How Foreign Income is Taxed in Germany? | Avoid Fines & Double Taxation | DTAA
Thousands of Euros in fines and multiple years in prison. Tax evasion is a serious offense in Germany and in basically all other countries.
If you don't declare your income from foreign sources in your tax return and pay taxes for that, then you could be in trouble. Because most countries have agreements with each other and there is a regular exchange of information. So just because the tax office hasn't asked you about your global income yet doesn't mean they won't ever. It's just a matter of time.
In this blog, I will explain to you what are the tax rules for foreign income and how to declare it properly to avoid penalties. Even though I have taken Germany here as a reference, the basic principles are kind of the same and there will be something for you here irrespective of where you live. Let's get started.
Who Should Pay the Taxes?
When it comes to taxation, there are two main principles that are globally applicable.
The Country of Residence Principle
Under the country of residence principle, a person is liable to pay tax in the country in which he or she is a resident regardless of where the income was earned. This means if you have a place of residence in Germany, you have an unlimited tax liability and have to pay taxes on all income in Germany, as well as your foreign income. This is also called as global income principle. But in most cases, the foreign country also collects taxes, because of the so-called country of source principle.
The Country of Source Principle
Under the country of source principle, all sources of income that are on the territory of a country are subject to taxation by that country. So a natural or legal person is liable to pay tax in the country from where the income is earned.
Now if we apply both the principles together there comes a conflict. Your income will be taxed twice. So if you are a resident of Germany and have some income in a foreign country, you pay taxes in Germany for your foreign income according to the global income principle, and also in the foreign country according to the source country principle.
This is not fair. Nobody should be forced to pay taxes twice on the same income. So most countries have come up with a mechanism to avoid this called DTAA or Double Taxation Avoidance Agreement.
DTAA
A double taxation avoidance agreement (DTAA) is an international agreement between two countries that regulates which of the two countries can treat you as a tax resident and are allowed to tax your income. In Germany, this is called Doppelbesteuerungsabkommen or DBA. Now the exact conditions in a DTAA or DBA could differ from country to country and agreement to agreement but the basic principles remain the same. The main focus of such an agreement is to decide where the taxpayer resides and how the income is taxed.
According to Article 4 of DTAA signed by Germany with most countries, you are considered a tax resident of Germany in the following cases.
If you have a permanent home in Germany. This could be both rented or owned.
If Germany is your country of vital interest or if your personal and economic relations are closer to Germany.
If your country of habitual stay is in Germany, in other words, where you live regularly.
If you are considered a resident, that brings an unlimited tax liability for you in Germany and your entire global income is taxable in Germany. But then there are provisions in DTAA to avoid double taxation. And there are two methods mainly used for that.
Exemption
With this one, the income is taxed only in the source country and exempted from taxes in the country of residence. However, this income must be declared in the tax return so that it can be included in the calculation of the final tax rate in Germany. This is called Progressionsvorbehalt in German. This is important because Germany uses a progressive tax system with tax brackets to tax the income. The higher the income the higher the tax percentage.
For example, Ben is a resident of Germany and earns an annual income of 50,000 euros. This puts Ben in the income tax bracket 2 in Germany and the 50,000 euros is taxed at around 35%. Now Ben has an additional annual income of 25,000 euros in Country B. If the tax rate in the foreign country is 10%, with the exemption method, Ben pays taxes of 2,500 euros on 25,000 euros only in Country A, where he earns the income.
The income from country A is not taxed in Germany but is added to the 50,000 euro income in Germany, which brings his overall income to 75,000 euros. Now his personal tax rate is recalculated based on this higher value. So he moves to the third tax bracket and his 50,000 euro German income is now taxed at 42% instead of the previous 35%.
Credit
With the credit method, you have to pay the taxes in the source country and also your country of residence. But then taxes paid in the source country could be offset against taxes in the country of residence. And for this, you just have to submit proof of taxes paid in the foreign country.
When we come back to Ben, if the crediting method is agreed upon in the double taxation agreement, Ben must pay 2,500 euro taxes for the 25,000 euro income in country A. He also has to pay taxes for that income in Germany at his German tax rate of 35%. And then deduct the tax paid in the foreign country from his German Tax.
Now how do we decide which method to follow? Let's just choose the one that has a lesser tax burden right? I wish it was that way. But things don't work like that. The method is decided based on the type of income. Let's start with the most common one.
Types of Income
Wages:
“Salaries, wages, and other similar remuneration derived by a resident of a contracting state in respect of employment shall be taxable in the other contracting state only if the employment is exercised there.”
This means in the case of income from employment activity, the right to tax usually lies with the country in which the activity is carried out and is exempt from taxation in Germany. This is also applicable if you are a resident of another country and work in Germany.
But Germany has the right to fully tax that income if
the employee does not stay in the other country for longer than 183 days in the tax or calendar year,
the wages are not paid by an employer who is resident in the country of employment and
the wages are not paid by a permanent establishment that the employer maintains in the country of employment.
However, even if the income is tax-free in Germany it is still subject to the Progressionvorbehalt and should be included in German tax returns to calculate the tax rates.
Rental Income:
Income from renting and leasing is classified as “income from immovable property” in the DBA and is normally taxed in the country in which the property is situated. To avoid double taxation, as a rule, the exemption method is applied. This means the rental income is tax-free in Germany, but is still subject to the Progressionsvorbehalt. So this income will still have to be reported in the German tax declaration to calculate the individual tax rate. There are special cases, such as if the property is within the EU, except for Spain, Progressionsvorbehalt is not applicable and you don't have to declare the income in Germany.
Dividends & Interests:
Now dividends here mean mainly the dividends from shares or stocks.
“Dividends paid by a company that is a resident of a contracting state to a resident of the other contracting state may be taxed in that other state. However, such dividends may also be taxed in the contracting state of which the company paying the dividends is a resident and according to the laws of that state, but if the recipient is the beneficial owner of the dividends, the tax so charged should not exceed x% of the growing amount of the dividends.”
I know tax language is complicated. Anyhow, what this means is that, if you have dividend income from a foreign country and also unlimited tax liability in Germany, it could be that you have to pay taxes in both countries. In the source country at x% depending on the agreement with each country and in the resident country or Germany as capital gains tax.
This is a flat rate of 25% plus a solidarity surcharge of 5.5% and church tax of 8 or 9% if applicable. To avoid double taxation, the credit method is applied here and the tax paid in the foreign country can be offset against the German Tax. This is also applicable to income from interest payments particularly the ones from deposits, bonds, securities, and so on.
For example, Ben is a resident of Germany but he has a fixed deposit in India that pays interest. Since Ben is a resident of Germany, DTAA usually limits India's right to tax and the Indian bank only withholds 10% in tax. Now this income from interest is taxable in Germany at a capital gain tax rate of 25%. So Ben has to declare this income in his German tax return.
However, since he has already paid 10% as foreign withholding tax in India, this can be deducted as a tax credit from the capital gain tax he has to pay in Germany. According to some agreements, it is not the actual tax paid that is to be credited against German tax, but rather a notional tax specified in the agreement.
Capital Gains:
Capital gain is any profit arising from the sale, exchange, or transfer of a capital asset, whether movable or immovable. According to the DTAA, capital gains may be taxed in the country in which the capital asset is situated at the time of such transaction. If you are subject to unlimited tax liability in Germany then the same principle that we discussed for income from dividends and interests applies here also. So you have to pay taxes in the source country at x% depending on the agreement with each country and in Germany as capital gains tax.
To avoid double taxation, in the case of property, the exemption method is applied with no Progressionsvorbehalt, and in the case of other capital assets such as stocks the credit method is applied.
Exceptions
Now there are additional rules and regulations for artists, government employees, those who own businesses, and other special cases. Unfortunately, I cannot cover all the cases here, so if you belong to any of these categories, do check the respective double taxation agreements.
Now what if there is no DTAA? In this case, the basic rule from the Income Tax Act applies again and you usually have to pay taxes in both countries.
It's important to keep in mind that the aim of a DTAA is not to achieve non-taxation but to avoid double taxation. So if the source country does not tax your income, the country of residence has the right to fully tax that foreign income. There has to be some form of double taxation for the DTAA to be applicable. For example, interest earned in NRE accounts in India is not taxable in India, so it’s fully taxable in Germany if you are a resident here.
What if the income is not reported?
If you fail to declare your foreign income and the tax office finds out, then the penalties can be quite drastic. And ignorance is not an excuse. Even though we can debate about the tax rates, taxes by themselves are important for the healthy functioning of a democratic government.
So do pay your taxes, and avoid problems in the future. In Germany, you can use the free tool from the Tax Office called Elster and declare foreign income in the tax forms N-AUS and KAP. I will soon create another blog on how to fill out these forms and I hope you got some value from this blog.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. It is important to do your own analysis before making any investment.
