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Current structure of privileges for business assets under the Inheritance Act not fully constitutional
Press Release No. 116/2014 of 17 December 2014
Judgment of 17 December 2014
1 BvL 21/12
In a judgment released today, the First Senate of the Federal Constitutional Court declared §§ 13a, 13b, and 19 sec. 1 of the Inheritance and Gift Tax Act (Erbschaftsteuer- und Schenkungsteuergesetz – ErbStG) unconstitutional. The provisions shall continue to apply for the time being, but the legislature must adopt new regulations until 30 June 2016. The legislature has discretion to award preferential treatment under the tax code to small and medium-sized companies managed by their owners in order to ensure their continued existence and to preserve jobs. However, it is disproportionate to favour business assets that go beyond the range of small and medium-sized companies without an economic needs test. It is also disproportionate to exempt companies with up to 20 employees from withholding the minimum of total wages and salaries and to exempt business assets containing up to 50 % operative assets for tax purposes. §§ 13a and 13b ErbStG are also insofar unconstitutional as they permit designs that lead to unjustifiable unequal treatment. These violations of the Constitution result in the incompatibility of the submitted provisions with Art. 3 sec. 1 of the Basic Law (Grundgesetz - GG). The decision was taken unanimously with regard to the results and the grounds; Justices Gaier, Masing, and Baer jointly submitted a separate opinion.
Facts of the Case and Procedural History:
The plaintiff in theinitial proceedings is co-heir of the testator, who died in 2009. The estate consisted of money in various bank accounts as well as a claim for a tax refund. The tax office determined that the inheritance tax amounted to 30% under tax bracket II. The plaintiff claims that it was unconstitutional to treat individuals under tax brackets II and III the same, which was only meant to apply for 2009. His objection and action, which aimed at a reduction of his taxes, were unsuccessful. In the course of the appeal proceedings, by decision of 27 September 2012, the Federal Finance Court (Bundesfinanzhof) submitted a question to the Federal Constitutional Court. It asked whether § 19 sec. 1 ErbStG, as applicable in 2009, and in conjunction with §§ 13a and 13b ErbStG, is unconstitutional because it violates Art. 3 sec. 1 GG. The Federal Finance Court argued that while the equal treatment of individuals falling under tax brackets II and III under § 19 sec. 1 ErbStG had to be accepted under the Constitution, § 19 sec. 1 ErbStG in conjunction with §§ 13a and 13b ErbStG violated the principle of equality. Further information on the background of the case can be found (in German) in Press Release no. 53/2014 of 12 June 2014.
Key Considerations of the Senate:
1. The submission of the Federal Finance Court is, for the most part, admissible. Art. 3 sec. 1 GG does not grant taxpayers a right to constitutional review of tax law regulations that favour third parties in violation of the principle of equality, but that do not concern the individuals’ own legal obligations under the tax code. However, this is different if tax breaks undermine the equitable burden the tax shall impose altogether. While the outcome of the initial court proceedings does not directly depend on the interpretation and application of §§ 13a and 13b ErbStG, the Federal Finance Court rightly considered them still sufficiently relevant. The violations of the principle of equality it alleges are significant enough to affect preferential treatment under inheritance tax law of business assets as a whole; moreover, the overall sum of the business assets that enjoy preferential treatment is of such weight that, in the event of its unconstitutionality, the taxation of non-business assets could not remain unaffected.
2. Pursuant to Art. 105 sec. 2 GG in conjunction with Art. 72 sec. 2 GG, the Federation was competent to enact the provisions submitted for review. Pursuant to Art. 72 sec. 2 GG, a federal regulation is necessary for reasons of national interest not only if it is indispensable to maintain legal or economic unity. It is sufficient if the federal legislature could otherwise expect problematic developments for the legal and economic unity of the country. The Federal Constitutional Court has to ascertain whether these conditions are met; the legislature has a prerogative for assessing the conditions of a federal regulation and its necessity in the interest of the state as a whole. In the present case, the federal legislature could assume that, without federal regulation, a fragmentation of the law could ensue that would entail significant disadvantages for the testator and the purchaser of business assets, as well as for the tax administration.
3. The preferential treatment accorded to the transition of business assets by inheritance tax law partly violates Art. 3 sec. 1 GG.
a) In the area of tax law, the principle of equality leaves a wide margin of appreciation to the legislature, both regarding the selection of the object to be taxed and the determination of the tax rate. In addition, deviations from a final decision on taxation issues must also be measured against the principle of equality. They require a special objective justification that increase in relation to the scope and extent of the deviation.
The legislature is not prevented from supporting, via tax law, goals outside the narrow fiscal scope. It has wide discretion in assessing which goals it deems worthy of support and which tax breaks it offers for their achievement. However, the legislature remains bound by the principle of equality. Depending on the intensity of unequal treatment, this can lead to a stricter review by the Federal Constitutional Court.
b) In principle, the exemption regulation as such is compatible with Art. 3 sec. 1 GG. However, corrections are in order with regard to the transition of large company assets.
aa) The exemption regulation leads to an unequal treatment of purchasers of business and non-business assets that can reach enormous proportions. Pursuant to §§ 13a and 13b ErbStG,85% or 100% of the value of business assets, of agricultural and forestry assets, and certain shares in corporations remain exempt if the other relevant legal conditions are met. Added to this are reductions pursuant to § 13a sec. 2 ErbStG,as well as a general application of the lower tax bracket pursuant to § 19a ErbStG.
bb) Since more than a third of the tax exempt assets transferred between 2009 and 2012 was exempt from inheritance tax pursuant to §§ 13a and 13b ErbStG,the distinction between assets with and without preferential treatment is much more than marginal. Thus, the legislature is subject a strict standard of proportionality. Moreover, purchasers usually have little influence on whether the assets given to or inherited by them are eligible for preferential treatment, which also implies a strict standard of review.
cc) The exemption regulations are primarily aimed at protecting companies which are characterised by a special personal bond of the testator or the heir to the company, as is typical for family-owned businesses. Their productive assets are to receive preferential treatment under tax law, so as not to jeopardise the company’s continued existence and its jobs because of tax-related liquidity problems. These objectives do not raise constitutional concerns.
dd) §§ 13a and 13b ErbStGare suitable as well as, in principle, necessary to achieve the objectives pursued. The legislature has a wide margin of appreciation and prognosis in this regard. Against this background, it is sufficient that it has, in a reasonable and plausible way, identified a serious risk of liquidity problems in the context of taxing a transfer of companies that does not involve payment; there is no need to empirically prove that taxation would give rise to dangers for the businesses in more than just exceptional cases. To make the exemption contingent on a needs test would not constitute a less restrictive measure because it would entail rather complicated procedures to determine inheritance tax – especially due to assessment questions. Neither would forbearance of debt constitute an equally effective but less restrictive measure.
ee) In principle, the unequal treatment effected by the exemption regulation is compatible with the principle of proportionality in the narrower sense, even if it leads to a tax exemption of 100%. The legislature is largely free to decide which instruments to use for ensuring a targeted promotion of its objectives. In view of the considerable degree of inequality, it would however be incompatible with Art. 3 sec. 1 GG to grant comprehensible yet unconditional exemptions.
Preferential treatment of business assets is disproportionate if, without an economic needs test, it covers more than small and medium-sized companies. In such cases, due to the mere scale of the tax exempt amounts, the unequal treatment reaches a scope that is no longer compatible with the principle of equal taxation unless a necessity to exempt the acquired company is specifically determined. It is for the legislature to choose precise and manageable criteria for determining what kind of companies can no longer be exempt from taxes without an economic needs test.
c) The design of the exemption provisions of §§ 13a and 13b ErbStGalso violate Art. 3 sec. 1 GG in parts.
aa) The determination of the types of assets that are to be treated preferentially is not objectionable. The requirement of a minimum participation of over 25% in corporations excludes mere financial investments. With a stake of more than 25% in the company, the legislature could assume that the shareholder is involved in the company’s business practice; the legislature’s power to classify and simplify covers the specification of a stake in the company. Also, the fact that the law takes account of the testator’s circumstances, while the person acquiring the company needs to have no personal influence over the company, does not raise constitutional concerns. Even where better solutions could be achieved in other ways, the legislature may hold on to a comprehensive system which, on the whole, is based on good reasons.
It is compatible with the principle of equality to generally favour the acquisition of shares in partnerships. This relates to the different ways civil law treats the assets of partnerships and corporations; the legislature is thus within its margin of appreciation for the assessment and classification of such matters. The legislature could also assume that any shares in agricultural and forestry businesses would entail some personal involvement in the company’s business practice; and in fact, such businesses are very frequently family businesses without major capital basis.
bb) While the aggregate wage regulation is in principle compatible with Art. 3 sec. 1 GG, this does not apply to the exemption of companies with no more than 20 employees. The aggregate wage regulation is based on the legitimate objective to preserve jobs. It is within the legislature’s discretion to apply an aggregate wage regulation instead of a strict commitment to preserve the specific jobs. However, the exemption of companies with no more than 20 employees violates Art. 3 sec. 1 GG. The provision especially aims at administrative simplification. It disproportionately privileges those who acquire companies with up to 20 employees. According to the Federal Finance Court, well over 90% of all businesses in Germany have no more than 20 employees. Thus, without regard to the preservation of jobs, nearly all companies can claim tax benefits, even though the administrative burden in connection with the proof and verification of the minimum of total wages and salaries is not as high as is sometimes alleged. Since the relationship of rule and exception is, because of this legislative decision on exemptions, virtually turned on its head, the boundaries of a permissible classification are exceeded. Should the legislature decide to hold on to the current exemption scheme, it will have to limit the exemption from the total wages and salaries requirement to companies with just a few employees.
cc) The period of five or seven years for which to hold a company to enjoy tax benefits is in principle compatible with Art. 3 sec. 1 GG, especially since it is adequately supplemented by the aggregate wage regulation and the test regarding operative assets for tax purposes.
dd) The provision on operative assets for tax purposes is incompatible with Art. 3 sec. 1 GG. The legislature’s objectives to only support productive assets and to prevent circumvention through tax planning are legitimate and reasonable. However, this does not apply if preferentially treated assets with of up to 50% operative assets benefit as a whole from tax breaks. Sound reasons for a justification of such an extensive inclusion of asset components that are not actually considered worthy of preferential treatment cannot be discerned. The provision can hardly achieve its goal to prevent opportunities for tax planning; on the contrary, it is more likely that this will encourage the relocation of private assets into business assets. There is also no noticeable effect of administrative simplification, since the share of administrative assets also has to be determined to apply the 50% rule. Lastly, the provision is incompatible with the classification of § 13b sec. 4 ErbStG, pursuant to which every company shall have administrative assets in the amount of 15% of the total business assets that are not tax exempt.
ee) A tax law is unconstitutional if – beyond atypical individual cases – it allows for situations in which one can attain unintended tax breaks that cannot be justified under the principle of equality. This is the case in constellations that bypass the obligation on total wages and salaries through corporate restructurings that use the 50% rule for business group structures, as well as to so-called cash companies.
(1) Since even the exemption of companies with up to 20 employees from the obligation on total wages and salaries constitutes a disproportionate preferential treatment, this applies even more to constellations that allow for the free transfer of businesses with more than 20 employees and without observing the requirement on total wages and salaries. The Federal Finance Court cites as an example for such a constellation a company with more than 20 employees that is split into a holding company and an operating company. By permitting that the connection with total wages and salaries is thus circumvented, § 13 sec. 1 sentence 4 ErbStGthus violates Art. 3 sec. 1 GG.
(2) Since the test regarding operative assets applies the “all-or-nothing principle”, the interest in a company does not constitute an administrative asset if the interest’s own share in administrative assets is 50% or less. In multi-layered corporate structures, this can have a cascading effect. An interest on the lower level with a share in administrative assets of up to 50% overall to completely exempt assets, which are considered completely exempt assets on the next level, even though an overall assessment of the company would show the predominance of administrative assets. By permitting the design of such corporate structures, § 13b sec. 2 sentence 2 no. 3 ErbStGintensifies the violation of the principle of equality that was already established with regard to the basic structure of the 50% rule.
(3) A “cash-GmbH” is a limited liability company whose whole assets consist of monetary claims. Until 7June 2013, monetary claims were not considered operative assets. There are clearly no reasons for a preferential treatment of monetary assets in a “cash company” that is restricted to asset management which are weighty enough to justify a complete and unlimited preferential treatment as compared to other non-monetary or operative assets.
4. The violations of the principle of equality that have been found concern §§ 13a and 13b ErbStGas a whole; this applies both to the original version of the Inheritance Tax Reform Act (Erbschaftsteuerreformgesetz) of 24 December 2008 and all subsequent versions. Due to the violations of the principle of equality, important elements of §§ 13a and 13b ErbStGare unconstitutional. Without them, the other elements of these provisions that were not challenged can no longer be applied in a meaningful way. Therefore, § 19 sec. 1 ErbStG, which covers the taxation of both exempt and non-exempt assets, has to be declared incompatible with Art. 3 sec. GG in conjunction with §§ 13a and 13b ErbStG. The mentioned provisions shall continue to apply until 30 June 2016, by which date the legislature must enact new regulations. The continued validity of the unconstitutional provisions does not mean that there is a protection of legitimate expectations with regard to new regulations that apply retroactively for the time since this judgment was delivered, and which do not recognise an excessive utilisation of §§ 13a and 13b ErbStG which, as mentioned earlier, violate the principle of equality.
Dissenting Opinion of Justices Gaier, Masing, and Baer:
We agree with the decision but believe that a further element must be included to support it: the principle of the social state of Art. 20 sec. 1 GG. This principle further supports the decision, and it is only through this principle that the justice-related dimension of the issue becomes fully visible.
Inheritance tax not only aims at providing revenue, but is also an instrument of the social state. It attempts to prevent that the succession of generations leads to wealth accumulating in the hands of few and increase disproportionately on the sole basis of background or personal relations. This is in fact a challenge today, as indicated by the development of the actual distribution of wealth. In his dissenting opinion to the decision on the 1993 property tax, Böckenförde already pointed out that 18.4% of all private households possessed 60% of all net financial assets. In 2007, this percentage was held by merely 10% of private households. It is within the responsibility – and not subject to mere discretion – of lawmakers to compensate for these inequalities that would otherwise become even more permanent. As the Senate already emphasizes with regard to the right to equality before the law, the Constitution accords to the legislature a wide margin of appreciation. Yet, since the legislature is bound by Art. 20 sec. 1 GG, it is subject to specific justification requirements. These requirements increase when those are exempted from taxation who are already more powerful in conditions of a market economy than others. The standards this decision is based on contribute to the goal that tax exemptions should not lead to wealth accumulating and concentrating in the hands of few.