By Anno Rainer and Lars Rehfeld

The European Court of Justice (ECJ) issued its decision in the Lidl case on 15 May 2008, concluding that the freedom of establishment principle of the EC Treaty does not require an EU Member State to allow a domestic head office to deduct the losses of a permanent establishment (PE) set up in another EU Member State to the extent a tax treaty between the two countries allocates the power to tax the PE income to the PE country where those losses can be carried forward to be deducted from future profits of the PE (Lidl Belgium GmbH & Co. KG, Case C-414/06).

Facts of the Case

Lidl Belgium GmbH & Co. KG (Lidl) is a German limited partnership that operated its Luxembourg business through a PE in Luxembourg. In 1999, the PE incurred a start-up loss that could be carried forward and, in 2003, the loss was deducted from the PE profits for Luxembourg tax purposes. Lidl initially deducted the 1999 PE loss from its revenue for German tax purposes. The German tax authorities disallowed the deduction on the grounds that the Germany-Luxembourg tax treaty allocates the right to tax PE income to the country of the PE (in this case, Luxembourg) and provides for an exemption of such income at the level of a German head office. According to German case law, the allocation of taxing power and the corresponding exemption applies symmetrically to PE profits and losses.

Following an unsuccessful appeal, the tax court of Baden-Württemberg rejected the taxpayer’s claim. On a subsequent appeal, the German Federal Tax Court referred the case to the ECJ asking whether the nondeductibility of foreign PE losses at the level of the German head office violates the freedom of establishment and the free movement of capitals provisions of the EC Treaty (i.e. articles 43, 48 and 56) if no such restriction applies to domestic PE losses.

The German Federal Tax Court specifically referred to the ECJ’s decision in Marks & Spencer (Case C-446/03), in which the ECJ held that the freedom of establishment principle requires a Member State (specifically, the U.K. in Marks & Spencer) that allows a transfer of tax losses between companies of the same group in a domestic situation to allow the transfer of losses incurred by group companies resident in another EU Member state to the extent the subsidiary’s losses can no longer be deducted in its country of residence. The German Federal Tax Court, in its referral, raised the issue whether an immediate deduction with a possibility of recapture would be more proportionate than postponing the deduction until it could no longer be used.

ECJ Decision

According to the ECJ, the issue must be examined only in the context of the freedom of establishment principle, which covers the creation and operation of PEs in other EU Member States. A potential breach of the free movement of capital is an unavoidable consequence of a restriction of the more specific freedom of establishment and, therefore, does not merit a separate analysis.

The ECJ concluded that a tax system that allows the deduction of losses incurred by domestic PEs at the level of a head office but disallows the same treatment to losses incurred by PEs situated in other EU Member States involves a restriction of the freedom of establishment. However, the Court decided that the restriction can be justified by the need to preserve the allocation of power to impose taxes between Member States and the need to prevent losses from being taken into account twice (these are two of the three justifications developed by the ECJ in Marks & Spencer). Both goals can be achieved by the application of the permanent establishment and relief from double taxation articles (i.e. articles 5 and 20) of the Germany-Luxembourg treaty, as interpreted by the German tax authorities and supported by jurisprudence.

With respect to the “proportionality issue” (i.e. whether the German treaty interpretation exceeds what is necessary to achieve the two justifying goals articulated in Marks & Spencer), the ECJ referred to its decision in that case, where it held that the U.K. rules on loss transfers must be extended to allow -- in the U.K. -- the deduction of losses incurred by a subsidiary resident in another EU Member State only where the losses could no longer be taken into account in the country where the loses were incurred. In the Lidl case, however, the start-up losses had been deducted in Luxemburg from the profits of the same PE in a later year.

The ECJ added that it would seriously undermine the balanced allocation of power to impose taxes between the Member States concerned if a company were given the right to elect to have losses of a foreign PE deducted in the country of the head office.

Preliminary Comments

The ECJ’s decision in Lidl does not follow the opinion of Advocate General (AG) Sharpston delivered on 14 February 2008. Similar to some of the reasoning in the referral by the German Federal Tax Court, AG Sharpston concluded that it is disproportionate to disallow the deduction of foreign PE losses in the same year in which they would have been accepted for deduction had the losses been incurred by a domestic PE. She specifically referred to German rules that had been abolished which, according to her, could have been deemed proportionate. (Under those rules, Germany allowed the deduction of foreign PE losses but the deduction was subject to recapture (e.g. when the PE became profitable or when it was liquidated). That rule was abolished as from assessment period 1999, although a potential for recapture through assessment period 2008 was included in the transition rules at the time. However, another law change in 2007 extended the 10-year recapture period indefinitely so that a recapture of losses deducted before 1999 will also be possible after 2008.) In fact, the ECJ has recognised in other decisions (as mentioned by AG Sharpston in her opinion) that a cash flow disadvantage qualifies as an unjustified restriction of the freedom of establishment.

The Lidl decision can be interpreted as requiring the deduction of losses incurred by PEs situated in other EU/EEA countries at the level of the head office where such losses can no longer be taken into account for tax purposes in the country of the PE. In that respect, the decision seems to be more taxpayer friendly than, for example, the former German recapture rules. Whether the deduction must be allowed where the PE country applies more stringent loss carryforward rules to PEs of nonresident companies than to resident entities is an issue that is now pending before the ECJ (Krankenheim Ruhesitz am Wannsee-Seniorenheimstatt, Case C-157/07).

Further, where the country of the head office applies the credit method to foreign PE income rather than the exemption method, a deduction must be allowed.

Finally, it should be noted that the ECJ held in its order dated 6 November 2007 that EC law does not require an EU Member State to accept at the level of a domestic head office the deduction of losses incurred by PEs situated outside the EU/EEA (SEW (Stahlwerk Ergste Westig GmbH), Case C-415/06). However, in the Ritter-Coulaiscase (Case C-152/03), the ECJ held that Member States need to take into account losses incurred in another EU Member State in the same way as domestic losses when determining the progressive tax rate applicable to the income that is subject to tax in the country of residence of an individual taxpayer.

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