Corporation tax provision with retroactive effect on surplus profit transfers resulting from events prior to tax consolidation is partly void

Corporation tax provision with retroactive effect on surplus profit transfers resulting from events prior to tax consolidation is partly void

Press Release No. 32/2023 of 17 March 2023

Order of 14 December 2023 - 2 BvL 7/13, 2 BvL 18/14

In an order published today, the Second Senate of the Federal Constitutional Court held that § 34(9) no. 4 in conjunction with § 14(3) first sentence of the Corporation Tax Act (Körperschaftsteuergesetz - KStG) as amended by the Act Transposing EU Directives Into Domestic Tax Law (Gesetz zur Umsetzung von EU-Richtlinien in nationales Steuerrecht und zur Änderung weiterer Vorschriften - EURLUmsG) of 9 December 2004 is partly void. Pursuant to § 14(3) first sentence KStG, surplus profit transfers (Mehrabführungen) resulting from events prior to membership within a consolidated tax group (Organschaft) are treated as profit distributions by the controlled company to the tax group parent. According to § 34(9) no. 4 KStG, this provision - which has the potential to increase a corporation's tax liability - is applicable to surplus profit transfers (resulting from events prior to tax consolidation) by controlled companies whose financial year ends after 31 December 2003. The resulting quasi-retroactive effects (unechte Rückwirkung) are in certain constellations incompatible with the constitutional principle of the protection of legitimate expectations.

Facts of the case:

The system of consolidated group taxation allows for the economic interdependence of related companies to be taken into account for corporation tax purposes. The conditions under which a controlled company's income is attributable to the parent company within a consolidated tax group are set out in § 14 KStG. A key requirement for establishing a tax group under corporation tax law is the conclusion of a profit transfer agreement - also referred to as a profit-and-loss transfer agreement. This profit transfer agreement must be concluded for a period of at least five years and must be properly carried out throughout its term. If the agreement is terminated prematurely without a compelling reason, the group is, for tax purposes, regarded as non-existent from the outset. Irrespective of this, the controlled company remains obliged under commercial law to transfer its profit to the parent company until the profit-and-loss transfer agreement has been effectively terminated in accordance with the requirements under commercial law.

The profit that the controlled company has to transfer to the parent company under commercial law is not the same as the controlled company's income that is attributable to the parent company for tax purposes, which is determined on the basis of the controlled company's tax balance sheet. If the profit transferred by the controlled company under commercial law is greater than the profit registered on its tax balance sheet, the difference is referred to as a surplus profit transfer. Discrepancies between the commercial balance sheet and the tax balance sheet can arise due to different accounting rules under tax law as opposed to commercial law that apply, for example, to the capitalisation of acquisition or production costs.

It was a contentious issue whether surplus profit transfers resulting from events occurring prior to tax consolidation should be classified as tax-neutral profit transfers within the meaning of §§ 14 ff. KStG or as profit distributions. The latter had the potential to increase a company's corporation tax liability both under the 'imputation system' (Anrechnungsverfahren), which was applicable until the end of the year 2000, and - until 2006 - under the interim rules that applied during the transition to the 'half-income system' (Halbeinkünfteverfahren). By judgment of 18 December 2002, the Federal Finance Court (Bundesfinanzhof) held that surplus profit transfers resulting from events prior to tax consolidation should be treated as tax-neutral profit transfers rather than profit distributions. This was contrary to the position taken by the tax authorities at the time. On 13 August 2004, the Federal Government submitted the draft of the Act Transposing EU Directives Into Domestic Tax Law to the Bundesrat with the aim of casting the earlier position held by the tax authorities into legislation. That legislation came into force on 16 December 2004 in the form of § 14(3) and § 34(9) no. 4 KStG.

The plaintiffs in the two cases initiated before the finance courts are housing development companies that until the end of the year 1990 had been non-profit entities and exempt from corporation tax. In 2004 to 2006, the period at issue here, they were members of consolidated tax groups. One of the plaintiffs had been part of a tax group since 1991. In the other case, the profit transfer agreement was not concluded until October 2002. In both cases, surplus profit transfers resulting from events prior to tax consolidation were treated by the tax authorities as profit distributions, resulting in higher corporation tax assessments. Appeals against these assessments were dismissed by the courts of first instance. The subsequent appeals on points of law were suspended by the Federal Finance Court, which referred to the Federal Constitutional Court the question of whether § 34(9) no. 4 in conjunction with § 14(3) first sentence KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) is constitutional.

Key considerations of the Senate:

I. Outside the field of criminal law, the general prohibition of laws retroactively imposing burdens is based on the interests (protected by fundamental rights) of affected persons as well as the principles of legal certainty and the protection of legitimate expectations (Art. 20(3) in conjunction with Art. 2(1) of the Basic Law, Grundgesetz - GG). The general protection of legitimate expectations is therefore not only an objective guarantee deriving from the principle of the rule of law, but is also rooted in the fundamental rights afforded to the individual.

1. A legal provision has real retroactive effects (echte Rückwirkung) if its onerous legal consequences apply to events that were already fully concluded before the provision was promulgated ('retroactive effecting of legal consequences', Rückbewirkung von Rechtsfolgen). Such provisions are in principle impermissible under constitutional law. In cases of real retroactivity, the protection of legitimate expectations generally takes precedence. A legal provision is considered to have quasi-retroactive effects, on the other hand, if the onerous legal consequences only come into effect after the provision is promulgated but the statutory requirements prompting these consequences apply to events that were already set in motion before the promulgation ('retroactive link of statutory requirements', tatbestandliche Rückanknüpfung). Although provisions with quasi-retroactive effects are not generally impermissible, the legislator must take sufficient account of the protection of legitimate expectations as required under constitutional law. The principle of proportionality must be observed; the public interests pursued with the provision must be balanced against legitimate expectations of individuals that the law will remain unchanged.

In the balancing of these interests, the weight given to frustrated expectations depends on the level of protection such expectations merit and require. The merely general expectation that the currently applicable law will not change in the future does not merit any special protection under constitutional law unless additional aspects come into play that do warrant special protection. Furthermore, the expectation that the law will remain unchanged only merits protection to the extent that the law in question provides a suitable basis for such expectation. In cases of quasi-retroactivity, the level of protection afforded to expectations rooted in the currently applicable law may be diminished if the relevant provision requires interpretation and the correct application of the principles of interpretation allows for divergent positions that are tenably argued across legal scholarship and judicial practice. It is for the courts, particularly the supreme courts, to provide binding interpretations of legal provisions. If the courts have yet to clarify the meaning of a provision that requires interpretation, fundamental rights holders cannot necessarily rely on the expectation that the courts will eventually settle on a meaning favourable to their interests as being the 'correct' and established interpretation.

Even where the legal situation is clear, the protection afforded to expectations rooted in the currently applicable law is diminished - or even completely nullified - if it becomes apparent that a change in the law is imminent because a draft bill has been introduced in the Bundestag or Bundesrat, and even more so when the bill has finally passed the Bundestag; in that situation, affected individuals are able to take the possible amendment into account when exercising their freedom of action protected by fundamental rights.

2. In tax law, real retroactive effects only arise in cases where the legislator subsequently alters an already existing tax liability. This means that legislative amendments in the area of income and corporation tax with effect on the current assessment period must generally be categorised as quasi-retroactive. In cases of quasi-retroactivity - unlike with real retroactivity - the protection of legitimate expectations does not generally take precedence. Nonetheless, any onerous consequences arising from the frustration of legitimate expectations in the ongoing assessment period must always be sufficiently justified in accordance with the standards of proportionality.

Where changes in the law have quasi-retroactive effects on future assessment periods, the level of protection afforded to expectations rooted in the old legislation is modified by the fact that the legislator typically amends income and corporation tax law with regard to the yearly tax assessment period and that taxpayers are required to take this into consideration. This generally diminishes the level of protection afforded to taxpayer expectations for future assessment periods. In cases where the performance of an agreement is not due until after the current assessment period has ended or the performance of an agreement is set to extend over several assessment periods - as, for example, with contracts for the performance of continuing obligations - it is generally incumbent upon the taxpayer to make the necessary arrangements for the possibility of unfavourable changes in tax law by agreeing adjustment clauses or legal options for terminating the contract.

In certain isolated cases, however, parties concluding a contractual agreement may have a mutual interest warranting protection in having the performance of the agreement carried out at some future point beyond the current assessment period. This is especially true in cases where the parties are obliged by law to enter into commitments of a longer-term nature.

In any case, the law's function as a guarantor of legal certainty (Gewährleistungsfunktion des Rechts) means that taxpayers may, in principle, rely on the validity of the laws in force at the time when the constituent elements of applicable tax provisions are fulfilled. If the constituent elements of applicable tax law - such as a cash inflow or outflow or tax-relevant appreciations in value - are fully completed or realised under the old legislation and it is only the legal consequence - i.e. the resulting tax liability - that arises at a later point after the law has been amended, the situation that is of relevance for tax purposes has already reached an advanced state of completion. In accordance with rule-of-law guarantees, the legitimate expectations associated therewith are afforded protection. The legislator therefore needs to demonstrate special reasons if it retroactively links statutory requirements to such events and thereby (partly) devalues assets that - following, for example, the performance of a contractual agreement or an appreciation in value - were obtained in accordance with the old law, i.e. before new legislation was promulgated.

II. Based on these standards, § 34(9) no. 4 KStG in conjunction with § 14(3) first sentence KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) partly violates the constitutional principle of the protection of legitimate expectations.

1. § 34(9) no. 4 KStG in conjunction with § 14(3) first sentence KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) has onerous consequences associated with quasi-retroactive effects.

a) According to § 14(3) first sentence KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law), surplus profit transfers are deemed to constitute profit distributions at the close of the financial year. Depending on which portions of equity were deemed to have been used for this purpose, this could have an onerous effect in combination with the interim rules that applied during the transition from the imputation system to the half-income system. Until 2006, this transitional regime included a mechanism whereby the corporation tax reduction potential and the potential for increase accumulated under the imputation system was realised in case of profit distributions. Insofar as the fiction of a profit distribution under § 14(3) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) led to a realisation of the potential for increasing corporation tax and therefore an increase in corporation tax liability which was not offset by a simultaneous reduction in corporation tax, § 14(3) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) had an onerous effect on the controlled companies affected.

b) By referring to surplus profit transfers by controlled companies whose financial year ended after 31 December 2003, the new framework set out in § 34(9) no. 4 in conjunction with § 14(3) first sentence KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) formally applies to future events. That is because the potential increase in corporation tax resulting from the qualification of surplus profit transfers as profit distributions only takes effect at the end of the current assessment period and was thus first applicable from 31 December 2004 onwards. In reality, however, the legal consequences are brought about by events that were already set in motion at the time when the legislative amendment was promulgated. It makes no difference whether the decisive event is considered to be the conclusion of the profit-and-loss transfer agreement or the event that resulted in the surplus profit transfer prior to tax consolidation. Both events are relevant for the fictitious statutory treatment at issue here, namely that § 14(3) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) treats surplus profit transfers as profit distributions that are deemed to have occurred at the end of the financial year. Both events were fully concluded before the provisions came into effect.

2. The quasi-retroactive effects of the legislation are incompatible with the constitutional principle of the protection of legitimate expectations insofar as they apply to surplus profit transfers by a controlled company to its tax group parent before 1 January 2007 on the basis of a profit-and-loss transfer agreement that was concluded in the period between the publication of the Federal Finance Court's judgment of 18 December 2002 on 5 March 2003 and the introduction of the new bill in the Bundesrat on 13 August 2004. During that period, the contracting parties could legitimately expect that surplus profit transfers resulting from events prior to tax consolidation would be classified as tax-neutral profit transfers within the meaning of §§ 14 ff. KStG, as taxpayers could regard the legal situation as having been conclusively clarified by the Federal Finance Court's judgment of 18 December 2002. The level of protection afforded to expectations rooted in that legal situation was only diminished when new legislation was introduced in the Bundesrat on 13 August 2004. In cases where the profit-and-loss transfer agreement was concluded prior to that date, these expectations are afforded protection until the end of the year 2006, i.e. beyond the assessment period in which the agreement was concluded, on account of the statutory obligation to remain in a consolidated tax group for a minimum of five years.

The frustration of these expectations by the introduction of § 14(3) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) and its retroactive effect is not justified by any overriding public interests. The legislative objectives cited in the explanatory memorandum to the Act - namely, to cast the position held by the tax authorities into law and to make a clearer distinction between the special provisions applicable to consolidated tax groups and the general provisions of the half-income system - only justify the legislator's interest in amending the law with regard to the future. The same applies to the objective stated by the Federal Ministry of Finance of removing inconsistencies otherwise occurring in the corporation tax system. When looking at fiscal aspects, too, the legislator's wish to rectify a position adopted by the Federal Finance Court only constitutes a general need for (future) amendment; it does not in itself provide a legitimate basis for a retroactive link of statutory requirements.

3. The quasi-retroactive effects of the legislation are also incompatible with the principle of the protection of legitimate expectations insofar as they apply to surplus profit transfers by a controlled company to its parent at the close of a financial year ending in the course of 2004 on the basis of a profit-and-loss transfer agreement that was concluded before 5 March 2003 if, after that date, the agreement would have allowed for ordinary termination with effect from 31 December 2003 at the latest, and insofar as they apply to surplus profit transfers at the close of the first financial year ending in 2005 if the agreement would have allowed for ordinary termination with effect from 31 December 2004 at the latest.

It is true that in such cases, prior to the Federal Finance Court's ruling of 18 December 2002, parties concluding a profit-and-loss transfer agreement could not yet legitimately expect to be dealing with a settled legal situation. However, their expectations with regard to the legal situation do warrant protection if, in 2003 or 2004, they allowed a then-available option for ordinary termination to lapse in view of the Federal Finance Court's ruling having been issued. This constitutes a new deliberate arrangement relevant for tax purposes. Given the far-reaching consequences of any decision to terminate a profit-and-loss transfer agreement - a decision that cannot be reversed without the other party's consent - taxpayers could legitimately expect the applicable law to remain unchanged until the new legislation had finally passed the Bundestag. Furthermore, when concluding a profit-and-loss transfer agreement, taxpayers cannot be expected to agree a right of ordinary termination with a shorter notice period than three months to the end of the financial year. This means that at the time when the legislation passed the Bundestag on 28 October 2004, taxpayers were no longer able to avoid the onerous consequences of § 14(3) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) in the 2004 and 2005 assessment periods.

In these cases too, there is no evidence of any sufficiently important reasons that would render the legislative amendment with its retroactive effects reasonable (zumutbar) for taxpayers when balanced against the associated frustration of their legitimate expectations.

4. In all other cases, i.e. where the profit-and-loss transfer agreement was concluded before 5 March 2003 and could neither be terminated with effect from 31 December 2003 nor with effect from 31 December 2004, or where the profit-and-loss transfer agreement was concluded after 13 August 2004, legitimate expectations that the law will remain unchanged solely exist under the aspect of the law's function as a guarantor of legal certainty. This covers surplus profit transfers that occur at the close of financial years ending after 31 December 2003 but no later than 15 December 2004 (the date on which the new legislation was promulgated). Other than in those cases, the legislator's legitimate interest in amending the law prevails in an overall balancing of interests.

III. Insofar as § 34(9) no. 4 KStG in conjunction with § 14(3) first sentence KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) violates Art. 20(3) in conjunction with Art. 2(1) GG, it was declared partly void. Insofar as § 14(3) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) is, in the aforementioned constellations, applicable by virtue of § 34(1) KStG (as amended by the Act Transposing EU Directives Into Domestic Tax Law) to surplus profit transfers occurring from 1 January 2005 onwards, the latter provision was also declared partly void, at least to ensure legal clarity.

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