Rule introduced in 2010 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. 11/2023 of 26 January 2023

Order of 24 November 2022
2 BvR 1424/15

Corporation tax reduction potential II

In an order published today, the Second Senate of the Federal Constitutional Court held that § 36(4) of the Corporation Tax Act (Körperschaftsteuergesetz – KStG) in the version of § 34(13f) KStG as amended in 2010 (hereinafter: § 36(4) KStG) is partly incompatible with Art. 14(1) in conjunction with Art. 3(1) of the Basic Law (Grundgesetz – GG). The provision deprives corporations with a certain equity structure of potential to reduce their corporation tax burden. To the extent that the reduction potential could have been realised at the time of the transition from the ‘imputation system’ (Anrechnungsverfahren) to the ‘half-income system’ (Halbeinkünfteverfahren), it falls within the scope of protection of Art. 14(1) GG. The interference with this protected legal interest is not justified under constitutional law.

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%. In view of this split tax rate, where profits were retained, a potential for reduction of corporation tax was accrued at the corporate level until the time when profits were distributed. The amount of the reduction potential was determined by the difference between the retention rate and the distribution rate, which most recently amounted to 10 percentage points. At the level of shareholders, distributions were taxed at their 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, corporate profits are subject to a uniform and final corporation tax rate of 15% (since 2008). At the shareholder level, only half (since 2009: 60%) of the dividends distributed are subject to personal income tax.

§ 36 KStG is part of the rules governing the transition from the imputation system to the half-income system. Under the imputation system, a company’s equity had to be displayed in a certain structure to reflect the tax burden each partial amount had been subject to at the corporate level. Under the challenged transitional rule, the partial amounts of a company’s equity accumulated before the transition were consolidated and reclassified in several steps. The corporation tax reduction potential contained in the remaining portions of equity stemming from taxable increases in capital was converted into corporation tax credits that could be used up over a transitional period of several years. The different portions of equity stemming from tax-exempt increases in capital were offset against one another, with the exception of the so called ‘EK 04’, which constitutes the portion of equity stemming from open and hidden contributions by partners or shareholders (§ 30(2) no. 4 KStG 1999). In certain cases, this approach diminishes the existing reduction potential. The complainant, for whom this is the case, lodged a constitutional complaint challenging decisions by the tax authorities and the finance courts based on § 36(4) KStG, as well as directly challenging the aforementioned provision itself.

The constitutional complaint is well-founded. § 36(4) KStG is incompatible with Art. 14(1) GG in conjunction with Art. 3(1) GG to the extent that the provision leads to a loss of reduction potential regarding the corporation tax burden, as it does not take into account the portion of equity allocated to EK 04 when offsetting the equity portions stemming from tax-exempt increases in capital against one another.

This decision was taken with 6:1 votes.

Facts of the case:

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. Undistributed profits that had been subject to a tax rate of 45% were allocated to ‘EK 45’, while profits that had been subject to a tax rate of 40% were allocated to ‘EK 40’. These portions of equity stemming from taxable increases in capital contained a reduction potential in the amount of the difference between the retention rate and the distribution rate. 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, 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 KStG, which were newly inserted into the Corporation Tax Act by the Tax Reduction Act (Steuersenkungsgesetz) of 23 October 2000, the legislator set forth transitional rules governing the shift from the imputation system to the half-income system. Under § 36 KStG, 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) KStG and any additional taxation of previously untaxed capital pursuant to § 38 KStG. By Order of 17 November 2009 (Decisions of the Federal Constitutional Court, Entscheidungen des Bundesverfassungsgerichts – BVerfGE 125, 1 – Corporation tax reduction potential I), the First Senate of the Federal Constitutional Court held that § 36(3) and (4) KStG in the version enacted in 2000 were incompatible with the Basic Law, because the provisions resulted in a loss of potential to reduce corporation tax through the reclassification of EK 45 into EK 40 accompanied by a decrease in EK 02.

In response, with the Tax Act of 2010, the legislator amended the transitional provisions of §§ 36 and 37 KStG by inserting § 34(13f) and (13g) into the Corporation Tax Act. The amendment repealed § 36(3) KStG (former version), which had provided for the reclassification of EK 45 into EK 40. Under the amended transitional framework, § 36(4) KStG provides that the equity components that carry no previous corporation tax burden (EK 01, EK 02 and EK 03) are offset against one another. If their sum is negative, they must first be offset against one another, and subsequently against the equity components that carry a previous corporation tax burden in the order in which the tax rate increases, that is, EK 30 before EK 40 before EK 45. The equity allocated to EK 04 in accordance with § 30(3) no. 4 KStG 1999 is disregarded.

Because EK 04 is disregarded, the complainant, a bank incorporated as a registered cooperative, lost some of its reduction potential when its equity was consolidated and reclassified in accordance with the challenged provision; this reduction potential would have been realisable at the time of the transition from the imputation system to the half-income system. The complainant therefore filed an objection in administrative proceedings and subsequently brought an action before the finance courts. Both were unsuccessful.

With its constitutional complaint, the complainant asserts a violation of the general guarantee of the right to equality (Art. 3(1) GG). The complainant challenges the administrative and court decisions as well as, indirectly, § 36(4) KStG.

Key considerations of the Senate:

The constitutional complaint is admissible and well-founded.

I. 1. The protection of property under Art. 14(1) first sentence GG covers not only tangible property under private law, but also other rights in rem and comparable rights effective vis-à-vis anyone, as well as claims under the law of obligations. It is not limited to certain rights constituting assets (vermögenswerte Rechte). At the same time, Art. 14(1) first sentence GG only protects legal positions that a natural or legal person is already entitled to; it does not protect mere interests, opportunities and earning potential.

According to the case-law of the Federal Constitutional Court, property that is protected under constitutional law is mainly characterised by its use for private benefit and the fact that it is, in principle, at the disposal of the owner. The Court has held that rights constituting assets under public law partake in the protection afforded by the guarantee of private property if they give rise to a legal position that is akin to that of private property rights and that is so strong that depriving the owner thereof without compensation would run counter to the rule-of-law guarantees of the Basic Law. To determine whether this is the case, it must be examined to what extent the legal position is equivalent to efforts made by the rights holder. In addition, the legal position must be dedicated to use for private benefit and the owner must have at least limited powers of disposal.

2. The guarantee of private property does not require that, once legal positions have been established, their contents must remain forever unchanged. In particular, where legal reform is necessary, the legislator may have to decide whether to eliminate or limit rights and powers previously granted. Under Art. 14(1) second sentence GG, the legislator has the right, when reorganising an area of law, to alter individual legal positions provided that the transitional framework is appropriate and reasonable (zumutbar).

However, the legislator is subject to particular constitutional limitations in this respect. Given the protection of individual rights guaranteed in Art. 14(1) first sentence GG, interferences with rights created under previous law are only justified if they serve public interests and adhere to the principle of proportionality. In determining the contents of the powers and obligations associated with property rights, the legislator must furthermore observe the principle of equality guaranteed by Art. 3(1) GG.

3. When redesigning complex systems, the legislator has broad leeway in creating transitional rules for existing legal frameworks, entitlements, and legal relationships. The Federal Constitutional Court only examines whether, in consideration of all relevant circumstances, the legislator exceeded the limits of what is reasonable in the overall balancing between the severity of the interference with constitutionally protected rights on the one hand, and the importance and urgency of the reasons invoked to justify the interference on the other.

II. Based on these standards, § 36(4) KStG is incompatible with Art. 14(1) GG to the extent that the provision leads to a loss of corporation tax reduction potential as it does not include EK 04 in the offsetting of the portions of equity that do not carry a previous tax burden.

1. To the extent that the potential for reduction of corporation tax accumulated under the imputation system could have been realised at the time of the transition from the imputation system to the half-income system, the reduction potential falls within the scope of protection of Art. 14(1) GG. It meets the criteria of use for private benefit and (at least limited) powers of disposal. Moreover, the reduction potential is based on the corporation’s own efforts as it is derived from its corporation tax paid at the retention rate. Insofar as the reduction potential could have been realised at the time the system was changed, it does not merely constitute an opportunity or future earning potential; rather, it amounts to a legal position constituting an asset, to which the corporation was entitled and which was quantifiable.

While the case-law of the Federal Constitutional Court recognises entitlements for a refund of overpaid taxes as property within the meaning of Art. 14(1) GG, the reduction potential at issue here does not fall into the same category. This is because the realisation of the reduction potential requires a distribution of profits or some other realisation event. Moreover, the amount of the potential reduction could vary over time and, as the case may be, even drop to zero in case of losses. At a given time, the specific amount of the corporation tax credit, which was conditional upon a future distribution of profits, depended on the liquidity of the corporation in question and on the composition of its equity, potentially resulting in restrictions for the distribution of profits under business law.

This notwithstanding, the maximum reduction potential that could have been realised – in case of a full distribution of equity – and that could have been used by the corporation in the form of a corporation tax credit was quantifiable at any given time. Therefore, at the time of the transition from the imputation system to the half-income system, it was possible to calculate precisely the amount of corporation tax credit any given corporation would be entitled to if it realised its accumulated reduction potential. In this amount, the reduction potential did not merely constitute an opportunity or future earning potential, but an asset that could be used by the corporation at the time.

2. For corporations with a certain equity structure, § 36(4) KStG interferes with the potential to reduce corporation tax that existed at the time of the transition from the imputation system to the half-income system.

a) Under the imputation system, the maximum amount available for distribution was more or less equivalent to the sum total of all partial amounts of equity. It is true that, in view of the distribution restrictions under company law, negative portions of equity would have influenced the maximum amount of profits available for distribution. However, when a corporation received shareholder contributions other than contributions to the nominal capital (positive EK 04), this would have increased the amount that could have been distributed.

When determining which partial amount of a company’s equity was used for distribution, negative portions were generally disregarded under the old system. In this regard, distribution restrictions under business law therefore had the same effect as an offsetting of negative equity portions against positive portions in the reverse sequence of § 28(3) KStG 1999 in conjunction with §§ 30 and 54(11) fifth sentence KStG 1999. As a result, when profits were fully distributed, the entire reduction potential contained in a positive EK 45 and/or EK 40 could be realised if and to the extent that the balance of all remaining portions of equity was not negative.

b) § 36(4) KStG changes this framework to the detriment of the complainant.

It provides that if the balance of the portions that do not carry a previous tax burden as set forth in § 30(2) nos. 1 to 3 KStG 1999 (EK 01 to EK 03) is negative, these portions first have to be offset against one another. They then have to be offset against the equity portions that do carry a previous tax burden, in the order in which the tax rate increases. The portion set forth in § 30(2) no. 4 KStG 1999 (EK 04) is not taken into account.

This leads to a situation where an offsetting against EK 40 and/or EK 45 – and thus a loss of reduction potential that could still be realised under the transitional framework – occurs if the negative balance of EK 01, EK 02 and EK 03 is not, or not fully, neutralised by a positive equity portion set forth in § 30(1) third sentence no. 2 KStG 1999 (EK 30). If, by contrast, EK 04 had been included in this assessment, the entire EK 45 and/or EK 40, or at least a bigger part thereof, would have been available for distribution, and thus for realising the reduction potential in the event of a full distribution of equity.

3. The interference with the reduction potential protected by Art. 14(1) GG that results from this is not justified by the public interest in accordance with the principle of proportionality.

a) In replacing the imputation system with the half-income system, the legislator pursued the legitimate aim of creating a competitive and performance-based corporate tax system in conformity with EU law. The system change was intended to bring about a simple and transparent corporation tax regime. As a result of the adoption of the half-income system, the classification of different portions of equity, which reflected the respective tax treatment prior to distribution under the imputation system, was no longer needed. It was therefore a legitimate (preliminary) aim of the legislator to phase out this equity classification. This applies all the more since the legislator sought to retain the reductions in corporation tax that accumulated under the imputation system in case of a future distribution of profits. At the same time, the legislator wanted the transition from the old to the new corporation tax regime to be as simple as possible.

b) In principle, § 36 KStG, including its section (4), which is at issue here, was a suitable means for phasing out the equity classification and simplifying the system. However, given the decision to not include EK 04 in the relevant determinations, the provision was not suitable for fully maintaining the reduction potential that could have been realised in case of a full distribution of equity at the time of the system change.

c) In any case, the challenged provision, and the resulting loss of reduction potential for corporations with a certain equity structure, was not a necessary means for achieving the legislative aims. An interference with the protection of individual rights guaranteed under Art. 14(1) first sentence GG in the context of the determination of the content and limits of property – like the one at issue here – is only necessary if no other equally effective means is available that interferes less with constitutionally protected property interests. This is not the case here.

If EK 04 were included in the calculation, the legislator could still achieve all aims pursued without restriction. It was not necessary to disregard EK 04, neither on the grounds that EK 04 is also relevant for tax purposes under the half-income system as a contribution account, nor on the grounds that there was to be no discrepancy between the shareholder contributions represented by EK 04 and the book value of the respective share in the company. The inclusion of EK 04 in the offsetting arrangements pursuant to § 36(4) KStG does not reduce the reflected shareholder contributions, nor does it lower the book value of shares. The offsetting arrangements are a mere interim step to include negative equity portions in the determination of the realisable reduction potential; this step must be considered separately from the subsequent determination and realisation of the corporation tax credit resulting therefrom (cf. § 37 KStG).

d) In addition, not including EK 04 in the offsetting arrangements set out in § 36(4) KStG is incompatible with the principle of equality (Art. 3(1) GG), which is binding on the legislator when determining and limiting the powers attached to property rights under Art. 14(1) second sentence GG. Burdens resulting from structuring property-related matters must be distributed equally in cases where the circumstances are essentially the same; differentiations must be justified by sufficient objective reasons. Such reasons are lacking in this case.

aa) EK 04 is not substantially different from the other portions of equity that do not carry a previous tax burden; in particular, there are no substantial differences between EK 04 and the portions included in the calculations pursuant to § 36(4) KStG (EK 01, EK 02 and EK 03).

bb) § 36(4) KStG results in different treatment of corporations with a positive balance overall, or a balance of zero, of equity that does not carry a previous tax burden (EK 0), depending on whether the sum of EK 01, EK 02 and EK 03 is positive (first scenario), or whether this sum is initially negative and is only neutralised or rendered positive by a positive EK 04 balance (second scenario). In the first scenario, the balance is not offset against the portions carrying a previous tax burden, meaning that no loss of reduction potential is incurred. In the second scenario, the negative balance of EK 01, EK 02 and EK 03 must be offset against the portions carrying a previous tax burden, in the order in which the tax rate increases, even if the overall balance of EK 0 is positive or zero due to a positive EK 04. Insofar as this negative balance is offset against EK 40 or EK 45, this leads to a loss of the reduction potential contained therein that could have been realised in case of a full distribution of equity.

cc) There is no compelling reason for this unequal treatment. The different equity structures as such are no sufficient reason under constitutional law. The Order of the First Senate of 17 November 2009 (BVerfGE 125, 1) does not merit a different conclusion. No objective reason justifying the different treatment is ascertainable since the legislator could have achieved all aims pursued with the transitional framework without restriction if it had included EK 04 in the offsetting arrangements provided for by § 36(4) KStG. Those concerned do not have to tolerate considerable unequal treatment that is not based on any factual reason, given that all aims pursued by the legislator could have been achieved while avoiding the unequal burdens and without other disadvantages.

e) In an overall assessment, the challenged provision exceeds the limits of what is reasonable, both with regard to Art. 14(1) first sentence GG and with regard to Art. 3(1) GG. This assessment is not altered by the broad leeway granted to the legislator when creating transitional rules for existing legal frameworks and entitlements.

III. Given that § 36(4) KStG is incompatible with Art. 14(1) GG in conjunction with Art. 3(1) GG, the notice issued by the tax office based thereon and the judgments of the Finance Court (Finanzgericht) and the Federal Finance Court (Bundesfinanzhof) violate the complainant’s rights.

IV. 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.