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Germany: Treaty override provision

On 11 December 2013, the German Federal Tax Court (FTC) submitted the question to the Federal Constitutional Court (FCC) whether the treaty override provision (article 50d (10) of the Personal Income Tax Act) is unconstitutional. This issue is relevant for many inbound German investments as foreign investors often organise their German investments in the legal form of a German commercial partnership.

Germany’s national tax law requalifies interest income paid by a German commercial partnership to its domestic or foreign partner as commercial income. The same requalification is applied for the purpose of interpreting and applying a tax treaty between Germany and the partner’s country of residence. The German tax authorities feel permitted to levy income tax on this interest income based on article 7 of the OECD Model Tax Treaty. Without this requalification stated in German national tax law, interest income would be subject to tax in the partner’s country of residence instead of in Germany.

The aforementioned German requalification of interest income to commercial income formally began as the German tax authorities’ interpretation of the tax treaties. It has, however, been transferred into a treaty overriding provision, because in earlier cases the German FTC has already decided that the interpretation used to requalify interest income was unacceptable.
The introduced provision shall be applicable with retroactive effect to all open cases. The interpretation of the German tax authorities and the introduced provision provoke double taxation since in the majority of cases, the country of residence will also see a legal basis to tax the interest income through article 11 of the OECD Model Tax Treaty. The importance of this allocation of the right to tax is not limited to interest, but is relevant for any kind of remuneration that a partner receives from its partnership (e.g. royalty fees).

In the opinion of the FTC, overriding bilateral treaty provisions that have been negotiated between two contracting states in order to reallocate the right to tax, is an unconstitutional breach of international law. Consequently, the German FCC was asked to decide on this issue. It is the first time the FCC has been involved in treaty overriding issues. Therefore, at this time it is unclear how the FCC will decide. Affected taxpayers should monitor future developments closely and cases should be kept open with the German tax authorities under reference to the case pending before the FCC.

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