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Decision regarding retroactive effect in tax law III: Reduction of the relief for compensation of loss of income past or present partly unconstitutional
Press Release No. 66/2010 of 19 August 2010
Order of 7 July 2010
2 BvL 1/03
The annual collection of income tax and the progression of the income tax scale can lead to a distortion of progression if income accrues which is combined in one year but constitutes economic yield from several assessment periods. A considerable share of the income is then taxed at a higher rate of tax than would have been the case were the income to be spread over several assessment periods without the financial capacity of the taxpayer being correspondingly assessed higher. This problem of possible distortions of burdens is taken into account by § 34 of the Income Tax Act (Einkommensteuergesetz - EStG) through a tax reduction for "extraordinary" income, including amongst other things compensation to substitute for loss of income past or present (§ 24 no. 1 (a) EStG).
Until the end of 1998, a reduced tariff applied to extraordinary income which was only half the average rate of the taxpayer's tax. This was particularly favourable for those on a high income for whom the income would have been subject to the top rate of tax, even had it not accrued in combination. After various amendment initiatives had initially been unsuccessful, after the change of government which took place in 1998, the half average rate of tax was replaced by the "fifths arrangement" according to § 34.1 EStG in the version of the Tax Relief Act 1999/2000/2002, which was introduced to the Bundestag on 9 November 1998 and promulgated on 31 March 1999. Accordingly, extraordinary income is taxed at the rate of tax which would have been applied with regard to the progressive tariff if one-fifth of it had each accrued on a pro rata basis in five assessment periods. According to § 52.47 EStG, the new regulation applied from the 1999 assessment period onwards, but - retroactively - also included compensation which had been agreed prior to the promulgation of the new provision.
As employees, the plaintiffs of the three sets of initial proceedings received settlements in the assessment period 1999 because of the termination of their employment relationship which in each case were disbursed in January and March 1999, respectively, and thus prior to the promulgation of the new provision. Some of the underlying termination agreements had already been concluded before the draft Bill was introduced (in October 1996 and July 1998, respectively), but one not until afterwards (in November 1998). In all cases, the tax office applied the fifths arrangement in place of half the average rate of tax, which resulted in an additional tax liability of roughly 5,000, 20,000 and 62,000 DM, respectively. The actions that were lodged each led to a submission by the Federal Finance Court (Bundesfinanzhof).
In the proceedings on the constitutionality of a statute, which were combined to form a joint ruling, the Second Senate of the Federal Constitutional Court (Bundesverfassungsgericht) ruled that the retroactive application of the fifths arrangement according to § 34.1 in conjunction with § 52.47 EStG in the version of the Tax Relief Act 1999/2000/2002, is partly unconstitutional because of a violation of the constitutional principles of the protection of legitimate expectations.
In essence, the decision is based on the following considerations:
A "real" retroactive effect, which is not permissible as a matter of principle, in which the statutory legal consequences are to already apply prior to the time of the promulgation to taxable events which have already been completed ("retroactive impact of legal consequences" - Rückbewirkung von Rechtsfolgen), does not apply. The fifths arrangement is not applied until from the assessment period still running at the time of the amendment, i.e. to compensation payments accrued from 1 January 1999 onwards. However, an "unreal", de facto retroactive effect applies where the underlying agreement had already been concluded at the time of the promulgation of the new provision on 31 March 1999 because the application of the fifths arrangement is attached to a past event in this respect. This is not prohibited as a matter of principle, but is only compatible with the principles, in terms of fundamental rights and the rule of law, of the protection of legitimate expectations if the retroactive attachment is suitable and necessary to promote the purpose of the statute and if the bounds of reasonableness are not overstepped in an overall weighing up between the import of the disappointed expectation and the urgency of the grounds justifying the legal amendment. This being the case, the application of the fifths arrangement (in place of the half average rate of tax) violates the constitutional principles of protection of legitimate expectations where it also covers compensation which had been agreed in 1998, but prior to the introduction of the new provision in the Bundestag or - if the agreement is older or newer - had at least been disbursed prior to the promulgation of the new provision.
Confidence in the application of the half average rate of tax at the time of the conclusion of the compensation agreement merits constitutional protection as a matter of principle. The net amount anticipated after tax is at least for the employee as a rule the basis for entering into the termination agreement. As the initial cases show, the transition to the fifths arrangement leads to a worsening of considerable significance. The grounds put forward by the legislature for the new provision do not justify evaluating this as acceptable. The interest in broadening the basis for assessment for financing to compensate for tax cuts made elsewhere does not have any sufficient weight since this purpose does not go beyond a general need for finance, and hence is unable to prevail over the protection of legitimate expectations of the taxpayers affected. The goal of reducing advantageous effects which overshoot the goal in breach of the purpose of the half average rate of tax with those on a higher income is also unable to justify refusing to provide protection of legitimate expectations. This also refers only to a general interest in a legal amendment, but not to grounds for retroactive inclusion, since the favouring effects of the half average rate of tax were known to the legislature and had been largely accepted by it in the past.
Insofar as, however, the compensation agreement was not concluded until after the introduction of the new provision in the Bundestag on 9 November 1998, or already before 1998, the retroactive application of the fifths arrangement is not objectionable as a matter of principle, given that in such cases the import of the disappointed confidence is to be assessed as being less significant. The introduction of the draft Bill in the Bundestag already gave concrete expression to the legal amendment, so that those concerned by a compensation agreement not concluded until after this time were able to allow for it. It is not unreasonable to expect the taxpayer to obtain information on ongoing legislative proceedings. Particularly in connection with the conclusion of specific agreements of some economic import, which includes settlement payments, it is customary, expedient and as a rule can also be expected to consult professional advice on their fiscal consequences. Compensation agreements are also less eligible for protection which were already concluded in 1997 or earlier, but which did not provide for disbursement until 1999 or later. Where possible expectations with regard to the continued application of the old law go beyond the year after the agreement, i.e. two or more changes of assessment period lie between agreement and disbursement, the taxpayer should have independently considered the possibility of future legal amendments and made allowance for this through contractual adjustment clauses. For this reason, in these cases the legitimate interests of the legislature in carrying out amendments suffice to justify a disappointment of the confidence in the future continuation of the law at the time of conclusion of the compensation agreements.
The situation is however different in these cases if the compensation accrued to the taxpayer prior to the entry into force of the new provision on 31 March 1999. In this constellation this constitutes income still made under the application of the old law. Even if the confidence exercised on conclusion of the compensation agreement was not eligible for protection without restriction, taxpayers may when deciding on savings, consumption or investment at any rate trust that the legislature handing down tax legislation does not retroactively make significant reductions to the net amount of the compensation which has already accrued without a factual reason of adequate import. This was also not changed by the legislative proceedings already pending at the time of accrual. An ongoing legislative procedure does result in a greater expectation being incumbent on the taxpayer to coordinate dispositions with a future effect with the future law, but cannot from the outset suspend the function of a guarantee accruing to the applicable law until the promulgation of the new provision. Taxpayers may also invoke this if the compensation with regard to the more favourable older legal situation was deliberately disbursed as early as March 1999, but the employment relationship was not terminated until later. It does not constitute abuse as a matter of principle, but is among the legitimate dispositions in the field of general (economic) freedom of action protected by fundamental rights if taxpayers make efforts to benefit from the advantages of the applicable law in view of possible disadvantages of a future law. The retroactive application of the new provision is in this respect also not justified by the interest - justified as a matter of principle - to correct unwelcome "competition" between the taxpayer and the legislature in view of invoking the old law. Such a situation as may occur for instance in the abolition of subsidies did not apply. The latter assumption is already suggested by the fact that compensation according to § 24 no. 1 (a) EStG is contingent on the agreement not having been brought about on a party's own initiative, but under considerable pressure, in particular under that of immanent redundancy.