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Decision regarding retroactive effect in tax law II: Reduction of the participation quota in the taxation of private sales of equity shares partly unconstitutional

Press Release No. 65/2010 of 19 August 2010

Order of 07 July 2010
2 BvR 748/05

Under the law applicable until 31 December 1998, gains from the sale of shares held in private assets in a corporation were liable to income tax as income from a business enterprise if the taxpayer had a holding of more than 25 % within the last five years prior to the sale - that is at any time within this period. After the change of government which took place in 1998, the participation threshold was reduced to 10 % by the 1999/2000/2002 Tax Relief Act (Steuerentlastungsgesetz), promulgated on 31 March 1999 (§ 17.1 sentence 4 of the Income Tax Act (Einkommensteuergesetz - EStG)). According to § 52.1 sentence 1 EStG, the new provision was valid from the 1999 assessment period onwards, but - retroactively - also included participating relationships which had already been established prior to its promulgation.

The complainants each held participations from 10 % up to 24.02 % in a limited company (GmbH) below the old materiality threshold, but above the new one, one complainant already having transferred a part to her husband in 1998 in anticipation of the legal amendment, thus reducing her participation to less than 10 %.As for the rest, the complainants partly sold their shares prior to the promulgation of the new regulation (on 11 March 1999), but partly also not until afterwards (in June 1999 and on 23 July 2001, respectively). The tax office applied the reduced materiality threshold in all cases and allotted the capital gain on disposal to the taxable income. These decisions were ultimately confirmed by the Federal Finance Court (Bundesfinanzhof) in response to the complainants' actions.

In response to the constitutional complaints, which were combined to form a joint ruling, the Second Senate of the Federal Constitutional Court (Bundesverfassungsgericht) ruled that § 17.1 sentence 4, in conjunction with § 52.1 sentence 1 EStG in the version of the Tax Relief Act 1999/2000/2002, is partly unconstitutional because of a violation of the constitutional principles of the protection of legitimate expectations. By contrast, the ten-percent participation threshold as such is not constitutionally objectionable. The material rulings at final instance have been quashed and the proceedings remitted to the Federal Constitutional Court for a renewed ruling.

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

A "real" retroactive effect, which is not permissible as a matter of principle, in which the statutory legal consequences are to already apply prior to the time of the promulgation to taxable events which have already been completed ("retroactive impact of legal consequences" - Rückbewirkung von Rechtsfolgen), does not apply. The reduced materiality threshold is not applied until from the assessment period still running at the time of the amendment, i.e. to capital gains accrued from 1 January 1999 onwards. However, an "unreal", de facto retroactive effect applies where the participation was already in existence at the time of the promulgation of the new provision on 31 March 1999 because the application of the reduced participation threshold is attached to a past event in this respect. This is not prohibited as a matter of principle, but is only compatible with the principles, in terms of fundamental rights and the rule of law, of the protection of legitimate expectations if the retroactive attachment is suitable and necessary to promote the purpose of the statute and if the bounds of reasonableness are not overstepped in an overall weighing up between the import of the disappointed expectation and the urgency of the grounds justifying the legal amendment. This is only partly the case in the event of the retroactive reduction of the participation threshold.

Where liability under the law on income tax is restricted to the value increases which did not occur until after the promulgation of the new regulation, this does not encounter any constitutional objections in terms of the protection of legitimate expectations, even if the value increases in question would have been free of tax according to the old law. The acquisition of a participation in a specific amount may be materially determined by the expectation of being able to realise any value increases free of tax. The mere possibility of gains subsequently accruing free of tax however does not give rise to a position which is protected by law on grounds of legitimate expectations. It is not possible to expect value increases with certainty at the time of acquisition, so that the disappointment of the hope of future tax-free asset increases also cannot be regarded as an impairment of tangible assets.

The application of the reduced participation threshold, however, violates the constitutional principles of protection of legitimate expectations and is null and void insofar as a value increase which had already accrued at the time of the promulgation is made subject to tax, even though it had already been realised under the law previously applicable, or at least could have been realised free of tax until promulgation of the new law because the old participation threshold had not been exceeded. In this respect, a concrete established asset position had already arisen the value of which is subsequently reduced by virtue of the retroactive reduction of the participation threshold. This furthermore leads to unequal treatment which, from the point of view of equality of burdens, requires a more exacting justification. For those taxpayers who had already sold their participations, which were immaterial according to the old law, by the end of 1998, the value increases made until then are tax free.

There are no sufficiently weighty reasons suitable to justify the retroactive liability under the law on income tax of value increases which had already materialised and which were acquired free of tax. As a matter of principle, the intention pure and simple to increase the state's income is per se not a public interest prevailing over the protection of legitimate expectations of the taxpayers affected; this would mean that the protection of legitimate expectations vis-à-vis retroactive tightening up of the tax law would practically be a toothless tiger. Also the need to fund tax relief granted in other places with additional revenue designates only a general need to change that justifies taxing value increases from the time of promulgation, but that particularly does not also legitimise the retroactive inclusion of asset increases that have already been acquired free of tax.

As a primarily future-orientated interest in a legal amendment, the aspect of combating abuse, which is mentioned in the reasoning for the Act, also does not justify the liability to tax of tax-free value increases which have already taken place. Moreover, making abuse more difficult is a side-effect which only concerns individual cases with specific circumstances, given that in general the tax-free sale of a participation does not constitute a misuse of rights. Over and above combating abuse, there is a legitimate interest in closing any gaps in taxation. This however also only refers to a general interest in a legal amendment, but not to one which specifically legitimises the retroactive effect.

Also, no such legitimation emerges from the difficulty and proneness to conflict attaching to ascertaining the market price at the time of the promulgation, to which the reasoning for the Act refers, given that this can only justify at best rough estimates to be made when ascertaining the value, but not waiving such ascertainment altogether.

The ten-percent participation threshold as such is, by contrast, not constitutionally objectionable. The differently effected income taxation of value increases in taxpayers' assets is compatible with Article 3.1 of the Basic Law (Grundgesetz - GG). It is the systematic and thus correct consequence of the historically developed dualism of types of income, and is hence within the latitude accruing to the legislature when seeking sources of taxation revenue.