In the Marks & Spencer case, the ECJ developed the concept of final loss for the first time. UK tax law stipulated that losses of foreign subsidiaries at a domestic parent company could not be allowed to deduct. Therefore, there is no offsetting of losses between the foreign subsidiary and the domestic parent company. In principle, the ECJ knew this regulation to be in conformity with EU law. Only in the event that the losses of the foreign subsidiary are final, a loss offset must be possible. However, he then made another exception for the purpose of avoiding abuse. We explain when there are final losses.

1st context of the decision

1.1. Problem: Setting off losses with foreign subsidiaries

In the Marks & Spencer case, the European Court of Justice (ECJ) had to decide in substance to what extent losses from foreign subsidiaries can be taken into account in the parent company of the group with its registered office in England.

Marks & Spencer plc retail chain is headquartered in the United Kingdom. The group includes subsidiaries in Germany, France and Belgium. The subsidiaries achieved a loss of approximately 150 million euros. Marks & Spencer wanted to take these losses into account as part of its tax return in England – i.e. at the group parent company. However, the corresponding application of the parent company rejected the English tax administration. The reason for the refusal was that the group deduction was limited to profits and losses falling within the scope of UK tax law. The claimed losses are those of the subsidiaries and therefore not eligible in England.

1.2.Law in England at that time

In English tax law, there was the possibility of group taxation at that time, whereby the parent company of a group could offset its profits against the losses incurred in its subsidiaries ("group relief"). However, as the British tax administration had correctly recognised, this offsetting of losses was limited to profits and losses which fall within the scope of British tax law. The High Court of Justice submitted these rules to the ECJ in the context of the preliminary ruling procedure and had them examined for their conformity with European law.

2. refusal of loss offsetting as an interference with the freedom of establishment actually justified

2.1. Freedom of establishment as a test measure

The ECJ examined the British regulation against the criterion of freedom of establishment. Today, freedom of establishment is regulated by Article 49 TFEU. The freedom of establishment shall guarantee the right to take up and pursue self-employed activities and to set up and manage undertakings and branches in another Member State. The free choice of location within the European Union is therefore guaranteed. Eligible persons are also companies, provided that they are incorporated in a Member State and have their principal place of business or head office in the EU.

Then there is the question of how far the protection of the freedom of establishment extends and when the Member States have sufficiently secured the freedom of establishment. Initially, it was argued that opening up the possibility of integrating a foreign society into the economy of the host state should actually be equal to the nationals. The granting of legal protection of the freedom of establishment has now extended the ECJ to a further restriction ban. It is therefore clear that, according to the understanding of the ECJ, the scope of protection of the freedom of establishment is not limited to clear discrimination, such as through exit taxation. Rather, the legal protection content goes beyond that. Nevertheless, there is no absolute European restriction ban. Otherwise, for example, the basic world income principle would always need justification from the outset. A restriction on the freedom of establishment shall apply where there is a difference in tax treatment which would penalise the foreign economic operator who exercised his right of establishment or which could have a deterrent effect on the exercise of the freedom of establishment.

It is therefore crucial which comparison pair is used for the assessment of unequal treatment. It is precisely the choice of comparison pairs that influences the outcome of the equality test and thus the examination of the freedom of establishment.

2.2. Unequal treatment in individual cases

In the Marks & Spencer decision, the ECJ made the following set of comparisons: on the one hand, there was a parent company which is based in the United Kingdom but which has a subsidiary whose main activity is in another Member State. On the other hand, there is a group whose subsidiary is equally economically active in England. Comparison is thus made between the cases in which the subsidiary is based once at home and once abroad. The ECJ accepted unequal treatment in so far as the preferential group taxation is not granted in the case of a foreign subsidiary. Thus, it is precisely the loss accounting that is failed. In the case of purely domestic matters (parent company and subsidiary in the country), on the other hand, there was the possibility of advantageous group taxation.

However, the ECJ has just not considered offsetting the losses of parent companies with permanent establishments. He alone compared purely domestic situations between parent company and subsidiary with the case in which the subsidiary has its registered office abroad. The ECJ therefore did not include premises in the consideration. However, the lack of inclusion cannot justify the conclusion that there is no comparability between a subsidiary and an establishment. The reason for the non-execution was that, in the case under assessment, only subsidiaries were involved and therefore premises were not relevant.

2.3 Justification of unequal treatment

2.3.1. Comprehensive justification

The consequence of this broad interpretation of the guarantee content of the freedom of establishment is, on the other hand, that the ECJ grants direct tax law the possibility of unwritten justification even in the case of discriminatory unequal treatment. The intervention is therefore more easily justified and thus more in line with EU law. The aim is to achieve at least the level of justification through this handling. If the Member State legislation does not already constitute an interference with the fundamental freedom – specifically the freedom of establishment – then the Member States will have almost freedom of action in this area. The measure need not be measured by the freedom of establishment. Control by the European courts is then limited to abuse cases or is no longer possible.

2.3.2 Reversal of the burden of proof

In any case, there is unequal treatment in purely domestic matters with regard to the situation with a foreign subsidiary. This unequal treatment is therefore in need of justification. Unequal treatment is justified if it suitably pursues a legitimate interest of the public interest. Where there is an interference with a fundamental freedom, this shall give rise to a presumption of infringement of that fundamental freedom. The consequence of this is the reversal of the burden of presentation and proof. So now the Member States have a duty of justification.

2.3.3. Possible grounds for justification

In addition to the written justification reasons, unwritten justification reasons come into consideration. An unwritten ground of justification lies in generally accepted public interest concerns. All interests in the general interest are taken into account.

No sufficient justification has, however, the undifferentiated appeal to the lack of harmonization in tax law. Nor is the argument of the loss of tax revenue sufficient. If the loss of tax revenue were sufficient justification, the state could always argue with lost tax money. Then any tax measure would be justified.

Nevertheless, the ECJ accepted the existence of a ground for justification. Specifically, the ECJ allowed for unequal treatment in order to safeguard the distribution of tax rights between the participating countries. The distribution of taxation rights between Member States is based on the preservation of the distribution of taxation powers, the prevention of double accounting for losses and the reduction of the risk of tax evasion. Under these considerations, the refusal to offset losses for a foreign subsidiary with the domestic group parent company is justified in principle.

No justification for final loss

3.1. Denial of loss offsetting disproportionately at final loss

However, the refusal to offset losses must also be proportionate. It is disproportionate if the loss of the subsidiary is no longer fully taken into account in any state by offsetting losses. Rather, a one-time use of the losses in Germany must be ensured. If the losses of the subsidiary have become final in other EU countries, the group parent company must be able to take them into account in the other Member State. However, the loss consideration via this way should only be made possible in exceptional cases – the case that final losses are present is the exception. Whether this exceptional case exists, the taxable person must prove.

3.2 But: Return exemption for abuse prevention

Therefore, the refusal of loss offsetting is justified in principle and thus also in accordance with EU law. Exceptionally, however, final losses at the parent company must be taken into account. This is the case when the losses have become final. However, the ECJ introduces a withdrawal exemption. As a result of the derogation, Member States do not have to take into account any finalised losses for the purpose of offsetting losses. This can be done by means of a concrete fight against abuse by the Member States in order to avoid loss transfer practices. If the Member State's objective is not to take a final loss into account for the purpose of combating abuse, this is legitimate.

4th definition of final losses

4.1. Significance of final losses

Decisive for the possibility of offsetting losses is therefore whether there are final losses. Losses are final if they are currently and will not be taxable in the source state. Only when this is the case must the Member State of the group parent company make cross-border loss offsetting possible.

When losses are final, however, the ECJ leaves open in its previous judgments. For companies, the incentives to finally incur losses abroad in order to be able to claim them in another state are high. Loss offsetting in the other Member State can reduce the overall burden there.

4.2 Relevant right to assess final loss

The loss must become final in the source state. Accordingly, in the source state, the exploitation possibility with regard to the loss must be eliminated. The law of the source state is therefore decisive. Actual circumstances also play a role here. There can only be a loss as long as profits are not made at some point.

The first criterion is therefore the legal settlement option in the source state. The legal circumstances are the yardstick of what is actually exhaustible. If the legal circumstance is established, the factual circumstances are relevant at the second stage. In particular, the active exercise of these legally available regulations by the subsidiary in individual cases must also be observed.

4.3 Case groups of final losses

4.3.1. Final loss on liquidation of a subsidiary

In the event of liquidation of the subsidiary, a loss may become final. There is no prospect that negative income will be taken into account in the source country in the future if the initial settlement assets exceed the final settlement assets. Then it is not possible to offset the liquidation loss with other income of the corporation, since this does not exist. Accumulated losses are to be offset against only possible unrealised gains (silent reserves). Loss carry-forwards in subsequent investment periods, on the other hand, are not possible since the limited company as such no longer exists. The liquidation can be proven by submitting the deletion in the commercial register.

4.3.2. Recruitment of an establishment

The assessment of final losses of a permanent establishment is much more difficult than in the liquidation of a subsidiary. Conceptually speaking, one cannot speak of a liquidation if the permanent establishment is no longer operated. It is rather a mere attitude.

Another problem is that the activity of an establishment is much more “volatile” than the operation of a subsidiary. The permanent establishment shall not have its own legal personality. Rather, it depends on the parent company. Because of this dependence, the finality of the loss of the permanent establishment is much more difficult to establish if the parent company maintaining the permanent establishment continues to exist.

Furthermore, it is problematic at which time the business activity was actually discontinued. If there are several loss-making establishments in the relevant Member State, it is already questionable whether their individual result is relevant or whether they should be recognised in their entirety in the Member State. If the latter is relevant, loss offsetting possibilities can also be opened up by subsequently established, profitable establishments. However, it is also conceivable that a company once set up will resume its activity after a certain period of time. Losses may then be usable abroad under certain circumstances. Then there is the danger of double loss use.

4.3.3. Mergers of companies

The merger causes the legal identity of the company being acquired to cease. As a result, existing loss carry forwards are regularly eliminated. Whether it comes to the removal, however, depends on the regulations in the relevant conversion tax law. In addition, a merger may result in the discovery of hidden reserves and their offsetting against existing loss amounts. Therefore, depending on the configuration of the conversion control law, a loss shift across the border can also occur by means of a merger. This can also be the goal of the merger.

In Germany, conversion tax law currently provides for the loss carry-forward to be cancelled: Although the acquiring company enters the tax position of the transferring company by way of universal succession (§ 14 (3) half sentence 1 UmwStG). Nevertheless, the reference in § 14(3), half-sentence, UmwStG to § 4(2), second sentence, UmwStG does not lead to the actually logical loss transfer. Rather, the loss goes down.

The reason for this is that the reduction in economic performance associated with the losses is considered a “highly personal circumstance”. Thus, the loss deduction authorization is restricted subject-related. The purpose of the regulation was precisely to avoid a loss offset that was actually required and not to have to take foreign losses into account at home. It is questionable, however, whether the opposite has not been achieved: the consequence of the scheme may be that the losses abroad become final precisely because of the lack of transfer possibility to the domestic market and therefore have to be taken into account in the domestic market precisely because of the Marks & Spencer decision.

4.3.4. Changes in legal form

A further conversion process concerns the change of legal form. Changes in the legal form of a limited liability company to a partnership result in a merger. Therefore, it also applies here that by way of a change of legal form, it can also be attempted to make losses final.

4.3.5. Sales

The subsidiary can also be sold. Then their legal identity does not change. In principle, the losses are therefore still usable with the acquirer. In some EU countries, however, there are rules according to which loss carry-forwards are lost when the company law participation is sold. The background to such regulations is that only the corporation should use a loss for tax purposes, which has also generated it. The aim is therefore to prevent trade with economically emptied, but taxable loss companies. Consequently, even if the shareholding is sold, the finality of the loss depends on the scheme in the State of the subsidiary.

5th Summary

Quintessence of the Marks & Spencer judgment is that a blanket exclusion of cross-border loss offsetting in the Group is no longer permitted under European law. It is true that there is a need for the correct allocation of control substrates within the internal market. However, the exclusion of loss offsetting must not lead to losses not being offset anywhere. In this case, the parent company’s country of residence must allow for loss offsetting.