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Treatment of Special Payments by German Partnerships Awaits Court Decision
Each partner of a German partnership is taxed on both his share of the profit and on the special payments he receives from the partnership for services (loan, licenses, etc.) rendered by the respective partner to the partnership. From a German tax point of view, these special payments are treated as income from commercial business, which is - in the case of foreign partners - allocated to the permanent establishment of the German partnership and therefore subject to limited taxation in Germany. However, according to former case law of the Federal Tax Court, the right of taxation of special payments is allocated on the basis of the Double Tax Treaty (DTT) article that governs the type of special payment (e.g., interest, license fees), meaning that it is, as a rule, allocated to the partner's country of residence. With the 2009 Tax Act the German legislator codified as response to this case law a new statutory treatment of special payments in Sec. 50d (10) Income Tax Act (ITA) which was now again subject of a decision of the Federal Tax Court. Taxand Germany examines the treatment of special payments by German partnerships in inbound cases.
According to Sec. 50d (10) ITA, for purposes of a DTT special payments are to be treated as business profits unless the relevant DTT expressly provides for a different treatment of these payments. The intention of this new legislation was to have the profit from special payments of German partnerships reallocated to Germany. However, in a recent ruling, dated 8 September 2010 (I R 74/09), the Federal Tax Court stated that Sec. 50d (10) ITA does not grant a right of taxation of the special payments to Germany.
The Federal Tax Court decided on the tax treatment of special payments by a German partnership to, in this case, a US resident partner under the applicable DTT. The ruling was based on the following (simplified) facts of the case:
Limited partner of a German partnership was - inter alia - an Inc. residing in the USA (US-Inc.). US-Inc. granted to the German partnership - in exchange for license fees - the right to merchandise and distribute its products as well as to use the trade mark and trade name of the US-Inc. The licenses have been administrated by US-Inc. in the USA.
The German tax office concluded that the payment of license fees made by the partnership to its non-resident limited partner would have to be qualified as special payments and would have to be attributed to the German permanent establishment of US-Inc. Consequently, the right of taxation of the special payments would be with Germany according to article 7 (1) DTT USA.
The Federal Tax Court ruled that the license payments may exclusively be subject to tax in the USA according to Art. 12 (1) DTT USA. According to the opinion of the Federal Tax Court, Sec. 50d (10) ITA does not change this qualification. This rule qualifies the special payments as business profits within the meaning of Art. 7 DTT USA. Consequently, in the case at hand Art. 7 (6) DTT USA, which governs the precedence of, inter alia, the license article, would be applicable as well.
Furthermore, the Federal Tax Court stated that the taxation right could not be allocated to Germany according to Art. 7 (1) DTT USA anyway as Sec. 50d (10) ITA requires the existence of a permanent establishment and the attribution of the business profits to the permanent establishment under treaty law. Thus, the allocation of the right to tax to Germany would basically require the license to be functionally connected to a permanent establishment in Germany.
The Federal Tax Court stated that the licenses cannot be attributed to the German permanent establishment as they were administrated in the USA. Consequently, such licenses could not be subject to German tax.
The Federal Tax Court's decision was of great relevance for all special payments to foreign partners of a German partnership if the applicable DTT does not provide for any specific provisions with respect to special payments. As the decision is also applicable to interest payments of a German partnership to foreign partners, it could be used as an approach for tax structuring to avoid the application of the German interest barrier rule on the level of German subsidiaries of multinational groups. Interest from partner loans is not considered interest in the sense of the interest barrier rule since the loans do not affect the overall profit of the partnership because of the interest's nature as special payments.
However, because of the case law of the Federal Tax Court these special payments are, in spite of Sec. 50d (10) ITA, tax free if they are paid to a foreign partner. A change of the legal form into a partnership might therefore be taken into consideration in certain cases. However, it remains to be seen whether or not the German legislator is going to adjust Sec. 50d (10) ITA.
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