Foreign losses incurred by EU permanent establishments and the exemption method

1 Introduction

Direct taxation is in conflict with EC law when, according to the fiscal principle of territoriality, the tax base of a company is fragmentised between the head office and an exempt permanent establishment. The possibilities to compensate profits and losses become isolated in each territory, which may result in a less favourable situation for a taxpayer than if the activity were purely domestic.1

The European Court of Justice (ECJ) considered in the Lidl Belgium case that exempted losses incurred by a permanent establishment in another EU Member State should not be deducted at the head office level when the losses are not final2. The Court did not follow the solution suggested by Advocate General Sharpston. Although this decision constitutes a welcomed relief for Member States applying the exemption method, it is technically questionable on the interpretation of the permanent establishment concept.

2 Facts

Lidl Belgium, a company with residence in Germany, was active in Luxembourg through a permanent establishment. The Germany-Luxembourg tax treaty3 provided for the exemption method as to taxation of permanent establishments4. The permanent establishment incurred a loss in 1999, and the German head office tried to offset that loss in its tax return. German tax authorities refused deduction, based on the exemption method in the tax convention.

The company appealed that decision, arguing that the exemption of losses incurred by a permanent establishment breaches the freedom of establishment since domestic losses would have been deductible. The Bundesfinanzhof stayed the proceedings and referred the question to the ECJ for a preliminary ruling.

3 Advocate General Sharpston's Opinion

Advocate General Sharpston, who already considered in a previous Opinion that the German exemption method was in breach with the freedom of establishment regarding nondeductibility of currency losses on allotted capital to a foreign exempt permanent establishment5, found that Lidl Belgium suffered a discrimination. The discrimination was justified, but it did not pass the proportionality test. Advocate General Sharpston observed – on the suggestion of Lidl Belgium and the European Commission – that Germany had until 1999 a recapture mechanism that permitted to deduct losses at the head office level once they were incurred abroad, for them to be recaptured when the permanent establishment became profitable. Since that recapture mechanism was more advantageous for the company than a pure rejection of deduction of foreign losses, she considered that the exemption method went beyond what is necessary to attain the objectives pursued. Therefore, the exemption method was found disproportional.

I believe this Opinion was too far reaching and eroded excessively Member States' sovereignty6. Two main arguments support this conclusion. First, Member States can freely decide upon the method to eliminate double taxation. The ECJ held in Gilly that ”(t)he Member States are competent to determine the criteria for taxation on income and wealth with a view to eliminating double taxation – by means, inter alia, of international agreements – and have concluded many bilateral conventions based, in particular, on the model conventions on income and wealth tax drawn up by the Organisation for Economic Cooperation and Development”7. The Court reaffirmed in Saint Gobain that ”Member States are at liberty, in the framework of bilateral agreements concluded in order to prevent double taxation, to determine the connecting factors for the purposes of allocating powers of taxation as between themselves”8. More recently, the ECJ stated that ”Community law, in its current state and in a situation such as that in the main proceedings, does not lay down any general criteria for the attribution of areas of competence between the Member States in relation to the elimination of double taxation within the Community”9. This caselaw strongly advocates for a liberty of Member States to choose the method to eliminate double taxation. Second, the ECJ in Marks & Spencer showed respect for the principle of territoriality and, as a principle, hold that each legal subject is taxed separately in its State of residence. The State of the parent company did not have to grant deduction for losses incurred by foreign subsidiaries. The only exception to this principle is in case there is no possibility for the subsidiary to have its losses taken into account in its residence State for previous or future periods10. In that case only, an exception to the principle of territoriality could be justified. In the present case, the loss was not final since Lidl Belgium could carry it forward in 2003 and the exemption method implied that the permanent establishment's tax base was taxed exclusively in the state of source. Therefore, there was no urgent need to grant deduction for the foreign loss in 1999 in the state of residence.

As a principle, Member States are sovereign in direct taxation matters; exceptions to their sovereignty should be limited to what is necessary to reinstate the breach in the EC Treaty. I believe that the proportionality test should be conducted at a minimum, i.e. amending Member States' tax systems only insofar as what is necessary to reestablish the freedom that was breached, and not going beyond that11. Hence, Advocate General Sharpston's Opinion was too far reaching.

4 The ECJ's ruling

The ECJ did not entirely follow the Opinion of Advocate General Sharpston. The Court considered that a restriction existed and that it could be justified by the need to preserve a balanced allocation of the power to impose taxes and the need to prevent the risk that losses are used twice. The exemption method was however deemed proportional. The Court therefore conducted the proportionality test at a minimum, since deduction of foreign losses seems to be compulsory only when these losses are final. Following the Advocate General's Opinion would have excessively and unnecessarily eroded Member States' sovereignty.

What are the consequences of the Lidl Belgium case? First, tax treaties choosing the exemption method should be ”EC-proof”, probably unless losses are final. There is no need to amend the exemption method present in existing tax conventions concluded by Member States. Second, countries that implement the exemption method or that apply exclusively the source principle in their domestic laws should also be relieved, as long as the ruling is transposable to domestic law. Such a transposition seems possible, since the Court focused more on the effects of the exemption method than the very fact that this method was part of a tax convention. In addition, the Court again mentioned that it is not unreasonable to find inspiration in the work of the OECD, which a State may do by enacting the exemption method in its domestic tax law.

The ruling is however criticisable regarding its definition of permanent establishments: ”a permanent establishment constitutes, under tax convention law, an autonomous fiscal entity”12. ”That definition of a permanent establishment as an autonomous fiscal entity is consonant with international legal practice as reflected in the model tax convention drawn up by the Organisation for Economic Cooperation and Development (OECD), in particular Articles 5 and 7 thereof”13. This definition is not correct, since a permanent establishment is by essence part of an enterprise: it is a ”fixed place of business, through which the business of an enterprise is wholly or partly carried on”14. This is why most countries tax income of foreign permanent establishments or deduct their losses at the head office level, in application of the residence principle. On the contrary, foreign subsidiaries are to be taxed separately in their State of residence, which the ECJ acknowledged in Marks & Spencer. The only way in which permanent establishments are considered fictively autonomous is when allocating profits, since the arm's length principle ”should apply in the context of the relationship between a permanent establishment and the rest of an enterprise to which it belongs”15. Through stating that a permanent establishment is an ”autonomous fiscal entity” the Court may be trying to be in line with the Saint-Gobain case where it found that a permanent establishment was entitled to treaty benefits of residents. It is hoped that the ECJ will clarify its definition of a permanent establishment in future case law.

As a consequence of the interpretation of the permanent establishment concept, the Court transpose tried to the solution reached in Marks & Spencer to the Lidl Belgium case. That is, it considered that the loss was definitely allocated to the permanent establishment through the exemption method, thus freeing the state of residence from any deduction obligation in that respect. As mentioned above, permanent establishments belong to an enterprise and their losses are often deducted at the head office level; such a solution is in principle not available to foreign subsidiaries. It is therefore surprising that the Court did not even consider this fundamental distinction with regard to the cash flow disadvantage suffered by Lidl Belgium, since the Court did pay attention to such arguments in the past16.

5 A necessary exception to the exemption method: final losses

There are good reasons to believe that the abovementioned conclusions are valid only in case losses are not final: ”Lidl Belgium has not shown that the conditions laid down in paragraph 55 of the judgment in Marks & Spencer, for establishing the situation in which a measure constituting a restriction on the freedom of establishment for the purposes of Article 43 EC goes beyond what is necessary to attain legitimate objectives recognised by Community law, were satisfied17”. Interpreting this sentence a contrario, if Lidl Belgium had losses fulfilling the conditions laid down in Marks & Spencer, losses would have to be deducted at the head office level. This solution is in conformity with the Deutshe Shell case18, where the ECJ considered that the nondeductibility of foreign currency losses, for startup capital allotted to a permanent establishment, was contrary to the freedom of establishment. Indeed, the currency loss could not appear in Italy since taxation was calculated in Lira. When the permanent establishment was disposed of, by way of transfer of assets to a subsidiary, the currency loss was final since it could not be deducted in Italy. Only the home State, Germany, could grant deduction for this currency loss. Refusal of deduction, in application of the German-Italy tax treaty went beyond what was necessary to attain the objective pursued. The Court rightly considered that the final losses should be an exception to the exemption method in the situation of Deutshe Shell.

Consequently, exempted losses of foreign permanent establishments should be deducted in the residence State when these losses are final according to the criteria provided for in Marks & Spencer. Those criteria may however lead to diverging interpretations. One can assume that if a permanent establishment is disposed of because it could not make profits on the local market, deduction for final losses should be granted in the residence State. But what if the company chooses to dispose of the lossmaking permanent establishment while better perspectives could be expected in the near future? What if a losscarry forward in the source State was denied or lost because the permanent establishment did not fulfil the local requirements? What if the company disposes of a lossmaking permanent establishment to benefit from deduction of losses at the head office level and later reestablishes a permanent establishment in the same Member State? Such questions show that some level of uncertainty is unavoidable. In addition, the interpretation of ”final losses” may be different in Member States, some granting deduction while others refusing deduction in a similar situation.19 The ECJ may need to provide some guidance, as it did in Deutshe Shell with regard to capital allotted to a permanent establishment. But again, the way Member States interpret and actually implement ECJ judgements may vary. The Lidl Belgium case therefore illustrates some of the problems linked with negative integration.

6 Conclusion

The Lidl Belgium case gave the ECJ the opportunity to transpose some of the consequences of Marks & Spencer to permanent establishments. While the outcome of the case may be satisfying, the reasoning of the Court remains questionable.

The ECJ did not require a Member State to grant deduction for losses incurred by a foreign permanent establishment the income of which is exempted through a tax treaty. This solution respects the tax convention entered into by two Member States, thus respecting their sovereign choice. The probable exception in case of final losses is reasonable and in accordance with a proportionality test conducted at a minimum. In addition, the tax treatment of final losses of permanent establishments and subsidiaries is now closer, which is likely to increase neutrality in the choice of an implementation form.

However, in order to reach that conclusion the Court had to consider a permanent establishment as an ”an autonomous fiscal entity”, which departs from the traditional definition provided by international tax law. In addition, the ECJ did not take the chance to discuss the cash flow disadvantage and its compatibility with the EC freedoms.

Lastly, combining Lidl Belgium to the previous rulings Gilly, Saint Gobain, Kerck-haert and Morres and Columbus Container Services seems to indicate that Member States can choose either of the double taxation relief methods described in the work of the OECD. That the Court does not explicitly favour one relief method does not put an end to discussions on which method actually best suits the Internal Market.

Jérôme Monsenego is a Ph.D candidate at the Stockholm School of Economics, guest researcher at the Centre for Tax Law at Uppsala University and tax consultant with Öhrlings PricewaterhouseCoopers in Stockholm. Centre for Tax Law at Uppsala University is supported by Deloitte, Ernst & Young, KPMG, Mannheimer Swartling, Skeppsbron Skatt and Öhrlings PricewaterhouseCoopers.