4.2.2.2 Loss compensation

Introduction

With respect to cross-border loss utilization, a distinction should be made between ‘losses of other entities’ and ‘own losses’,1 or ‘losses of a subsidiary’ and ‘losses of a permanent establishment’. The first, for example, concerns a taxpayer that has – legally independent – group members in different countries of which one or more are loss-making. These losses are generally not taken into account at the level of the parent company. An example of the second, a loss within a company, is the negative income attributable to a foreign permanent establishment. In many countries those permanent establishment losses are automatically imported, as the foreign permanent establishment is not a separate legal entity. Permanent establishment losses are thus treated different for national tax purposes than losses from a subsidiary. The reason for the difference in approach is the fact that the income – being either positive or negative – of the foreign permanent establishment is part of the worldwide income of the resident taxpayer. From a legal perspective this is logical, as the permanent establishment is part of the head office. From the perspective of economic reality as well as neutrality, the outcome should be the same whether or not cross-border activities are conducted either via a subsidiary company or via a permanent establishment, as the juridical design of a structure should not impact its tax implications. Thus, from an economic perspective both situations should be treated in the same manner, as the difference in outcome is solely caused by a difference in legal form.

Generally, loss-making permanent establishments or subsidiaries have the possibility to set off losses against their own profits in previous or future years. So at a first glance, it does not seem conceptually necessary to provide for any rules that deal with cross-border loss compensation. However, if there are no profits from previous years and no future profits are expected, the question arises whether the possibility should be provided to compensate the losses with profits made by group companies in the same country or abroad. Additionally, not being able to compensate losses cross-border in the year they occur, leads to a liquidity disadvantage for the group. From a group perspective, providing a loss compensation rule that does not restrict the loss compensation possibilities solely to the loss-making entity but also considers group entities (either domestically or abroad) is more in line with economic reality.2 After all, if no such loss compensation is possible, the group could have to pay more taxes on balance than would be logical given its economic situation.3

Various existing group taxation regimes provide loss compensation possibilities. Both the group contribution system and the group relief system allow a transfer of income between companies to relieve losses against profits of group entities. Under a consolidation regime all profits and losses of the various group members are attributed to one group entity, generally the parent company.4 Those systems normally only apply to domestic subsidiaries.

To create more equality between domestic and cross-border investments, a system would be required that allows foreign losses to be deducted against domestic profits, followed by a recapture in subsequent years.5 Under such a mechanism a country can tax foreign profits up to the amount of the losses that were previously deducted. This prevents one of the downsides of cross-border loss relief: the risk that the same loss is used in more than one jurisdiction. Restrictions on cross-border loss compensation are an obstacle for cross-border activities.6 The principles of the internal market require the possibilities for balancing cross-border profits and losses within the EU should be as extensive as they are for national groups of companies.7 Limited loss compensation possibilities entail a risk of economic double taxation if the losses cannot be used at the local level. Under these rules domestic investments are favoured over investments abroad.8 Moreover, investments in larger Member States might be more favourable.9

Various loss relief methods that provide some form of fiscal consolidation or loss or profit carry-over mechanism are currently applied in the Member States. In many of these Member States, foreign permanent establishment losses are automatically imported (applying a credit or recapturing method), as they are part of the head office. However, losses from subsidiaries that are part of the same group but are located in different EU countries are generally not available for loss set off.

Several attempts to introduce general rules on loss compensation have been made by the EC. In 1984 and 1990, the EC presented proposals for a Directive10 that allows parent companies to take into account losses incurred by permanent establishments and subsidiaries situated in another Member State. The EC sought to ensure that companies carrying out activities within different Member States are not treated less favourably than undertakings operating in a single Member State.11 In order to qualify for the draft Directive, a direct participation of at least 75% was required. The draft Directive essentially aimed to establish the principle of equal treatment for all manners in which businesses are conducted. The group approach in this system eliminates economic double taxation. The losses of foreign permanent establishments or subsidiaries would be included in the taxable basis of the head office or parent company. Moreover, the draft Directive included an automatic recapture rule after expiration of five years. Even though the automatic recapture rule does not make sense from an economic point of view, the implementation of this Directive would have been a good step towards better reflecting the economic reality of groups of companies within the EU with regard to loss compensation. This is the case because the proposal provides for rules to take cross-border losses into account. Also, the proposal aims to treat permanent establishments and subsidiaries in a similar manner. However, the proposal has been withdrawn as it was no longer considered topical.12

In 2003, a tax policy document was published indicating that the EC was considering a joint taxation system.13 The considered system was based on the Danish group taxation system. According to those rules, a Danish parent company, its permanent establishments and its foreign subsidiaries are, in certain cases, jointly taxed in Denmark. The parent company thus was able to take into account losses incurred not only by its foreign permanent establishments, but also by its foreign subsidiaries. Hence, foreign subsidiary losses are imported under the rules as if they were permanent establishment losses. Such a system would better reflect economic reality within a group. However, the idea for a joint taxation system based on the Danish system has not resulted in a proposal.14

Instead, after the Marks & Spencer case to be discussed below, the EC published a Communication that explains the basic principles and problems with respect to cross-border loss relief in 2006.15 In the Communication suggestions are made for ways in which Member States may allow the cross-border relief of losses in certain situations. The Communication aims at co-ordinating systems of cross-border loss relief between Member States. It focuses both on loss relief for ‘losses of other entities’ and for ‘own losses’. The Communication not only aims at ensuring that loss relief can be implemented in these cases, but also that both categories mentioned above are treated equally. As indicated, in my view a similar treatment of ‘losses of other entities’ and ‘own losses’ is something positive, as it would not be relevant from an economic perspective through which legal form losses have been incurred within a group. However, the soft law Communication seems to have had very little effect.

In 2008, the EU Parliament issued a resolution that calls for adequate coordination among Member States.16 Later on, the EC tried another approach: the draft CCCTB and CCTB directives would, inter alia, provide for cross-border loss compensation for groups of companies within the EU. These draft directives will be discussed in chapter 5.17

All in all, it does not seem likely that a specific directive on loss compensation will be agreed upon any time soon. In the meantime, various judgments on cross-border loss relief have been rendered. Below several important judgments are described briefly.18 Subsequently, it is analysed whether or not a group approach is applied. Then, the extent to which cross-border loss compensation is already part of the OECD MTC is elaborated upon. Furthermore, it is discussed whether, assessed from the goals of the OECD MTC, cross-border loss compensation should be part of the model.

Marks & Spencer (‘losses of other entities’)

The Marks & Spencer case19 concerned a United Kingdom rule regarding the carry-over of losses. This rule made it possible for one group company to transfer its losses to another group company (e.g., from a subsidiary to a parent company). However, such transfers of losses were restricted to group companies that were established in the United Kingdom. It was impossible for a subsidiary in another Member State to transfer a loss to its parent company in the United Kingdom. According to the CJEU, the liquidity deficiency resulting from not using the foreign losses immediately constituted a restriction to the freedom of establishment.

Three factors to justify the restriction were put forward. First, profits and losses should be treated in a symmetrical manner to protect the balanced allocation of the powers to impose taxes between Member States. Second, taking the loss into consideration at the level of the parent company could lead to double loss compensation. Third, the rules were imposed to avert the risk of tax avoidance.20 Considering the three reasons – taken together – the CJEU concluded that the restrictive provisions pursue legitimate objectives which are compatible with the treaty freedoms and constitute overriding reasons in the public interest and that they are apt to ensure the attainment of those objectives.21 In principle the denial of cross-border loss relief was considered a proportional measure. However, the CJEU concluded that an entire exclusion of the import of foreign losses in the United Kingdom goes beyond what is necessary to attain the objectives pursued.

The United Kingdom in principle did not have to accept foreign losses to be compensated with domestic profits. Still, in situations in which the foreign subsidiary has exhausted the possibility to use those losses in its Member State, the United Kingdom has to allow cross-border loss compensation. This would be the case if the non-resident subsidiary has exhausted the possibilities available in its residence state of having the losses taken into account for the accounting period concerned by the claim for relief as well as for previous accounting periods,22 and there is no possibility for the foreign subsidiary's losses to be taken into account in its residence state for future periods either by the subsidiary itself or by a third party, in particular where the subsidiary has been sold to that third party.23

Taking into account the final losses of a group company, as is prescribed by the Marks & Spencer case, entails a variant of a group approach. It is a logical outcome from a conceptual point of view. By so doing, the economic double taxation that would result from not being able to take into account the final losses at the local level can be avoided. From the Marks & Spencer case it does not clearly follow when a loss is considered to be a final loss. This has been the subject of debate in various following judgments. The CJEU cases that have been delivered on cross-border loss compensation after Marks & Spencer narrow the possibilities under which it is required to take losses into account.24 The case law is not entirely clear,25 but generally the CJEU does not consider losses to be final losses easily. Losses cannot be considered to be final if there is a possibility of deducting those losses economically by transferring them to a third party.26 The approach for final losses may also apply with respect to losses of a sub-subsidiary.27

Lidl Belgium (‘own losses’)

In Lidl Belgium28 the CJEU had to render a judgment regarding the possible deduction of cross-border losses incurred by a foreign permanent establishment.29 Lidl Belgium, a limited partnership with its registered office in Germany, conducted activities via a permanent establishment in Luxembourg. The permanent establishment incurred a loss. Lidl Belgium sought to deduct the foreign loss from its German tax base. The German tax authorities denied the deduction of the loss based on the allocation of taxing rights provided for in the tax treaty between Germany and Luxembourg. In line with the tax treaty, the permanent establishment profits were exempted from taxation in Germany. Therefore, the results of the permanent establishment were eliminated from the taxable base of the undertaking altogether.

The CJEU judged that, due to the application of the freedom of establishment, Germany was not allowed to make it less attractive to set up a secondary establishment in a foreign country. This is also the case for permanent establishments which, according to the CJEU, are considered to be autonomous entities under tax treaty law.30 In a purely domestic situation (i.e., a German head office and a German permanent establishment), the permanent establishment loss would have been immediately deductible at the level of the head office. Therefore, a company with a registered office in Germany and a permanent establishment in another Member State is treated less favourably, which means the freedom of establishment is restricted. Two justification grounds were successfully put forward: the need to preserve the allocation of the power to impose taxes between the Member States concerned and, secondly, the need to prevent the danger that losses may be taken into account twice. Unless all possibilities have been exhausted in the host state, the offsetting of cross-border losses is not mandatory for a Member State. Thus, the Lidl Belgium case in essence extended the scope of the Marks & Spencer decision to foreign intra-EU permanent establishments.31 However, the Marks & Spencer criteria were not met in the case.32

In the Lidl Belgium judgment, a juridically dependent permanent establishment is seen as equal to a legally independent entity.33 It seems strange that the CJEU states that the permanent establishment is normally seen as an autonomous entity under tax treaty law. It is true that a separate entity approach is applied to determine the profits of a permanent establishment, but from a tax treaty perspective the permanent establishment as such is viewed as part of the head office. A foreign subsidiary is not part of a domestic taxpayer and thus not subject to domestic tax. As a starting point, horizontal loss relief is not possible in that case. For a foreign permanent establishment, however, as it is part of the domestic taxpayer, horizontal loss relief is often the rule. Irrespective of the above, the outcome is clear: the CJEU extends the Marks & Spencer decision to permanent establishments. Even though this seems questionable from a juridical perspective, from an economic perspective is makes perfect sense. As the Lidl Belgium case revolves around own losses, it cannot be said to entail a group approach.

X Holding (‘losses of other entities’)

In the X Holding judgment,34 the CJEU ruled that a statutory prohibition of a cross-border fiscal unity does not meet with objections under EU law. X Holding is an entity established in the Netherlands, which holds all shares in company Y. Y, which is incorporated under Belgian law and is effectively established in Belgium, does not have a permanent establishment in the Netherlands and is also not subject to Dutch corporate income tax. X Holding and Y wish to form a fiscal unity for purposes of the Dutch corporate income tax Act. This request is not granted by the tax inspector because Y is not established in the Netherlands.

The CJEU ruled that the situation in which a resident parent company with a resident subsidiary wishes to form a fiscal unity is objectively comparable to the situation in which a resident parent company with a non-resident subsidiary wishes to form a fiscal unity. Because of the comparability of the two situations, there is, in principle, an infringement of the freedom of establishment. The restriction in the Dutch fiscal unity regime, as a result of which only companies which are subject to Dutch corporate income tax are eligible for application of the regime, is justified by the need to maintain the division of the taxing rights between the Member States of the EU. If a cross-border fiscal unity were to be allowed, parent companies would have the option of forming a fiscal unity with subsidiaries in one year and ending this fiscal unity again in a subsequent year. In this way, they would have freedom of choice as to in which Member State they wish to deduct the losses of a foreign subsidiary.35 It therefore follows from the judgment that the Netherlands is not obliged to include entities established abroad that are not resident taxpayers or foreign taxpayers in the Netherlands in a fiscal unity.

The X Holding judgment seems to reject extending domestic group taxation regimes to cross-border situations as such. The CJEU interpreted the case as a material case on the allowability of cross-border loss compensation, even though no reference was made to losses in the facts of the case.36 If the request for a cross-border fiscal unity would have been allowed, this would have meant that the Belgian subsidiary would have been treated as a permanent establishment. The losses of this permanent establishment would have been deductible from the profits of X Holding. By rejecting the possibility to include the foreign entity in the fiscal unity, the group situation is not taken into account. This could lead to economic double taxation. The X Holding judgment has been heavily criticized in the literature, as it does not seem to be in accordance with other judgments.37

A Oy (‘losses of other entities’)

The case A Oy38 concerns a Finnish undertaking (A) whose business is retailing furniture. A Oy has a subsidiary (B) in Sweden.39 Due to trading losses, several sales outlets of B are closed. B did not intend to continue trading in Sweden; however, it was still bound by two long term-lease contracts for business premises. Considering the cessation of B’s activities, A planned to merge cross-border with B, with A as the surviving entity. By so doing, it would be possible to transfer B’s lease contracts to A. The question arose whether A would be allowed to deduct B’s existing losses after the merger. According to the Finnish tax authorities this would not be the case. Still, the Finnish court raised the question whether the Finnish legislation contains a restriction of the freedom of establishment and if so, whether such a restriction may be justified. If both A and B would have been resident in Finland, A would have been allowed to use B’s losses, as long as the merger had not been carried out for the sole purpose of obtaining a tax advantage. The CJEU concluded that the situations were objectively comparable40 and the approach taken in Finnish law restricted the freedom of establishment. In line with the Marks & Spencer judgment, the CJEU ruled that the restrictive measure goes beyond what is necessary to attain the essential part of the objectives pursued in a situation in which the non-resident subsidiary has exhausted the possibilities available in its state of residence of having the losses taken into account.41

This case entails a variant of a group approach, as the outcome of the Marks & Spencer judgment is extended to the cross-border merger of the undertakings. As in a domestic context there would have been the possibility to transfer the losses, this possibility should also be given in a cross-border situation if the losses are final.

Papillon (‘losses of other entities’)

In the Papillon case42 the CJEU gave its judgment on the compatibility of the French group regime with the freedom of establishment. The case revolved around the answer to the question whether it is in accordance with EU law that a resident company is allowed to form a tax group with a resident sub-subsidiary if the entity is held through one or more resident companies, while this is not allowed if the entity is held through a non-resident intermediary company that does not have a permanent establishment in that Member State. In this case a French company held 100% of the shares in a Dutch entity. The Dutch entity held 99,99% of the shares in a French company, which held various subsidiary companies in France. The parent company in France opted for application of the French group consolidation regime. This request was rejected, as the parent company may hold another of the group’s member companies indirectly only through a company which in itself is a member of the integrated group and is therefore subject to corporate taxation in France.43

The CJEU noted that the group taxation regime aimed to treat, as far as possible, a group constituted by a parent company with its subsidiaries and its sub-subsidiaries in the same way as an undertaking with a number of permanent establishments, by allowing the results of each company to be consolidated.44 According to the CJEU that objective can be attained both in a situation in which all entities are established in the same Member Sate, as well as in the situation in which the parent company holds sub-subsidiaries in its Member State through a subsidiary in another Member State. Therefore, both situations were considered to be objectively comparable. As a result, the difference in treatment led to a restriction which is in principle prohibited by the freedom of establishment.45 One of the justifications that was put forward was that the restriction was necessary in order to prevent losses being used twice. Double loss compensation could be the outcome if a loss would be suffered at the level of the consolidated group as well as at the level of the parent company of the group via a write-down of the value of the shares in the non-resident intermediate company. Excluding the possibility of loss compensation altogether was considered a disproportionate measure by the CJEU, inter alia, due to the existence of a Directive on administrative cooperation which provides the possibility for France to request Member States for all relevant information. In the end, the CJEU judged that the consolidation of the two French companies with an intermediary foreign link should be possible. It should thus be possible to apply a group regime for the parent and the sub-subsidiary, even though there is a foreign intermediary company in the structure. As a direct shareholding between the two French companies was not required, the range of situations that can fit within the definition of tax group for French tax purposes is broadened by this judgment.46 This means the group concept is given a broad scope of application.

A group approach for loss compensation?

As follows from the case law, the CJEU applies a variant of a group approach in various situations. As the CJEU does not consider a loss to be a final loss easily, strict requirements are imposed to be required to apply a group approach with respect to loss compensation. Of course, countries can choose for more flexible loss compensation rules under their national law. However, the general point that can be extracted from the case law is that in group situations it can under certain circumstances be necessary to take into account losses of a foreign subsidiary to ensure that the freedom of establishment is not hindered. In this respect a similar approach is applied for subsidiaries as well as for permanent establishments, as the Marks & Spencer approach has been extended to permanent establishments. This seems logical from an economic perspective, as from that perspective it does not matter whether the losses have been incurred via a permanent establishment or a subsidiary. Apart from that, under certain conditions the A Oy case prescribes a group approach for cross-border mergers. In the Papillon judgment the CJEU in essence ruled that the group treatment for French resident companies had to be possible, also in situations where the connecting company was located abroad. This broadens the scope of the concept of tax group for French tax purposes. The outlier regarding applying a group approach is the X Holding judgment: in that case the group situation was not taken into account.

Loss compensation & the OECD MTC

Is a group approach with respect to loss compensation, that is to some extent applied on an EU level, applied in the OECD MTC? Tax treaties do not provide for a rule that deals with loss compensation for losses of other entities as such.47 The intra-group transfer of losses mainly gives rise to a tax treaty issue if the transfer has a cross-border element. Basically, a tax treaty issue will therefore only arise if a domestic group taxation regime is applicable to cross-border situations.48 It could be argued that art. 7 OECD MTC would apply in this regard, which would not object against foreign loss recognition.49

Additionally, a provision that is potentially relevant for loss compensation in a treaty context is the non-discrimination article.50 In brief, this article provides for an equal treatment principle. Based on this principle, it could be argued that the domestic rules that allow for the transfer of losses should be extended to non-resident companies. This would allow cross-border loss relief. According to the OECD Commentary this is not the case.51 It is stated that par. 5 of the non-discrimination article only relates to the taxation of resident enterprises and not to that of the persons owning or controlling their capital. It does not extend to rules that take into account the relationship between a resident enterprise and other resident enterprises, such as rules that allow a transfer of losses. According to the OECD, it is thus not possible to extend domestic transfer of loss rules via the non-discrimination article.52

Would a group approach with regard to loss compensation fit within the scope and objective of the OECD MTC? The fact that tax treaties do not provide a rule to deal with loss compensation is logical, as tax treaties allocate taxing rights. Thus, all issues (i.e., if a carry-back or carry-forward mechanism is available) regarding the treatment of losses are left to domestic law. Whether or not a country would be open to some form of cross-border loss compensation is in essence a policy decision. It can be argued that, as tax treaties aim to stimulate cross-border investments,53 some form of cross-border loss relief in group situations seems logical. In cross-border cases, the set-off of losses once also fits within the policy goal of preventing double taxation, without providing possibilities for tax avoidance. In the case of losses in a group company, a separate entity approach can give a wrong picture. It does not reflect economic reality if companies within a group are regarded as independent legal entities. However, a general provision on loss compensation would not fit within the OECD MTC in its current format as the treatment of losses is solely governed by domestic law.54 More attention for cross-border losses in tax treaty situations would require a comprehensive solution. In my view this could be done by treating a multinational group of companies as one single taxpayer, which would automatically provide loss compensation possibilities. This will be elaborated in more detail in the next chapters.