In addition to the refundable 25-percent withholding tax, Germany provides "integration," or relief from the taxation of corporate earnings at both the corporate and individual shareholder levels, through two other features of its tax treatment of dividends. First, Germany imposes a "split rate" on corporate income; under this system, earnings distributed by German resident companies as dividends are subject to a lower corporate income tax rate than are retained earnings. Currently, the tax rate on retained earnings (or "statutory burden") is 50 percent, and the corporate-level tax on distributed earnings (or "distribution burden") is 36 percent. Second, German resident shareholders receive an imputation credit for the corporate-level distribution burden. The credit is applied against the shareholder's German income tax liability or, if the credit exceeds the liability, the excess is refunded to the shareholder. In the absence of a tax treaty, nonresidents of Germany do not receive the imputation credit. This imputation system was introduced into the German tax laws in 1977.

Under the German tax system, the taxable profits of a branch of a foreign corporation are taxable at a flat rate, rather than under the split rate system. Currently, the flat rate is 46 percent.

Treaty reduction of dividend taxes.-Under the proposed treaty, each country may tax dividends paid by its resident companies, but the rate of tax is limited by the treaty if the beneficial owner of the dividends is a resident of the other country. Paragraph 10 of the proposed protocol provides that a country shall deem the recipient of dividends, interest, or royalties who is a resident of the other country to be the beneficial owner for the purposes of this article (and the interest and royalties articles) if the recipient is the person to which the income is attributable for tax purposes under the laws of the first country. Thus, the protocol makes explicit that internal law of the source country governs in determining beneficial ownership for purposes of the rate reductions.

Source country taxation is generally limited to 5 percent of the gross amount of the dividends if the beneficial owner of the dividends is a company which holds directly at least 10 percent of the voting shares of the payor corporation. The tax is generally limited to 15 percent of the gross amount of the dividends in other cases involving dividends paid to residents of the other country.

The prohibition on source country tax in excess of 5 percent on direct investment dividends does not apply to a dividend from a RIC or REIT, or to a distribution on certificates of a German investment trust. Thus, the proposed treaty allows the United States to impose a 15-percent tax on a U.S. source dividend paid by a RIC to a German company owning 10 percent or more of the voting shares of the RIC. In addition, there is no limitation in the proposed treaty on the tax that may be imposed by the United States on a dividend paid by a REIT to a German resident, if the recipient is either an individual holding a 10 percent or greater interest in the REIT, or a company. Such a dividend would thus be taxable by the United States, assuming no change in present internal law, at the full 30-percent rate.

The limitations on source country taxation of dividends do not affect the taxation of the profits out of which the dividends are paid.

Imputation-related benefit.-The effective rate of German and U.S. tax on dividends paid by a German resident company and beneficially owned by a U.S. resident are reduced further by means of an imputation-related German tax reduction and U.S. credit. This benefit is available as long as Germany's imputation system is in effect for natural persons resident in Germany. The Committee understands that the proposed treaty clause providing German integration-related relief was the first such treaty clause negotiated and signed by Germany. To date, it is understood that Germany has signed but not yet ratified one other similar treaty clause with Switzerland.

Under the German imputation system, German resident_shareholders generally receive a "gross-up" in their dividend, and a corresponding equal imputation tax credit, equal to a percentage of the dividend. The credit and gross-up are currently 56.25 percent (9/16, or 36/64) of the dividend, or 36 percent of the grossed up dividend. (For simplicity, use of the terms "dividend" and "grossed up dividend" here ignores the 25-percent withholding mechanism under German law.) The grossed up dividend represents the pre-tax corporate profits distributed to the shareholder.

For example, assume that a German corporation with a single German shareholder earns 100. The statutory burden is 50. Assume that the entire 50 is distributed. This results in a decrease of 14 in the corporate tax burden if the full 14 is also distributed. Assume that this is the case. The shareholder has received a cash dividend of 64 (ignoring withholding taxes). This dividend must be grossed up by 56.25 percent (9/16, or 36/64) in computing the shareholder's taxable income. The gross up here equals 36, or 36/64ths of 64. The shareholder's income associated with the dividend therefore equals 100, or 64 plus 36. (This is also the amount of the corporation's pretax income.) Because the amount of the gross-up is also a tax credit to the shareholder, this 100 of shareholder income carries a credit of 36, which equals the corporate tax paid and not previously refunded to the corporation. The income tax imposed on these earnings will thus be whatever tax is imposed on the 100 at the individual level, minus 36. This, in turn, is the same tax that would have been imposed had the 100 been earned directly by the shareholder. The credit, when considered together with the split rate system, alleviates the double taxation of distributed profits earned by German companies.

For practical reasons, the credit is allowed under German law for dividends treated as having been derived from corporate profits on which the payor corporation has not paid the distribution burden, i.e., the lower of the two corporate rates. In such cases, an increased corporation tax will be imposed in the period of distribution to compensate for the amount of the shareholder credit in excess of the corporate tax previously paid.

As described above, under German law, the imputation credit either is applied against a resident shareholder's German income tax liability or, if the credit exceeds such liability, is refunded to the shareholder. Shareholders who have no German tax liability obtain a refund on demand. No imputation credit is allowed by Germany with respect to dividends paid to nonresidents of Germany, however, either by statute or treaty currently in force. Thus, a

higher tax burden is imposed on dividends paid to nonresident shareholders than is imposed on dividends paid to German resident shareholders.

For example, assume that a German corporation with a single individual U.S. shareholder earns 100 and fully distributes the earnings. After any necessary adjustments in the corporation tax, the German corporation will have paid a tax of 36 on the earnings. The shareholder has received a cash dividend of 64 (ignoring withholding taxes). Under the present treaty, Germany will withhold a nonrefundable tax of 15 percent, or 9.60. Combined German tax on these earnings is therefore 45.60. Assuming a U.S. tax rate of 28 percent on the individual, the pre-foreign tax credit U.S. liability is 17.92. Less credits, the amount of tax paid to the United States is 8.32. The German (corporate and shareholder) and U.S. income tax imposed on the original 100 of pre-tax corporate earnings will thus total 53.92.

The proposed treaty and protocol reduce, although they do not eliminate, the disparity between the German tax burden imposed on dividends paid to nonresident shareholders and that imposed on dividends paid to German resident shareholders. Under the proposed treaty, U.S. portfolio investors in German resident companies generally will be entitled to a reduction in the 15-percent treatyreduced German tax equal to an additional 5 percent of gross dividends beneficially owned. For U.S. tax purposes, the recipient is treated as having received a dividend approximately equal to an amount 85 percent of which would equal 90 percent of the gross dividend actually paid. The recipient is further treated as having paid creditable foreign income tax equal to 15 percent of that deemed dividend amount. Arithmetically, the U.S. shareholder receives the same U.S. tax treatment as if he or she had received a refund (and an income gross-up) for a corporate level tax equal to 5.88 percent of the cash dividend, and had in addition paid a withholding tax equal to 15 percent of the grossed up dividend.

For example, assume that a German corporation with a single individual U.S. shareholder earns 100 and fully distributes the earnings. After any necessary adjustments in the corporation tax, the German corporation will have paid a tax of 36 on the earnings. The shareholder has received a cash dividend of 64 (ignoring withholding taxes). Under the proposed treaty, Germany will withhold a nonrefundable tax of 10 percent, or 6.40. Combined German tax on these earnings is therefore 42.40. For U.S. purposes, however, the shareholder will be treated as having received (before tax) approximately 67.76, or 64 grossed up by 5.88 percent (rather than by the 56.25 percent by which a comparable German shareholder's dividend would have been grossed up). Because the amount of the gross-up is also a tax credit to the shareholder, this shareholder income carries a credit of 10.16 (or 6.40 plus 3.76), which is also 15 percent of the grossed up dividend. This credit exceeds the German withholding tax imposed on the dividend, but is less than the 42.40 combined corporate and shareholder level German tax burdens. Assuming a U.S. tax rate of 28 percent on the individual, the pre-foreign tax credit U.S. liability is 18.97. Less credits, the amount of tax paid to the United States is 8.81. The German (corporate and

shareholder) and U.S. income tax imposed on the original 100 of pre-tax corporate earnings will thus total 51.21.

This rate is similar to the combined U.S. corporate and U.S. individual tax rates imposed on income earned by a U.S. corporation and distributed to a U.S. shareholder.11 It is also similar to the rate of German corporate tax on undistributed corporate profits. Finally, it is not dissimilar from the German marginal income tax rate applicable to individuals in the upper German income tax brackets. (Currently the top marginal rate is 53 percent.) Thus, unlike the German investor, a U.S. investor in a German corporation does not get the full benefit of applying domestic individual tax rates to distributed German corporate profits. On the other hand, his German taxes are reduced by the proposed treaty's additional 5 percent benefit more than his U.S. taxes are increased, without reducing the total tax imposed below the levels imposed by Germany on German investors or by the United States on investment income generally of U.S. persons. As compared to the result under the present treaty, the earnings bear $3.20 less German tax, and 49 cents more U.S. tax under the proposed treaty. However, the earnings still bear considerably more tax than if Germany were to allow the U.S. resident, as it does the German resident, a refund of the corporate tax paid on the earnings (whether or not a 15 percent withholding tax were retained by Germany). The upward adjustment to German corporate tax for dividends paid out of low-taxed earnings arguably means that the treaty's mechanism for providing the additional 5 percent benefit to U.S. portfolio investors does not result in U.S. taxpayers receiving credits for foreign taxes not paid.

The United States has income tax treaties with numerous countries the internal tax laws of which provide for some degree of integration of the tax liabilities imposed on domestic corporations and domestic shareholders. Treaties with some of these countries provide no extension of the domestic shareholder imputation benefits to U.S. resident shareholders. By contrast, the U.S. income tax treaties with the United Kingdom and France provide U.S. resident shareholders refunds of the imputation credits provided under the laws of those countries to domestic resident shareholders.

The additional 5 percent benefit provided under the proposed treaty to U.S. portfolio investors in German companies is arithmetically similar to the refund of an imputation credit. However, two aspects of the proposed treaty distinguish it from the French and U.K. treaty refunds. First, the amount of benefit provided under the French and U.K. treaties is greater than that provided under the proposed German treaty. For example, under the French treaty, a U.S. resident who receives a portfolio dividend from a French company is entitled to a refund equal to the French imputation credit (the avoir fiscal) that a French resident would receive on the dividend, less a withholding tax of 15 percent of the sum of the cash dividend plus the refund. Currently, the avoir fiscal for a

11 For example, if a U.S. corporation earns $100, pays tax of $34, and distributes the rest to an individual, the individual receives taxable income of $66, on which the tax due, at the 28 percent rate, is $18.48. Total U.S. income tax burden on the $100 of pre-tax earnings is therefore $52.48.

French resident amounts to 50 percent of the cash dividend. Under the U.K. treaty, a U.S. resident who receives a portfolio dividend from a U.K. company is entitled to a refund equal to the British imputation credit (the rate of which corresponds to the rate at which the Advance Corporation Tax, or ACT, is imposed), less a withholding tax of 15 percent of the sum of the cash dividend plus the refund. Currently, the British shareholder credit for a British resident amounts to 25/75ths of the dividend paid. A U.S. company that receives a direct dividend from a U.K. company is entitled to a refund equal to half of a British individual's imputation credit less a withholding tax of 5 percent of the sum of the cash dividend plus the refund.

Second, the proposed German treaty also differs from the French and U.K. treaties insofar as it is based not on the actual refund or credit that a German shareholder would receive, but rather on a fixed percentage of the cash dividend. However, the substantial German tax burden even on distributed profits appears to ensure that in fact the fixed "further relief" provided for in the German treaty is matched by tax actually collected by Germany at the corporate level.

Definition of dividends.-The proposed treaty provides a definition of dividends that is largely identical to the definition in the OECD model treaty and some U.S. treaties. Like the U.S. model treaty, the proposed treaty generally defines “dividends” as income from shares or other rights which participate in profits and which are not debt claims. The term also includes income from "jouissance" shares or "jouissance" rights, mining shares, founders' shares, or other rights which participate in profits and which are not debt claims. Dividends also include income from other rights that is subjected to the same tax treatment by the country in which the distributing corporation is resident as income from shares. The proposed treaty further specifies that in Germany the term "dividends" also includes income under a sleeping partnership (Stille Gesellschaft), "partiarisches Darlehen," or "Gewinnobligation" as well as distributions on certificates of an investment trust.

Special ?8<; 4? 9?8><=?4>;

Neither the dividend article nor the interest article is to prevent either country from applying its internal laws to payments arising in that country from arrangements, including debt obligations, carrying the right to participate in profits, that are deductible in determining the profits of the payor. In Germany, the amounts to which this rule may apply include income under a sleeping partnership, "partiarisches Darlehen," "Gewinnobligation," or "jouissance" shares or "jouissance" rights.

The treaty's reduced rates of tax on dividends will not apply if the dividend recipient has a permanent establishment (or fixed base in the case of an individual performing independent personal services) in the source country and the shareholding on which the dividends are paid forms part of the permanent establishment (or . fixed base). Dividends paid on shareholdings of a permanent establishment are to be taxed as business profits (Article 7). Dividends