The treatment of so-called hybrid entities (that is, entities which are treated as non-transparent for income tax purposes in one jurisdiction but qualify for tax transparent treatment in another) for treaty purposes is of particular importance in the US/German context due to the check-the-box election regulations under US tax law, under which an eligible entity can elect to be treated as either transparent or non-transparent for US tax purposes. However, it is not only US entities which make such a check-the-box election - in deviation from their qualification for German tax purposes - that qualify as hybrid entities, but so-called S-Corporations do as well. An S-Corporation is a US corporation that is treated for US tax purposes as transparent and is, therefore, not subject to corporate income tax in the US, but that nonetheless regularly qualifies as a non-transparent corporation for German tax purposes. The treatment of such S-Corporations under the amended DTT US 2006 and, in particular, the interpretation of its new Article 1 paragraph 7, is disputed in German tax literature. In June 2013, the FTC had to rule on a case concerning a US S-Corporation as the recipient of dividends paid by its 50% owned German subsidiary, and had, for the first time, the opportunity to outline its position regarding the treatment of such hybrid entities under the DTT US 2006 (decision of the FTC dated June 26 2013 – I R 48/12).
S-Corporation as recipient of dividends from a German company
In the case decided by the FTC in June 2013, a US S-Corporation with US shareholders had a 50% share in a German resident Gesellschaft mit beschränkter Haftung (GmbH) and had received a dividend payment from this German subsidiary. The German subsidiary had withheld taxes of 21.1% on such dividend payments. The S-Corporation applied for a partial refund of the withholding tax arguing that the withholding tax had to be reduced to 5% under Article 10 paragraph 2 (sentence 1) lit. a) of the DTT US 2006. The German Federal Central Tax Office (FCTO) rejected the application and took the position that the requirements of the dividend article had not been satisfied.
The court of the first instance decided in favour of the FCTO and denied the application of Article 10 paragraph 2 (sentence 1) lit. a) of the DTT US 2006. The S-Corporation appealed the decision.
Requirements for a withholding tax reduction
The relevant passages of Article 10 of the DTT US 2006 which list the conditions to be satisfied for a reduction of withholding tax, read as follows:
(1) Dividends paid by a company which is a resident of a contracting state to a resident of the other contracting state may be taxed in that other state.
(2) However, such dividends may also be taxed in the contracting state of which the company paying the dividends is a resident and according to the laws of the state, but if the recipient is the beneficial owner of the dividends the tax so charged shall not exceed:
(a) 5% of the gross amount of the dividends if the beneficial owner is a company (other than a partnership) which holds directly at least 25% of the capital of the company paying the dividends; (…)
Therefore, the following requirements must be satisfied to benefit from the withholding tax reductionunder Article 10 paragraph 2 (sentence 1) of the DTT US 2006: (i) the recipient of the dividends must be a “company” within the meaning of the DTT US 2006; (ii) the recipient of the dividends must be a resident of the ”other contracting state“ (in the case at hand the US); (iii) the claimant must be the beneficial owner of the dividends; (iv) the claimant must hold at least 25% of the shares in the company paying the dividends; and (v) the company paying the dividends must also be a “company” in the sense of the DTT US 2006.
The FTC came to the conclusion that all these requirements had been satisfied and that, therefore, a reduction of the withholding tax to 5% based on Article 10 paragraph 2 of the DTT US 2006 was available to the S-Corporation. More particularly:
(i) Recipient of the dividend is a company within the meaning of the DTT US 2006
Article 3 paragraph 1 lit. e) of the DTT US 2006 defines the term company as ”any body corporate or any entity which is treated as a body corporate for tax purposes”. Since the S-Corporation is not treated as a body corporate for tax purposes due to its transparency for US tax purposes, it can only be a company within the meaning of the DTT US 2006 if it is a “body corporate”. This requirement would be, in the FTC’s opinion, satisfied if the civil law structure of the relevant entity was comparable to a German body corporate (Typenvergleich). Based on such review of the corporate structure, the FTC held that the S-Corporation was a body corporate and, therefore, also a company for treaty purposes.(ii) Recipient of the dividends is a resident of the “other contracting state”
Article 4 paragraph 1 of the DTT US 2006 defines ”resident of a contracting state” as ”any person who, under the laws of that state, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of similar nature”. As the S-Corporation is not subject to tax in the US, but only its shareholders are, it is not a US-resident within the meaning of the DTT US 2006. However, the fact that the S-Corporation is not a resident in a contracting state for the purposes of the DTT US 2006 is, in the FTC’s view, overcome by Article 1 paragraph 7 of the DTT US 2006 and the application of Article 10 paragraph 2 (sentence 1) lit. a) of the DTT US 2006 is therefore not excluded.
Article 1 paragraph 7 of the DTT US 2006 reads as follows:
(7) In the case of an item of income, profit or gain derived by or through a person that is fiscally transparent under the laws of either contracting state, such item shall be considered to 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.”
The requirements of Article 1 paragraph 7 of the DTT US 2006 were satisfied since the S-Corporation was transparent for tax purposes and its profit was subject to tax at the level of its shareholders, who were residents in the US. As a consequence, Article 1 paragraph 7 of the DTT US 2006 led to an allocation of the income for treaty purposes. Moreover, the FTC took the position that the article also deems that the relevant dividends are derived by a resident of the other contracting state. Based on the wording of the relevant article in the DTT US 2006, the FTC came to the conclusion that the resident who receives the income, profit or gain is not necessarily identical to the shareholders of the S-Corporation, but also that the S-Corporation itself – and although the S-Corporation does not satisfy the residency requirements pursuant to Article 4 of the DTT US 2006 – can be treated as resident which derives the relevant income, profit or gain. The FTC concluded that the regulations of the DTT US 2006 should not deviate from the former version of the DTT US insofar, under which the S-Corporation was treated as a resident in a contracting state.
(iii) The S-Corporation is the beneficial owner of the dividends
The DTT US 2006 does not define the term beneficial owner. If a term is not defined in the DTT US 2006, Article 3 paragraph 2 of the DTT US 2006 states that the term shall have the meaning which it has under the laws of the contracting state applying the applicable double tax treaty. Therefore, the FTC drew the conclusion that the term beneficial owner must be interpreted from a German law perspective. From a German law perspective only the S-Corporation, as the 50%-shareholder of the GmbH, is the beneficial owner of the dividends.
This result was not affected by the position taken by the FTC in connection with Article 1 paragraph 7 of the DTT US 2006. Article 1 paragraph 7 of the DTT US 2006 only assumes that ”a” person resident in the US is the recipient of the dividends, but it leaves open who the recipient actually is.
Withholding tax reduction pursuant to Article 10 paragraph 2 (sentence 1) lit. a) of the DTT US 2006
Since the further requirements for the withholding tax reduction pursuant to Article 10 paragraph 2 (sentence 1) lit. a) of the DTT US 2006 were also satisfied (in particular the holding percentage), the FTC came to the conclusion that the withholding tax reduction had to be granted to the S-Corporation. The advantage of this interpretation of Article 1 paragraph 7 of the DTT US 2006 by FTC for the taxpayer is that the relevant shareholding percentages must only be satisfied at the level of the S-Corporation, and not based on a pro rata allocation to the shareholders of the S-Corporation.
Relevance of the FTC decision for the treatment of hybrid entities under the DTT US 2006
The decision is not only relevant for the treatment of S-Corporations for treaty purposes, but also with respect to other hybrid entities (for example, a LLC which is treated as a corporate body for German tax purposes, but as transparent from a US tax perspective) and clarifies the interpretation of Article 1 paragraph 7 of the DTT US 2006 which was disputed in the tax expert literature. It remains to be seen whether the German tax authorities will publish the decision of the FTC and apply the principles outlined by the FTC on a general basis.
Oliver Rosenberg (Oliver.Rosenberg@linklaters.com) is a partner at Linklaters, principal Corporate Tax correspondent for Germany. He is based in Dusseldorf.