Hybrid US S-Corporation eligible for participation exemption. Refund practice of taxes withheld remains to be seen.

In a recent judgment (file no. I R 48/12), the German Federal Fiscal Court has commented on Art. 1 para. 7 of the new tax treaty between Germany and the US dated 2008. The central issue of the judgment is the different tax treatment of US S-Corporations (i.e. corporations which have opted for a pass-through taxation for US federal tax purposes) under US and German tax law. The SCorporation itself is not subject to federal corporate income taxes in the US, but the corporation’s income is taxed at shareholder level (so-called transparent/pass-through taxation). However, German tax law does not recognize a transparent taxation of corporations. This difference in the tax treatment of S-Corporations raises the question how to apply provisions in the tax treaty that require the residence of the S-Corporation in one of the contracting states. According to the definition of “residence” in the tax treaty, a person needs to be liable to tax in one of the contracting states in order to be resident in that state.

The Federal Fiscal Court now had to decide, whether the residence of an SCorporation can be established by means of Art. 1 para. 7 of the tax treaty. Art. 1 para. 7 of the treaty provides that, in case of income derived by or through a person that is fiscally transparent under the laws of one of the contracting states, such income shall nevertheless be considered to be derived by a resident of one of the contracting states to the extent the income is treated as income of a resident under the law of such state.