Changes to treaty override provision may affect taxation of foreign persons with interests in German partnerships

Recent changes to the tax treaty override rules could trigger potential taxation of reorganizations and other transactions involving German partnerships with foreign individual or corporate partners.

Legislation from July 2014 has amended and extended a treaty override provision introduced in June 2013 (section 50i of the Income Tax Act) that may apply to German partnerships with partners that are considered resident abroad under an applicable tax treaty. The revised rules potentially could trigger taxation of reorganizations and other transactions involving German partnerships with foreign individual or corporate partners that otherwise could be carried out on a tax-neutral basis.

By way of background, the German tax authorities previously treated any partnership earning trade income for German tax purposes - including partnerships with deemed trade income - as earning business profits for tax treaty purposes, which generally would be subject to tax in Germany. However, Germany’s federal tax court has ruled that deemed trade income does not qualify as business profits for treaty purposes, so the new legislation was introduced to specifically address cases involving the exit of a partner from Germany.

Under the tax authorities’ former understanding and application of tax treaties, exit taxation of an individual (or a corporation) giving up tax residence in Germany could have been avoided if assets otherwise subject to exit taxation, including shares in corporations, were transferred to a German partnership earning deemed trade income at book value. In these cases, the tax authorities assumed that an ongoing right of taxation continued to exist regarding current income and capital gains derived from the assets or shares transferred to the partnership and, therefore, no exit taxation applied. Although exit taxation cannot be imposed retroactively, the introduction of the treaty override provision was intended to ensure future taxation in Germany of income derived from the transferred assets, regardless of whether the other contracting state is allocated taxation rights under the applicable tax treaty.

The treaty override provision potentially has broad applicability and may have a significant tax impact. It applies to any partnership with partners (individuals or corporations) resident in a treaty partner state, regardless of whether the partners have exited Germany in the past. The only requirements to apply the provision are that there must have been a transfer of assets to the partnership at book value before June 29, 2013, and the partnership must earn deemed trade income (which could be the case if the partnership only partially earns trade income, i.e. it has assets that are not functionally related to a business and a German permanent establishment under the terms of the treaty). If these requirements are satisfied, any current income and capital gain derived from the assets formerly transferred to the partnership at book value are taxed in Germany, even if the applicable treaty did not allocate taxing rights to Germany.

Under the recent amendments and the extension of the treaty override provision, reorganizations and certain other transactions carried out after December 31, 2013 can no longer be carried out on a tax-neutral basis at book value, but instead must be carried out at market value, which will trigger taxation in Germany. This would be the case if, under the circumstances mentioned above, an asset that was transferred to the partnership at book value in the past (i.e. before June 29, 2013) is part of a reorganization or transaction involving a bundle of assets, e.g. a viable business, the partnership’s entire business or all (or part) of a partnership interest. The following transactions may be subject to the rule:

• Reorganizations covered by the Reorganization Tax Act;
• Transfers of assets between the partnership and a partner, or between
  different businesses of a partner;
• Conversions of a deemed trade business into an operating trade business;
  and
• Gratuitous transfers of a business or all (or part) of a partnership interest.

In these cases, the amended treaty override provision may apply even if the entire transaction is not carried out at book value. Taxation is not limited to the assets formerly transferred at book value and applies to all partners, both resident and nonresident.

There currently are many uncertainties and questions regarding application of the amended treaty override provision. Therefore, its potential impact should be analyzed carefully before any reorganization or transaction involving a German partnership with foreign partners.