Switch-over clause in Section 20 (2) of the German Foreign Tax Act requires majority shareholding in foreign company

If income accrues in the foreign permanent establishment of a person who is subject to unlimited tax liability in Germany, which is exempt from taxation under a double taxation agreement and would be taxable as so-called intermediate income within the meaning of the German Foreign Tax Act (AStG), if this permanent establishment were a foreign company, Section 20 (2) AStG stipulates that double taxation is not to be avoided by exemption, but by crediting the foreign taxes levied on this income. This so-called switch-over clause is intended to prevent the skimming of so-called passive income (Sections 7 et seq. AStG) intended by the addition of income from foreign intermediate companies from being circumvented by interposing permanent establishments in low-tax countries instead of corporations.

For this change from the exemption method to the crediting method pursuant to Section 20 (2) AStG, the tax authorities do not require a majority shareholding in a partnership based abroad that has a foreign permanent establishment. This view is controversial, as the fictitious addition of income from a foreign corporation requires that the person subject to unlimited tax liability controls that company, i.e., holds more than half of its shares (Section 7 (1) and (2) AStG). Against this background, in its decision of April 8, 2025, case no. IX R 32/23, the German Federal Fiscal Court (BFH) examined the highly practical legal question of whether the application of the switch-over clause in Section 20 (2) AStG also requires a majority requirement in the case of a participation in a foreign partnership in a low-tax country.

In the case in question, a German corporation held a 30 % stake in a US-based partnership, which did not constitute a majority shareholding. This partnership generated profits from the international licensing of intellectual property. The licensees were companies not based in the US, some of which belonged to the same group and some of which were outside the group. The resulting profits were allocated to the German corporation in proportion to its shareholding. In the US, it paid only low taxes on this income due to a tax exemption for license income generated by companies within its own group. The double taxation agreement between the US and Germany in force in the disputed years 2007 to 2009 provided that profits from foreign permanent establishments in Germany were to be exempt from tax. However, with reference to Section 20 (2) AStG, the tax office subjected the foreign profits in full to German corporation tax with regard to the license income that was partially exempt from tax in the US and offset the tax paid in the US against this.

Both the Düsseldorf Fiscal Court and the BFH ruled that the requirements of Section 20 (2) AStG were not met in the present case, as the German corporation only held a 30 % stake in the US-based partnership with a foreign permanent establishment, which was therefore not a majority shareholding. This is justified by the wording of Section 20 (2) AStG and its systematic embedding in the context of Sections 7 et seq. AStG. In addition, the purpose pursued by Section 20 (2) AStG, namely to prevent the circumvention of additional taxation in cases where a permanent establishment is interposed in a low-tax country instead of a corporation, would have an excessive effect if the requirement of control of the partnership were waived. This is because the provision in Section 20(2) AStG aims to treat foreign permanent establishments in the same way as foreign corporations for the purposes of foreign tax law.

Therefore, in the opinion of the BFH, for Section 20 (2) AStG to apply, it is necessary that the domestic person subject to unlimited tax liability, i.e., in the case in question, the German corporation, legally or effectively controls the foreign partnership. Otherwise, even the smallest shareholdings would lead to the application of Section 20(2) AStG, even though this would be ruled out in an economically comparable case involving an intermediate foreign corporation.