By Christian Ehlermann and Mike Neuschel

The German Federal Tax Court (BFH) recently ruled on the tax treatment of loans granted by a U.S. resident partner of a German limited partnership (KG) to the partnership. According to the BFH, the interest income of the U.S. resident partner may not be taxed as partnership income in Germany, but instead constitutes interest income that may be taxed only in the U.S. under the Germany-U.S. tax treaty.

The BFH overturned a decision of the lower tax court of Baden-Wuerttemberg, according to which the loan receivable would be part of the partner’s special business assets and the resulting interest income would be deemed trading income from the partnership. According to the BFH, however, the obligation between the partner and its partnership also is recognized from a civil law and a tax perspective and the relevant payments constitute interest income under the treaty definition. This view is not changed by the principles set forth in the subject-to-tax clause in the protocol to the 1989 Germany-U.S. treaty (in effect at the time) or by other technical explanations to the treaty.

The BFH’s view on the taxation of loans granted by a U.S. resident partner to the German partnership should apply under the treaty with the U.S., as amended by the revised protocol that entered into effect as from 1 January 2007 (for withholding taxes) and 1 January 2008 (for all other aspects). The principles of the BFH decision also should apply to royalty payments from a German partnership to its U.S. partners. Similar to the treatment of interest payments, there should be no German taxing rights on royalty payments from a partnership to its U.S. partners. It remains to be seen how the German tax authorities will react to this decision because they only recently published draft guidance on the tax treatment of partnerships in a cross-border context in which they take a position deviating from the recent BFH decision.

If the German partnership is treated as a transparent entity from a U.S. tax perspective, the loan between the German partnership and its U.S. resident partner should be disregarded for U.S. tax purposes and the interest payments from the German partnership should neither be taxed in Germany nor in the U.S. If the German partnership is “checked” from a U.S. tax perspective, the interest is taxable income in the U.S. In such a scenario, the new BFH decision should help to avoid any double taxation issues on this interest income.

Contrary to the draft technical explanations on the new German earnings stripping rules that exclude interest payments from a partnership to its partners from the application of the interest expense limitation rules, it should be assumed that, if the interest expense on such a loan is not treated as special business income of the partnership, the interest expense may be limited by the new earnings stripping rule if no other exception applies (so that deductible interest expense should be limited to 30% of tax EBTIDA).

For additional alerts, visit the Global Tax Alerts archive.