Vermogensbelasting

Supreme Court of the Netherlands rules on “Box 3” wealth tax: out of the frying pan, into the fire?

Opinion 8min. Annemeike Tan

At the end of last year, the Supreme Court ruled that the way wealth is taxed in the Netherlands – based on a hypothetical return – violates the European Convention on Human Rights. According to the ruling, only actual returns should be taxed. This generated a lot of controversy and raised a number of important questions. What does the current situation look like exactly? And what are the implications of this ruling for the legislature and, more importantly, for the tax payer? In this interview, Dr. Sonja Dusarduijn, associate professor at Tilburg Law School, shines her light on this complicated issue.

Could you give us a brief refresher on the so-called “Box 3” wealth tax in the Netherlands? Why has it been mired in controversy for the past several years?

“The Dutch tax system is divided into three “boxes.” In Box 1, tax is levied at a progressive rate on income from work and homeownership. Box 2 contains a proportional tax on income generated as a result of holding a substantial interest in a company – simply put, this applies to people who own at least 5% of the shares, options, or profit certificates of a company. Except for the tax on homeownership, the taxes in these two boxes are primarily based on actual income.That’s not the case in Box 3, which taxes “savings and investments,” which includes assets like savings, stocks, bonds, and second homes. Prior to 2001, these assets were taxed based on actual, direct income in the form of interest, dividends, or rent. But capital gains remained untaxed, leaving lots of room for tax avoidance, for instance through special banking products that produced a lot of untaxable exchange rate gains and no taxable dividends. On balance, very few people actually paid taxes on their wealth income – basically, only “fools” paid their taxes.  To remedy this situation, a very robust and simple new system was introduced in 2001. This system no longer taxed actual income, but an assumed – hypothetical – income, based on a percentage of the assets held on a yearly reference date. It’s a system that does indeed produce much more tax revenue, but its robustness also makes it unfair. After all, the assumptions in this system are based on averages, conflicting with the rule that an income tax should be levied on the basis of individual income, which reflects the ability to pay. A tax based on hypothetical income clashes with that principle, especially if the assumptions that income is based on are incorrect. Moreover, this means that unequal situations are treated as if they were equal for tax purposes.”

TUM - Sonja Dusardeijn

Taxation is a beautiful and valuable thing, because that’s how we finance society

Mr. dr. Sonja Dusarduijn

Foto: Sandor van Tuel

“In 2001, the legislature assumed that everyone could easily earn a 4% return on their assets in Box 3 – regardless of how they were invested – without taking any risk, but this has certainly not been the case since 2008. Savings rates have yielded much less interest, as have bonds, with interest rates as low as 0%. At the moment, we’re even seeing negative interest rates. But the legislature never adjusted that assumed 4% return. This resulted in a situation where, for many years, the wealth tax people paid far exceeded their actual income from wealth. People were taxed up to 250% of their actual income from wealth. At the same time, there were also many taxpayers who made much higher returns than 4%, for instance thanks to real estate investments. This group paid far too little. So that’s another consequence of this incorrect assumption: on the one hand you’ve got people paying far too much, but on the other you’ve got people paying far too little. This led to a growing wave of criticism starting in 2008, resulting in an adjustment of the assumed rate of return in 2017. Since then, it’s become clear that this wasn’t exactly a silver bullet. The legislature chose to introduce a distinction between assumed savings returns (1.63% in 2017, currently -0.01%) and assumed investment returns (5.39% in 2017, currently 5.53%), and to adjust these assumptions every year. These percentages seem more aligned with reality, but two important drawbacks remain. The first concerns the legislature’s adherence to the use of a yearly reference date – January 1 – to determine the size and value of someone’s wealth. This means that the assets you hold on that day are considered to be a reliable reflection of the assets you will hold throughout the year. But if someone loses the €300,000 worth of assets they had on January 1 on January 10 – because of a scam for instance, or due to expropriation by the legislature (without compensation) – these are still taxed as if they were going to generate another full year of returns. This was also an important weakness in the pre-2017 system.The other drawback is that the legislature is assuming that everyone invests a portion of their assets. If you have up to €100,000 in savings, 33% of that is assumed to be invested and taxed based on the higher returns this is expected to generate. For those with larger assets, it is even assumed that the portion of their assets in the third bracket, which currently starts at €963,000, is fully invested. This places people who are risk averse, and who therefore have little or no investments, at a disadvantage: they receive low returns on their savings but are taxed based on high hypothetical investment returns. But “unsuccessful” investors are also negatively affected by this. So even under this new system, some people are taxed far too heavily, which is at odds with the right to own property. Moreover, this new capital gains tax also leads to equal treatment of unequal cases. All of this has caused a great deal of dissatisfaction: the system feels unfair because it is unfair. This prompted a large group of people to pursue legal action.”

How did the Supreme Court handle the case?

There were so many notices of objection about the system itself that it was decided to use a so-called “mass objection procedure” for this new system as well, which at that time had been in place from 2017 to 2020.  Instead of dealing with each objection separately, a Supreme Court’s mass objection ruling applies to all plaintiffs collectively, even if the court has only looked at a few individual cases. This makes for a more efficient process. On December 24, 2021 – Christmas Eve – the Supreme Court issued its ruling in the case: the capital gains tax system that had been in place since 2017 was in violation of the European Convention on Human Rights (ECHR). This caused quite a stir. Normally, the Supreme Court exercises extreme caution when handling these kinds of cases. While it may rule that a certain tax law encroaches on fundamental human rights, it rarely passes judgment on how such a law should be repaired. That’s something the Court usually leaves up to the legislature – after all, judges don’t make laws. In this matter, however, it decided otherwise. This was partly due to the nature of the violation, but also because the issues regarding Box 3 had been known for years and the legislature had taken no action to fix them, despite promises to do so. According to the Cabinet’s current plans, assets in Box 3 won’t be taxed based on actual income until 2025. This is another reason why the Supreme Court decided to intervene this time. It not only ruled that the system violated the ECHR for all taxpayers whose actual returns were lower than the assumed – and taxed – returns, but also that legal redress had to be provided to all plaintiffs in the mass objection procedure.

It concerns a lot of people, which means it also concerns a lot of money

This is a group of 200,000 people. As a result of pressure from the House of Representatives, it may soon be decided that this ruling will even apply to all taxpayers who have overpaid. The State Secretary for Finance has already hinted that this would be his preferred solution. That’s 3 million tax returns. It concerns a lot of people, which means it also concerns a lot of money.

Sounds good, right? Free money for everyone!

“Well, if only it were that simple!
This ruling presents a real quagmire for the State Secretary, because there’s not only uncertainty about the size of the group that can claim legal redress, but also about what that legal redress should entail for the years in question. The Supreme Court provided an optimal form of legal redress in its Christmas Eve ruling, which stipulated that only actual returns on wealth should be taxed. This means that the difference between the assumed return and the actual return must be compensated. But it doesn’t necessarily follow that compensation for other taxpayers can and should be based only on actual returns – the Supreme Court simply notes that this compensation must be reasonable.The precise interpretation of the word “reasonable” in this context is reserved for the fact-finding judges and the relevant courts, who may favor a different solution.”

There are many inconsistencies in the ruling

“Should the fact-finding judges follow the Supreme Court’s lead, the question arises as to what exactly should count as an actual return. After all, assets not only produce direct income through interest, rent, and dividends, but they also increase and decrease in value. The Supreme Court has not ruled on this as the Christmas Eve ruling only applied to tax returns involving assets with known returns. Another important issue is the way in which taxpayers must demonstrate their actual returns. For savings accounts and listed investments, the annual statements will probably suffice, but what’s your return on a second home that you don’t rent out? And would you be able to deduct expenses incurred for such things as home maintenance, property taxes, and insurance premiums? The ruling also creates a lot of uncertainty on this point, not only for the period from 2017 to 2020, but also for the years to come. So this mass objection procedure could potentially lead to huge numbers of new cases down the road, which is odd. These cases would, with respect to the burden of proof, weigh on the shoulders of individual taxpayers, but also on the courts and the Tax Authority, representing the executive branch.”

“There are so many contradictions in the ruling, which raises complex questions with regard to the past, present and future. After all, it’s still not clear what the ruling means for our taxes this year or in the years to come. As a result, the Tax Authority is currently unable to process tax returns containing Box 3 income. So the implications are enormous.  The Supreme Court did not think this through. It could have – and should have – entered into a dialogue with the legislature and the Tax Authority shortly after the ruling to explain its definition of reasonable legal redress and actual returns. Unfortunately, that didn’t happen. From what I understand, the choices that need to be made regarding legal redress are so complicated that taxpayers might have to wait until May 1, 2022, for a decision to be published. For many people, this will be a disappointment after their initial joy at the Christmas Eve ruling.”

How do you think the debate in the House of Representatives is going at the moment?

“Shortly after the judgment, the State Secretary for Finance had to field an enormous number of questions – by individual members of parliament, but also by the Standing Parliamentary Committee on Finance. Even though there was a lot of overlap between these questions, they all had to be answered separately by the State Secretary. The questions that were asked also made it clear that people hadn’t thoroughly read the Christmas Eve ruling, and there was a lot of cherry-picking. Many of the questions focused on the supposed disadvantages for senior citizens with savings, but more than half of all Box 3 taxpayers whose assets consist solely of savings are actually young people.  Sure, seniors are well represented in Box 3, but that makes sense – they’ve had more time to build wealth. The excessive focus on seniors does suggest that we’ll soon see motions in Parliament to ease the blow for this demographic. This would be misguided, in my opinion. It should also be noted that answering all these questions puts enormous pressure on the State Secretary, who is also currently tasked with solving a very difficult problem.”

What’s also annoying is that all of the criticism in these questions is aimed at the Tax Authority, despite the fact that the mistakes in this matter were made by the legislature – the very people asking the questions. After all, the laws this system is based on were adopted by both the House of Representatives and the Senate. In that sense, this situation is very different from the childcare benefits scandal. This was a mistake on the part of the legislature, compounded by a judiciary that responded too slowly. You could blame the Tax Authority for having outdated IT systems that are unable to calculate actual returns, but the legislature could have addressed those issues five years ago.”

The whole system should be reconsidered

What should the Box 3 Adjustment Act look like?

“What bothers me at the moment is that the House of Representatives is pushing for urgency. It’s important that we approach a review of the way we tax assets and capital income very carefully. Hasty decisions could lead to new injustices, which would be very damaging to public confidence in the legislature. And that’s crucial to the acceptance of taxation. It would also be good for the legislature and the judiciary to engage in a dialogue centered around this Christmas Eve ruling, because the way we shape our legal system, which includes our tax laws, is a matter that concerns both branches of government. Joint action would also be good for trust. That’s the kind of message you want people to hear.”

“I should say that, in my estimation, revising only Box 3 will always lead to an imperfect solution. The whole system should be reconsidered. The separate boxes, the analytical nature of it all – are these things optimal? How should we handle homeownership? How do we prevent Box 2 from remaining “the fun box,” filled with opportunities for tax avoidance? As we await the arrival of a totally new system, we should, for the time being, base our wealth tax only on actual returns on savings and listed investments. And for those assets for which it is very difficult to calculate actual returns, we could temporarily use a different approach. But if we’re talking long term, the whole system needs a complete overhaul. Unfortunately, that’s not something I’ve heard politicians say yet.Our current Income Tax Act was passed 21 years ago, in 2001. It’s high time we grow up and choose a new course!”