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In article no. 74, we reported on subject-to-tax clauses as they appear in various German tax treaties.

Among the cases discussed in our article was one which was then pending before the Federal Tax Court. This case has now been decided, and the outcome is something of a surprise (decision dated 27 August 1997 - IStR 1998, 83).

The Federal Tax Court holds that clauses of the sort discussed in our previous article (referred to by the court and the tax authorities as "reversion clauses" - Rueckfallklauseln) are to be understood as relating to the categories of income defined in tax treaties (e.g. business profits, interest income, dividend income, etc.), not to each specific item of income falling within a particular category. As long as the other treaty state in fact imposes tax on the category of income in question, income of that category is deemed to be derived from sources within that treaty state (assuming the tax imposed is in accordance with the treaty). The fact that the other treaty state fails to tax certain income items falling into the overall tax treaty income category does not cause the right of taxation to revert to Germany with respect to such items.

The case was decided under the German tax treaty with Canada. The profits of the Canadian permanent establishment of a German insurance company included sums from U.S. insurance transactions and passive investments (e.g. dividends). These sums were not taxed in Canada in the relevant years (1985 - 1988) under special provisions of the Canadian tax code.

The article on avoidance of double taxation in Germany's tax treaty with Canada contains the following clause (Article 23 (3)):

For the purposes of this Article, profits, income or gains of a resident of a Contracting State shall be deemed to arise from sources in the other Contracting State if they are taxed in that other Contracting State in accordance with this Article.

The tax authorities argued that the income in question was not from Canadian sources because it had not been taxed in fact in Canada. Business profits of a German resident attributable to a Canadian branch are only excluded from the German tax base if from Canadian sources. Therefore, in the opinion of the tax authorities, the failure of Canada to exercise its right of taxation under the tax treaty caused this right of taxation to revert to Germany.

Germany's highest tax court disagreed. In the court's opinion, business profits are deemed to be from Canadian sources under Article 23 (3) as long as Canada taxes this general category of income as defined by the tax treaty. The precise extent of the taxation of business income is irrelevant. At least, it makes no difference if there are certain gaps in the Canadian domestic tax rules as regards branch business profits. Since the general category of business income attributable to the Canadian permanent establishment had been taxed in fact by Canada in the years in question, all income in this income category was deemed to arise from Canadian sources. This applied as well for the specific income items which were tax-exempt in Canada.

The reported facts of the case do not specify the amounts of "normal" branch income taxed in Canada and "special" branch income not so taxed. Nor is it clear whether the court requires a preponderance of such "normal" income over special tax exempt income in order for the entire income category to be sourced in the other treaty state.

The court sees its latest decision as consistent with its previous ones regarding "reversion" clauses.

Certain language in the decision and comments thereon by "FW" indicate that the court was worried by the consequences of interpreting the "reversion" clause in the strict manner advocated by the tax authorities. What if, asks FW, the U.S. branch of a German company earns profits of DM 120,000 under U.S. law but profits of DM 200,000 as measured by German law because German tax accounting contains a currency gain in dollars not reflected by the U.S. accounts? The tax authorities' interpretation of the reversion clause would have justified German taxation of the difference (DM 80,000). FW's example is the reverse of our own at the end of article no. 74: What if there is a currency loss from a German point of view? The interpretation of the tax authorities would indicate that the loss is deductible by the home office in Germany.

FW goes on to argue that the court's entire interpretative approach to such "reversion" clauses is misconceived. The clause states an affirmative proposition: if income is taxed by the other treaty state in accordance with the tax treaty, it is deemed to come from sources in the other treaty state. The converse, says FW, need not hold. In other words, if income is not taxed in the other treaty state, Germany should apply its own domestic source rules to see where the income is sourced.

This approach accords with common sense, but so far not with the decisions of the Federal Tax Court.

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