A giant step forward

David Evans and Liam Delahunty report on the recent landmark ruling that means Marks & Spencer can now claim tax relief on losses incurred in other EU countries

On 7 April 2005, the advocate-general gave his opinion in the Marks & Spencer Plc (M&S) cross-border group relief case.

As was widely anticipated, the advocate-general found that the UK group relief rules, to the extent they disallow cross-border loss relief within the EU, are contrary to Articles 43 and 48 of the EC Treaty.

However, he also noted that if domestic legislation limits cross-border group relief where the relevant losses may also be utilised in another member state, such restrictions would not be contrary to the EC Treaty.

As the UK's domestic law does not currently provide for such restrictions in relation to loss-making subsidiaries, the opinion has been widely regarded as representing a significant step forward for M&S.

It also gives member states scope to introduce rules to restrict cross-border group relief claims where relief may be obtained in other member states.

Of course, it is the European Court of Judgment's (ECJ) decision - anticipated to be delivered in the next two to six months - that is what counts, but the ECJ follows the advocate-general's opinion in the vast majority of cases.

Background

M&S is a company incorporated in England and Wales and is a UK tax resident. M&S operates a profitable trading activity in the UK as a general retailer, selling mainly food, homeware and clothing. Its less successful expansion to continental Europe is well documented, with its French, German and Belgian trading subsidiaries incurring losses totalling approximately £100m (EU losses).

Although the current group relief provisions under the UK's domestic law preclude relief for losses sustained by non-UK subsidiaries, M&S submitted group relief claims in its computations for the years ended 31 March 1998, 1999, 2000 and 2001, in respect of the EU losses. Not surprisingly, the claims were rejected by the Inland Revenue on the grounds that group relief was available in respect only of losses arising in the UK.

The UK courts

Initially, M&S appealed to the Special Commissioners, claiming that the UK's domestic group relief provisions, in 'subsidising' losses of a group's UK subsidiary but not an EU subsidiary, made investing in the UK more attractive, and constituted a restriction on establishing operations in other EU member states. The group relief provisions were, M&S claimed, contrary to Articles 43 of the EC Treaty, which provides for freedom of establishment for persons who have a seat in one member state to take up and pursue operations in another member state, without restriction of any kind.

M&S was unsuccessful before the Special Commissioners but then appealed against that decision to the High Court, which ultimately decided to refer the matter to the ECJ, on the grounds there was a prima facie argument that Articles 43 and 48 did apply.

ECJ oral hearing

The oral hearing was heard before the ECJ on 1 February 2005. In the hearing M&S, supported by the European Commission, set out its claim that the UK's domestic group relief system was contrary to Articles 43 and 48 of the EC Treaty.

As it is not just the UK's taxation system that could potentially be affected by the M&S case - which has EU-wide relevance as most member states group relief systems are 'discriminatory' in this sense - a number of member state governments also made submissions to the ECJ alongside the UK Government.

Notably, in view of the tax at stake, the German Government submitted that if the ECJ were to decide in favour of M&S, it should impose a temporal restriction, to mitigate member states' liabilities for damages. Although temporal restrictions are not a common feature of ECJ judgments, they have been granted on other occasions, so this possibility cannot be disregarded.

Advocate-general's opinion

In his opinion, the advocate-general addressed three main questions. First, he asked whether excluding a company with subsidiaries in other member states from the benefit of consolidation for tax purposes (that applies to a company with branches in other member states) constitutes a restriction on the freedom of establishment. However, such an exclusion was, in the advocate-general's view, not contrary to any of the freedoms in the EC Treaty as their purpose is not to impose uniformity in the regimes applicable to different types of establishment.

Secondly, the advocate-general considered the legality of a rule excluding a company with subsidiaries in another member state from the benefit of the group relief provisions, where relief would apply to a company with subsidiaries in the same member state. In this regard, the advocate-general held that such a general restriction does constitute a restriction on the freedom of establishment under the EC Treaty.

Essentially, the advocate-general accepted the M&S argument, noting that that there is a difference in treatment and that, as the situations of a UK subsidiary and a subsidiary resident in another member state are comparable, that difference in treatment constitutes an 'exit restriction', which is contrary to the freedom of establishment.

The third question considered was whether such a restriction could be justified on any legitimate grounds recognised by community law, and the advocate-general answered this question in the negative. In particular, he rejected the UK Government's argument that the 'territoriality' and 'fiscal cohesion' principles provided a justification for the general restriction in the group relief provisions that relief could not be available for the losses of a subsidiary resident in another member state.

However, the advocate-general did note that the EC Treaty should not preclude member states from introducing legislation, which make entitlement to cross-border group relief subject to a requirement that the losses arising in another member state cannot be carried forward, surrendered, or otherwise utilised in that other member state.

This would be consistent with the current UK group relief rules that only permit loss relief claims between companies where the losses are irrevocably surrendered.

The advocate-general considered that such a restriction would, under the principle of fiscal cohesion, be a justified restriction on the fundamental freedoms contained in the EC Treaty, provided the risk of 'dual use' could be verified.

EU implications

If the ECJ follows the advocate-general's opinion, the current group relief system in the UK - to the extent it disallows cross-border group relief for the losses of EU subsidiaries as a general principle - would be rendered illegal.

M&S itself would stand to reclaim up to £30m in tax from the Government. However, the effect would be much wider, as a number of other UK corporates have lined-up behind M&S, either by making claims in their tax computations or by bringing legal action. Many estimates of the potential cost to the UK Treasury run to billions.

Furthermore, as most member states' loss compensation regimes are 'discriminatory' in this sense, the group relief system in Ireland could be considered illegal, as could the 'group contribution' systems in Finland and Sweden, the 'fiscal consolidation' regimes in France, Italy, Luxembourg, Portugal, the Netherlands and Spain, and the 'organschaft' system in Germany.

Alter systems

As ECJ decisions are binding, member state governments would be obliged to alter their domestic systems to ensure that such discrimination on the grounds of residency did not occur, or they would need to argue that the regime is sufficiently different to the UK system to survive the judgment.

However, going forward, it would appear open to the UK Government to introduce a legislative restriction on cross-border group relief, to make entitlement subject to the requirement that the losses incurred by the subsidiary in the other member state have not been utilised in that other member state. The advocate-general suggested that such a requirement could be policed by the UK Revenue by invoking existing EU mutual assistance procedures.

If this option were left open to the UK Government, it would appear to assuage widespread fears that an M&S victory may necessitate the abolition of group relief.

As noted above, the possibility remains that the ECJ may allow a temporal limitation on any judgment in favour of M&S. As such, even if M&S wins, it does not necessarily follow that cross-border group relief claims would be successful. It is possible that the ECJ may limit reliance on a favourable decision to those companies that have already brought a legal action or made a claim in the relevant computations as at a specified date (such as the date of the ECJ's judgment).

Although there have long been moves towards the introduction of an EU-wide group relief system known as common (consolidated) base taxation (CCBT), the lack of political will to date means this is many years away.

David Evans is a tax director and Liam Delahunty is a tax adviser in Ernst & Young's European Union tax group, which is part of International Tax Services.