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14.06.2024
German Tax and Legal News

Federal tax court clarifies application of switch-over clause in the Germany-US tax treaty

Certain payments made to German resident partners in a US partnership are tax exempt even if only partially taxed in the US.

The German federal tax court (BFH) in its decision dated 5 December 2023 (published on 2 May 2024) confirmed the decision of the lower tax court of Munich and ruled that guaranteed payments under a profit sharing agreement to German resident partners in a US professional services partnership were exempt from German taxation to the extent the profits (including the guaranteed payments) were attributable to a US permanent establishment pursuant to the Germany-US double tax treaty (DTT), even if only partially taxed in the US. The BFH further ruled that the “switch-over clause” in the Germany-US DTT, which changes the exemption method to the credit method for double taxation relief, did not apply since only a portion of the payments was not taxed in the US.

In its ruling, the BFH made clear that, in the case of a professional services partnership, the Germany-US DTT provides for the allocation of income based on general permanent establishment principles (under the prior version of the DTT, such allocation was based on where the services were performed).

Furthermore, the BFH ruled that the requirements of the domestic switch-over clause under section 50d (9) of the Income Tax Code (ITC) were not met in the case at hand. 

Facts of the case

The taxpayers were German resident partners of a US law firm in the legal form of a limited liability partnership (LLP) having its registered office and place of management in the US. The LLP generated most of its profits in the US, but also maintained several permanent establishments outside the US, including one in Germany. The taxpayers worked predominantly in Germany as part of the German permanent establishment, but also worked in the US for a limited number of days.

According to the profit allocation rules of the partnership, all partners had an individual, contractually determined entitlement to a share of the LLP’s total (worldwide) profit. For tax purposes, the total (worldwide) profit of the LLP was allocated to the respective countries by using permanent establishment principles. Under article 7 (1) of the Germany-US DTT, the profits of an enterprise (including a professional services partnership) can only be taxed in another country to the extent they are attributable to a permanent establishment of the enterprise in that country (regardless of where an individual partner receiving a profit share is working from).

In addition, all partners had the option to receive a part of their profit share in the form of guaranteed payments, which were structured as advance payments on the account of the respective profit share. The taxpayers made use of this option in 2008 (the year in dispute), which did not change the total amount of their remuneration in such year.

The guaranteed payments of the partners in the LLP not resident in the US were only taxed under US federal tax law to the extent the partners were physically present and actively working in the US.

Rather than granting an exemption for the portion of the guaranteed payments that were attributable to the US permanent establishment as provided in the Germany-US DTT, the German tax authorities treated the payments (that had not yet been taxed in the US) as fully taxable income by applying the credit method as also provided in the Germany-US DTT. The taxpayers, however, argued that such portion of the guaranteed payments should be exempt from German taxation. 

BFH decision

The BFH ruled that to the extent the profits received by the taxpayers (including the guaranteed payments) were attributable to a US permanent establishment, they are exempt from German taxation under the Germany-US DTT (but may be considered when calculating progressive tax rates for German tax purposes), even if only partially taxed in the US. The BFH explained that such profits are part of the commercial profits of an enterprise (including a professional services partnership) in accordance with article 7 (1) and (7) of the Germany-US DTT (relating to business profits and permanent establishments) and, if such profits are attributable to the US permanent establishment, are exempt from German taxation in the hands of the taxpayers in accordance with article 23 (3a) of the Germany-US DTT (allowing for certain relief from double taxation). The BFH emphasized that, in the case of a professional services partnership, the Germany-US DTT provides for the allocation of income based on general permanent establishment principles, as opposed to the prior version of the DTT where the allocation was based on where the services were performed.

The BFH also discussed the switch-over clause under article 23 (4b) of the Germany-US DTT, which denies the exemption method (but allows the credit method) in certain circumstances where the relevant income is not taxed in the other jurisdiction. Under one such circumstance, an exemption is not allowed where the other jurisdiction exempts the income pursuant to another provision in the DTT. The BFH ruled that such provision does not apply, since the partial nontaxation of the profit share paid to the taxpayers is based on a US federal tax law and not under the provisions of the Germany-US DTT.

However, under another circumstance in the switch-over clause under article 23 (4b) of the Germany-US DTT, an exemption is not allowed “where” the other jurisdiction exempts the “income” pursuant to its domestic laws. The BFH pointed out that the wording of the clause contains the qualitative-conditional link “if” (or “where” in the English version of the DTT) instead of the quantitative-conditional link “insofar as.” In cases where the qualitative-conditional link “if” has been used, the BFH has denied the application of the switch-over clause where the nontaxation only occurred for some portion of the income in the other jurisdiction. In addition, the English version of the switch-over clause refers to "income" and not to "items of income." Based on the view of the BFH, portions of profit may not be “dissected” and broken down into individual parts for the application of such clause. The German tax authorities relied upon wording in the commentary to the OECD Model Tax Convention on Income and on Capital (model tax treaty), which referred to “an item of income.” The BFH noted, however, that the commentary to the OECD Model Tax Convention on Income and on Capital (model tax treaty) may only be relied upon if the wording of the respective DTT is the same as (or comparable to) the wording of the model tax treaty. Moreover, the interpretation of DTTs (contrary to the view of the German tax authorities) follows a static and not a dynamic approach. At most, the version of the commentary to the model tax treaty that was applicable at the time the legislator approved the respective DTT may play a role (but not a later change to such commentary).

Finally, the BFH ruled that the prerequisites of the unilateral switch-over clause under domestic legislation (section 50d (9) ITC) that was applicable for the period in question were not fulfilled when a partial exemption applies in the other jurisdiction. However, based on a 2017 amendment to section 50d (9) sentence 1 ITC (the wording was changed from “if” to “insofar” and a newly added sentence now states that the rule applies to “portions of income”), the result may likely be different for periods after 2016. 

Comments

The BFH ruling may be of specific interest for certain international professional services partnerships whose profit distribution rules contain guaranteed payment allocations. Moreover, the ruling touches upon various important topics in international tax law and leads to an increase in legal certainty, as the ruling confirms established case law on how to interpret DTTs (denying the contrary view of the German tax authorities). However, the unilateral subject-to-tax provision of section 50d (9) ITC was changed after 2016; as such, the applicability of this provision should be carefully examined in similar cases, as it could lead to a different outcome.

Your Contact

Martin Ulrich
Senior Manager

mulrich@deloitte.de
Tel.: +49 211 8772 3995

Stefan May
Senior Manager

stmay@deloitte.de
Tel.: +49 211 8772 5974

Andreas Maywald
Client Service Executive | ICE - German Tax Desk

anmaywald@deloitte.com
Tel.: +1 212 436 7487

Your Contact

Martin Ulrich
Senior Manager

mulrich@deloitte.de
Tel.: +49 211 8772 3995

Stefan May
Senior Manager

stmay@deloitte.de
Tel.: +49 211 8772 5974

Andreas Maywald
Client Service Executive | ICE - German Tax Desk

anmaywald@deloitte.com
Tel.: +1 212 436 7487

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