Purpose and aim of the introduction of settlement tax
In order to increase the attractiveness of Germany from the perspective of taxes and to counter tax evasion, a flat-rate settlement tax of 25% plus solidarity surcharge on certain income from capital assets was instituted as part of corporate tax reform beginning 1 January 2009. This income includes interest, dividends and profits from the sale of securities. Under the motto of “25 per cent of x is better than 42 per cent of nothing” the government of the time hoped the settlement tax would prevent the flight of German capital abroad. The settlement tax thus represented an instrument for securing the interests of German taxation.
A further reason for disrupting the principle of uniformly taxing all kinds of income and creating a special taxation system for capital income was to simplify the taxation process: The settlement mechanism of having credit institutions withhold capital gains tax was intended to free numerous private investors from the obligation of submitting an income tax declaration and so significantly reduce the associated bureaucratic workload.
Reasons for abolishing the settlement tax system for interest income
One of the main arguments for abolishing the flat tax system for interest income is the demand for an equal taxation of income from work and capital gains. Proponents of the planned change argue that income from wage employment is subject to a progressively increasing rate, while private interest income is subject to a flat tax rate of 25% plus solidarity surcharge. The effect of this unequal tax treatment increases as the amount of interest income and total income of those filing taxes increases.
The increasing international exchange of tax data is the second main argument for abolishing the existing system. Adherents of returning to a progressive tax system for interest income argue that the passage of a law providing for the automatic exchange of information about financial accounts in relation to taxes created the basis for the effective taxation of capital invested abroad. In the future, Germany should receive information about all international accounts that is necessary for the taxation of individuals obligated to pay taxes in Germany. This should make it possible to more effectively combat cross-border tax evasion: The application of a lower flat-rate tax will no longer be necessary to prevent capital flight from Germany.
Concrete form of the new regulation
The settlement tax is currently imposed on dividends, capital gains from the sale of securities and income from interest. The coalition agreement from 7 February 2018 plans to abolish only the settlement tax on interest income. The settlement tax will continue to exist for dividends and profits from the sale of securities. The very brief formulations in the coalition agreement unfortunately provide no details about the concrete form of the future regulation for taxation of interest income: The concept of “interest income” is not concretely defined and the agreement gives no concrete details about the planned time line for introducing the new rule.
The question also remains open of whether the previously valid saver's allowance for interest income of € 801.00 or € 1,602.00 for joint assessment will continue to exist. We should assume that the consideration of an appropriate saver’s allowance for interest income will continue to exist in the future. Such a regulation would significantly limit the administrative burden and the number of cases in which an assessment of income taxes was necessary. If there were no saver’s allowance for interest income, every person obligated to pay taxes – even those with only the smallest amount of interest income – would have to submit an income tax declaration. Should the flat rate amount for interest income continue to exist, another interesting question arises: May actual personal business expenses be deducted when these exceed this amount?
Interest income from investment funds
The definition of the word “interest income” will be decisive for the future application of the personal tax rate in the taxation of interest. While there is no doubt that interest from cash accounts or investments belong to this category, the question of how interest from capital gains from other sources will be considered cannot be answered so easily.
In the context of the planned regulation, the coalition partners write that “circumvention should be prevented”. An interest question remains in this regard of how the taxation of interest income from an investment in investment funds will be determined.
The recently reformed Investment Tax Act provides that interest from income, in contrast to dividends, for example, is not taxed at the level of the investment fund. This income is taxed exclusively at the level of the investor in the case of a pay-out, when investment shares are sold or in the context of what is often called an advance lump sum. Currently, the settlement tax applies to interest income as well as all other income.
For reasons of simplification, investment funds have not been required to publish their tax bases in the electronic Federal Gazette since 1 January 2018. Since all fund income of private investors is taxed uniformly with the settlement tax, a fund must no longer decipher the specific composition of its income. If the settlement tax on interest income is abolished, however, it would become mandatory to produce such a division into interest income and other income. Taxation according to the personal tax rate would only be possible on this basis. It would be possible to avoid the taxation of income from interest at the personal tax rate by investing money in an intermediary investment fund rather than collection through a direct investment.
These are the concrete effects of abolishing the settlement tax
While the personal income tax rate and flat-tax rates in per cent are relatively vague numbers, investors are asking how abolishing the settlement tax will concretely affect them? The following example concretely illustrates the effects of the planned abolition of the settlement tax for interest income.
Taking a look at things in practice: an example calculation
Taxpayer A has income from wage labour that produces the following taxable income (zvE):
Case 1: € 10,000 (personal tax rate under 25%)
Case 2: € 100,000 (personal tax rate over 25%)
In addition, A receives income from interest from a corporate bond in the total amount of € 5,000 a year. For the calculation, we assume that the saver's allowance in the amount of € 801.00 for income from interest also continues to exist under the new law and that actual personal business expenses cannot be considered if they exceed this flat amount.
- Case 1: Personal tax rate under 25%
According to current law, A can benefit from what is often called the most-favourable test. Since their personal tax rate is less than the settlement tax rate of 25%, their income from interest is subject to the personal tax rate and not the settlement tax rate together with their other income. In this way, their total tax liability is reduced by € 254.49 in comparison to taxation by settlement tax.
For taxpayers with a personal tax rate of less than 25%, abolishing the settlement tax would not fundamentally change anything. If the personal tax rate is less than the rate of the settlement tax, then – as the above example demonstrated – this lower rate now already applies because of the most-favourable test. The only difference would be that the new law would automatically subject all interest income to the personal income tax rate. In the future, it would no longer be necessary to submit a claim for a most-favourable test as part of an income tax assessment and thus to submit a comparative analysis of both ways of preparing the assessment.
- Case 2: Personal tax rate under 25%
The taxation of interest income at the personal tax rate envisioned by the planned new law will cause the tax liability in this example to increase by € 752.47 in comparison to the current settlement tax.
Taxpayers with a personal tax rate that is higher than the settlement tax rate will suffer – more or less significant – losses if the system of settlement tax for income from interest is abolished. They would be adversely positioned in comparison to the current legal situation. The higher their income from interest, the higher their tax liability. This increase in tax liability is due to two effects: Income from interest is itself subject to a higher tax rate than in the case of the settlement tax and the personal tax rate for other income would also increase as a result of the progressive tax rate schedule.
Effective date of abolishing the settlement tax
The concrete date on which the settlement tax on interest income should become effective has also been left open in the coalition agreement. It could be possible to understand the phrase “... with the establishment of automatic information exchange” to mean that the abolition of the settlement tax will be concretely implemented only when this exchange of information with foreign countries is functioning well, that is, perhaps not for several years.
If the settlement tax on income from interest that was part of the coalition agreement should be implemented this year, the question arises of whether this new regulation could be applied already to returns for the assessment period of 2018. A retroactive effect would doubtless exist, since in this case a regulation issued at a later point in time would be valid for a previous period. Retroactive legal norms that favour taxpayers are allowed. In the case of retroactive legal norms that burden taxpayers, by contrast, a difference is made between genuine and not genuine retroactive effect.
The planned change of settlement taxation would most likely be a not genuine retroactive effect. According to decision by the Federal Constitutional Court (BVerG), this exists when the legal consequences of a law only come into force after the law has been promulgated but its effects include circumstances that had already been “put into motion” before the law was promulgated. In the case of income tax, changing legal norms with an effect for the current period of assessment is categorically judged to be a not genuine retroactive effect. The reason is that a tax obligation arises only at the conclusion of the assessment period, in this case, 31 December 2018. A legal change in the current year is thus effective retroactively only in a not genuine way; it applies only to taxes that arise in the future. The BVerfG considers not genuine retroactive effects to be allowable only in limited situations. This is the case, for example, when taxpayers ought to have expected a change in the law. Abolishing the settlement tax is a topic that has been in discussion for a long time, at the very latest since a petition by the state of Brandenburg compelled the Bundesrat to take up a resolution on abolishing settlement tax on 4 November 2016. For this reason, the government will likely be able to apply adverse regulations for taxpayers regarding the taxation of interest income at the personal tax rate already in the assessment period of 2018. This would be possible, however, only if the planned changes in the law were actually passed in 2018. It remains to be seen whether the implementation would then actually occur retroactively or beginning 1 January 2019.
Many consider the settlement tax system that was introduced in 2009 to be a violation of fair taxation. With the planned change in taxation of interest, the coalition intends to reduce the unequal tax treatment of income from capital and from wage labour. In the current period of low interest rates, however, the higher tax rate for interest income would at first hardly be noticeable. Only if interest rates rise would the state realize moderately higher tax receipts.
The question of how taxation of interest income according to the personal tax rate will be concretely implemented remains open. In particular, it remains to be seen what particular income the new law will categorize as “interest income”. It will also be interesting to see whether the currently valid saver’s allowance will continue to exist for interest income in the future and whether actual personal business expenses will be considered if they exceed this fix-rate amount. We will carefully follow these developments and keep you up to date with further publications.