Exceptions from the progression clause
Under the so-called progression clause, income that is tax-exempt in Germany is under certain conditions not taxed, but is considered when calculating the tax rate applicable to taxable income. This applies, for example, to domestic wage replacement benefits or foreign income (Section 32b (1) sentence 1 of the German Income Tax Act (EStG)); sentence 2 of the provision contains a number of exceptions. In its decision of May 21, 2025 (case no. I R 5/22), the Federal Fiscal Court (BFH) clarifies that these exceptions only apply to income that is subject to the progression clause due to a tax exemption under treaty law.
In the case in question, a person subject to unlimited tax liability in Germany received income from self-employment. His wife lived in Poland and earned income there from, among other things, rental property. The spouses, who were not permanently separated, applied for joint assessment in Germany for the year in question. According to Section 1a (1) no. 2 EStG, a spouse without a domicile or habitual residence in Germany is treated as having unlimited income tax liability. The spouses assumed that the Polish rental income was tax-exempt in Germany under the double taxation agreement (DTA) with Poland and was exempt from the progression clause. However, in the course of the income tax assessment, the tax office subjected all of the wife's income earned in Poland to the progression clause pursuant to Section 32b (1) sentence 1 no. 5 EStG. This provision stipulates that the progression clause applies to fictitiously unlimited taxpayers not in the case of an exemption under treaty law, but in the case of no domestic income. Appeals and legal action against the application of the progression clause to the Polish rental income were unsuccessful.
The Federal Fiscal Court followed the findings of the tax office and the tax court. According to the wording, the exemption provision in Section 32b (1) sentence 2 (here no. 3) EStG only applies to income that is tax-exempt under a double taxation agreement. However, the DTA with Poland does not apply in this case: due to the location of the rental property and the fact that the wife is exclusively resident in Poland under the terms of the agreement, there is no cross-border situation and her rental income is not taxable in Germany. Consequently, as assessed by the tax office, the progression clause pursuant to Section 32b (1) sentence 1 no. 5 EStG applies, for which, however, no exception is provided for in the case of only fictitious unlimited tax liability. According to the Federal Fiscal Court, an extension of the exception from the progression clause to such foreign income that is not tax-exempt under a double taxation agreement is out of the question.
In the opinion of the Federal Fiscal Court, this legal consequence does not violate EU law either. This is because the unequal treatment compared to those with regular unlimited tax liability is not based on the wife's tax residence in Poland, but on the use of the advantages of joint assessment regardless of this circumstance. At the same time, the symmetry required by ECJ case law is maintained: in the case of negative Polish rental income, a negative progression clause would have to be applied.
Notice:
The ruling makes it clear that only fictitiously unlimited taxpayers in Germany are not to be unrestrictedly treated as unlimited taxpayers. In practice, the problem of the dispute could be avoided by establishing the wife's residence and/or habitual abode in Germany. In case of doubt, taxpayers would have to weigh up whether the tax advantages of joint assessment without progression clause outweigh the costs incurred, e.g., for a larger apartment or higher travel expenses. Beyond the circumstances described above, the case law can also be applied to other income from EU/EEA countries mentioned in Section 32b (1) sentence 2 EStG, e.g., from a commercial permanent establishment that does not meet the activity requirements of Section 2a (2) sentence 1.
