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Under German commercial accounting law (sec. 244 HGB), the year-end balance sheet must be prepared in the German language and in German marks. Under the principle of linkage between the commercial and tax balance sheets, this provision applies for tax purposes as well. If, however, the entity preparing the balance sheet has transactions in foreign currencies, these can result in exchange gains and losses which are in principal also part of the German tax result.

Limits are, however, placed on the utilisation of foreign losses for tax purposes by sec. 2a EStG, which prevents the netting of foreign losses against other income in a variety of instances, in particular where the foreign loss is attributable to a foreign permanent establishment which does not meet certain activity requirements. A second limit results from the exclusion method of avoiding double taxation which Germany follows in most of its tax treaties. These treaties result in exclusion of the net result of a foreign permanent establishment, whether positive or negative, from German taxation, subject to a progression clause in the case of individuals, though not corporations.

Under two decisions rendered last year by the Federal Tax Court dated 16 February 1996 (IStR 1996, 435 and BB 1996, 2030), foreign exchange profits and losses which result solely from the need to express the result of a foreign permanent establishment in German marks form part of the net result of the permanent establishment and can therefore not be netted against domestic income even if the permanent establishment meets the activity requirement of sec. 2a EStG.

Of the two reported cases, one involved Germany's tax treaty with the United States in the version in effect prior to 1990 (old tax treaty) and the other was decided under the tax treaty with Belgium. Grounds of decision were published only for the latter case. Only a casenote was published for the case decided under the old German-American tax treaty.

The Belgian case involved a German corporation which had maintained a permanent establishment in Belgium for a number of years before selling the branch to one of its own subsidiaries. The assets purchased by the subsidiary did not include the branch capital, which reverted to the German head office. Because of fluctuation in the exchange rates, reconversion of the branch capital into German marks resulted in a substantial loss, even though, expressed in Belgian Francs, no such loss had taken place. The court held that this loss was part of the exempt result of the permanent establishment and therefore not deductible for German tax purposes even though the branch met the activity requirements of sec. 2a EStG. While noting that its holding meant that such losses, which can occur in a variety of circumstances, would as a rule fall into a sort of tax "no-man's-land" and not count for tax purposes in either treaty state, it considered this to be an unavoidable anomaly of the exclusion method, pointing out that the anomaly would work to the taxpayer's advantage in the event of exchange gains. The court also noted that account could be taken of such currency conversion losses to the same extent as German law allowed recognition of foreign tax exempt branch losses in general. Briefly stated, such losses can be deducted in Germany subject to taxation of later gains in like amount if the branch meets the basic activity requirements (sec. 2a par. 3 EStG). Furthermore, if attributable to an individual, a foreign branch loss can result in a negative progression effect under the standard progression clause, again providing the branch meets certain activity requirements.

There are, however, a number of German tax treaties in effect which make the exclusion of foreign branch profits contingent on actual taxation of these profits in the other treaty state. The current tax treaty between Germany and the United States is one such treaty. An important difference between the old and the new tax treaty with the United States is the addition of a somewhat obscurely worded subject-to-tax clause in Article 23 par. 2 sent. 2. Since the effect of such clauses is to prevent exclusion of income in Germany as the country of residence where no taxation in fact occurs in the source country, the two decisions here reported on would apparently have to be decided differently under a tax treaty with a subject-to-tax clause. See in this connection article no. 74 as well.

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