Marks & Spencer: EU claims for cross-border loss relief.

Introduction

The European Court of Justice (ECJ) is charged with hearing cases and deciding whether the domestic law of member states of the European Union is in breach of the fundamental freedoms laid down in the various EU treaties (collectively, the "EC treaty"). Initially, the ECJ was not focused on direct taxation matters and, indeed, there were only three direct taxation cases heard by the ECJ by the mid-1980s--more than two decades after the ECJ was created. Since then, however, the number of direct taxation cases heard by the ECJ has accelerated year on year and, more important, in 95 percent of the direct tax cases heard by the ECJ, the taxpayer is victorious.

There have recently been a number of cases heard by the ECJ where the taxpayer has won which have had, and continue to have, a profound effect on the direct and indirect taxation of EU residents (e.g., Lankhorst-Hohorst concerning the legality of German "thin capitalization" rules, and Bosal concerning the legality of Dutch interest deductibility rules). In these cases, a decision by the ECJ has often led to changes in domestic legislation, not only in the country directly concerned but also in other EU jurisdictions. This is not surprising since (a) the EC treaty and ECJ case law take precedence over domestic law, (b) extrapolation of a decision regarding one jurisdiction's law to other jurisdictions is relatively straightforward in many cases, and (c) ECJ decisions are generally made on broad principles and are not focused on the detailed provisions in question.

Whilst the previous cases have prompted a significant amount of change, along with which comes opportunity and risk, there is one particular case that may have a revolutionary effect on multinational taxpayers operating through multiple entities or business units in the EU. Although judgment has not yet been delivered, the Marks & Spencer (M&S) case has been heard by the ECJ and the Advocate-General has issued an opinion.

Background of the M&S Case

M&S is a household name in the United Kingdom, a high-street retail company that is listed on the U.K. stock exchange. In the early 1990s, M&S decided to expand into continental Europe and to do so set up, among others, a French subsidiary to operate a retail outlet in Paris. Unfortunately, the commercial experiment was not a success and the French and other European subsidiaries incurred significant losses before M&S withdrew from the continental Europe retail market.

In the same period, the U.K. operations of M&S were profitable and a U.K. tax liability was incurred. Under U.K. domestic rules, there was no way to use the losses of the French subsidiary to reduce the profits of the U.K. operations for U.K. tax purposes, since the UK group relief provisions (a statutory scheme that affords an entitlement to certain commonly controlled company groupings to surrender or share losses between group members) restricts loss claim and surrender to U.K. resident companies and foreign resident companies with a U.K. business.

M&S challenged the law, contending that the UK rules were in breach of the fundamental freedom of establishment under the EC Treaty, inasmuch as group relief would have been granted if the two entities or units were resident in the U.K. M&S's litigation objective is to invoke the supremacy of EU law (i.e., the EC treaty) to obtain refunds of UK corporate income tax paid in prior periods by claiming the right to re-compute the U.K. group members' aggregate taxable income, net of operating losses incurred by its European subsidiaries over the same periods.

If M&S is successful in its claim to the ECJ, taxpayers will need to consider their own facts and circumstances in order to determine the impact this may have on their structure. The likely conclusion, however, is that several other European jurisdiction tax consolidation or group relief systems will be deemed equally in breach of the EC Treaty, such that claims could follow across Europe. The exact nature of the illegality, how a claim would be made, and the consequences of making a claim will vary from territory to territory.

M&S Case Hearing

The M&S case was heard by the ECJ on February 1, 2005 and the arguments which were put forward are set out below. The Advocate-General's opinion in favor of M&S was delivered on April 7. Judgment in the case is not expected until perhaps as late as September or October.

M&S Arguments

In challenging the denial of group relief, M&S argued that the U.K. rules plainly breach Articles 43 & 48 of the EC treaty by discriminating against investments in foreign subsidiaries (since there is a complete denial by the U.K. of cross-border group relief for losses of foreign (EU) subsidiaries). In principle, Member States may treat purely domestic situations differently from how they treat cross-border situations, as some differences may be unavoidable and indeed there may be objective differences in the circumstances of foreign entities compared with domestic entities which warrant a different treatment. In reality, however, the term "unavoidable" does not include differences in treatment that involve the restriction of a fundamental freedom and foreign residence is not of itself a factor which justifies different treatment. In this respect, Denmark, France (with French Finance Ministry's permission), Italy, and now Austria all have rules allowing some form of cross-border loss relief for foreign subs, so that the U.K.'s "all or nothing" approach goes beyond what might be considered unavoidable or justifiable in distinguishing between a wholly domestic and a cross-border situation.

U.K. Government's Arguments

The U.K. government argued that the group relief rules only extend as far as the U.K.'s taxing jurisdiction (notwithstanding the U.K.'s CFC regime and taxation of foreign dividends), and therefore should only include U.K. losses and not foreign (EU) losses. The government further argued that Articles 43/48 of the EC treaty do not require the U.K. to go beyond its taxing jurisdiction. Interestingly, this argument ignores a previous ECJ opinion stating that an EU Member State, in any exercise of its own taxing jurisdiction (whether domestically or via treaties, etc.), must respect the EC treaty fundamental freedoms.

The U.K. government noted that extending U.K. group relief to foreign subsidiaries would go beyond the policy goal of U.K. group relief, and would produce a new form of inequality, as the losses of the foreign subsidiaries would still remain available for local carry forward. This contrasts with the position whereby a U.K. resident company surrenders its losses under group relief as the losses are then utilized and are no longer available for carry forward for U.K. tax purposes. This "unacceptable" outcome, however, is exactly the position already existing under U.K. tax law in respect of losses of foreign branches of U.K. resident companies that may qualify for group relief as well as being carried forward locally, so long as they are not offset against the non-U.K, profits of another person.

The U.K. government argued that the availability of losses of foreign branches of U.K. resident companies for group relief surrender (subject to certain anti-avoidance rules) does not result in the same issue as the relief is effectively recaptured in years in which the branches are profitable. There being no double tax relief in the U.K. (because of the carried forward foreign branch loss).

The U.K. government mentioned that Denmark is currently reviewing its cross-border loss relief system. While true, Denmark is not undertaking this review with a view to repealing their cross-border loss relief system.

The U.K. government stated that if M&S is successful, U.K. group relief may have to be abolished completely. No other alternatives under consideration were mentioned, even though U.K. Treasury and Inland Revenue have said that they will recommend that if M&S wins, for competitive reasons, group relief should be retained and (subject to tighter anti-abuse provisions) extended to foreign subsidiaries' losses.

Advocate-General's Opinion

In April, the Advocate-General opined in favor of M&S, concluding that the U.K. group relief legislation is in breach of the freedom of establishment provisions of the EC Treaty. The summary reads:

According to Advocate-General Poiares Maduro, a group relief scheme which does not allow a parent company to deduct the losses of its subsidiaries established abroad under any circumstances is incompatible with Community law. However, such a scheme would be compatible with the freedom of establishment if it made the right to deduct the losses of foreign subsidiaries subject to fulfillment of the condition that those losses cannot be accorded equivalent tax treatment in the Member States in which the foreign subsidiaries are established."

If the ECJ follows the Advocate-General's opinion, then in general the denial of cross-border group relief would appear to be a breach of the EC Treaty.

The position is not entirely clear from the Advocate-General's opinion if the losses have actually been used in the foreign jurisdiction, or are being carried forward and may be used in the foreign jurisdiction in the future. It is possible to construe the opinion to mean that where the legislation does not specifically deal with these issues (which is the case in the U.K.), the denial of cross-border group relief is still in breach of the EC Treaty in these circumstances. The judgment of the ECJ may provide greater clarity on this point.

Scope of M&S Case

If M&S is successful, the ECJ ruling will apply to the specific facts and circumstances of the M&S case. The relevant group structure for M&S is, as follows:

[ILLUSTRATION OMITTED]

Therefore, the M&S claim is for the surrender, against U.K. profits, of the losses of German, Belgian and French subsidiaries held through an EU resident holding company, to provide immediate U.K. tax savings.

Before Finance Act 2000 (FA 2000), all entities within a U.K. grouping had to be U.K. resident and all U.K. group members had to be held through U.K. resident companies. After FA 2000 (itself spurred by the ECJ's decision in the case of ICI v Colmer), the provisions were altered to look through worldwide companies; to make a claim, however, both the recipient and surrendering company have to be U.K. resident or trading through a U.K. branch or agency.

The implications of FA 2000 for non-EU multinationals are extensive. Consider the following scenarios in terms of holding company structures for, say, a U.S. multinational:

(1) EU Holdco

In line with the above detail of the M&S group structure, it is easy to see how a decision in favor of M&S in this case can be extended where there is a common EU Holdco to allow for the surrender of losses of an EU subsidiary against U.K. profits where that EU Holdco is located in the U.K. It is also relatively easy to see that based on the EC principles of freedom of establishment group relief should also be available where the Holdco is elsewhere in the EU.

(2) US Holdco

As previously explained, FA 2000 extended a UK grouping to look through worldwide companies, such that it seems reasonable to extend the outcome of a successful M&S case to allow for the surrender of EU losses against U.K. profits where there is a common U.S. holding company.

In addition, the U.K./U.S. treaty contains a nondiscrimination article, (1) which states that "nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith that is more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances, particularly with respect to taxation on worldwide income, are or may be subjected." (2) This should therefore provide a strong argument that a common U.S. holding company should not adversely affect the application of extended U.K. group relief rules, where M&S is successful.

There is a concern, however, where the group structure includes a common U.S. holding company, the subsidiaries may have paid dividends up to US Holdco, which were ultimately taxable in the U.S. with relief provided for foreign tax credits. If M&S is successful (i.e., EU losses can be offset against U.K. profits in this structure), the foreign tax credits applicable to such foreign dividends paid into the United States are likely to be reduced, potentially resulting in an additional U.S. tax liability falling due. It is equally plausible that a refund of taxes may simply result in an adjustment to the foreign taxes associated with as yet undistributed earnings & profits. It is also necessary to consider the effect of a U.K. tax reduction from a Subpart F perspective, where the U.K. may have benefited from the high tax exception to Subpart F inclusion.

There is a further issue for U.S. multinational corporations--foreign taxes are only eligible as foreign tax credits where the foreign tax paid is not voluntary in nature. The applicable U.S. regulations effectively import a "reasonableness" test on interpretation of foreign law to determine whether a foreign tax is voluntary. In a developing area such as ECJ case law and the M&S case in particular, U.S. MNCs will have to determine at what point it would be unreasonable not to make claims for cross-border loss relief in order to ensure that foreign taxes paid do not become voluntary taxes.

(3) Non-EU (and non-U.S.) Holdco

FA 2000 suggests that it would be reasonable to extend the outcome of a successful M&S case to allow for the surrender of EU losses against U.K. profits where there is a common non-EU holding company. Where that jurisdiction has a treaty with the U.K. that includes a non-discrimination article, there may be arguments available similar to those identified above for the US Holdco. Furthermore where the ultimate parent is U.S. based, it may be possible to invoke the nondiscrimination article of the U.K./U.S. treaty since it refers to capital held both directly and indirectly. Finally, there may be an argument based on Article 56 of the EC Treaty, which prohibits restrictions on movements of capital both within the EU but also between the EU and third countries.

Where the Holdco is located in a non-EU jurisdiction that does not have a treaty (containing a non-discrimination article) with the U.K., the arguments for the availability of cross-border group relief may be more difficult than in some of the other identified situations.

American Jobs Creation Act

The American Jobs Creation Act of 2004 (AJCA), signed into law by President Bush on October 22, 2004, is the first major U.S. corporate tax act in many years, with the most sweeping business tax changes since the Tax Reform Act of 1986. One of the key relief provisions of the AJCA is a temporary incentive for U.S. multinationals to repatriate foreign earnings as a so-called Homeland Investment Dividend. Many U.S. companies are investigating the techniques to make the most of this planning opportunity. The AJCA sets out the various requirements to be met in order to qualify under the Homeland Relief mechanism, so that an 85-percent dividends-received deduction can be obtained on repatriation of funds to the United States. To be eligible, a Homeland dividend and a qualifying Base Period dividend must be paid before the end of 2005 (for calendar-year taxpayers).

If cash is to be repatriated as a Homeland dividend or a Base Period Dividend from foreign affiliates located in Europe, it is of particular importance to consider the effect of a loss of foreign tax credits attributable to such dividends, if M&S is successful.

Next Steps

U.S. multinational corporations should identify, as soon as possible, any open years when there were both material taxpayers and material loss-makers within their European subsidiaries. Consideration should be given to submitting protective group relief claims to protect a taxpayer's right to refunds in the event the M&S position prevails (i.e., to instigate potential tax savings in the U.K.). In respect of periods where the tax assessment is now final and conclusive, (such that a protective group relief claim cannot be made), there is also the option of joining the Group Litigation Order to submit a claim for damages in respect of the tax refund due.

Germany has asked that if the ECJ finds in favor of M&S, the judgment be limited to: (i) claims already made; and (ii) tracts of time on or after the date of the judgment. There is, however, no mention whatsoever of this request for a temporal restriction to the ECJ's M&S judgment in the Advocate-General's opinion. Accordingly, a temporal restriction is not considered likely and claims can still be made now, which should be valid under the current U.K. legislation, at least up until the date of the ECJ judgment. In this way, it should be assumed that current claims made can include losses of foreign subsidiaries, even where such losses have been utilized in the local jurisdiction, as the U.K. does not currently have a rule to prevent such "double-dipping."

Ritter-Coulais

On March 1, 2005, the Advocate-General delivered his opinion (for the taxpayers) in the ECJ case of Ritter-Coulais, (3) concerning relief for expenses of cross-border workers. Although not directly applicable to corporations, and only preliminary to the eventual ECJ decision, the principles established by the Advocate-General may be extended to corporate situations. In particular, the opinion may be helpful to the M&S case, since it establishes that the ECJ views a cross-border worker's situation with respect to cross-border expenses or "losses" as comparable with that of a person working wholly in their Member State, notwithstanding that they are not taxable in the other Member State.

Conclusion

The M&S case (if successful) may provide access to tax-saving benefits for many non-EU multinationals for whom the effects of ECJ cases are often limited, depending on the jurisdiction of the relevant EU subsidiary and the group structure. This gives rise to both challenges, in terms of the uncertainty of the outcome and complexity of the U.K. group relief provisions (and potential impact on consolidation/group relief systems in other EU jurisdictions), and opportunities, for restructuring, reducing the EU tax burden, and mobilizing income and assets.

The time to act is now, to ensure protective group relief claims are submitted in advance of the ECJ's judgment.

(1) Article 25, U.K./U.S. Double Taxation Convention.

(2) Article 25(1), U.K./U.S. Double Taxation Convention.

(3) Hans-Jurgen & Monique Ritter-Coulais v Finanzarnt Germersheim [C-152/03].

JONATHAN HARE is a partner with PricewaterhouseCoopers LLP. A member of the firm s European Tax Group, he is currently resident in New York.