Dispute over treaty participation exemption for hybrid U.S. entities comes to an end

Hybrid U.S. entities and their treatment under tax conventions have kept German tax courts busy for years. In its decision dated 11 March 2026 (I R 13/23) that was published yesterday Germany’s highest tax court, the Federal Fiscal Court (BFH) once again addressed this issue. In doing so, the BFH not only reaffirms its established case law on Article 1(7) of the Germany-US Tax Treaty (US-DTT) but also clearly rejected the German tax authorities’ view that former Section 50d para. 1 sentence 11 German Income Tax Act (ITA) has more than just procedural effects.

Especially for the U.S. mid-market, where S Corporations are widely used, the decision is likely to provide significant relief after years of uncertainty. At the same time, the judgment extends well beyond the specific facts of the case. Its implications are relevant for all structures in which U.S.-resident investors hold interests in German corporations through hybrid U.S. entities that are treated as fiscally transparent for U.S. tax purposes but are opaque from a German tax perspective.

Reduction of withholding tax to 0% rather than to 15% as core issue

Where a U.S.-resident company holds at least 80% of the shares in a German corporation, the US-DTT permits, subject to additional conditions, for a full exemption from German withholding tax on dividends (so-called participation exemption). That may sound straightforward. The controversy arises where the U.S. parent company, although treated as a corporation for German tax purposes, has elected to be treated as a flow-through entity, or a disregarded entity – such as a S-Corp. – for U.S. tax purposes. In such cases, the income of the entity – including dividends received from the German subsidiary – is not taxed at entity level under U.S. tax law. Instead, corporate income is passed through to the U.S.-resident individual shareholders and taxed in their hands.

The German tax authorities have challenged this outcome for well over a decade. Under the US-DTT, dividends received directly by individual shareholders generally qualify only for a reduction of German withholding tax of 15%, rather than a full exemption. Consequently, individual shareholders investing through a U.S. disregarded of flow-through entity, such as an S Corporation, could effectively obtain a treaty relief that, in the view of the German tax authorities, should be reserved for corporate shareholders.

Article 1(7) US-DTT as key provision

The BFH first addressed this issue under the current US-DTT in its landmark decision dated 26 June 2013 (I R 48/12). Although an S Corporation is not a resident under Article 4(1) DTT, as it is not subject to U.S. corporate income tax, the BFH concluded that Article 1(7) DTT fills this gap. Under the provision, income derived through a fiscally transparent entity is treated as income of a U.S. resident to the extent that such income is attributed to a U.S.-resident under U.S. tax law. As a result, the S-Corp. is effectively treated as if it were resident in the United States for treaty purposes. Consequently, the treaty participation exemption applies, and the dividends are ultimately exempt from German withholding tax.

No different result following the introduction of former section 50d para. 1 sentence 11 ITA

Afterwards, section 50d para. 1 sentence 11 ITA (old version) was introduced. The provision stipulates that, in the case of hybrid entities, treaty-based refund claims are available only to the person to whom the investment income is attributed as income of a resident under the tax law of the other contracting state (here: the United States).

As dividends received by an S-Corp. are taxed directly in the hands of its individual shareholders under U.S. tax law, the conditions of the provision are literally satisfied. Accordingly, the treaty refund claim is transferred to the individual shareholders.

This mechanism gave rise to the central question that has been debated extensively in both academic literature and tax practice for years: what does section 50d para. 1 sentence 11 ITA actually govern?

The German tax authorities, together with parts of the academic literature, took the view that the provision has substantive legal effect. According to this interpretation, the provision determines the person to whom the dividend income is attributed and thereby directly influences the treaty relief available.

The opposing view, supported by the wording of the provision, its systematic context, and the legislative history, regarded the rule as purely procedural. Under this interpretation, the provision determines only who is entitled to formally assert a treaty relief claim that has already arisen. In other words, it merely identifies the person entitled to file the claim and does not affect the availability or extent of treaty benefits. The BFH has now endorsed this interpretation and rejected the tax authorities’ opposite approach.

Relevance for all U.S./Germany structures involving hybrid entities

The judgment significantly enhances legal certainty for Germany/U.S. cross-border structures involving hybrid entities. Whether the German tax authorities will seek to revisit the issue by relying on current section 50d para. 11a ITA remains to be seen. In our view, however, there is little room for a different outcome, as the current provision adopts the wording of its predecessor virtually unchanged. The decision should therefore be equally relevant to the interpretation of current section 50d para. 11a ITA.

As a consequence, the BFH's judgment may also call into question the position recently adopted by the German Federal Central Tax Office (BZSt) in its administrative practice regarding distributions made by a hybrid German corporation such as a GmbH.