In a recent judgment, dated 28 April 2010 (I R 81/09), the Federal Fiscal Court decided the highly disputed question of the qualification of a resident taxpayer’s income deriving from a foreign partnership which is merely asset administrating but treated as a deemed business partnership (gewerbliche Prägung) under German tax law. The judgment was based on the following (simplified) facts of the case:
The partners in a US partnership were: A US corporation as the general partner and — inter alia — several German tax residents as limited partners in the US partnership. The US partnership generated income from the rent and lease of real estate located in the US and interest income from the investment of such rental income. The interest income was subject to US tax under US tax law. The German limited partners in the US partnership argued that the interest income would be tax exempt in Germany; however, the German tax office subjected such income to German taxation.
The Federal Fiscal Court held that the income derived from a mere asset administrating foreign partnership, which is treated as a deemed business partnership for German tax purposes, is not to be treated as business profits (article 7 Tax Treaty USA-Germany) but rather qualified under the special tax treaty articles (here article 11 Tax Treaty US-Germany). Accordingly, the Federal Fiscal Court subjected the interest income of the resident partners of the US partnership to German taxation. In absence of any mutual agreement procedure, the Federal Fiscal Court refused to grant a tax credit for the taxes on the interest income paid under national US tax law.
Contrary to the position of the tax authorities (see Federal Ministry of Finance circular as of 16 April 2010, see also III. 4., the Federal Fiscal Court takes the view that the tax treaty term „business profits“ shall be interpreted in the context of the tax treaty on an individual basis independently from German domestic tax law. Therefore, solely income derived through a permanent establishment with commercial business activity is to be qualified as business profits under the tax treaty. According to the Federal Fiscal Court, the German tax concept of a mere asset administrating partnership (vermögensverwaltende, aber gewerblich geprägte Personengesellschaft) which is deemed as a business partnership and the fiction of business income connected to such concept does not apply in the context of a tax treaty. In a decision dated 19 May 2010 (I B 191/09), the Federal Fiscal Court confirmed such jurisprudence.
The relevance of this decision is not limited to the Tax Treaty US-Germany, rather it is of great importance as the qualification of income under the applicable tax treaty is fundamental for the allocation of the right of taxation between the contracting states. As a general rule, the right of taxation of business profits generated by a permanent establishment is with the source state (article 7 Model Tax Treaty). The right of taxation for other types of income, however, is generally (if applicable, subject to certain withholding taxes) with the state of residence according to the so-called special articles (articles 10 through 13 Model Tax Treaty).
It should be noted that certain types of income might be subject to a conflict of qualification and double taxation which may solely be eliminated by a time-consuming mutual agreement procedure. This could be the case if — as in the case at hand — the income of the partnership is taxed under the domestic law of a contracting state (here: US taxation of the interest income as effectively connected income) and is qualified in the state of residence (here: Germany) as special income (here: interest income) and taxed there as well.
The application of the principles of the judgment should not be limited to the outbound scenario in the case at hand but may also apply to so-called inbound scenarios, i.e., when a person being resident in the other contracting state is partner in a domestic asset administrating partnership which is treated as a deemed business partnership for German tax purposes. Such scenario might also result in a double taxation, if the tax authorities — contrary to the jurisprudence — insist on their interpretation as described in the circular of the Federal Ministry of Finance (see III. 4.): According to the current position of the fiscal authorities the income of a domestic asset administrating partnership which is treated as a deemed business partnership is qualified as business income and subject to German taxation. At the same time, such income might be taxed in the resident state of the foreign partner of such partnership under the special articles of the applicable tax treaty, provided that the resident state as the other contracting state does not acknowledge the concept of deemed business income.