Withholding Tax Relief for US-Owned Disregarded Entities at Risk?

Recently, concerns have arisen that the German tax authorities may be reconsidering their long-standing administrative practice regarding withholding tax relief on dividend distributions made by German corporations to US shareholders. Any such change would primarily affect German companies that are treated as disregarded entities for US federal income tax purposes.

If this emerging approach were to be implemented, dividend distributions made by such German entities could become fully subject to German withholding tax at a rate of 26.375%, with treaty relief under the Germany–US Double Taxation Agreement potentially being denied. At present, however, it remains unclear whether this view will ultimately be adopted and consistently applied by the German tax authorities.

Background

As a general rule, dividend distributions by German corporations are subject to German withholding tax at a rate of 26.375% (including solidarity surcharge; “WHT”).

US tax resident shareholders are, in principle, entitled to reduced WHT rates under the Germany–US Double Taxation Agreement (“DTA”). Depending on the shareholder’s legal form (individual vs. corporation) and the level of participation, the applicable treaty rate is typically 15% or 5%. Under the additional requirements of Article 10(3) of the DTA, a full exemption from WHT (0%) may be available.

The application of treaty relief requires a prior application by the US shareholder and the issuance of a tax exemption certificate (Freistellungsbescheinigung) by the German Federal Central Tax Office (“FCTO”). This process requires proof of US tax residence (Form 6166) and, in the case of corporate shareholders, extensive substance documentation, such as employment contracts, payroll records and evidence of operational substance.

While processing times have improved in recent years, exemption procedures still typically take more than six months, with expedited processing largely limited to EU shareholders.

New Focus on US Tax Classification

To date, the availability of treaty relief did not depend on how the German distributing entity was classified for US tax purposes, i.e. whether it was treated as a corporation or, following a check-the-box election, as a disregarded entity.

Recent experience, however, suggests a potential shift in focus. In current exemption proceedings, the FCTO has increasingly requested information on the US tax classification of the German company, in particular whether dividend distributions qualify as taxable dividend income at the level of the US shareholder.

Where the German company is treated as a disregarded entity, distributions generally do not constitute dividend income for US tax purposes and therefore do not trigger separate taxation at the shareholder level. The apparent concern of the FCTO seems to be that treaty relief should not be granted where the corresponding income is not subject to taxation in the United States.

On this basis, there is a concern that the withholding tax exemption could be denied in full in such cases. 
This position is based on Article 1 (7) of the tax treaty and Section 50d (11a) of the German Income Tax Act (EStG), both of which grant treaty relief only to the person to whom the dividend income is actually attributed under U.S. tax law - a condition that is generally not met in the case of dividends involving disregarded entities.In our view, however, a denial of treaty relief would be substantively unjustified. In particular, this is because U.S. shareholders of disregarded entities are already required to include the German entity’s income in their U.S. taxable income on a current (look-through) basis.

Current Practice and Outlook

To date, no withholding tax exemption applications appear to have been formally rejected on this basis. The issue has so far been limited to additional information requests by the FCTO. Furthermore, these inquiries seem to be confined to cases involving full WHT exemption on dividends under Article 10 (3) of the DTA and do not currently extend to other categories of income, such as royalties.

It therefore remains to be hoped that the FCTO will reconsider its emerging approach and maintain its established practice with respect to German entities treated as disregarded entities for US tax purposes.

Should this restrictive interpretation nevertheless be implemented, a significant number of US-controlled German companies would be affected, given the widespread use of check-the-box elections by US investors. Depending on the circumstances, this could lead to a substantial additional tax burden and may ultimately discourage investment in Germany.

To the extent that US tax authorities would grant foreign tax credits for German WHT, the economic burden would effectively shift to the US tax base, potentially increasing the risk of retaliatory measures, such as renewed discussions around Section 899 of the Internal Revenue Code.

At present, it remains to be seen how the FCTO will decide pending and future cases. US shareholders with interests in German disregarded entities should therefore closely monitor further developments and review their existing structures accordingly.

Please feel free to contact us should you have any questions or wish to discuss the implications for your specific situation.