The consideration of final losses in international tax law - Sudden change of strategy by ECJ towards the revival of border-crossing setting-off of losses

Lawyers/tax lawyers/tax advisers from Cologne report on the legal wrangling regarding the issue of "final losses", providing a perspective on existing certainties - and uncertainties.

Which rules apply if national tax laws prevent border-crossing offsetting of losses in companies operating internationally? For more than a decade, both the national courts and the European Court of Justice (ECJ) have dealt with this question which, as a result, also raises complex issues.

ECJ first developed the legal concept of "final losses" in the well-known leading Marks & Spencer decision (ECJ dated 13/12/2005 - C-446/03). Since then, the concept developed thereby has been continuously expanded, modified and amended. While, the penultimate ECJ ruling (Timac Agro, ruling of 17/12/2015 - C-388/14) denied the border-crossing consideration of final losses in the case of the double taxation agreement exemption of profits generated by a business establishment abroad, this strategy was suddenly changed with the latest ECJ ruling on this (Bevola/Trock, ruling of 12/06/2018 - C-650/16). 

In order to develop a better understanding of the issue of final losses, the "Bevola and Trock" ruling as well as the consequences thereof are to be discussed below, in addition to an overview of the rulings on this aspect delivered so far.

In view of the complex situation, we advise all taxpayers who might be affected by this issue to seek professional advice on this early on in order to discuss existing as well as future design possibilities.

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

The issue in international taxation law on which these rulings are based is embedded in a field of tension between the European internal market and national tax laws:

The internal market - which constitutes a central element of European integration - is based on the free movement of goods, persons, services and capital within the European Union. In order to ensure free movement, the European legislator has established so-called fundamental freedoms in the Treaty on the Functioning of the European Union (TFEU): the free movement of goods, the free movement of workers, the freedom of establishment, the freedom of services and the free movement of capital.

In international tax law, in particular, the freedom of establishment (art. 49 TFEU) is of central importance. It comprises the right of every citizen of the European Union to take up and carry out any employment in another EU member state and the right to set up and manage a company. In the case of legal entities, the freedom of establishment includes, in particular, the right to set up agencies, branch establishments or subsidiaries in every member state. However, in addition to this dimension regarding the rights of freedom, the freedom of establishment also comprises an equal rights aspect: It outlaws discrimination on the basis of nationality. Within the sphere covered, citizens of another EU member state may not be treated any differently to the citizens of the host country.

However, this is affected by the national tax provisions of the member states. Because these serve the purpose of funding national budgets, fiscal sovereignty and tax competences still rest 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 (VAT) act.

Therefore, in international tax legislation, a collision between the right of establishment (or another fundamental freedom) and national laws is possible, for example because the national tax law includes banned discrimination. Such a collision is possible, in particular, whenever a national provision bans the consideration of foreign losses in the country, which also forms the initial situation for the problem of the final losses.

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

In order to understand the further development of the jurisdiction and the problem, it is helpful to first take a closer look at the concepts and the approach adopted by ECJ in the "Marks & Spencer" ruling.

In the legal matter on which the ruling is based, the British retailer Marks & Spencer asserted the deduction of the losses incurred by its subsidiaries based in Belgium, France and Germany from its taxable profit in the United Kingdom. However, the British fiscal administration denied this application on grounds that, according to British tax legislation, group relief is only possible for losses incurred in the United Kingdom.

At the national level, the lawsuit initiated by Marks & Spencer with regard to this ended before the High Court of Justice as the last instance, which then decided to suspend the proceedings and refer the case to ECJ. It was to determine by means of a preliminary ruling procedure whether the deduction of losses which is only possible with regard to losses by domestic subsidiaries - but impossible with regard to losses incurred by foreign subsidiaries - is compatible with the freedom of establishment.

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 limitation of the deduction of losses to national subsidiaries constitutes national tax relief and might provide liquidity benefits for companies exclusively operating nationally. If the possibility of the border-crossing deduction of losses is refused, this is considered to obstruct the parent company's freedom of establishment by preventing it from establishing subsidiaries in other EU member states.

It has to be noted that, at this point, the court only very briefly dealt with the question of whether there was unequal treatment within the meaning of the ban on discrimination included in the freedom of establishment. Since unequal treatment can only apply if similar matters are treated differently, the decisive aspect in this case was whether British subsidiaries are comparable 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: Now, if this argument alone were sufficient, it would completely undermine the freedom of establishment. ECJ failed to provide a further explanation of this point - even though, as we will see in due course, it is a very difficult one.

Step 2: The second step of the examination deals with the question of whether the restriction of the right of establishment found can possibly be justified. In this context, the court recognises three justifications which must be cumulatively 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 members 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" in 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 state of residence of the subsidiary and in the state of residence of the parent company - i.e. twice.

Justification 3: "Prevention of tax avoidance" Finally, prevention of tax avoidance is also intended  to justify the intervention in the right of establishment. 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 restricting 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 of the consideration of losses in it country of residence and there will be no options for considering the losses of subsidiary itself or through third parties also in future.

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 in the name of the freedom of establishment.

Further development of the ECJ jurisdiction after "Marks & Spencer" and the "Timac Agro" breakthrough

The concept of "final losses" developed in the case of "Marks & Spencer" was taken up repeatedly by ECJ during the following decade. While, in some of the following rules, ECJ initially confirmed the strategy adopted (e.g. in "Lidl Belgium", "KR Wannsee" and "Nordea Bank"), this was broken in the "Timac Agro" ruling (ECJ ruling of 17/12/2015,case no. C388/14).

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

If we analyse the judgements issued since 2005, we can see that ECJ transfers the concept of "final losses" developed by it on the basis of group consolidation to other cases. Initially, ECJ expanded the scope of application to the deduction of losses of foreign branch offices in the case of "Lidl Belgium" (ECJ on 15/5/2008 - C-414/06). In the two rulings regarding "KR Wannsee" (ECJ dated 23/10/2008 - C-157/07) and "Nordea Bank" (ECJ dated 17/7/2014 - C-48/13) these principles were applied to the somewhat more complex case in which losses of foreign branch offices which had already been taken into account were again added to the taxable income of the company in the state of residence either because the unprofitable foreign branch office suddenly generated profits (as in the case of "KR Wannsee" or because the foreign branch office was abandoned (as in the legal case of "Nordea Bank"). Afterwards, this concept was transferred to a situation in which a border-crossing loss carry-forward was banned in the event of a merger between the parent company and the foreign branch office in the ruling "A Oy" (ECJ dated 21/2/2013 - C-123/11). And, finally, in case "K" (ECJ dated 7/11/2013 - C-322/11) ECJ transferred the principle to non-entrepreneurial income of natural persons: In this case, the Finnish fiscal administration had refused taxpayer "K" the right to deduct losses incurred in 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. It does not only concern groups but also companies with foreign branch offices and private persons.

A further important development which can be considered as being "stable" today concerns the exact definition of the finality of losses. The definition proposed in "Marks & Spencer" (i.e. that finality applies if all possibilities provided for the consideration of losses in the state in which the subsidiary resides and if there is no possibility for the subsidiary or a third party to have the losses considered in said state) has been elaborated and significantly restricted by ECJ thereafter. The wording selected at the time comprised both a legal and an actual "impossibility" of the utilisation of losses. However, in its ground-breaking "KR Wannsee" ruling (ECJ dated 23/10/2008 - C-157/07) ECJ clarified that finality does not apply if the lack of such possibility for the consideration of losses is only legal in nature. There is no obligation to consider the final losses of a branch office in the state of the parent company if the finality of the losses is solely attributable to the legal system of the state of the branch office. According to this ruling, the freedom of establishment cannot be interpreted as requiring a member state to adjust its tax rules to those of another member state in order to ensure the consideration of losses, which would remedy every possible inequality resulting from national tax provisions, in all situations. This jurisdiction significantly narrows the scope of application of the legal concept of "final losses". Today, conceivable cases of finality are limited to commercial facts. For example, finality would apply if a permanently unprofitable branch office is abandoned on the basis of commercial considerations alone.

"Timac Agro": A break with the jurisdiction so far and its effects

In the "Timac Agro" ruling (ECJ ruling of 17/12/2015, case no. C-388/14), ECJ already adopted a new solution with regard to the aspect of comparability (step 1 of the examination) outlined above. In the first "Marks & Spencer" ruling, ECJ remained largely silent on this issue. It only commented on this issue in more detail in rulings K (ECJ dated 7/11/2013 - case no. C-3222/11), "Nordea Bank" (ECJ dated 17/7/2014 - C-48/13) and in the "Timac Agro" ruling.

These considerations were based on the concept that unequal treatment can only apply if similar things are given different legal treatment. In the border-crossing cases referred to herein, the answer to this question hinges on whether, e.g., a branch office abroad and a domestic branch office can be considered as being comparable. If this is not the case, any impairment of the freedom of establishment and, hence, the consideration of final losses is excluded as early as during this level of the examination.

In this respect, the principle of territoriality causes problems - also in combination with the respective double taxation agreement (DTA): In principle, the state in which the company resides does not have fiscal sovereignty with regard to the foreign branch office. As a result, comparability does not apply.

This characteristic of the DTA was also perceived by ECJ. However, in the "K" and "Nordea Bank" rulings, it still concluded that comparability applies because of special circumstances.

In case "K", this was the case because the income which was generally taxable abroad pursuant to the relevant DTA was subject to a progression proviso (DTA exemption method). According to this, the income was not taxed; however, because of the progression effect, it increased the material tax rate. Therefore, the foreign income was considered domestically, at least, indirectly through the progression proviso. As a consequence, ECJ confirmed comparability in this case because of the applicable exemption method in the DTA in conjunction with a progression proviso.

In the "Nordea Bank" case, ECJ followed a similar line of argumentation. Here, ECJ arrived at the conclusion that, in spite of the applicability of the principle of territoriality and of the corresponding DTA - which did not provide for the exemption method - comparability was ensured since the state of residence had considered losses and income of foreign branch office through the application of the credit method.

The situation on which the "Timac Agro" ECJ ruling, in turn, is based resembles the situation on which ECJ had to rule in the “K” case - at least, according to the parameters. Essentially, a German company refused to accept the non-consideration of losses incurred by its branch office based in Austria. Under the corresponding DTA, Austria had the taxation right; however, it also provided for the exemption method using the progression proviso for Germany.

Surprisingly, however, ECJ denied comparability here with the brief explanation that (because of the exemption method provided for in the DTA) Germany did not have any taxation rights regarding the income of the Austrian branch office overall.

This decision for which the judges unfortunately did not provide any detailed reasons has caused extensive confusion both in the practice of international tax law and in tax jurisprudence. It was doubtful whether ECJ now considered the progression proviso insignificant - in contrast to its ruling in the matter of "K" - in principle or only in this specific case because it was not important because of the proportionate taxation of stock corporations.

Moreover, the ECJ approach to other particularities of international tax law and, in particular, the classification of international and national "subject-to-tax" and "switch-over" provisions was also uncertain (in Germany, e.g. art. 50d section 9 EStG or art. 20 section 1 AStG [Foreign Tax Act]). In exceptional cases, these provisions can lead to a situation in which a state "regains" the taxation or in which a switch from the exemption to the credit method is effected. The question was just whether their application would or would not ensure comparability. The same also applied to "taxation for companies added to the proceedings as third parties" ("Hinzuziehungsbesteuerung") which might apply under certain circumstances (art. 7 ff. AStG). In this case too, the question arises as to whether comparability has to be answered in the affirmative or denied.

It has to be noted that both the national fiscal administration and the German Federal Fiscal Court (BFH) fully followed this jurisdiction, as can, e.g., be seen in the ruling issue by BFH in 2017 regarding the non-consideration of final losses as a result of the sale of a partner's share in an Austrian limited partnership (BFH, ruling dated 22/02/2017 - I R 2/15).

Unexpected change of course by ECJ in the recent "Bevola/Trock" ruling

In its most recent ruling dated 12/06/2018 (C-650/16, "Bevola Trock"), ECJ revived the possibility of the border-crossing consideration of final losses of a branch office based in a member state in the parent company's state of residence, which had been presumed dead.

The case on which this ruling is based can briefly be summarise as follows: A Danish joint-stock company wanted to deduct the losses incurred by its Finnish branch office in 2009 (which were no longer usable because of the closing of the Finnish branch office) from the taxable base for corporation tax at the Danish parent company. This was done by referring to the fact that these were losses incurred by a Danish branch office and that the unequal treatment connected with it constituted a restriction of the freedom of establishment. In this context, Danish taxation has the special characteristic that income of foreign branch offices is not subject to taxation in Denmark right from the outset (regardless of the exemption under the DTA), while, at the same time, corporate groups can opt for "joint international taxation" with the consequence that the income of all foreign branch offices is included in the taxable base of the Danish parent company, which is binding for a period of ten years. Against this background, the Danish court asked ECJ whether a consideration of losses is conceivable if the conditions specified in the "Marks & Spencer" ruling are fulfilled even though the right of option was not used.

The ruling dated 12/06/2018 (C-650/16, "Bevola/Trock") also shows the three-level ECJ examination already outlined above. In this respect, the different treatment of the consideration of losses between companies which have a branch office in the member state of the parent company and companies whose branch office is located in another member state must constitute unequal treatment in objectively comparable situations. ECJ found a corresponding unequal treatment which, in particular, is not rejected on grounds of the fact that there is the possibility to opt for "joint international taxation". This is because the right of option is tied to the fulfilment of two preconditions; namely, on the one hand, that the entire income of all subsidiaries and branch offices in Denmark is necessarily subject to corporation tax, i.e. that a right of option is not granted with regard to individual subsidiaries/branch offices, and that, on the other hand, the choice of option is binding for ten years which makes the establishment of a branch office in another member state significantly less attractive than the establishment of a national branch office and, as a result, it can be said to restrict the freedom of establishment.

The examination of the question of whether this unequal treatment also applies in situations which are objectively comparable forms the main aspect of the ruling. Referring to the "Nordea Bank" and "Timac Agro" rulings, the governments and the commission stated that comparability between the domestic and the foreign case cannot apply because the foreign branch office is not subject to Danish fiscal sovereignty and because comparability only applies if the residence of the parent company also taxes the income of the foreign branch office. In addition, in these rulings, ECJ found that the reason for the unequal treatment should probably not play any role in the framework of the comparability examination.

However, ECJ objected to this and expressly emphasised that the comparability of an international and national case also has to be examined under consideration of the aim which the national provisions pursue with the corresponding provision and that the corresponding rulings do not state otherwise. The purpose of the national provision does not play any role only in those cases in which a member state treats the national and the international case identically. However, in the event of unequal treatment, the purpose (i.e. the avoidance of double taxation as a result of the non-consideration of the profits generated by foreign ranch offices or the double deduction of losses) has to be considered. With regard to current income or losses, ECJ does not see this comparability. In the case of the "final losses" of a foreign branch office, comparability is ensured, on the other hand, since the situation of a company with international branch offices does not differ from the situation of a company which only has national branch offices with regard to the aim of avoiding the double deduction of losses (margin number 38). This applies, in particular against the background that the general aim is to tax the company on the basis of its performance. However, the performance of a company with foreign branch offices suffering final losses is limited to the same degree as the performance of a company with national branch offices suffering final losses (margin number 39).

In the framework of the justification examination, ECJ arrived at the conclusion that the non-consideration of foreign losses and the unequal treatment associated with this can be justified for mandatory reasons of the general interest by referring to the reasons already discussed, i.e. "Maintaining the balanced division of the powers of taxation between the members states", "Coherence of the tax system" and "Prevention of double consideration of losses". However, the need to ensure the coherence of the tax system only constitutes a corresponding justifying reason if a direct connection between the tax advantage concerned (possibility of consideration of the losses incurred by the company in the case of a national branch office) and offsetting of such through a given tax burden (inclusion of the profits of the national branch office in the taxable income of the company) is shown with the directness of this connection having to be assessed with the help of the aim of the provision in question. This is also justified against the background of taxation of the company based on its performance since the assumption of the possibility of the consideration of losses incurred by an international branch office while, concurrently, the profits generated by the foreign branch office are not considered would distort the performance of said company (margin number 45 – 51).

Finally, in the framework of the proportionality assessment, ECJ arrived at the conclusion that the restrictive national tax provision which does not provide for the deduction of losses incurred by a non-resident branch office goes beyond what is required in order to attain the targets specified in the context of the justification examination. This, at least applies, if these are "final losses". In this context, ECJ states that, in this respect, the finality requirements specified in the "Marks & Spencer" ruling must be fulfilled and that the jurisdiction regarding the consideration of final losses of a non-resident subsidiary can be transferred to final losses of a non-resident branch office. This means that losses are final under the following conditions:

1.     The company must have used all deduction options regarding these losses which it has under the laws of the member state in which foreign branch office is located.

2.     The branch office must no longer generate any income, so that there is no possibility for considering the losses incurred in another member state. Now, this has to be established by the Danish court of law.

Effects of the ECJ "Bevola/Trock" ruling on the legal concept of final losses

The "Bevola/Trock" ruling is good and correct as regards the express ECJ reference to the fact that the findings made in the "Timac Agro" ruling regarding the comparability of two matters treated differently by national tax law have to be applied restrictively (margin number 35). Because of this statement, (which is very clear), from the ECJ, we can assume that, in future, comparability will have to be affirmed in general in future if the profits of foreign branch offices are exempt in the member state of the parent company but there concurrently are also final losses. This should apply regardless of the question of whether such exemption applies because of a unilateral waiver or is based on double taxation agreements.

Moreover, it has to be noted that the ECJ Grand Chamber, which usually comprises 15 judges, issued this ruling. In this respect, it has to be assumed that future ECJ chambers will also use this legal interpretation as a guideline.

This means that comparable cases of final losses always have to be considered by the national tax advisers. In this case, negative decisions will have to be appealed against. This has to be considered, in particular, with a view to possible questions of liability and claims to damages accompanying such.

The national courts and the fiscal administration are also bound by the ECJ jurisdiction, which is why a change in the jurisdiction of BFH (in contrast to BFH, ruling dated 22/02/2017 - I R 2/15) has to be expected in corresponding cases. 

Legal advice in international tax law

As 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 of foreign branch offices 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 fiscal courts and the federal fiscal court or even the ECJ. Afterwards, together with our clients we can decide which alternatives are available and which approach is best.