Federal Constitutional Court - Press office -

Press release no. 106/2010 of 18 November 2010

Order of 12 October 2010 – 1 BvL 12/07 –

Flat-rate non-deductible business expenses under § 8b.3 sentence 1 and
§ 8b.5 sentence 1 of the Corporate Income Tax Act constitutional


Between 2001 and 2008, and thus also in the year at issue, 2005, 
corporate tax law was based on what is known as the half-income system. 
Under this system, the profits earned at corporate level were taxed at a 
flat rate and half of the dividend income paid to the shareholder was 
taxed at the shareholder's personal income tax rate. The intention was 
that in effect two stages of taxation of half the income would amount to 
one full taxation of the whole. Since 2009, shareholdings held as 
business assets have been subject to the part-income system, which is 
similarly structured. 

Part of the half-income system and now of the part-income system is § 8b 
of the Corporate Income Tax Act (Körperschaftsteuergesetz - KStG), which 
governs the tax treatment of income of corporations from shares held in 
other corporations (earnings and capital gains on the sale of shares) 
and the expenses and profit reduction associated with these earnings. 
The provision is intended to avoid double taxation burdens at the 
corporate level in chains of companies by ensuring that corporate tax is 
charged only once before the profit leaves the corporate level and is 
paid out to a natural person. For this purpose, § 8b.1 and § 8b.2 of the 
Corporate Income Tax Act exempts from taxation all earnings which accrue 
to a company from its interest in another company. Under the principle 
of § 3c.1 of the Income Tax Act (Einkommensteuergesetz - EStG), which 
also applies in corporate tax law, expenses which are directly connected 
to tax-exempt earnings may not in addition be applied to reduce income. 
Despite several legislative attempts, the legislature failed to 
effectively curb problems of allocation between operating expenses which 
were not tax deductible and those which were tax deductible, and 
possibilities of abuse entailed by this, and it then, in § 8b.3 sentence 
1 and § 8b.5 sentence 1 of the Corporate Income Tax Act, in the version 
in force since the year 2004, introduced a flat rate of 5% of the 
tax-exempt investment income and capital gains as non-tax-deductible 
operating expenses (flat-rate non-deductible business expenses). This is 
effected by adding 5% of the tax-exempt earnings to the taxable income 
of the company involved, increasing the tax payable; the amount of 
operating expenses actually incurred in the direct business context is 
irrelevant. It remains possible to deduct the operating expenses 
connected to the shareholding or the capital gain over and above this. 

The plaintiff in the original proceedings, a holding company with the 
legal form of a GmbH, had an income of approximately 12 million euros in 
the year at issue, 2005; this essentially consisted of capital gains of 
approximately 11.6 million euros from the sale of shares it held in its 
subsidiary. In addition, it earned dividends from shareholdings in the 
amount of approximately 700,000 euros. On the other hand, its operating 
expenses in connection with the shareholdings were only just under 
28,000 euros. In the course of the corporate tax assessment under § 8b.3 
sentence 1 and § 8b.5 sentence 1 of the Corporate Income Tax Act, the 
tax office added 5% of the earnings, that is, a total of approximately 
600,000 euros, to the plaintiff's income. In response to the action 
instituted against this, the Finance Court (Finanzgericht), in 
proceedings on the review of the constitutionality of a statute, 
referred to the Federal Constitutional Court the question as to whether 
§ 8b.3 sentence 1 and § 8b.5 sentence 1 of the Corporate Income Tax Act 
is compatible with the principle of equality in that it takes account of 
a standard rate of 5% of earnings and capital gains as non-deductible 
business expenses as increase of income and does not permit the taxpayer 
to show that the operating expenses were lower. 

The First Senate of the Federal Constitutional Court decided by 6 votes 
to 2 that the flat-rate provision of § 8b.3 sentence 1 and §8b.5 
sentence 1 of the Corporate Income Tax Act is compatible with the 
general principle of equality before the law (Article 3.1 of the Basic 
Law (Grundgesetz - GG). It neither violates the principle of taxation 
according to ability to pay, nor does it constitute an unconstitutional 
deviation from the principle of consistency. It is supported by 
sufficient grounds of justification which uphold the use of a flat rate. 

In essence, the decision is based on the following considerations: 

The flat rate for non-deductible business expenses does not violate the 
principle of taxation according to ability to pay. For at all events it 
does not result in a tax burden unless the company's ability to pay has 
correspondingly increased. The legislature is not constitutionally 
prevented, in answering the question as to whether an enterprise has 
experienced an increase in performance which is in principle taxable, 
from considering the legal independence of the company, in this case the 
parent company. The fact that the legislature has in principle exempted 
the income from shareholdings from taxation under § 8b of the Corporate 
Income Tax Act does not alter the fact that they nevertheless increase 
the company's ability to pay tax. Even if the income from shareholdings 
has been earned by the parent company in return for business expenses of 
less than 5% of the income or without any business expenses whatsoever, 
the "increased taxation" of an effective 5% in this statutory structure 
is always accompanied by a far greater increase of 
performance-increasing income which accrues from the subsidiary. 

Nor does the blanket provision of non-deductible business costs in the 
amount of 5% of the earnings and capital gains violate the principle of 
consistency in a manner which burdens the taxpayer. In connection with 
the half-income system, § 8b of the Corporate Income Tax Act, in order 
to avoid double taxation burdens at corporate level, provides that 
dividend payments and capital gains between companies subject to 
corporate tax are in principle not subject to taxation. Under § 3c.1 of 
the Income Tax Act (Einkommensteuergesetz - EStG), expenses that are 
related to tax-exempt income may not be deducted. § 8b.3 and § 8b.5 of 
the Corporate Income Tax Act connects to this basic principle in that on 
the one hand it provides that § 3c.1 of the Income Tax Act is 
inapplicable and thus permits the deduction of business expenses in 
principle in full, notwithstanding the fact that the income connected 
with them is exempt from taxation, but on the other hand replaces the 
general exclusion of deduction of business expenses which would 
otherwise apply by the blanket 5% rate for non-deductible business 
expenses with regard to the parent company. Adding 5% to the dividend 
income is therefore within the scope of the legislature's total concept 
for corporate taxation law. 

In this provision, the legislature also remains within its authority to 
classify broadly and to use flat rates. For the fixed rate for 
non-deductible business expenses pursues legitimate targets which are in 
principle suitable to justify rules of classification and in its 
specific design is compatible with the requirements developed by the 
Federal Constitutional Court for permissible classification. 

The classification and use of a flat rate of the provision of § 8b.3 
sentence 1 and § 8b.5 sentence 1 of the Corporate Income Tax Act serves 
to simplify the tax treatment of shareholdings in other companies, since 
on the one hand it removes the allocation of financing costs and other 
expenses to the individual participations which was necessary under the 
earlier legal position and in the individual case could be difficult, 
and in addition a consistent treatment of domestic and foreign dividend 
income is now permitted. 

In addition, § 8b.3 sentence 1 and § 8b.5 sentence 1 of the Corporate 
Income Tax Act also removes the possibilities of tax abuse which existed 
before the provision entered into effect, despite a number of 
legislative attempts to correct them, and which were often exploited. 
Thus, for example, the prohibition of deduction which formerly existed 
under § 3c.1 of the Income Tax Act could be circumvented in particular 
by above all financially sound enterprises deliberately concentrating 
the distribution of profits in assessment periods in which the loans 
providing external funding of their participation had been repaid and 
therefore there were no longer any expenses subject to the prohibition 
of deduction (known as ballooning). Since the taxation of the business 
income by adding back the non-deductible business expenses at a flat 
rate now occurs in every case of dividend payouts or the sale of shares, 
the retention of profits has largely lost its tax benefit. The inclusion 
of an escape clause providing that in the case of low expenses the 5% 
addition could be reduced to the actual amount of expenses incurred, in 
contrast, would open the door to new possibilities of organisation and 
circumvention with which the legislature's aim of restricting the 
deduction of operating expenses could be evaded to a large extent. 

It is necessary for the legislature to generalise when drafting 
legislation, and in doing so it may in principle take the normal case as 
a basis and is not obliged to take account of all special cases by 
individual special provisions. It is constitutionally unobjectionable 
that in the provisions submitted the legislature proceeded on the 
realistic assumption that a parent company incurs expenses for having a 
subsidiary and took account of this in a blanket amount of 5% of the 
participation income. Nor is it constitutionally objectionable that the 
blanket treatment of non-deductible business expenses is based on the 
dividend income and capital gains from the sale of shares. For the 
assumption that the expenses of participation to be expected customarily 
stand in a particular relation to the earning power of the associated 
company appears at least arguable, in the absence of better suited 
standards. The legislature's provision that the flat rate should be 5% 
is also constitutional. It is true that in choosing this figure the 
legislature did not rely on statistical surveys or itself create such 
bases for the flat rate. But there is no argument to suggest that this - 
specifically taking account of the relatively low figure of the amount 
added to income - is not a plausible and therefore justifiable 
assumption on the part of the legislature. Since it is not possible to 
establish a normal case for the financing and costs structure in the 
company, no clearly more suitable measure for the flat rate is available 
which the legislature might have failed to use in determining its 
proportion. 

Finally, the burden caused by the flat-rate effect of the provisions at 
issue is relatively small. This flat-rate effect only results in an 
unequal burden if expenses were not incurred at all or were incurred 
only in an amount of less than 5%. However, the tax burden is relatively 
small, since only 5% of the tax-exempt earnings are added and in the 
legal position that applied in the referral proceedings they are subject 
to a 25% tax rate, which corresponds to an effective tax burden on the 
income which otherwise would be tax-exempt of 1.25%. In addition, in the 
majority of companies the lump-sum add-back will ultimately be 
advantageous, because they may also set off without restriction business 
expenses far higher than 5%. The hardships of an unequal burden which 
may possibly result from the use of a flat rate, in particular since 
they are likely to occur only rarely, are therefore not so grave that 
the legislature was not permitted to pursue the legitimate goals 
intended by the provision. 


This press release is also available in the original german version.