Whenever a U.S. Limited Liability Company (“US-LLC”) is involved in cross-border shareholding structures concerning the United States and Germany, the implications under German tax law can be complex. For German tax purposes, a US-LLC may qualify as an opaque entity (corporation) or as a transparent entity (partnership) or even as a dependent branch office (permanent establishment) of a sole shareholder of the US-LLC. The qualification is particularly relevant (i) for the taxation of profits, distributions and advance remunerations which a German tax resident shareholder of the US-LLC receives, and (ii) for the application of the double tax treaty between the United States and Germany (the “DTT”) to a US-LLC receiving German source income, e.g., capital gains or distributions. The latter question is subject to the following explanations.
The view of the German tax administration is that the qualification of a US-LLC for German tax purposes and the application of the DTT to a US-LLC is exclusively subject to domestic German tax law. The DTT does not stipulate that the law of the country of residence is relevant for the qualification of an entity. In fact, each contracting state qualifies a respective entity in accordance with its own domestic law when applying the DTT. Therefore, for German tax purposes it is not decisive how the tax law of the United States and the states qualify a US-LLC or how the shareholders of a US-LLC exercise their option rights under the check-the-box rules.
During recent decades the German Supreme Fiscal Court (the “BFH”) has developed a number of principles for determining the qualification of a foreign entity. According to these principles, a foreign entity qualifies as a corporation if it can be compared legally and economically to a German corporation on the basis of an overall view against the background of the applicable foreign law provisions and of the decided organization and structure of the entity (the so-called comparison of types”-test).
Tax consequences arising from the qualification
In order to benefit from the DTT, the US-LLC must qualify as a “person” within the meaning of Article 3 sec. 1 lit. d of the DTT. For that purpose the US-LLC must qualify as a corporation under German tax law. In addition, such US-LLC must also have substance from a German tax perspective, otherwise the German tax administration may consider the interposition of a mere letter-box company as abusive, leading to the consequence that such corporation without substance is disregarded. Consequently, once it is confirmed that a US-LLC would qualify as a corporation, in a next step it would be necessary to examine whether the US-LLC meets the substance requirements.
In case the US-LLC qualifies as a partnership for German tax purposes, the German tax authorities would regard the US-LLC as transparent and examine whether the DTT (or a different double tax treaty) could be applied to the shareholders of the US-LLC.
On the basis of the judicature of the BFH, the German Federal Ministry of Finance has provided guidelines in an official statement dated March 19, 2004, regarding the application of the "comparison of types”-test to a US-LLC (the “LLC-Decree”). According to the LLC-Decree, the following criteria are relevant for the classification of the US-LLC as a corporation from a German tax perspective:
- centralized management;
- limited liability of the shareholders;
- possibility of unrestricted transfer of shares;
- distribution of profits;
- raising of capital;
- unlimited term of the entity;
- profit and loss allocation in accordance with nominal shares; and
- certain formal requirements for the establishment of the entity.
According to the LLC-Decree, a centralized management and administration of the entity is characteristic of a corporation.
Such centralized management means the entitlement of one or more persons—in contrast to all shareholders or partners—to pass management decisions without the approval of the shareholders/partners in their entirety (e.g., management decisions made by an independent board, which can consist of third parties and shareholders/partners). By contrast, if the shareholders/partners in their entirety represent the entity internally and externally without the involvement of any third party, a centralized management would not exist, which implies characteristics of a partnership.
If some of the shareholders/partners are excluded from the management, and provided the entity is exclusively represented by managers in their capacity as partners (in contrast to an appointment of directors), a centralized management would still not exist. On the other hand, a centralized management could still exist if the articles of association rule that individually appointed managers must come from the board of shareholders.
If a corporation represents the entity, and the management of the corporation also includes nonshareholders, a centralized management can be assumed.
A typical indication of a corporation is the limited liability of the shareholder. The limited liability provides that a shareholder is not liable with his own private property for liabilities of the entity.
Unrestricted transfer of shares
Whereas shares in corporations can be transferred without further restrictions, the transfer of interests in partnerships is usually excluded, restricted or subject to the consent of some or all partners.
Distribution of profits
While the distribution of profits of a corporation requires a shareholders’ resolution, each partner of a partnership is entitled to dispose of his profit share without further resolution.
Raising of capital
With regard to a corporation the shareholders are obliged to contribute the share capital into the corporation. In contrast, German law does not explicitly demand the provision of share capital for partnerships. In case the articles of association waive the obligation to contribute capital or stipulate that contributions may also be made by ways of providing services, such clauses indicate a qualification as a partnership.
Unlimited term of the entity
The lifetime of a corporation is usually unlimited and does not depend upon the consistency of shareholders. In case the articles explicitly provide for a limited term, this would be an indication of a partnership. A limited term can be assumed if the articles provide that the entity is terminated without additional actions from the shareholders once certain events occur. On the other hand, if the articles set forth that the entity is terminated on certain conditions precedent but allow the continuation of the entity without further conditions, the term of the entity is deemed as unlimited.
Profit and loss allocation
In general, the profit share of a shareholder of a corporation amounts to the relation of the shareholder’s share capital and the entire capital. In comparison, partnerships distribute profits in correspondence with the relation of contributions and per head. Any distribution of a partnership irrespective of the contributions considers the personal commitment of each partner, whereas the position of the shareholder as capital provider prevails.
Formal requirements for the establishment
A corporation under German law becomes effective once it is registered in the commercial register. A partnership becomes effective upon conclusion of a partnership agreement.
Decision with regard to the individual case
The overall picture is relevant with regard to the decision whether an entity would qualify either as a corporation or as a partnership. None of the above individual criteria is finally decisive for the final qualification. If the examination does not allow a clear qualification, an entity is to be qualified as corporation if the majority of the criteria “centralized management”, “limited liability”, “unrestricted transfer of shares”, “distribution of profits” and “raising of capital” imply the qualification as a corporation.
Different qualification of the US-LLC for German and for U.S. tax purposes
The qualification of a US-LLC for German tax purposes on the one hand and for U.S. tax purposes on the other can be different, in particular due to the check-the-box rules, for which there is no German equivalent.
No particularities exist if both tax administrations qualify the US-LLC as a partnership or as a corporation. When both sides agree on the qualification of the US-LLC, this concurring qualification is decisive.
According to the LLC-Decree, the German tax perspective is decisive. If the U.S. tax law qualifies the US-LLC as a corporation, while the German tax administration considers the USLLC as a partnership, the German tax administration would examine whether or not the DTT would apply to the shareholders of the US-LLC. In principle, the LLC-Decree is still in force, therefore, its principles must be observed by the German tax administration.
However, the LLC-Decree was issued prior to the modifications of the DTT coming into force. Since 2008, Art. 1 sec. 7 of the DTT rules that “in the case of an item of income, profit or gain derived by or through a person that is fiscally transparent under the laws of either Contracting State, such item shall be considered to be derived by a resident of a State to the extent that the item is treated for the purposes of the taxation law of such State as the income, profit or gain of a resident.” This clause is now interpreted by the German tax literature such that also a US-LLC which qualifies as a partnership from the German tax perspective benefits from the DTT, provided that the U.S. tax law qualifies the US-LLC as corporation. Something different could apply if the US-LLC qualifies as a “disregarded entity” in the United States. In such a case, German tax law would consider the shareholder of the US-LLC as recipient of the income and would apply the treaty benefits, if available, to the shareholder.
Currently, the interpretation of Art. 1 sec. 7 of the DTT is subject to a case which is pending on the level of the BFH (file no. I R 48/12). The court of first instance, the Local Tax Court of Cologne, held that entities, which are considered as transparent by the German tax administration, are per se not resident in the other contractual state. Therefore, such entity is disregarded for DTT purposes so that the shareholders of the transparent entity are automatically subject to the examination as to whether treaty benefits apply. This appears to be a misinterpretation of Art. 1 sec. 7 of the DTT, whose scope of application would be reduced to zero. Nevertheless, it has to be awaited what the outcome of the case will be.
In case the German tax authorities qualify the US-LLC as corporation, whereas for U.S. tax purposes the US-LLC is considered as partnership, the German tax literature argues that the US-LLC should not be regarded as a U.S. tax resident person. However, the rules of the DTT would then be applied to the shareholders of the US-LLC, provided that they are U.S. tax residents themselves