Article 10 provides rules — U.S. Income Tax Treaty

dividends and similar amounts paid by a company resident in one Contracting State to a resident of the other Contracting State. Article 10 also provides rules for the imposition of a tax on branch profits. Generally, the article limits the source country's right to tax dividends and amounts treated as dividends or dividend equivalents.

Paragraph 1 preserves the residence country's general right to tax dividends arising in the source country by permitting a Contracting State to tax its residents on dividends paid by a company that is a resident of the other Contracting State. Under the provisions of subparagraph

2(a) of Article 23, Germany may not exercise this right with respect to certain direct investment dividends.

Paragraph 2 grants the source country the right to tax dividends paid by a company that is a resident of that country. If the beneficial owner of the dividend is a resident of the other Contracting State, the source country tax is limited to 5 percent of the gross amount of the dividend if the beneficial owner is a company that holds directly at least 10 percent of the voting shares of the company paying the dividend and 15 percent of the gross amount of the dividend in all other cases. Indirect ownership of voting shares (e.g., through tiers of corporations) and direct ownership of nonvoting shares are not included for purposes of determining eligibility for the 5 percent direct dividend rate. Paragraph 10 of the Protocol provides that the source state shall treat the recipient of a dividend as the beneficial owner of such dividend for purposes of Article 10 if the recipient is the person to which the dividend income is attributable for tax purposes under the laws of the source state.

Under the 1954 Convention, dividends are generally taxable by the source country at a maximum rate of 15 percent. Paragraph 4 of Article 32 (Entry into Force) provides a special phase-in rule for the 5 percent direct dividend rate, which will generally not be available until 1992. Between 1990 and 1992, direct dividends are generally subject to a 10 percent source country tax under the phase-in rule.

The second and third sentences of paragraph 2 relax the limitations on source country taxation for dividends paid by U.S. Regulated Investment Companies and Real Estate Investment Trusts and by German investment trusts. Dividends paid by Regulated Investment Companies and German investment trusts are denied the 5 percent direct dividend rate and subjected to the 15 percent portfolio dividend rate regardless of the percentage of voting shares held directly by the recipient of the dividend. Generally, the reduction of the dividend rate to 5 percent is intended to relieve multiple levels of corporate taxation in cases where the recipient of the dividend holds a substantial interest in the payor. Because Regulated Investment Companies, Real Estate Investment Trusts, and German investment trusts do not themselves generally pay corporate tax with respect to amounts distributed, the rate reduction from 15 to 5 percent cannot be justified by the "relief from multiple levels of corporate taxation" rationale. Further, although amounts received by a Regulated Investment Company may have been subject to 11.5. corporate tax (e.g., dividends paid by a publicly traded U.S. company to a Regulated Investment Company), it is unlikely that a 10 percent shareholding in a Regulated Investment Company by a German resident will correspond to a 10 percent shareholding in the entity that has paid U.S. corporate tax (e.g., the publicly traded U.S. company). Thus, in the case of dividends received by a Regulated Investment Company and paid out to its shareholders the requirement of a substantial shareholding in the entity paying the corporate tax is generally lacking.

The third sentence of paragraph 2 further limits the availability of the 15 percent portfolio dividend rate in the case of Real Estate Investment Trusts. The 15 percent rate is available only to individual residents of the Federal Republic of Germany holding a less than 10 percent interest in the Real Estate Investment Trust. The exclusion of corporate shareholders and 10 percent or greater individual shareholders from the 15 percent portfolio rate is intended to prevent indirect investment in U.S. real property through a Real Estate Investment Trust from being treated more

favorably than investment directly in such real property. Dividends paid by a Real Estate Investment Trust (other than amounts subject to tax as effectively connected income under section 897(h) of the Code) that are not entitled to the 15 percent portfolio rate are subject to the U.S. statutory rate of 30 percent.

Paragraph 2 does not affect the taxation of the profits out of which the dividends are paid.

Paragraph 3 provides that as long as natural persons resident in the Federal Republic of Germany are entitled under German law to a tax credit in respect of dividends paid by a company that is a resident of Germany (i.e., as long as the German imputation system remains in force), the U.S. beneficial owner of portfolio dividends subject to the 15 percent rate of subparagraph 2(b) shall be entitled to a further relief of German tax equal to 5 percent of the gross amount of the dividend. For United States income tax purposes (including for purposes of credit for foreign taxes paid), the benefit resulting from the further 5 percent relief of German tax shall be treated as a dividend paid to the U.S. beneficial owner. Paragraph 8 of the Protocol clarifies the U.S. tax treatment of the 5 percent reduction in German tax. For U.S. tax purposes, the U.S. shareholder is treated as if it had received as a dividend a refund of German corporate tax equal to 5.88 percent of the dividend actually paid, determined before the German withholding tax on such dividend. The sum of this refund and such actual dividend are deemed to have been subject to the 15 percent German tax on portfolio dividends prescribed in subparagraph 2(b) of Article 10

For example, if a German company pays an actual dividend of $I00 to a resident of the United States, such dividend will, under subparagraph 2(b), be subject to German tax of $15. However, the "further relief" described in subparagraph 3(a) of Article 10 effectively reduces the German withholding tax to $10. Pursuant to subparagraph 3(b) of Article 10, for U.S. tax purposes the U.S. resident is treated as if it received a dividend of $105.88 consisting of the $l00 actual dividend and a refund of German corporate tax of $5.88. The notional $105.88 dividend is deemed to have been subject to a German withholding tax of $15.88 (15 percent of $105.88 equals $15.88). The U.S. resident will include in gross income $105.88 and will be entitled to a foreign tax credit of $15.88, subject to the generally applicable limitations of U.S. law.

Paragraph 4 defines the term dividends as used in Article 10 to mean income from shares, "jouissance" rights, mining shares, founders' shares, or other rights (not being debt-claims) participating in profits, as well as other income derived from other rights that is subjected to the same taxation treatment as income from shares by the laws of the Contracting State of which the company making the distribution is a resident. In the case of the Federal Republic of Germany dividends also include income from sleeping partnerships and certain participating loans, as well as distributions on a certificate of investment trust. Under the 1954 Convention, income from participating loans was generally treated as interest.

Paragraph 5 provides that, notwithstanding the limitations on source country taxation contained in paragraph 2 of Article 10 and paragraph 1 of Article 11, income from arrangements, including debt obligations, carrying the right to participate in profits that is deductible in determining the profits of the payor may be taxed in the source state according to the laws of such state. In the case of the Federal Republic of Germany, as long as income from sleeping

partnerships, participating loans, and jouissance shares remains deductible in determining the profits of the payor, such income is excepted from the Article 10 and Article 11 limitations on the source country's right to impose its domestic law. In the case of the United States, paragraph 5 permits the United States to impose its statutory regime on similar deductible distributions of profits. Thus, for example, interest paid with respect to a loan that gives the German lender a right to participate indirectly in the profits of the U.S. obligor through the receipt of contingent interest calculated by reference to the profitability of the U.S. obligor (or property held by the U.S. obligor) is subject to the U.S. statutory system of withholding on interest not attributable to a permanent establishment. The U.S. withholding tax, if any, on such interest is not affected by the Article 11 source country exemption. This exception from the source country limitation does not apply to interest paid with respect to debt convertible into an equity interest in the obligor, so long as the interest payments themselves are not contingent on the profitability of the obligor. If either Contracting State enacts domestic legislation that denies the deductibility of payments otherwise addressed in paragraph 5, then paragraph 5 by its terms no longer applies. In such a case, the limitations on source country taxation contained in Articles 10 and 11 would govern source country taxation.

Paragraph 6 excludes dividends paid with respect to holdings that form part of the business property of a permanent establishment or fixed base from the general source country limitations. Such dividends will be taxed on a net basis using the rates and rules of taxation generally applicable to residents of the state in which the permanent establishment or fixed base is located, as modified by the Convention.

Paragraph 7 bars one Contracting State from imposing any tax on dividends paid by a company resident in the other Contracting State except insofar as such dividends are otherwise subject to net basis taxation in the first-mentioned Contracting State because such dividends are paid to a resident of such first mentioned Contracting State or the holding in respect of which the dividends are paid forms part of the business property of a permanent establishment or fixed base situated in such first-mentioned State.

Paragraph 8 provides for the imposition of a branch profits tax by the State in which certain items of income arise. Paragraph 8 permits the State in which the branch operates to impose an additional tax (e.g., a branch profits tax such as that imposed by section 884(a) of the Code) on a company that is resident in the other Contracting State and that has a permanent establishment in the first mentioned State or that is subject to net basis taxation in such State under Article 6 or paragraph 1 of Article 13. In the case of the United States, such additional tax may be imposed only on the portion of the business profits of a company attributable to the permanent establishment and the portion of net income subject to tax under Article 6 or paragraph I of Article 13 that represent the dividend equivalent amount. For this purpose, "dividend equivalent amount" has the same meaning it has under United States law, as amended from time to time without changing the general principle thereof.

Thus, for example, the United States may impose its branch profits tax on business profits of a German company attributable to a permanent establishment in the United States. In addition, the United States may impose its branch profits tax on income of a German corporation subject to taxation on a net basis because the German corporation has elected under Code section 882(d)

to treat income from real property not otherwise taxed on a net basis as effectively connected income, or because the gain arises from the disposition of a United States Real Property Interest other than an interest in a United States corporation. The United States may not impose its branch tax on the business profits of a German corporation that are effectively connected with a U.S. trade or business but that are not attributable to a permanent establishment and are not otherwise subject to U.S. taxation under Article 6 or paragraph 1 of Article 13.

In the case of the Federal Republic of Germany, the additional tax permitted by paragraph 8 may be imposed only on that portion of income that is comparable to the amount that would be distributed as a dividend by a German corporation to its U.S. shareholder.

Paragraph 9 provides that the branch profits tax permitted by paragraph 8 shall not be imposed at a rate exceeding the direct dividend withholding rate of five percent. Subparagraph 5(a) of Article 32 (Entry Into Force) provides for the imposition of the branch tax for the first time for assessment periods or taxable years beginning on or after January 1, 1991. This means, also, that in computing the base of the U.S. tax, only post-effective date not-previously-taxed effectively connected income will be taken into account.

Paragraph 10 further limits the imposition of a branch profits tax by the Federal Republic of Germany. Such a tax may be imposed only if, under German law, a foreign corporation is subject to a rate of tax that does not exceed the rate of corporation tax applicable to the distributed profits of a German company by 5 percentage points or more. If the branch tax is permitted, the sum of the branch tax rate and the number of percentage points by which the German tax on a permanent establishment of a foreign corporation exceeds the German tax on distributed profits of a German corporation may not exceed 5 percentage points. Thus, as long as Germany taxes foreign branches at a rate of 46 percent and distributed profits of a German corporation at a rate of 36 percent, the imposition of a further German branch tax is proscribed.

Notwithstanding the foregoing limitations on source country taxation of dividends, the saving clause of subparagraph (a) of Paragraph 1 of the Protocol permits the United States to tax dividends received by its residents and citizens, subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from Double Taxation), as if the Convention had not come into effect.