Hybrid US S-Corporation eligible for participation exemption. Refund practice of taxes withheld remains to be seen.

In a recent judgment (file no. I R 48/12), the German Federal Fiscal Court has commented on Art. 1 para. 7 of the new tax treaty between Germany and the US dated 2008. The central issue of the judgment is the different tax treatment of US S-Corporations (i.e. corporations which have opted for a pass-through taxation for US federal tax purposes) under US and German tax law. The S-Corporation itself is not subject to federal corporate income taxes in the US, but the corporation’s income is taxed at shareholder level (so-called transparent/pass-through taxation). However, German tax law does not recognize a transparent taxation of corporations. This difference in the tax treatment of S-Corporations raises the question how to apply provisions in the tax treaty that require the residence of the S-Corporation in one of the contracting states. According to the definition of “residence” in the tax treaty, a person needs to be liable to tax in one of the contracting states in order to be resident in that state.