In its decision of 19 May 2010 (case reference: I R 75/09), the Federal Tax Court (BFH) held that, under the Germany-U.S. tax treaty, the exemption method applies to interest payments made to a German resident on a profit participating loan. The tax authorities have now published guidance on this decision.
The case involved a pool of investors consisting of 25 German resident persons who granted a profit participating loan to U.S.-based F-Inc. F-Inc. used the funds to acquire a sub-prime leasing portfolio by taking over subordinated tranches of a securitization transaction. Interest payments made to the German creditors were deductible as business expenses at the level of F-Inc. The German tax office took the position that the interest payments were, in principle, taxable at level of the creditors.
The BFH noted that interest payments on profit participating loans are covered by the dividend article (article 10) in the treaty. Article 10(5) allows the source state to tax such interest payments if the interest is deductible at level of the debtor, which was actually the case. In its decision, the BFH ruled that interest payments on profit participating loans, even though generally covered by article 10, do not fall within the scope of the credit method in article 23 rule but rather than under the general rule providing for the exemption method. Thus, because the attribution of profits from the interest payments to the Germany-based investors was in contradiction to the treaty, the BFH decided in favor of the claimant.
The German Ministry of Finance (BMF) reported on the decision in official guidance published on 28 February 2011 (IV B 5 - S 1301-USA/10/10006), which is to be published in the Federal Tax Gazette and pointed out that, under the 2006 version of the Germany-U.S. treaty, the credit method rather than the exemption method applies if the interest payments are not taxed in the hands of the recipients under U.S. tax law.
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