Following a recent amendment of the German Income Tax Code effective as of 1 January 2004, severance payments paid to non-resident employees have to be apportioned on a time basis depending on where the employee was working. They are subject to German income tax according to the extent that the employee was working in Germany. Christiane Bourseaux and Matthias Hoeninger of Deloitte give the details.

Basically, the German legislator has extended the scope of the provisions concerning the taxation of non-resident individuals with limited tax liability by implementing a new no. 4 (d) into Sec. 49 (1) German Income Tax Code.

According to this provision, severance payments are considered as German sourced income and subject to German income tax to the extent the regular remuneration relating to the underlying employment activities has already been subject to German income tax.

This provision is in contradiction to a court ruling of the Federal Tax Court concerning severance payments. In this decision dated 10 July 1997, Federal Tax Law Gazette 1997 II at 341, the Federal Tax Court had to decide on the qualification of severance payments for treaty purposes:

It was clearly stated that severance payments are considered as employment income in the sense of Art. 15 Organisation for Economic Co-operation and Development (OECD) Model Treaty. With regard to the place where the employment activities have been performed, the court decided that a severance payment should not be considered as an additional remuneration granted for employment activities performed in the past.

Since a severance payment is not paid for certain employment activities performed in Germany or a foreign state, the sole right to tax the severance payment should be allocated to the residence state (within the sense of the respective treaty) of the employee at the time of payment.

This statement is now clearly contradicted by the newly implemented Sec. 49 (1) no. 4 (a) German Income Tax Code, which creates a clear link between the former employment and the severance payment. At present, it is not clear whether the Federal Tax Court will maintain his position with regard to the new Sec. 49 (1) no. 4 (d) German Income Tax Code, or whether the Federal Tax Court will align his court ruling concerning severance payments.

With regard to severance payments paid to non-German residents in 2004, in treaty cases it is unsure how they will be treated for income tax purposes. There is a risk that the German tax authorities seek to tax the severance payments to the extent that the underlying employment activities were performed in Germany, regardless of the current court ruling.

In the case of German residents a tax exemption should be applied for with regard to employment services performed abroad in view of the new law, but there is a risk that the German tax authorities may tax the entire severance payment.

In non-treaty cases, the income tax position of German residents is not affected since the entire severance payment is generally subject to German income tax. Foreign taxes on the severance payment may be credited under certain conditions.

Non-resident employees have to file an income tax return for taxpayers with limited liability if they receive a severance payment and this severance payment relates to activities performed in Germany. The portion of the severance payment, which relates to work carried out in Germany, is subject to German income tax.

March 2004

Christiane Bourseaux and Matthias Hoeninger work for Deloitte in Germany.

For more information regarding this new ruling please contact Christian Levedag by phone: + 49 (0) 211 8772 3916, or by email to clevedag@deloitte.de