The LLC and its members based in Germany (Part 1)

In the USA, the Limited Liability Company (LLC) is regarded as a form of company that is easy to set up, flexible to handle and yet beneficially offers personal limitation of liability for its shareholders (members). Special features must be observed if its shareholders are resident in Germany. Some of the special features are described in these two articles.

The content of both articles is shown in the following table:

1) General

These articles cover the tax treatment of small companies whose shareholders are individuals. It should be noted that the LLC arrangement is also used by US corporations as parent companies or for special business activities. Particular issues arising from this use of LLC companies are not however dealt with in this series of articles.

The LLC is a special legal form which, in terms of its legal structure, represents a hybrid form between a corporation and a partnership. This hybrid character under company law and the various options to choose the tax treatment in the US makes it difficult to categorize the LLC for tax purposes in Germany. These articles will try to help to clarify the situation.

Another special feature derives from the US taxation regime for US citizens. This is because the USA recognizes its citizens as resident for tax purposes in the US regardless of their place of physical residence. US citizens therefore remain taxable persons under US tax law even if they are resident outside the USA. This means that shareholders of an LLC, resident in Germany, must generally file income tax returns in both countries. This also applies to persons who have dual citizenship. This special feature is also reflected in special regulations for US citizens in the double taxation agreement between Germany and the USA (DTC USA).

2) Residency

The first step is always to examine the question of determining the tax residency of both the LLC itself and its shareholders. In the case of the shareholders, the tax effects depend crucially on how the question regarding their tax residency is answered. The following scenarios are possible:

1. Sole residency in Germany
2. Sole residency in the USA
3. Dual residency with center of vital interests in Germany
4. Dual residency with center of vital interests in the USA

We cover here the special features of dual residency. In the case of US citizens, a dual tax residency results from having a permanent home in Germany and being a US citizen. For citizens of other countries, dual residency always requires permanent homes in both countries. This results in two scenarios for the analysis: Scenario I = main residence in Germany and Scenario II = main residence in the USA

One significant issue is the very different definition of tax residency:

1. Germany determines tax residency according to the place of a permanent home or the habitual abode (details in https://scheller-international.com/blog-beitraege/german-tax-residence.html). It should be noted that a person who has a secondary residence in Germany is nevertheless considered as being tax resident.
2. The USA taxes persons who are resident in the USA, but tax residency is based on different criteria than in Germany (https://www.irs.gov/individuals/international-taxpayers/substantial-presence-test). In the case of permanent residence (green card), the USA generally assumes that the person is resident in the USA. US citizens are covered by unlimited tax liability in the US regardless of their residency.

The DTC USA (see section 1 above) contains its own regulations on tax residency. These are in particular the regulations regarding dual residency (Art. 4 (2) DTA USA). In the case of a permanent home in both countries, residency depends on the center of vital interests. Determining this is particularly difficult if personal (especially family) and professional ties are in different countries.

A distinction must be made between the residency of a natural person and that of companies. There are two main forms:

1. Corporation: A corporation is subject to unlimited tax liability in Germany in accordance with Section 1 (1) KStG if it has its statutory seat or its management in Germany. The determination of the statutory seat is simple; the GmbH has it in Germany and the LLC in the respective US state of incorporation. However, the place of management may be in a different location (see point 3 below).
2. Partnership: The partnership follows different rules because it is considered transparent both under German and US tax law. This means that in both countries the partners of the partnership are relevant subjects for tax purposes and not the company itself. In Germany, however, the partnership is a taxable entity for trade tax purposes. In addition to the place of management, the existence of one or more permanent establishments are relevant for the tax treatment in both countries (see point 4 below).
3. A special feature of US tax law is that the place of management or a permanent establishment has no significance in domestic US tax law. With regard to an individual or legal entity, US tax law is based on the concept of “effectively connected income” (https://www.irs.gov/individuals/international-taxpayers/effectively-connected-income-eci).

The DTA USA refers primarily to the national law of the state who applies the provisions of the DTC (Art. 4 (1) DTA USA). There is a particular problem with dual resident corporations. For these, the DTA USA does not contain a clear allocation rule (tie-breaker rule); instead, the tax authorities are required to reach an agreement on residency in a consultation procedure. However, there is no obligation for the tax authorities to reach an agreement. If the tax authorities do not reach an agreement, the company is not deemed to be resident in any of the countries and cannot claim treaty benefits. In this case, double taxation can only be avoided if one of the countries has favorable provisions in its national law. In general, it will only be possible to reduce the double tax burden by claiming for a tax credit.

A special issue with regard to the Limited Liability Company (LLC) has to be considered. Although the LLC is a separate legal entity under US law, it is not a corporation. Under US tax law, the members can choose whether the company should be taxed as a corporation or as a partnership/disregarded entity. In addition, the shareholders can choose whether the LLC should be taxed as a C or an S corporation. The tax implications of this election cannot be discussed in detail here.

Whether the LLC (as a person in the sense of the DTC) is entitled to treaty benefits or its shareholders depends on the election of the form of taxation in the US and the classification of the LLC in Germany (for the classification, see section 6).

3) Place of effective management

A company is resident in Germany for tax purposes if it has its statutory seat or its place of effective management in Germany. The statutory seat of a foreign company is always situated abroad.

The key question is where the company has its place of effective management. The place of effective management is the place where the management makes decisions and takes actions that are of essential importance for the legal, organizational and economic operations of the company. It is therefore the place where the management carries out its day-to-day management activities. The term "fixed place" does not require actual premises of the company. For example, the place of management may be in the private home of a managing director.

A sole shareholder and managing director of a US-company who is resident in Germany often carries out their management activities in Germany. To prove that his or her management activities are carried out in another country is difficult:

• The managing director must regularly travel abroad to carry out his management duties there (the majority of his working time). He or she has to keep time records.
• He or she must provide evidence of this in the form of travel reports and receipts, minutes of meetings with employees, customers, other business partners, etc.
• There shall be economic substance abroad (e.g. employees, an office or workplace, telecommunications, etc.) that is require or at least makes it possible to perform management duties.
• In most cases, sole shareholders of a foreign companies cannot prove that the place of management has not been moved to Germany if they are resident in Germany.

Further information can be found at: https://scheller-international.com/blog-beitraege/the-unwanted-permanent-establishment-in-germany.html.

It is often difficult to determine the place of management or the location of a permanent establishment for small service companies, particularly those with innovative products, such as development and operation of online platforms. They often only have one managing director and no offices or employees of their own. Necessary activities such as platform maintenance and customer service are carried out by external service providers (freelancers) who may be based in different countries. According to the rulings of the Federal Fiscal Court (BFH), in cases where the place of management cannot be clearly determined, the managing director's home is to be regarded as the company's place of effective management.

4) Permanent establishment

A company may have several permanent establishments in addition to the place of management, possibly also in several countries.

A permanent establishment is any fixed place of business or facility that serves the activities of a company (§ 12 AO). It must have a certain physical rootedness (connection to the ground) and be set up for a certain duration (usually more than six months). The following are to be regarded as permanent establishments, particularly for smaller service companies:

1. the place of management,
2. a branch
3. an office

It is often difficult to determine a permanent establishment for small service companies without a fixed place of business (see point 3).

A special feature of US tax law is that a permanent establishment is not a criterion for the taxation of income. In the German American context, however, the permanent establishment is an essential criterion for the allocation of income if permanent establishments exist in both countries (Art. 5 DTA USA). A significant difference between the DTA USA and German tax law (Section 12 AO) is that certain supporting and auxiliary activities are not considered to be permanent establishments. According to Art. 5 (4) DBA USA, the following activities or facilities are not considered permanent establishments:

1. he use of facilities solely for the purpose of storage, display, or delivery of goods or merchandise belonging to the enterprise;
2. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or delivery;
3. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
4. the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
5. the maintenance of a fixed place of business solely for the purpose of advertising, of the supply of information, of scientific activities, or of similar activities that have a preparatory or auxiliary character for the enterprise; or
6. the maintenance of a fixed place of business solely for any combination of activities mentioned before, provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

A further essential precondition for the existence of a permanent establishment is that it serves a commercial enterprise. Therefore, partnerships whose sole purpose is the management of private assets cannot have a permanent establishment (see point 8). This applies, for example, to an LLC that only holds real estate. The real estate also does not constitute a permanent establishment if held by such an LLC. However, this only applies to an LLC if this company is classified as a partnership in Germany. If it is classified as a corporation, it generates by law income from trade and business due to a legal fiction. In this case, the LLC may also have permanent establishments.

The following should also be taken into consideration: It is often not very beneficial for small companies to establish a permanent establishment in one state if the LLC has its head office in the other state. This applies even if the tax burden in the USA is lower than the one in Germany. In such cases, a profit split must be carried out between the head office and the foreign permanent establishment. The necessary analysis and the preparation of the required report often lead to unreasonably high administrative and financial burdens for small companies.

Authors:

Peter Scheller, Steuerberater, Master of International Taxation. Fachberater für Zölle und Verbrauchsteuern

Alexander Wangerowski, Steuerberater, https://aw-stb.de/

Bildquelle: www.fotalia.com