The Federal Tax Court (BFH) recently published a decision relating to the tax treaty characterization of royalties paid by a German partnership to its U.S. resident partner (case reference I R 74/09). The partnership conducted its business through a permanent establishment (PE) in Germany and was involved in the sale of the products of its U.S. partner in Germany. The partnership and the U.S. partner had agreed on a royalty in exchange for permission to sell the products of the U.S. partner and the use of the U.S. partner’s brand.
According to the Germany-U.S. tax treaty, such payments generally qualify as royalties and the right to tax royalty payments received by a U.S. resident is allocated to the U.S. The treaty, however, does not specifically address situations where royalties are paid by a partnership to its nonresident partner. Following a taxpayer favorable decision of the BFH in 2007 (see GTLN 3/2008), according to which interest payments made by a German partnership to its U.S. partner were exempt from German tax, the German tax rules were amended in the 2009 Annual Tax Act (see GTLN 11/2008). Under the amended rules, expenses for services, interest paid on loans, payments for the use of assets, etc. made by a partnership to its foreign partners are treated as business income under the applicable tax treaty in both inbound and outbound situations. In inbound situations, this leads to the partner’s income being subject to tax in Germany. This law change was to apply to all cases that were still open for review by the tax authorities at the time the amendment became effective, and based on this rule, the tax authorities included royalty income in the partnership income of the nonresident partner and subjected it to German tax.
The BFH has now held that even if the amended rule applied to the case decided, the right to tax these payments would still be allocated to the U.S. because under the treaty, business income of a U.S. resident is taxable in Germany only if it is allocated to a German PE. The BFH considered the German partnership as establishing a PE of its U.S. partner in Germany, but did not allocate the royalties to the PE. For treaty purposes, the royalties would be allocated to the German PE only if there is a functional relationship to the PE. Since the royalties were based on rights that were managed and marketed in the U.S., this would not apply in the case.
It is not yet clear how the tax authorities will react to this decision and/or whether they will push for a legislative change to address the BFH decision.
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