On June 1, 2006, the United States and Germany signed a protocol amending their 1989 income tax treaty and protocol. The new protocol thoroughly updates the existing treaty and includes several noteworthy changes, including a zero-rate provision for subsidiary-parent dividends, a more restrictive limitation-on-benefits provision and a mandatory binding arbitration provision.
The zero rate on subsidiary-parent dividends and the tightening of the limitation-on-benefits provision are generally similar to provisions that have been added to several other U.S. tax treaties in recent years, although with some significant differences (discussed below). The mandatory binding arbitration provision, long advocated by the U.S. business community, is without precedent in U.S. tax treaty practice.
Germany, on the other hand, has had significant experience with arbitration under some of its other tax treaties, although only one of those provisions is mandatory. Germany normally does not agree to zero-rate dividend provisions in its tax treaties, although it of course participates in the intra-European zero rate under the EU Parent-Subsidiary Directive.
In extending a zero rate to the United States, German negotiators were aware that a U.S. parent company may already effectively obtain the benefits of the EU zero rate in connection with direct investment in Germany, by holding a German subsidiary through a holding company formed in another EU country with which the United States has a zero rate (e.g., the Netherlands).
It is expected that the protocol will be ratified later this year. On the U.S. side, it is likely that the Senate Foreign Relations Committee and the full Senate will take up the protocol in the fall (along with recently signed protocols with Denmark and Finland and any other tax treaty instruments that might be concluded in time for consideration). On the German side, ratification also is expected by the end of 2006.
If ratified this year, the zero-rate provision would be effective retroactively to the beginning of 2006. Other changes would be effective at the start of 2007, again assuming ratification this year. A transition rule would allow taxpayers to elect to apply the current version of the treaty for an additional year.
Zero Rate for Subsidiary-Parent Dividends
The current treaty, like most other U.S. and recent German tax treaties, limits withholding tax rates to 15 percent on portfolio dividends, and to five percent on dividends paid to shareholders owning at least 10 percent of the stock of the dividend-paying company. The protocol leaves these two categories largely in place but adds a new category of direct-investment dividends eligible for zero withholding tax.
The zero rate applies to dividends received by a company that has owned (directly) shares constituting at least 80 percent of the voting power of the dividend-paying company for a 12-month period ending on the date on which entitlement to the dividend is determined. In addition, in order to qualify for the benefits of the zero rate, the taxpayer must qualify for treaty benefits under one of the following provisions:
- the public trading test (including the subsidiary test)
- the ownership/base erosion and active trade or business tests
- the derivative benefits test
- competent authority discretion
While this zero-rate provision is similar to provisions included in several recent U.S. treaties, some differences are worth noting. Unlike the other most recent U.S. zero-rate provisions (i.e., provisions with Sweden, Denmark and Finland, as well as the older provision with Japan), which allow indirect ownership, the provision in the protocol requires direct ownership (as in the U.S. treaty with the Netherlands, as well as in treaties with the United Kingdom, Australia and Mexico, per language in Treasury technical explanations).
The direct ownership requirement is consistent with general German treaty policy, which does not place indirect ownership on the same footing as direct ownership (although Germany did make an exception to this policy in its treaty with Japan). On the U.S. side, it is worth noting that the Internal Revenue Service (IRS) has ruled privately that, in applying the holding period requirement of the UK treaty, the ownership of stock of the dividend-paying company through a third-country disregarded entity was considered direct ownership (PLR 200522006). It remains to be seen whether such a flexible approach will be taken in applying other zero-rate provisions that require direct ownership.
The ownership threshold, holding period and special limitation-on-benefits rules are similar to those included in other recent treaties. The 80-percent ownership threshold is in line with all other U.S. zero-rate provisions with the exception of the provision with Japan, which provides a 50-percent threshold. The holding period requirement, which is intended to prevent short-term shifting of ownership in order to secure the benefit of the zero rate, appears in all of the provisions. The special limitation-on-benefits rule denying the benefit of the zero rate to taxpayers meeting only the active trade or business test now appears to be standard practice.
Another noteworthy consequence of the zero-rate provision for a German direct investor in the United States is that the U.S. branch profits tax (assessed at a 5 percent rate under the current treaty) may be eliminated on investments in a U.S. branch or partnership, provided the necessary limitation-on-benefits requirements are met.
The most unusual feature of the protocol’s zero-rate provision may be its effective date. The provision is effective as of January 1 of the year that the protocol enters into effect. Thus, if the provision is ratified later this year, the provision could apply retroactively to dividends paid throughout 2006.
Tightened Limitation-On-Benefits Provision
The protocol replaces the current treaty’s limitation-on-benefits article with an updated article similar to those included in other recent U.S. treaties.
Most notably, the protocol tightens the public trading rule by requiring a stronger nexus to the country of residence. Under the new rule, if a company seeks to qualify for treaty benefits by way of the public trading test, the company’s stock must be regularly traded on a recognized stock exchange, and either the company’s stock must be primarily traded on a recognized stock exchange in the residence country or the company’s place of primary management and control must be in such country. A company’s place of primary management and control is in the residence country if executive officers and senior managers exercise day-to-day responsibility for more of the strategic, financial and operational policy decisions for the company in that country than in any other country.
This rule is similar to provisions recently agreed to with the Netherlands, Sweden, Denmark and Finland, although it is more restrictive in some respects. For example, unlike these other provisions, the “primarily traded” rule in the protocol looks only to trading in the residence country, as opposed to trading in that country’s general economic zone. In addition, little guidance is provided as to the level of trading required to satisfy the “regularly traded” and “primarily traded” terms of the test. The inability to take into account trading in the broader economic zone under the “primarily traded” test, combined with the potential lack of clarity as to the definition of that term in some cases, may force many public companies to contend with difficult issues that may arise in applying the fact-intensive “primary management and control” test. This problem, as well as the lack of a “regularly traded” definition, may make it difficult for some public companies to attain the necessary level of comfort as to qualification for treaty benefits under this test.
Other limitation-on-benefits changes worthy of note include a modification to the ownership/base erosion test to provide that “qualified owners” include only persons resident in the same country as the person claiming treaty benefits, as opposed to the other treaty country. In addition, unlike other recent treaties, no exception from the base erosion test is provided for arm’s length payments for services or tangible property.
The protocol also includes a “triangular” provision similar to those included in other recent treaties. Under this provision, income received by a third-country permanent establishment of a treaty-country resident is not entitled to full treaty benefits if the combined tax paid in the residence country and in the permanent establishment country is less than 60 percent of the tax that would have been due if the income had been received directly by the residence-country home office. Unlike other recent triangular provisions, the provision in the protocol generally applies to all types of income, as opposed to just certain types (such as interest and royalties). When applicable to dividends, interest and royalties, the provision results in a 15-percent rate of withholding tax, instead of the more favorable rates. As to other items, treaty benefits are denied altogether.
Taken together, the changes described above would make the treaty’s limitation-on-benefits article one of the most restrictive in the U.S. treaty network. This is a noteworthy outcome given that the benefits available under the treaty are not unusual, and Germany is not normally viewed as an especially attractive holding company jurisdiction. The inclusion of such terms in the treaty with Germany will likely serve as precedent for including similarly restrictive terms in other treaties in the future.
Under the protocol’s general transition rule, taxpayers may elect to apply the current version of the treaty for an additional year. This election may be of some benefit to taxpayers who may need time to reassess and possibly restructure their arrangements in response to the more restrictive limitation-on-benefits rules.
Mandatory Binding Arbitration
The protocol adds a mandatory binding arbitration mechanism for settling certain issues that cannot be resolved through the normal competent authority process. This provision is the first of its kind in a U.S. tax treaty. Germany, on the other hand, has arbitration provisions under four of its tax treaties, although only one of these provisions is mandatory. Germany also has experience with the arbitration of transfer pricing disputes under the EU Arbitration Convention.
The U.S. business community has long sought this provision to speed up the resolution of issues submitted to the competent authorities, to moderate the authorities’ positions, and to assure eventual relief from double taxation. Under the provision, issues relating to individual residence, permanent establishments, business profits, associated enterprises and royalties generally must be submitted to binding arbitration if they cannot be settled within two years.
The arbitration panel consists of three members: each competent authority appoints one member, and these two members appoint a third. This third member, who cannot be a citizen of either treaty country, chairs the panel. After the appointment of the chair, each competent authority has 90 days to submit a proposed resolution and a position paper and another 90 days to submit a reply. The panel must adopt the resolution of one of the two parties (a model often referred to as “baseball arbitration”) within six months of the chair’s appointment.
The panel’s determination is binding on the competent authorities, but the taxpayer has the right to opt out of the process until 30 days after the issuance of the determination. All parties to the proceeding must agree to terms of confidentiality, and the arbitration panel will not provide a rationale for its determination, which is said to have no precedential value.
The provision applies to issues under consideration by the competent authorities on or after the date on which the protocol enters into force. Thus, the provision may provide immediate relief for some cases currently before the competent authorities.
The protocol’s use of the baseball arbitration model is noteworthy, as it is not the model preferred by the Organization for Economic Cooperation and Development (OECD) or the European Union. By limiting the possible determinations to one of the two parties’ submissions, the model is intended to encourage each party to moderate its position. The taxpayer does not have the right to submit a proposed determination, but the protocol does give the taxpayer the right to walk away from the process and to reject the panel’s determination. It is unclear, however, whether doing so might render any German taxes at issue in the process uncreditable in the United States, under rules requiring taxpayers to “exhaust [ ] all effective and practical remedies, including invocation of competent authority procedures…to reduce…the taxpayer’s liability for foreign tax” (Treas. Reg. sec. 1.901-2(e)(5)(i)). Treasury guidance on this point would be helpful.
It remains to be seen whether similar arbitration provisions will be added to other U.S. tax treaties. Hopefully the Treasury Department and the Senate Foreign Relations Committee will express their intentions and views in the ratification hearing presumed to be planned for the fall.
While the zero-rate, limitation-on-benefits and arbitration provisions are the most significant changes, the protocol also includes a number of other important changes, generally in line with recent U.S. treaty practice. For example, the protocol addresses many cross-border pension issues and includes now-standard U.S. provisions dealing with hybrid entities, regulated investment companies (RICs), real estate investment trusts (REITs) and information exchange.
One of the protocol’s provisions also requires that the principles of the OECD transfer pricing guidelines be used in determining the profits attributable to a permanent establishment. Given the consternation that has been caused by the OECD’s ongoing project on the attribution of profits to a permanent establishment, some taxpayers may find this provision a point of concern.
In view of the size and importance of the U.S.-German trade and investment relationship and the very significant changes made by the protocol—some taxpayer-favorable and others not—a wide range of multinational businesses will have occasion to revisit their tax planning in response to the protocol’s opportunities and risks.