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Provisions for the transition from the imputation system to the half-income system incompatible, in the case of corporation tax, with the principle of equality before the law
Press Release No. 9/2010 of 19 February 2010
Order of 17 November 2009
1 BvR 2192/05
From 1977 until the end of 2000, the income of corporations was taxed using the imputation system (§§ 27 et seq. of the Corporation Tax Act (Körperschaftsteuergesetz - KStG 1977/1999). It provided for two tax rates at the company level. Profits that were retained by a company and not distributed were initially taxed at the rate of 40% (just prior to the repeal of the old legislation). If profits were later distributed, the corporation tax was reduced to 30% and, as a result, the company received a rebate for the difference in amount. In view of this split tax rate, where profits were retained, potential tax savings existed at the corporate level up until the time profits were distributed; the amount of the potential savings was determined by this difference in tax rate and represented an asset. Due to earlier amendments to the corporation tax rate, potential tax savings were different in respect of different partial amounts of a company's equity; this potential had to be shown in an annual income statement up until the respective distribution. Profits were taxed at the level of shareholders at the shareholders' personal income tax rate; however, at the same time, a credit for corporation tax paid by the company was allowed.
The change in the system of taxing corporate income from the imputation system to the half-income system that was carried out in 2001 led to the imposition at the level of the company of corporation tax at a uniform and final rate of only 25% for retained and distributed profits. In the case of shareholders who were individuals, tax was payable on only half of the dividends distributed.
The legislature introduced the transition from the imputation system to the half-income system through the enactment of the Tax Reduction Act (Steuersenkungsgesetz) that added sections 36 - 40 to the Corporation Tax Act; these sections consolidated and reclassified partial equity amounts charged to different corporation tax rates in several conversion steps. For the purposes of simplification, the potential tax savings that previously existed were converted into a uniform corporation tax credit, which could be used up step-by-step over what was originally a 15-year transitional period. It was the legislature's intention that the reclassification rules would ensure that any potential tax savings accrued under the application of the imputation system would essentially be retained and still be available for use even after the change of system.
In the case of the complainant, a stock corporation, the reclassification led to the loss of potential tax savings amounting to approximately DM 1 million. The action brought by the complainant remained unsuccessful in all instances. The Federal Finance Court (Bundesfinanzhof) responded in its judgment to the complainant's constitutional challenge to the transitional provisions mainly by pointing out that the company threatened with losing its potential tax savings could have avoided the problem through appropriate tax planning. Thus, in the eyes of the Federal Finance Court, the legislature had still been within the scope of its operating latitude in relation to the provisions in question.
With its constitutional complaint against this decision, the complainant asserted that the application of the transitional provisions led to a violation of its fundamental rights under Article 2.1 in conjunction with Article 20.3 and Article 14.1 of the Basic Law (Grundgesetz - GG) and, due to its function in relation to the latter provision, under Article 3.1 GG.
The decision of the Federal Constitutional Court
The First Senate of the Federal Constitutional Court granted the relief sought by way of the constitutional complaint. The provisions in § 36.3 and § 36.4 KStG, in the version enacted by the Tax Reduction Act of 23 October 2000, which are relevant for the reclassification, are incompatible with the general principle of equality before the law. For the proceedings that have not yet been finally and conclusively resolved, the legislature is required to pass new legislation, which will take effect from 1 January 2011 at the latest. Such legislation must ensure that the potential tax savings that were available and realisable at the time of the change in system are preserved in a manner that ensures rights of equality before the law.
In essence, the decision is based on the following considerations:
There is no objective reason that justifies the unequal corporation tax burden imposed on companies whose potential tax savings remained - as a rule - fully intact after reclassification and those companies such as the complainant's company which, solely as a result of the technicalities of the reclassification of potential tax savings, suffered considerable losses when the change from the imputation system to the half-income system occurred. It is true that the legislature was pursuing through the reclassification the legitimate goal of effecting a simple and quick change of system. However, the legislature could have achieved all the objectives sought with the challenged transitional provisions through drafting them in such a way that their effect was less harsh. This could have been done by deriving the corporation tax credit pursuant to § 37 KStG directly from the partial amounts of equity subject to corporation tax available on the relevant date without first making the loss-causing reclassification pursuant to § 36.3 KStG between partial amounts subject to different amounts of tax. In this way, the corporation tax credit available in the transitional period could have been brought under the new legal regime without any reduction in size. In particular, the simplification intended by the legislature as part of the change of system would not have been impeded and the speed of the change of system would not have been jeopardised.
It is beside the point that reclassifications of partial amounts of equity were already made previously under the imputation system in a manner similar to that provided for by the current provisions. This is due to the fact that the reclassification provisions used previously served what was a legitimate legislative objective, namely to reduce the partial amounts of equity, with the imputation system continuing in existence. In addition, a transitional period extending over several years was attached to them. As a consequence, companies had sufficient time to avoid any unfavourable effects of reclassification by distributing profits in good time.
The alternatives available to the parties affected in the form of the "pay out/pay in method" or the "pay in/take back method" do not justify the violation of the principle of equality before the law inherent in the reclassification provisions. The fact that the companies affected by the reclassification had had such an opportunity brought to their attention cannot be held against them if for no other reason than it would have been easily possible for the legislature to draft the legislation in a manner that avoided the imposition of a burden. In addition, the "pay out/ pay-in method" and the "pay-in/take-back method" are not courses of action that are easy to execute, particularly as they carry with them significant financial risks.
The loss of potential tax savings resulting from the reclassification cannot be justified by arguing, along the lines of a benefit set-off, that an overall review of the burden on companies and shareholders shows that, all in all, tax advantages, even, ensue from the half-income system applicable after the change of system. The reason for this is that the benefits of the half-income system benefit all companies and shareholders in a similar fashion, while the loss of potential tax savings only affect a specific group of them.
The First Senate has instructed the legislature to pass new legislation, which will take effect from 1 January 2011 at the latest, for the proceedings that have not yet been finally and conclusively resolved. Such legislation must ensure that the potential tax savings that were available and realisable at the time of the change in system are preserved in a manner that ensures rights of equality before the law. The vote on the decision was six in favour and two against.