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The United States and Germany Amend Reciprocal Tax Treaty

LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PHILADELPHIA PHOENIX SACRAMENTO SILICON VALLEY TALLAHASSEE TOKYO TYSONS CORNER WASHINGTON, D.C. WEST PALM BEACH ZURICH ____________________ Strategic Alliances with Independent Law Firms* BRUSSELS

June 2006

LONDON MILAN ROME TOKYO

GREENBERG TRAURIG, LLP | ATTORNEYS AT LAW | WWW.GTLAW.COM

Gute Dinge bekommen diejenigen, die warten! (Goods things come to those who wait!) During my tenure with Deutsche Bank, I once attempted to begin a presentation by thanking my colleagues, in German, for the opportunity to speak to the assembled group. An English-speaking attendee promptly asked a German-speaking attendee what I had said. The quick-minded German attendee responded that he’d let his colleague know as soon as I said something in a language that resembled German. Well, the good news is that one doesn’t have to a have fluency with the German language in order to appreciate the changes made to the 1989 U.S.-Germany Income Tax Treaty (the “Treaty”)1 by the new Protocol signed on June 1, 2006 in Berlin. This GT Alert provides an outline of how certain business and capital market provisions of the 2006 Protocol affect the Treaty and cross-border U.S.-German transactions. The 2006 Protocol is itself accompanied by a protocol (which we’ll call a “Joint Explanation” to avoid confusion). Effective Dates The 2006 Protocol is not immediately effective but, most likely, will have retroactive effect. •

Withholding Taxes (on Dividends). The new withholding rate regime is effective as of January 1 of the year in which the Protocol is ratified by both countries. For example, if the Protocol is ratified in December 2006, the new withholding rules would apply as of January 1, 2006.

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Other Income and Capital Taxes. The other income and capital tax provisions are effective as of January 1 of the year following the year in which the Protocol is ratified by both countries.

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Election to Defer Effective Date. If a person would be adversely affected by the Treaty as amended by the Protocol, relative to its position under the existing Treaty, such person may elect to defer the application of the Protocol for 12 months.

The Permanent Establishment Provisions Article 7 of the Treaty contains limitations on when the business profits of a person in one country may be taxed in the other country. In general, such profits can be taxed only when the person carries on business in the other country through a so-called “permanent establishment” (a “PE”). The Protocol amends Paragraph 3 of Article 7 to specifically state that “executive and general administrative expenses” will be deductible in computing net income attributable to PE, regardless of where incurred. Accordingly, the Treaty now specifically provides that home office expenses incurred by a German bank in running its U.S. branch are deductible in determining its U.S. taxable income (and vise versa). In the Joint Explanation, the governments made clear that the principles contained in the OECD Transfer Pricing Guidelines will apply for the purpose of attributing profits to a PE. (Similar rules apply to the U.S. treaties with the United Kingdom and Japan.) In addition, equity capital will be attributed to financial institutions based “upon the amount of capital that it would need to support activities if it were a distinct and separate enterprise engaged in the same or similar activities.” Capital may be risk-weighted if the institution risk-weights its capital in the ordinary course of its June 2006

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trade or business. This “color” on the amount of capital that will be attributed to financial institutions poses very current and interesting questions regarding U.S. regulatory rules regarding capital imputation.2 Taxation of Dividends Article 10 of the Treaty, addressing the taxation of dividends received by a resident of one country from stock issued by a company that is resident of the other has been completely rewritten. Here’s a summary of the new rules: •

Payee holds less than 10% of the voting stock of the issuer. The withholding rate is 15%.

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Payee holds at least 10%, but less than 80%, of the voting stock of the issuer. withholding rate continues to be 5%.

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Payee is a company directly holding at least 80% of the voting stock of the issuer for the 12 months preceding the dividend record date. The withholding rate is zero if one of four additional “limitation on benefits” requirements is met. These tests include that the principal class of the recipient’s shares is primarily traded on a stock exchange in the recipient’s home jurisdiction, the recipient’s primary place of management is in the recipient’s home jurisdiction or at least 50% of the vote and value of the recipient’s stock is owned by 5 or fewer companies meeting either the trade or management test. Eligible recipients also include companies (i) 95% or more of the vote and value of whose shares are held by 7 or fewer persons who are entitled to equivalent benefits under another treaty and (ii) that pay less than 50% of their gross income to persons who are not eligible for equivalent benefits under another tax treaty.

The

NOTE: If the dividend is being paid by a German subsidiary to a U.S. parent, Germany will not look-through partnerships or limited liability companies (even if they are check-the-box nothings for U.S. purposes) in determining if the 80% directly owned test is met. Vise versa, however, the U.S. should allow a German dividend recipient to look-through a check-the-box nothing. •

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Dividends Paid to a Pension Fund. Dividends paid to a pension fund are now tax-exempt, provided that the dividends are not derived from the conduct of a trade or business. In the context of similar rule under the U.S.-Netherlands Treaty, the U.S. Treasury Department has stated that this rule incorporates the full “unrelated business taxable income” (“UBTI”) regime under U.S. law. The UBTI rules treat debt-financed dividends as taxable income to a pension, in proportion to the amount of debt-financing. The new Protocol exemption for pensions does not apply to REIT dividends.

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Real Estate Investment Trust Dividends. In general, the lower withholding tax rates do not apply to dividends paid by real estate investment trusts (“REITs”). REIT dividends are eligible for the 15% rate, however, if one of three tests is met: 1. The recipient is an individual who own 10% or less of the REIT; 2. The stock paying the dividend is publicly-traded and the recipient holds 5% or less of any class of the REIT stock; or 3. The recipient holds not more than 10% of the REIT and the REIT is diversified. A REIT is diversified if no single interest in real property constitutes more than 10% of its total real property interests. The Joint Explanation provides that if and when Germany exempts REITs from taxation, U.S. pension funds will not be able to claim a blanket exemption from German withholding taxes on German REIT dividends.

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Mutual Fund (a/k/a regulated investment companies or “RIC”) Dividends. Pension funds may receive RIC dividends free from withholding taxes imposed by the other country, subject to the rules described in Sections A, B and C above. In addition, RIC dividends are eligible for the 15% rate (in lieu of the normal 30% rate that would apply under U.S. law), but not the 5% rate.

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Branch Profits Tax. The Protocol contains a complex branch profits tax provision. Under this provision, no branch profits tax is imposed on any corporation if the principal class of the corporation’s shares is primarily traded on a stock exchange in the corporation’s home jurisdiction, the corporation’s primary place of management is in the corporation’s home jurisdiction or at least 50% of the vote and value of the corporation’s stock is owned by 5 or fewer companies meeting either the trade or management test. In addition, a corporation is exempt if (i) 95% or more of the vote and value of whose shares are held by 7 or fewer persons who are entitled to equivalent benefits under another treaty and (ii) it pays less than 50% of its gross income to persons who are not eligible for equivalent benefits under another tax treaty. In clearer words, if the affected corporation could have received a direct dividend free from withholding tax if the branch were a subsidiary, no branch profits tax is imposed. Other exemptions apply as well. If a corporation is not exempt, branch profits tax is limited to the dividend equivalent amount of gains from dispositions of real and immovable property (FIRPTA gains). In any event, generally the amount of branch profits tax will be limited to 5%.

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Indirect Foreign Tax Credits. When a U.S. corporation holds at least 10% of the voting stock of a non-U.S. corporation, it may claim an indirect foreign tax credit for taxes imposed on the foreign corporation when dividends are paid by the foreign corporation to the U.S. shareholder.3 (Code § 78 provides the fiction that the actual amount of the dividend is increased by the taxes imposed on the paying corporation.) The Protocol specifically provides that the German capital tax (Vermogensteuer) is not a creditable tax. The Joint Explanation states that regardless of future changes in U.S. tax, German taxes are to remain creditable taxes for U.S. tax purposes.

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Interest Two changes are made to the taxation of interest income. •

Contingent/Participating Interest. U.S. debtors generally can pay interest to non-U.S. persons free from U.S. tax under the so-called portfolio interest rules. Portfolio interest, however, does not include interest that is determined with reference to the cash flow, sales, receipts, income, profits or changes in value of the debtor or an affiliate of the debtor.4 Many tax treaties providing for a zero withholding tax rate on interest do not treat participating or contingent interest differently than index-based or fixed rate interest. The result is that participating interest can be paid free from withholding tax under such a treaty. The Treaty, as amended by 2006 Protocol (Art. 10(6)), however, provides special rules for participating or contingent interest: 1. If the participating or contingent interest would not qualify as portfolio interest and 2. Such participating interest or contingent interest is deductible in the U.S. then, neither of the interest nor dividend provisions of the Protocol apply and the participating or contingent interest could be subject to the default 30% withholding tax regime.

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REMIC Excess Inclusion Income. Real estate mortgage investment conduit (“REMIC”) residual interests pose thorny tax challenges for U.S. taxpayers because the income generated by these securities acts as a floor on their taxable income.5 Certain taxpayers have placed REMIC residuals with foreign subsidiaries and non-U.S. branches.6 (In general, the REMIC phantom income is not taxable in Germany or other foreign countries, although such countries could tax it.) As a result, these taxpayers have argued that the REMIC residual income is foreign-source income and can be sheltered by foreign tax credits (FTCs).7 The 2006 Protocol prohibits this strategy with respect to Germany by specifically providing that REMIC residual income may be taxed by the “United States in accordance with its domestic rules.”

Unique Dispute Resolution Provision Included When a taxpayer has a tax dispute in a country that has tax treaty with another and the dispute relates to the application of the treaty, the taxpayer may seek resolution by asking “Competent Authorities” of both countries to provide a solution that addresses the issue in both jurisdictions. Competent Authority proceedings have been notoriously slow and ineffective. The 2006 Protocol contains – for the first time in a tax treaty to which the United States is a party -- a binding arbitration provision to resolve such disputes. The binding arbitration provisions apply to the issue as whether a permanent establishment exists, the amount of profits to be attributed to a permanent establishment and royalty rates. Here’s an overview of how the binding arbitration provisions will work: •

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The taxpayer must have filed tax returns for at least one year in either Germany or the U.S.

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The U.S. and Germany must not have agreed, before arbitration, that the issues involved are not suitable for arbitration.

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The arbitration will not begin before the earliest of (i) two years after the date upon which the taxing authorities of both countries have received all information necessary for a determination and (ii) the taxpayer has agreed to a confidentiality agreement with respect to the proceedings.

One arbitrator is picked by the U.S., one by Germany and the third by two so chosen (or the OECD if the two arbitrators cannot agree on the third). Only time will tell if the binding arbitration provision provides any benefit. It is quite possible that if an issue is so thorny that Competent Authority proceedings cannot provide a solution, that one or other taxing authorities will stand in the way of allowing the issue to be resolved by arbitration. Updated Limitation on Benefits (“LOB”) Provision When the U.S.-Germany Tax Treaty was negotiated in 1989 (it was ratified in 1991), it was one of the first U.S. tax treaties to contain a LOB provision. In general, LOB provisions prohibit the practice of treaty shopping by requiring a substantial nexus between the company claiming treaty benefits and the country that is the party to the tax treaty. Since that time, the U.S. has negotiated LOB provisions with most of the countries with which it has a tax treaty. The LOB provision in the Treaty, as amended by 2006 Protocol, generally follows the more updated U.S. model but, of course, has its own special provisions. •

Public Trading Test. A company is entitled to the benefits of the Treaty as amended by the Protocol if its principal class of shares is primarily traded on a recognized stock exchange where the company is resident. Note: In every other Treaty between the U.S. and a European Union member, the company’s shares need only be traded on a recognized EU or EEA stock exchange.

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Place of Management. A company is entitled to the benefits of the Treaty as amended by the Protocol if its principal class of shares is regularly traded on a recognized stock exchange (any German stock exchange or the NSDAQ or any SEC registered stock exchange) and its primary place of management and control is in either the U.S. or Germany. The Protocol specifies that the management and control of a company occurs where its “executive officers and senior management employees exercise day-to-day responsibility for . . . strategic, financial and operational policy decision making for the company.”

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Subsidiaries. If at least 50% of the vote and value of the company is owned by 5 or fewer companies meeting the Trading Test, it is entitled to the benefits of the Treaty as amended by Protocol.

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Pensions. A pension organized in either the U.S. or Germany is entitled to the benefits of the Treaty if either more than 50% of its beneficiaries are either U.S. or German individuals or the sponsor of the pension is entitled to the benefits of the Treaty as amended by the Protocol.

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Base Erosion/Trading Test. A company is entitled to the benefits of the Treaty if, for at least half of the year, at least 50% of each class of its shares are owned by U.S. or German individuals, a company that meets the Trading Test (or certain other criteria) and less than 50% of its gross income is paid or accrued in the form of deductible payments to persons who are not residents of the country in which the payor is resident.

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Equivalent Benefits Test. If a U.S. or German company fails to qualify under any of the above tests, it will still be eligible for benefits under the Treaty as amended by the Protocol if: 1. At least 95% of the vote and value of its shares are owned, directly or indirectly, by 7 or fewer persons who are equivalent beneficiaries;8 and 2. Less than 50% of the company’s gross income is paid or accrued in the form of deductible payments to persons who are not equivalent beneficiaries.

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Active Trade or Business Test. If a person fails the above tests for Treaty eligibility, it will be entitled to the benefits of the Treaty, as amended by the Protocol for a particular item of income if it is engaged in the active conduct of a trade or business in its home jurisdiction and the person derives such item of income in connection with that trade or business. For companies that do business in both the U.S. and Germany, the amount of activity conducted in the company’s resident jurisdiction must be substantial in relation to the business undertaken in the other country.

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Special Rules for Income Derived from a Branch Located in a Third Country. If a German company maintains a branch in a third country and income is paid to the branch located in the third country, the Treaty, as amended by the Protocol, will not apply to an item of income unless the combined tax rate (German and branch country) on that item of income is at least 60% of the rate that would have applied if it had been paid directly to Germany. (The reverse is likewise true for U.S. companies with third country branches.) If an item of income becomes ineligible for Treaty benefits because of this rule, and such item is dividends, interest or royalties, the maximum tax rate applicable from the source country is 15%. These rules do not apply if the item of income is derived from the active conduct of a trade or business conducted in the third country.

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Pass-Through Entities. Payments made to partnerships and other fiscally-transparent entities, such as check-the-box entities, are eligible for Treaty benefits only to the extent that the partners are eligible for Treaty benefits.

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1

The full title of the Treaty is the “Convention Between the United States and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and to Certain Other Taxes.” For obvious reasons, we’ll just call it the “Treaty” in text. This Treaty took effect on August 21, 1991. The 2006 Protocol completely supersedes and replaces a 1991 Protocol.

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For additional background on this issue, see Leeds, “Revisiting U.S. Taxation of Global Banking: NatWest II and Its Implications for Foreign Bank Branches,” Derivatives: Financial Products Report (Vol. 5, No. 5) (January 2004). 3

See sections 78 and 902 of the Internal Revenue Code of 1986, as amended (the “Code”).

4

See Code § 871(h)(4).

5

See Code § 860E(a).

6 It is worth pointing out that the ability to place REMIC residuals in the hands of foreign persons is extremely limited. See Treas. Reg. § 1.860G-3. 7

For more information on this topic in connection with 2006 tax planning, see Leeds, Melnick and Friedman, 2006 Federal Tax Provisions Affecting Business and the Capital Markets (June 2006) (http://www.gtlaw.com/pub/alerts/2006/0602.pdf) 8

Equivalent beneficiaries means a resident of the EU or NAFTA and is entitled to equivalent benefits under a tax treaty.

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This Alert was written by Mark Leeds in the New York office. Please contact Mr. Leeds at 212.801.6947, or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this GT Alert. Albany 518.689.1400

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