ol. 4 No. 1, January/February 1997 TPJ from a foreign subsidiary, which are tax exempt in Germany mean that both direct and indirect costs relating to it are not under a tax treaty. Where the German subsidiary passes on tax deductible. By contrast, if one assumes that the treaty hese tax-free dividends to the parent company, the latter exemption applies to the gross amount of the dividends no does not have to include them in taxable income either. With costs are excluded from tax deductibility under the tre regard to the costs incurred in connection with the tax-free exemption. German domestic law prohibits the deduction of income, the law states that direct costs cannot be used to expenses directly related to exempt( foreign) income. How reduce the taxable basis of the parent. The treatment of these ever, the Tax Court did not identify what these directly relat costs corresponds to that of costs incurred in connection with ed costs are In this respect, the wording of the German tax other income for which the relevant tax treaty provides a tax law provision is not clear. The Court, which had to decide on exemption. This issue is dealt with in more detail in B the deductibility of interest payments in connection with a Costs incurred in connection with the acquisition of a domes- loan obtained by a geman parent company to finance the tic participation(e.g- purchase price, notary public fees)have acquisition of its foreign subsidiary, provided the following to be capitalized. Because German tax law does not allow solution: interest payments are fully deductible from the tax- ordinary depreciation on participations, these costs affect the able income of the parent company. Only in the yeshe taxable income of the parent only if the conditions for hich dividends are paid sidiary to write-down are fulfilled (e.g. a long-term decrease in the German parent, is the deductibility restricted in so far as th value of the participation)or when the participation is sold amount of dividends corresponds to the amount of the inter Capital gains realized on the sale of a' domestic participation are included in the current taxable income of the parent com- Example pany and are not taxed differently from other income. The former special tax-free amount(DEM 30,000 reduced by any ear 3 excess of the capital gain over DEM 100,000)which was dividend 0 50,000 applicable upon the sale of a 100% shareholding to one pur- interest 30.000 30000 30,000 chaser was abolished as of the beginning of 1996. Costs deductible interest 30.000 incurred in connection with the sale of the participation are 20,000 deductible from taxable income which, as mentioned earlier, As mentioned earlier, the Court,'s decision expressly applies includes capital gains. ayments. Whe r the restriction also applies to other costs (e.g. monitoring costs)is unclear. B. Foreign participations Costs incurred in connection with the acquisition of a foreign participation are treated in the same manner as those incurred The tax treatment of income received by a German parent in the acquisition of a domestic participation. 2 company from foreign participations depends on whether the The sale of a foreign participation by a german parent com- tax credit method or the exemption method applies to such pany is treated in the same way as the sale of a domestic par- income. The tax credit method is laid down in German ticipation: the capital gain is included in taxable income domestic law. The exemption method is usually provided for However, there is an important exception for foreign partici- by German tax treaties. If the relevant conditions imposed pations of greater than 10% If the dividends from that parti for the exemption method takes precedence over the credit the absence of a treaty, the foreign subsidiary aty, or in under the. treaty are satisfied, the treaty clause that provides cipation would have been tax exempt under a ta method in German domestic law income from activities for which the law does not expresso rule out tax privileges, the capital gain derived from the sa Under the credit method, dividends are treated as ordinary of that participation is tax exempt. current income of the German parent company and foreign taxes can be credited under certain circumstances against the Costs incurred in connection with such a sale reduce the cap. German tax liability. Costs incurred in connection with this ital gain and not the current taxable income of the parent income are generally fully deductible from the German tax company. The parent company is required to recapture liability. Nevertheless, the allocation of costs to the foreign amounts written down in previous tax years. Thus, it has to income is necessary in order to determine the maximum reduce the amount of tax-free capital gains by the amount of amount of creditable foreign tax. the recapture. However, if the German parent company real in connection with this income are not tax deductible. The from its taxable income. This regime is aimed at encouraging German Supreme Tax Court recently affirmed its earlier foreign investors to set up holding companies in Germany opinions by stating that the exemption for dividends under most tax treaties refers to the gross amount of the dividend rather than the dividend net of charges incurred in connection with it, as some german state tax authorities had assumed The difference between the two opinions may be significant if one assumes that the exemption under a tax treaty applies to the net income derived from the participation, that would 2. See IL.Aabove @1997 International Bureau of Fiscal Documentation