Provisions retroactively restricting income tax deductibility of full advance payments on ground rents are void in part

Press Release No. 35/2021 of 11 May 2021

Order of 25 March 2021
2 BvL 1/11

In an order published today, the Second Senate of the Federal Constitutional Court held that the amendment of the outflow principle retroactively effected by § 11(2) third sentence, first half-sentence in conjunction with § 52(30) of the Income Tax Act (Einkommensteuergesetz – EStG), as amended by the Act Implementing EU Directives Into Domestic Tax Law (Richtlinien-Umsetzungsgesetz), partially violates the constitutional principle of the protection of legitimate expectations. As a result of this amendment, advance payments made in respect of a lease of land for a term longer than five years (ground rents, Erbbauzinsen) are no longer deductible in full as income-related expenses (Werbungskosten) in the year in which they are paid; instead they can only be deducted pro rata over the period for which they are incurred. Even though the act containing this amendment was only promulgated in the Federal Law Gazette on 15 December 2004, the amendment took effect for all advance payments on ground rents made after 31 December 2003. The Court held that this retroactive effect amounts to a violation of the constitutional principle of the protection of legitimate expectations where a binding agreement on payment was concluded between 1 January and 27 October 2004 (the date the amendment was introduced in the German Bundestag) and the advance payments were made by the end of 2004, as agreed. The same applies to agreements entered into before the start of the year 2004 in respect of which, as per the agreement, advance payment was only made in 2004 but no later than 15 December 2004 (the date on which the amendments were promulgated).

Facts of the case:

Pursuant to § 11(2) first sentence EStG, income-related expenses, in principle, must be deducted in full for income tax purposes in the year in which they are paid (outflow principle). In its judgment of 23 September 2003, the Federal Finance Court (Bundesfinanzhof) expressly and for the first time held that this also applied to ground rents that constitute income-related expenses in respect of rental income and are paid in advance as a lump sum. Since the governing parties at the time expected the unlimited application of this judgment to lead to considerable revenue shortfalls, they made use of an ongoing legislative process to initiate the amendment to the outflow principle that is the subject of these proceedings. The amendment was proposed to the Bundestag by the Finance Committee on 27 October 2004; it was adopted by the Bundestag on 28 October 2004 and promulgated in the Federal Law Gazette on 15 December 2004. The amendment, which entered into force the following day, provides that for income tax purposes, advance payments for leases of more than five years must be distributed across the period for which the advance payment is made (§ 11(2) third sentence EStG as amended by the Act Implementing EU Directives Into Domestic Tax Law). With regard to ground rents and other payments for the use of land, this change was to apply to all advance payments made after 31 December 2003 (§ 52(30) EStG in the version of the Act Implementing EU Directives Into Domestic Tax Law).

In August 2004, the plaintiff in the initial proceedings acquired a leasehold (Erbbaurecht) granted for a term of 99 years in connection with a flat he rented out. In September 2004, he paid a total of EUR 36,350 to settle the full ground rent for the term of the leasehold. He claimed that amount in full as income-related expenses in relation to his rental income for 2004. However, the tax office and the Finance Court (Finanzgericht) only recognised the part of the ground rent paid for the year in question (i.e. ¹/₉₉ of the advance payment, approximately EUR 368). The Federal Finance Court suspended the appeal on points of law (Revision) and referred to the Federal Constitutional Court the question of whether the provisions at issue in the proceedings violate the constitutional principle of the protection of legitimate expectations.

Key considerations of the Senate:

1. 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 and on the principles of legal certainty and the protection of legitimate expectations (Art. 2(1) in conjunction with Art. 20(3) 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 also derives from fundamental rights afforded the individual.

2. § 52(30) EStG, as amended by the Act Implementing EU Directives Into Domestic Tax Law, has a quasi-retroactive effect (unechte Rückwirkung). Indeed, § 11(2) third sentence, first half-sentence EStG, as amended by the Act Implementing EU Directives Into Domestic Tax Law, formally has future implications given that it only concerns future income tax liability arising, at the earliest, at the end of 2004, for years from 2004 onwards. However, the statutory prerequisites prompting the legal consequences in question apply to circumstances that have already been set in motion, insofar as the advance payment for ground rents was made, or had at least been bindingly agreed upon, before the law was promulgated on 15 December 2004 (‘retroactive link of statutory prerequisites’, tatbestandliche Rückanknüpfung). The legal consequences arising from the refusal to deduct the full expenses in the year in which they were incurred impose a burden because affected persons face liquidity costs and the loss of interest.

3. While such quasi-retroactive effects are not generally impermissible, the legislator must sufficiently take into account the constitutionally required protection of legitimate expectations and the principle of proportionality. Quasi-retroactive effects are only compatible with the principle of the protection of legitimate expectations arising from fundamental rights and from the rule of law if they are suitable and necessary for helping achieve the purpose of the law and if the limits of what is reasonable (zumutbar) are observed in an overall balancing (see 4. to 6. below) between the weight of the frustrated expectations and the weight and urgency of the reasons invoked to justify specifically the retroactive change in the law. In consideration of the (at least potential) need for legislative change, taxpayers cannot claim absolute protection of their previously formed expectations under constitutional law since they cannot expect the law to remain unchanged indefinitely.

4. a) Arrangements made by taxpayers merit less protection where binding agreements on advance payments were only reached after 27 October 2004 (the date on which the amendments were proposed to the Bundestag by the Finance Committee) because from that time onwards, the contracting parties could already anticipate that the law might change. Moreover, agreements concluded by 27 October 2004 in which payment in subsequent years had been agreed upon merit less protection because it seems less reasonable to expect that currently applicable tax law will remain unchanged in subsequent years, and more common to instead stipulate the distribution of risk of future tax tightening measures within the contract.

b) By contrast, arrangements made by taxpayers merit unconditional protection in cases where the agreements that were affected by the amendment were concluded in 2004, but no later than 27 October 2004, and payment, as agreed, was made in 2004. Affected persons could expect that, under the law as it stood at the time, advance payments on ground rents could be deducted in full as income-related expenses in the year in which they were incurred. It is true that the Federal Finance Court had only expressly and for the first time settled this particular question in its decision of 23 September 2003, deviating from the administrative practice followed at the time. However, as this decision was consistent with the Federal Finance Court’s established and longstanding case-law on the tax treatment of ground rents, affected persons did not reasonably have to anticipate a change of the court’s legal view in the foreseeable future. The legitimate expectations can also not be called into question on the grounds that, prior to the amendment, the tax authorities neither updated their administrative directives to conform with the decision of the Federal Finance Court, nor published the Federal Finance Court’s decision in the Federal Tax Gazette Part II (Bundessteuerblatt Teil II) [to indicate that they intended to follow said case-law in their administrative practice]. This is because under the Basic Law, the binding interpretation of laws is exclusively reserved to the judiciary.

Moreover, not only could affected persons expect the interpretation of the applicable law set out by the Federal Finance Court to stand, but, prior to 27 October 2004, they could also expect the applicable law to remain unchanged. While the legislator may change the contents of a statutory provision which it enacted at any time and, in doing so, potentially correct the case-law of the ordinary courts with which it disagrees, its powers to change the law primarily relate to the future. However, taxpayers’ expectations that the law will continue to apply do not merit protection where it could not be assumed that the law would remain unchanged, and an amendment should reasonably have been expected. Yet from the taxpayers’ perspective, which is the relevant perspective in this case, there were no indications suggesting that an amendment was imminent until the amendment was introduced in the Bundestag, despite the non-conforming administrative directives and the failure to publish the judgment of the Federal Finance Court of 23 September 2003 in the Federal Tax Gazette, which is binding on the tax authorities. The decision to amend the law was not taken until an internal review of possible courses of action by a working group of the Federation and the Länder set up by the Federal Ministry of Finance had been concluded. The tax authorities’ intention to amend the law only became known because the press and the real estate and fund industry made isolated inquiries to this effect, without a bill having been introduced in the Bundestag at that point. Predominantly internal administrative acts, not involving the bodies entitled to introduce draft laws, do not, in principle, diminish the legitimate expectations of taxpayers in the continued application of the law. Speculation on tax-saving schemes made possible by the judgment of the Federal Finance Court of 23 September 2003 and on potential reactions by the tax authorities appeared in the media in early 2004, yet such speculation constitutes even less grounds for diminishing the legitimate expectations in question.

5. To the extent that the expectations of taxpayers in the unchanged continuity of applicable law and the relevant provisions must be considered as meriting protection in a balancing of interests (see 4.b) above), quasi-retroactive effects are impermissible under constitutional law, even in consideration of the purpose of the law. In the present case, the taxpayers’ expectations take precedence over the assumption that led to the amendment, according to which the unlimited application of the judgment of the Federal Finance Court would lead to unacceptable tax revenue shortfalls. This is because the mere intention of obtaining higher public revenue does not in itself constitute an interest of the common good that outweighs the interest in the protection of legitimate expectations of affected taxpayers. Otherwise, the protection of legitimate expectations would be practically meaningless with regard to the retroactive tightening of tax law provisions. Neither the legislative intent to close a tax loophole nor the aspects of equal burden-sharing are capable of justifying the failure to protect legitimate expectations. If, in consideration of potential disadvantages from impending amendments, taxpayers try to make use of the advantages arising from applicable law, this does not, in principle, amount to abuse, but is part of legitimate arrangements made within the scope of the general freedom of (commercial) action, which is protected by fundamental rights. The, in principle, justified interest in avoiding “announcement or free-rider effects” and an undesirable “race” between the taxpayer and the legislator could not legitimise the retroactive effects imposed in respect of agreements entered into prior to the introduction of the bill in the Bundestag in this specific case, because no major “announcement or free-rider effects” occurred until that time. The legislator is, of course, entitled to use typification to classify undesired tax structures as abuse and to ban them. However, such interest in legislative change does not provide specific grounds justifying retroactive changes.

6. By contrast, in the cases where the taxpayers’ arrangements merit less protection as set out above (see 4.a) above), quasi-retroactive effects are, in principle, not objectionable under constitutional law (see a) below); they are only objectionable in exceptional cases (see b) below).

a) In respect of cases in which agreement on the advance payment was reached in 2004, but where –­ either in accordance or in breach of the contractual agreement – payment was made only in 2005, it would have been for the taxpayer to take into account the risk of future changes in the law and make arrangements for such changes by means of contractual adjustment clauses. Therefore, in these cases, the legislator’s legitimate interests in changing the law are sufficient to justify the frustration of the taxpayer’s expectations – held at the time of agreement – that the then applicable law would not change.

The application of the amendment is even less objectionable where the agreements were concluded at a time when, in 2004, specific indications had already emerged that the amendment would be enacted within the year because the bill had been introduced in the Bundestag. Thus, insofar as the amendment applies to cases in which agreement was concluded after the introduction of the amendment in the Bundestag on 27 October 2004, even if payment was made before the amendment was promulgated on 15 December 2004, the legislative interest in changing the law does not have to stand back behind taxpayers’ legitimate expectations. In this regard, the retroactive effects served the legitimate interest of avoiding a “race” between the taxpayer and the legislator as well as considerable “announcement and free-rider effects”. This scenario bore the plausible risk that the – as such legitimate – tax advantages obtained by a minority of professionally-advised taxpayers within this presumably small window of opportunity would lead to shortfalls in tax revenue at the expense of the common good, which would by far exceed the shortfalls seen before the amendment was introduced.

b) Only in cases where advance payment was already agreed upon before 2004, but the payment, as agreed, was not made until the period between 1 January and 15 December 2004 (the date on which the amendments were promulgated) – and thus while the old law was still applicable –, does the legislative interest in changing the law prove insufficient to retroactively deprive the taxpayer of the advantages that were associated with the advance payment, namely its full deductibility as income-related expenses in the year of payment. Even in this scenario, the need for protection of the expectations reflected in the conclusion of the agreement was initially diminished because the agreement extended beyond the calendar year. However, the transaction gained a higher degree of completion from a tax law perspective when the taxpayer fulfilled his contractual obligation, as agreed, while the old law was still in force. Accordingly, it would require particular reasons to change the previously applicable full deductibility of the expenses in question. In this respect, the general legislative interest of avoiding shortfalls in tax revenue does not suffice. Appreciable “announcement and free-rider effects” are not evident for agreements concluded before 2004.