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3.9 Losses

Although companies expect to earn profits, they may incur losses. Virtually all tax systems
within the EU treat profits and losses asymmetrically: profits are taxed for the tax year in
which they are earned but the tax value of a loss is not refunded by the tax administration
when the loss is incurred. It is thus necessary to set losses off against another positive tax base
within the company or within the group of companies in order to avoid “overtaxation”. That
avoids cash-flow disadvantages resulting from the time lag in the taking into account of the
loss, i.e. as a loss carry-forward and a set-off against future profits, in comparison with an
immediate set-off against another positive tax base. Cross-border loss relief would prevent
losses becoming stranded in different entities. In Case C-397/98 Metallgesellschaft [2001] ECR I-1727 the ECJ already held that cash-flow
disadvantages, as they arise in situations where there is no immediate relief for losses, are sufficient to
conflict with EU law.

A company with several domestic branch operations will in principle be automatically taxed
on the net result, i.e. both the profits and the losses of these branches will be automatically
and immediately taken into account. In most other situations, relief for losses is possible only
where authorised by a specific provision adopted by the respective Member States.

Cross-Border Loss Relief and the Case Law of the ECJ
The ECJ has dealt with cross-border loss offset involving permanent establishments in the
Futura (Case C-250/95 Futura [1997] I-2492)
and AMID (Case C-141/99 AMID [2000] I-11621).

In Futura, the Court looked at the situation from the perspective of the host State of the
permanent establishment, finding that the territoriality principle could justify limiting the
amount of loss carry-forward available in that State to the losses that had an economic link
with income earned there.
In AMID, adopting a home State perspective, the Court found that the exemption from
taxation of Luxembourg permanent establishment profits under Belgium’s double tax
agreement (DTA) with that country did not establish, in respect of loss relief, an objective
difference between the situation of a Belgian company with a permanent establishment in
Luxembourg and that of a Belgian company with an establishment (branch) in Belgium. In
the absence of justification, different treatment of those two companies as regards the
deduction of losses was contrary to the freedom of establishment and could not be accepted, according to the AMID case.

Marks & Spencer Case
The issue of cross-border loss relief between companies was the subject of an ECJ decision
for the first time in the Marks & Spencer case (Case C-446/03 Marks & Spencer [2005]). It was claimed that the refusal to allow the UK
parent to set off against its profits the losses of its foreign EU subsidiaries which did not carry
on business in the UK infringed the freedom of establishment provided for by the EC Treaty.
Trading losses had eventually led to the complete cessation of the activities of most of the
subsidiaries.
The UK put forward several justifications for this restriction: (a) the need for a balanced
allocation of taxing powers between the Member States, (b) the need to prevent losses from
being taking into account twice, and (c) the risk of tax avoidance. The ECJ accepted that these
three factors, taken together, could justify provisions restricting the freedom of
establishment. However, it found that the UK group relief scheme did not respect the
principle of proportionality where the possibilities for having the losses taken into account in
the subsidiary’s State of residence had been exhausted.

The following principles and guidelines may be deduced from the Marks & Spencer judgment: first, in order to
protect a balanced allocation of taxing powers, the State of the parent company would only
grant permanent loss relief in the case of terminal losses. Second, the need to prevent
companies from taking losses into account twice can be addressed by making relief
conditional upon the subsidiary having exhausted the immediate possibilities for loss relief
available in its Member State of residence. Third, the risk of tax avoidance increases when a
group of companies is free to determine when and where it wishes to have its losses (and
profits) taken into account for tax purposes. This problem is greater the more choice a
company has in offsetting its losses horizontally or vertically downwards. Companies would
naturally tend to allocate the loss to companies where the tax value is the highest.

LOSSES INCURRED BY PEs
Losses within a company may be defined as losses incurred by dependent parts of a company,
e.g. separate departments, branches or permanent establishments.

Tax Treatment of Losses in Domestic Situations
Relief for losses arising in domestic operations within a single company is automatically
granted in all Member States ensuring that losses within the company are immediately taken
into account. Since the company will be taxed on the net result of all domestic branch
activities, the relief will be automatically recaptured where the loss-making part of the
company returns to profit.

Tax Treatment of Losses in Cross-Border Situations
The company will usually be taxed, as a non-resident, on the results of the permanent
establishment in the Member State in which the permanent establishment is situated. Under
EC law, the permanent establishment must be granted the same treatment under national law
as resident entities: for example, loss carry-forward or carry-back (e.g. Case C-311/97 Royal Bank of Scotland [1999] ECR I-2651).
The results of the permanent establishment then form part of the overall results of the
company in the Member State of the head office. DTAs normally give the host Member State
the primary taxing rights for the profits of the permanent establishment. The Member State of
the head office will usually have only secondary taxing rights to those profits. The Member
State choice of technique for eliminating double taxation depends on which of the two
methods outlined in Art. 23 of the OECD Model Convention (the credit method or the
exemption method) has been adopted in DTAs with other Member States.

a) Credit Method
The credit method takes worldwide income into account in the company’s State of residence.
Taxes paid abroad are credited against the part of the domestic tax levied on the income taxed
abroad. The credit method therefore works in a similar way to the treatment of losses of
domestic establishments. Any loss will be taken into account when determining worldwide
income.

b) Exemption Method
The exemption method generally excludes foreign income taxed in the source country from
the tax base of the head office. There are generally two possibilities:

  • Without loss deduction. Since results of a permanent establishment are not taken into account at the level of the head
    office, no loss relief is available. This approach is applied by seven Member States.
  • With (temporary) loss deduction. At present, five Member States provide for a deduction of losses sustained by permanent
    establishments situated in another Member State, although profits are exempted. These losses
    are recaptured once the permanent establishment returns to profitability (thereby ensuring tax
    cohesion).

Losses within one Company
Where losses incurred by permanent establishments may not be set off against profits of a
head office (“vertical upward” set-off), there will be a difference in treatment in comparison
with a purely domestic situation. This makes it less attractive to exercise freedom of
establishment and a company may refrain from setting up a permanent establishment in
another Member State. Such a difference in treatment constitutes an obstacle to the freedom
of establishment which is prohibited by Article 43 EC. The ECJ explicitly stated in AMID that
the situation of a company with a permanent establishment abroad is in a comparable situation
to that of a company without one.

The need to prevent losses being taken into account twice may be addressed by a recapture
mechanism. Whereas in domestic situations loss recapture occurs automatically, in crossborder
situations such a recapture mechanism has to be provided for expressly. The fact that
five Member States already do so shows that a system with loss deduction and recapture from
future profits is feasible.
The risk of tax avoidance is very limited for the losses incurred by a permanent establishment,
since losses are taken into account only at the level of the head office (“vertical upward” setoff).

LOSSES WITHIN A GROUP OF COMPANIES
Loss Relief within a Group of Companies
Companies which have legal personality under civil law are generally subject to corporate
income tax in all Member States. The incorporation of an activity results in a separate entity,
not only from a legal, but also from a tax point of view. A group of companies does not have
legal personality under corporate law; nor is such a group recognised as a single taxable entity
in its own right. Therefore, within a group of companies, losses are not taken into account
automatically in the way they are within a company. However, from an economic point of
view, a group of companies can be regarded as a single economic unit. Many Member States
have introduced a domestic system for group taxation in order to treat a group as a single
economic unit. However, only a limited, albeit increasing number of Member States have loss
relief systems that also apply to cross-border situations. Denmark and France have applied such schemes for many years. Italy and Austria have introduced
them as of 2004 and 2005.

The lack of a domestic group taxation scheme distorts investment decisions mainly regarding
the legal form of the investment (it favours the establishment of a branch rather than a
subsidiary), but not decisions regarding the location of the investment. The lack of crossborder
loss relief for groups of companies, however, can also distort business decisions as
regards both the legal form and the location of investment.

Domestic Relief for Losses within a Group of Companies
A minority of Member States do not provide for a domestic system of group taxation. The schemes
applied by the other Member States may be broadly classified in the following three
categories:
(a) system of “intra-group loss transfer”;
(b) “pooling” of tax results of a group; or
(c) full tax consolidation (one Member State).

The term “intra-group loss transfer” covers both “group relief” and the “intra-group contribution”.
Both these types of system allow a definitive transfer of income between companies in
order to relieve losses against profits within a group. Under a “group relief” system a loss
from one group member can be transferred (or “surrendered”) to a profitable group member.
Under an “intra-group contribution” system the profits from one group member can be transferred
to a loss-making group member. To the extent that the “intra-group contribution”
system is used to eliminate losses, it therefore has the same economic effect as a system of
“intra-group loss transfer”.
A “pooling” system involves aggregating all individual tax results (i.e. profits and losses)
from the members of a group at the level of the parent company. This “pooling” is not
necessarily linked to the existence of losses although this will be the main reason for applying
such a system. “Full tax consolidation” goes beyond a pooling system, since for tax purposes
the legal personality of the group members and any intra-group transactions are disregarded.
The results of the group are determined on the basis of a single profit and loss account.
When applied domestically, all methods provide for full vertical upward/downward (i.e.
between parent and subsidiary) and horizontal (i.e. between subsidiaries) loss compensation
within a group. This means that if the group shows an overall net loss, the profits of individual
members of the group will not be subjected to tax, but will be set off against the losses of
other group members. All methods have the effect of providing immediate relief by
preventing losses being stranded in different entities. Owing to automatic recapture, the relief
is generally temporary, until the loss-making subsidiary becomes profitable again. The relief
is permanent only where the losses are terminal.
Simply extending regimes applicable in domestic situations to cross-border situations,
although representing an improvement over the current situation, would not produce an ideal
solution. In domestic situations recapture of the losses is automatic: extending such a scheme
to cross-border situations therefore needs an explicit mechanism for recapture. It could also be
technically difficult to extend all aspects of a domestic system for loss relief to a cross-border
situation. All Member States with a system for cross-border loss relief apply different rules in
cross-border and domestic situations.