Taxation of US Investment Income for German Non-Resident Aliens

I. Executive Summary

This report analyzes the tax implications for a non-resident alien residing in Germany who invests in US stock exchanges through stocks, bonds, and Exchange Traded Funds (ETFs). It outlines the key US and German tax treatments of interest, dividends, and capital gains derived from such investments, emphasizing the crucial role of the tax treaty between the United States and Germany in mitigating double taxation. The analysis reveals that while the United States generally does not tax capital gains earned by non-resident aliens, dividends and certain interest income are subject to withholding tax, which can be significantly reduced by the US-Germany tax treaty. In Germany, residents are subject to tax on their worldwide income, but provisions such as the foreign tax credit and the exemption method, along with specific regulations for investment income, impact the final tax liability. The report concludes by presenting several tax-efficient strategies that German residents can employ to minimize their overall tax burden when investing in US markets.

II. Introduction: Taxation of US Investments for German Non-Resident Aliens

In an increasingly interconnected global economy, individuals frequently seek investment opportunities beyond their country of residence. This trend has led to a rise in cross-border investments, offering diversification and access to different markets. However, navigating the complexities of international taxation is paramount for investors to ensure compliance and optimize their financial returns. International taxation involves the intricate interplay of tax laws in both the country where the income originates (the source country) and the country where the investor resides (the residence country), alongside any applicable bilateral tax treaties designed to prevent double taxation.

This report specifically addresses the scenario of a German resident who invests in the United States stock exchanges, focusing on investments in stocks, bonds, and ETFs. The objective is to provide clarity on the tax treatment of income generated from these investments in both the US and Germany and to propose strategies that can lead to a more tax-efficient investment approach. Understanding the nuances of both tax systems and the provisions of the US-Germany tax treaty is essential for German residents seeking to invest in the US financial markets effectively.

III. US Tax Framework for Non-Resident Alien Investors

To determine the US tax obligations of a German investor, it is crucial first to establish their tax status under US law. The United States distinguishes between resident and non-resident aliens for tax purposes.¹ An individual who is not a US citizen is considered a non-resident alien unless they meet specific criteria outlined in either the "green card test" or the "substantial presence test" for the calendar year.¹ The green card test applies to individuals who have been lawfully admitted for permanent residence in the US. The substantial presence test is met if an individual is present in the US for at least 31 days during the current year and a total of 183 days during the three-year period that includes the current year, the year immediately preceding, and the second year preceding, with specific weighting applied to the days present in each year.1 For the purposes of this analysis, we assume the German investor does not meet either of these tests and is therefore classified as a non-resident alien under US tax law.

Generally, the United States taxes non-resident aliens only on their income that is sourced within the US.¹ This US source income for non-resident aliens falls into one of two primary classifications: Effectively Connected Income (ECI) and Fixed, Determinable, Annual, and Periodical (FDAP) income.¹ Effectively Connected Income is income that is derived from engaging in a trade or business within the United States.¹ For most non-resident alien investors, passive investment income such as that generated from holding stocks, bonds, and ETFs is generally not considered ECI unless it is directly connected to a US trade or business they are actively involved in.¹ Income that is classified as ECI is taxed by the US at the regular US graduated income tax rates, similar to those applied to US citizens and residents.¹

The second classification, Fixed, Determinable, Annual, and Periodical (FDAP) income, broadly encompasses US source income that is not effectively connected with operating a US trade or business.¹ This category includes various types of passive income, such as interest from US sources (with some exceptions) and dividends from US stocks.¹ FDAP income is typically subject to a flat 30% tax rate in the United States, although this rate can be reduced if the non-resident alien's country of residence has a tax treaty with the US that specifies a lower rate.¹ This tax is usually collected through withholding at the source of the payment. Understanding this fundamental distinction between ECI and FDAP income is crucial for a German resident investing in US markets, as their investment income will predominantly fall under the FDAP classification, which carries its own specific tax implications.

IV. US Taxation of Investment Income for Non-Resident Aliens

The specific types of investment income relevant to a German non-resident alien investing in US markets are interest, dividends, and capital gains. Each of these income types is subject to distinct US tax rules for non-resident aliens.

Generally, US source interest income received by a non-resident alien is subject to a flat tax rate of 30%, unless a lower rate is provided by a tax treaty between the US and the investor's country of residence.¹ This tax is typically withheld at the source. However, a significant exception to this rule is the "portfolio interest" exemption.¹ This exemption allows certain US source interest earned by non-resident aliens to be generally exempt from US federal income tax. To qualify as portfolio interest, several conditions must be met.⁹ Firstly, the debt instrument must be in registered form, meaning the ownership is recorded. Secondly, the interest cannot be received by a 10% shareholder of the issuing corporation or a 10% partner in the issuing partnership. Finally, the interest payment cannot be contingent on the debtor's cash flow, income, or profits. Besides the portfolio interest exemption, other types of US source interest are also often exempt from US tax for non-resident aliens, such as interest paid by US banks, savings and loan institutions, credit unions, and insurance companies.1 This makes certain types of US debt instruments, like US Treasury securities, potentially tax-efficient for non-resident aliens.

Dividend income derived from US sources and paid to non-resident aliens is generally subject to a default withholding tax of 30%.¹ However, this rate can be reduced by the provisions of an applicable tax treaty between the US and the investor's country of residence.¹ To claim the benefits of a tax treaty, the non-resident alien must typically provide a completed Form W-8BEN to their US brokerage firm or the entity paying the dividend.¹ This form certifies the individual's foreign status and allows the payer to withhold tax at the treaty rate. When a non-resident alien invests in US domiciled ETFs, any dividends distributed by these ETFs are also subject to US withholding tax, even if the underlying assets held by the ETF are not US-based.1 This is because the ETF itself is a US entity. It is important to note that a portion of a dividend paid by a US domiciled ETF might be exempt from non-resident withholding if it is attributable to short-term capital gains or qualified interest income received by the ETF.¹ However, correctly identifying and claiming this exemption requires the ETF provider and the broker to be aware of the relevant regulations and report the income appropriately.

In contrast to interest and dividends, capital gains earned by non-resident aliens from the sale of securities, such as stocks and ETFs, are generally not taxable in the United States.¹ There is an exception for certain non-resident aliens who are physically present in the US for 183 days or more during the tax year, provided that their tax home has also shifted to the US.⁶ However, this scenario is unlikely for a typical German resident who is investing in the US market remotely. It's also worth noting that capital gains from the sale of US real property interests are taxable in the US, regardless of the non-resident alien's presence in the country.⁶ For a German resident investing in US stocks and ETFs through a US stock exchange, the general rule of capital gains exemption will typically apply.¹ This can be a significant advantage for non-resident alien investors.

V. US Withholding Taxes on Investment Income

As discussed, the United States employs a withholding tax system for certain types of income paid to non-resident aliens. The standard withholding tax rate for FDAP income, which includes dividends and non-exempt interest, is 30%.¹ This means that when a US company pays a dividend or non-exempt interest to a non-resident alien, the payer is required to withhold 30% of the payment and remit it to the Internal Revenue Service (IRS).

However, this standard rate is often reduced or even eliminated by bilateral tax treaties that the US has entered into with various countries. To benefit from these reduced treaty rates, a non-resident alien must provide the payer of the income with a valid Form W-8BEN.¹ This form serves as a certification of the recipient's foreign status and their claim to treaty benefits. By submitting Form W-8BEN to their US broker, a German resident can inform the broker of their residency status and request that the withholding tax on their dividend and interest income be applied at the rate specified in the US-Germany tax treaty, rather than the default 30% rate. It is important to note that withholding tax generally does not apply to capital gains earned by non-resident aliens from the sale of securities, as these gains are typically exempt from US taxation.¹ The tax treaty between the United States and Germany plays a crucial role in determining the actual withholding tax rates applicable to a German resident's investment income from US sources.

VI. The US-Germany Tax Treaty: Impact on Investment Income

The "Convention between the United States of America and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital," along with its subsequent amendments, most notably the Protocol signed in 2006, significantly impacts the taxation of investment income earned by German residents from US sources.⁵ Articles 10, 11, and 13 of this treaty are particularly relevant to the tax treatment of dividends, interest, and capital gains.

Article 10 of the tax treaty addresses the taxation of dividends. It states that dividends paid by a company that is a resident of one contracting state (e.g., a US company) to a resident of the other contracting state (e.g., a German resident) may be taxed in that other state (Germany).¹⁴ However, the treaty also limits the tax that the source state (US) can impose on such dividends if the beneficial owner is a resident of the other contracting state.¹⁴ The withholding tax rate in the US is limited to 5% of the gross amount of the dividends if the beneficial owner is a company that directly holds at least 10% of the voting shares of the company paying the dividends. In all other cases, including dividends paid to individual investors, the withholding tax rate is capped at 15% of the gross amount of the dividends.¹⁴ It is important to note that special rules apply to dividends paid by US Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs). For RICs, the 15% rate applies, while for REITs, the 5% rate does not apply, and the 15% rate is limited to individuals holding less than a 10% interest.¹⁴ The 2006 Protocol to the treaty further eliminated withholding tax on certain cross-border dividend payments, primarily between parent and subsidiary companies and to pension funds.⁵ For individual German residents investing in US stocks and ETFs, the 15% withholding tax rate on dividends under Article 10 is a significant reduction from the standard 30% US rate.

Article 11 of the US-Germany tax treaty deals with the taxation of interest. The general rule under this article is that interest derived and beneficially owned by a resident of one contracting state (e.g., a German resident) from sources within the other contracting state (US) is taxable only in the state of residence (Germany).¹⁴ This means that the US generally cannot impose its tax on interest paid to a German resident. The treaty defines interest broadly as income from debt claims of every kind.¹⁴ There is an exception to this rule for interest that is effectively connected with a permanent establishment or a fixed base that the German resident has in the US.¹⁴ In such cases, the interest may be taxed in the US. Additionally, the treaty includes a provision addressing situations where there is a special relationship between the payer and the beneficial owner of the interest, resulting in an excessive amount of interest being paid. In such cases, only the arm's length interest amount is subject to the treaty provisions.14 The general exemption of US-sourced interest paid to German residents under Article 11 aligns with the portfolio interest exemption in US domestic law, further facilitating tax-efficient investment in US bonds for German residents.

Article 13 of the US-Germany tax treaty addresses the taxation of capital gains. It specifies that gains derived by a resident of one contracting state from the alienation of immovable property situated in the other contracting state may be taxed in that other state (the US, in this case).¹⁴ However, for gains from the alienation of any other property, including stocks, bonds, and ETFs, the general rule is that these gains are taxable only in the contracting state of which the alienator is a resident (Germany).¹⁴ There is a specific rule for individuals who were residents of one state and become residents of the other, concerning gains from shares held in a company resident in the first state, but this is typically applicable for a limited period after the change of residency and might not affect a standard portfolio investor.¹⁴ Therefore, under Article 13 of the US-Germany tax treaty, a German resident who sells stocks, bonds, or ETFs on US stock exchanges generally will not be subject to capital gains tax in the United States.

VII. German Taxation of Foreign Investment Income for German Residents

In Germany, the tax system operates on the principle of worldwide taxation, meaning that individuals who are considered tax residents of Germany are subject to German income tax on their income from all sources, both within Germany and abroad.¹⁷ Tax residency in Germany is typically established if an individual has a domicile (a permanent home) or a habitual abode (living in Germany for at least six months in a calendar year) in Germany.¹⁷ German income tax rates are progressive, meaning they increase as the level of taxable income rises.¹⁷

For investment income, including interest, dividends, and capital gains, Germany levies a special tax known as the "Abgeltungssteuer" (final withholding tax).¹⁷ The standard rate for the "Abgeltungssteuer" is a flat 25%, to which a solidarity surcharge (Solidaritätszuschlag) of 5.5% is added, resulting in an effective tax rate of 26.375%.¹⁷ Additionally, if the investor is a member of a church entitled to levy church tax (Kirchensteuer), an additional surcharge of 8% or 9% (depending on the federal state) may apply to the income tax liability.¹⁷ Germany also provides an annual investor's allowance (Sparerpauschbetrag), which is a tax-free amount for investment income. As of recent regulations, this allowance is €1,000 per year for single taxpayers and €2,000 per year for married couples filing jointly.¹⁸

Interest income received by a German resident, including interest from US bonds, is generally subject to the "Abgeltungssteuer" at the rate of 25% plus the solidarity surcharge and any applicable church tax.¹⁹ This results in an effective tax rate of approximately 26.375% (plus church tax). Importantly, related expenses incurred in generating this interest income are typically not deductible for the purposes of the "Abgeltungssteuer".¹⁹ However, the interest income does qualify for the annual investor's allowance, meaning that the first €1,000 (or €2,000 for married couples) of investment income, which can include interest, dividends, and capital gains, is tax-free.¹⁹

Dividend income received by a German resident from US stocks and ETFs is also subject to the "Abgeltungssteuer".¹⁷ However, for investments in funds, including ETFs, that qualify as equity funds (Aktienfonds) or mixed funds (Mischfonds) under German tax law, a "Teilfreistellung" (partial tax exemption) applies.²⁴ For equity funds, which are generally defined as funds that invest more than 50% of their assets in equities, 30% of the dividend income is tax-exempt for private investors.³⁶ This means that only 70% of the dividend income from such ETFs is subject to the "Abgeltungssteuer." For mixed funds, which invest at least 25% of their assets in equities, a lower partial exemption rate applies. Dividend income also qualifies for the annual investor's allowance. Furthermore, any withholding tax paid in the US on these dividends, such as the 15% withheld under the US-Germany tax treaty, may be creditable against the German tax liability on this income.¹⁷

Capital gains realized by a German resident from the sale of shares and ETFs are also generally taxed under the "Abgeltungssteuer" regime at a rate of 25% plus solidarity surcharge and church tax if applicable.¹⁷ Similar to dividends, the "Teilfreistellung" also applies to capital gains from equity funds and mixed funds, providing a 30% exemption for gains from equity funds held by private investors.²⁴ For accumulating ETFs, which reinvest their earnings rather than distributing them as dividends, Germany has a system called "Vorabpauschale" (advance lump sum).²⁶ This is a form of annual pre-taxation on a deemed profit, even if no actual sale has occurred. Capital gains also qualify for the annual investor's allowance. It is important to note that the tax rules for capital gains from other types of assets, such as real estate and cryptocurrency, can differ significantly.²¹

To prevent double taxation of foreign income, Germany primarily employs the exemption method under its tax treaties.¹⁷ This means that income from foreign sources, such as the US, may be exempt from German tax but is taken into account when determining the overall German income tax rate applicable to the taxpayer's other income (exemption with progression). However, in some cases, a foreign tax credit may be available if explicitly provided in the applicable tax treaty or if no treaty exists.¹⁷ This credit is usually limited to the amount of German income tax that would be payable on that specific foreign income. For US withholding tax on dividends, it is possible that this can be credited against the German "Abgeltungssteuer" liability, effectively reducing the German tax payable.³⁹

VIII. Interplay of US and German Tax Laws and the US-Germany Tax Treaty

The tax treaty between the United States and Germany serves as a crucial mechanism to prevent the double taxation of income earned by residents of one country from sources in the other. It achieves this through a combination of measures, including the reduction of withholding taxes in the source country and the provision of either exemptions or credits in the residence country.

Specifically, the treaty, as analyzed in the previous section, reduces the US withholding tax on dividends paid to German residents to 15% (in most cases) and generally exempts interest income from US withholding tax. For capital gains from the sale of securities, both the treaty and US domestic law generally provide an exemption for non-resident aliens.

Germany, as the country of residence for the investor in this scenario, taxes the worldwide income of its residents. However, the provisions of the US-Germany tax treaty and Germany's domestic tax laws work together to avoid double taxation.

Consider the specific scenarios:

• Interest: When a German resident receives interest income from US bonds, this income is likely to be exempt from US withholding tax due to Article 11 of the treaty and the portfolio interest exemption in US domestic law. This interest will then be taxable in Germany under the "Abgeltungssteuer" regime, but the annual investor's allowance will apply, potentially reducing the taxable amount.

• Dividends: Dividends from US stocks and ETFs paid to a German resident will be subject to a US withholding tax of 15% under Article 10 of the treaty. This dividend income will also be taxable in Germany under the "Abgeltungssteuer" regime. If the investment is in an ETF that qualifies as an equity fund, the "Teilfreistellung" will provide a 30% exemption from German tax. Furthermore, the 15% US withholding tax already paid may be available as a credit against the German tax liability, further mitigating double taxation.

• Capital Gains: Capital gains from the sale of US stocks and ETFs by a German resident are generally not taxable in the US due to Article 13 of the treaty and US domestic law. These gains will be taxable in Germany under the "Abgeltungssteuer" regime, and if the investment is in a qualifying ETF, the "Teilfreistellung" will provide a 30% exemption.

IX. Tax-Efficient Strategies for a German Resident Investing in US Markets

To minimize the tax burden associated with investing in US stocks, bonds, and ETFs, a German resident can employ several tax-efficient strategies, taking into account both US and German tax laws and the provisions of the US-Germany tax treaty.

Firstly, it is crucial to utilize the reduced withholding tax rates provided by the US-Germany tax treaty. To benefit from the 15% withholding tax rate on dividends (as opposed to the standard 30%), the German resident must ensure that they have correctly completed and submitted Form W-8BEN to their US broker. For interest income from US bonds, structuring the investments to qualify for the portfolio interest exemption is key. This aligns with Article 11 of the treaty, typically resulting in no US withholding tax on such interest.

Secondly, German residents should consider the domicile of the ETFs they invest in. US domiciled ETFs are subject to US withholding tax on dividends, even if the ETF's holdings are primarily non-US assets.1 A potential strategy to mitigate this is to invest in ETFs that are domiciled outside the US, for example, in Ireland. Under the US-Ireland tax treaty, the US withholding tax rate on dividends paid to Irish investment funds is often 15%.3 While this tax is paid at the fund level, it might still result in a lower overall tax burden compared to the 30% (or even 15% after treaty) withholding on dividends from a US domiciled ETF, especially when considering the German tax treatment and potential foreign tax credits.

Thirdly, when investing in US bonds, ensure that the conditions for the portfolio interest exemption are met. This includes holding the bonds in registered form and not holding a 10% or greater ownership stake in the issuer. By adhering to these conditions, the German resident can typically avoid US withholding tax on the interest income.

Fourthly, while the US generally does not tax capital gains for non-resident aliens, these gains are taxable in Germany. For assets other than stocks and ETFs, German tax law may have specific holding period rules that affect taxation. However, for stocks and ETFs, the "Abgeltungssteuer" applies regardless of the holding period. Therefore, while timing the realization of capital gains might be relevant for managing overall tax liability in Germany, it does not offer a direct tax benefit in the US for a non-resident alien.

Fifthly, German residents investing in US ETFs should be mindful of the German tax rules regarding foreign investment funds, particularly the "Teilfreistellung." Choosing ETFs that qualify as equity funds (Aktienfonds) is advantageous as it allows for a 30% tax exemption on both dividends and capital gains at the German level. Information about an ETF's equity ratio is usually provided by the fund manager and is crucial for making informed investment decisions from a tax perspective.²⁴

Finally, proper documentation and reporting are essential for tax compliance in both the US and Germany. This includes correctly filing Form W-8BEN with the US broker to claim treaty benefits. All US-sourced income must be accurately reported on the German tax return (Einkommensteuererklärung) using the appropriate forms, such as Anlage KAP and Anlage KAP-INV.²¹ Maintaining detailed records of all investment transactions and income received is also crucial. Additionally, the German resident should consider whether to claim a foreign tax credit in Germany for any US withholding tax paid on dividends, as this can help to further reduce their German tax liability.

The following table summarizes the standard US withholding tax rates and the reduced rates applicable to German residents under the US-Germany Tax Treaty:

X. Summary of Key Tax Implications and Tax-Efficient Strategies

In summary, for a German resident investing in US markets, the key US tax implications are generally no capital gains tax on the sale of securities, a reduced withholding tax rate on dividends (typically 15% under the treaty), and generally no withholding tax on interest income due to the treaty and the portfolio interest exemption.

The key German tax implications include the taxation of worldwide investment income under the "Abgeltungssteuer" regime (currently 26.375% plus potential church tax), the availability of an annual investor's allowance (€1,000 for singles, €2,000 for married couples), the "Teilfreistellung" providing a 30% tax exemption for dividends and capital gains from qualifying equity ETFs, and the potential to claim a foreign tax credit in Germany for US withholding tax paid on dividends.

The main tax-efficient strategies for a German resident investing in US stocks, bonds, and ETFs include: utilizing the reduced withholding tax rates under the US-Germany tax treaty by correctly filing Form W-8BEN, considering investing in non-US domiciled ETFs to potentially reduce the initial US dividend withholding tax, maximizing the portfolio interest exemption when investing in US bonds, strategically choosing ETFs that qualify for the German "Teilfreistellung" to reduce German tax on dividends and capital gains, and ensuring proper documentation and reporting of all investment income in both the US and Germany.

XI. Conclusion

Understanding the intricacies of both US and German tax laws, as well as the provisions of the US-Germany tax treaty, is paramount for a German resident seeking to invest in US financial markets in a tax-efficient manner. While the US offers a favorable tax environment for non-resident aliens regarding capital gains, dividends and interest require careful consideration of withholding taxes and treaty benefits. On the German side, the "Abgeltungssteuer" provides a relatively straightforward system for taxing investment income, with additional benefits available through the "Teilfreistellung" for ETFs and the annual investor's allowance. By strategically employing the tax-efficient strategies outlined in this report and ensuring full compliance with the tax regulations in both countries, German residents can optimize their investment returns from US markets. It is always recommended to seek professional tax advice to ensure that investment strategies are tailored to individual circumstances and fully compliant with all applicable laws and regulations.

Last updated: April 7, 2025