Tax Assessment of Undeclared Income

By Decision No. U-I-113/17, dated 30 September 2020 (Official Gazette RS, No. 145/20), the Constitutional Court decided on a request of the Administrative Court to review the constitutionality of Article 68a of the Tax Procedure Act, which determined that a 70% tax rate shall apply to undeclared income and that the assessment of such tax was admissible for the period of the last ten years prior to the year in which the tax assessment procedure was initiated. It abrogated this provision insofar as the 70% tax rate determined therein exceeded the tax rate that was prescribed by the regulation previously in force for the taxation of undeclared income and insofar as also undeclared income that originated from the periods before 1 January 2009 could be subject to taxation on the basis thereof.

The Constitutional Court first assessed the legal nature of the increased tax rate on undeclared income. Although the challenged regulation enacted a measure that is formally determined as a tax in the law, it was important for the review whether also in a constitutional sense it can be considered to be such. The fundamental characteristic of taxes follows from Article 146 of the Constitution, which in the first paragraph determines that the state and local communities raise funds for the performance of their duties by means of taxes and other compulsory charges, as well as from revenues from their own assets. From a constitutional point of view, taxes are a duty that are primarily intended to pursue the objective of financing public spending, although not necessarily merely that, as the purpose of imposing taxes is not necessarily only to ensure budgetary funds; namely, also other objectives are attained by levying taxes, such as restructuring the economy, boosting employment, and fostering the development of demographically and otherwise marginalised areas. Hence, in addition to fiscal objectives, also concrete social objectives can be directly realised by means of taxes.

The regulation of the tax assessment of undeclared income that was in force prior to the challenged regulation made the tax rate that was applicable for these taxes dependant on the tax rates that follow from the law regulating income tax (that law determines a 50% rate as the highest income tax rate for the highest income tax class). Therefore, the Constitutional Court proceeded from the assessment that, by determining a 70% tax rate, the legislature substantively enacted, in addition to tax assessed in accordance with the income tax rate otherwise in force, also an increase, i.e. a surcharge on the regular income tax rate. The surcharge serves to dissuade taxable persons from violating tax law obligations and to encourage them to observe these obligations. The Constitutional Court assessed that by enacting a surcharge, the legislature did not pursue the objective of financing public spending or any socio-political objective (within the framework of social or economic policy), which, in accordance with the constitutional determination of taxes and the case law of the Constitutional Court, are admissible objectives of taxes. Therefore, it concluded that, in a constitutional sense, the surcharge is not a tax but a measure intended to either 1) remedy the damage sustained by public finances and its incomes due to a violation of the obligation to declare income; 2) nullify the benefits that the taxable persons had as a result of such violations (i.e. a restitutive measure); or 3) punish the taxable persons for such violations (i.e. a punitive measure).

The Constitutional Court assessed the reasons by which the Government substantiated that the surcharge is a restitutive measure by its nature. In this respect, the key argument advanced by the Government was that the surcharge is intended to compensate for the loss of funds acquired through compulsory social contributions. The Constitutional Court recognised that this argument has some weight; however, it attributed even greater importance to the fact that the surcharge in question does not entirely compensate for the loss of social contributions and also does not produce an equal effect on all of its addressees. The Constitutional Court dismissed the remaining reasons by which the Government substantiated that the surcharge is of a restitutive nature (e.g. compensation for interest due to the payment of taxes not being made in due time, compensation for procedural costs), as in these instances no objective or reasonable connection existed between the measure at issue and the alleged objective that the measure purportedly pursued (i.e. remedying the damage or nullifying the unjustified benefit), or because these reasons were too general. In view of the non-demonstrated restitutive nature of the surcharge, the Constitutional Court deemed it to be a measure that is at least partially of a punitive nature.

The legislature must regulate procedures in which measures of a punitive nature are adopted in such a manner that the persons who can be affected are ensured the constitutional guarantees determined by Article 29 of the Constitution. Essentially, these guarantees apply to procedures in all criminal law cases, not only to procedures relating to criminal offences. If such a measure is to be decided on in a single procedure jointly with tax assessment, the legislature must ensure in such a procedure at least the essence of the constitutional procedural guarantees determined by Article 29 of the Constitution. Since the regulation of the tax procedure in which also the imposition of the mentioned surcharge is decided on failed to ensure these constitutional procedural guarantees, the Constitutional Court assessed that the challenged regulation, insofar as it enabled the surcharge to be imposed in a tax procedure, was inconsistent with Article 29 of the Constitution.

Furthermore, the Constitutional Court assessed that the challenged regulation has a partial retroactive effect. In view of the fact that it enables the assessment of taxes for the last ten calendar years, and that it entered into force on 1 January 2014, it enabled taxes to be assessed also for income that originated from 2004. The previous regulation that ceased to be in force upon the entry into force of the challenged regulation allowed taxes to be assessed only for the last five calendar years before the year of the initiation of a tax inspection. Hence, as the regulation previously in force ceased to be valid, the possibility to initiate a tax assessment procedure for income that originated from the period prior to 2009 ceased, whereby taxable persons obtained a legally protected guarantee that it would no longer be possible for their income from that period to become subject to taxation. Therefore, the challenged regulation, insofar as it enabled the initiation of a procedure and the assessment of taxes also for income originating from the period prior to 2009, had the effect of retroactively interfering with the legal positions of taxable persons that had already been concluded due to the fact that the regulation previously in force ceased to be valid. Such a retroactive effect of a law is only exceptionally admissible when the conditions determined by the second paragraph of Article 155 of the Constitution are fulfilled. These conditions include the condition that such retroactive effect is required in the public interest. In accordance with the established case law of the Constitutional Court, such public interest must be expressly established and explained as early as in the legislative procedure. In the case at issue, the Constitutional Court established that the legislature failed to demonstrate that the public interest required the challenged regulation to have retroactive effect, and also the Government failed to do so in the procedure for the review of constitutionality. The Constitutional Court therefore concluded that, in the relevant scope, the challenged provision was inconsistent with the first paragraph of Article 155 of the Constitution.