How the U.S.-Germany Tax Treaty Affects Your Taxes

The United States and the Federal Republic of Germany share a bilateral income tax treaty to manage taxation for those with financial activities in both nations. Its purpose is to mitigate double taxation, where the same income is taxed by both countries. The agreement establishes guidelines for determining which country has the primary right to tax different forms of income, including employment wages, business profits, and investment returns. The treaty also includes provisions for the exchange of tax information between the U.S. Internal Revenue Service (IRS) and German tax authorities to prevent tax evasion.

Determining Residency for Treaty Purposes

The U.S.-Germany tax treaty first defines who qualifies as a “resident of a Contracting State” to determine eligibility for its benefits. A person is considered a resident of a country if they are liable for tax there based on factors like their domicile, place of residence, or place of management. This definition can result in an individual being classified as a resident of both the United States and Germany under their respective domestic laws, creating a dual-residency situation.

To resolve this, the treaty establishes a sequence of “tie-breaker” rules to assign a single country of residence for tax purposes. The first test is the “permanent home” rule. An individual is deemed a resident of the country where they have a permanent home available to them.

If an individual has a permanent home in both countries, the next test is the “center of vital interests.” This analysis examines where the person’s personal and economic ties are closer. Factors considered include family and social relationships, occupation, political and cultural activities, and place of business.

Should the center of vital interests be unclear or if the individual has no permanent home in either country, the “habitual abode” test is applied. This test looks at where the individual spends more time. If residency cannot be determined by this measure, the final tie-breaker is citizenship.

Taxation of Specific Income Types

Pensions and Annuities

The treaty sets specific rules for the taxation of retirement income. For private pensions and similar remuneration, the income is taxable only in the recipient’s country of residence. This means a U.S. resident receiving a pension from a German company would only pay U.S. tax on that income.

A similar rule applies to social security benefits. Payments made under the social security legislation of one country to a resident of the other are taxable only in the country of residence. For example, U.S. Social Security benefits paid to a person residing in Germany are subject to tax only in Germany.

Income from Employment

Income from employment is taxed in the country where the work is physically performed. The treaty, however, provides an exception commonly known as the “183-day rule,” detailed in Article 15. Under this provision, employment income is taxable only in the individual’s country of residence if three specific conditions are met.

The first is that the employee must be present in the other country for a period not exceeding a total of 183 days in any twelve-month period. Second, the remuneration must be paid by an employer who is not a resident of the other country. Third, the remuneration must not be borne by a “permanent establishment,” such as a branch or office, which the employer has in the other country.

Dividends and Interest

The treaty provides for reduced tax rates on dividends and interest to prevent excessive taxation at the source. For dividends paid by a company in one country to a resident of the other, the treaty limits the withholding tax that the source country can impose. The rate is capped at 15% for portfolio investors.

A lower rate of 5% applies to “direct dividends,” which are dividends paid to a company that owns at least 10% of the voting shares of the paying company. For interest income, the treaty provides for a 0% withholding rate. This means that interest arising in one country and paid to a resident of the other country is taxable only in the recipient’s country of residence.

Capital Gains

The taxation of capital gains under the treaty depends on the type of asset sold. Gains from the sale of personal property are taxable only in the seller’s country of residence. This applies to assets like stocks and bonds, meaning a German resident selling U.S. stocks would only be taxed on the gain in Germany.

The primary exception to this rule is for gains derived from the sale of real property. The treaty allows the country where the real property is located to tax any gains from its sale. This means if a resident of Germany sells a vacation home located in the United States, the U.S. has the primary right to tax the capital gain.

Government Service

Special rules apply to income earned from government service. Wages, salaries, and similar payments, including pensions, paid by one of the countries for services rendered to that government are taxable only by that paying country. For instance, a salary paid by the German government to one of its employees working at a consulate in the U.S. would be taxable only by Germany.

There is an exception to this rule. If the services are rendered in the other country by an individual who is a resident and a citizen of that other country, the income is taxable only in that country.

Relief from Double Taxation

When both the U.S. and Germany have a right to tax the same income under the treaty, specific mechanisms are used to provide relief from double taxation. The approach used depends on the country of residence and the type of income involved.

United States Method

The United States primarily uses the foreign tax credit to alleviate double taxation for its citizens and residents. Under this system, a U.S. taxpayer can claim a credit against their U.S. income tax liability for income taxes paid to Germany on foreign-source income. This credit, calculated on Form 1116, Foreign Tax Credit, directly reduces the U.S. tax bill.

Germany Method

Germany employs both the exemption method and the credit method. For certain types of income, such as employment income earned by a German resident in the U.S. that meets specific treaty conditions, Germany will exempt that income from its tax base. For other income types, like dividends or interest received from the U.S., Germany will allow its residents to credit the U.S. tax withheld against their German tax liability.

Information Needed to Claim Treaty Benefits

To claim benefits under the U.S.-Germany tax treaty, taxpayers must disclose their position to the IRS by completing Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). This form is required for taxpayers asserting that a treaty provision overrides or modifies the Internal Revenue Code, resulting in a reduction of their U.S. tax. Failure to disclose a treaty-based position can result in a penalty.

When preparing Form 8833, a taxpayer must provide specific details. This includes citing the U.S.-Germany tax treaty and the particular articles being relied upon. The form also requires a summary of the facts supporting the claim and an explanation of the treaty-based position. For example, a taxpayer claiming an exemption under the 183-day rule would need to state the relevant facts, such as days of presence and employer details.

How to Claim Treaty Benefits on Your Tax Return

The completed Form 8833 must be attached to the annual tax return for the year the treaty position is taken. The method of submission depends on whether the return is filed electronically or by mail.

For individuals, Form 8833 is attached to their U.S. tax return, such as Form 1040 for U.S. citizens and residents or Form 1040-NR for non-resident aliens. When filing a paper return, the form should be physically attached. If filing electronically, tax software will provide instructions for attaching the form.