Memorandum of Understanding

MEMORANDUM OF UNDERSTANDING

UNDERSTANDINGS REGARDING THE SCOPE OF THE LIMITATION ON BENEFITS ARTICLE IN THE CONVENTION BETWEEN THE FEDERAL REPUBLIC OF GERMANY AND THE UNITED STATES OF AMERICA

A. BUSINESS CONNECTION

Paragraph 1 (c) of Article 28 (Limitation on Benefits) of the Convention provides that benefits will be granted with respect to income derived in connection with or incidental to an active trade or business in the State in which the income recipient resides. This provision is self-executing; unlike the provisions of paragraph 2, discussed in section B, below, it does not require advance competent authority ruling or approval.

The following examples illustrate the intention of the negotiators with respect to the interpretation of the provisions of paragraph 1 (c). The examples are not intended to be exhaustive of the kinds of cases which would fall within the scope of the paragraph.

For purposes of exposition, the examples are structured in terms of a German entity claiming U.S. treaty benefits; they are intended to be understood reciprocally. Paragraph 1(c) is relevant only in cases in which the entity claiming treaty benefits is not entitled to benefits under either the ownership and base erosion tests of paragraph 1(e) or the public trading test of paragraph 1(d).

Example I

Facts: A German resident company is owned by three persons, each resident in a different third country. The company is engaged in an active manufacturing business in the Federal Republic of Germany (Germany). It has a wholly-owned subsidiary in the United States which has been capitalized with debt and equity. The subsidiary is engaged in selling the output of the German parent. The active manufacturing business in Germany is substantial in relation to the activities of the U.S. subsidiary. Are the subsidiary’s interest and dividend payments to its German parent eligible for treaty benefits in the United States?

Analysis: Treaty benefits would be allowed because the treaty requirement that the U.S. income “is derived in connection with or is incidental to” the German active business is satisfied. This conclusion is based on two elements in the fact pattern presented: (1) the income is connected with the active German business — in this example in the form of a “downstream” connection; and (2) the active German business is substantial in relation to the business of the U.S. subsidiary.

Example II

Facts: The facts are the same as in Example I except that while the income is derived by the German parent of the U.S. subsidiary, the relevant business activity in Germany is carried on by a German subsidiary company. The German subsidiary’s activities meet the business relationship and substantiality tests of the business connection provision as described in the preceding example. Are the U.S. subsidiary’s dividends and interest payments to the German parent eligible for U.S. treaty benefits?

Analysis: Benefits are allowed because the two German entities (i.e., the one deriving the income and the one carrying on the substantial active business in Germany) are related. Benefits are not denied merely because the income is earned by a German holding company and the relevant activity is carried on in Germany by a German subsidiary. The existence of a similar holding company structure in the United States would not affect the right of the German parent to treaty benefits. Thus, if the German parent owns a subsidiary in the United States which is, itself, a holding company for the group’s U.S. activities, which are related to the business activity in Germany, dividends paid by the U.S. holding company to the German parent holding company would be tested for eligibility for benefits in the same way as described above, ignoring the fact that the activities are carried on by one entity and the income in respect of which benefits are claimed is paid by another, related, entity.

Example III

Facts: A German resident company is owned by three persons, each resident in adifferent third country. The company is the worldwide headquarters and parent of an integrated international business carried on through subsidiaries in many countries. The company’s wholly-owned U.S. and German subsidiaries manufacture, in their countries of residence, products which are part of the group’s product line. The United States subsidiary has been capitalized with debt and equity. The active manufacturing business of the German subsidiary is substantial in relation to the activities of the U.S. subsidiary. The German parent manages the worldwide group and also performs research and development to improve the manufacture of the group’s product line. Are the U.S. subsidiary’s dividend and interest payments to its German parent eligible for treaty benefits in the United States?

Analysis: Treaty benefits would be allowed because the treaty requirement that the United States income “is derived in connection with or is incidental to” the German active business is satisfied. This conclusion is based on two elements in the fact pattern presented: (1) the income is connected with the German active business because the United States subsidiary and the German subsidiary manufacture products which are part of the group’s product line, the German parent manages the worldwide group, and the parent performs research and development that benefits both subsidiaries; and (2) the active German business is substantial in relation to the business of the U.S. subsidiary.

Example IV

Facts: A third-country resident establishes a German company for the purpose of acquiring a large U.S. manufacturing company. The sole business activity of the German company (other than holding the stock of the U.S. company) is the operation of a small retailing outlet which sells products manufactured by the U.S. company. Is the German company entitled to treaty benefits under paragraph 1(c) with respect to dividends it receives from the U.S. manufacturer?

Analysis: The dividends would not be entitled to benefits. Although there is, arguably, a business connection between the U.S. and the German businesses, the “substantiality” test described in the preceding examples is not met.

Example V

Facts: German, French and Belgian companies create a joint venture in the form of a partnership organized in Germany to manufacture a product in a developing country. The joint venture owns a U.S. sales company, which pays dividends to the joint venture. Are these dividends eligible for benefits of the Convention?

Analysis: Under Article 4, only the German partner is a resident of Germany for purposes of the Convention. The question arises under this Convention, therefore, only with respect to the German partners share of the dividends. If the German partner meets the ownership and base erosion tests, or the public trading test of paragraph 1 (d) or (e) , it is entitled to benefits without reference to paragraph 1 (c). If not, the analysis of the previous examples would be applied to determine eligibility for benefits under 1 ( c ). The determination of treaty benefits available to the French and Belgian partners will be made under the United States Conventions with France and Belgium.

Example VI

Facts: A German company, a French company and a Belgian company create a joint-venture in the form of a German resident company in which they take equal shareholdings. The joint venture company engages in an active manufacturing business in Germany. Income derived from that business that is retained as working capital is invested in U.S. Government securities and other U.S. debt instruments until needed for use in the business. Is interest paid on these instruments eligible for benefits of the Convention?

Analysis: The interest would be eligible for treaty benefits. Interest income earned from short-term investment of working capital is incidental to the business in Germany of the German joint venture company.

B. COMPETENT AUTHORITY DISCRETION UNDER PARAGRAPH 2

As indicated above, treaty benefits may be claimed by the taxpayer under the provisions of paragraph 1 (ownership, base erosion, public trading, or business connection) without reference to competent authority. It is anticipated that in the vast majority of cases, eligibility for treaty benefits will be determinable without resort to competent authorities. The tax authorities of the Contracting States may, of course, in reviewing a case determine that the taxpayer has improperly interpreted the provisions of paragraph 1, and that benefits should not have been granted. Furthermore, under paragraph 2 the competent authority of the source State may determine that, notwithstanding failure to qualify for benefits under paragraph 1, benefits should be granted.

It is assumed that, for purposes of implementing paragraph 2, taxpayers will be permitted to present their cases to the competent authority for an advance determination based on the facts, and will not be required to wait until the tax authorities of one of the Contracting States have determined that benefits are denied. In these circumstances, it is also expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later.

In making determinations under paragraph 2, it is understood that the competent authorities will take into account all relevant facts and circumstances. The factual criteria which the competent authorities are expected to take into account include the existence of a clear business purpose for the structure and location of the income earning entity in question; the conduct of an active trade or business (as opposed to a mere investment activity) by such entity; and a valid business nexus between that entity and the activity giving rise to the income. The competent authorities will, furthermore, consider, for example, whether and to what extent a substantial headquarters operation conducted in a Contracting State by employees of a resident of that State contribute to such valid business nexus, and should not, therefore, be treated merely as the “making or managing of investments” within the meaning of paragraph 1 (c) of Article 28.

The discretionary authority granted to the competent authorities in paragraph 2 is particularly important in view of, and should be exercized with particular cognizance of, the developments in, and objectives of, international economic integration, such as that between the member countries of the European Communities and between the United States and Canada.

The following example illustrates the application of the principles described in Section B, above.

Example VII

Facts: German, French and Belgian companies, each of which is engaged directly or through its affiliates in substantial active business operations in its country of residence, decide to cooperate in the development, production, and marketing of an advanced passenger aircraft through a corporate joint venture with its statutory seat in Germany. The development, production and marketing aspects of the project are carried out by the individual joint venturers. The joint venture company, which is staffed with a significant number of managerial and financial personnel seconded by the joint venturers, acts as the general headquarters for the joint venture, responsible for the overall management of the project including coordination of the functions separately performed by the individual joint venturers on behalf of the joint venture company, the investment of working capital contributed by the joint venturers and the financing of the project’s additional capital requirements through public and private borrowings. The joint venture company derives portfolio investment income from U.S. sources. Is this income eligible for benefits of the Convention?

Analysis: If the joint venture company’s activities constitute an active business and the income is connected to that business, benefits would he allowed under paragraph 1 (c). If not, it is expected that the U.S. competent authority would determine that treaty benefits should be allowed in accordance with paragraph (2) under the facts presented, particularly in view of (1) the clear business purpose for the formation and location of the joint venture company; (2) the significant headquarters functions performed by that company in addition to financial functions; and (3) the fact that all of the joint venturers are companies resident in EC member countries in which they are engaged directly or through their affiliates in substantial active business operations.

The competent authorities shall consult further on these issues, and may also take into account the views of the tax authorities of other States, including, in particular, member States of the European Communities.