Peter Scheller
Berater für Wirtschaftsprüfer, Rechtsanwälte, Steuer- und Unternehmensberater

„Wenn es knifflig wird.“

US-Citizens living and working in Germany (2)

von Peter Scheller

Tax Issues in Germany – Part 2

Living and working in another country requires careful tax planning as there are always many tax issues to be considered. In addition, social security and other legal issues such as immigration law must be observed. This applies for all US citizens who relocate to Germany and it is important to note that there are special issues to be observed. Different tax and social security systems in Germany and the USA may cause problems in addition to those contained in special provisions in the Double Taxation Convention between Germany and the USA (DTC USA).

There are several special arrangements of a general nature to consider for employees and for self-employed persons, for shareholders of US companies and for pensioners living in Germany.

There are two parts with 10 different special issues:

1

Saving Clause

6

Income from capital investments

2

Tax assessment

7

Income from real estate

3

The obligation to file income tax returns in Germany

8

Income from US companies

4

Salaries paid by US employers to US citizens living in Germany

9

Payments out of US pension plans

5

German social security system

10

Trust taxation in Germany

6) Income from capital investments

Income from capital investments are dividends, interest, profits from silent partnerships, income from investment certificates, mutual funds and other capital investments such as payments from life insurances with saving elements. Capital gains are also taxed under this regime if the shareholder does not hold more than 1% of the share capital of the company. A full listing of income categories can be found in paragraph 20 of the German income tax code. However, these earnings do only qualify as income from capital investments if they are not part of business or trade activities.

The income tax rate is 25%. In addition to that a solidarity surplus charge of 5.5% of the income tax has to be paid which makes a total tax rate of 26.375%. Financial institutions and other debtors of capital income who are resident in Germany have to withhold the tax and transfer it to the German tax authorities. There is a general yearly allowance of 801 Euros (1,602 for married couples).

Individuals who are tax resident in Germany have to pay income tax on their worldwide income in Germany. This means that income from capital investments held outside Germany are also subject to German income tax in Germany. Income from capital investments which are held abroad (for example in a foreign bank) must be declared in the German income tax return. Dividends, interest and capital gains deriving from US sources will also be taxed in the US. Germany credits US income tax against the German income tax up to the following percentages:

  • Dividends: 15%
  • Interest: 0%
  • Capital gains: 0%

US citizens have to pay income tax on this income in the US as well. However, they can credit at least some parts of the German income tax against their US Federal income tax.

7) Income from real estate

Expatriates who relocate to Germany often retain their US property and use it for rental purposes. Rental income and profits from selling US rental property is tax-free in Germany but they do affect the German income tax rate. Losses from US rental property are not deductible for income tax purposes. The before mentioned rules do not apply if the rental property is part of permanent establishment of a US business in Germany or is owned by a German business entity.

Expatriates who plan to stay longer in Germany often purchase German real estate. If this property is used as own home there are no income tax implications. The selling of this property at a later stage will not be taxed if the house or flat was used in the year of selling and during the previous two years for the owner’s residential purposes. The purchase will be subject to a real estate transfer tax between 3.5% and 6.5% of the purchase price (depending on the federal state where the home is situated). The owner has to pay also a yearly real estate property tax which in general is moderate.

If a German house or flat is rented out the rental income is subject to the regular German income tax. Losses can be deducted against other income (e.g. salaries, business income and income from self-employment). A specialty of German income tax law is that gains from selling this kind of property will only be taxed if the period between purchasing and selling of the property is less than ten years. Again this only applies if the property is not part of a business entity. Gains realised after the ten-year-period will not be taxed in Germany. However, this advantage for US citizens will be limited because the gains will be taxed in the US. For more information see here.

8) Income from US companies

US citizens who relocate to Germany are often shareholders or members of US business entities. If these persons carry out their own business activities through these entities there are two predominant forms to be aware of:

  • S corporation (S corp)
  • Limited Liability Company (LLC)

In general, both forms are transparent for income tax purposes in the USA. The profits will not be taxed on the level of the company but as ordinary income on the level of the shareholders or members. A S corp can have one or more shareholders. Whether a LLC can have only one member depends on the LLC law of the state it is situated in. A company with more than one shareholder or member is taxed in the USA as a partnership. A one-person company is taxed as a sole proprietorship. A one-person LLC is classified by the IRS as a disregarded entity. The advantage of carrying on one’s own business in the form of a S corp or a LLC is first of all the limited liability of its shareholders or members. There are especially for smaller businesses tax advantages in running the business as a S corp or a LLC and not as a C corporation. The C corporation is subject to the corporation income tax in the USA.

Germany does not follow the US tax classification. A S corp is classified as a corporation. This results in the following tax treatment:

  • The corporation will not be taxed in Germany as long as it has no permanent establishment in Germany.
  • Profit distributions to its shareholders will be taxed in Germany as income from capital investments. The tax calculation will be as follows (as an example):

 

 

Euro

Profit distribution

 

100.000

Fictional US corporation tax

21%

21.000

 

 

79.000

Tax-free amount

40%

31.600

Taxable amount

 

47.400

Income tax (given the tax rate is 30%)

30%

14.220

  • The German tax authorities disallow the crediting of US income tax against the German income tax. This results in a (partial) double taxation. If the US income tax rate is 30% the combined German and US tax rate on distributed profits is about 45%. For more information see here.

If a US citizen who relocates to Germany is a member of a LLC, things become even more confusing because the German tax authorities see the LLC as a hybrid company form. The LLC may be either classified as a corporation or as a partnership. If the LLC is classified as a partnership the profits attributable to the member who is resident in Germany will be tax-free if the LLC has no permanent establishment in Germany. However, the profit share of the member who is resident in Germany will  impact his or her German income tax rate and therefore it has to be declared in the German income tax return. If the LLC is classified in Germany as a corporation the taxation is the same as the one described above for a S corp. The actual classification of a LLC is determined by a check list provided by Germany’s Federal Financial Ministry. More information see here.

There are various other tax relevant issues to be considered:

  • Permanent establishment: This is relevant especially for shareholders or members of smaller business units who continue to work for or with their US companies. Often they are still managers of a S corporation or a LLC. If a managing shareholder or member carries out his or her activities predominantly in Germany there is the risk that the company becomes tax resident in Germany. This will apply if this person is the only manager of the company. A S corp or a LLC which is classified as a corporation becomes liable to German corporation and trade and business tax as well as the solidarity surplus charge (total tax rate about 32%). If a LLC is classified as a partnership the company is subject to Germany’s trade and business tax. In addition to that the profit share will be taxed on the level (at the rate?) of the member. He or she has to declare the profit share in his or her income tax return. If the member is not manager of the company or if there are other managers who are resident in the US the risk of creating an unwanted permanent establishment in Germany is lower (see also here).
  • Employment: If a shareholder or member who is resident in Germany is employed by the S corp or the LLC, salaries and fringe benefits will be taxed in Germany as far as the remuneration is connected to work physically performed outside of the USA. Work physically performed in the US is tax-free in Germany but has an effect on the German income tax rate. More information you may see in chapter 4 (part 1 of this article).
  • Corporate restructuring and selling of shares or membership interests: In general the taxation of a LLC in Germany as a partnership is more beneficial than that of a corporation. Therefore members who are tax resident in Germany try to alter the classification by changing the Article of Foundation and the Operating Agreement In the USA a member can do this without tax implications so the changes should therefore be carried out before the member of the LLC relocates to Germany. To change the Operating Agreement after moving to Germany is risky. German tax authorities might see the switch from corporation to partnership as a taxable corporate restructuring. If the LLC has significant hidden reserves (e.g. goodwill or values in intellectual property) the tax bill can be very high. In addition, another scenario happens quite often. Young profitable businesses in the form of a S corp or a LLC are interesting for new investors. In general these investors demand a switch into a C corporation. This is also a restructuring in respect of German tax law. Under strict rules this restructuring can be carried out without any tax implications in Germany, however, this requires a very careful tax planning. The same applies for situations when a shareholder or member who is tax resident in Germany sells shares or membership interests.

9) Payments out of US pension plans

US citizens may stay in Germany as pensioners. In most cases they receive payments out of the US pension plans or the US social security system. Former military personal or civil servants may get governmental pensions. US citizens either pay income tax in Germany or in the US or in both states. If they are tax liable in both countries in general the German income tax will be credited against the US Federal income tax up to certain maximum amounts. The tax situation is as follows:

Payments

Taxation in Germany

Taxation in the USA

Tax regime in Germany

Social security benefits (US or German)

yes

no

Depending on the first year of payment (e.g. 2020: 80% of the payment)

Company pension plans (tax beneficials)

401(k), IRA etc.

yes

yes

Opinion of German tax authorities: full taxation

Private pension plans   (tax beneficial)

Traditional IRA

yes

yes

Pension payments minus contributions to the plan (under certain preconditions ½ of the difference)

Private pensions plans  (not tax beneficial) Nonqualified Deferred Compensation Plans

yes

yes

Pension payments minus contributions to the plan (under certain preconditions ½ of the difference)

Private pension plans (other)

Roth IRA

yes

no

Pension payments minus contributions to the plan (under certain preconditions ½ of the difference)

Governmental pensions

no

yes

Tax-free in Germany (but payments have a impact on the German income tax rate)

You will find more information here.

There are two mayor uncertainties concerning the tax implications of pensions:

  • Payments out of company pension plans: Payments out of qualified German pension plans are taxed on the full amount, because there are various tax benefits during the saving period. Contributions paid by the employee are tax deductible up to certain maximum amounts, contributions paid by the employer are tax-free up to certain maximum amounts and the earnings within the plan are not taxed. This justifies a taxation in the pay-out phase. The German tax authorities’ view is that this also applies for qualified US company pension plans such as a 401(k)-plan. However, the fiscal court of Cologne ruled differently, deciding that a pension plan receiving tax benefits in the USA has no influence on the tax treatment in Germany. The payments may only be taxed with the difference between the payments minus the sum of contributions within the pay-in phase. If the payments are paid out after the person is aged 60 and the plan was agreed 12 years before the payment only half of the difference is taxed. This reduces significantly the tax liability on payments out of company pension plans as 401(k)-plans or IRAs. The tax authorities filed an appeal with the Federal Fiscal Court (Bundesfinanzhof – BFH). As yet the highest German fiscal court has not decided the case, so there is uncertainty remaining about the amount that will be liable to tax.
  • Roll over: Often people who leave work transfer the money in one or more 401(k)-plans into a traditional IRA. This is called a roll over and will not trigger income tax or penalties in the USA. If the roll over takes place while the US-citizen is tax resident in Germany it might be seen as a taxable event by German tax authorities. The argument could be that the transfer could be seen as a pay-out of the 401(k)-plan and a new investment in the IRA. German tax law does not provide any provisions to allow a tax-free transfer of assets from a company pension plan into a private pension plan. The argument against the tax liability of the transaction is that the person does not receive any cash and that he or she continues the pension plan simply in another form. So far there are no defining statements by German tax authorities and no rulings of German fiscal courts in regard to these cases meaning that US citizens should be careful when initiating roll overs while being tax resident in Germany.

10) Trust taxation in Germany

Trusts are quite common in the Anglo-Saxon world and the USA. They are used for various purposes, for example to avoid complicated and expensive probate. However, if beneficiaries of a trust relocate to Germany the trust can turn out to be a very difficult problem to resolve. The German tax regime for trusts is extremely unfavourable for two main reasons. Germany’s civil law does not contemplate the legal form of a trust and this therefore causes uncertainty about the legal status of trusts. The second reason for the unfavourable taxation position is the fact that German individuals tried to avoid high German tax burdens in the 1960’s and 1970’s by setting up trusts in tax havens, resulting in punitive anti-avoidance tax legislation being introduced. Unfortunately, this tax legislation not only punishes German tax avoiders but also foreign beneficiaries of a trust who are relocating to Germany.

Two questions have to be answered before it is possible to determine Germany’s taxation of any trust:

  • Most importantly, does the trust qualify as a transparent or as an in-transparent ´
  • If it qualifies as an in-transparent entity, can it be classified as a “family-trust”?

The tax regime of a trust in Germany depends mainly on its legal structure. If the settlor or a beneficiary is the beneficial owner of trust’s funds the trust will be treated as transparent for tax purposes. The high fiscal court of Germany (Bundesfinanzhof / BFH) ruled in a landmark case regarding a Liechtenstein Stiftung as follows. It determined that the settlor was able to control the Stiftung. It also found that the settlor had the right to appoint or remove trustees and to transfer all funds back to him or to third parties. The BFH therefore classified the Liechtenstein Stiftung as transparent. The same tax treatment should apply for trusts. If the trust is revocable and the beneficial owner has the right to remove trustees and transfer funds of the trust to him or third parties at his free will the trust will be classified as transparent.

The tax situation of beneficial owners of transparent trusts being resident in Germany is as follows:

  • The trust income is taxed at the level (rate?) of the beneficial owner as it is his own personal income. The trust income is taxed in Germany. Dividends, interest and other income from capital funds are subject to German taxation. Business or rental income might be tax free under provisions of the respective double taxation treaty.
  • Transfers of funds of the beneficial owner to the trust or repayments will not be subject to German income or inheritance and gift tax.
  • A problem can arise with the crediting of foreign taxes at source. This applies, for instance, if the trust receives dividends from foreign sources and the foreign country imposes a withholding tax on these dividends. German tax regulations or provisions of the respective double taxation may deny the full crediting of the withholding tax on German income tax.

A beneficiary of an in-transparent trust might face far more severe tax implications if he or she is tax resident in Germany. This especially applies for irrevocable trusts.

  • Payments from an in-transparent trust to a beneficiary who is resident in Germany trigger German gift tax. It does not matter whether the payments are made out of the trust’s income or capital stock. The tax rate and possible allowances depend on the family relationship between the settlor/grantor and the beneficiary. If the beneficiary is a child of the settlor the tax rates of tax class I are applicable. The beneficiary is also entitled to the general allowance of 400,000 Euro. However, if payments from the trust to the beneficiary and direct gifts from the settlor to the beneficiary exceed the amount of 400,000 Euro within the previous 10 years the allowance is exhausted. Any payments of the trust in excess of the applicable allowance will be taxed.
  • The transfer of funds to the trust by the settlor or beneficiary resident in Germany also triggers German gift tax. The very unfavourable tax class III is applicable (low allowances, tax rates between 30% and 50% on transferred funds).
  • The termination of a trust and the distribution of funds will trigger inheritance or gift tax.
  • If the trust does not qualify as a family trust there will be no taxation of the earnings of the trust. However, payments to beneficiaries who are tax resident in Germany will be taxed as income from capital investments. This is only the case if the earnings of the trust are distributed. Payments out of the capital stock of the trust will not trigger an income taxation. This requires a division of payments if they derive from both the trust’s earnings and capital stock. In general taxable distributions will be taxed at a flat rate of 25% plus solidarity surplus charge (total tax rate 26.375%).

The German tax authorities’ view is that a double taxation of payments (income and gift tax) to the beneficiary resident in Germany is in line with German tax law. However, it is questionable whether the Federal high tax court will allow this kind of double taxation of distributed earnings.

A family trust qualifies as such if more than 50% of the beneficiaries are the settlor, his spouse or any related person. A beneficiary has to pay tax on the portion of the trust’s earnings which he or she is entitled to. Whether these earnings are distributed to the beneficiary or not is irrelevant. As a result of this, the trust will be treated as a transparent entity as far as the beneficiaries are concerned and they are entitled to the income or property of the trust. In practice it can be difficult to determine the relevant portion of the earnings for tax purposes.

German income tax calculation regulations have to be followed. The earnings of a beneficiary of a family trust are classified as income from capital investments. German tax authorities are of the opinion that the flat income tax rate of 25% is not applicable on this income. The calculation used by the tax authorities is as follows: 40% of the income is tax free and 60% will be taxed at the regular income tax rate. Foreign taxes paid by the trust can be credited against the German income tax under the precondition that the beneficiary would be entitled to the same treatment if he or she received the earnings directly. If earnings have been taxed under this tax regime and will be distributed at a later stage, these distributions will not be taxed again.

Individuals who are tax resident in Germany and who are beneficiaries of a trust have to observe the following specific features (requirements?):

  • Whether trusts are classified as transparent or in-transparent is sometimes not easy to determine. Trust deeds often reserve certain of above mentioned rights to the beneficial owner but deny others. The most important criterion should be the revocability of the trust. However, in cases like this there remains a legal uncertainty.
  • In general (but not in all cases) it is more tax beneficial for beneficiaries of a trust who are tax resident in Germany to treat the trust as a transparent entity. This avoids the unwanted gift tax on payments to the beneficiary. However, income taxation of the trust’s income attributable to a beneficiary who is tax resident in Germany cannot be avoided under any circumstances.
  • The punitive tax legislation may violate European freedom rights (especially the right of free movement of capital). However, beneficiaries will be forced to seek their right in front of fiscal courts and this has an uncertain outcome.
  • If transactions will be subject to both US and Germany tax it is necessary to check whether the tax of one country can be credited against the tax of the other country.

Author: Peter Scheller, German tax adviser, Master of International Taxation

Bildquelle: www.fotalia.com

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