DOUBLE TAXATION AND U.S. CITIZENS IN GERMANY
by Dagmar Gessner Gaspar and Michael Koehler, KPMG, Frankfurt

A U.S. citizen who establishes residency in Germany will be taxed by Germany on his or her worldwide income. Germany will tax the expatriate’s compensation and most types of investment income even if earned outside Germany. As a U.S. citizen, the expatriate is also liable for tax on his or her worldwide income in the U.S. under the provisions of the U.S. Internal Revenue Code (IRC).

Foreign Tax Credits
According to the IRC, relief from double taxation through the foreign tax credit rules is granted only with respect to income from sources outside the U.S. Absent special provisions of a treaty, generally no foreign tax credit is available on U.S.-source income taxed by a foreign country. Germany, on the other hand, will not allow an exemption from tax or a credit for foreign taxes incurred on income for which the primary right of taxation has been given to Germany as the country of residence under an income tax treaty.

Consequently, Germany will not allow a credit for U.S. taxes incurred by a U.S. citizen on U.S.-source income if, under the U.S.-Germany income tax treaty, the primary right of taxation has been given to Germany as the country of residence. At the same time, the foreign tax credit rules of the IRC limit the ability to utilize a credit for German taxes incurred on such U.S.-source income.

Mechanisms for Avoiding Double Taxation
Several mechanisms exist for avoiding the double taxation described above, the main one being the re-sourcing provisions under Article 23 (3) of the U.S.-Germany income tax treaty. Pursuant to Article 23 (3) of the U.S.-Germany income tax treaty, the U.S. will treat U.S.-source income earned by a U.S. citizen residing in Germany as though it was derived from German sources. Consequently, the U.S. will allow a foreign tax credit for such income to the extent that German tax is actually imposed on such income in accordance with the treaty.

Relief May or May Not Be in Sight
Below are several examples of when Germany will tax U.S.-source income without relief or limited relief for U.S. tax incurred on such income by a U.S. citizen.

  • One of the most common situations involves U.S. assignees who reside in Germany and take business trips to the U.S. during their international assignment in Germany. The compensation allocable to the U.S. workdays is considered U.S.-source income under the IRC since the services were performed in the U.S. On the other hand, this compensation will be subject to undiminished German taxation under Article 15 of the U.S.-Germany income tax treaty if the expatriate is present in the U.S. for less than 183 days during the calendar year and the compensation is borne by a German entity or permanent establishment of a U.S. entity in Germany. To avoid the double taxation of such wages, the compensation allocable to U.S. workdays will be treated as foreign-source income on the U.S. return under Article 23 (3) of the U.S.-Germany treaty. It is important to note that the income is treated as foreign source for foreign tax credit purposes only and will not qualify for the foreign earned income exclusion under IRC Section 911.
  • Investment income is another category of income for which Germany, as the country of residence, will grant no or only limited relief for U.S. taxes incurred. Investment income includes interest income, dividend income, and capital gains distributions from certain mutual funds. Germany will tax investment income of a German resident to the extent it exceeds DM 3,100, for single taxpayers and DM 6,200, for married taxpayers filing jointly (DM 6,100, and DM 12,200, respectively for years prior to 2000) – hereinafter referred to as exclusion amount. [DM 1 = USD 0.479].
    • Under Article 11 of the U.S.-Germany treaty, the U.S. is not allowed to impose any tax on U.S.-source interest earned by a German resident, and Germany will not grant any relief for U.S. tax imposed on U.S.-source interest income earned by a U.S. citizen residing in Germany. Therefore, U.S.-source interest income in excess of the pro-rata share of the exclusion amount must be treated as foreign source income on the U.S. return.
    • The U.S. may impose a tax of 15 percent on U.S.-source dividends earned by a German resident under Article 10 of the U.S.-Germany treaty. Germany will therefore grant a credit for U.S. tax imposed on U.S.-source dividends up to 15 percent of the U.S.-source dividends subject to German tax. To the extent that the effective U.S. tax rate of the expatriate exceeds 15 percent, a portion of the U.S.-source dividend exceeding the pro-rata share of the exclusion amount must be partially treated as foreign source on the U.S. return to limit the U.S. tax imposed to 15 percent of the dividend taxable in Germany.
    • Germany treats capital gains distributions from mutual funds not registered in Germany as dividend income. A credit for U.S. tax under Article 10 of the U.S.-Germany treaty is not possible, since the U.S. treats such distributions as capital gains income and would not impose the 15 percent withholding tax if the distributions were earned by a person other than a U.S. citizen. However, the U.S. will consider capital gains from the disposition of personal property as foreign source income under IRC Section 865 if the foreign tax imposed thereon is at least 10 percent. Consequently, capital gains from mutual funds not registered in Germany are treated as foreign source on the U.S. return under IRC Section 865 if the German tax imposed thereon (computed considering the pro-rata share of the exclusion amount) is 10 percent or more of the gain recognized.
  • Under Article 19 of the U.S.-Germany treaty, U.S. social security benefits may be taxed only by the country of residence. The saving clause otherwise applicable to U.S. citizens does not apply to social security benefits pursuant to Article 1 of the Protocol of the U.S.-Germany treaty. Therefore, U.S. social security benefits received by a U.S. citizen residing in Germany are completely exempt from U.S. tax.
  • Pensions other than social security benefits or U.S. government pensions may also be taxed only by the country of residence under Article 18 of the U.S.-Germany income tax treaty. However, the extent to which a pension is taxed by Germany may differ from the extent to which it is taxed by the U.S. Re-sourcing pursuant to Article 23 (3) of the U.S.-Germany income tax treaty is limited to the portion of the pension taxed by Germany under its national tax provisions.

Relief Is Possible, but Coordinate Return Preparation
As can be seen from the examples above, relief from double taxation for U.S. citizens residing in Germany must be claimed on the U.S. return in many cases. In addition, relief will only be granted on the U.S. return under Article 23 (3) of the U.S.-Germany treaty to the extent that German tax is actually imposed on U.S.-source income. Therefore, it is important to closely coordinate the preparation of the U.S. and the German returns to determine to what degree Germany will actually impose tax on U.S.-source income. Relief, therefore, should be claimed on the U.S. return; if not, the income of U.S. citizens residing in Germany will be subject to double taxation.