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We report in this article on constitutional challenges raised in recent weeks against various aspects of the German tax laws.

As a general matter we note that the German Federal Constitutional Court, which has subject matter jurisdiction to review the compatibility of federal or state law with the German federal constitution, has in the past often held German tax laws to be unconstitutional. The most far-reaching decision of this sort declared the German net worth tax and inheritance tax to be unconstitutional with respect to their real estate valuation provisions (BVerfG BStBl II 1995, 655 - 22 June 1995; see articles nos. 25 and 58, sec. VIII and IX). This decision is at issue in the cases reported on in sections 2 and 3 below. Prior to the commencement of this series of articles in the summer of 1995, the Federal Constitutional Court also held the zero bracket amounts and the child deduction amounts to be unconstitutionally low and forced the German legislature to enact a withholding tax on interest income by declaring the taxation of interest income unconstitutional unless steps were taken to collect the tax in a more efficient and equitable fashion (BVerfG BStBl II 1991, 654 - 27 June 1991). The taxation of interest income is at issue in the case reported on in section 4 below.

1. Constitutionality of the trade tax on earnings

Pursuant to Article 100 (1) of the German constitution, a court which is persuaded of the unconstitutionality of a legal provision at issue in a case before it must suspend proceedings and refer the question to the Federal Constitutional Court. In its ruling of 23 July 1997 (EFG 1997, 1456), the Tax Court of Lower Saxony has concluded that the trade tax on earnings violates Article 3 of the German constitution (principle of equality before the law) in two respects and placed the issues before the Federal Constitutional Court for ultimate determination.

The ruling is exceptional in a procedural respect because it was handed down by a single judge sitting without co-justices. While the decisions of a tax court are normally reached by panels of three justices, a single judge sitting without co-justices may decide a case if the parties so consent (sec. 78a (3) AO). This occurred in the case reported on. However, as a procedural matter it is not clear whether a single judge is permitted to rule on so fundamental a matter as the constitutionality of a federal law. In a recent essay (DB 1997, 2454), Pahlke argues that a single judge is required to refer matters of this sort back to the full panel, hence that the ruling in question was procedurally inadmissible. Were this the case, the Federal Constitutional Court would refuse to hear the matter. The taxpayer would then not be able to appeal to the Federal Constitutional Court until he has exhausted his normal remedies, that is, lost an appeal to the Federal Tax Court.

Keeping in mind that the ruling may be procedurally invalid, the reasoning of the court (single justice) in holding the trade tax on earnings to be unconstitutional was as follows:

1. The trade tax on earnings is imposed on commercial businesses (trades) but not on the businesses of independent professionals (the liberal professions such as law, architecture, medicine, or accounting and other occupations deemed sufficiently similar thereto) or on non-commercial farming and forestry businesses. The court sees no sufficient basis for this distinction under modern economic conditions. The historical justification for the trade tax, which can be traced back to the high middle ages and has been part of German tax law in its modern form since the Prussian Tax Reform of 1891, is that commercial businesses (trades) place special burdens on local communities (e.g. with respect to water and waste disposal, roads, other infrastructure, community services, etc.) which do not arise in conjunction with independent professional practices or non-commercial farming and forestry. Critics have often contended that the distinction between commercial and non-commercial economic activity has outlived its validity and its constitutional justifiability. The Tax Court of Lower Saxony has now adopted the position of these critics.

2. The court is also persuaded that sec. 15 (3) no. 1 EStG (German income tax act) is unconstitutional in that it treats a civil law partnership (Gesellschaft buergerlichen Rechts) as a commercial business subject to trade tax with respect to all of its income if any such income is of a commercial nature. The partners in civil law partnerships are thus seen as unconstitutionally disadvantaged vis-a-vis sole proprietors, whose commercial income does not taint their non-commercial income and cause it to become subject to trade tax as well.

2. Constitutionality of real estate transfer tax on private homes

Three other Tax Court decisions concern the constitutionality of imposition of real estate transfer tax on the purchase of a dwelling to satisfy basic personal needs. The decisions are contradictory, although all three stem from the 3rd Chamber of the Tax Court of Lower Saxony.

In a ruling dated 28 May 1997 (see press release of 27 October 1997, BB 1997, 2307), a judge sitting without co-justices reaches the conclusion that real estate transfer tax (raised in 1997 from 2 % to 3.5 %) may not be constitutionally imposed on such home purchases and hence refers the issue to the Federal Constitutional Court for resolution. However, see section 1 above concerning the possible invalidity of such a ruling on procedural grounds.

In the other two cases, a full panel of justices reaches the opposite result on sets of facts posing the same issue (judgements of 18 July 1997 - EFG 1997, 1324 and 9 September 1997 - StEd 50/1997 of 9 Dec. 1997).

The ruling of 28 May 1997 holds that the imposition of the real estate transfer tax on the purchase of a home for the purchaser's private use as his principal dwelling is unconstitutional to the extent the value of the home does not exceed a monetary limit to be drawn between DM 400,000 and DM 600,000 ($ 228,000 and $ 342,000 respectively at an exchange rate of $ 1.00 = DM 1.75). To put these figures in perspective: In and around Germany's large population centres, the lower limit is at best sufficient to purchase a modest condominium adequate for the needs of a family with one or at most two children. The upper limit is at most adequate for the purchase of a small row house or duplex with a tiny garden in an inexpensive neighbourhood.

While the details of the case are not available as this article is being prepared, the court argues that imposition of the tax on the purchase of a dwelling to satisfy basic personal needs would violate the property guarantee of Article 14 (1) of the German constitution. The court also relies on Article 3 (1) of the constitution (equality under law and the concomitant principle of equitable taxation). The ruling apparently relies on the June 1995 decisions of the Federal Constitutional Court regarding the net worth and inheritance taxes. In these decisions, the Federal Constitutional Court stated that a certain basic amount of personal wealth to be determined with reference to a typical house with furnishings should be exempted from the net worth tax and should be allowed to pass free of inheritance tax between close relatives.

The full panel of justices which reaches the opposite result in the other two cases does so at least in part because it believes the June 1995 decisions of the Federal Constitutional Court to relate exclusively to the taxation of income from property. One may question whether this is a correct reading of the June 1995 decisions. The taxpayer has appealed to the Federal Tax Court, direct appeal to the Federal Constitutional Court being impossible.

3. 50 % constitutional limit on total taxation?

In its June 1995 decisions declaring the real estate valuation provisions of the net worth tax and inheritance tax laws to be unconstitutional, the Federal Constitutional Court also appeared to say that the total tax burden on an individual could not constitutionally exceed roughly half of the individual's income (BVerfG BStBl II 1995, 655 - 22 June 1995; see article no. 25). This comment sparked lively comment and criticism at the time, inter alia from a dissenting justice on the Court. Commentators were quick to observe that, even if a 50 % total taxation limit were to apply, this would not per se invalidate Germany's current top marginal income tax rate of 53 % since the 50 % limit could be construed as applying to the average tax rate.

At present, individuals paying church tax in addition to income tax and solidarity surcharge are subject to an approximate 60 % marginal income tax rate starting at income levels of DM 120,000 / DM 240,000 for single and joint filers respectively. This marginal tax rate rises if taxable income includes income subject to trade tax, although the full impact of the trade tax is mitigated for higher income earners by sec. 32c EStG. In addition, individuals pay 15 % value added tax on most purchases and, as remarked above, 3.5 % real estate transfer tax on the purchase of a home.

It is therefore not surprising that taxpayers are attempting to rely on the so-called "50 % division principle" (Halbteilungsprinzip) referred to by the Federal Constitutional Court. Recently, the Berlin Tax Court was asked to stay enforcement of a tax assessment on the grounds that the assessment was unconstitutional under the 50 % division principle (EFG 1997, 546 - 16 January 1997). The court refused to do so, stating that the relevant passages in the decision of the Federal Constitutional Court were probably "mere obiter dicta and thus non-binding expressions of opinion". At most, the court considered the statements by Germany's highest court to constitute "a guideline for future legislative decisions," hence by no means a firm basis on which individual taxpayers could rely.

The court's decision was merely on the issue of a stay of enforcement, not on the merits. The taxpayer has appealed the refusal of the stay to the Federal Tax Court.

Prior to publication of the ruling of the Berlin Tax Court in October 1997, the Chemnitz Regional Tax Office issued an administrative order stating that numerous administrative appeals based on the 50 % division principle had been filed and directing the tax offices in its jurisdiction to reject all such appeals despite the case pending before the Federal Tax Court. Normally, administrative appeals posing the same constitutional issue as a case pending before the Federal Tax Court would be suspended pending the outcome of that case (sec. 363 (2) sent. 2 AO).

4. Constitutionality of taxation of interest income

In its decision of 18 February 1997 (BFH HFR 1997, 676) the 8th Chamber of the Federal Tax Court rejects the constitutional challenge of a taxpayer to taxation of interest income in the year 1993. The taxpayer relied on the decision of the Federal Constitutional Court referred to in the introduction to this article (BStBl II 1991, 654 - 27 June 1991) in which this court held that the German taxation of interest income was so lax as to constitute unconstitutional inequality before the law (Article 3 (1) of the German constitution) because persons who so desired could with impunity avoid taxation of their interest income. The court said, in effect, that if the government failed to take steps within a certain period to correct the "tax enforcement deficit" and collect tax on interest income on a more equitable basis, it would be barred from taxing this type of income at all.

The basic change made was introduction of an interest withholding tax effective 1993. The taxpayer in the present case argued essentially that this was inadequate to comply with the decision of the Federal Constitutional Court and that hence taxation of his interest income was barred by the decision. He in particular argued that sec. 30a AO placed unconstitutional restrictions on the tax authorities in their investigation of customers of German banks.

In rejecting the taxpayer's arguments, the Federal Tax Court held that the legislature had done enough to comply with the judgement of the Federal Constitutional Court at least with respect to the year 1993. The Federal Tax Court implied in the headnote of its decision that the legislature was entitled, so to speak, to "wait and see" whether the steps it had taken would prove adequate to correct the "tax enforcement deficit," hence that it was in 1993 too soon to recognise any possible failure to correct the deficit. The Federal Tax Court also interpreted the critical passages of sec. 30a AO, certain of which had been expressly criticised by the Federal Constitutional Court with regard to the forerunner provision of sec. 30a AO, in such manner as to render them constitutional.

The decision by the Federal Tax Court exhausts the normal legal remedies available to the taxpayer. The taxpayer has filed an appeal to the Federal Constitutional Court (case no. AR 3844/97).

The Magdeburg Regional Tax Office has issued an administrative order (2 October 1997 - BB 1997, 2467) noting both the appeal to the Federal Constitutional Court and a second case on the same issue pending before the Federal Tax Court. It directs the tax offices under its jurisdiction to permit suspension of other proceedings posing the same issue pending the outcomes of these cases (sec. 363 (2) sent. 1 and 2 AO), but to reject requests to stay collection of the tax.

This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.