In a decision dated 12 October 2010, the Constitutional Court upheld the German rules on the 5% add-back of deemed nondeductible business expenses from a dividend distribution or capital gain arising from a sale of shares under the participation exemption rules, concluding that the rules do not violate the Constitution (case reference: 1 BvL 12/07).
Under the participation exemption, dividend distributions, as well as gains from the alienation of shares, are 95% tax-exempt at the level of a corporate shareholder. However, 5% of such income is deemed to constitute nondeductible business expenses related to tax-exempt income; this 5% of income is included in the tax base. Business expenses that are actually incurred by the taxpayer relating to a shareholding (e.g. financing costs) are deductible.
In the case, a holding company received income from the sale of shares and dividends from its subsidiaries. The expenses incurred by the taxpayer on the shareholding were actually less than the 5% lump sum inclusion amount under the participation exemption. The taxpayer filed a protest against the 5% inclusion, arguing that the rule infringed its rights under the Constitution, in particular, the ability-to-pay principle and the principle of consistent taxation.
The local tax court of Hamburg stayed the proceedings in 2007 and requested a ruling from the Federal Constitutional Court on whether the 5% inclusion violates the constitutional rights of the taxpayer. The Court has rejected the taxpayer’s arguments and confirmed that the rule is in line with the constitution.
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