Germany: New Germany - Luxembourg Tax Treaty

On 23 April 2012 the Federal Republic of Germany and the Grand Duchy of Luxembourg signed a new Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital ("Treaty"). The new Treaty is based on the OECD Model Tax Convention and follows the current German policies on double taxation treaties, e.g. regarding the exchange of information between the fiscal authorities of both contracting states. It is amended by a protocol ("Protocol") that constitutes an integral part of the Treaty.

The new Treaty results in an extensive revision of the currently applicable double taxation treaty dated 1958 ("1958 Treaty"). The new provisions affect, among others, the taxation of funds. Some of the new provisions specifically relate to certain types of funds, e.g.

  • the explicit provisions regarding the entitlement of regulated funds to Treaty benefits.

Other amendments typically affect the taxation of funds, in particular German inbound investment structures used by Luxembourg private equity funds. We would like to draw your attention to the following:

  • change of the withholding tax rate with respect to dividends;
  • increase in taxation of payments on certain hybrid financing instruments;
  • establishment of right to tax with respect to capital gains from the disposition of shares in real estate companies.

I. Entry into Force

The new Treaty will enter into force on 1 January of the year following the completion of the ratification process, i.e. presumably on 1 January 2013. The Treaty will replace the 1958 Treaty which is currently in force.

II. Treaty Benefits for Regulated Funds

The Protocol explicitly states that regulated funds will be entitled to claim Treaty benefits regarding the reduced withholding tax rates applicable to dividends and interest. In this context, the Protocol differentiates between investment companies and investment funds (Investmentvermögen); unlike the nomenclature of the German Investment Act ("GIA"), the term "investment funds" (Investmentvermögen) relates exclusively to funds of contractual type.

1. Investment Companies

Investment companies are entitled to claim a reduction of withholding taxes on dividends and interest payments in their own name (no. 1 para. 2 Protocol). The following entities qualify as investment companies: German Investment Stock Corporation and Luxembourg venture capital investment company (société d'investissement en capital à risque; SICAR), investment company with variable capital (société d'investissement à capital variable; SICAV) and investment company with fixed capital (société d'investissement à capital fixe; SICAF).

The explicit confirmation of the entitlement of investment companies to Treaty benefits is to be welcomed. Such entitlement has been largely recognized under the 1958 Treaty and has been allegedly confirmed in correspondence exchanged between the German and Luxembourg fiscal authorities. However, based on the personal tax exemptions of SICAVs and SICAFs, occasionally the question was raised whether those investment companies were resident in Luxembourg for treaty law purposes.

Luxembourg investment companies are defined exclusively by reference to the regulatory regime; a body corporate is not explicitly required. Nonetheless, under the general rules on the application of double tax treaties to partnerships SICAFs and SICARs organized as partnerships (e.g. a société à responsabilité limitée; SCS) are likely not to be deemed entitled to Treaty benefits.

2. Funds of Contractual Type

Funds of contractual type (i.e. asset pools (Sondervermögen) organized under the GIA and Luxembourg fonds commun de placement; FCP) are entitled to claim Treaty benefits regarding the reduced tax rates applicable to dividends and interest (only) to the extent that their unit holders are resident in the same state as the fund. As a consequence of the fund's eligibility for Treaty benefits the investor's right to a corresponding reduction of source taxation ceases to exist (no. 1 para. 1 Protocol).

The partial entitlement of asset pools (Sondervermögen) and FCPs to Treaty benefits is primarily of procedural importance. Funds of contractual type will be entitled to claim in their own name Treaty benefits available to their investors residing in the same contracting state. However, in particular with respect to mutual funds there is no rule how to determine in which state the fund's investors are resident. The tax treaty between Germany and the U.S. of 2006 contains a similar provision. The German-U.S. treaty provides that the authorities of the contracting state shall establish procedures to determine the residency of their investors (including statistically valid sampling techniques), but such procedures have not yet been implemented.

The provision regarding the entitlement of German funds to Treaty benefits is too narrow insofar as no. 1 para. 1 lit. a) of the Protocol relates only to asset pools (Sondervermögen) managed by a "Kapitalanlagegesellschaft", i.e. a German investment management company (§ 2 para. 6 GIA). To the extent German investors are invested in a Sondervermögen organized under German law, the Treaty benefits regarding the withholding tax deduction should be also available in the case the Sondervermögen is managed by a EU management company, regardless of whether such management company is resident in Luxembourg or another EU member state (cf. § 1 para. 1a German Investment Tax Act).

3. Impact on the German Domestic Law

For purposes of defining the terms investment company and investment fund (Investmentvermögen) within the meaning of the Treaty it is irrelevant whether a Luxembourg investment company or a FCP qualifies as a "foreign investment fund" under GIA. In particular, private equity funds organized as Luxembourg investment companies do not qualify as "foreign investment funds" within the meaning of GIA. Moreover, under German domestic law it is uncertain how to qualify a Luxembourg FCP for German tax purposes. Unfortunately there is no clarification regarding this issue in the Treaty.

III. Dividends

1. General

Generally, the withholding tax on dividends remains unchanged at a rate of 15%. However, under the new Treaty each contracting state is explicitly entitled to enforce the anti-avoidance provisions of its domestic law. In particular, this relates to the domestic anti-treaty shopping provision of § 50d para. 3 of the German Income Tax Act ("GITA"). Under this provision foreign companies without sufficient substance are not entitled to treaty benefits with respect to German source "passive" capital income. As a consequence, German source tax would be levied at the statutory withholding rate of 25% plus solidarity charge.

2. Intercompany Dividends

Under the new Treaty, the maximum withholding rate on intercompany dividends is reduced from 10% to 5%. Moreover, the minimum participation required for the intercompany benefits has been lowered from 25% to 10%.

The Treaty provisions regarding intercompany dividends are likely to become relevant where the requirements of the parent subsidiary directive (e.g. the minimum holding period of one year) are not met. While the application of the parent subsidiary directive requires the same minimum participation as the Treaty, under the parent subsidiary directive the withholding tax is reduced to zero (i.e. no tax is levied by way of withholding).

3. Investment Companies and Partnerships as Beneficial Owners

The Treaty limits the withholding tax rate to 15% in case the beneficial owner of the dividend is an investment company (i.e. German Investment Stock Corporation or Luxembourg SICAR, SICAV or SICAF), a partnership or an individual; the additional reduction applicable to intercompany dividends is not available.

Furthermore, if a Luxembourg investment company qualifies as a "foreign investment fund" within the meaning of GIA the application of the domestic anti-treaty shopping provision of § 50d para. 3 GITA is excluded. It should be noted, however, that private equity funds do not qualify as such foreign investment funds.

4. Real Estate Companies as Distributing Companies

The withholding tax rate is limited to 15% with respect to dividends paid by any real estate investment company which is tax-exempt regarding all or parts of its profits or which can deduct the distributions in determining its profits. Real estate investment companies are, among others, German REIT Stock Corporations.

It is, however, still unclear which other types of companies may qualify as real estate investment companies.

IV. Hybrid Debt Instruments

The Treaty provides for an increase in taxation of payments on hybrid debt instruments issued by German debtors. No. 2 para. 1 of the Protocol reserves the right to tax German source income derived from payments in consideration for profit sharing rights or debt claims (including silent partnerships or profit participating loans) to Germany, provided that those payments are deductible in determining the profits of the debtor. Unlike most German tax treaties such income is not treated as dividend income for Treaty purposes. Hence, such income may be subject to the statutory withholding rate of up to 25% plus solidarity surcharge.

The aforementioned financing instruments are often employed by foreign (e.g. Luxembourg) private equity or real estate funds for their German acquisition structures. Accordingly, it is advisable to critically reconsider repatriation strategies that were employed in the past.

V. Capital Gains; Real Estate Companies

Private equity funds, including real estate private equity funds, typically generate a major portion of their profits from capital gains realized upon the sale or other disposition of equity shareholdings in their portfolio companies.

Germany's right to levy German tax on capital gains realized by a Luxembourg fund upon the disposition of an equity shareholding in a portfolio company with its seat or place of management in Germany has been waived under both, the new Treaty as well as the 1958 Treaty (unless such shareholding is attributable to a German permanent establishment of the fund). Up to now, such waiver has equally applied with respect to dispositions of shares in portfolio companies holding German real estate.

Pursuant to the new Treaty capital gains derived by a resident of a contracting state from the disposition of shares deriving more than 50% of their value directly or indirectly from real estate situated in the other contracting state may be taxed in that other state. The new provision may particularly impact indirect investments in real estate located in Germany.

The new provision is based on the OECD Model Convention. According to the official commentary of the OECD Model Convention, the determination of the company's real estate assets will be done by comparing the value of the real estate situated in a contracting state to the value of all the assets held by the company without taking into account debts or other liabilities of the company; debts and liabilities are likely to be disregarded even if the underlying debt instrument is secured by real estate. Furthermore, the purpose of the company is supposedly irrelevant, i.e. the term "real estate company" includes companies that use the real estate assets from which the shares derive their value to carry on a business (e.g. a hotel).

Under the new Treaty, Germany would have a right to tax also capital gains realized by a shareholder resident in Luxembourg upon the disposition of shares in a Luxembourg real estate company holding German real estate. However, under its domestic law Germany has not exercised its right to tax such capital gains and, as a consequence, no German taxes will be levied.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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