The UK corporation tax code allows a company to surrender losses to another company within the same group provided that both are either UK resident or have a permanent establishment in the UK.
These rules were challenged by the retailer Marks & Spencer (M&S), which sought to surrender losses of its subsidiaries in Germany, Belgium and France against the trading profits of the UK resident parent. M&S’s claim was rejected by the UK Inland Revenue as none of the surrendering companies was either resident or economically active in the UK.
The preliminary opinion of the European Court of Justice in the case was released on 7 April 2005, and, as widely expected, has ruled that the UK's group relief rules contravene the principle of freedom of establishment enshrined in the EU Treaty.
In his opinion, Advocate-General Miguel Poiares Maduro found that the UK rules contravened the freedom of establishment rules on two grounds: firstly, because they disadvantaged companies with foreign subsidiaries as opposed to those with foreign branches, and secondly, groups of companies wishing to establish themselves abroad were disadvantaged compared to those resident wholly within the UK.
The Advocate-General rejected various justifications for the rules offered by the British and other governments which put arguments before the Court. These included concerns that a ruling for M&S would cause significant revenue losses to member states and arguments relating to the principle of territoriality.
The Advocate-General also considered in some detail whether granting relief as claimed by M&S would damage the cohesion of national tax systems by allowing groups to claim relief in two different jurisdictions in respect of the same loss, or by leading to "trafficking" in losses in the EU country with the highest effective rate of tax.
Whilst he considered these fears justified, the Advocate-General took the view that the UK rules went beyond what was necessary. Instead, UK law could simply deny group relief where the losses could be carried forward against future profits of the company, or transferred to another person in the surrendering company’s country of residence. As M&S had closed or sold the continental operations in question, it was unable to do this.
Although this opinion is not final, the judges of the Court follow the Advocate-General’s opinion in the majority of cases. The final decision is expected later this year, possibly in July.
If the Court agrees with the Advocate-General, the effect on the UK Exchequer could be substantial. M&S alone is claiming a tax rebate of £30 million, and a number of other multinational enterprises (including some of Britain’s largest companies) have joined a group litigation against the Inland Revenue. The Advocate-General’s decision is likely to encourage more to do so, meaning that the tax refunds could run into billions.
The decision is also expected to have a similar effect in a number of other member states. Eight member states (including France, Germany and the Netherlands) made representations before the Court, and the majority of the "old" member states have similar restrictions on group relief, although Austria, Denmark and Italy have adopted rules allowing cross border loss relief.
However, the opinion is by no means a total defeat for the Inland Revenue. The Advocate-General acknowledged that member states had a legitimate interest in preventing multinational groups from obtaining double deductions in respect of the same losses, and they could protect their position by denying relief in respect of losses which could be relieved in the subsidiary’s state of residence. Legislation introduced in 2000 to allow group relief in respect of UK losses of non-resident companies and non-UK losses of UK resident companies similarly denies group relief if the profits could be relieved abroad.
Although obtaining relief abroad was not possible for M&S (which had wound up its continental operations), it will be theoretically possible where the subsidiary continues in business and its state of residence allows indefinite carry forward of losses (in the same way as the UK does). In such circumstances no relief will be available for the losses in the UK, even if they are so substantial that the likelihood of them being used against profits of the state of residence is remote. Where carry-forward is time-barred (such as in France, where losses can be carried forward for 10 years only), the question arises as to whether, following the expiry of this period, UK law would need to allow the carry-back of losses against profits of preceding years and whether it would be allowed to apply the normal limitation periods in such circumstances.
The Advocate-General also acknowledged the need to avoid opening the door to "loss trafficking" around the EU. For this reason, it must be doubtful that his opinion extends to allowing loss-making parent companies to surrender their losses to subsidiary companies, or to allow surrender between subsidiary companies in a group. It is doubtful in any case whether this would be regarded as impeding the freedom of establishment of the parent company, which is the basis of the opinion.
Although the UK Government has made no official response as yet, reform of the UK group relief rules will be essential if it loses the final case and may feature in the Finance Bill which is expected to follow this May’s general election, regardless of the political complexion of the new government.
The government can be expected to take as restricted a view of the decision as possible. With regard to the position going forward, it is probably safe to assume that any new legislation will allow relief for the losses of foreign subsidiaries in as restricted circumstances as possible (and certainly not where relief might be obtainable elsewhere). Holding companies resident in the UK (and indeed, in a number of other EU states) should therefore consider making claims if they have loss-making overseas subsidiaries and those losses are likely to go unrelieved in the subsidiary’s country of residence.
It is worth noting that in the past the government has legislated "after the event" to limit the effect of European Court decisions: notably, following the Deutsche Morgan Grenfell case concerning group income elections for advanced corporation tax, it restricted the limitation period to effectively deny relief to companies that had not already brought claims. There is currently no indication that any such legislation is being considered, and indeed, the legitimacy of any such measures under European law is debatable. However, they would potentially have the effect of frustrating potential claimants not prepared to go to the expense of challenging the legislation. Eligible companies would therefore be well advised to file a claim as soon as possible in case such measures are in the pipeline.