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Tax Advice

Federal Constitutional Court Overturns Favorable Inheritance Tax Treatment of Business Assets

In a judgment on 17 December 2014 (Case No. 1 BvL 21/12), the Federal Constitutional Court held that the current favorable tax treatment of business property is unconstitutional and ordered legislators to establish new rules by 30 June 2016. The Federal Ministry of Finance has already reacted to the Federal Constitutional Court's decision and instructed tax authorities that all rulings on inheritance and gift taxes must be provisional until further notice.

What is the issue? The ver­sion of the Inhe­ri­tance Tax Act that has been in effect since 1 January 2009 pro­vi­des for com­pre­hen­sive tax relief for the trans­fer of busi­ness assets, but this relief can only be clai­med when strict con­di­ti­ons are met. Thus 85% or 100% of the value of busi­ness assets, agri­cul­tu­ral and forest assets and sha­res of cor­po­ra­ti­ons with a mini­mum inte­rest of over 25% is not taxed. Addi­tio­nal dis­co­unts, such as the gene­ral app­li­ca­tion of a more favora­ble tax bra­cket, are also pro­vi­ded. By estab­lis­hing this rule the legis­la­tors parti­cu­larly inten­ded to pro­tect com­pa­nies in which the dece­dent or the heirs are parti­cu­larly invol­ved in the com­pany, as is typi­cal of a family-owned busi­ness. The pro­duc­tive assets of these com­pa­nies should enjoy favora­ble tax tre­at­ment so that tax-rela­ted liqui­dity pro­b­lems will not jeo­par­dize the exis­tence of the com­pany and the jobs it crea­tes.

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The Federal Con­sti­tu­tio­nal Court has gran­ted legis­la­tors some lee­way in making their deci­sion on how to grant favora­ble tax tre­at­ment for this type of com­pany, in order to secure their exis­tence and main­tain the jobs they create, but the Court has criti­ci­zed the fol­lo­wing details:

  • The far-rea­ching or com­p­lete tax exemp­tion of busi­ness assets is con­s­i­de­red unrea­sonable to the extent that such exemp­tion extends beyond small and mid-sized com­pa­nies wit­hout pro­vi­ding for a needs test. In this connec­tion the Court has instruc­ted legis­la­tors to estab­lish pre­cise, easy-to-apply cri­te­ria to deter­mine which com­pa­nies are no lon­ger eli­gi­ble for tax bene­fits of this kind wit­hout a needs test. 
  • The exemp­tion of com­pa­nies with not more than 20 emp­loyees from the agg­re­gate wage regu­la­tion, with the goal of pre­ser­ving jobs, is uncon­sti­tu­tio­nal. This excep­tion must be limi­ted to com­pa­nies with only a very few emp­loyees.
  • The com­pre­hen­sive inclu­sion of admi­ni­s­t­ra­tive assets – up to 50% in the case of the exclu­sion pro­vi­ded for by the rule – is uncon­sti­tu­tio­nal. 
  • The cur­rent rules can be avo­i­ded by struc­tu­ring tran­sac­ti­ons in a cer­tain way. For example, there are struc­tu­res using the 50% rule in group struc­tu­res (this is known as the "cas­cade effect") that make pos­si­ble a tax-free trans­fer of a con­s­i­de­ra­ble amo­unt of assets qua­li­fied as non-ope­ra­tive with a harm­ful effect from an inhe­ri­tance stand­po­int. In addi­tion, until 7 June 2013, cash com­pa­nies were pos­si­ble, but they are no lon­ger regar­ded as favo­red busi­ness assets.

Even though they have been held uncon­sti­tu­tio­nal, the pro­vi­si­ons will remain in effect until 30 June 2016. The legis­la­ture is requi­red to estab­lish new rules by that date. Howe­ver, accor­ding to a press release, the fact that the uncon­sti­tu­tio­nal rules remain in effect does not pro­vide pro­tec­tion against new rules that could be retroac­tive to the time of the ruling of uncon­sti­tu­tio­na­lity and "pro­hi­bit an exces­sive exp­loi­ta­tion of the pro­vi­si­ons that vio­late equa­lity." Accor­din­gly, the cur­rent law will pro­bably con­ti­nue to apply until the legis­la­ture issues new rules, at least in cases of inhe­ri­tance and trans­fers of busi­ness assets whose favora­ble tre­at­ment was not dee­med uncon­sti­tu­tio­nal in the judg­ment. Howe­ver, to be on the safe side, gifts should be pro­tec­ted by inclu­ding a right of revo­ca­tion in agree­ments to make a gift lest taxa­tion be trig­ge­red unin­ten­tio­nally.

If the legis­la­ture deci­des to make the new rules retroac­tive, then they can pro­bably be expec­ted to be imp­le­men­ted quickly, in order to keep legal uncer­tain­ties to a mini­mum. On the other hand, if it takes the legis­la­ture the ent­ire period estab­lis­hed by the court in order to estab­lish new rules, then the legis­la­ture would be well advi­sed not to make them retroac­tive.

Rumors sug­gest that the Federal Govern­ment is keen on main­tai­ning the tax bene­fits for busi­ness assets. So it is not very likely that a fully new tax bene­fit sys­tem will be imp­le­men­ted. Howe­ver, it will likely be dif­fi­cult in the future for com­pa­nies that exceed the limits of small and mid-sized com­pa­nies to trans­fer assets tax-free or mostly tax-free. The needs test requi­red by the Federal Con­sti­tu­tio­nal Court could force these com­pa­nies to demon­s­t­rate a need for liqui­dity, which would likely be dif­fi­cult to do in practice. It is to be hoped that the legis­la­ture will demon­s­t­rate sound judg­ment in this case. It is also con­ceivable that dif­fe­rent exemp­ti­ons or dif­fe­rent pre­re­qui­si­tes for exemp­tion could be estab­lis­hed for small and mid-sized busi­nes­ses than for large com­pa­nies, in order to take into acco­unt the con­cerns of the Federal Con­sti­tu­tio­nal Court. 

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