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Provisions for long-service awards under the Income Tax Act held constitutional
Press Release No. 58/2009 of 09 June 2009
Order of 12 May 2009
2 BvL 1/00
Before the Tax Reform Act (Steuerreformgesetz - StRefG) of 25 July 1988 went into effect, the question as to whether and how employers may account for long-service awards and similar fringe benefits, and charge them against income, before they are actually paid was determined according to the rules that generally govern provisions. Since 1969, the Federal Finance Court (Bundesfinanzhof) has rendered differing judgments on the question as to the admissibility of provisions for long-service awards. In a leading judgment in the year 1987, the Court decided - unlike in the case of previous decisions and by way of deviation from administrative practice which had not as a rule recognised such provisions - that provisions for long-service awards not only may, but must be, regularly established. The German Federal Ministry of Finance (Bundesministerium der Finanzen - BMF) then decreed on 28 December 1987 that, in view of the possibility of a change in the law, there can be no objection to failure to show, or fully show, provisions for long-service awards in financial statements prepared for tax purposes despite the current case-law of the Federal Finance Court unless a legally binding commitment has been made in writing and the beneficiary is in any case entitled to at least a proportionate part of the benefit in the event of premature termination of employment. With the 1990 Tax Reform Act of 25 July 1988, the legislature then added two special provisions to the Income Tax Act (Einkommensteuergesetz - EstG) that restricted the establishment of provisions for long-service awards in terms of both substantive content (§ 5.4 EStG) and timing (§ 52.6 EStG). According to § 52.6 EStG (old version), the establishment of provisions was not allowed for the years 1988 to 1992 and provisions that had been established previously had to be released and recognised as income within three years. The essential reason for this provision, which was submitted to the Federal Constitutional Court for review, was the fear that a significant shortfall in tax revenues, possibly up to DM 5 billion, would result without the change due to the possibility of establishing new provisions for commitments made in the past on the basis of the new case-law.
In the initial proceedings, the plaintiffs, a married couple who file joint income tax returns, sought recognition of a provision for a long-service commitment that would have reduced income from commercial activities for the year 1988. The plaintiff had made such a commitment to the employees of his service enterprise in the year 1981 by posting an announcement on the notice board of his enterprise. In the income tax assessment notice for 1988, the Tax Office disallowed the increase in the provision for the year ended 31 December 1988 and required the release of one-third of the provisions established in previous years on the basis of § 52.6 EStG of the 1990 version of the Tax Reform Act. The Federal Finance Court dismissed the ensuing "leapfrog appeal" as unfounded. In an appeal on points of law, the Tenth Senate of the Federal Finance Court submitted the issue as to whether § 52.6 sentences 1 and 2 EStG of the 1990 version of the Tax Reform Act, which prohibit provisions for the years 1988 to 1992 and require the release of provisions for long-service awards established previously, is in violation of Article 3.1 of the Basic Law (Grundgesetz - GG) to the Federal Constitutional Court for review.
The Second Senate of the Federal Constitutional Court came to the conclusion that § 52.6 sentences 1 and 2 of the 1990 version of the Tax Reform Act of 25 July 1988 that was in effect up to and including 1998 was compatible with Basic Law and in particular with Article 3.1 GG. The Senate reasoned that the statutory regulation deviates from the general principle to the effect that the determination of taxable income is subject to the principle of prudence that applies under commercial law, but such deviation, in any case in respect of provisions for contingent liabilities, is amenable only to restrained constitutional review as regards the requirements ensuing from the prohibition of arbitrary treatment. As far as substantive content is concerned, the statutory regulation is not arbitrary and lies within the broad scope of legislative operating latitude; there is also no evidence of unequal treatment in violation of the Basic Law as regards timing.
In essence, the decision is based on the following considerations:
Deviation of tax law from the standard of the principle of prudence called for under commercial law in connection with the determination of taxable income is in violation of the requirement that follows from Article 3.1 GG to the effect that the construction of decisions pertaining to imposition under tax law must be consistent only if an objective reason for such deviation is lacking and the "special provision" under non-constitutional law is for that reason to be considered arbitrary. The requirement of consistency that follows from the legal principle of equality limits the authority of the (fiscal) legislature to decide central issues regarding equitable distribution of the tax burden with extensive freedom from constraint. Constitutional law, and in particular the fundamental rights of taxpayers, constitutes in this case only a general framework for the far-reaching operating latitude of the legislature. In the construction of decisions in respect of the distribution of the tax burden, the constitutional requirements of consistency and proportionality do, however, bind the exercise of legislative freedom to an adequate measure of rationality and balance. Insofar as it is also necessary to develop "convincing" dogmatic structures through systematically consistent and practicable construction of fact, this is left to the discretion of the legislature and the competent courts. It is not the task of the Federal Constitutional Court to review and guarantee the "correctness" of solutions to complex dogmatic issues of dispute such as may be, and are in any case in the area of provisions, typical of many areas of legislation governing accounting for tax purposes.
The individual provisions of law involved in the construction of fiscal fact that are not necessarily relevant as regards constitutional law include decisions of the fiscal legislature concerning restriction of the principle of congruency and the establishment of provisions for contingent liabilities in keeping with the principle of prudence pursuant to commercial law.
The temporary retention of the application of the law as practiced under the guidance of the highest fiscal court for many years prior to the change in the case-law effected by the judgment of the Federal Finance Court of 5 February 1987 - IV R 81/84 (Collection of the decisions of the Federal Finance Court (Sammlung der Entscheidungen des Bundesfinanzhofs - BFHE 149, 55) - was not arbitrary either in terms of substantive content or timing. By disallowing the establishment of provisions for long-service awards in the years 1988 to 1992 and requiring the release of provisions previously established over the period of three years from 1988 to 1990, the legislature extended for a further five years the administrative practice based on the case-law of the highest fiscal court that had been in place for decades. Independently of whether the more recent case-law of the Federal Finance Court is to be welcomed as a significant gain in systematic clarity and consistency, especially because of the judgment in the year 1987, it cannot be assumed that the reasons advanced in the previous case-law for disallowing provisions for long-service awards were arbitrary within the meaning of the Basic Law.
In view of the way the law was applied in practice for many years, without arbitrariness and on grounds provided by the highest fiscal court, the reaction of the legislature to the shift in the case-law of the highest fiscal court to recognition of provisions for long-service awards in the year 1987, which was expected to result in a significant revenue shortfall, did not exceed its broad operating latitude. Not least of all to protect fiscal interests, the legislature had the right to maintain, for the time being - up to the entry into force of a basic statutory reform of the legal situation -, the old legal practice in force through temporary disallowance of provisions and the simultaneous gradual release of existing provisions.
The progressive legislative reaction to the change in the case-law of the highest fiscal court also does not result in a violation of the general equality provision of Article 3.1 GG as regards its timing. The same reasons that preclude inference of an arbitrary substantive conflict from the timing of the progressive reaction of the legislature to the decision of the Federal Finance Court also preclude the presumption of a violation of Article 3.1 GG in respect of timing. The commencement of the disallowance of provisions and the requirement that they be released in the year 1988 was the direct reaction to the decision of the Federal Finance Court in the year 1987, and the end of the disallowance when the reform started to be applied as of the year 1993 reflected the interest in handling the legal situation in a manner that would spare the budget. This fiscal interest in retaining an "old" legal situation that was not arbitrary for a limited period of time in conjunction with the goal of creating a uniform initial situation for the reform that would be conducive to equality delivers adequate objective grounds for the concomitant unequal treatment as regards timing.
The regime pursuant to § 52.6 sentences 1 and 2 EStG (old version) submitted for review contained no constitutionally prohibited retroactive effect that violates the principle of legitimate expectation under the rule of law that follows from Article 2.1 in conjunction with Article 20.3 GG. A legitimate expectation could result neither from the initially inconsistent case-law of the Federal Finance Court nor from the fact that a change in the case-law due to significant changes in the factual or legal situation was obviously required and to be expected. The time that elapsed between publication of the judgment of the Federal Finance Court of 5 February 1987 and the 1990 Tax Reform Act that was enacted on 25 July 1988 and went into effect on 3 August 1988 also provided no grounds for the existence of a legitimate expectation since an objective observer could not have anticipated that the legal situation that has since been clarified by the Federal Court of Finance would remain as it was.