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Double taxation agreement
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Double taxation agreement: In which country is an entrepreneur subject to tax and why are traders treated differently than freelancers? In national tax laws and double taxation agreements, commercial entrepreneurs are treated differently than freelancers.

An entrepreneur is liable to tax on his income in the country from which he operates his business. Unless he/she has a so-called tax permanent establishment in another country. In terms of content, the permanent establishment is determined differently under national law than under the double taxation agreements. This is also different for traders than for freelancers.

In German tax law, so-called freelancers are given preference because they are allowed to calculate their profit using the income-excess calculation, regardless of the amount of their sales. You do not have to prepare complex annual financial statements, which means you have significantly fewer legal obligations and, on top of that, significant financial advantages. Above all, freelancers do not pay trade tax on their income. Unlike traders, they generally only owe the sales tax on the invoices they issue when payment is received, but they are still allowed to deduct the input taxes when the invoice is received.

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Double taxation treaties: freelancers and commercial entrepreneurs

According to the double taxation agreement (DTA), people who receive income from a freelance profession or from other self-employed activities of a similar nature are treated differently than commercial entrepreneurs. You can tell that the choice of words is different. For entrepreneurs, especially if they operate internationally, it is important to know whether they are considered a commercial entrepreneur or a freelancer. The boundaries are fluid and shift quickly.

Different definition in the DBA

The term freelance profession is not conclusively regulated by law and, furthermore, national tax law does not correspond to the definition in the double taxation agreements (DTA).

There is no uniform definition of a freelance profession. In commercial law, one speaks of freelance professions in the exercise of “free scientific, artistic and literary activities of a higher nature as well as personal services of a higher nature that require a higher level of education”.

Higher education means graduating from a university or technical college. Tax law defines freelance work as: “independently carried out scientific, artistic, literary, teaching or educational work”. In addition, some “catalog jobs” are listed as examples. However, a university education is not mandatory.

It is sufficient if the taxpayer can demonstrate comparable knowledge, for example through professional training and later work. While traders have to become a mandatory member of an IHK, freelancers are exempt from this. Depending on the professional group, they are compulsory members of a professional chamber, which assumes legal supervision over the fulfillment of professional duties (e.g. doctors, lawyers, tax advisors). These professional groups also maintain their own pension insurance, so-called pension funds, in which you are required to be a member. In Germany, artists are mandatorily assigned to the artists' social security fund under similar conditions.

According to the double taxation agreement (DTA), the expression “freelance profession” includes in particular the independently carried out scientific, literary, artistic, educational or teaching activity, as well as the independent activity of doctors, lawyers, tax advisors, auditors, auditors, engineers, architects, dentists and others other medical professions, e.g. midwives. This list is not exhaustive.

However, according to the double taxation agreement (DTA), you can only work as a freelancer if you exercise your ability as an independent entrepreneur. However, there are also DBAs that do not differentiate between entrepreneurs and freelancers, such as the DBA Germany-USA.

No equal treatment despite identical work

According to German law, it doesn't just depend on what activity you do, you also have to be able to provide evidence of the training required for this freelance profession. If two people carry out exactly the same activity, for example as IT specialists, they may still not be treated equally for tax purposes. The person who has studied electrical engineering earns income from freelance work in Germany, while the other, who taught himself, comes from a different industry and is considered a tradesman, although he may be much better qualified than the engineer.

Whether training completed abroad is considered equivalent is not decided by the place of residence or the company's headquarters, but rather by the bilateral negotiation results of the countries involved. In the relationship between Hong Kong and Switzerland, for example, there is more recognition in terms of training than in the relationship between Hong Kong and Germany. An exiled Hong Kong Chinese who lives in Switzerland and takes part in a freelance business there does not bring anything out of balance in tax terms. But if Germany has a say, the company may no longer be classified as freelance but as commercial.

Society with non-freelancers

If several freelancers join together, they will only generate income from a freelance profession if all partners qualify as freelancers. If just one person without the appropriate qualifications joins, be it with a mini-participation, then the type of income of everyone involved changes and they will from now on be treated and taxed as commercial entrepreneurs. This makes it difficult for others to involve deserving employees of a freelance company.

If, in addition to the freelance work, commercial transactions are also carried out, for example the sale of goods or other activities, then the activities of a sole proprietor are divided. Some remain freelance, the other part becomes commercial. If the same thing happens in a partnership, there is no division and the entire company is considered commercial. At least that is the German view. Other countries are less critical of this and, according to double taxation agreements, allow division into partnerships. If someone from outside the profession participates in the freelance company, a reclassification of the income as income from commercial activity can also be considered under contract law to a certain extent.

Legal forms

In principle, partnerships are taxed in a similar way to sole proprietors. Two freelancers running your business together still earn freelance income. If a third partner joins, for example as a pure investor, this can immediately turn into a commercial activity, with potentially serious tax consequences.

Freelancers can join together as a practice group or partnership. From a legal perspective, these are always civil law companies. The negative consequence of this is that each co-partner is liable for all of the company's debts, regardless of the amount of their shareholding. In Germany, freelancers can also organize themselves in a partnership company created specifically for them and reserved for them, which is entered in the public register. In this legal form, the co-partners are only ever liable for the service provided personally. The GbR is also available to business owners as a legal form of cooperation. However, you can also join forces in an OHG, a KG or another legal form.

Tax liability of partnerships

In any case, a partnership does not yet pay any income tax in Germany. An option model is currently being considered, according to which partnerships would be given the right to choose to be taxed like a corporation. Partnerships are taxed “transparently”. For this purpose, the company's income is determined uniformly, but then each partner's share of the result is allocated separately and recorded and taxed in the respective individual income tax return.

Nevertheless, caution is advised because the partnership, unless it works as a freelancer, does not pay income tax in Germany, but does pay trade tax and sales tax. A special feature is that trade tax is not only payable on the company's income, but under certain circumstances also on the shareholders' income or withdrawals. This occurs when a partner has so-called special business assets, for example by renting a building that belongs to him to the partnership, or he/she is the owner of a patent that is used by the company. If the partner sells the building or passes it on to a non-partner, the building loses its status as business assets.

The partner is treated as if he had sold the building. The commercially active partnership actually has nothing to do with this, but must pay trade tax on this fictitious profit. These cases could be regulated, but it is usually forgotten in the partnership agreements and leads to a lot of trouble later.

Cross-border companies

Business tax business establishment

Trade tax is only an issue in Germany; other countries do not have this tax. If a commercial company carries out orders abroad, it must be checked whether a permanent establishment exists under national law or under the respective double taxation agreement (DTA). Here, for example, a German company has a construction contract for nine months in a country whose double taxation agreement (DTA) only allows for a permanent establishment after 12 months, then the company taxes its profits from the project in Germany. However, under German law, the construction site in the other country is considered a foreign business tax establishment. The tax consequence is that no trade tax is due on this part of the profit. The definition of a permanent establishment for trade tax purposes is therefore not identical to the permanent establishment under DBA law.

DBA permanent establishment

If there is a business establishment under the provisions of the DBA, a share of the result is allocated in each country. It can also happen that there is a profit in one country and a loss in the other. Tax offsetting can only take place under the conditions of “final losses”. You can find a separate treatise on this on our website.

Freelance entrepreneurs (as far as the DBA knows the term, not: USA) are treated differently here too. Because, purely fictitiously, a freelancer only has one permanent place of work. If there are several places where the activity is carried out via a permanent place of work and one of these places is in the country in which the freelancer is privately based, then this takes precedence. Unlike commercial companies, the freelance results are not divided.

Determination of taxable profit

The company's profit is taxable and, depending on the type and size of the company, can be determined either in an income surplus statement or in a tax balance sheet. A commercial balance sheet is only required for merchants and commercial companies.

Commercially active entrepreneurs are only obliged to prepare balance sheets if their sales or profits exceeded certain limits in the previous year. Craft businesses that had a profit of more than 60.000 euros or a turnover of more than 600.000 euros in the previous year must also switch from simple income surplus accounting to accounting at the request of the tax office.

Anyone who earns freelance income can always determine their profit using the income surplus calculation, even if the limits mentioned have been exceeded. Because the profit and sales limits only apply to commercially active entrepreneurs. If you want, you can also switch to accounting voluntarily. This right to choose also applies to freelancers and entrepreneurs based abroad. The profit is taxable even if it is not withdrawn.

The income is not taxed by the company, but by each co-partner on a pro rata basis in his or her private income tax return. In addition, the commercially active company is obliged to pay trade tax. Due to special additions to the trade tax (rents, leasing installments, interest, salaries to co-entrepreneurs), taxes are also assessed in cases of losses. Since the trade tax can only be credited but not separately refunded, Germany also taxes losses in certain cases.

The distribution of results can be determined differently from the shareholding ratio. Any remuneration paid to co-entrepreneurs, be it salaries, interest or rent, is not treated as an expense for tax purposes, but is part of commercial income. This can be advantageous or disadvantageous. Assets that a co-entrepreneur leaves to the company for use are treated as business assets for tax purposes. This has far-reaching consequences in the event of a later change of use, closure of the business or sale.

Limited partners have limited liability, You can therefore only offset losses against other income up to the amount of the registered liability amount. This is different for shareholders in a general partnership. They have unlimited liability and can therefore fully offset the losses. The tax and legal consequences can be influenced through clever, forward-looking design. The change from a legal form, for example from an OHG to a KG or a GmbH, can be made tax-free.

Jürgen Bächle
Jurgen Bachle

has been working as an independent tax consultant and expert in international tax law since 1989 and has been a member of the board of the German Association of Tax Consultants Baden-Württemberg, DSTVBW, for over 20 years.

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