New tax return filing obligation for non-residents in Germany

In Germany, a new fact has been introduced that has led to an obligation for non-residents to file a German income tax return. In the majority of cases, this will cause a considerable additional tax burden in addition to the additional effort of submitting the declaration. It applies as of the 2020 German tax return filing season which should start in 2021.

Previous legal situation

Before 2020, wage tax withholdings on employment income for non-residents was generally considered as the final tax. Only in exceptional cases there was an obligation to file a German income tax return, for example in cases of allowances that were considered for German withholding tax purposes or where the tax return filing was requested on a voluntary basis. The latter only applied if the requirements were met (i.e. voluntary tax return only possible for EU/EEA nationals residing in an EU/EEA state). In these cases, the tax assessment via the tax return was also conducted including the foreign income for progression clause purposes.

If a person is not resident for the whole calendar year and has not met one of these exceptional cases, the withholding tax was the final tax. It was not possible to file an annual German tax return.

New legal situation as of 2020

As of 2020, non-residents are required to file a German income tax return if they receive extraordinary income that is subject to German withholding tax according to the so-called 1/5^th-rule. This rule favours extraordinary income under German tax law. A one-time high income is treated for tax purposes as if the recipient is receiving it evenly distributed over the next five years. This avoids a one-time high tax burden, as due to the tax progression, the tax rate would be significantly higher than if the income would have been spread over five years.

In the case of extraordinary income, employers are generally obliged to determine withholding taxes based on the 1/5^th-rule.

What does this mean in practice?

The payment of extraordinary income subject to withholding tax based on the 1/5^th-rule, in particular, the payment of severance payments and remuneration for activities lasting several years, such as non-cash benefits from employee participation schemes (stock options, RSUs, etc.) leads to a German tax return filing obligation for individuals that were German non-residents throughout the entire calendar year. Within the tax return, foreign income needs to be declared for progression clause purposes which increases the German tax return on the extraordinary income. In most scenarios, this should lead to an additional tax liability throughout the tax return.

Example:

A non-resident employee exercises stock options in 2020. The benefit in kind amounts to EUR 30,000 and is fully taxable in Germany (vesting period relates to Germany). In addition, the employee has foreign income in 2020 in the amount of EUR 270,000 which is not taxable in Germany based on the double tax treaty.

Withholding tax is calculated by the employer on the benefit in kind of the stock options. Since the extraordinary income is the only income that is still subject to withholding tax in 2020, the withholding tax is EUR 0.00 considering the 1/5^th-rule. In years prior to 2020, this would have been the final tax, i.e. no German tax payment on the benefit in kind from exercising stock options.

Due to the newly introduced obligation to file a German income tax return in this case for 2020, the foreign income in the amount of EUR 270,000 will be taken into account so as to determine the tax rate in the German tax return. Consequently, the individual can expect a tax payment throughout the income tax return on the extraordinary income in the amount of approximately EUR 11,900.

Conclusion

The new regulation may lead to a significantly higher tax burden for the employee. In cases of a tax equalisation agreement, this greater tax burden must be borne by the employer. If the employer provides the employee with a tax advisor, this also extends the engagement to periods after leaving Germany, for example, after the end of an assignment in Germany or during an assignment from Germany to a foreign country. The employer is also well advised to inform the employee in advance about the tax consequences of this new regulation so that they can fulfil their declaration obligations and are also prepared for an additional tax payment.

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