Federal Central Tax Office (BZST) changes practice for relief from withholding tax on US income

US investments have traditionally been of great importance to the German economy. The return on investment of US corporations is significantly influenced by the tax burden on their German subsidiaries and the German withholding taxes on profit distributions. In this context, the Federal Central Tax Office (BZSt) typically did not take the US tax view under special consideration. This now appears to have changed. In future, it is to be expected that applications for exemption or refund will in many cases no longer be approved. In detail:

Relief from German withholding tax (background)

Dividends paid by a German subsidiary to its US parent are initially subject to withholding tax (plus solidarity surcharge) at a rate of 26.375%. Relief is regularly available under the double taxation agreement between Germany and the US (down to 0% in some cases). This requires an application to be submitted to the Federal Central Tax Office (BZSt), whereby either a refund can be requested retrospectively (i.e. after the taxes have been withheld) or an exemption certificate can be requested in advance (i.e. before the profits are distributed).

Various, sometimes complex regulations must be observed when distributing profits to the USA. On the one hand, a withholding tax reduction available under Article 10 of the DTA between Germany and the USA is subject to the demanding reservations under Article 28 of the DTA. In addition, Section 50d (3) of the German Income Tax Act (EStG) must be observed, which imposes further requirements for the granting of treaty benefits.

Particular complexity in the case of hybrid companies

Particularly in the case of US structures, the question regularly arises as to who (the company receiving the payment or its shareholders) should apply for exemption or refund of withholding tax. This is important because US tax law provides options with regard to the tax treatment of corporations. These may then be considered "hybrid," i.e., treated differently for tax purposes from a German and a US perspective. Nevertheless, the first step in submitting an application should be a legal type analysis, i.e., to determine how the US company receiving the payment should be assessed from a German tax perspective.

In addition, it should be noted that Art. 1 (7) of the DTA between Germany and the US provides for a special rule for cases in which income is received "through" a company that is fiscally transparent under the laws of either state. This may be relevant, for example, for US corporations that are treated as transparently taxed Scorporations or partnerships in the US under the "check-the-box" approach. In such cases, the double taxation agreement may provide for the fiction of tax residency.

In addition, Section 50d (11a) of the German Income Tax Act (EStG) must be taken into account, according to which the entitlement to a withholding tax refund may be attributed to another person in case the income in question being attributed to a person different from the remuneration creditor under foreign law.

It is unclear who should submit a corresponding application to the Federal Tax Office in such cases. The Cologne Tax Court recently confirmed an approach as effective where the company receiving the payment (in this case, a US corporation that was treated as a fiscally transparent S-corporation) submitted the application "similar to a representative action" on behalf of its shareholders as the parties entitled to a refund (see Cologne Tax Court, November 16, 2022, 2 K 750/19). An appeal is currently pending before the Federal Tax Court (Ref. I R 13/23).

Change in legal position of the BZSt

In the past, it was often possible to obtain a refund even in the case of hybrid structures. In such cases, there was often disagreement about the amount of the withholding tax reduction or the question of whether the fictions laid down in Section 50d (11a) of the German Income Tax Act (EStG) only concerned formal issues relating to the application or whether they also had a material effect on the entitlement to a refund. However, the fact that there was a entitlement to a withholding tax reduction was not fundamentally questioned.

The BZSt seems to have moved away from this practice recently and repositioned itself with regard to the treatment of hybrid companies. The following points are particularly important in this context:

• The application submitted by a transparent company (from a US tax perspective) for or in the interest of its shareholders, an approach confirmed by the Cologne Tax Court in the past, is rejected by the BZSt. This is surprising because the Federal Tax Court's decision on this matter is still pending. According to the BZSt's strictly formal interpretation, the application in these cases must be submitted by the shareholders themselves.
• The BZSt also considers the US tax treatment of the distributing (German) company. The background to this consideration is the fact that, regardless of how it is treated under German law, a domestic corporation can optionally be treated as a "disregarded entity" from a US perspective. As a result, the domestic company is treated as a permanent establishment of the US shareholder for US tax purposes. If the shareholder is also treated as fiscally transparent in the US, the profit generated at the level of the domestic company may even be attributed to the (indirect) shareholders (i.e., the shareholders behind the US company) and taxed at their level. This may result in the taxes levied at the level of the domestic company (corporate income tax and trade tax, and possibly also withholding tax) being credited. Profit distributions by these companies should be irrelevant from a US tax perspective. In such cases, the BZSt appears to reject a refund of capital gains tax as a matter of principle. This is based on the administrative interpretation of Art. 1 (7) of the DTA between Germany and the US, according to which a withholding tax reduction under Art. 10 of the DTA between Germany and the US should only be considered if the profit distribution subject to withholding tax is also treated as such (i.e. as income) from a US perspective.

Impact on the exemption and refund procedure

US-Inbound structures are anything but rare in Germany. Accordingly, the question of reducing the withholding tax burden in context of profit distributions made within these structures is common. The BZSt now appears to have changed its position in these cases to the effect that the tax treatment of the companies involved from a US perspective is considered decisive for the question of relief from German withholding tax. On the one hand, this applies to the question of the formal right to apply for a refund, i.e. who is entitled to submit a corresponding application for relief. On the other hand, the possibility of a withholding tax reduction is also fundamentally questioned in some cases: If the German distributing company is treated as fiscally transparent in the US (a so-called "disregarded entity"), the BZSt appears to categorically refuse a withholding tax refund.

The BZSt's change in legal position, which was made without any apparent reason, is not convincing or even compelling. Neither does Art. 1 (7) of the DTA between Germany and the USA in conjunction with § 50d (11a) EStG require shareholders of a tax-transparent company to submit an application, nor does Art. 1 (7) of the DTA between Germany and the USA require that the profit distribution be treated as such in the USA. Following the fiscal policy debacle of the so-called "register cases," one must fear that a new point of contention with political dimensions is emerging based on an administrative interpretation.

In view of the pending appeal proceedings, it is important to keep contentious proceedings "open." At the same time, when planning distributions, it must be taken into account that withholding tax relief for certain US structures may first have to be litigated. If a valid exemption certificate is already available, it may therefore be advantageous in individual cases, given the current legal uncertainty, to bring forward profit distributions or increase the distribution volume as long as relief from German withholding taxes is (still) guaranteed under the exemption certificate.