Rule introduced in 2008 concerning the transition from the imputation system to the half-income system for the taxation of corporations partly incompatible with the Basic Law

Rule introduced in 2008 concerning the transition from the imputation system to the half-income system for the taxation of corporations partly incompatible with the Basic Law

Press Release No. 29/2023 of 08 March 2023

Order of 7 December 2022
2 BvR 988/16

Corporation tax increase potential

In an order published today, the Second Senate of the Federal Constitutional Court held that § 38(5) and (6) in conjunction with § 34(16) first sentence of the Corporation Tax Act (Körperschaftsteuergesetz - KStG) in the version of the Tax Act 2008 (Jahressteuergesetz2008) of 20 December 2007 is incompatible with the general guarantee of the right to equality following from Art. 3(1) of the Basic Law (Grundgesetz - GG).

The provisions are part of the rules governing the transition from the imputation system (Anrechnungsverfahren) to the half-income system (Halbeinkünfteverfahren). Under the imputation system, a corporation's equity had to be allocated to different 'equity pots' (Eigenkapitaltöpfe - EK) to reflect the tax burden each partial amount had been subject to. Tax-free increases in capital were, inter alia, allocated to 'EK 02'. If this equity was distributed and left the tax-exempt sphere, it became taxable at a rate of (most recently) 30%. At the shareholder level, distributions were taxed at the shareholders' personal income tax rate, with the tax paid by the corporation credited towards the personal income tax payable by the shareholder. Under the half-income system, tax-free profits generated by a corporation are not subject to additional taxation in case of their distribution; only half (since 2009: 60%) of the distribution is subject to personal income tax at the shareholder level.

According to the transitional rules initially introduced in 2000, EK 02 was to be taxed at 30% only in the event that it was distributed at some point during a 15-year transitional period (later extended to 18 years). The Tax Act 2008 replaced this rule with § 38(5) and (6) of the Corporation Tax Act, which provides that the remaining EK 02 is taxed at a flat rate of 3% regardless of whether or not it is distributed. Pursuant to § 34(16) first sentence of the Corporation Tax Act (in the version of the Tax Act 2008), certain real estate companies and tax-exempt corporations could apply for an exemption from the new legal framework and for the continued application of the initial rules. Due to this exemption, the EK 02 of these companies was only taxed if it was distributed during the 18-year transitional period, while the EK 02 of other corporations was always subject to taxation pursuant to § 38(5) and (6) of the Corporation Tax Act - regardless of whether or not it was distributed.

In itself, § 38(5) and (6) of the Corporation Tax Act, which provides that EK 02 is subject to corporation tax regardless of whether or not it is distributed, is compatible with the general guarantee of the right to equality, the principle of the protection of legitimate expectations, the protection of property and the general freedom of action. However, read in conjunction with § 34(16) first sentence of the Corporation Tax Act, which provides that certain corporations can apply for an exemption from § 38(5) and (6) of the Corporation Tax Act, the provision violates the general guarantee of the right to equality. The exemption results in an unequal treatment of corporations, which is not justified under constitutional law.

Facts of the case:

Under the imputation system, which was in place until the end of the year 2000, a corporation's undistributed taxable profits were subject to corporation tax at the 'retention rate' (Tarifbelastung) of (most recently) 40%. If profits were later distributed, the corporation tax was reduced to the 'distribution rate' (Ausschüttungsbelastung) of (most recently) 30%. Corporations therefore accrued a potential for reduction of corporation tax, the amount of which was determined by the difference between the retention rate and the distribution rate. A corporation's equity had to be allocated to different 'equity pots' to reflect the tax burden each partial amount had been subject to. Undistributed profits that had been subject to a tax rate of 40% were allocated to 'EK 40', while tax-free increases in capital were allocated to 'EK 0'. This pot was further divided into the following subcategories: foreign profits and losses exempt from tax under double taxation agreements (EK 01), old reserves from before 1977 (EK 03), open and hidden contributions by partners or shareholders (EK 04) and other increases in capital not subject to corporation tax (EK 02). When profits were distributed and left the tax-exempt sphere, the previously untaxed EK 02 and EK 03 became taxable at the distribution rate of 30%; they thus contained a potential to increase corporation tax.

In §§ 36 to 40 of the Corporation Tax Act, which were newly inserted into the Corporation Tax Act by the Tax Reduction Act of 23 October 2000, the legislator set forth transitional rules governing the shift from the imputation system to the half-income system. Under § 36 of the Corporation Tax Act, as applicable at the time, the various portions of equity, which had been subject to different corporation tax treatments, were consolidated and reclassified in several steps, and the final balances thereby calculated were then separately assessed. This assessment formed the basis for calculating the corporation tax credit pursuant to § 37(1) of the Corporation Tax Act and any additional taxation of previously untaxed capital pursuant to § 38 of the Corporation Tax Act.

If the final balance of EK 02 was positive, this positive balance had to be carried forward and assessed separately at the end of the following financial years pursuant to § 38(1) first sentence of the Corporation Tax Act (as amended by the Tax Reduction Act). In the following years, it was reduced pursuant to § 38(1) of the Corporation Tax Act (as amended by the Tax Reduction Act) insofar as it was deemed to have been used for profit distributions. Pursuant to § 38(2) first and third sentence of the Corporation Tax Act (as amended by the Tax Reduction Act), a company's corporation tax increased by 3/7 of the amount of any profit distribution deemed to have come from EK 02 in the transitional period of 15 (later 18) years.

With the Tax Act 2008, the legislator introduced § 38(5) and (6) of the Corporation Tax Act, the provision at issue in the present proceedings. According to this provision, the balance of EK 02 remaining on 31 December 2006 is taxed at 3% regardless of whether or not it is distributed. This is equivalent to taxing 10% of the remaining EK 02 at the previous distribution rate of 30%. The increase in corporation tax is limited to the amount that would result if a corporation were to distribute its entire equity as determined in its tax balance. The increase in corporation tax resulting therefrom had to be paid in ten equal amounts in the years from 2008 to 2017.

Certain real estate companies - especially those in which at least a 50% stake is directly or indirectly held by the public sector - and tax-exempt corporations (§ 34(16) of the Corporation Tax Act) could apply to remain under the framework previously set out in § 38 of the Corporation Tax Act. In this case, their EK 02 would remain taxable only in case of a distribution.

With reference to this provision, the complainant - a real estate company not within the scope of § 34(16) first sentence of the Corporation Tax Act (in the version of the Tax Act 2008) - requested to be exempt from the taxation of EK 02 regardless of distribution. The tax office rejected this request and issued an assessment of an increase in corporation tax. The complainant's challenge before the finance courts was unsuccessful. With its constitutional complaint, the complainant asserts that the assessment of the increase in corporation tax violates its general guarantee of the right to equality (Art. 3(1) of the Basic Law), the prohibition of retroactivity (Art. 2(1) in conjunction with Art. 20(3) of the Basic Law) and the freedom from levies (Art. 2(1) of the Basic Law) and/or the guarantee of private property (Art. 14(1) of the Basic Law).

Key considerations of the Senate:

The constitutional complaint is admissible and in part well-founded.

I. In itself, the taxation of EK 02 regardless of distribution as set out in § 38(5) and (6) of the Corporation Tax Act (in the version of the Tax Act 2008) is compatible with Art. 3(1) of the Basic Law.

1. It is debatable whether the transitional framework's effect of making a corporation's retained profits, which were tax-free and therefore allocated to EK 02, subject to taxation leads to an unequal treatment that is relevant under constitutional law. This framework deviates from the way such profits were treated both under the imputation system as well as under the half-income system and (since 2009) the partial-income system. However, there is no need to decide at this point whether and to what extent the new and/or previous fundamental legislative decisions regarding the corporation tax system are binding under Art. 3(1) of the Basic Law with regard to transitional rules, particularly whether and to what extent transitional rules may deviate from these decisions in view of the legislator's broad leeway when redesigning complex systems, without such deviation constituting unequal treatment that requires justification under constitutional law.

2. The taxation of EK 02 regardless of whether or not it is distributed is justified. In this respect, the applicable standard of review is solely the prohibition of arbitrariness. There are objective reasons for the challenged provision.

a) The legislator provided plausible justification for changing the framework for the realisation of the potential for increase of corporation tax from the original framework, which required distribution for the realisation of the potential, to the new framework that does not take into account whether or not profits are distributed. As stated by the legislator, the old framework was very complex. § 38 of the Corporation Tax Act (in the version of the Tax Act 2008) led to a notable simplification for cross-border cases, which were one of the legislator's main priorities. By taxing EK 02 regardless of its distribution, complicated rules for such cross-border cases were rendered obsolete.

b) Another objective reason for taxing EK 02 regardless of its distribution is the legislative intent to remove de facto distribution restrictions. In an expert hearing on the Tax Act 2008 before the Finance Committee, the taxation of EK 02 only in case of distribution was considered to have "far-reaching prohibitive effects" due to its limitation to an 18-year transitional period. The taxation regardless of distribution was seen as the right approach to eliminate such effects, and the rate of 3% was considered to be adequate by most experts.

c) Ultimately, the taxation of EK 02 regardless of distribution is also supported by the concept of a notional full distribution of equity at the time of the system change, which underlies the entire transitional framework. The legislator based the transitional framework (§§ 36 ff. of the Corporation Tax Act) on the concept of a notional full distribution of equity at the time of the system change. This is not objectionable under constitutional law, even in cases where this leads to an increase in corporation tax. Under the imputation system, taxpayers also had to expect that EK 02 would eventually be subject to taxation - at least in principle and at the time of liquidation. In light of this, even though the tax paid by the corporation is no longer credited towards the personal income tax payable by the shareholder, the continued taxation of EK 02 under the transitional framework accommodates the legislator's legitimate interest in financing the preservation of the corporation tax reduction potential as intended by the legislator and required by Art. 14(1) of the Basic Law.

The taxation of EK 02 regardless of distribution is thus justified at least in cases where - like in the case at issue here - EK 02 would have been used if there had been a full distribution of equity at the time of the transition from the imputation system to the half-income system. The legislator designed the taxation in a manner that protects corporations' liquidity by spreading the payment of the corporation tax increase over ten years. In a general manner, the legislator took into account losses potentially incurred since the assessment of the final balances of usable equity pursuant to § 36 of the Corporation Tax Act (in the version of the Tax Reduction Act) by only subjecting 10% of the remaining EK 02 to the 30% distribution rate and limiting the corporation tax increase to the amount that would have been payable in case of a full distribution of equity as set out in the tax balance on 31 December 2006.

II. In itself, the taxation of EK 02 regardless of distribution resulting from § 38(5) and (6) of the Corporation Tax Act (in the version of the Tax Act 2008) is also compatible with the principle of the protection of legitimate expectations following from Art. 2(1) in conjunction with Art. 20(3) of the Basic Law.

1. 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. 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.

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

2. a) Based on these standards, § 38(5) and (6) of the Corporation Tax Act (in the version of the Tax Act 2008) gives rise to onerous quasi-retroactive effects. With effect for the future, the provision sets out legal consequences applying to the previously assessed final EK 02 balance that are potentially more onerous than those resulting from the previously applicable § 38(2) of the Corporation Tax Act (in the version of the Tax Benefit Reduction Act, Steuervergünstigungsabbaugesetz). It imposes a burden at least on such businesses that opted to, or were only able to, distribute less than 10% of their remaining EK 02 in the period from 2007 to 2019.

b) However, the quasi-retroactive effects brought about by the transition to a framework where EK 02 is taxed regardless of distribution are justified.

aa) It is true that § 38 of the Corporation Tax Act (in the version of the Tax Act 2008) replaced a framework that, during the transition from the imputation system to the half-income system, provided for taxation only in case of a profit distribution and was limited to a specified transitional period. However, the protection of legitimate expectations in accordance with the rule of law only results in special requirements with regard to changes to a temporary transitional framework if the framework in question was itself enacted to protect legitimate expectations. Such a framework gives rise to legitimate expectations warranting protection. This was, however, not the case here. The limitation of the transitional period to initially 15 and later 18 years did not serve to protect legitimate expectations. Rather, the transitional period was limited in this way to ensure a uniform transitional period for corporation tax reductions and corporation tax increases.

bb) It is not ascertainable that other circumstances existed which would give rise to a special need for protection of taxpayers' legitimate expectations that their EK 02 would only be taxed in case of a distribution during the transitional period. 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. The legislative interest in amending the corporation tax regime prevails over such general expectations. In an overall balancing between the weight of the frustrated expectations and the weight and urgency of the reasons invoked to justify the change in the law, the limits of what is reasonable (zumutbar) for taxpayers have been observed in the present case.

III. For the reasons set out above, the taxation of EK 02 regardless of distribution resulting from § 38(5) and (6) of the Corporation Tax Act (in the version of the Tax Act 2008) violates neither the prohibition of excessive tax burdens derived from Art. 14(1) of the Basic Law nor the general freedom of action of the affected corporations protected by Art. 2(1) of the Basic Law.

IV. However, when § 38(5) and (6) of the Corporation Tax Act is read in conjunction with § 34(16) first sentence of the Corporation Tax Act, which provides that certain corporations can apply to remain under the previous framework, the provision violates the general guarantee of the right to equality (Art. 3(1) of the Basic Law).

1. While § 34(16) first sentence of the Corporation Tax Act grants certain real estate companies and tax-exempt corporations the right to remain under the previous legal framework, meaning that their EK 02 is only subject to taxation in case of a profit distribution, the companies that do not fall within the scope of this provision are, pursuant to § 38(5) of the Corporation Tax Act, subject to taxation of EK 02 regardless of distribution.

In particular with regard to the comparison between private real estate companies, which are ineligible for an exemption from the taxation regardless of distribution, and other real estate companies, which are eligible, this unequal treatment can be considerable in scope, depending on the amount in which such companies would actually have made distributions during the transitional period. This generally calls into question the equal distribution of tax burdens. The unequal treatment therefore requires justification with regard to the tax treatment of corporations which cannot apply for an exemption from the taxation regardless of distribution.

2. The unequal treatment of corporations eligible for an exemption from the taxation regardless of distribution pursuant to § 34(16) first sentence of the Corporation Tax Act and corporations that are ineligible is not justified.

a) Given that the unequal treatment affects the occupational freedom of the businesses concerned, which is protected by Art. 12(1) of the Basic Law (in conjunction with Art. 19(3) of the Basic Law), the applicable standard of review is not merely the prohibition of arbitrariness, but the standard of proportionality. Public taxes and other levies interfere with occupational freedom (Art. 12(1) of the Basic Law) if they are closely related to the exercise of an occupation and objectively have an inherent regulatory effect (objektiv berufsregelnde Tendenz). For § 34(16) first sentence of the Corporation Tax Act (in the version of the Tax Act 2008), this is the case.

Insofar as it concerns real estate companies, the provision contains a list of activities that delimits the group of corporations which can avoid the new framework that does not take into account distribution and apply to remain under the previous legal framework instead. It favours companies that generate their revenues predominantly through the management and use of their own real estate serving housing purposes, through the management of residential buildings or through the construction and sale of homes, small housing estates or owner-occupied flats. It thereby ties the privileged tax treatment to certain business activities; it does not apply to all businesses regardless of the type of their activities.

It is evident that the framework serves to promote the provision of housing. In limiting the privileged treatment to certain real estate companies, in particular those in which the public sector or non-profit corporations directly or indirectly hold at least a 50% stake, and to purchasing and business cooperatives, the provision has inherent regulatory effects on occupations, just like direct subsidies that are paid to only a limited group of companies.

b) In principle, the legislator pursued a legitimate aim when enacting § 34(16) first sentence of the Corporation Tax Act. The legislative intent was to give certain companies that typically serve a public purpose, or a special purpose laid down in the law, which also has structural effects on distribution ability and distribution policy, a choice between taxation at the flat rate and the previous legal framework. The aim was thus to make a distinction on the basis of the likelihood that a corporation with remaining EK 02 would make distributions. In light of the legislative intent pursued with § 38 of the Corporation Tax Act - to simplify and to remove a de facto distribution restriction - this distinction is not objectionable under constitutional law.

c) However, the criteria for differentiation selected by the legislator in § 34(16) first sentence of the Corporation Tax Act (in the version of the Tax Act 2008) are unsuitable for distinguishing companies that are generally likely to make distributions from companies that are expected to make little or no distributions. This also holds true when taking the legislator's authority to use typification into account. The selected criteria are not suitable to realistically determine a typical case.

aa) Insofar as is ascertainable, the legislative procedure did not involve an assessment of the different likelihoods to make distributions on the part of corporations eligible for privileged treatment as opposed to those ineligible, especially private real estate companies. Nor was the suitability of the chosen criteria demonstrated in the present proceedings.

bb) There is also no sufficient legal basis for the typification made by the legislator.

(1) According to the Federal Government's submissions, the link between the two groups of real estate companies listed in § 34(16) first sentence no. 1 of the Corporation Tax Act (in the version of the Tax Act 2008) - namely, corporations in which the public sector or non-profit corporations directly or indirectly hold at least a 50% stake - is that they serve the common good. However, with regard to the legal rules which their business activities are subject to it cannot be concluded that when such companies use equity for housing-related activities, they primarily do so to pursue interests of the common good - providing housing - rather than aiming to generate returns.

(a) With regard to the participation of public law legal persons in real estate companies, such interests of the common good cannot be derived from the municipal codes of the Länder. It is true that the provisions of Land law regarding municipal economic activity apply not only to the municipalities themselves, but also to legally independent companies, as long as the municipality controls the company and can thus enforce the requirements arising from public law. However, this requires that the municipality holds a stake of more than 50% in the company. Yet § 34(16) first sentence no. 1 of the Corporation Tax Act (in the version of the Tax Act 2008) only requires a minimum stake of exactly 50%. Where a municipality holds a 50% stake, it may be able to press for a certain line of action, but usually does not have any possibilities under company law to enforce such action since it does not hold a majority stake.

In addition, the provisions applicable to municipalities that hold stakes in private law real estate companies vary between the different Länder. In some places, entities that serve to provide housing are considered non-economic companies, which are not bound by the standards applicable to municipal economic activity. Where these standards do apply, the question of whether and in what amount such companies can distribute profits at all is largely dependent on the extent to which they are allowed to charge fees for their services that go beyond the mere recovery of their costs. This is mainly governed by the legal framework for the generation of profits by companies with public sector participation, the contents of which are far from clear. The provisions of Land law regarding the generation of profits in any case differ substantially between the different Länder. It can therefore not be found that the public purpose pursued by such companies typically has legal effects on whether distributions are made when profits are generated.

(b) With regard to stakes held by non-profit corporations, too, the legal framework does not entail any effects on distribution ability or distribution policy. It is true that non-profit corporations serve a special purpose as set out in § 52(2) of the Fiscal Code (Abgabenordnung - AO) and that they are precluded from distributing profits to their members under § 55(1) no. 1 second sentence of the Fiscal Code. However, this does not prevent a real estate company in which a tax-exempt corporation holds a share (of at least 50%) from making distributions.

(2) The special purpose laid down in the law that is served by purchasing and business cooperatives within the meaning of § 34(1) first sentence no. 2 of the Corporation Tax Act (in the version of the Tax Act 2008) also does not have any notable effects on the distribution ability or distribution policy of these corporations. § 1(1) of the Cooperatives Act (Genossenschaftsgesetz - GenG), which applies to purchasing and business cooperatives, provides that they must be aimed at supporting their members' acquisitions or economic activities or their social or cultural interests through joint special-purpose operations. A cooperative is defined by its aim to support its members. While making a profit as an end in itself runs counter to the basic principles of cooperatives, enabling the members to participate in the commercial success of a cooperative through a distribution of profits or the granting of other benefits is not precluded.

(3) For tax-exempt corporations that do not operate in the real estate sector but can, pursuant to § 34(16) first sentence of the Corporation Tax Act (in the version of the Tax Act 2008), nonetheless apply for an exemption from the taxation regardless of distribution, a (uniform) special purpose laid down in law cannot be ascertained given the diversity of the corporation tax exemptions set out in § 5 of the Corporation Tax Act. The various corporation tax exemptions are tied to state policy, social policy or economic policy grounds, which are all in the broader sense based on civic action serving the common good. That said, § 5(1) of the Corporation Tax Act 2002 contains many very different corporation tax exemptions without a clear underlying teleological principle and moreover pursuing different policy objectives. Given the various aims of the corporations eligible for a corporation tax exemption, contrary to what was assumed in the legislative materials on the Tax Act 2008, it is not ascertainable that the corporations in question have a uniform special purpose laid down in the law which could have effects on the distributions made by these taxpayers.

V. Given that § 38(5) and (6) of the Corporation Tax Act (in the version of the Tax Act 2008) in conjunction with § 34(16) first sentence of the Corporation Tax Act (in the version of the Tax Act 2008) is incompatible with the general guarantee of the right to equality, the notice issued by the tax office regarding the assessment of the corporation tax increase pursuant to § 38(5) and (6) of the Corporation Tax Act and the challenged judgments of the finance courts also violate the complainant's fundamental right under Art. 3(1) of the Basic Law in conjunction with Art. 19(3) of the Basic Law.

VI. The legislator is required to remedy the violation of constitutional law by 31 December 2023 with retroactive effect. This affects all decisions that are based on the unconstitutional provision and that have not yet become final. To the extent that the challenged provision is incompatible with the Basic Law, the courts and administrative authorities may no longer apply it until new provisions have been enacted; pending proceedings must be suspended.

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