By Anno Rainer

European Court of Justice (ECJ) Advocate General (AG) Sharpston issued her non-binding opinion in Lidl Belgium GmbH & Co KG (C-414/06) on 14 February 2008. According to AG Sharpston, it is incompatible with the freedom of establishment principle to preclude a company, when calculating its taxable profits, from deducting losses realized by its permanent establishment (PE) in another EU Member State on the grounds that, under a relevant tax treaty, the PE’s income is not subject to taxation in the country where the head office is located.

Facts

Lidl Belgium GmbH & Co KG (Lidl) is a German limited partnership that operated its Luxembourg business through a PE situated in Luxembourg. In 1999, the PE realized a loss, which Lidl initially deducted from its German tax base. The German tax authorities disallowed the deduction on the basis of articles 5 and 20 of the Germany-Luxembourg tax treaty, combined with the German “symmetry theory,” under which the exemption of foreign PE income in Germany includes positive as well as negative PE income. Following an unsuccessful administrative appeal, the tax court of Baden-Württemberg rejected the taxpayer’s claim. On subsequent appeal, the German Federal Tax Court referred to the ECJ the question of whether such an interpretation of the exemption provisions of tax treaties is compatible with the freedom of establishment and the free movement of capital principles of the EC Treaty.

Opinion of AG Sharpston

AG Sharpston clearly states in her opinion that a country disallowing at the level of a head office the deduction of losses realized by a foreign PE restricts the freedom of establishment. She then turns swiftly to the decisive questions of whether such a disallowance can be justified (answering in the affirmative) and whether it is proportionate (answering in the negative) .

On the first issue, AG Sharpston points out that the ECJ recognized in the Marks & Spencer case three justifications for a denial of the U.K. tax system to allow the transfer of losses of non-U.K. subsidiaries to U.K. group companies: (1) the goal of preserving the balanced allocation of the power to impose taxes; (2) the danger that losses might be taken into account twice; and (3) the risk of tax avoidance.

From AG Sharpston’s perspective, it is not necessary for all three risks to be present simultaneously and she suggests that the risk of tax avoidance is not present where a head office claims a deduction of foreign PE losses within the same legal entity because no jurisdiction shopping can be involved. However, the recognition of cross-border PE losses would put the allocation of taxing powers at risk and might lead to losses being taken into account twice. Therefore, she does not argue against the basic idea of the symmetry theory.

According to AG Sharpston, however, the total denial of cross-border losses is disproportionate and goes beyond what is necessary to limit the two risks. In examining alternatives, she points out that, in the case, the Luxembourg PE subsequently returned to a profit situation and, therefore, the deduction of losses at the head office would only have to be temporary, since the deduction could be coupled with a recapture clause. On the other hand, it would not be an option in the Lidl case to delay – as the ECJ did in Marks & Spencer – the deduction at the level of the head office until the losses could no longer be taken into account in the country in which they were incurred.

Preliminary Comments

The ECJ was much criticized for its application of the proportionality principle in Marks & Spencer, i.e. for delaying a deduction at the level of U.K. group entities for losses incurred by foreign group entities until the losses could no longer be taken into account in the country of their origin, while losses of U.K. group entities could be surrendered without such delay. AG Sharpston notes that the non-U.K. companies in Marks & Spencer were already being liquidated or had been sold and, therefore, the ECJ had no reason to extend its findings in that judgment to other situations. However, contrary to the general wording of the Marks & Spencer decision, the ECJ has been able to indicate in other decisions that the interpretation of the applicable freedoms and general principles might lead to different results when applied to different facts.

In any event, AG Sharpston seems to agree with the criticism and makes it clear that, if the restriction is constituted by a liquidity disadvantage, immediate deduction must be granted but could be accompanied by a recapture rule. Such recapture could take place when the foreign PE returns to profitability or potentially even after a fixed period or when the foreign PE ceases to exist in that form. However, recapture after a fixed period of time (even though suggested in 1991 in a draft directive by the European Commission) or at the time the PE is liquidated or dissolved by a merger without taking into account whether, at that point in time there is a loss or loss carryforward and their treatment in the country where the loses were incurred, would fall short of the basic principle that guided the ECJ in Marks & Spencer: losses must be and must remain deductible at least once.

If the ECJ follows AG Sharpston’s opinion, it is likely that new cases will be brought before the ECJ seeking to require national systems to allow intercompany recognition of losses across borders between EU/EEA countries in the same or similar way as for PE losses. On the basis of AG Sharpston’s comments on Marks & Spencer, other U.K. groups might seek an immediate deduction of foreign group companies’ losses. It might even be possible that Nordic countries applying group contribution systems would need to recognize – at least temporarily – the deductibility of cross-border group contributions if the recipient is in a real loss situation, even though the ECJ did not seem to be in favor of such an option in the Oy case (Case C-231/05).

Under existing ECJ case law, EU/EEA countries do not have to recognize the losses of third country PEs. In exceptional cases, the result might be different if EU/EEA companies hold minority participations in loss-making third country entities that are qualified as transparent in the respective EU/EEA country or potentially where minority partnership interests are held in a tax transparent EU/EEA entity, which itself operates a PE in a third country.

The date of the ECJ decision in Lidl is not yet known.

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