Freedom of Establishment: Tax relief for parent company as a result of losses incurred by its subsid

On 13 December 2005 the Grand Chamber of the European Court of Justice (hereinafter the “ECJ”) issued a long-awaited decision concerning the interpretation of Articles 43 and 48 of the EC Treaty, which govern freedom of establishment. The proceedings related to a reference for a preliminary ruling that the High Court of Justice of England and Wales referred to the ECJ in connection with a dispute between Marks & Spencer (hereinafter the “Claimant”) and the United Kingdom tax authorities. The tax authorities rejected the Claimant's application for group tax relief filed under applicable provisions of the Income and Corporation Taxes Act in respect of losses incurred by the Claimant’s subsidiaries in Belgium, Germany and France in 1998-2001. Each of the subsidiaries had operated in the Member State in which it had its registered office. The subsidiaries had no permanent establishment in the UK and had never operated there. The claim for relief was rejected mainly on the ground that group tax relief could only be granted for losses recorded in the UK.

The High Court sought a preliminary ruling by the ECJ on whether the laws of a Member State are contrary to Articles 43 and 48 of the EC Treaty if such laws prevent a parent company, which is resident for tax purposes in that Member State, from reducing its taxable profits in that State by setting off losses incurred in other Member States by its subsidiary companies resident for tax purposes in those States, where such set off would normally be possible if the losses were incurred by subsidiary companies resident in the State of the parent company. In other words, the question is whether such provisions constitute a restriction on freedom of establishment, contrary to Articles 43 and 48 of the EC Treaty.

Firstly, the ECJ stated that although direct taxation falls within their competence, Member States must nonetheless exercise that competence consistently with Community law. Group tax relief such as described above constitutes a tax advantage for the companies concerned and confers a cash advantage on the group; the exclusion of this advantage could hinder the parent company in exercising its freedom of establishment by deterring it from setting up subsidiaries in other Member States. Past decisions by the ECJ clearly show that such a restriction is permissible only if it pursues a legitimate objective compatible with the EC Treaty and is justified by imperative, public interest reasons. It is further necessary, in such a case, that it is applied appropriately with a view to ensuring that the objective thus pursued is attained, and not go beyond what is necessary to do so.

The UK and other Member States that submitted observations argued that in tax matters, profit and loss are two sides of the same coin and must be treated symmetrically in the same tax system in order to protect a balanced allocation of the power to impose taxes between the different Member States concerned. If the losses were taken into consideration in the parent company's Member State they might well be taken into account twice. Lastly, if the losses were not taken into account in the Member State in which the subsidiary is established, there would be a risk of tax evasion.

Although the ECJ held that concerns relating to reduction in tax revenue cannot be regarded as an overriding reason in the public interest, it also stated that restrictive provisions such as those in question in the main proceedings pursue legitimate objectives that are compatible with the EC Treaty and constitute overriding reasons in the public interest, and that they are capable of ensuring that those objectives are obtained. However, when the ECJ considered whether the restrictive measure at issue in the main proceedings complied with the principle of proportionality, it concluded that it went beyond what is necessary for attaining the essential part of the objectives pursued where (a) a subsidiary has exhausted the possibilities available in its Member 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 (b) there is no possibility for the foreign subsidiary's losses to be taken into account in its Member 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.

In its judgement, the ECJ held that in circumstances where the parent company demonstrates to the tax authorities that it has complied with both of the above cumulative conditions, to preclude the possibility for the parent company to deduct from its taxable profits in that Member State the losses incurred by its non-resident subsidiaries would constitute a restriction on the freedom of establishment contrary to Articles 43 and 48 of the EC Treaty. The ECJ’s conclusions in this particular judgement are, however, only applicable to parent companies with their main seat in a Member State that allows group taxation on a national level, i.e. deduction of losses incurred by their respective resident daughter companies, which is currently not the case of the Czech Republic.