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German Federal Fiscal Court Ruling Potentially Provides Reduced Withholding Rates to Certain US Entities

In a decision dated June 26, 2013 (Doc No I R 48/12, original available here), the German Federal Fiscal Court (a court of last resort in Germany over tax and custom matters) was tasked with determining whether an “S” corporation (a US corporation that is a pass-through for US tax purposes but not for German tax purposes) is considered a US resident under the 2006 protocol of the German-US income tax treaty (the “Treaty”).  Article 10, Paragraph 2 of the Treaty provides in part that if a German company pays a dividend to a US resident, German withholding tax imposed on the receipt of such dividend shall not exceed (i) 5% if the beneficial owner of the dividend is a company that directly owns at least 10% of the voting stock of company paying the dividend, or (ii) 15% in all other cases.  Article 1, Paragraph 7 of the Treaty generally states that if “an item of income, . . . derived by or through a person that is fiscally transparent” pursuant to US or German law, then “such item shall be derived by a resident of a State to the extent that the item is treated for the purposes of the taxation law of such State as the income, profit or gain of a resident.”

In the case, the S corporation, a 50% shareholder of a German company, received dividends from the German company.  The German court held that the S corporation was considered a US resident for purposes of the Treaty and thus subject to a reduced withholding tax rate of 5%.  In interpreting Article 1, Paragraph 7 of the Treaty, the German Federal Fiscal Court determined that the two references to “resident” did not necessarily imply the same resident.  The German Federal Fiscal Court determined that the income may be considered derived by “a resident of a State” (here, the S corporation) so long as the income is treated by the US as “profit or gain of a resident” (i.e., the shareholders of the S corporation).  The German court reasoned that, because, under US federal income tax law, income derived by an S corporation is “income, profit or gain” of its shareholders, such items of income derived by or through the S corporation should be considered derived by a US resident.  Accordingly, the German Federal Fiscal Court held that the S corporation was a “US resident” for purposes of Article 1, Paragraph 7.

Additionally, the German court had to decide whether the S corporation is the beneficial owner of the respective dividends although under US federal income tax law, the respective income is attributed to the shareholders of the S corporation. The withholding tax reduction to 5% under Article 10, Paragraph 2 of the Treaty is only granted if (inter alia) the beneficial owner of the dividends is a company. The German court came to the conclusion that the term “beneficial owner” is not defined in the Treaty and, hence, has to be determined under German law. Under German law, the S corporation, irrespective of its tax treatment in the US, qualifies as a corporation so that income of the S corporation must under German law be attributed to the S corporation itself – not to its shareholders. Therefore the dividends were paid to a US resident corporation as beneficial owner (i.e., the S corporation). As a consequence, the withholding tax reduction to 5% was granted.

Whether this case could be extended to other US entities is unclear.  For example, a limited liability company provides corporate-like limited liability for its shareholders, but is fiscally transparent for US federal income tax purposes (unless a check-the-box election is filed for the LLC).  Therefore, the holding of this case may apply to an LLC if German tax law classifies a US LLC as a corporation, which mainly depends on the content of the articles of association of the respective US LLC.  However, this case should not apply to an entity that is a US partnership for state law purposes as, under Article 3, Paragraph 1 of the Treaty, a partnership is generally not treated as a “body corporate” and thus is not treated as the beneficial owner of dividends.

While in the case it was clear that the S corporation itself (and not its shareholders) could file for the refund, a recent change in German tax law enacted in 2013 may have changed this. However, the new provision in German tax law was not intended for cases such as US S corporations and the German tax authorities have not yet issued clear guidance on whether the S corporation or its shareholders should apply for the refund. For now it is therefore advisable for both the S corporation and its shareholders to file refund claims simultaneously to avoid a potential statute of limitations issue in the event that the German tax authorities interpret its refund provisions in a different manner.

Michael Graf, a partner in Dentons’ Frankfurt office specializing in Taxation, co-authored this article.

Cross-border exchange of information procedures

In this issue of Vox Tax, we analyze the recent wave of information sharing among national tax authorities.

As tax regimes around the world place an increased emphasis on transparency and international cooperation to combat tax evasion, a host of new laws, rules and regulations have been enacted.

In the report, lawyers from Dentons’ Global Tax Team examine the practices and policies in 15 countries across North America, Europe and Central Asia. Learn about the type of information that may be shared among nations, and what that means for your capital and tax strategies. For your reference, this report also includes a table comparing these 15 countries on several key intricacies of their respective tax laws.

Read the complete analysis

Opportunity to Claim Withholding Tax Overpayment on Dividends Received by Non-EU Investment Funds from Europe

In its verdict in Case C-190/12 (Emerging Markets Series of DFA Investment Trust Company), the European Court of Justice (ECJ) confirmed that investment funds based outside the EU should benefit from the EU’s free movement of capital rule regarding investments in Europe.

Dentons’ global Tax team discusses the implications of this verdict in Europe.

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Karina Furga-Dąbrowska, Cezary Przygodzki, and Rafał Mikulski, all members of Dentons’ Tax practice in Poland, co-authored this article.

Automatic Information Exchange: Did the Dog Just Catch the Bus?

John Harrington recently published an article in Tax Notes Today (available through the Lexis paywall) regarding eight potential challenges presented by an international automatic exchange system. 

On February 13, the OECD released details of its proposed common reporting standard, or CRS.  With the release of this report, the OECD and G-20, like the dog intent on catching a bus that it has long chased and finally caught, now have to figure out what do to with the prize they have captured.  Harrington discusses how an automatic information exchange could affect taxpayers, financial intermediaries, and governments.

Notice 2013-78: IRS Proposed Significant Changes to Competent Authority Procedures

U.S. tax treaties generally permit taxpayers to request assistance from the U.S. government to alleviate double taxation or taxation otherwise inconsistent with tax treaties.  The component of a government that handles these requests is typically known as the “competent authority”.   Competent authority provisions are usually contained in a particular treaties’ Mutual Agreement Procedure (“MAP”) article.

The IRS, on November 22, 2013, released Notice 2013-78, proposing a revenue procedure (to supersede Rev. Proc. 2006-54) and providing updated guidance related to requesting U.S. Competent Authority (“Competent Authority”) assistance.  The proposed revenue procedure is also intended to “improve clarity, readability, and organization” and reflect IRS structural changes that have occurred since 2006.  The changes contained within the notice are, in some cases, substantial.

One of the key changes is that, in certain situations, a taxpayer seeking Competent Authority assistance must file a “pre-filing memorandum”.  These situations include, but are not limited to, certain issues relating to a foreign-initiated adjustment of more than $10 million, a taxpayer-initiated position (e.g., a request for refund), the taxation of intangibles, and requests for discretionary limitations of benefits relief.  The pre-filing memorandum must, in the case of a foreign-initiated adjustment, explain the factual and legal basis of the action and describe the steps undertaken in the foreign country and any communications with the foreign competent authority regarding the matter.  Additionally, the pre-filing memorandum must state whether the taxpayer wishes to have a pre-filing conference with the Competent Authority and propose at least three possible dates for such a conference, whether or not the taxpayer wishes to have a conference.

That is, the Competent Authority could require a pre-filing conference–something not provided for in current guidance.  Pre-filing conferences could, however, prove helpful to taxpayers, because the Competent Authority can provide preliminary advice, although such advice is advisory only.

The proposed guidance also greatly expands the Competent Authority’s ability to expand the scope a matter.  Under current guidance, a taxpayer may use a procedure known as the Accelerated Competent Authority Procedure (“ACAP”) to request the expansion of a matter to subsequent taxable periods, if the same issues exist in those periods.  Current guidance also requires the consent of the IRS field office with jurisdiction over the matter.  Under the proposed guidance, however, the Competent Authority is not required to obtain IRS field office consent or even wait for a taxpayer’s request for an expanded scope.  Instead, the proposed guidance permits the Competent Authority to seek to include other years where it is “feasible, practicable, and in the interest of sound tax administration to do so.”  The proposed guidance further provides that the Competent Authority may expand the scope of issues because of its “strong interest in resolving all potential .. . issues in a timely manner”.

Under the proposed guidance, taxpayers must think far in advance whether they wish to seek Competent Authority assistance.  If the IRS memorializes in writing an examination resolution (e.g., a resolution with IRS Examination that is memorialized in a Fast Track Settlement Session Report, a Form 870 waiver, a Form 870-AD offer, a closing agreement, or any other similar agreement) relating to a U.S.-initiated adjustment, it may be too late.  The Competent Authority will accept a request for its assistance relating to U.S.-initiated adjustment memorialized in a such a resolution only if the terms of the resolution are agreed to by the Competent Authority, in writing, prior to its execution.  If the Competent Authority disagrees with the resolution, the Competent Authority will request that the examination team and the taxpayer amend the terms accordingly.  With respect to Fast Track Settlement proceedings, the Competent Authority will accept a MAP request relating to a U.S.-initiated adjustment only if the Competent Authority was named as a participant, and given a reasonable opportunity to participate, in the proceeding (and related IRS meetings).

The proposed guidance also shrinks the time in which a taxpayer may request IRS Appeals assistance through the Simultaneous Appeals Procedure (“SAP”).  Through SAP, as the procedure’s name suggests, IRS Appeals considers the same issues simultaneously with the Competent Authority.  Current guidance provides that a taxpayer may request IRS Appeals assistance, at any time, after filing for Competent Authority assistance.  Under the proposed guidance, a taxpayer has only 60 days after the Competent Authority accepts the taxpayer’s request for assistance.

On the whole, the proposed guidance is intended to make the Competent Authority process more efficient.  If the guidance is issued in its current form, seeking Competent Authority assistance will be more difficult for taxpayers as they will have to decide earlier to request Competent Authority assistance.  Lastly, the Competent Authority would be granted substantially greater powers such as requiring pre-filing conferences and expanding the scope of its assistance to other years or issues.

Can the IRS Circumvent U.S. Law by Issuing a Treaty Request?

Shortcuts to identifying the “soft spots” of a tax return have long tempted the IRS. Those shortcuts are generally quite controversial and have included the aggressive use of penalties to force a reasonable cause defense and the resulting disclosure of privileged materials and, as another example, transparency programs such as Schedule UTP that arguably strain the credibility of the IRS’s policy of restraint with regard to tax accrual workpapers. More recently, with the increasing prevalence of complex, cross-border transactions having multi-jurisdictional tax consequences, there is often a paper trail of tax analysis strewn around the world that is providing the IRS with a new temptation. Would the IRS be tempted to quietly make a treaty request in an attempt to circumvent U.S. privilege protections and obtain the materials without the fuss of a privilege fight? Unfortunately, the IRS and foreign taxing authorities have succumbed to this temptation, and it is something that practitioners should be aware of. The propriety of any such request must be carefully scrutinized and the appropriate interventions should be considered.

Indeed, the IRS has used treaty requests in lieu of following the administrative summons process (as well as its own internal directives) in order to bypass procedural safeguards for the taxpayer to attempt to obtain privileged and protected documents that would otherwise be unavailable to the IRS under U.S. law. This premature and improper use of treaty requests violates two core principles contained in most bilateral tax treaties, and in articles 18-26 of the Convention on Mutual Administrative Assistance in Tax Matters and article 26 of the OECD Model Tax Convention and its Commentary.

First, the issuance of a treaty request to circumvent domestic law is improper and objectionable because the requested nation is not obligated to employ procedures or obtain information that is at variance with or not obtainable under the laws of either country. This means that, for example, where the U.S. issues a treaty request, the same procedural safeguards that exist in the U.S. would also effectively be available with respect to the request. Additionally, the privileges and protections that exist in the requested country also apply. Under U.S. law, the IRS has broad authority to issue a summons for the production of documents or testimony relevant to the purpose of ascertaining the correctness of a return or determining the liability of any person or any internal revenue tax. But the IRS is subject to specific limitations. Significantly, pursuant to United States v. Powell, 379 U.S. 48 (1964), a summons is not enforceable unless it is (1) issued for a legitimate purpose; (2) the material sought is relevant to that purpose; (3) the information sought is not already within the possession of the IRS; and (4) the administrative steps required by the Internal Revenue Code have been followed. Further, the IRS is limited to materials in the possession, custody, and control of the summonsed party and is not entitled to documents that are privileged or protected under U.S. law, including the attorney-client privilege, attorney work product protection, and the privilege against self-incrimination. A requested nation will not employ measures to circumvent these U.S. laws. As noted in the OECD Commentary, one nation cannot take advantage of its treaty partner’s information system merely because it is wider than its own. Thus, a treaty request at variance with the U.S. law, including those discussed above, should be denied.

Second, the issuance of a treaty request before exhausting domestic measures is a clear violation of the international authorities and is grounds for rejection of a request. Under U.S. law, a summons is not self-enforcing. Instead, if the summonsed party fails to comply with the summons, the U.S. government must bring an enforcement action in the appropriate federal district court. And, both the taxpayer and the recipient of a summons have the right to protest the enforcement of a summons by filing a petition to quash in federal district court. The administrative summons procedures thereby provide the prerequisite mechanisms for a court to review the legitimacy of the summons and/or whether the claims of privilege are well-founded. The IRS cannot circumvent a taxpayer’s privileges or right to have a court review these claims by simply pursuing the documents through a treaty request because a request made prior to exhausting the domestic administrative summons procedures should be denied.

The premature and improper issuance of a treaty request merely shifts the burden of potentially protracted and costly disputes to a foreign nation, attempting to force the foreign nation to interpret and decide U.S. law. In addition to the potentially resulting prejudice against the rights of the taxpayer, this shifting aspect is itself clearly an inappropriate imposition on a treaty partner. See article 26 of the OECD Model Tax Convention and its Commentary. Treaty partners are usually quite receptive to these arguments by the objecting taxpayer in intervention proceedings.

New Foreign Tax Credit Regulations Issued

On February 14, 2012, the US Treasury Department (“IRS”) published in the Federal Register regulations dealing with two separate but related foreign tax credit issues. One set of regulations, which are proposed and temporary, provide guidance to taxpayers on how to interpret section 909 of the US Internal Revenue Code which denies a foreign tax credit for certain “foreign tax credit splitting events.” The other set of regulations, which are final, provide guidance on which person is considered to pay a foreign tax and is therefore eligible to claim a credit for the foreign tax paid.

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