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Flat-rate non-deductible business expenses under § 8b.3 sentence 1 and § 8b.5 sentence 1 of the Corporate Income Tax Act constitutional
Press Release No. 106/2010 of 18 November 2010
Order of 12 October 2010
1 BvL 12/07
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.