The credit method and the exemption method are two procedures in international tax law to treat the taxation of foreign income. In the case of the credit method, one pays taxes on the world income in Germany, but may set the tax paid abroad tax-reducing. In the exemption method, on the other hand, taxation falls to only one of the countries, while the other waives its right to collect taxes. Whether the crediting method or the exemption method applies depends on the agreements in the respective double taxation agreement. However, an exemption in Germany can also be achieved with an accounting method through tax design.

International tax law deals with cross-border tax issues – from the point of view of the country in which there is a tax liability. This is a common misunderstanding that we often perceive. Because many believe that a law firm that understands international tax law automatically also has tax expertise about foreign tax laws. We have now cleaned up and can now look at an aspect that is particularly relevant in international tax law, namely the credit method and the exemption method.

These two procedures specify how to tax foreign income domestically. You have to know that as a taxable person in Germany you are in principle taxable with all income. This includes both domestic and all foreign income. This tax procedure is also called the world income principle. It is widespread in the major industrial nations. The counter-proposal to this is called the territoriality principle and takes into account exclusively domestic income. Many tax havens advertise it, for example. Which of the two methods is actually used in cross-border taxation, determine the states involved in double taxation agreements. Often one follows the OECD model agreement.

Now there are serious differences between the credit method and the exemption method. The credit method pays tax in both countries, both in the country where the income was generated and in the country where the person receiving it is taxable. However, the credit method allows the taxes previously paid abroad to be credited to the domestic tax; hence the name. If, for example, you make a profit of EUR 1,000,000 abroad and pay 20% tax there, then you still have to pay income tax in Germany. For example, we calculate the rich tax rate of 45%, which is equivalent to a German income tax of EUR 450,000. The credit method reduces the German income tax to EUR 250,000, because you have already paid EUR 200,000 in taxes abroad. This avoids double taxation.

In the exemption method, it is important to distinguish which country is entitled to exclusive taxation in certain tax situations. If, for example, a person taxable in Germany rents out real estate abroad and the double taxation agreement stipulates the exemption method for such income, then it is usually the case that the country in which the property is located has the sole right to tax. Thus, you only pay taxes on these incomes abroad.

Many may now think that one has no choice but to submit to the respective regulations of bilateral double taxation agreements. So if the credit method is to be applied, you pay taxes in total, which are based on the highest tax rate – depending on which state sets it.

However, we can help to effectively exchange the credit method for the exemption method. Of course, we cannot in any way persuade the respective governments to amend the double taxation agreements to our liking, so that the credit method becomes the exemption method. But we can design taxes. And how we manage that for a person taxable in Germany the credit method is not taken into account, so that he only pays (the lower) taxes abroad, we want to show you in this article. And since real estate is also subject to the credit method in many cases, we outline an example of this.

Suppose Mr. Casa lives in Germany and is fully taxable here. He wants to buy a property in Spain to rent it there. In the double taxation agreement between Spain and Germany, however, the accounting method is prescribed. Thus, in Spain, Mr Casa would have to pay a tax on rental income. Since the tax rate for this tax in our example in Spain should be lower than the personal tax rate to which Mr Casa is subject in Germany, he would have to pay the difference in Germany downstream.

If, on the other hand, Mr. Casa first sets up a partnership in Spain and then acquires and rents the property, then the following happens: Unlike in Germany, a partnership in Spain pays corporate tax. The corporate tax rate in Spain is lower than the personal tax rate of Mr Casa in Germany.

If you now look at the facts from the point of view of the German tax authority, you have to treat the partnership as a transparent tax subject. In other words, only taxation applies in Spain. The fact that there was a corporation tax from the partnership instead of an income tax plays no role here. The payment of rental income by the partnership to Mr. Casa, on the other hand, is considered as withdrawal. It is therefore irrelevant from a tax point of view, since this does not constitute income; After all, the rental income was obtained solely by the partnership.

Strictly speaking, neither the credit method nor the exemption method apply. De facto, however, taxation proceeds as if the exemption method had been agreed in the double taxation agreement. Because as we have shown, Mr. Casa pays taxes on rental income in Spain alone. In Germany, however, no credit was made; We have successfully avoided them.

Let us now come to a final consideration. What applies to our fictional Mr. Casa and his real estate acquisition in Spain can also be applied in a similar form in many other tax regimes. Of course, in each individual case, the corresponding double taxation agreements must be examined and the respective national tax law must also be taken into account. Therefore, it goes without saying that such a cross-border tax structure should always rely on the expertise of experienced tax consultants in order to gain legal certainty. For example, it is also necessary to check whether such designs are permitted in the respective country at all or perhaps even count as misuse of design. Equally relevant are tax collection issues; This also applies to Spain. For this reason, we explicitly point out that the previously designed example with its reference to Spain is an overly simplistic one that excludes all other relevant tax aspects.