In the the international context of double taxation agreements Wages are generally taxable in the country in which the employee is resident. However, if the employee carries out their work in another country for an employer based there, or if they stay in that other country for more than 183 days, the wages are taxed in the country in which the employee carries out their work.
However, many double taxation agreements do not expressly address the question of in which country severance payments received by an employee upon termination of employment are to be taxed. According to German case law, severance payments do not constitute income paid in respect of work previously performed (Federal Fiscal Court, 10 June 2015, Case No. I R 79/13). Consequently, from the perspective of the German courts, they are not taxable in the country in which the work was carried out, but in the country in which the employee resides at the time of receiving the severance payment. Consequently, changing one’s place of residence before the severance payment is made could have a significant impact on the amount of tax payable, particularly if the employee moves to a country with which Germany has a double taxation agreement and which has a low tax rate.
Here is an example:
Employee A lives and works in Germany. After many years of service, he is made redundant by his employer. As compensation for lost earnings, he is to receive a severance payment of 750,000 euros. In view of this payment, the employee decides to spend his retirement on the beautiful Mediterranean coast and moves permanently to Malta. After he has cut all ties with Germany, the severance payment is credited to his account.
Solution to the example:
Under the previous legal position, the wages were not regarded as having been paid in respect of the previous employment in Germany. Under the double taxation agreement between Germany and Malta (Article 15), the wages would therefore be taxable in Malta, the country of residence, and Germany would receive nothing.
However, with effect from 1 January 2017, the legislature introduced new provisions through the Anti-BEPS Act (Act Implementing the Amendments to the EU Mutual Assistance Directive and Further Measures against Profit Erosion and Profit Shifting of December 2016). A provision was introduced in Section 50d(12) of the Income Tax Act (EStG) under which severance payments made on the termination of an employment relationship are deemed, for the purposes of applying double taxation agreements, to be additional remuneration paid for past work, provided that the agreement does not contain any express provision to the contrary. The aim of this provision is to prevent untaxed (so-called „white“) income.
‘White’ income arises when the country of residence interprets the treaty in such a way that the right of taxation lies with the former country of employment, whilst the former country of employment interprets the treaty in such a way that the right of taxation lies with the country of residence. Under this interpretation, neither state would levy tax, as a conflict of classification arises which is favourable to the taxpayer. With the new Section 50d(12) of the Income Tax Act (EStG), Germany would resolve this conflict of classification in such a way that Germany, as the former state of employment, would levy tax in all cases.
In the example given involving Malta, however, there was no conflict of jurisdiction at all; rather, the wages would be taxable in Malta. However, a literal interpretation of Section 50d(12) of the German Income Tax Act (EStG) gives rise to a new conflict of jurisdiction – one that actually leads to double taxation. This is because, under the new law, Germany would have to assert its right of taxation. If Malta does not have a similar provision, Malta, as the state of residence, will also assert its right to tax. It remains to be seen how the tax authorities will address this issue in future. A similar problem arises, for example, when moving to France, Spain, Italy or Portugal.
Practical tip: If, as an employee, you are due to receive a severance payment, please contact your tax adviser well in advance to avoid unnecessary double taxation and any uncertainty.