The European Court of Justice (ECJ) ruled that art. 43 EC and 48 EC did not preclude a member state which generally prevented a resident parent company from deducting from its taxable profits losses incurred in another member state by a subsidiary established in that member state, although they allowed it to deduct losses incurred by a resident subsidiary. However it was contrary to those provisions to prevent the resident parent from doing so where the non-resident subsidiary had exhausted the possibilities in its state of residence of having the losses taken into account by a claim for relief for the accounting period concerned and previous accounting periods, and where there was no possibility of those losses being taken into account in its state of residence in future, either by the subsidiary itself or by a third party to which the subsidiary had been sold.

Facts

The taxpayer established subsidiaries, incorporated and resident for tax purposes in Belgium, France and Germany. The taxpayer did not own the subsidiaries directly. In the years under appeal they were held through a UK incorporated and tax resident subsidiary of the taxpayer (MSIH), and through a Dutch incorporated and tax resident holding company (BV). The foreign subsidiaries were not resident in the UK in the relevant years and traded only in their state of establishment. No part of the foreign subsidiaries’ activities were conducted in the UK and the losses in issue arose from activities that were outside the scope of UK tax.

The trading performance of the foreign subsidiaries was variable but a trend developed towards rising losses and on 29 March 2001, the taxpayer announced its intention to divest itself of its Continental European activities. By 31 December 2001 the French subsidiary (MSF) had been sold to a third party and trading operations had been discontinued in the German and Belgian subsidiaries (MSG and MSB) which became essentially dormant.

The taxpayer had sufficient other profits to absorb the foreign subsidiaries’ losses and made group relief claims accordingly. The Revenue refused to allow the taxpayer's claims for group relief for 1998, 1999 and 2000 on the basis that the foreign subsidiaries were not resident in the UK as required by ICTA 1988, s. 413(5). That requirement was repealed by the Finance Act 2000 so that for accounting periods beginning on or after 1 April 2000, group relief was available in cases in which the loss making company was either resident in the UK or carrying on a trade in the UK through a branch or agency. The Revenue accordingly refused the taxpayer's claim for 2001 on the basis that the foreign subsidiaries satisfied neither of those requirements. The taxpayer appealed against the refusal of relief for the years ended 31 March 1998, 1999, 2000 to 2001. The special commissioners dismissed the appeal ((2002) Sp C 352). They decided that it was clear that under Community law the UK was not required to accord the same group relief for losses of a branch of a UK subsidiary as those of its foreign subsidiaries so that it was unnecessary to make a reference to the ECJ for guidance. The taxpayer appealed to the High Court which made a reference to the ECJ for a preliminary ruling on the compatibility of the UK group relief legislation with EC law (without giving detailed reasons) on the basis that it was not clear that the application of a different rule to situations that were not objectively comparable did not amount to a discriminatory restriction on the freedom of establishment guaranteed by art. 43 EC.

Issue

Whether by virtue of European law the taxpayer was entitled to relief for losses incurred by subsidiaries established and resident in Belgium, France and Germany against the profits of the taxpayer parent company which was resident in the UK.

Decision

Excluding tax advantage a restriction on freedom of establishment The ECJ (Grand Chamber) said that group relief such as that in issue constituted a tax advantage for the companies concerned. By speeding up the relief of the losses of the loss-making companies by allowing them to be set off immediately against the profits of other group companies, such relief conferred a cash advantage on the group. The exclusion of such an advantage in respect of the losses incurred by a subsidiary established in another member state which did not conduct any trading activities in the parent company's member state was such as to hinder the exercise by that parent company of its freedom of establishment by deterring it from setting up subsidiaries in other member states. It thus constituted a restriction on freedom of establishment within the meaning of art. 43 EC and 48 EC, in that it applied different treatment for tax purposes to losses incurred by a resident subsidiary and losses incurred by a non-resident subsidiary.

Such a restriction was permissible only if it pursued a legitimate objective compatible with the Treaty and was justified by imperative reasons in the public interest. It was further necessary, in such a case, that its application was appropriate to ensuring the attainment of the objective thus pursued and did not go beyond what was necessary to attain it. Objective justification of advantage only available to residents In tax law, the taxpayer's residence might constitute a factor justifying national rules involving different treatment for resident and non-resident taxpayers. However residence was not always a proper factor for distinction. In effect, acceptance of the proposition that the member state in which a company sought to establish itself might freely apply to it a different treatment solely by reason of the fact that its registered office was situated in another member state would deprive art. 43 EC of all meaning. In each specific situation, it was necessary to consider whether the fact that a tax advantage was available solely to resident taxpayers was based on relevant objective elements apt to justify the difference in treatment.

Principle of territoriality

In the present case, by taxing resident companies on their worldwide profits and non-resident companies solely on the profits from their activities in that state, the parent company's member state was acting in accordance with the principle of territoriality enshrined in international tax law and recognised by Community law. However the fact that it did not tax the profits of the non-resident subsidiaries of a parent company established on its territory did not in itself justify restricting group relief to losses incurred by resident companies. In order to ascertain whether such a restriction was justified, it was necessary to consider what the consequences would be if an advantage such as in this case were to be extended unconditionally. A reduction in tax revenue could not be regarded as an overriding reason in the public interest which might be relied on to justify a measure which was in principle contrary to a fundamental freedom. Nonetheless the preservation of the allocation of the power to impose taxes between member states might make it necessary to apply to the economic activities of companies established in one of those states only the tax rules of that state in respect of both profits and losses. In effect, to give companies the option to have their losses taken into account in the member state in which they were established or in another member state would significantly jeopardise a balanced allocation of the power to impose taxes between member states, as the taxable basis would be increased in the first state and reduced in the second to the extent of the losses transferred.

Risk of tax avoidance

As regards the danger that losses would be used twice, it had to be accepted that member states should be able to prevent that from occurring. Such a danger did in fact exist if group relief was extended to the losses of nonresident subsidiaries. It was avoided by a rule which precluded relief in respect of those losses. As regards the risk of tax avoidance, it had to be accepted that the possibility of transferring the losses incurred by a nonresident company to a resident company entailed the risk that, within a group of companies, losses would be transferred to companies established in the member states which applied the highest rates of taxation and in which the tax value of the losses was therefore the highest. To exclude group relief for losses incurred by non-resident subsidiaries prevented such practices, which might be inspired by the realisation that the rates of taxation applied in the various member states varied significantly.

Restrictive measures in this case went beyond what was necessary

Restrictive provisions such as in the present case pursued legitimate objectives which were compatible with the Treaty and constituted overriding reasons in the public interest and were apt to ensure the attainment of those objectives. However the court considered that these restrictive measure went beyond what was necessary to attain the essential part of the objectives pursued. Where, in one member state, the resident parent company demonstrated to the tax authorities that the conditions for relief were fulfilled, it was contrary to art. 43 EC and 48 EC 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 subsidiary. It was important to note that member states were free to adopt or to maintain in force rules having the specific purpose of precluding from a tax benefit wholly artificial arrangements whose purpose was to circumvent or escape national tax law. Furthermore, in so far as it might be possible to identify other, less restrictive measures, such measures in any event required harmonisation rules adopted by the Community legislature.

European Court of Justice (Grand Chamber).

Judgment delivered 13 December 2005.