Per country limitation when claiming foreign tax credit
Basic principles for crediting foreign taxes
Corporations with unlimited tax liability in Germany also have to pay tax in Germany on their foreign income (Section 1(2) of the Corporation Tax Act [Körperschaftsteuergesetz, KStG], so-called worldwide income principle). In Section 34d of the Income Tax Act [Einkommenssteuergesetz, EStG] (Section 26(1) KStG in conjunction with Section 34c EStG) German legislators have definitively set out what income is considered to be foreign income. Under German tax law, foreign income has to be defined and determined.
Germany has concluded double taxation agreements (DTA) with many foreign states. These agreements govern which country has the right to collect tax on the foreign income and provide the appropriate method for avoiding potential double taxation. It is not uncommon for the credit method to come into play.
Even if there is no such DTA, Section 26 KStG likewise governs how double taxation of foreign income can be avoided or reduced (not possible with the exemption method, cf. Section 34c(6) sentence 2 in conjunction with (1) EStG).
Please note: As an alternative to crediting, it is possible, upon request, to claim a deduction of the foreign tax when determining domestic income (business expenses); this follows from Section 26(1) KStG in conjunction with Section 34c(2) EStG.
Determining the maximum amount of the tax credit (per country limitation)
Foreign taxes can be credited against German corporation tax, subject to the conditions of Section 34c EStG, up to a maximum amount of the German tax applicable to such foreign income. The calculation is based on the following formula:
Maximum amount = corporation tax x foreign income / taxable income
This calculation has to be performed separately for each individual foreign state. Here, only the foreign tax assessed and paid on income from a foreign state and minus any reduction entitlement that arose there may be credited (Section 26(1) KStG in conjunction with Section 34c(7) No.1 EStG, Section 68a of the Income Tax Implementing Regulation [Einkommensteuer-Durchführungsverordnung, EStDV]). It is not possible to carry forward or carry back unused portions of the maximum amount that can be credited, nor can these be offset between different countries.
A particular condition for the foreign income to be included is that this income has to have been taxed in accordance with the laws in force in the foreign state. It is not important here whether or not the income would also have been tax-exempt under German law. Foreign income does not include such income that would be tax-exempt as a result of the DTA (exemption method).
Please note: When determining the respective country-specific maximum amounts that can be credited it should be taken into account that business expenses have to be deducted from the foreign income if there is an economic connection (direct and indirect) between the two. Here, this connection to the specific taxed income abroad has to have been in place during the assessment year, i.e. foreign operations are not sufficient.
Effects of per country limitation
The point and purpose behind the per country limitation regulations consist in preventing German corporations from being able to use the portion of a country’s foreign tax that exceeds German tax as a credit against income from a different foreign country where the tax rate is low. Furthermore, the limitation means that incomes that have been variously taxed at low and high rates will be added together if they originate from the same country.
Please note: The German Trade Tax Act basically does not have any corresponding foreign tax credit rules. However, the Hesse tax court, in its ruling of 26.8.2020, decided that a trade tax offset could indeed be possible. A precondition for this is that the DTA has to include a clause to the effect that foreign tax may be offset against “German tax (on income)” (Hesse tax court ruling of 26.8.2020, case reference: 8 K 1860/16, EFG 2021 p. 779). In this case, it was thus possible for the foreign withholding tax that had been deducted on taxable capital gains to be offset against German trade tax.