Concerning the consideration of final losses in international tax law

The Timac Agro ruling by the ECJ raises more questions than it answers! Lawyers/tax lawyers/tax consultants in Cologne report on mistakes and confusion in the jurisdiction regarding the subject of "final losses" and provide a perspective on existing certainties and uncertainties.

Which rules apply if national tax laws prevent the border-crossing consideration of losses for companies that operate internationally? For more than one decade, both the national courts and the European Court of Justice (ECJ) have dealt with this question, which raises complex issues.

The ECJ developed the legal concept of the "final losses" for the first time in its well-known landmark Marks & Spencer decision (ECJ on 13/12/2005–C-446/03). Since then, the concept developed therein has been constantly expanded, modified and supplemented. As a result, the last ECJ ruling regarding this issue (Timac Agro, ruling of 17/12/2015) is part of a series of inconsistent rulings. Unfortunately, this last ruling did not provide the much hoped-for clarifications. Instead, it caused further confusion for consultants and jurisprudence and even called the entire concept of "final losses" into question.

In spite of this unfortunate development in jurisdiction, we are able to find some consistencies, after considering all rulings. And below we provide an approximate overview of the consistencies - as well as the existing inconsistencies.

In view of the complex situation, we recommend that all taxpayers who might be affected by the problem obtain professional advice early on in order to jointly discuss existing and future options.

International Tax Law

The consideration of final losses or: The European internal market versus the fiscal interests of the member states

The problems of internal tax law on which these rulings are based are embedded in the field of tension that exists between the European internal market and national tax laws:

The internal market - a central element of European integration - is based on the free movement of goods, persons, services and capital within the European Union. To ensure this free movement, the European legislator has standardised so-called fundamental freedoms in the Treaty on the Functioning of the European Union (TFEU): the free movement of goods, the free movement of employees and the self-employed, the freedom of establishment, the freedom of services and the freedom of capital.

In particular, the freedom of establishment (art. 49 TFEU) is of central importance in international tax law. This includes the right of every citizen of the European Union to take up and carry out a form of employment in another EU member state - as well as the right to set up and manage a company. For legal entities the right of establishment includes, in particular, the right to establish agencies, branch offices and subsidiaries in every member state without any obstacles. However, in addition to this dimension of rights of freedom, the right of establishment also comprises a dimension of rights of equality: These ban discrimination on the basis of citizenship. Within the area covered, “foreign” EU citizens must not be treated differently from the host country’s own citizens, in principle.

On the other hand, there are the national tax provisions of the member states. Because they are satisfying the purpose of financing national budgets, fiscal sovereignty and tax competences still lie with the individual member states. In this respect, the European Union does not have any legislative powers - with the exception of the harmonised sales tax law.

Therefore, there might be a contradiction between the EU international tax law and national tax laws with regard to the right of establishment (or any other fundamental freedom), for example, because the national tax legislation might contain a prohibited discrimination. Such a collision can arise, in particular, in the event of a national rule banning the consideration of foreign losses with their home country and this is also the initial situation regarding the issue of final losses.

International Tax Law

The birth of the legal concept of "final losses" and the "Marks & Spencer" ECJ ruling

In order to understand the further development of jurisdiction and the problems involved, it is worthwhile taking a close look at the ECJ reasoning and the approach adopted in the "Marks & Spencer" ruling.

In the legal matter on which the ruling is based, the British retail chain Marks & Spencer requested the deduction of the losses incurred by its subsidiaries based in Belgium, Germany and France from its taxable profits in the United Kingdom. However, the British fiscal administration rejected this request on the grounds that, according to British tax legislation, intra-group deductions are only permitted for losses incurred in the United Kingdom.

At the national British level, the action brought by Marks & Spencer in this respect ended in the last court of appeal before the High Court of Justice, which decided to suspend the proceedings and to refer the case to the ECJ. This court was to carry out a preliminary ruling procedure to sort out the question of whether a situation in which the deduction of losses is only possible with regard to losses of domestic subsidiaries but cannot be carried out with regard to losses incurred by foreign subsidiaries is compatible with the right of establishment.

International Tax Law

The consideration of "final losses" is examined in three steps

Step 1: In a first step, the court confirmed the fact that there was a restriction of the right of establishment. The restriction of the deduction of losses to domestic subsidiaries constitutes a national tax relief and might create liquidity advantages for companies which only operate nationally. If the option of the border-crossing deduction of losses is refused, this obstructs the parent company in its freedom of establishment since it is thereby inhibited from establishing subsidiaries in other EU member states.

In this context it has to be mentioned that, in its ruling, the court only very briefly dealt with the question of unequal treatment within the meaning of the ban on discrimination contained in the right to establishment. Since unequal treatment only applies if comparable matters are treated differently, the decisive point in this case was whether British subsidiaries can be compared with foreign subsidiaries. Even though the ECJ concedes that comparability does not apply here because of the principle of territoriality established in international and community law - after all, the country of residence of the parent company does not have fiscal sovereignty over a foreign subsidiary - in concluding, it removes all concerns with one sentence only - without an in-depth examination: If this point in itself was sufficient, this would totally undermine the freedom of establishment. The ECJ does not provide any further reasons at this point, even though this aspect is crucial - as will be shown in the following analysis.

Step 2: The second step of the examination deals with the question of whether the restriction of the right of establishment found can perhaps be justified. In this context, the court recognises three reasons which all have to be fulfilled in order to justify the restriction of the freedom of establishment.

Justification 1: "Maintaining the balanced division of the powers of taxation between the member states" This is because the restriction of the consideration of losses prevents a company from choosing the state in which the losses are to be considered. Otherwise, there is the risk that the respective taxation bases might be distributed "unjustly" between the two states: While in one state, the assessment basis declines as a result of offsetting of losses, it expands accordingly in the other state.

Justification 2: "Prevention of the double consideration of losses" This is because the restricting rule prevents losses from being considered both in the country of residence of the subsidiary and in the country of residence of the parent company - i.e. twice.

Justification 3: "Prevention of tax avoidance" Finally, the intervention in the right of establishment is also intended to prevent tax avoidance. After all, if a company could choose the member state in which the losses are to be considered, this entails the risk that it would do that in the state with the highest tax rate, i.e. in the state in which the tax value of the losses is the highest.

In the second stage of examination, in the "Marks & Spencer" ruling, the ECJ arrived at the conclusion that the British tax provision regarding the restriction of the deduction of losses of foreign subsidiaries at the national parent company does not violate the freedom of establishment.

Step 3: In a third stage of examination - the so-called proportionality assessment - the court examined whether less onerous measures than a general ban on the consideration of losses might be considered for the attainment of the above-mentioned targets (justifications). So far, the ruling did not contain any major surprises, the ECJ only developed a ground-breaking innovation at this point: the legal concept of "final losses".

The court found: The restrictive national tax provision exceeds the requirements for the attainment of the above-mentioned targets if the non-national subsidiary concerned has used all available options for the consideration of losses in its country of tax residence and there are, or will be, no options for considering the losses of the subsidiary itself, or through third parties.

In short: According to the ECJ "Marks & Spencer" ruling, final losses apply if the foreign subsidiary does not have any possibility for offsetting of losses in its country of residence - i.e. it is "stuck" with its losses. In this case, the parent company's country of residence is obliged to consider these "final losses" in a manner reducing losses according to the freedom of establishment.

International Tax Law

Further developments after the ECJ "Marks & Spencer" ruling and current status

The concept of "final losses" developed in the "Marks & Spencer" case was taken up several times by ECJ in the following decade - most recently in the "Timac Agro" case as described above. Even though some principles have become firmly established over recent years, the latter ruling, unfortunately, leaves many questions unanswered.

Well-established principles: Transfer of the ECJ jurisdiction to other matters and settled case-law on the "finality" of losses

If we analyse the rulings rendered since 2005, we can initially observe that the ECJ has transferred the concept of "final losses" developed by it on the basis of group consolidation to other matters. Initially, ECJ expanded the scope of application to the deduction of losses of foreign establishments in the "Lidl Belgium" case (ECJ of 15/5/2008 – C-414/06). In the two rulings regarding "KR Wannsee" (ECJ of 23/10/2008 –C-157/07) and "Nordea Bank" (ECJ of 17/7/2014- C-48/13), the principles were applied to the somewhat more complex case in which losses of foreign establishments which had already been considered were again added to the taxable income in the company's country of residence - for example because the loss-making foreign establishment suddenly generated profits (as in the case of "KR Wannsee") or because the foreign subsidiary was closed down (as in the case of "Nordea Bank"). In the "A Oy" ruling (ECJ of 21/2/2013-C-123/11), the concept was transferred to a situation in which a border-crossing loss brought forward was banned in the event of a merger between the parent company and the foreign subsidiary. Finally, in the case "K" (ECJ on 7/11/2013-C-322/11), the ECJ transferred this principle to non-entrepreneurial income of natural persons: In this case, the Finnish fiscal administration had banned taxpayer "K" from deducting the losses incurred through the sale of a real estate property located in France.

This shows that the problem of the collision between national tax laws and fundamental freedoms inherent in international tax law is multi-faceted. This does not only concern groups but also companies with foreign subsidiaries and private persons.

Another important development which can be considered as being firmly established today concerns the exact definition of the "finality" of losses. The definition proposed in the "Marks & Spencer" ruling, i.e. that finality applies (if all possibilities provided for in the subsidiary's country of residence have been used and if there is no possibility for the losses to be considered by the subsidiary or a third party there in future), has been specified by the ECJ in more detail and restricted significantly. The wording selected at the time comprised both the legal and actual "impossibility" of loss exploitation. In the ground-breaking "KR Wannsee" ruling (ECJ of 23/10/2008 - C-157/07), however, the ECJ found that finality does not apply here when the missing possibility of consideration is only legal in nature. There is no obligation to consider final losses of an establishment in the country of the parent company if the finality of the losses exclusively has to be attributed to the legal system of the state of the establishment. The freedom of establishment cannot be interpreted as requiring the member state to adjust its tax provisions to those of another member state in order to ensure the consideration of losses in all situations in order to remedy every inequality resulting from the national tax provisions. This jurisdiction significantly restricts the scope of application of the concept of "final losses". Today, conceivable cases of finality are limited to commercial matters. For example, finality could apply when an establishment which consistently incurs losses is shut down for purely commercial reasons.

International Tax Law:

Open questions after the ECJ "Timac Agro" ruling: How should we approach the aspect of comparability? Are there still cases to which the legal concept of "final losses" can be applied?

The most recent ruling regarding the above-mentioned aspect of comparability which needs to be examined (examination step 1) poses difficulties in this respect. In the first ruling on this subject ("Marks & Spencer"), the ECJ largely remained silent on this issue. The ECJ only commented on this issue in more detail in the rulings "K" (ECJ of 7/11/2013-C-322/11), "Nordea Bank" (ECJ of 17/7/2014-C-48/13) and in the last ruling on "Timac Agro".

The consideration was based on the assumption that unequal treatment only applies if comparable matters are given different legal treatments. This means what matters in the border-crossing cases described here is whether, for example, an establishment abroad and a domestic establishment can be considered as being comparable. If this is not the case, an impairment of the freedom of establishment and, as a result, the consideration of final losses do not apply even at this stage of the examination.

At this point, the principle of territoriality causes problems - also when combined with a respectively valid double taxation agreement (DTA): In principle, the country of residence of the company does not have any fiscal sovereignty over the foreign establishment. In this respect, "comparability" does not apply.

And the ECJ also perceived this particularity of DTA. However, in the "K" and "Nordea Bank" rulings it still arrived at the conclusion that comparability applies because of special circumstances.

In the "K" case, this applied because the income which is, in principle, subject to taxation abroad according to the relevant DTA, was subject to a progression proviso in the country of residence (DTA exemption method). According to this, the income was not taxed; however, because of the effect of progression, it increased the applicable tax rate. Ultimately, this meant that foreign income was, at least, considered indirectly via the progression proviso within the country. As a result, the ECJ confirmed the comparability in this case because of the valid exemption method in the DTA in connection with a progression proviso.

In the "Nordea Bank" case, the ECJ followed a similar line of argumentation. In this case, the ECJ arrived at the conclusion that comparability applies in spite of the principle of territoriality and the corresponding DTA - which did not provide for the exemption method, since the country of residence had considered the losses and income of foreign establishments by applying the tax credit method.

The situation on which the last ECJ ruling ("Timac Agro") is based resembles the legal environment on which the ECJ had to decide in the "K" case - at least, in terms of the parameters. Essentially, a German company defended itself against the non-consideration of losses which its establishment located in Austria had incurred. The corresponding DTA allocated the taxation right to Austria; however, it also provided for the exemption method by applying the progression proviso for Germany.

Surprisingly, the ECJ refuted comparability at this point giving the concise and short reason that Germany simply did not have any right to tax the income of the Austrian establishment (because of the exemption method provided for in the DTA).

This decision for which the judges, unfortunately, did not give any more detailed reasons understandably leaves a lot of confusion both in the practice of international tax law and in jurisprudence focusing on tax law. Does that mean the ECJ considers the progression proviso as being insignificant, in principle - in contrast to the ruling in the "K" case? Or is it only insignificant in the special case because it was unimportant on account of the proportionate taxation of corporations? Or did the ECJ unknowingly overlook something?

Unfortunately, this question cannot be answered satisfactorily at the current point in time.

Moreover, the answer to the question of how the ECJ wants to deal with other particularities of international tax legislation is also still uncertain. These concern, in particular, the classification of international and national "subject-to-tax" and "switch-over" clauses (in Germany, e.g., art. 50d para. 9 Income Tax Act or art. 20 para. 2 Foreign Tax Act). In exceptional cases, such clauses lead to a situation in which a state is "given back" the taxation right or in which a switch from the exemption to the tax credit method is carried out. Now, does the application of these mean that comparability applies? The same also applies to “taxation for companies added to the proceedings as third parties” (Hinzuziehungsbesteuerung), which might apply under certain circumstances (art. 7 ff. Foreign Tax Act). In this case too, the question arises as to whether comparability has to be answered in the affirmative or denied.

All of these questions are of fundamental importance for the establishment of the legal concept of final losses under international tax law. If this question has already been answered in the negative during the first examination step, a potential finality no longer plays any role.

It remains to be hoped that the ECJ will soon be given the opportunity to sort out all these open questions. Until then, all parties involved have to live with a high degree of uncertainty regarding border-crossing offsetting of losses.

Legal advice in international tax law

As general commercial lawyers, tax consultants and tax lawyers in Cologne and Zurich, we have offered our clients comprehensive advice regarding international tax law for many years. If the fiscal administration refuses offsetting of losses incurred by foreign establishments or subsidiaries we recommend that a comprehensive examination of the prospects for success be carried out first - before a time- and cost-intensive action is brought before the German fiscal courts or the German federal fiscal court - or even the ECJ. Afterwards, we can decide together with our clients as to which alternatives there are, and which options are best selected.