On 31 January 2008, Advocate General Paolo Mengozzi of the European Court of Justice (ECJ) gave his opinion in the case of Burda Verlagsbeteiligungen GmbH v. Finanzamt Hamburg-Am Tierpark (C-284/06). The German Federal Finance Court (Bundesfinanzhof) had requested a preliminary ruling from the ECJ on 29 June 2006.

In this case, the Advocate General concluded that national legislation which, where profits are distributed by a subsidiary to its parent company, provides for taxation of the distributing capital company's income and asset increases, while stipulating no such taxation if the profits are retained by that company, is not contrary to Art. 5(1) of the Parent-Subsidiary Directive 90/435/EEC. The AG further opined that a national rule which provides for divergent set-off arrangements for the distribution of profits by a capital company using portions of its own capital, resulting in consequent tax liability even in cases in which the capital company demonstrates that it has distributed dividends to non-resident shareholders, even though, under national law, such non-resident shareholders, unlike resident shareholders, are not entitled to set off against their own tax the corporation tax thus determined, is compatible with the EC free movement of capital (Art. 56 of the EC Treaty) and the EC freedom of establishment (Art. 43 of the EC Treaty).

ECJ: Advocate General finds non-deductibility of foreign PE losses in Germany incompatible with EC freedom of establishment – details

On 14 February 2008, Advocate General (AG) Eleanor Sharpston of the European Court of Justice (ECJ) gave her opinion in the case of Lidl Belgium GmbH & Co. KG v. Finanzamt Heilbronn (C-414/06). Details of the opinion are summarized below.

(a) Facts. The plaintiff, a limited partnership with a limited liability company as general partner, carried on its business activities in Luxembourg through a permanent establishment (PE). In 1999, the Luxembourg PE incurred losses. The German tax authorities denied the offset of these losses against German income tax, as profits attributable to a PE are generally exempt under the Germany-Luxembourg tax treaty. The tax administration allowed the losses only to be taken into account in the determination of the progressive tax rate pursuant to the exemption-with-progression method.

(b) Issue. The issue was whether or not the denial of offsetting in Germany of the losses of a German company's Luxembourg permanent establishment (PE) is compatible with the EC freedom of establishment and the EC free movement of capital (Arts. 43 and 56 of the EC Treaty, respectively), in view of the fact that that PE's income is not subject to taxation in Germany under the Germany-Luxembourg tax treaty.

(c) Advocate General's Opinion.

Scope of EC fundamental freedoms

At the outset, AG Sharpston noted that the German legislation at issue must be examined in the light of the EC freedom of establishment (Art. 43 of the EC Treaty). Referring to the ECJ's settled case law, the AG considered Art. 56 of the EC Treaty (free movement of capital) to be irrelevant in the underlying case.
Infringement of the freedom of establishment

The AG opined that it is prima facie contrary to Art. 43 of the EC Treaty that a company established in one Member State may not deduct losses from a PE in another Member State on the ground that, under the relevant tax treaty, that PE's income is not subject to taxation in the first Member State. According to the AG, an infringement of Art. 43 of the EC Treaty is due to the fact that a German company with a foreign PE is treated less favourably than a German company with a domestic PE (domestic PE's losses can be offset against the company's taxable profits).

Justifications

AG Sharpston first observed that a similar approach as used in the ECJ's decision in Marks & Spencer can be applied to the case at issue, since, from the company's perspective, the ability to deduct losses of a foreign subsidiary by way of group relief is clearly analogous to the ability to deduct losses of a foreign PE. According to the AG, the purpose of group relief is, in fact, to avoid penalising companies which, rather than establishing branches, decide to expand their activities by setting up subsidiaries. The AG thus went on to examine whether the denial of the deduction of the Luxembourg PE's losses could be justified by the grounds accepted in ECJ's Marks & Spencer judgment and, if so, whether the rule in question complied with the principle of proportionality.

AG Sharpston opined that the rule at issue could, in principle, be justified by the first and second Marks & Spencer justification grounds, i.e. (i) the need to preserve the balanced allocation of the power to impose taxes and (ii) the risk that losses could be used twice.

With regard to the first justification, the AG argued that it would constitute a breach of the symmetry between taxation and reliefs agreed by Germany and Luxembourg and reflected in the respective tax treaty if Germany had to grant relief for losses incurred by a Luxembourg PE of a German company where it had waived the right to tax profits made by such PE. In respect of the second justification, AG Sharpston observed that if the losses could be used in the company's residence state, there is a risk that they would be claimed again in the PE state once the PE became profitable, without the company's State of residence being able to recapture the benefit obtained.

The AG further found that the third justification ground, relating to the risk of tax avoidance, is not relevant in this case. In Marks & Spencer, the ECJ considered that the exclusion of group relief for losses incurred by non-resident subsidiaries prevents that within a group of companies, losses are transferred to high tax jurisdictions, where the tax value of such losses is higher. However, the AG argued that in the case of PEs there is clearly no scope for such "jurisdiction shopping" if a company in one Member State is allowed to deduct losses made by its PE in another Member State. Losses made by a PE are losses of the taxpayer "parent" company and they can be directly and immediately deducted in case of a domestic PE. The difference between the domestic and cross-border situation results from the allocation of taxing rights under the relevant tax treaty, which does not affect the fact that the loss accrues to the taxpayer company, directly reducing its taxable income in the residence state. The other state's right to tax simply creates a second connecting factor for the same loss and, therefore, the potential for double deduction.

In view of the doubts expressed by the referring court, as to whether all three justifications must be considered cumulatively, AG Sharpston noted that recent ECJ case law (Oy AA, N and Amurta) shows that this is not necessary.

The AG further opined that an outright prohibition of a loss offsetting is disproportionate as such prohibition may lead to the fact that in certain circumstances, a company will be taxed on more than its total net profits. AG Sharpston considered a deduction-and-recapture rule to be less restrictive than an outright prohibition of loss offsetting for foreign PE losses. In addition, AG Sharpston opined that a loss carry-forward in the PE state could not be considered to be an acceptable alternative to the immediate offset of the PE's losses in the residence state with a subsequent recapture, since it would result in a cash flow disadvantage.

AG Sharpston further rejected the German government's argument that practical difficulties preclude adopting a system allowing for deduction of losses combined with recapture of loss relief, as German law provided for such a rule from 1969 until 1999. Referring to the European Commission's 2006 communication on cross-border loss relief, she also noted that the deduction-and-recapture rule is, currently, applied in 5 Member Stated. She concluded that, in any event, practical difficulties cannot justify an infringement of an EC Treaty freedom.

Finally, the AG opined that the temporal effects of the decision, if the Court were to rule that the freedom of establishment has been infringed, should not be limited. AG Sharpston observed that Germany cannot argue that an objective, significant uncertainty regarding the implications of Art. 43 of the EC Treaty existed at the relevant time, since it reinstated the contested measure by repealing the earlier legislation. By 1999 the Court had already ruled in  ICI that national legislation which essentially denied group loss relief where a majority of the subsidiaries were resident in other Member States was contrary to Art. 43 of the EC Treaty and in Commission v. France (C-270/83) that the freedom of companies exercising their right of establishment to choose whether to do so by a PE must not be limited by discriminatory tax provisions.

ECJ: German treatment of currency loss from repatriation of PE's start-up capital incompatible with EC freedom of establishment

On 28 February 2008, the European Court of Justice (ECJ) gave its decision in the case of Deutsche Shell GmbH v. Finanzamt für Grossunternehmen in Hamburg (C-293/06). The Hamburg Financial Court (Finanzgericht Hamburg) had requested a preliminary ruling from the ECJ on 3 July 2006.

The ECJ ruled that it is contrary to Art. 43 of the EC Treaty, in conjunction with Art. 48 of the EC Treaty, for a Member State, when determining the national basis of assessment, to exclude a currency loss suffered by a company, with a registered office in that State, upon the repatriation of start-up capital granted to its permanent establishment in another Member State.

The Court further held that it is also contrary to Art. 43 of the EC Treaty, in conjunction with Art. 48 of the EC Treaty for a Member State to allow a currency loss to be deducted as operating expenditure in respect of an undertaking with a registered office in a Member State only in so far as its permanent establishment in another Member State does not make any tax-free profits.