Treaty Override: New German Constitutional Court decision
By Bernhard Schwechel, FACT GmbH Steuerberatungsgesellschaft, Wirtschaftsprüfungsgesellschaft
In a decision in December 2015, the German Federal Constitutional Court confirmed the practice of treaty override in tax law. “Treaty override” described the procedure whereby the German legislator adopts a law which violates a prior international treaty (often a treaty on double taxation).
The German Federal Fiscal Court (Bundesfinanzhof) had doubts about the constitutionality of this practice. It was convinced that a recent amendment to the Income Tax Act, which is incompatible with a German-Turkish dual taxation treaty of 1985, is unconstitutional for this very reason.
If in a pending judicial proceeding, a German court is convinced that a legal provision, which it needs to apply to resolve the case under scrutiny, is unconstitutional, that court must stay the proceeding and pose a “reference question” on the law’s constitutionality to the Federal Constitutional Court. This ensures that the Constitutional Court remains the only body with the right to declare a law unconstitutional. The court thus retains its status as a hallmark of the concentrated system of constitutional control in Germany.
This judicial proceeding is available only for questions of constitutionality, not for questions of compatibility with international law. This worked, because the courts involved in fact “translated” the question of the relationship between international law and domestic law into a constitutional law question of the separation of power and of constitutional principles: rule of law versus democracy.
The German Federal Fiscal Court deemed treaty override unconstitutional, saying that it is a violation of the rule of law and of the German constitutional declaration on the primacy of international law.
The Constitutional Court did not share this view. It opined that the constitutional principle of democracy (which includes the principle of discontinuity of parliament following elections) demands that the German Parliament is free to change its mind and to make or amend a law even if this violates an international treaty which had been ratified by a previous Parliament. Also, the constitutional declaration on the primacy of international law does not have the legal effect to render statutes which violate international law at the same time (and for that reason) unconstitutional. Put differently, this commitment does not create a constitutional obligation to comply with international treaties “unconditionally”, since the constitution does not prohibit Germany as a state from violating international law. The Basic Law “does not renounce the sovereignty which lies in the last say of the German constitution” (note that the Court, as set out in the Görgülü Decision of 2004, ascribes “sovereignty” to the constitution, not to the state).
The constitutional requirement to interpret statutes in conformity with international law does not require a “schematic parallelism of the internal legal order with international law”, but also a “maximal adoption of substantive value judgments” – and only “to the extent that this is compatible […] with the precepts of the Basic Law”.
Ultimately treaty override is lawful and constitutional, independently of the option of denouncing the treaty first. Withdrawal can only be brought about by the executive branch, and Parliament cannot compel the government to do so. Also, from the perspective of the affected tax payer, denunciation of the double taxation treaty is not necessarily the better option.
In another case on 11 December 2013, the German Federal Fiscal Court submitted a question to the Federal Constitutional Court as to whether the treaty override provision (article 50d (10) of the Income Tax Act) is unconstitutional. This issue is relevant for many inbound German investments as foreign investors often organise their German investments in the legal form of a German commercial partnership.
Germany’s national tax law requalifies interest income paid by a German commercial partnership to its domestic or foreign partner as commercial income. The same requalification is applied for the purpose of interpreting and applying a tax treaty between Germany and the partner’s country of residence. The German tax authorities feel permitted to levy income tax on this interest income based on article 7 of the OECD Model Tax Treaty. Without this requalification set out in German national tax law, interest income would be subject to tax in the partner’s country of residence instead of in Germany.
The aforementioned German requalification of interest income to commercial income formally began as the German tax authorities’ interpretation of the tax treaties. It has, however, become a treaty override issue, because in earlier cases the German Federal Fiscal Court decided that the interpretation used to requalify interest income was unacceptable. The introduced provision shall be applicable with retroactive effect to all open cases. The interpretation of the German tax authorities and the new provision will lead to double taxation, since in the majority of cases, the partner’s country of residence will also see legal grounds on which to tax the interest income as defined under Article 11 of the OECD Model Tax Treaty. The allocation of taxation rights does not just affect interest, but also any kind of remuneration that a partner receives from its partnership (e.g. royalty fees).
In the opinion of the Federal Fiscal Court, overriding bilateral treaty provisions that have been negotiated between two contracting states in order to reallocate taxation rights is an unconstitutional breach of international law. For this reason, the German Federal Constitutional Court was asked to decide on this issue. It is the first time the Federal Constitutional Court has been involved in issues relating to treaty override. Therefore, at this time, it is unclear how it will decide. Affected taxpayers should monitor future developments closely and cases should be kept open with the German tax authorities with reference to the case pending before the Federal Constitutional Court.
This case is still pending but in light of the aforementioned decision we expect that the Federal Constitutional Court will decide in the same direction: that article 50d of the German Income Tax Act is in accordance with the German constitution.
Therefore, the fundamental decision of the Federal Constitutional Court is likely to open the door for further additional tax provisions introduced by the German Bundestag, however with a focus on increasing the German Ministry of Finance’s budget without affecting tax treaties.
Bernhard SchwechelFACT GmbH - Steuerberatungsgesellschaft, Wirtschaftsprüfungsgesellschaft, Kassel, Germany
T: +49 561 316 686 0
FACT GmbH is a tax consultancy, public auditing company and law firm located in Kassel, known as the heart of Germany. FACT provides German and international accountancy and tax services to companies and individuals. The experienced team works on cross-border issues for German clients as well as for foreign clients. FACT works closely with its clients and responds rapidly to their needs.
Bernhard Schwechel is a Managing Partner of FACT. He is experienced in the field of International Taxation. His areas of expertise include Tax and Business Advice for large multinational corporations and mid-sized companies, as well as for internationally-oriented individual clients. He supports his clients in inbound and outbound M&A projects.
Published: May 2016 l Photo: Klaus Eppele - Fotolia.com