Germany-US Tax Treaty: Avoiding Double Taxation

The tax convention between the United States and Germany aims to prevent double taxation for individuals and entities with financial ties to both countries. The agreement achieves this by establishing rules that assign the primary right to tax specific income to either the source country (where income is generated) or the residence country (where the recipient lives). This framework provides a predictable system for taxpayers and is designed to foster economic activity and investment between the nations. The treaty also includes provisions for cooperation in preventing tax evasion.

Determining Residency Under the Treaty

A person’s obligations under the treaty depend on their residency status. Both the U.S. and Germany have domestic laws for determining tax residency. For the U.S., this includes the Green Card test and the Substantial Presence Test. Germany’s rules are based on having a domicile or habitual abode within its borders.

An individual can be considered a resident of both countries simultaneously under their respective laws, creating a “dual-resident” scenario. To resolve this, the treaty provides a sequence of four “tie-breaker” tests to assign a single country of residence for treaty purposes. The tests are applied in order until one determines residency.

• Permanent Home: If the individual has a permanent home available in only one country, they are a resident of that country. If they have a home in both, the next test is used.
• Center of Vital Interests: This test identifies where the person’s personal and economic ties, such as family and business activities, are closer.
• Habitual Abode: If the center of vital interests cannot be determined, this test looks at the country where the person spends more time.
• Citizenship: If the previous tests are inconclusive, the individual is considered a resident of the country of which they are a citizen. If they are a citizen of both or neither, the authorities of the U.S. and Germany settle the issue by mutual agreement.

The Saving Clause and Its Exceptions

A provision of the Germany-US tax treaty is the “Saving Clause.” This clause allows both the United States and Germany to tax their own residents and citizens as if the treaty did not exist. For U.S. citizens, this means that even if they live in Germany, the U.S. government retains its right to tax their worldwide income based on citizenship.

The Saving Clause prevents a country’s own citizens from using the treaty to claim benefits intended for residents of the other country. However, the clause has several exceptions that specify certain treaty articles that remain in effect, allowing citizens to claim specific benefits. For instance, the article governing Social Security benefits is excluded from the Saving Clause, which allows the treaty’s rule on Social Security taxation to prevail and prevent double taxation on that specific income.

How Specific Income is Taxed

The treaty establishes distinct rules for different categories of income, assigning the primary taxing right to either the source or residence country.

Pensions and Social Security

Retirement income rules vary by type. Private pensions are taxable only in the individual’s country of residence. A resident of Germany receiving a private pension from a U.S. source would only pay German tax on that income.

Pensions for government service are taxed by the country that pays the pension. A pension paid by the U.S. government to a former federal employee living in Germany would be taxable by the United States.

Social Security benefits are taxable only in the recipient’s country of residence. As an exception to the Saving Clause, a U.S. citizen in Germany receiving U.S. Social Security is taxed in Germany, not the U.S.

Dividends and Interest

The country of residence has the primary right to tax dividends and interest, but the source country may also levy a tax at a reduced rate. The withholding tax on dividends paid to a resident of the other country is limited to 15%. This rate is reduced to 5% if the owner is a company holding at least 10% of the voting stock. For certain dividends, such as those paid to a qualifying pension fund, the withholding tax may be eliminated entirely.

For interest income, the treaty is more favorable. Interest is taxable only in the recipient’s country of residence, meaning there is a 0% withholding tax at the source.

Capital Gains

The taxation of capital gains depends on the asset type. Gains from selling immovable property, like real estate, are taxed in the country where the property is located. For example, the U.S. has the primary right to tax gains from a U.S. property sold by a German resident.

Gains from selling movable property, such as stocks and bonds, are taxable only in the seller’s country of residence. This rule simplifies the tax situation for investors with portfolios in the other country.

Income from Employment and Self-Employment

Income from employment, addressed in Article 15, is taxable only in the employee’s country of residence, unless the employment is performed in the other country. In that case, the country where the work is performed may tax the income.

However, this income is exempt from tax in the source country under the “183-day rule” if three conditions are met. The first is the employee is present in the source country for 183 days or less in a twelve-month period. The second is the employer is not a resident of the source country. The third is the pay is not borne by a permanent establishment that the employer has in the source country.

For self-employment income, a similar principle applies, where income is taxed in the residence country unless the individual’s activities are performed through a permanent establishment in the other country.

Methods for Eliminating Double Taxation

The treaty provides mechanisms for the country of residence to prevent double taxation after determining which country has the primary right to tax. The United States and Germany use different primary methods to provide this relief.

The United States uses the foreign tax credit. When a U.S. citizen earns income that is taxed by Germany, the U.S. still taxes that person’s worldwide income. To prevent double taxation, the U.S. allows a credit against U.S. income tax for the taxes paid to Germany. For example, if the German tax on employment income is $15,000 and the U.S. tax on that same income would have been $12,000, the foreign tax credit would eliminate the U.S. tax liability on that income. The credit is subject to limitations to ensure it only offsets U.S. tax on foreign-source income.

Germany uses the exemption method. When a German resident earns income that the treaty allows the U.S. to tax, Germany will exempt that income from its own taxation. This method is often applied as “exemption with progression.” While the U.S.-source income is exempt, its amount is still taken into account when determining the tax rate that will be applied to the resident’s other German-taxable income, which can result in that income being taxed at a higher rate.

Claiming Treaty Benefits

Claiming treaty benefits requires specific procedural steps, as taxpayers cannot assume these benefits will be applied automatically. They must file the correct forms and disclose their treaty-based positions to the respective tax authorities.

For U.S. tax returns, Form 8833, Treaty-Based Return Position Disclosure, is required whenever a taxpayer takes a position that their U.S. tax liability is reduced or altered because of the treaty. The form requires explaining the basis for the claim and citing the specific treaty article being relied upon.

Filing Form 8833 is not required for every treaty benefit, such as claiming a reduced rate of withholding tax on dividends. When claiming the foreign tax credit, taxpayers use Form 1116, Foreign Tax Credit, which is attached to the Form 1040 tax return.

In Germany, the process involves declaring foreign-source income on the annual German income tax return. To claim the exemption method for U.S.-source income, a German resident would report this income on a specific schedule, “Anlage AUS,” and must provide documentation to substantiate their claim.