Further rule introduced in 2010 concerning the transition from the imputation system to the half-income system incompatible with the Basic Law

Press Release No. 16/2023 of 07 February 2023

Order of 6 December 2022
2 BvL 29/14

Corporation tax reduction potential III

Following a referral for judicial review from a finance court, the Second Senate of the Federal Constitutional Court held in an order published today that § 36(6a) of the Corporation Tax Act (Körperschaftsteuergesetz – KStG) in the version of § 34(13f) KStG as amended by the Tax Act 2010 (Jahressteuergesetz 2010; hereinafter: § 36(6a) KStG) is also incompatible with Art. 14(1) in conjunction with Art. 3(1) of the Basic Law (Grundgesetz – GG). The provision can result in a loss of potential to reduce a company’s corporation tax that could have been realised at the time of the transition from the ‘imputation system’ (Anrechnungsverfahren) to the ‘half-income system’ (Halb-einkünfteverfahren). The fact that the provision simultaneously leads to a reduction of potential to increase corporation tax does not fully compensate for this loss.

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. Tax-free profits, on the other hand, contained a potential to increase a corporation’s tax liability, as in case of profit distribution they were partly taxed at the distribution rate of 30%.

§ 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.

§ 36(6a) KStG provides that equity carrying a previous tax burden of 45% (‘EK 45’) is to be reclassified into equity carrying a previous tax burden of 40% (‘EK40’). At the same time, a positive portion of equity carrying no previous tax burden (‘EK 02’) is reduced until it is used up. This reclassification can lead to a loss in reduction potential that could have been realised at the time of the transition from the imputation system to the half-income system. This loss is not fully compensated by the reduction of the potential for increase of a corporation’s tax liability contained in EK 02 that could have been realised at the time of the transition.

To the extent that the corporation tax reduction potential accumulated under the imputation system could have been realised at the time of the transition from the imputation system to the half-income system, it falls within the scope of the protection of property (Art. 14(1) GG). For corporations with a certain equity structure, § 36(6a) KStG interferes with this protected legal interest. This interference is not justified. The interference is not necessary for achieving the legislative aims and does not satisfy the requirements arising from the general guarantee of the right to equality for the restructuring of property rights.

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 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 of the Tax Reduction Act 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) to (6) KStG provides that the equity components that carry a previous corporation tax burden and those that do not are offset against one another in several steps. Subsequently, pursuant to § 36(6a) KStG, EK 45 is reclassified into EK 40 while EK 02 is reduced if there is still a positive amount of EK 02 left following the aforementioned steps of offsetting equity components. EK 02 is initially reduced by 5/22 of a positive amount of EK 45, to no less than zero, and EK 45 is increased accordingly. EK 40 is then increased by 27/5 of the amount by which EK 02 was reduced, and EK 45 is reduced by the same proportion. Unlike § 36(3) KStG as introduced by the Tax Reduction Act, this approach prevents EK 02 from becoming negative following the reclassification and thus prevents a situation where the subsequent offsetting against equity portions that have been subject to corporation tax would result in a loss of potential to reduce corporation tax due to the reclassification.

The plaintiff in the initial proceedings is a bank incorporated as a registered cooperative. Based on the tax office’s assessment of the final amounts of equity pursuant to § 36(7) KStG on the basis of § 36(6a) KStG, the plaintiff’s corporation tax credit pursuant to § 37(1) KStG was less than the realisable reduction potential at the time of the system change. Following an unsuccessful objections procedure, the plaintiff brought an action before the Finance Court (Finanzgericht). The Finance Court suspended the proceedings under Art. 100(1) GG and referred to the Federal Constitutional Court the question whether § 36(6a) KStG is incompatible with Art. 3(1) GG.

Key considerations of the Senate:

§ 36(6a) KStG violates Art. 14(1) in conjunction with Art. 3(1) GG.

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 in question 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) 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 (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(6a) KStG is incompatible with Art. 14(1) in conjunction with Art. 3(1) GG.

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.

2. Depending on a corporation’s equity structure, § 36(6a) KStG interferes with the reduction potential contained in EK 45 that could have been realised at the time of the transition from the imputation system to the half-income system. The provision results in a loss of potential to reduce corporation tax as compared to the time before the system change. This loss is not fully compensated by the simultaneously occurring reduction in the potential to increase corporation tax.

a) Under the imputation system, if equity were to be fully distributed, given the distribution sequence set out in § 28(3) first sentence in conjunction with § 30 KStG 1999, the only scenario in which reduction potential stored in a positive EK 45 could not be (fully) realised was if the sum of all other partial amounts of equity was negative. In all other cases, § 36(6a) KStG leads to a loss of potential to reduce corporation tax that could have been realised under the transitional framework. While the reclassification of EK 45 into EK 40 pursuant to § 36(6a) second sentence KStG leads to a higher amount of EK 40, EK 40 only has a reduction potential of 1/6, and thus a lower potential than EK 45 with a reduction potential of 15/55. This leads to an overall loss of reduction potential.

b) Nevertheless, the loss of reduction potential is arithmetically compensated by the corresponding decrease in EK 02, and thus by the reduction of the potential for increasing corporation tax contained therein. Pursuant to § 36(6a) first sentence KStG, EK 02 is reduced by 5/22 of EK 45 until EK 02 is used up. Given that offsetting is limited to a positive amount of EK 02, the decrease of the potential for reducing corporation tax accumulated under the imputation system, which results from reclassification, always corresponds to the decrease of the potential for increasing corporation tax resulting from reclassification.

Yet under § 36(6a) KStG, it is only the balance between the reduction potential and the potential for increase that remains identical, rather than the reduction potential as such. Arithmetic compensation notwithstanding, the provision therefore entails two adverse changes compared to the imputation system:

aa) First, the offsetting against EK 45 leads to the mandatory subsequent taxation of EK 02 at a rate of 30%, while under the imputation system, subsequent taxation was only applied if profits were actually distributed. Under the imputation system, the corporations concerned were able to realise the reduction potential without incurring increases in their corporation tax liability by managing their distribution policy in a certain way.

bb) Second, even if equity had been fully distributed at the time of the transition from the imputation system to the half-income system, EK 02 would only have been subject to subsequent taxation to the extent that it would have been considered as having been used for distribution at that time. This depends on whether negative partial amounts of equity would have led to distribution restrictions and, where applicable, which parts of equity would have been affected by this based on the sequence laid down in § 28(3) first sentence in conjunction with § 30 KStG 1999. Since EK 02 was considered as used for distribution only subsequent to those partial amounts of equity that carried a previous tax burden, it cannot be ruled out that, in the case of a full distribution of equity, the potential for reducing corporation tax would have been realised, while the potential for increasing corporation tax would not – or at least not fully – have been realised.

This is not taken into consideration by § 36(6a) KStG, which only takes the remaining amount of EK 02 into account. The previous steps set out in § 36(4) to (6) KStG that serve to determine the final amounts of the portions of equity also do not guarantee a concentration on the part of EK 02 that would have been used in case of a full distribution of equity at the time of system change. That is because the offsetting of the different partial amounts of the equity, some of which carry a previous corporation tax burden while others do not, is not based on the sequence laid down in § 28(3) first sentence in conjunction with § 30 KStG 1999.

3. The adverse effects brought about by § 36(6a) KStG result in an interference with the reduction potential protected by Art. 14(1) GG. This interference is not justified.

a) In enacting the new transitional framework, the legislator pursued legitimate aims. The legislator intended to implement a decision of the Federal Constitutional Court (BVerfGE 125, 1), but wished to retain the previous transitional framework to the greatest possible extent. In this transitional framework, it was a legitimate (preliminary) aim of the legislator to phase out the equity classification that was no longer needed under the half-income system. 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. Part of this simplification was the legislator’s goal of reducing, from the start of the transition, the equity pots to the minimum that was absolutely necessary, that is: to one portion of equity with a previous tax burden of 40%, with this being used to determine the corporation tax credit (§ 37(1) KStG); one portion of equity with no previous corporation tax burden (former EK 02), the distribution of which results in an increase in corporation tax of 3/7 of the profit distribution (§ 38 KStG); and a contribution account for tax purposes (§ 27 KStG, formerly EK 04).

The mandatory realisation of the potential to increase corporation tax contained in a positive EK 02, which occurs by way of offsetting this amount against the potential to reduce corporation tax contained in EK 45 of the same corporation, was also in principle a legitimate legislative aim, even though it had not been expressly set out as such. Insofar as both potentials could have been realised, this corresponds to the concept of a notional full distribution of equity at the time of the system change, which was the basis for the transitional framework in §§ 36 ff. KStG. This approach is not objectionable under constitutional law because under the imputation system, too, taxpayers had to expect that EK 02 would eventually be subject to taxation – at least in principle and at the time of liquidation.

b) § 36(6a) KStG was only in part a suitable means for achieving the aforementioned legitimate aims. It is true that the provision achieved the intended reduction of equity portions carrying a previous tax burden and, for the most part, eliminated EK 02, provided that a sufficient positive amount of EK 02 was available to offset against EK 45. Yet wherever a corporation had an amount of EK 02 that, after application of § 36(4) to (6) KStG, was lower than 5/22 of the amount of EK 45, a certain amount of EK 45 remained. Overall, this had considerable adverse effects on the intended simplification.

The provision was also not completely suitable for maintaining (in full) the potential to reduce corporation tax. What was retained was merely the balance between the reduction potential and the potential for increase. The higher amount of EK 40 remaining after EK 45 and EK 02 had been offset against one another had a lower reduction potential than the original amount of EK 45. The simultaneous reduction in EK 02 did at least not constitute legitimate and reasonable compensation for the taxpayers insofar as the potential for increase contained therein could not have been realised at the time of the system change because EK 02 would not have been used in the case of a full distribution of equity, as set out in § 28(3) KStG 1999, owing to distribution restrictions under business law.

c) Even if the offsetting of equity components in § 36(6a) KStG were considered to be at least in part a suitable means for simplifying the transition and for maintaining the reduction potential, it was in any case not a necessary means.

The legislator could have achieved an arrangement that would have been just as simple while fully maintaining the (realisable) reduction potential by drawing the corporation tax credit pursuant to § 37 KStG directly from the partial amounts carrying a previous tax burden existing at the specified date – EK 45 and EK 40 – without prior reclassification of EK 45. This would only have required the separate assessment of the final balance of both partial amounts at the relevant date. With this solution, too, the corporation tax credit could subsequently have been balanced against the corporation tax increase for individual taxpayers.

d) In addition, § 36(6a) KStG is incompatible with the principle of equality under 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. 

aa) EK 45 is not substantially different from EK 40. Both are partial amounts of equity that carry a previous tax burden, and thus contain a corporation tax reduction potential. They only differ as to the amount of reduction potential they contain, which depends on the time at which the equity was formed.

bb) Given the reclassification arrangement in § 36(6a) KStG, corporations with EK 45 that must be reclassified are placed in a less favourable position than corporations with EK 40 (which is not subject to reclassification). The reclassification leads to a partial loss of the reduction potential contained in EK 45. While this is arithmetically compensated by a reduction in EK 02, it entails the mandatory realisation of the potential to increase corporation tax contained in EK 02. By contrast, the reduction potential contained in EK 40 remains completely unaffected by the reclassification. A general mandatory realisation of the potential to increase corporation tax was initially not provided for; such mandatory realisation was only put in place through the Tax Act of 2008, and even then it only amounted to 3%.

cc) There is no compelling reason for the unequal treatment of EK 40 and EK 45. This unequal treatment was not a suitable means for maintaining the potential to reduce corporation tax in all cases, as had been intended by the legislator. It was in any case not necessary for simplifying the transition from the imputation system to the half-income system.

III. 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.