The Federal Constitutional Court on Inheritance Tax

On December 17, 2014, the Federal Constitutional Court issued a ruling on the current inheritance tax. Overall, the judges found the tax to be in compliance with the law. However, the legislature was instructed to adjust the exemption for business assets—which is too generous compared to other types of assets—by June 30, 2016.

Under current law, business assets are subject to an 85% tax exemption if certain conditions regarding the composition and retention of the assets and the preservation of jobs are met. No more than 50% of the assets may consist of so-called administrative assets, and they must remain in the acquirer’s possession for five years. In addition, the jobs must be preserved for five years. Businesses with up to 20 employees are exempt from the job preservation clause.

A 100% tax exemption can be obtained if the purchaser declares that the jobs will be maintained for seven years and that they will continue to operate the business for seven years, and if the proportion of administrative assets is only 10%.

Where must the legislature make improvements?

1. The court considers the preferential treatment of business assets to be constitutional. However, it is disproportionate to the extent that the exemption extends beyond the scope of small and medium-sized enterprises without providing for a needs assessment. The judges mention two possible definitions in this regard. Businesses that employ fewer than 250 workers and either have an annual turnover of no more than €50 million or a balance sheet total of no more than €43 million. Another conceivable definition, in the court’s opinion, would be a maximum business assets threshold of €100 million.

2. The judges consider the threshold of 20 employees for waiving the wage clause to be too high. It is uncertain what figure the legislature will settle on; a reduction to 5 employees is expected.

3. The fixed upper limit of 50% administrative assets is incompatible with the Basic Law. The judges appear to prefer a tax exemption limited to the individual percentage rate in this case.

Excessive exploitation is immediately unlawful

The judges also consider the current law unconstitutional insofar as it permits arrangements that lead to unjustified unequal treatment. The judges cite the following examples:

1. Excessive exploitation of the exemption from the payroll tax obligation by splitting the entity into a holding company with between 0 and 20 employees and an operating company with all remaining employees.

2. Circumvention of the 50% rule for administrative assets through corporate or holding structures.

3. Favoring financial assets through the creation of cash companies, i.e., the deliberate transfer of funds into business assets in order to take advantage of the inheritance tax exemption.

In the opinion of the Constitutional Court justices, the legislature may subject such arrangements—as well as “normal cases”—to new regulations with retroactive effect to December 17, 2014. It remains to be seen to what extent the legislature will make use of this authority to apply the new regulations retroactively.