By Anno Rainer

The European Court of Justice (ECJ) issued its decision in the Deutsche Schell case on 28 February 2008, concluding that Germany’s treatment of exchange rate losses incurred by a resident company when repatriating the start-up capital it had provided to its permanent establishment (PE) in another EU Member State violated the freedom of establishment principle in the EC Treaty (Case C-293/06). The Court further held that the deduction of such losses must not be limited to the portion that exceeds any tax-exempt profits the German company realized in the PE country.

The ECJ essentially follows the 8 November 2007 opinion of AG Sharpston.

The Case

In 1974, a German limited liability company (GmbH) set up a branch (PE) in Italy which it provided with start-up capital. This capital was recorded at the level of the branch in Italian lira (LIT) and at the level of the German head office in a separate German commercial and tax account in Deutsche mark (DEM) amounts reflecting the exchange rate between DEM and LIT at the time of each payment made in LIT.

In 1992, all of the Italian PE’s assets were transferred to an Italian subsidiary of Deutsche Schell, the shares in which were sold (in LIT) on the same day to an unrelated acquirer. Taking into account changes in the exchange rate, the closure of the branch office resulted in an exchange rate loss of approximately Euro 63 million for the German head office. The transfer of the assets and the sale of the shares where taxed in Italy on the basis of LIT amounts.

The German tax authorities disallowed a deduction of the exchange rate loss at the level of the German head office. The authorities doubted that the loss represented a real economic loss because it was counterbalanced by a taxable capital gain in Italy; therefore, according to the German authorities, the GmbH was seeking to neutralize, at the level of the German head office, the tax burden suffered at the level of the Italian PE. The German authorities also considered that since the exchange rate loss arose from the activities of the Italian branch, it had to be regarded as part of the PE’s income, which was exempt from taxation in Germany under the 1925 Germany-Italy tax treaty. Furthermore, under German law, losses incurred by a foreign PE could be deducted at the level of the German head office only to the extent they exceeded positive income from the country where the PE was located.

After an unsuccessful administrative appeal, GmbH brought a case before the local tax court of Hamburg contending that the fact that it was unable to deduct the exchange rate loss for corporation tax purposes is incompatible with the freedom of establishment. The tax court of Hamburg referred the case to the ECJ.

ECJ Decision

The ECJ first points out that it is up to the national courts to analyze the facts and to determine whether the exchange rate loss represents a real economic loss for the relevant financial year. However, the ECJ considers itself competent to answer the legal issues proceeding on the assumption that a real economic loss has been incurred.

According to the ECJ, Germany’s disallowance of a deduction of the financial exchange rate loss at the level of the German head office constitutes a restriction on the freedom of establishment principle of articles 43 and 48 EC because the loss cannot be taken into account at the level of the PE whose books are kept in the foreign currency. The Court rejected the German government’s argument that the restriction could be justified by the coherence of the tax system (because foreign PE profits are not subject to taxation in Germany) and by the existence of a tax treaty that allocates the taxing powers between the two countries concerned and excludes the deduction at issue. The ECJ concluded there is no relevant direct link between the non-deductibility of the exchange rate loss and the exemption applicable to foreign PE; further, by its nature, the exchange rate loss can only be taken into account at the level of the head office.

For the same reason, the ECJ concluded that the limitation on the deductible loss to the portion that exceeds the profits of the foreign PE constitutes in itself an unjustified restriction of the freedom of establishment.

Preliminary Comments

Notably, the ECJ previously rejected the main arguments advanced by the German government back in 2003 in the Bosal Holdings BV case (Case C-168/01). The Court held in Bosal that the Netherlands had to allow, at the level of the Dutch parent company, the deduction of holding costs incurred on shares in foreign EU subsidiaries even if the subsidiaries’ profits and the dividends paid by them were not taxed in the Netherlands. Also, in the 2000 AMID decision, the ECJ rejected a Belgian rule that allowed a deduction of foreign PE losses at the level of the Belgian head office only after compensation with, inter alia, foreign PE profits that were tax-exempt in Belgium (Case C-1421/99).

The provision in the German income tax code allowing the deduction of foreign PE losses – subject to conditions which, according to the ECJ, are precluded by the freedom of establishment – was abolished with effect as from assessment period 1999. From that year, such deductions are excluded entirely, which according to AG Sharpston, violates articles 43 and 48 EC (see opinion of AG Sharpston of 14 February 2008 in Lidl Belgium GmbH & Co KG (C-414/06)).

While the operative part of the Deutsche Schell decision is a welcome clarification, the reasoning contains a statement that seems unnecessary and confusing. According to the ECJ, a Member State cannot be required to take account, for purposes of applying its tax law, of the negative results of a PE situated in another Member State which belongs to a company with a registered office in the first state solely because those negative results are not capable of being taken into account for tax purposes in the Member State where the PE is situated. It would appear from ECJ case law, as recently summarized by AG Sharpston in her opinion in the Lidl case that a Member State would have to allow a deduction for losses of foreign PEs situated in EU/EEA countries in the same way as losses incurred by domestic PEs. According to AG Sharpston, the country where the head office is located, however, would have the option to apply a recapture rule, even if her remarks on that point do not seem entirely consistent with the basic principles enunciated by the ECJ in the Marks & Spencer case (Case C-446/03)

To a certain extent, the introduction of the Euro in 15 EU Member States countries has mitigated the risk at issue in Deutsche Schell. However, the risk could have materialized on the various dates the Euro was introduced and still could be relevant in situations involving the 12 EU Member States that have not yet adopted the Euro (i.e. Bulgaria, Czech Republic, Denmark, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, Sweden and the U.K.), and the three EEA countries (i.e. Iceland, Liechtenstein and Norway).

The freedom of establishment principle does not encompass third country situations. And, according to recent ECJ case law, the free movement of capital in article 56 et seq. EC that generally applies to capital transfers to and from third countries cannot be invoked on its own where a potential restriction on the capital movement would be a mere unavoidable consequence of a restriction on the freedom of establishment, even where the latter does not cover third country situations.

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