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In an as yet unpublished decision (case no. I R 178/94) in which KPMG Germany represented the taxpayer, the Federal Tax Court was asked to decide a dispute concerning the correct calculation of creditable foreign withholding tax with respect to dividends earned by a German insurance company. The stockholdings were in all cases too small to qualify for the participation exemption. Hence, the tax treaties in question (ten in all including the old version of the U.S. tax treaty) and German domestic law provided for crediting the foreign withholding tax to avoid double taxation.

Under German domestic law (sec. 34c, 34d EStG), 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).

An initial problem arises because the German word for "income" used in the above provisions is "Einkuenfte," a term which in German domestic usage refers strictly to net income as opposed to gross income or revenue (Einnahmen). However, as used in tax treaties, the word "Einkuenfte" can refer to either net income or revenue, depending on context, which is not always clear. In the case at hand, the tax authorities sought to reduce the amount of the gross dividends received by certain business expenses allegedly allocable thereto, in other words, to calculate the per country limitation using the fraction "net dividends over net income" instead of "gross dividends over net income". The taxpayer, on the other hand, argued that, where the tax treaties in question provided for a credit of foreign tax withheld on "dividend income" received, they were referring to gross dividend income, hence that the numerator in the fraction used to calculate the credit limitation should be gross dividend income.

The court in effect held that the tax treaties in question permitted the source countries to withhold tax based on gross dividend income and permitted Germany to calculate the limitation on credit with respect to German tax imposed on net dividend income.

The outcome of the case finally turned, therefore, on the issue of what expenses were properly allocable to the foreign dividend income. The court followed the taxpayer's argumentation here and determined the allocable expenses by looking at the dividend revenue in isolation instead of in the context of the taxpayer's insurance business. Hence, of the four types of expenses the tax authorities sought to allocate to the dividend revenue, namely:

  • accrual for interest contractually payable on whole life insurance policies (rechnungsmaessige Zinsen),
  • accrual for bonus interest on such policies (ausserrechnungsmaessige Zinsen),
  • trade tax on the dividend revenue, and
  • allocable administrative charges,

the court held that only allocable administrative charges were properly deductible from dividend revenue in determining the numerator of the fraction for calculating the foreign tax credit limitation. Since the lower court had decided on other grounds, its factual findings were insufficient as to which administrative charges were properly allocable. Hence, the court remanded for further findings.

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