Germany: 165. Tax Reform Outlook After Constitutional Ruling and Bruehl Recommendations

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It was always the government's intention to couple the tax reform legislation which it introduced in November 1998 and enacted in March 1999 with a subsequent reform of the taxation of business enterprises so as to reduce the cumulative trade tax and income/corporation tax burden to approximately 35 % for all businesses, whether operated as corporations, partnerships, or sole proprietorships, beginning in the year 2000 (see article. no. 151, sec. 3.3).

The unpopularity of the measures enacted in March 1999 has prompted the government to accelerate its efforts to enact further reforms with the goal of markedly reducing taxes on active trades and businesses.

The following events are noteworthy in the context of the continuing German tax reform debate:

• Upset victory by the opposition parties in the state elections in Hesse in February 1999.
• Resignation of Oskar Lafontaine as Minister of Finance in March 1999.
• Ruling by the Federal Tax Court released in April 1999 indicating that central aspects of the government's tax reforms as enacted and as contemplated are unconstitutional.
• Presentation in late April 1999 of a report by a government commission formed to make recommendations for further business tax reform measures (so-called "Bruehl Recommendations").
• Statements by the new Minister of Finance, Hans Eichel, in early May 1999 to the effect that it will probably not be impossible to enact further reforms by the year 2000.

More detail on the above is provided below.

By losing the election in the German state of Hesse in February 1999, the Social Democrats and Greens forfeited their majority on the Federal Council, a body composed of representatives of the German states, as of 7 April 1999. Since the concurrence of the Federal Council is necessary in order for major tax legislation passed by the Federal Parliament to become law, the governing parties are currently unable to enact further tax reforms without support from at least one state in which the opposition parties are in office. Unless the balance of power in the Federal Council tips again, further tax reform would therefore appear to require a bipartisan consensus.

The abrupt resignation of Oskar Lafontaine as Minister of Finance in early March 1999 may improve chances for a more liberal, and hence consensus-oriented, approach to further tax reform. Mr. Lafontaine was identified with the fiscally conservative contours of the tax legislation enacted so far. The new Minister of Finance is Hans Eichel.

In a ruling which became public in late April (X R 171/96, dated 24 Feb. 1999), the German Federal Tax Court certified to Germany's Federal Constitutional Court the question of the constitutionality of sec. 32c EStG, a provision which has been in the income tax code since 1994. Under German law, such certification is permissible only when the certifying court is itself convinced of the unconstitutionality of the measure at issue (Art. 100 (1) GG). The Federal Tax Court accordingly explains in its ruling why it considers sec. 32c EStG to be unconstitutional.

Ultimate decision on the constitutional issue is reserved to the Federal Constitutional Court. However, the certification ruling itself, coming from Germany's highest tax court, is sufficient to undermine a principle which, only a few weeks ago, was a central pillar of the government tax reforms as so far enacted and as planned for the near future.

Sec. 32c EStG provides for application of a reduced maximum marginal tax rate of 47 % to an individual's commercial business income in excess of DM 100,224, provided such income is subject to trade tax in his hands. Without sec. 32c EStG, a maximum income tax rate of 53 % would apply on taxable income from DM 120,000 onwards (DM 240,000 for joint filers). The statute thus confers a maximum reduction of 6 percentage points in the marginal tax rate falling on commercial business income.

The majority of tax and constitutional experts have all along considered sec. 32c EStG to be unconstitutional. The voluminous ruling of the Federal Tax Court deals extensively with both the arguments in the literature and the legislative history of the statute, which was linked to the 1994 reduction of the corporation tax rates from 50 % to 45 % for retained earnings (and from 36 % to 30 % for distributed earnings). Without concomitant relief for income derived through businesses operating in non-corporate form, the total tax burden (trade tax plus 45 % corporation tax) on earnings retained in a corporation would have been significantly less than that (trade tax plus personal income tax of up to 53 %) on earnings retained in a commercial partnership or sole proprietorship (personal businesses), thus giving an undesirable tax preference to businesses operating in corporate form.

While the Federal Tax Court considered avoidance of such a preference to be a legitimate goal, it pointed out that the goal was not achieved because the reduced income tax rate of 47 % applied whether or not the earnings of a personal business were retained in the business or withdrawn for private use. The statute thus overshot its mark of equal tax treatment of all forms of business associations and conferred a preference on income earned through personal businesses.

The case before the court involved an individual who had leased his operative business, including fixed assets, to a GmbH of which he was the sole shareholder. Under the German tax principles involving division of a business into an asset-holding entity (here, a sole proprietorship) and an operative entity (here, the GmbH), the shares in the GmbH were deemed held as business property and the dividends received therefore constituted commercial business income (not income from capital) in the hands of the taxpayer.

The taxpayer sought the preferential income tax rate of 47 % with respect to the dividends received. This was denied, however, because the dividends were exempt from trade tax in his hands under sec. 9 no. 2a GewStG (trade tax law) as having already been subjected to trade tax at the level of the GmbH. The statute at issue (sec. 32c EStG) explicitly provides that commercial business income exempt from trade tax in the hands of the shareholder under sec. 9 no. 2a GewStG does not qualify for the reduced income tax rate.

The taxpayer thus found himself in the situation of the typical private shareholder, who likewise is not entitled to a reduced income tax rate on dividends received even though the income in question has already been subjected to trade tax at the level of the distributing corporation.

To the extent the statute was intended to reduce the "double burden" of trade tax and personal income tax, this purpose was likewise not served by maintaining the double burden on income earned through dividends and providing relief only when the income was earned directly.

As a matter of basic constitutional theory, the court stated that the legislature's discretion in the area of taxation was limited by its own fundamental legislative decisions. The decision to tax all seven forms of income distinguished by the German income tax code on an equal basis at the same tax rates as applied to a taxpayer's net available income constituted such a fundamental decision. If the legislature now wished to introduce provisions inconsistent with its own fundamental decision, then the mere fact that such provisions were not completely arbitrary was not sufficient to make them constitutional. They must instead meet a stricter standard of constitutional scrutiny.

Applying this stricter standard, the court found the statute to be unconstitutional in three respects:

• Without sufficient objective justification, the statute departs from the principle of equal and consistent taxation of all types of income. The fact that the income given preferential treatment has been subjected to trade tax is not a sufficient justification. The deductibility of trade tax for income tax purposes ensures that taxpayers deriving commercial business income pay income tax on their net income, just like all other taxpayers. Furthermore, no "double taxation" of commercial business income is involved because trade tax and income tax are imposed on different tax subjects (the objectified business as opposed to the individual) and on different tax bases. The court stated that a credit of trade tax paid against income tax liability might constitute a constitutional alternative to the statute as written.
• The statute unconstitutionally discriminates against those who derive dividend income as opposed to those who derive income directly from commercial business activities because it grants a lower income tax rate to the latter, but denies such a rate to the former, even though the income received has in both cases been subjected to trade tax and has left the business sphere and become available for private consumption.
• The statute unconstitutionally discriminates against those who derive commercial business income in amounts under the threshold of DM 100,278 at which the preference begins.

The ruling has substantial negative impact on the government's tax reform plans in two respects:

• The tax relief act enacted in March 1999 increases to 8 percentage points the income tax preference for commercial business income which the Federal Tax Court considers unconstitutional. The chances are therefore good that the March 1999 tax relief act is unconstitutional to this extent.
• Prior to the high court ruling, the government appeared inclined to expand the income tax preference for commercial business income still further as part of its promised additional reform of the taxation of business enterprises. Now, other options are being explored instead (see below).

It is again emphasised that the ultimate constitutional decision is reserved to the Federal Constitutional Court. If this court were to adopt the holdings of the Federal Tax Court, this would probably lead to denial of the preference granted by sec. 32c EStG with respect to all assessments which are not yet final.

On 30 April 1999, a bipartisan commission appointed by the government to devise a means of reforming the taxation of business enterprises presented its report (the so-called Bruehl Recommendations) at the Federal Finance Academy in Bruehl. The commission's membership included senior representatives of the German tax authorities. Its goal was to devise a plan for reducing the cumulative trade tax and income/corporation tax burden from the year 2000 onwards to approximately 35 % for all businesses, whether operated in corporate form or as partnerships or sole proprietorships.

The commission itself makes clear, however, that its proposals fall somewhat short of meeting the goal of a combined tax rate of 35 %.

The premise underlying the commission's work is that the economy can be stimulated and unemployment reduced by permitting businesses to retain a higher percentage of their gross earnings for purposes of investment and expansion. The converse of this premise is that the economy would not be commensurately stimulated nor jobs created to the same degree by permitting individuals to retain more of their gross earnings for purposes of consumption. Since small and medium sized businesses operating as sole proprietorships and closely held partnerships account for a major part of all German business activity and are looked upon as the most likely source of new jobs and dynamic growth, it is considered important to find a solution which would not be limited to corporations.

The highlights of the commission's recommendations are as follows:

• The goal of a 35 % combined tax rate is presently unattainable in light of the current economic and budgetary situation. Nevertheless, significant tax reduction is possible from the year 2000 on.
• Since the proceeds of the trade tax are constitutionally guaranteed to local government, there is no short-term prospect of amending or repealing this tax. It would accordingly be left unchanged for the time being, although its repeal and integration into the corporate and individual income tax is considered a desirable middle-range goal.

• The present split corporation tax rates of 40 % for retained earnings and 30 % for distributed earnings are to be replaced by a single unitary rate of 28 %, later falling to 25 %.
• Based on our simplified calculations, which ignore the solidarity surcharge and assume a net trade tax burden of approx. 17 % (trade tax multiplier of 410 %), the resulting combined trade tax and corporate tax rates would be approx. 40 %, falling to just under 38 % upon introduction of the lower corporate tax rate. This compares with a current combined rate of just over 50 % for retained earnings. (The trade tax burden in fact varies depending on location, and the trade tax is not directly comparable to the corporation tax because of differences in the tax bases on which each is calculated.)
• Under the commission's plan, there would be no tax on dividends paid by domestic corporations to domestic corporations. Dividends received by domestic corporations from foreign corporations would be tax free if sufficiently taxed in the country of origin.
• Corporation tax will no longer be creditable against income tax. Instead, only half of dividends received by natural persons resident in Germany will be taxable.
• According to our simplified calculations, this means that the total tax burden on a dividend received by taxpayers paying a marginal tax rate of 51 % in the year 2000 would be appox. 55.5 %. When the personal tax rate falls to 48.5 % in the year 2002, this figure would fall to approx. 54.7 %. Assuming the lower corporate tax rate of 25 %, the figures would be 53.6 % and 52.8 % respectively.
• Implementation of the proposed new corporation tax system poses the question of how to deal with the earnings currently retained by domestic corporations, which have been taxed at rates much higher than the proposed new unitary rate. The commission recommends a relatively short transition period. This could mean refunding considerable amounts of corporation tax to reduce the tax burden on retained earnings to a uniform level.

• The recommendations for reforming the taxation of partners in business partnerships and sole proprietors are more complicated. The commission notes that such entities could reorganise tax free as corporations and enjoy the lower corporate tax rates outlined above, but does not regard this as an adequate solution.
• Accordingly, four alternative models are presented for the taxation of "personal businesses". Of these, two involve reducing the personal income tax to take account of trade tax paid on personal income from commercial businesses. One of these models is in effect rejected because of the recent Federal Tax Court ruling (see above), and it is noted that the other must be studied carefully in light of this ruling.
• The other two models involve taxing the retained earnings of partnerships and sole proprietorships at rates equivalent to those which are to apply for corporations. Under one of these models, partnerships and sole proprietorships would simply be offered the option of electing treatment as corporate entities for tax purposes. Businesses which so elect would be subject to all corporate tax provisions. The other model would create a special personal business tax, equal to the current corporation tax, for the retained earnings of non-corporate businesses. Distributions (withdrawals) would then either be fully taxable to the recipient with a credit for personal business tax already paid, or half of such distributions would be taxable at the full personal income tax rate.
• Whatever solution is adopted for commercial businesses operating in partnership form or as sole proprietorships might also apply to personal service businesses and agriculture and forestry business as well, either mandatorily or on an opt-in basis.

The commission's estimates of reduced cash inflow to the Federal treasury from the proposed reforms in the year 2000 alone range from DM 13.5 billion to DM 22.0 billion, depending on which model is adopted for personal business taxation and assuming the corporation tax is lowered to only 28 % to begin with. The commission makes no specific recommendations as to tax-increasing countermeasures to reduce the net cost of the reforms, but mentions possibilities for consideration by the legislature and in general leaves the impression that the reforms it recommends would have to go hand in hand with more broadening of the tax base, including, but not limited to, a tightening of the German thin capitalisation rules (sec. 8a KStG).

The commission sets the goal of a future "business owner tax" for all partners and sole proprietors and recommends integrating the current trade tax into the corporation tax and business owner tax as a surtax on these taxes. The commission notes as well the high level of German economic subsidies in international comparison and proposes that these be substantially reduced.

Two distinguished members of the commission presented separate opinions voicing objections to the basic idea of reducing taxes on income retained inside enterprises while maintaining general income tax rates at a level some 13 - 15 percentage points above that of business tax rates. Such a tax differential would, it was argued, foster misallocation of resources and promote all manner of artificial tax planning schemes to obtain the benefit of the lower tax rates. Both separate opinions therefore advocated considerable reductions in income tax rates as such, not just lower business taxes. One of these opinions also criticised the commission's failure to address the issue of low flat rate taxation of personal passive investment income in response to the problem of capital flight, which was seen as intertwined with the question of taxation of business profits in a global economy.

Far from being a blueprint for construction of a new enterprise tax system, the Bruehl Recommendations are but a rough sketch which raise more questions than they answer. Even though falling short of the goal of a 35 % combined trade tax and corporation/income tax rate for retained business profits, the proposals are still costly, perhaps too much so. Also, the process of analysing and drafting the changes needed throughout German tax law is so formidable that it may be impossible to accomplish this in time for the law to go into effect in the year 2000. There is also an acute need to test the operation of the commission's various proposals through involved hypothetical studies.

The Minister of Finance has stated that implementation of the Bruehl Recommendations in the year 2000 is doubtful both for fiscal reasons and because of the need for careful draughtsmanship in what amounts to a re-writing of much of the German tax code. Nevertheless, many believe that the Bruehl Recommendations lay out the lines along which the architecture of German business taxation will be redesigned in the foreseeable future to make the German tax system more competitive in international comparison and more compatible with other tax systems in the European Union.

One may also conjecture that the much discussed tightening of the German thin capitalisation rules (sec. 8a KStG) will not be enacted in isolation from the business tax reform, hence that if business tax reform is delayed until the year 2001, any changes in sec. 8a KStG will likewise be delayed.

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