Legislature’s clarification of applicable law may be unconstitutional if it has “true” retroactive effect

Press Release No. 12/2014 of 20 February 2014

Order of 17 December 2013
1 BvL 5/08

In an order published today, the First Senate of the Federal Constitutional Court further clarified its jurisprudence on “true” retroactivity (echte Rückwirkung). The legislature may define or clarify the content of applicable law with effect for the past only within the constitutional limits for retroactive legislation. From the perspective of constitutional law, a law is constitutive if it is intended to clarify an unresolved question of interpretation for the past. In the instant case, the First Senate found that there existed no exception from the principle of impermissibility of retroactivity, and it nullified the retroactive law. The Senate adopted the decision with 5:3 votes regarding its final conclusion, and with 6:2 votes regarding the constitutional principles. Justice Masing submitted a dissenting opinion.

Facts of the Case and Course of the Proceedings:

The proceedings for specific judicial review concerned the question of whether § 43 sec. 18 of the Act on Investment Companies (Gesetz über Kapitalanlagegesellschaften – KAGG) violates the prohibition of retroactivity.

1. In the second half of 2003, the legislature addressed a problem of interpretation, namely whether reductions in the profits on fund shares could be deducted for income tax purposes. The question at issue was whether § 8b sec. 3 of the Corporation Tax Act (Körperschaftsteuergesetz – KStG), in the version in force since 1 January 2001, also applies to investment companies, even though § 40a sec. 1 KAGG did not originally refer to that provision. On 22 December 2003, the “Basket II Act” (Korb II-Gesetz – Federal Law Gazette, Bundesgesetzblatt – BGBl I p. 2840) inserted § 40a sec. 1 sentence 2 KAGG, which contains an express reference to § 8b sec. 3 KStG; according to the reasons given for the government’s bill, this was an “editorial clarification”. Under § 43 sec. 18 KAGG, the new § 40a sec. 1 sentence 2 KAGG is “to be applied to all tax assessment periods for which assessments are not final”.

2. The claimant in the original proceedings is a bank. It held among its current assets shares of investment funds whose trading prices had decreased on 31 December 2002 below the carrying amounts of the 2001 annual financial statements. The claimant recognised impairment losses against its income and initially treated them as applicable for tax purposes. Because of the Korb II-Gesetz, the claimant lodged an amended corporation tax return with the tax office for the year 2002. In accordance with § 40a sec. 1 sentence 2 KAGG in conjunction with § 8b sec. 3 KStG, it increased its profit off the balance sheet by the write-downs it had claimed, but cited the unconstitutional nature of the retroactive effect. The Finance Court hearing the complaint stayed the proceedings in order to obtain a decision from the Federal Constitutional Court. The Finance Court believes that § 43 sec. 18 KAGG is unconstitutional because the new version of § 40a sec. 1 KAGG is not merely a clarification but has an impermissible “true” retroactive effect.

Key Considerations of the Senate:

§ 43 sec. 18 KAGG is unconstitutional and void insofar as it orders the retroactive application of § 40a sec. 1 sentence 2 KAGG to the 2001 and 2002 tax assessment periods.

1. In formal terms, § 43 sec. 18 KAGG has retroactive effect for those years. In its established jurisprudence, the Federal Constitutional Court distinguishes between laws with “true” retroactive effect (echte Rückwirkung), which are generally incompatible with the Constitution, and those with “quasi” retroactive effect (unechte Rückwirkung), which are generally permissible. A legal provision has retroactive effect if it intervenes ex post facto in a settled matter, and in particular if it alters a tax liability that has already been established. A change in a provision of tax law that affects past assessment periods constitutes “true” retroactivity.

2. In the case at hand, the constitutional principles prohibiting retroactive laws also apply with regard to the substance of the case. In constitutional terms, § 40a sec. 1 sentence 2 KAGG must be treated as a constitutive amendment of the law.

a) The courts are not bound by the view that the provision is a mere clarification, as was stated in the government’s bill of the Korb II-Gesetz. As a rule, it is the judiciary that is called to provide binding interpretations of the law; this also applies to the question of whether a provision is constitutive or declaratory in nature. The legislature has no authority to provide authentic interpretations of legal provisions. It may, of course, amend the content of a provision it has enacted, or further specify its details for clarification, and in doing so, may correct case-law with which it does not agree. But in so doing, it must remain within the bounds of the constitutional system.

b) To answer the question of whether a retroactive provision is, from a constitutional-law perspective, constitutive, it is sufficient to find that the amended provision, in its original version, could be interpreted by the courts in a way that the new provision was intended to exclude. This is the case here.

c) Under the Constitution, the legislature’s wish to clarify a legal situation retroactively can generally only be permitted within the limits set by the prohibition of retroactivity. To do otherwise would seriously compromise the protection of the legitimate expectation that the law remain stable, which is required by the rule of law. In view of the fact that the law tends to both lend itself to interpretation and to need interpretation, the legislature could otherwise easily justify a need for clarification. The competence to retroactively clarify the applicable law, largely exempt from the requirements of protecting legitimate expectations, would grant the legislature a broad ability to intervene in legal positions that had previously been settled and would retroactively open the door for politically opportunistic considerations.

d) Nor does a right of the legislature to intervene in past matters proceed from the principle of democracy; rather, there is a tension between these principles. Parliament’s democratic responsibility applies to the present and the future. Legislative decisions made earlier have an autonomous democratic legitimation. The historical context of legitimation – at least insofar as the effects of the law lie in the past – cannot simply be excluded by the retroactive intervention of a present-day legislature. The democratic principle, too, requires that the legislature’s intervention in the past remain an exception.

3. The burden imposed by the constitutive effect of § 40a sec. 1 sentence 2 KAGG is unconstitutional insofar as, pursuant to § 43 sec. 18 KAGG, it has a retroactive effect on the 2001 and 2002 assessment periods.

a) The principles of legal certainty and legitimate expectations, which are anchored in the rule of law and the fundamental rights, generally oppose laws with retroactive effect. However, there are exceptions to this prohibition: The prohibition of retroactivity does not apply if it was impossible that somebody would form legitimate expectations regarding the continued application of the current law, or if the expectation of a certain legal position was objectively unjustified and thus not worthy of protection. The groups of cases recognised in the jurisprudence of the Federal Constitutional Court, which are not conclusively defined, concern situations in which, as an exception, there are no legitimate expectations regarding an existing legal position.

b) Only two of the recognised case groups could be applicable in the instant case: Cases in which the original state of the law was unclear and confused, or cases in which the law was incompatible with the legal system and unfair. Neither of them can, however, justify the retroactive effect of § 43 sec. 18 KAGG on the 2001 and 2002 assessment periods.

aa) The interpretation of § 40a sec. 1 KAGG, which has not been clarified by jurisprudence of the highest courts, and the resulting inconsistent case-law of the fiscal courts do not yet qualify as a confused state of the law. The mere fact that a law is in need of interpretation does not justify amending that law retroactively. Otherwise, especially in the early years of a statutory provision, one could normally never develop the legitimate expectation of having no retroactive amendments before relevant established case-law has evolved.

bb) The original unamended law was also not sufficiently incompatible with the system or unfair as to justify retroactivity. Neither of the two interpretations (applicability or inapplicability of § 8b sec. 3 KStG to investment companies) is mandated by the Constitution. It is within the discretion of the legislature to structure the taxation of investment companies in the way that the referring court used for its interpretation; no serious doubts exist regarding its constitutionality. In the instant case, investment companies do not pass their losses to the general public in a way that is incompatible with the legal system.

c) There is also no cause to deviate, for reasons beyond the recognised case groups, from the protection of legitimate expectations, which is anchored in the rule of law and the fundamental rights, and from the exceptional character of permissible “true” retroactivity that is rooted in this principle. Such a deviation would, however, exist if the legislature’s wish to define ex post facto the “true” content of previously enacted law, and to correct – including for the past – an interpretation that does not conform with the legislature’s ideas, would only be limited in individual proceedings that have become final, or in the case of legal situations that allow no serious room for interpretation. This would sacrifice both the special protection against “true” retroactive laws, which the Court developed through its established jurisprudence, and the differentiation between generally impermissible “true” retroactivity and generally permissible “quasi” retroactivity.

4. If, as in the instant case, the Federal Constitutional Court holds that a retroactive legislative “clarification” is unconstitutional and void, the regular courts must decide the disputes affected by this decision through an interpretation in accordance with the old status of the law. Thus the result of the clarification by the Federal Finance Court as the highest competent court may, in the present case, be that the law is to be interpreted in such a way as the legislature intended by the ex post facto “clarification”.

Dissenting Opinion of Justice Masing:

Contrary to first appearances, the decision does not merely concern specific problems of ordinary law, but fundamental questions regarding the reach of the legislature’s authority to define unclear legal questions of the past that have remained unresolved – here, the possibility of tax deductions for losses that financial institutions incurred in particular as a consequence of the attacks of 11 September 2001. The decision contains a serious disruption of the balance between the principles of democracy and the rule of law, to the detriment of parliament.

1. The decision dismantles the foundation on which the prohibition of retroactivity rests, which focusses on safeguarding personal freedom, and replaces it with abstract notions of the separation of powers that are inappropriate. The Senate majority expressly holds that, on the basis of the original law, the regular courts can conclude that § 8b sec. 3 KStG is applicable in the instant cases. Nevertheless, the Senate finds that this question cannot be clarified retroactively by the legislature; clarification is reserved for the regular courts alone. Thus, the legislature may not adopt a ruling that the courts are readily permitted to make through interpretation.

In effect, this puts an end to basing the prohibition of retroactivity in the protection of legitimate expectations. The only, and in any case far-fetched, expectation to be protected one might find here is the abstract expectation of the validity of a law with an uncertain meaning – and therefore the adjudication by the regular courts of a question that has remained politically unresolved. What is protected is the concerned parties’ expectation to have a chance of a favourable decision. However, this very aspect shows how far the majority decision diverges from the original aim of the jurisprudence on retroactivity. Whereas the jurisprudence on retroactivity initially protected legitimate expectations in clearly established legal rules in order to safeguard the individual exercise of freedoms, it now asserts objective notions regarding the separation of powers, and thus safe-guards an area of competence for the judiciary versus the legislature.

2. As a consequence, the prohibition of retroactivity is rendered autonomous as an a priori principle of the separation of powers. As such it has no foundation in the Basic Law. Under the democratic rule of law, it is generally for the legislature to decide what the law is supposed to be. The legislature is elected for this purpose and is responsible to the public in a political process. In general, this also concerns decisions about problems that originated in the past, and covers the clarification of contentious issues that have remained politically unresolved and are in need of a solution. The idea that the legislature has only one try, after which it can no longer take on the arising problems unless in order to amend the provisions for the future, has no basis for legitimation under our constitutional system. Obviously the legislature cannot simply interfere ex post facto in individual proceedings that have become final, or reassess conduct of the past and impose sanctions on that conduct which the parties had no reason to expect. This is the correct core of the jurisprudence on retroactivity. But such restrictions on the legislature must always be based on a specific need for protection of those affected.

The decision furthermore does not make sense either functionally or practically: In view of the increasingly complex requirements that the legislation must meet, one cannot seriously expect that it will always be possible to foresee all ambiguities, misunderstandings, and unintended practices that may arise from a new provision. In such situations, a retroactive clarification by the legislature might immediately and uniformly resolve all pending disputes and, with one stroke, establish legal certainty. As a result of the majority decision, however, now all unclear cases that have arisen to date must proceed through the appeals process in court – possibly at great cost and over long periods of time. In this process, the courts, which normally should search for the legislative intent – often, however, being impossible to establish in these cases – could find themselves obliged to establish their own ideas of justice, without being able to refer to any democratically legitimised basis.

3. The decision furthermore incorporates a far-reaching change in the jurisprudence on retroactivity. It is true that the decision ties in with some general statements of the Federal Constitutional Court’s prior case-law referring to some of its explanatory wording on a very abstract level; according to the majority’s understanding, it merely develops these statements in more specific detail. However, in reality the decision separates those principles from their prior case-based context and accords them a new meaning that breaks with the assessments in the Court’s previous decisions.

A review of the jurisprudence to date shows that the Federal Constitutional Court has so far been very reluctant to revoke laws because of a violation of the prohibition of retroactivity, and has always strictly focused on protecting a specific legitimate expectation in clearly established legal rules. The Court has only ever revoked provisions in which legitimate expectations in clearly established legal rules were frustrated if these provisions could have served as a basis for individual arrangements. This has especially been the case where the legislature invoked an “authentic interpretation.” Especially in recent times, the Court did not recognise such legitimate expectations even where the legislature had amended new case-law of the highest competent court. It is not evident why these criteria, which were applied with regard to certain retirees and civil servants, should not apply to banks engaged in a largely speculative line of business.

One cannot object to this that, if one consistently used the criterion of legitimate expectations, one would sacrifice the principle of the prohibition of retroactive laws and the case-law standards of protection, because decisions that have been codified in statutes could be turned on their heads ex post facto by arbitrarily invoking the need for clarification. The mere fact that laws need to be interpreted does not mean that fundamental legislative decisions and the provisions on their implementation are open to unbounded interpretation. We would not say our legal system is unable to establish specific legitimate expectations of certain legal consequences, or to establish principles on which arrangements can be based. The prohibition of retroactivity is always warranted where such a legitimate expectation exists, but only there.

4. Neither do the challenged provisions indicate that the claimant banks had legitimate expectations that the tax laws would make allowance for their losses. It is unlikely that the legislature intended to exempt gains on investment fund shares from taxation, but allow the corresponding losses to be tax-deductible. Under a proper interpretation, it is in any case likely that such a solution was not intended. At any rate, the banks could not legitimately base any arrangements on such an interpretation. Furthermore, the decision contains supplementary distinguishing criteria for recognising exceptions which are not convincing. The decision holds that a retroactive provision is only permissible under the Constitution if the old provision would have led to a completely incomprehensible or confused state of the law. Accordingly, the legislature is not permitted to clarify what it views as an editorial error because the mistake was too insignificant; yet this would have been possible if the legislature had committed more serious mistakes causing greater confusion. Such distinctions fail to convince.