Germany: 074. "Subject-to-Tax" Clauses in German Tax Treaties

Last Updated: 1 July 1997
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1. Subject-to-tax clauses in German tax treaties

Most German tax treaties avoid double taxation by means of the so-called exclusion method for a number of types of income as to which the source country has the primary right of taxation under the OECD Model Treaty and which involve a high degree of contact with the source country. Business income attributable to a foreign permanent establishment including gains on the sale of assets belonging to the permanent establishment, foreign personal service income, both independent and dependent, and income from foreign real property including gains on the sale thereof are perhaps the most important examples of income which is typically exempt from German taxation (subject to a progression clause in the case of individuals) if taxable in the other treaty state.

Under the majority of German tax treaties, the only requirement for the exclusion is taxability of the relevant income in the other treaty state. Whether the income is taxed in fact is irrelevant (so-called avoidance of "virtual" double taxation).

However, there are a number of newer tax treaties in which Germany has inserted language making the grant of the exclusion contingent on actual taxation in the other treaty state. Such provisions are referred to as "subject-to-tax" clauses. These clauses have in most cases not been worded in such a way as to alert the reader to their intended meaning. The relevant clause in Article 23 par. 2 sentence 2 of the German-American tax treaty reads as follows:

"For purposes of this paragraph, profits, income, or gains of a resident of the Federal Republic of Germany shall be deemed to arise from sources within the United States if they are taxed in the United States in accordance with this Convention. "

This passage must be read in connection with Article 23 par. 2 sentence 1 (a), which states that "except as provided in subparagraph (b), there shall be excluded from the basis on which German tax is imposed any item of income from sources within the United States ... that, according to this Convention, may be taxed in the United States." Article 23 par. 2 sentence 2 is interpreted by the German courts as meaning that income which is not actually taxed by the United States in accordance with the treaty shall not be treated as from sources within the United States, hence it cannot qualify for the exclusion of sentence 1.

Germany's treaties with Canada, Italy, New Zealand, Norway, Sweden, and its new treaty with Denmark have clauses similar to the above. These clauses have not, however, until recently attracted much attention from either taxpayers, the tax authorities, or scholarly commentators. A decision published in 1992 (DStR 1992, 1126 - 5 Feb. 1992) on the tax treaty with Canada had, however, made it clear how the Federal Tax Court would interpret such clauses.

2. Recent decisions on subject-to-tax clauses

In a decision published in late 1996, the Federal Tax Court took advantage of a case which came before it to remind all concerned that the clause existed (IStR 1996, 536 - 11 June 1996). The case came up under the U.S. tax treaty and involved a German who had worked in the United States for a number of months and then vacationed there. On his German tax return, the individual sought to exclude the earnings attributable to the work in the United States. In the lower court, the only issue apparently argued was whether the individual had spent more than 183 days in the United States or not in the year in question (here a necessary condition of the U.S. right to tax since the salary was borne by the German employer). The lower court denied the exclusion on the grounds that the vacation time did not count because it came after the end of the actual employment and was motivated by private considerations (FG Schleswig-Holstein, EFG 1995, 642 - 5 Dec. 1995).

The Federal Tax Court brushed aside this issue under the 183-day rule and instead decided the case under the subject-to-tax clause, stating that no exclusion was possible because no taxation in fact of the earnings by the U.S. was in evidence. The individual had not even filed a U.S. tax return. The earnings were thus, under the subject-to-tax clause, not from "sources within the United States" and hence not excludable in Germany. Should the individual later establish that the earnings had in fact been taxed in the United States, his assessment could be reopened by reason of an event with retroactive effect under German tax procedure law (sec. 175 par. 1 sent. 1 no. 2 AO). (The Federal Tax Court also hinted that the lower court had incorrectly decided the issue under the 183-day rule and that vacation immediately following a stay for work purposes was indeed to be counted in deciding whether the 183 day limit had been exceeded.)

A case involving a subject-to-tax clause under the Canadian tax treaty is also currently pending on appeal to the Federal Tax Court (I R 127/95). The lower court's decision (FG Munich, EFG 1996, 206 - 11 Oct. 1995) is consistent with that in the case under the U.S. tax treaty just discussed. The Canadian case involves the U.S. profits of the Canadian permanent establishment of a German insurance company. The U.S. profits were exempt from tax in Canada under a special provision of the Canadian tax code.

3. Recent directive on point and loss utilisation issue

The above decisions may have been among the factors prompting the Duesseldorf Regional Tax Office to issue a lengthy directive on subject-to-tax clauses in late 1996 (directive of 11 Dec. 1996, IStR 1997, 53). The directive is far more detailed than that of the Munich Regional Tax Office of 10 May 1995 (DB 1995, 1488).

Besides repeating much of what has been said above, the Duesseldorf directive also outlines the position of the tax authorities as to application of subject-to-tax clauses in the case of foreign losses. The directive states that, for foreign losses, "actual taxation" by the source country has in any event occurred if the losses in question are potentially capable of being deducted for tax purposes in that country, either in the same tax year or in a different one. It makes no difference whether the taxpayer in fact ever earns the positive income necessary to make the deduction. The directive furthermore expresses doubt as to whether the subject-to-tax clause could ever apply to losses, as this is alleged to be inconsistent with its purpose. The directive therefore instructs the Duesseldorf tax authorities to refuse to apply the subject-to-tax clause to all losses irrespective of their treatment by the foreign source country pending court clarification of the state of the law.

The facts of the cases discussed in article no. 73 on currency conversion losses in foreign permanent establishments constitute an ideal test of the issue posed by the directive with regard to loss treatment. Since the foreign exchange losses do not even exist from the point of view of the foreign source state, the taxpayer has no possibility of using them in that country. They are hence "not taxed in fact" by the foreign treaty state and therefore arguably not excluded from the German tax base. Logic would seem to dictate that such exchange losses are deductible in full in Germany if they arise in a treaty state as to which a subject-to-tax clause is in effect, provided the activity requirements of sec. 2a EStG are met by the permanent establishment in question.

Given the volatility of the U.S. dollar, it would seem that a case testing the above argument should not be long in coming.

Disclaimer and Copyright
This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.

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