On 16 April 2010 and almost three years after a first draft had been circulated, the Federal Ministry of Finance issued a circular regarding the application of Tax Treaties to partnerships. To a large extent, the circular matches the previous draft as of May 2007. The circular will not eliminate all legal uncertainties as the positions taken by the Federal Ministry of Finance are not always consistent with the case law of the Federal Fiscal Court.
Due the different national tax concepts, the tax treatment of partnerships under Tax Treaties is rather complex and raises numerous questions. From a German tax law perspective, this is in particular true, e.g., with respect to deemed commercial partnerships (gewerbliche Prägung) or provisions regarding special business assets (Sonderbetriebsvermögen) which are internationally unknown.
In the circular, the tax authorities comment on various tax issues of internationally active partnerships and aims at applying the domestic special tax rules concerning the taxation of partnerships also to cross-border scenarios. According to case law of the Federal Fiscal Court, however, domestic tax law provisions are to be interpreted in the context of cross-border scenarios on a standalone basis according to international standards (see the recent judgment of the Federal Fiscal Court regarding deemed commercial partnerships, see IV. 1.)
The partnership itself is, generally, not subject to income or corporate income tax und therefore not entitled to treaty benefits; rather, treaty entitlement is determined according to the residence of the partners in the partnership. This also applies to withholding taxes (e.g., on dividend income); any potential right to a relief from withholding taxes is also determined by the residence of the partners. However, an exemption applies with respect to such foreign partnerships which are subject to tax in their state of residence. An annex to the circular provides a list of the respective foreign partnerships.
According to the circular, profits arising from commercially active partnerships as well as deemed commercial partnerships and commercially “infected” partnerships are to be qualified as business profits pursuant to article 7 Model Treaty. This contradicts the general understanding of article 7 (7) Model Treaty according to which the special articles — e.g., articles 10 or 11 Model Treaty — prevail, unless the special income is attributable to a permanent establishment taking into account the functions of the permanent establishment and — consequently — is to be qualified as business profits. In a recent judgment the Federal Fiscal Court already ruled – contrary to the view of the tax authorities taken in the circular — that income derived from a foreign asset administrating but deemed commercial partnership is subject to taxation under the special articles of the Tax Treaty rather than business income (article 7 Model Treaty) (see IV. 1.). It is uncertain, whether the view taken by the Federal Fiscal Court would apply mutatis mutandis to commercially infected partnerships, i.e., that income of such partnerships would solely be treated as business income if such income is functionally attributable to a permanent establishment.
Germany, as the resident state, generally exempts foreign business income of resident partners of a foreign partnership from German taxation (articles 7, 23 Model Treaty), unless an activity clause or a subject-to-tax clause are applicable (e.g., article 23 (4) lit. b) US — Germany Tax Treaty). In addition, the application of the tax exemption method may be excluded by the national subject-totax clause pursuant to Sec. 50d (9) ITA (so-called „Treaty Override“). It should be noted that the Federal Fiscal Court in a recent decision regarding the suspension of enforcement (Aussetzung der Vollziehung) expressed serious doubts whether Sec 50d (9) s. 1 No. 1 ITA would be constitutional.
The circular makes comprehensive statements regarding the handling of conflicts of qualification. Positive conflicts of qualification (i.e., a double taxation) should be eliminated by mutual agreement procedure; double taxation remaining after such procedure (if any) should be eliminated by crediting the foreign taxes against the German tax liability, provided that the respective Tax Treaty stipulates a tax credit system. In the event of a negative conflict of qualification (i.e., a double non-taxation or a taxation at a reduced Tax Treaty rate), the respective income is not exempt from German taxation according to the German subject-to-tax clause Sec. 50d (9) No. 1 ITA (see above for concerns under constitutional law). Finally, the circular makes references to the tax treatment of special partner remuneration (Sondervergütungen). According to the view of the tax authorities, such remuneration is to be qualified as business profits (article 7 Model Treaty); this should apply to special partner remuneration of a resident partner in a foreign partnership (outbound scenario) as well as to special partner remuneration of a foreign partner in a resident partnership (inbound scenario). Domestic tax law (i.e., Sec. 50d (10) ITA) prevents the attribution of special partner remuneration to other articles of the tax treaty, e.g., for interest income article 11 Model Treaty.
In an inbound scenario for example, the interest income received by a foreign partner as remuneration of a loan granted to the resident partnership is to be qualified pursuant to the circular as business profits in the meaning of article 7 Model Treaty. The position of the tax authorities is contrary to case law of the Federal Fiscal Court and may cause a positive conflict of qualification and the risk of double taxation, provided that the resident state of the foreign partner qualifies such remuneration under the applicable Tax Treaty as interest income.
Vice versa, the position of the tax authorities — in an outbound scenario – generally results in an exemption of the foreign special partner remuneration of a resident partner (e.g., interest income) and a negative conflict of qualification as the other contracting state would not tax or tax such income at a lower withholding tax rate under the applicable Tax Treaty. The tax authorities, however, apply the domestic subject-to-tax clause pursuant to Sec. 50d (9) No. 1 ITA to eliminate the negative conflict of qualification (see above). As a result, special partner remuneration in outbound scenarios is also subject to German tax.