Investment activities between the UK and Germany are substantial. However, until recently, taxpayers resident in these two countries have been encumbered by a rather outdated regime dealing with the avoidance of double taxation.
On 30 March 2010, Germany and the UK signed a new version of the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital (the Convention), which will replace the convention dated 26 November 1964 (the 1964 Convention, amended 23 March 1970). In many respects, the Convention reflects the model double tax convention issued by the OECD (the OECD model).
Although not all of the new regulations introduced by the Convention are beneficial to taxpayers, it is generally welcomed that the regulations have adopted more of the OECD model, which is familiar to tax practitioners and provides increased guidance when applying the Convention.
In Germany, the Convention came into effect on 1 January 2011. In the UK, the new regulations had effect from 1 April 2011 (for corporate tax) and 6 April 2011 (for income tax and capital gains tax).
CHANGES TO THE CONVENTION
This article provides a short overview of the changes to the Convention when compared to the 1964 Convention, particularly focusing on how the changes will affect corporate entities.
Article 10 of the Convention provides for the right to tax dividends in the state in which the dividend’s recipient is resident and a right to tax at source in the state in which the distributing company is resident. The 1964 Convention provided for a reduction of withholding taxes to 15% if either the dividends were taxable in the other state or the distribution was made by a UK company to a German recipient company holding at least 25% of the distributing company. The Convention now introduces split withholding tax rates, which are:
- 5% of the dividends if the beneficial owner is a company (other than a partnership) that holds directly at least 10% of the capital of the company paying the dividends;
- 10% of the dividends if the beneficial owner is a pension scheme; and
- 15% in all other cases.
The reduced withholding tax of 5% will often be available where relief under the Parent-Subsidiary Directive is also applicable. This may reduce withholding tax to zero and is thus more favourable than the Convention. However, reliance on the Convention may remain important where the requirements of the Parent-Subsidiary Directive are not fulfilled, such as the need for there to be a minimum holding period of 12 months at the time of the distribution.
Aside from distributions from corporate entities, the definition of ‘dividends’ in the Convention also includes distributions from investment funds and real estate investment trusts. From a German perspective, pursuant to previously common practice, distributions from investment funds should contain dividend-equivalent amounts (ausschüttungsgleiche Erträge) ie certain profits of the investment fund, which are deemed to be distributed for investment tax purposes despite the fact that they are retained by the investment fund. Under the Convention’s revised Article 10, where distributions of investment funds qualify as dividends, it should be possible to secure a reduction of withholding tax from 26.375% to 15%. In Germany, from 2011 onwards, following a change to the law, such withholding tax is not only due on any actual dividend income contained in the profits of an investment fund but also on rental income from real estate for which Germany has the right to tax under the Convention.
With respect to interest income, the general rule is that the right to tax lies with the state in which the recipient of the interest is resident. Akin to Article VII of the 1964 Convention, the new Article 11 of the Convention prevents the state in which the debtor is resident from taxing interest that is not associated with a permanent establishment in that state.
The term ‘interest’ now also comprises income from debt claims carrying a right to participate in the debtor’s profits, and therefore includes, for example, income from profit-participating loans and bonds and silent partnerships. However, for these types of income, the general rule (described above) is suspended by No 2 of the Convention’s protocol. Consequently, income from rights and debt claims with profit participation, which qualifies as a deductible expense for the debtor, can be taxed in the debtor’s state of residence. Therefore, for German debtors, such payments generally carry an obligation to withhold tax at a rate of 26.375% on the recipient’s account.
It should be noted that Article 11 only applies to interest payments made between related parties that have been determined on an arm’s-length basis. Any interest exceeding arm’s-length calculations will remain taxable according to the national provisions of either the UK or Germany, whichever is relevant. With respect to Germany, excessive interest payments would constitute hidden dividend distributions and therefore would be subject to a 26.375% withholding tax. However, such withholding tax could be reduced in accordance with Article 10 of the Convention.
In certain circumstances, if an individual resident in one state is seconded to the other state for employment purposes without becoming resident there and spends in aggregate no more than 183 days in that other state, the right to tax the employment income remains with their state of residence. In practice, this can help to reduce the tax compliance burden on individuals seconded to the UK or Germany and potentially prevent such individuals from losing certain tax allowances.
The 1964 Convention calculated whether the 183-day threshold had been exceeded by reference to the relevant fiscal year. However, pursuant to Article 14 para 2(a) of the Convention, the right to tax may now shift to the state where an individual’s employment is exercised (ie the state where an individual has been seconded) if the individual spends more than an aggregate of 183 days in that other state during a 12-month period commencing or ending in the fiscal year concerned. This new method of calculation needs to be based on a rolling period and requires careful calculation of days spent by that individual in the other state for employment purposes. Under the 1964 Convention, it was possible for an individual to spend almost a whole year in the state in which they are employed without becoming tax resident in that state; however, this will no longer be possible under the new Convention.
Income from offshore activities
The Convention now contains a separate Article 20 dealing with offshore activities. The Article outlines the circumstances in which an enterprise of one contracting state will be deemed to have a permanent establishment in the other state, where it carries on activities offshore in the other contracting state in connection with exploring or exploiting the sea-bed and subsoil and their natural resources.
In addition to domestic legislation combating tax evasion or tax avoidance, the Convention contains a number of provisions intended to prevent its abuse for tax evasion or avoidance purposes.
Limitations on the exemption method in Article 23 of the Convention
Under Article 23 para 1 of the Convention, for German tax residents, double taxation is generally avoided by exempting certain types of UK-sourced income from German taxation (the exemption method), including: income from real estate situated in the UK (Article 6); and business income derived from a permanent establishment of a German tax resident in the UK (Article 7). However, the exemption method is subject to certain conditions that are outlined below.
Subject to tax clause
Pursuant to Article 23 para 1 of the Convention, the exemption method is not available if the German tax resident’s UK-sourced income is not effectively taxed in the UK. According to the German government, income is not considered to have been effectively taxed if either:
- the income is not taxable;
- a tax exemption applies and therefore the income has not been taxed; or
- a tax procedure has not been properly undertaken.
Article 23 of the Convention now applies to all UK-sourced income of a German tax resident. It is worth noting that the 1964 Convention contained a similar provision to avoid untaxed income, although its application was limited to income that a German resident derived from the sale of UK real estate and its wording was open to an interpretation that was more beneficial for the taxpayer.
Switch over clauses
Article 23 of the Convention also avoids double taxation by applying the German tax credit system for German tax residents whose income is sourced from a UK permanent establishment or a UK company that does not have exclusively (or almost exclusively) ‘active’ income within the meaning of the German Law on External Tax Relations (Außensteuergesetz) ie the activities abroad need to generate at least 90% profits from, for example, production, services or trade.
It should also be noted that pursuant to Article 23 para 1(e) of the Convention the exemption method is not applicable in circumstances where the UK and Germany apply different Articles of the Convention to certain types of income, or where the UK and Germany deem different persons taxable for the same income and these differences create lower or no taxation of that income.
Main purpose clause
At the UK’s request, several articles of the 1964 Convention were amended to ensure that relief was not available where the main purpose (or one of the main purposes) of anyone involved in the creation or assignment of the relevant type of income was to take advantage of the provisions of the Convention. A ‘main purpose clause’ is now included in the articles relating to dividends, interest and royalties. The clause is widely drafted and the scope is not clearly defined and it remains to be seen how this clause will be applied in Germany and the UK.
Remittance base taxation
Under UK legislation, certain income will only be liable to UK tax where it is remitted to the UK. It should be noted that Article 24 of the Convention enables Germany to limit the application of relief under the Convention to income that is actually remitted to and taxed in the UK.
Many of the Convention’s provisions are now similar to those provided by the OECD model. This provides increased certainty regarding the Convention’s application. However, the anti-abuse provisions are extensive and require careful consideration when structuring investments between the UK and Germany.