Some people that move to Germany (“expats” or returnees) expect outstanding compensation or severance payment from an earlier employment or activities abroad, outside Germany. Does Germany have a right to tax such payments? The answer is: That depends. (continue reading)
2. GERMAN TAXATION OF RESIDENTS – CROSS-BORDER CONFLICTS
Germany taxes the worldwide income of its residents, irrespective of a German citizenship and irrespective of whether or not such income is actually transferred to Germany or held in a foreign account. Hence, even if payments are received in a foreign bank controlled by a German resident, they will be subject to German income tax in the same calendar year.
For the currently applicable German income tax rates, see here.
In general, salary payments or benefits in kind (such as free company shares) received by a German resident from an employment are taxable once actually in the possession (e.g. in the bank account) of the respective individual.
In some scenarios people have worked abroad before moving to Germany and subsequently collect a significant settlement payment from the former employer (or other contractual partner), e.g. due to the termination of that former employment.
The question arises whether the right to tax such payments is (i) with Germany or (ii) the exit State or (iii) both States (worst case).
The answer depends on the nature and wording of the underlying agreement, according to recent German case law.
3. IS THE SETTLEMENT PAYMENT LINKED TO A SPECIFIC “ACTIVITY”
In a case decided by the Cologne Tax Court in 2014, an individual had moved (back) to Germany from Italy after twelve years of employment in Italy. When the individual then received a large settlement payment from its former Italian employer the question arose whether or not Germany had the right to fully tax that payment.
Technically, in order to determine the German tax law situation one needs to distinguish two steps:
Step 1: Under domestic German income tax rules, Germany has the right to tax that payment as it is a payment received by a German tax resident. The income tax charge (including the compulsory solidarity surcharge, Solidaritätszuschlag) may be as high as 48%, depending on the applicable overall annual income tax in the respective calendar year (progressive income tax system).
Certain requirements being met and in order to ease the disadvantage of the progressive income tax rate system, a (slightly) lower tax rate may be available for settlement payments.
The individual would declare the payment as income in his/her annual German income tax filing (normally due until the end of May of the following year). Foreign income taxes on the settlement payment can be credited on the German income tax charge.
Step 2: In order to avoid double taxation in cross-border tax conflicts, Germany has entered into international tax treaties with most countries. The applicable treaty may exempt income received by a German tax resident from activities abroad from taxation in Germany.
The requirements for such tax exemption are narrow and the wording of the settlement decisive, as the Cologne tax court points out in detail. As a rule of thumb, only if a payment specifically refers to an activity performed abroad in the past, Germany may be obliged to grant a tax exemption. If that is not the case, or if the wording is too vague, Germany will tax the payment.
Whether or not a “foreign” source of income of a German tax resident is subject to German income taxation depends on the applicable tax treaty. In some scenarios, tax exemption is available.
If tax exemption is not available, foreign income taxes may be credited against German taxes on the income from the foreign source.
It is crucial to understand that as a rule Germany taxes the worldwide income of its residents, unless tax treaty protection is available. In some cases retroactive voluntary disclosures of foreign income (e.g. rental income) are necessary to avoid tax fraud proceedings in Germany, even if such foreign income is tax exempt in Germany.