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German Federal Fiscal Court decides on treatment of hybrid entities under the German-US double taxation treaty

Hybrid entities have long been a tool for corporate tax planning. While tax authorities have fought the use of such hybrid mismatches for tax planning purposes, national efforts to prevent the use of hybrid mismatches have not proven to be very efficient, explain Michael Graf and Timothy Santoli, of Dentons

In a decision dated June 26 2013 (Doc No I R 48/12), the German Federal Fiscal Court (FFC) was tasked with determining whether a hybrid entity (in this case a US S corporation, that is a pass-through for US tax purposes but not for German tax purposes), is considered a US resident under 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 be more than 5% if the beneficial owner of the dividend is a company that directly owns at least 10% of the voting stock of the distributing company. Article 1, paragraph 7 generally states that if “an item of income, . . . derived by or through a person that is fiscally transparent” under 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’s shareholders were US residents and the S corporation was a 50% shareholder of a German company, which distributed the dividend. The FFC:

  • held that the S corporation was considered a US resident for purposes of the treaty; 
  • in interpreting article 1, paragraph 7 of the treaty, determined that the two references to “resident” did not necessarily imply the same resident; 
  • 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” (that is, the shareholders of the S corporation); and
  • 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 FFC held that the S corporation was a US resident for purposes of the treaty and, hence, entitled to the reduction of the withholding tax to 5%.

Against the background of decisions such as the above, one of the seven so-called BEPS 2014 deliverables of the OECD published on September 16 2014 addresses the tax treatment of hybrid mismatch arrangements. However, when implementing these OECD recommendations into national law, legislators need to consider that not every hybrid entity is used intentionally to avoid taxes.

Michael Graf ( is a partner in the Frankfurt office; and 

Timothy Santoli ( is a partner in the New York office of Dentons.

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