A new law that gained traction this year in Germany removes a tax benefit US S corporations have been able to use for withholding tax rates on dividends from German companies.
The new regulation, included in Section 50d(1) of the German income tax book, will limit US S corporation benefits that permit them to apply a lower withholding tax rate on dividends received from German companies.
The benefit was established by a German Supreme Tax Court decision in 2013 determining that US S corporations should be able to apply a beneficial withholding tax rate on dividends paid by a German company to a US corporation. Specifically, it decided US S corporations should benefit from Article 10(2)(a) of the US-German income tax treaty (the treaty), which limits the withholding tax to 5 percent on dividends paid to a corporate owner that directly owns 10 percent or more of the voting stock, rather than the statutory withholding tax rate for dividends, which is 26.375 percent.
The decision describes the following structure:
The German tax administration and German legislators disagreed with the court’s decision, and in reaction, they proposed a new regulation in Section 50d(1). Found in sentence no. 11 of that section, the new regulation would deny US entities the ability to apply Article 10(2)(a) of the tax treaty to any US entity that’s fiscally transparent for US tax purposes. Instead, the proposed law would look through the entity and apply the treaty to the ultimate shareholders.
Germany Withholds Tax on Dividend Payments to the United States
German national tax law requires an overall 26.375 percent tax to be generally applied to all dividend payments, national or international. That rate is based on a withholding tax rate of 25 percent plus a 5.5 percent solidarity surcharge on this.
The tax treaty may lower this rate to 0 percent, 5 percent, or 15 percent based on the qualifications of the recipient. Corporations qualify for 0 percent or 5 percent, while individuals qualify for 15 percent.
Germany, as a standard procedure, doesn’t allow taxpayers to apply the tax treaty’s lower withholding tax rate directly to the dividend payment. That means the German dividend-paying corporation must withhold the entire 26.375 percent and that a US shareholder must then claim a refund after payment. The refund process takes approximately six to nine months.
Payment of the complete German withholding taxes can only be avoided if the US shareholder is a corporation and applies for an exemption prior to the dividend payment—a so-called application for an exemption certificate. An exemption certificate will normally be valid for three years. The application process for an exemption certificate typically takes about six to eight weeks.
Transparent Entities for US Tax Purposes
A sole proprietorship and US partnership will generally classify as transparent entities for the purposes of both the US IRS and foreign tax authorities. US LLCs and S corporations, on the other hand, often present difficulties for international tax authorities.
Because US LLCs and S corporations provide their shareholders with limited liability, many tax authorities would classify these as corporations or the local equivalent. Yet for US tax purposes, these entities are generally treated as transparent.
The new law is applied to dividend payments from a German corporation to a US shareholder that’s transparent for US tax purposes. It stipulates:
If the recipient of German dividends or other German income is a person that’s transparent for US tax purposes, the application for the refund of withholding taxes has to be sent by the US person that’s paying taxes on the (German) dividend in the US.
Summary of Major Impacts
To sum up the effects of the new regulation in Section 50d(1), these are the primary impacts for US S corporations:
- US shareholders get a 15 percent withholding rate. Based on Article 10(2)(b) of the tax treaty, this rate is applied if the US shareholder who’s responsible for taxes paid on the dividend is an individual. For German tax purposes, the ultimate US shareholder is the one who pays taxes relevant for any tax refund.
- Exemption certificates will only apply to US C corporations. Shareholders that are individuals or transparent entities aren’t eligible to apply for exemptions. For German tax purposes, the ultimate US shareholder will be decisive, and the exemption from German withholding tax shouldn’t be available for S corporations. In other words, the statutory tax rate must be paid initially, and the US shareholder must then apply for a refund. The refund will be 10 percent, plus a 5.5 percent solidarity surcharge, providing a final withholding tax rate of 15 percent. The application for the refund must be filed within four years from the end of the year the dividend was paid in.
- US S corporations can’t submit refund requests on behalf of shareholders. Instead, the ultimate US shareholders must apply individually. As illustrated in the diagram above, if five individuals hold shares in a US S corporation that’s receiving a German dividend, then five applications must be filed with German tax authorities. A Form 6166 is required for each ultimate shareholder and for all interposed S corporations as necessary.
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To learn more about the US-German income tax treaty and how it might affect your company, and for tips on how to respond to the changes, contact your Moss Adams professional.
* Steuerberater is an esteemed professional tax advisor license in Germany.