August 20, 2008, the German Federal Fiscal Court (Bundesfinanzhof) opined on the qualification of income for purposes of the double tax treaty between Germany and the United States (“Treaty”) derived by a German resident individual from a limited liability company (“LLC”) established under the laws of Florida. In order to determine the tax nature (and time of taxation) of income which German resident shareholders/partners derive from foreign entities, it has to be determined whether the distributing entity is treated as a corporation or partnership for German tax purposes. This analysis is based on whether the entity has predominantly corporate or partnership features. While distributions from foreign corporations are generally taxable upon distribution and taxed as dividends, the allocable share of partnership profits are taxable at the time they are determined (recognized) irrespective of the distribution to its partners. Under an applicable double taxation treaty, distributions from foreign corporations are generally taxable in Germany under Art. 10 (Dividends) of the applicable treaty, while business profits attributable to a permanent establishment from partnerships are regularly exempt from German taxation under Art. 7 (Business Income) of the applicable treaty.
The German Federal Fiscal Court has now specified the application of these general principles to an LLC established under the laws of Florida and has confirmed the position adopted by the German tax authorities in a previous ruling dated March 19, 2004. In this ruling, the German tax authorities stated that the qualification of an LLC either as a corporate body or a transparent entity (i.e., a partnership) depends on a case by case analysis of the applicable US federal and state company law provisions which regulate the LLC in question and the concrete structural features of the LLC that the shareholders agreed upon. For this purpose, the German tax authorities list specific features – e.g., transferability of shares, personal liability of partners, etc. –, which the German tax authorities view as characteristic of a corporation or a partnership.
This “autonomous” German qualification approach may cause double taxation conflicts where an LLC is treated as a transparent entity for US federal income tax purposes, while Germany assumes predominating corporate features and thus treats the entity as a corporation for German tax purposes. In such case, the US would tax the profits of the (non-US-resident) LLC members at partner level (and, in case of business profits attributable to a permanent establishment in the United States, claim a corresponding taxation right under Art. 7 of the Treaty), while Germany would tax the same profits – upon distribution to the members – as a dividend and would also claim a taxation right under Art. 21 (Other Income) of the Treaty. Because Germany claims the sole taxation right under Art. 21 of the Treaty, there is a risk that Germany would regularly not grant any tax credit for US taxes paid by the members on income allocated to them on the level of the LLC. While the confirmation of the position adopted by the German tax authorities with respect to the analysis of an LLC by the German Federal Fiscal Court provides planning security, careful tax planning is required to avoid double taxation conflicts before establishing, or making an investment in, an LLC in the United States. Although the decision is based on the Treaty prior to the ratification of the Protocol, signed June 1, 2006, the same principles should apply under the “new” Treaty.