German tax falling on this income is in turn determined by multiplying total tax owing by a fraction formed by dividing foreign income (numerator) by total income (denominator). Allocation of domestic expenses to gross dividends received reduces the numerator of the fraction and so reduces creditable foreign tax.

Of the four types of domestic expenses the tax authorities sought to allocate pro rata, the court held that only one (administrative expense) was in fact properly allocable. The theory of the decision was that the dividend revenue should be analysed in isolation as income from capital instead of in the context of the taxpayer's insurance business. Hence, only those domestic expenses were allocable which are typically incurred to earn income from capital. The other types of expense the taxpayers sought to deduct were associated with the commercial activities of the insurance company.

The Federal tax authorities have now issued a directive dated 23 December 1997 (IStR 1998, 120) concerning this matter. They acquiesce in the decision only so far as it relates to the foreign income of domestic insurance companies. They state that the decision is not to be applied to the foreign income of domestic banks. For banks, the interest expense incurred for refinancing purposes is to be deducted pro rata from foreign earnings because income and expense are here allegedly more closely related than is the case for insurance companies.

It is unclear from the directive whether the tax authorities are prepared to apply the court's decision to businesses other than insurance companies and banks.

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