Change in German Administrative Practice: Risk to Withholding Tax Relief in US Group Structures
A recent shift in the administrative practice of the German tax authorities entails significant tax risks for German-connected US group structures, particularly where German subsidiaries are treated as “disregarded entities” (DREs) for US tax purposes.
Key Risks
Affected corporate groups, whether publicly listed or privately held, may face the following consequences:
- Denial of withholding tax relief under the Germany–US income tax treaty, also referred to as the double tax treaty (DTT)
- German withholding tax exposure of up to 26.375% on dividends, interest, and royalty payments
- Suspension or delay of pending refund applications with the Bundeszentralamt für Steuern (German Federal Central Tax Office)
- Prolonged objection and court proceedings
- Liquidity constraints due to capital being tied up for an indefinite period
- Potential inability to credit German withholding tax through a foreign tax credit mechanism in the United States
These risks may affect both future payment flows and currently open tax years.
Background
Under German domestic tax law, cross-border payments of dividends, interest, and royalties are generally subject to withholding tax of up to 26.375%.
The DTT provides for substantial relief from taxation in many cases, including a reduction to a 15% or even a 5% withholding tax rate, or a full exemption in the case of certain types of income. Access to DTT benefits in respect of German taxes requires an application for exemption or refund filed with the German Federal Central Tax Office.
Increased Scrutiny of “Check-the-Box” Structures
Historically, when assessing whether the DTT benefits would be available to a taxpayer, the German tax authorities focused primarily on verifying the taxpayer’s residence, beneficial ownership, and compliance with the limitation on benefits (LOB) provision of the DTT. Most US income tax treaties have an LOB provision under which an entity taxpayer must qualify in order to receive the benefits of the treaty. The LOB provision is designed to prevent so-called “treaty shopping” whereby persons establish entities in a jurisdiction for the purpose of taking advantage of the reduced treaty tax rates without a sufficient nexus or substance in the jurisdiction.
The German tax authorities have now begun systematically reviewing the US tax classification of German subsidiaries under the US “check-the-box” (CTB) regime. The United States allows many eligible entities to make a CTB election, resulting in a different tax classification than would otherwise apply for US tax purposes, either as a corporation, a partnership, or a DRE, depending on the circumstances. In particular, the German tax authorities will assess whether the German entity has elected to be treated as a DRE for US income tax purposes, that is, fully tax transparent in the United States.
The new position is primarily based on Article 1(7) of the DTT. According to the German tax authorities, DTT relief should be denied where the payment is not recognized, for US tax purposes, as a separate item of income (i.e., dividend, interest, or royalty income, respectively) in the hands of the US shareholder.
Importantly, no statutory amendment or DTT modification has occurred. The development reflects a change in German administrative interpretation of the existing treaty terms.
US Tax Considerations
The German tax authorities’ evolving position also raises significant US tax considerations that should be evaluated in parallel with the German analysis.
First, where a German subsidiary has elected to be treated as a DRE for US income tax purposes, payments of income (e.g. dividends, interest, or royalties) may not be recognized as separate items of income in the United States. If Germany nevertheless imposes withholding tax at the full domestic rate, affected US taxpayers could face challenges in claiming a foreign tax credit under Section 901 of the Internal Revenue Code, which governs foreign tax credits against US tax with respect to taxes levied by other jurisdictions. In particular, the absence of corresponding income recognition in the United States may give rise to creditability concerns, potentially resulting in non-creditable foreign tax and effective double taxation, in a given tax year.
Second, even where income inclusion occurs for US tax purposes, the Treasury regulations governing foreign tax creditability impose stricter attribution and nexus requirements. Taxpayers should carefully assess whether German withholding tax imposed under this new interpretation would satisfy US creditability standards, including the compulsory payment and attribution rules.
Third, the interaction with the US GILTI (now net CFC tested income) and Subpart F taxation regimes may require renewed modeling, where groups have DREs and structures involving controlled foreign corporations (CFCs). Higher withholding could alter effective foreign tax rates and potentially impact the availability of deemed-paid foreign tax credits, available high-tax exclusions, and overall effective tax rate projections, depending on underlying structures.
Finally, companies or groups using US GAAP reporting should consider whether the development necessitates adjustments to uncertain tax position reserves or valuation allowances relating to foreign tax credits.
Assessment
From a technical and treaty-law perspective, the sustainability of this interpretation appears open to serious challenge. Nevertheless, current indications suggest that the German tax authorities intend to apply this approach consistently, both to new applications and to cases already pending.
Given the widespread use of check-the-box elections in US multinational structures, the potential exposure across affected groups is substantial. Therefore, multinational groups and other structures, also including privately held businesses, with US parents should reassess entity classification elections, intercompany payment structures, and foreign tax credit modeling in light of the German authorities’ emerging position.
Recommended Actions for Existing and Planned Structures
We recommend that affected or potentially affected companies:
- Conduct a structural review of existing German-US corporate structures, with particular attention to US income tax classifications
- Analyze open withholding tax years and pending refund claims
- Assess defensive strategies in objection and litigation proceedings
- Factor the current administrative practice into structuring decisions, especially prior to implementing new check-the-box elections or establishing German subsidiaries
Companies currently considering an investment into Germany or the establishment of a German subsidiary should incorporate this development into their tax modeling and structuring analysis at an early stage.
Next Steps
This shift in German administrative practice creates a material element of uncertainty for German-US group structures. Absent judicial clarification, a near-term reversal appears unlikely.
We are closely monitoring further developments and can assist with a tailored risk assessment and the development of robust strategic responses, as part of a confidential initial evaluation of your specific structure.
Article by:
- Gregory Walsh and Tomislav Krmek, Spencer West Switzerland
- Dominique Tabit, Spencer West Germany
