Refund of withholding taxes made easier in Germany and possible effect on US foreign tax credits

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A reduction in or exemption from German withholding taxes on German source income (such as dividends, royalties, and certain interest payments) is possible under (i) German domestic law, (ii) an applicable European Union (EU) directive, or (iii) an applicable income tax treaty.  Under the German Anti-Treaty/Directive Shopping Rule, a foreign company cannot claim German withholding tax relief if, and to the extent, the foreign company does not meet certain strict requirements.  If, however, a limitation on benefits provision of an applicable income tax treaty with Germany applies (such as Article 28 of the US‑Germany income tax treaty), the German Anti-Treaty/Directive Shopping Rule should not apply with respect to withholding tax relief.  Thus, if a US corporation invests in a German company through a non-US corporation, the German Anti-Treaty/Directive Shopping Rule generally should apply with respect to any withholding tax relief requested by the intermediate non-US corporation unless an applicable income tax treaty with a limitation on benefits clause exists between the residence country of the intermediate corporation and Germany.

On December 20, 2017, and June 14, 2018, the European Court of Justice (ECJ) found that the German Anti-Treaty/Directive Shopping Rule (prior and current versions) breached EU law (including the EU freedom of establishment).  The ECJ held that, even though the economic activities of the taxpayer consist of the management of assets of the subsidiary or its income is solely derived therefrom, this is not an abuse per se.  In response, German tax authorities issued guidance on the ECJ’s December 2017 judgment.  While the German guidance is silent on the current version of the German Anti-Treaty/Directive Shopping Rule, it relaxed the requirements to permit a non-German EU company that owns an interest as a pure holding company (i.e., lacking its own staff and infrastructure) to apply for relief from withholding tax imposed on German source dividends.

Michael Graf and Marcus Seiboth, both of Dentons’ Frankfurt office, published the article “The German Anti-Treaty/Directive Shopping Rules Are Under Fire” in International Tax Report.  They analyze the guidance issued by German tax authorities and address whether and under what circumstances non-EU companies may benefit from recent ECJ case law.

The recent ECJ decisions add to the growing body of ECJ court decisions permitting refund claims by foreign entities to recover withholding taxes paid on dividends received from companies resident in certain EU jurisdictions.  For example, in 2014, the ECJ decided that US funds (and other funds outside of the EU in a similar position) are entitled to rely on the free movement of capital under EU law enabling non-EU investment funds to recover withholding taxes from certain EU member states.1  More recently, though, on February 26, 2019, the ECJ issued two rulings involving Danish companies that paid either dividends or interest to their EU parent companies that were directly or indirectly owned by companies resident in third countries or by private equity funds with investors whose residency status was unknown.  Denmark had imposed a withholding tax on the Danish companies because the recipient of the payments (i.e., the EU parent companies) were not the beneficial owners of the payments.  The ECJ agreed with Denmark’s interpretation and noted that the freedom of establishment and free movement of capital principles cannot be relied on in the case of abusive or fraudulent acts.

Implications on claim of US foreign tax credits

Section 901 of the US Internal Revenue Code of 1986, as amended (the Code) allows a taxpayer to elect to claim a credit against its US income tax liability for foreign income taxes paid or accrued during the tax year to any foreign country.  In order for a foreign income tax to qualify for a US foreign tax credit, the tax must be (i) paid or accrued by the taxpayer; (ii) imposed on the taxpayer by a foreign country or possession of the United States; (iii) compulsory; and (iv) an income tax or a tax levied in lieu of an income tax.

The amount of foreign tax that is eligible for a credit is not necessarily the amount of tax withheld by or paid to the foreign country.  The legal and actual foreign tax liability that the taxpayer paid or accrued during the year qualifies for the credit.  This payment of tax must be made based on a reasonable interpretation and application of foreign law (including applicable tax treaties).  Thus, if it is reasonably certain that the foreign income taxes paid or accrued would be refunded or rebated if a claim was made, such foreign taxes would not be creditable.  Actual knowledge that another similarly situated taxpayer has successfully obtained a refund of foreign tax may constitute notice to the taxpayer that a claim for refund would likely prevail.  The taxpayer must also exhaust all effective and practical remedies to reduce the taxpayer’s liability for foreign tax.  Thus, it is the taxpayer’s responsibility to take all necessary steps and exhaust all available remedies with the foreign country to properly resolve the final tax liability in order for the tax to be considered due and legally owed.  Moreover, Code Section 905(c) requires a redetermination of a taxpayer’s US foreign tax credit if a foreign tax is refunded.

Thus, if an EU member state determines that a reduced withholding tax applies, two issues may arise for US federal tax credit purposes:  (i) is the withholding tax “compulsory”; and (ii) is a foreign tax redetermination required under Code Section 905(c).  Under the German guidance noted above, it appears that the German tax authorities would only allow non-German EU companies that own interests in a German company as a holding company (as opposed to non-EU holding companies) to benefit from the recent favorable case law of the ECJ.  An effect on US foreign tax credits would arise, for example, where a US corporation wholly owns an EU holding company that received dividends from a Germany company on which German taxes were withheld.  Under US tax rules, the EU holding company should qualify as a “controlled foreign corporation”.  As a result, the US corporate shareholder should generally be entitled under Code Section 960 to claim indirect foreign tax credits for deemed income inclusions attributable to its ownership of a CFC under the Subpart F and global intangible low-taxed income (GILTI) rules whether or not such income is distributed to the US corporate shareholder.  The GILTI rules were enacted by last year’s tax reform legislation known as the Tax Cuts and Jobs Act (TCJA).  If the US corporate shareholder has Subpart F income attributable to the dividends received by the EU holding company from its German investments, the US corporate shareholder should be deemed to have paid the German withholding taxes incurred by the EU holding company that is properly attributable to that income.2  Thus, if the EU holding company obtains a refund of German withholding tax imposed on the dividends it receives, the US corporate shareholder may lose the ability to claim an indirect foreign tax credit for such German withholding taxes.

On the other hand, if, for example, non-EU holding companies with German investments argue that they also benefit from the recent judgments of the ECJ with respect to German withholding taxes imposed on German source dividends, consideration must be given to whether any German withholding taxes incurred by a non-EU intermediary company that is a CFC of a US corporate shareholder are noncompulsory.  In order for the German withholding tax to be treated as noncompulsory, it must be “reasonably certain” that the amount will be refunded.  While a US taxpayer is required to exhaust all effective and practical remedies to reduce its foreign tax liability, the taxpayer is not required to pursue administrative and judicial remedy if it would be unreasonable in light of the amount at issue and the likelihood of success.  If the non-EU intermediary company successfully challenges the German guidance and obtains a refund of German withholding taxes (assuming the statute of limitations for the relevant year has not expired), Code Section 905(c) would generally require that the US corporate shareholder file an amended US tax return reducing the amount of foreign tax credit claimed for the year of the withholding tax and reflecting any additional US tax liability owed.  This is true even though the US taxpayers’ foreign refunds may not be finally adjudicated.3  Thus, in light of the growing influence of EU law on the local tax rules of EU member states, taxpayers should consider the potential benefits of withholding tax refunds, the likelihood of success, and, in the case of a US taxpayer, the implications of Code Section 905(c) if a refund of German withholding tax is obtained even though such refund is not a final determination of foreign tax liability.

  1. See previous Dentons client alerts, “An update on refund claims for EU withholding tax overpayments” (May 23, 2014) and “Opportunity to claim withholding tax overpayment on dividends received by non-EU investment funds from Europe” (April 11, 2014).
  2. For dividends paid by the German company after December 31, 2017, if the EU holding company did not qualify as a “controlled foreign corporation” (i.e., a foreign corporation in which “US shareholders” own more than 50 percent of the vote or value of the foreign corporation; for this purpose, a “US shareholder” means a US person who owns 10 percent or more of the vote or value of a foreign corporation), the US foreign tax credit rules should not apply.  If a US corporate shareholder owned 10 percent or more of the voting stock of an EU holding company that was not a CFC, the US corporate shareholder should not be entitled to claim an indirect foreign tax credit for the German withholding tax incurred by the EU holding company with respect to dividends received by the US corporate shareholder.  Effective for taxable years beginning after December 31, 2017, the TCJA repealed the Code Section 902 indirect foreign tax credit as a result of the enactment of new Code Section 245A which provides a 100 percent dividends received deduction (DRD) for foreign source dividends received by a US corporation that owned 10 percent or more of the voting stock of the foreign corporation.  Thus, if an EU holding company that is not a CFC obtains a refund of German withholding tax, there should be no adverse US tax effect to the US corporate shareholder.  Alternatively, if the EU holding company is an eligible entity and a check-the-box election was made to treat it as a pass through entity for US federal tax purposes, the US corporate owner should be treated as having incurred the German withholding tax directly under Code Section 901 and may have to reduce its US foreign tax credit claimed for the year of the withholding tax in the event of a refund (assuming the DRD rules of Code Section 245A do not otherwise apply with respect to the US corporation’s ownership of the German company).
  3. See Sotiropoulos v. Comm’r, T.C. Memo. 2017-75.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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