Favourable tax treatment of income from trade or business, self-employment, agriculture and forestry (‘profit income’) for the year 2007 unconstitutional

Press Release No. 2/2022 of 12 January 2022

Order of 8 December 2021
2 BvL 1/13

In an order published today, the Second Senate of the Federal Constitutional Court decided that freezing the maximum income tax rate exclusively for income from trade or business, self-employment, agriculture and forestry (referred to in German income tax law as ‘profit income’ – Gewinneinkünfte) in accordance with provisions in the 2007 Tax Amendment Act (Steueränderungsgesetz) and the 2007 Annual Tax Act (Jahressteuergesetz) is incompatible with the general guarantee of the right to equality. The provisions result in an unjustifiable favouring of ‘profit income’ over income from employment, capital investments and rent (referred to in German income tax law as ‘surplus income’ – Überschusseinkünfte). The legislator is obliged to revise the provisions by 31 December 2022 with retroactive effect for the 2007 tax year.

Facts of the case:

The 2007 Tax Amendment Act increased the maximum income tax rate – applicable to income over €250,000 (for single persons) or €500,000 (for married couples filing joint returns) – from 42% to 45% with effect from 2007 (§ 32a(1) second sentence no. 5 of the Income Tax Act, Einkommensteuergesetz – EStG). ‘Profit income’ was exempt from this increase for the 2007 tax year (§ 32c EStG), so that the maximum tax rate of 45% only applied to taxpayers earning ‘surplus income’. The legislator explained this by arguing that ‘profit income’ is associated with a specific entrepreneurial risk. Moreover, in anticipation of a major business tax reform due to be introduced in 2008, the legislator felt that raising the maximum tax rate for income from entrepreneurial activities would send the wrong message and would moreover have negative economic consequences. The 2007 Annual Tax Act made further adjustments to the Income Tax Act with regard to freezing the maximum tax rate for ‘profit income’ at 42%.

The plaintiffs in the initial proceedings are spouses who filed jointly for the 2007 tax year. As the managing director of a large accounting firm, one of the plaintiffs earned over €1.5 million in wages. The tax office therefore applied the maximum tax rate of 45% when calculating the plaintiffs’ income tax.

Following an unsuccessful objection, the plaintiffs filed an action with the Finance Court, claiming that the less favourable treatment of ‘surplus income’ in comparison to ‘profit income’ violated the ability-to-pay principle of taxation. The Düsseldorf Finance Court suspended the proceedings and referred the question to the Federal Constitutional Court as to whether freezing the income tax rate for ‘profit income’ but not for ‘surplus income’ for the 2007 tax year was compatible with the Basic Law.

Key considerations of the Senate:

§ 32c EStG as amended by the 2007 Tax Amendment Act and the 2007 Annual Tax Act, in conjunction with § 32a(1) second sentence no. 5 EStG as amended by the 2007 Tax Amendment Act, is incompatible with Art. 3(1) of the Basic Law (Grundgesetz – GG).

1. The general guarantee of the right to equality (Art. 3(1) GG) requires that the legislator accord equal treatment to matters that are essentially alike, and unequal treatment to such matters that are essentially different. Art. 3(1) GG leaves the legislator a considerable amount of leeway, especially when it comes to the determination of tax rates. However, the principle of equality binds the legislator to the principle of equitable taxation. This requires that taxation which primarily serves the generation of revenue be based on the taxpayer’s ability to pay.

a) With regard to income tax, the legislator has leeway when it comes to the specific design of a tax rate applicable to all types of income. If, however, the legislator applies different tax scales to different types of income – even though these types of income represent the same ability to pay according to the initial legislative decision – then the resulting unequal treatment needs to be justified.

b) One possible justification here can be the pursuit of non-fiscal objectives. In principle, the legislator is not prevented from using tax law to pursue non-fiscal objectives for reasons of the common good. However, the pursuit of non-fiscal objectives only provides suitable justification for imposing tax burdens or granting tax relief if the purpose and limits of the strategy are defined with sufficient specificity in the relevant legislation, or if the strategy’s intended non-fiscal objective is at least based on a recognisable legislative decision. This legislative decision to pursue non-fiscal objectives must be sufficiently specific. Vague goals mentioned in the preparatory legislative materials are not in themselves sufficient to justify deviating from the ability-to-pay principle of taxation.

2. Measured by these standards, the preferential treatment of ‘profit income’ at issue here is incompatible with the general guarantee of the right to equality.

a) The provisions cause ‘profit income’ and ‘surplus income’ to be treated unequally. Whereas ‘surplus income’ over €250,000 (for single persons) or €500,000 (for married couples filing joint returns) was subject to a tax rate of 45% in the 2007 tax year, the maximum tax rate for ‘profit income’ was frozen at 42%.

b) This unequal treatment is not justified.

aa) The specific entrepreneurial risk cited by the legislator as justification for the unequal treatment is not a sound objective reason for differentiating between ‘profit income’ and ‘surplus income’. While it is true that those who generate ‘profit income’ carry an entrepreneurial risk, the specific entrepreneurial risk carried by traders – just like the risk carried by farmers, foresters and self-employed professionals – does not indicate that the same generated profit reflects a lower ability to pay tax. There are also risks involved in earning ‘surplus income’, such as the risks associated with capital income, rental income and – given the uncertainties in the employment market – even wage income. Furthermore, under German income tax law, entrepreneurial risk only leads to a reduction of the tax burden if the risk materialises. If profits are low or non-existent, the amount of payable income tax will also be minimal or non-existent. Entrepreneurial risks of a purely theoretical nature – along with entrepreneurial opportunities of a purely theoretical nature – are disregarded by German income tax law. The decisive factor is the amount of income actually generated from an activity.

bb) Insofar as the legislator gave preferential treatment to ‘profit income’ in anticipation of the major business tax reform due to be introduced in 2008, this was not based on a recognisable legislative decision to pursue a sufficiently specified non-fiscal objective.

The objective given by the legislator is not reflected in the language of § 32c EStG as amended by the 2007 Tax Amendment Act. It is not apparent from the provision why ‘profit income’ should receive preferential treatment. Although the preparatory legislative materials do mention the planned business tax reform, they do not specify the legislator’s intended objective in adopting the reform. All that can be inferred from the preparatory legislative materials is the general intention to grant tax relief on entrepreneurial income. They do not identify the precise reasons for the legislator wanting to grant relief, nor do they specify the type or extent of such relief. At the time, the legal framework for granting tax relief within the context of the business tax reform had yet to be worked out in detail. No bill had been introduced in the Bundestag. There was not even a government draft to which the Bundestag could have tacitly referred in the explanatory memorandum to the legislation.

At the time when the 2007 Tax Amendment Act was adopted, the only indication of the planned business tax reform’s general direction came from the coalition agreement of 2005. In the coalition agreement, the governing parties had expressed their intention of reforming business tax law in order to simplify the tax regulations and to make them internationally competitive, to secure the tax base in Germany, to provide incentives for investment and thus to create new jobs, and to stimulate overall economic growth. The reform was supposed to cover not just corporations but also partnerships, since more than 80% of German companies are structured as such. While the coalition agreement does thereby provide an explanation as to why the legislator wished to reduce the tax burden on entrepreneurial income, it sheds no light on the intended type and extent of such relief. For this reason alone, it cannot be considered as providing detailed specification of the non-fiscal objectives to be recognisably pursued with the 2007 Tax Amendment Act. In light of the above, the Court has left open the question of whether coalition agreements between political parties are at all suitable for providing the specificity required of a legislative decision regarding the use of a tax measure to pursue non-fiscal objectives.

Similarly, no recognisable legislative decision can be found in the Federal Cabinet’s key issues paper of 12 July 2006 concerning a reform of business taxation. The Federal Cabinet’s decision on the key issues of the planned business tax reform was only made after the 2007 Tax Amendment Act was adopted by the Bundestag on 29 June 2006 and the Bundesrat gave its consent on 7 July 2006. Furthermore, the paper left central questions of the business tax reform unanswered.