"‘Marks & Spencer v Halsey: The Implications for Cross Border Loss Relief in the European Union," BNA Inc. Special Report "The European Union and Group Relief,"

The EC Treaty lays down several freedoms. These are free movement of goods (Articles 23 to 28 EC); free movement of workers (Articles 39 to 42 EC); freedom of establishment (Articles 43 to 48 EC); freedom to provide services (Articles 49 to 55 EC); and free movement of capital (Articles 56 to 60 EC). The essential objective of Community law is the establishment of a single market, where nationals within the Community can trade and move without the impediment of national boundaries.

The classic mechanism of protection or impediment is tax and consequently an obvious area for conflict with Community law. Indirect tax has been confronted by legislating to transform it into a European tax. However, the vested interests of member states in their direct tax base have meant that with a few notable exceptions [1} the collision of domestic tax regimes with the single market has been left to the European Court of Justice as arbiter.

Cross-border tax issues are of increasing importance to multinational corporate decision making in the developed world. Services, goods, and capital are increasingly fluid, allowing location to be driven by considerations other than where the market is. The marketplace is global, rather than national, so it’s necessary to have the ruthless paring of costs that global competition entails. Many more of us work for very large companies which operate in multiple jurisdictions, as opposed to the national giants of the past, so cross-border tax issues arise more commonly.

Multinational companies are now firmly wedded to viewing tax as a cost to be managed rather than a levy to be accepted. One of the ways to manage tax cost is to find parts of existing rules that may not be legal and to challenge them, either politically or in the courts.

Possibly the most important collision between domestic tax regimes and the single market is in regard to group relief. It is obvious that the risk of losses, especially in the start-up period, when this risk is highest, may compel enterprises to refrain from any activity in another member state. If a European group of companies has to pay corporate income tax in one of its E.U. subsidiaries in a particular year, even though the consolidated fiscal result of the group is zero or negative, the competitiveness of this group, compared to groups in the same position in the USA, China, India or Japan, will be weakened. So, what to do about it?

Article 43 of the EU Treaty provides:

“Within the framework of the provisions set out below, restrictions on the freedom of establishment of nationals of a member state in the territory of another member state shall be prohibited. Such prohibition shall also apply to restrictions on the setting up of agencies, branches or subsidiaries by nationals of any member state established in the territory of any member state.

Freedom of establishment shall include the right to take up and pursue activities as self-employed persons and to set up and manage undertakings, in particular companies or firms … under the conditions laid down for its nationals by the law of the country where such establishment is effected, subject to the provisions of the Chapter relating to capital”.

There is a Loss Relief Group Litigation Order covering more than 70 company groups waiting in the wings for this decision in the Marks & Spencer case. Also under attack by Group Litigation in the United Kingdom are the U.K. thin capitalisation rules pre-2004, the controlled foreign companies and dividend rules, the franked investment income rules, the foreign income dividend rules and the U.K.’s ACT rules pre-1999. Similar cases are increasing being referred to the ECJ by courts in other member states. [2] Sometimes the decisions are being made at national level. [3]

Many E.U. governments anticipated that M&S would win. Some governments have already provided for cross border consolidation rules, most with significant restrictions. Today, Italy, Austria, Denmark and France allow for cross border consolidation: Italy and Austria under new rules, France under its longstanding option for worldwide taxation and Denmark under its recently amended system of cross border consolidation. However, we understand that in France only 13 (this is not a misprint) companies have opted for cross border consolidation. In Italy it seems that almost no one is willing to apply for cross border consolidation. We can reasonably expect that the new Danish cross border consolidation rules will also prove unpopular. This is because these systems are “all in or all out” and have long minimum lock-in periods. The inflexibility of these systems may yet prove to be contrary to European law. The Austrian system is more flexible and is linked to a series of wider reforms of taxation of corporate income.

The Law and the Facts

The law and facts surrounding the Marks & Spencer case are well known and thus the briefest of recitals will suffice. The U.K.’s group relief provisions only allow for losses of a U.K. resident subsidiary (or U.K. permanent establishment of a non-U.K. resident subsidiary) to be surrendered to its U.K. parent and not losses incurred by a foreign subsidiary without a U.K. permanent establishment. This is as you would expect from the U.K.’s territorial-based system of taxation, under which U.K. residents are taxed on their worldwide profits, but non-U.K. residents are taxed only on U.K. source profits.

Marks & Spencer had subsidiary companies resident in Belgium, Germany and France that were loss making. It sought to surrender these losses by way of group relief to shelter U.K.-taxable profits of the U.K. parent. The retailer argued that the U.K.’s restrictions on group relief to U.K. resident companies were in contravention of paragraph two of Article 43 of the EC Treaty, in that by preventing the loss-surrender of a non-U.K. resident subsidiary, they constituted a barrier to the exercise of the freedom of establishment and made it less attractive to set up a subsidiary outside the United Kingdom.

History of the Litigation

In 2002 Marks and Spencer Plc appealed against the refusal of group relief, on the ground that the statutory limitations on the territorial scope of group relief were incompatible with, and overridden by, Community law. The U.K. Special Commissioners denied relief to Marks & Spencer, based on an extensive analysis of ECJ decisions. [4] Remarkably, they found that it was “acte clair” that cross border group relief was not available.

Marks & Spencer appealed to the High Court. In that court, Park J. was of the opinion that the matter was not “acte clair” and made a preliminary reference to the European Court of Justice. The court asked two questions. The first deals with the general issue of community law, namely, is it permissible to deny group relief for the losses of a non-resident subsidiary where group relief is permitted for the losses of a resident subsidiary? If not, can such a restriction be justified under community law? The second question only arises if the answer to the first is in favour of the taxpayer. In those circumstances, the second question raises the issue of whether the use of the losses in the foreign jurisdiction would make a difference and identifies a number of specific possibilities.

Advocate General Maduro delivered his opinion on April 7, 2005. The decision of the European Court of Justice was given on December 13, 2005.

The Advocate General's Opinion

As has been much reported in the press since April 7, 2005 the Advocate General concluded that denial of cross border group relief offended community law. The opinion is divided into two sections. The first is a determination of the substantive question: is the restriction of group relief to domestic company groups compatible with community law? The second question is a refutation of the two primary defences raised by member states: the principle of territoriality and the defence of fiscal cohesion.

Manninen [5] and Lenz [6] both concerned the different tax treatment of dividend income in the hands of a shareholder depending on whether the company paying the dividend was resident or non-resident. To the Advocate General there was no discernable difference between the circumstances of the resident and non-resident company. Both paid corporation tax on their profits somewhere in the community and a system that sought to alleviate economic double taxation in the hands of the shareholder and company but failed to take account of the cross border transaction did not achieve its objective and thus could not be justified.

In the instant case the Advocate General went further. To him arguments of discrimination on nationality grounds were old news. [7] He invited the Court to conclude that community law had developed beyond that point. [8] No longer was it necessary to make a comparison between the nationals of two different member states [9] but rather it was necessary merely to ask whether the provision in question made more difficult the exercise of a freedom of movement within the community.

The result of this approach, to the Advocate General, was the establishment of a coherent E.U.-wide tax system, notwithstanding the individual member states’ taxing powers:

“... the principle of non-discrimination on the ground of nationality is not sufficient to safeguard all the objectives comprised in the establishment of an internal market. The latter seeks to secure for the citizens of the Union all the benefits inherent in the exercise of the freedoms of movement. It thus constitutes the trans-national dimension of European citizenship.

All these reasons explain the need to retain in tax matters the same concept of restriction on freedom of establishment which is applicable on other areas. Thus ‘all measures which prohibit, impede or render less attractive the exercise of that freedom’ must be regarded as restrictions ...” [10]

The Advocate-General accepted that a system of group relief would not offend community law if it permitted the surrender of cross border losses from other community residents but subject to the condition that those losses could not be accorded “equivalent tax treatment” in their local jurisdiction (“double-dipping”). His comments on what this might mean in practice were imprecise.

The Advocate-General went even further than previous decisions in embracing the concept of community-wide-coherence in direct tax. To the Advocate General it was no longer necessary to find discrimination between a national and a non-national. One need look only at the cross-border transaction and ask if it was impeded. The result of this approach is that no comparator is required to decide whether national provisions breach community law: treating domestic transactions in the same way as cross-border transactions may well not protect legislation from offending community law. This has obvious and far-reaching implications particularly for attempts by member states to amend their legislation in response to the rulings in these cases.

The Judgment of the Court

The opinion of the Advocate-General is not of course binding on the Court, and in some notable tax cases [11] it has not been followed, usually to the detriment of the corpus of European law. As the gap between the appearance of the opinion and the judgement grew longer speculation mounted that the opinion of April 7, 2005 was not going to be followed, at least in full. This speculation was wrong. The judgement of the Court follows the Advocate General quite closely. The ECJ ruled that the U.K.’s group relief rules hinder the exercise by the parent company of its freedom of establishment in contravention of Articles 43 EC and 48 EC by deterring it from setting up subsidiaries in other member states. [12]

The ECJ’s criticism of the U.K.’s rules is qualified. It stated that this restriction on the parent’s freedom of establishment is in principle justified since it pursued legitimate objectives compatible with the Treaty. These legitimate objectives were its attempts to preserve a balanced allocation of the power to impose taxes as between the member states; its attempts to prevent “double dipping”, that is, losses being used twice; and its attempts to prevent “jurisdiction shopping”– tax avoidance by allowing losses to be surrendered to companies established in states applying the highest rates of tax.

Notwithstanding these legitimate objectives, the ECJ concluded that the U.K.’s rules offend the principle of proportionality. In certain cases the U.K.’s restrictions on group relief go beyond what is necessary to attain the legitimate objectives referred to above. The U.K. rules are incompatible with the freedom of establishment in Article 43 in so far as they prevent losses being offset against the profits of the parent where the non-resident subsidiary has exhausted all possibilities of using the losses in its own state. [13] The ECJ listed a number of these possibilities.

“… the non-resident subsidiary has exhausted the possibilities available in its State of residence of having the losses taken into account for the accounting period concerned by the claim for relief and also for previous accounting periods, if necessary by transferring those losses to a third party or by offsetting the losses against the profits made by the subsidiary in previous periods, and there is no possibility for the foreign subsidiary’s losses to be taken into account in its State of residence for future periods either by the subsidiary itself or by a third party, in particular where the subsidiary has been sold to that third party”. [14]

The court comments that member states are free to adopt or maintain rules which preclude wholly artificial arrangements from achieving a tax benefit. This comment is less of a warning than it might seem: the ECJ has an extremely restricted view of what constitutes a “wholly artificial arrangement” with regard to the treatment of freedoms. [15]

The Court has expressly avoided the question of whether losses should be computed on a U.K. or local basis, [16] noting that the parties in this case had agreed for the losses to be computed on a U.K. basis.

Legal Implications for the United Kingdom

The ECJ can impose temporal or other limitations on the rights of other claimants to bring similar claims. [17] In the absence of any such restriction claims in similar cases will be subject to the usual domestic time limits [18] for making claims and bringing appeals (although it would be open to a member state to introduce special rules). Since the ECJ made no mention of temporal restrictions on the implications of their judgment there is likely to be a period of time in which companies can bring claims if they have not already done so.

Nevertheless, the decision is unlikely to “open the floodgates” to other tax claims based on discrimination in the United Kingdom. We would of course recommend that specific advice be taken on whether High Court and/or protective statutory claims should be made in respect of these and other potentially discriminatory regimes. Most of the issues are already being litigated by means of Group Litigation in the United Kingdom so the possibilities are clear, although there are not as yet active GLOs based on exit charges, the pre-FA2004 transfer pricing rules, or pre FA-2006 U.K. foreign leasing rules. However, not all other E.U. countries where there is a difference in treatment based on tax residency have yet been called to account by their corporate sector on this point.

It must seem unlikely that the United Kingdom will now simply abolish group relief. Other countries have (as described above) introduced provisions allowing for cross border loss relief As to possible U.K. legislative amendments perhaps deduction of the foreign losses in the United Kingdom, or of U.K. losses in another jurisdiction, could be restricted by being deductible once only; and for deductions to be recaptured when and if relief is also provided in the residence states of the subsidiaries.

For claimants in the Loss Relief Group Litigation, which awaits a reference to the ECJ, the judgment is qualified good news. A number of questions remain open. How should losses be computed? The U.K. system is incompatible with Community Law. Does this mean that claims can still be maintained where the conditions of paras 55 and 56 are not made out? The judgment does not deal with the timing differential point. Can a damages claim still be run where a group has suffered a timing disadvantage by the need to use the loss only in the source state? It is likely that a further reference to the ECJ will be necessary to resolve these issues.

For claimants in many of the other Group actions being brought in the United Kingdom the decision is unqualified good news. The insistence of the ECJ that restrictions which can be objectively justified should nevertheless be strictly proportionate will add weight to claims in the Thin Capitalisation, Franked Investment Income, and Controlled Foreign Companies GLOs.

Practical Implications for
Multinational Companies

All of the above is very well but how does this judgment change decision making now in a practical business sense? Many businesses are interested not just in making money from their operations in their home state, but expanding market share and finding new markets. There are several direct results from the Marks & Spencer decision for companies in this position.

Freedom to offset losses cross border is not, at the moment, unrestricted. Domestic possibilities such as loss carry-back, group relief within the member state of the subsidiary and so on must be explored first. Nevertheless the decision is of immediate practical application where investments are not going well.

In the past, where a company based in one member state decided to expand into another member state and unfortunately made large losses, it might have been tempted to carry on trading there simply in the hope of one day making a profit and recapturing some of the losses it has made in the early years of the operation which would otherwise be lost. Those days are gone. If the parent is profitable, the subsidiary or group of subsidiaries can be liquidated and the losses set off against the parent’s profits without further ado.

The decision also has the effect of setting a minimum sale price for loss making subsidiaries in other member states in circumstances where the subsidiary is the sole operation the parent has in that other member state. That minimum sale price is the corporate income tax rate of the member state of the parent multiplied by the accrued losses of the subsidiary. In circumstances where no one is prepared to offer that sum, parents will be better off liquidating the subsidiary.

Companies should take legal advice and review their operations outside their home state taking these factors into account.

Summary

The desire for Cross-Border Loss Relief within the European Union has been with us a long time. Article 7 of the draft parent-subsidiary directive read “a parent company established in the EC which holds a stake of at least 50 percent of the capital of a subsidiary in another EC member state may opt for a system of consolidated profits” … and later “the country of the parent company will have to take into account tax paid by the subsidiaries in the other countries”. That was in 1969.

The case echoes the European Commission’s attempt to introduce a system of cross-border loss relief in a Directive proposed in 1990. The ECJ makes it clear that the introduction of less restrictive measures is possible but that this will require harmonisation rules to be adopted by the Community legislature. [19] Perhaps we will see new insights into the limitations of power of member states to tax and an impetus to the widely reported initiative to create a common consolidated corporate tax base within the European Union.

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