After England’s disappointing showing in the recent Euro 2004, the latter part of 2004 could prove to be equally disappointing for the UK Government in its dealings with the Continent. The European Court of Justice (ECJ) is poised to hear the latest in a succession of tax cases that will strike at the heart of the UK tax system and its relationship with European Community (EC) law. Marks & Spencer v Halsey should soon be heard by the ECJ, which many commentators see as a seminal case in the ECJ’s tax jurisprudence. A victory for the taxpayer will call into question the legitimacy of the territorial basis of taxation and will leave the relationship between UK domestic law and EC law in tatters.
Since 1962, the European Commission has harboured ideas of a harmonised corporate tax system throughout the member states, acknowledging that having different tax regimes in member states creates significant obstacles to the free and full functioning of a single European market. However, it has been recognised in a number of ECJ cases, from Schumacker to Hughes de Laysteyrie, and indeed vocalised by the current Government, that direct taxation does not fall within the jurisdiction of the EC.
Direct taxation belongs to the member states, albeit that they must exercise their powers in compliance with EC law, in particular so as to not infringe any of the fundamental freedoms set out in the EC Treaty. The EC Treaty does not deal with direct taxation as such, although two of the fundamental freedoms have been regularly used by the ECJ to strike down domestic tax legislation. Article 43 of the EC Treaty enshrines one of the fundamental freedoms – the freedom of establishment. The second paragraph of Article 43 prohibits any restriction on the right to set up and manage undertakings, such as subsidiaries, in another member state. Article 56 prohibits all restrictions on the movement of capital between member states and between member states and third countries.
Marks & Spencer
The facts of the Marks & Spencer case are well known. The retailer had subsidiary companies resident in Belgium and France that were loss-making. It sought to surrender these losses by way of group relief to shelter UK-taxable profits of the UK parent. The UK’s group relief provisions only allow for losses of a UK resident subsidiary (or UK permanent establishment of a non-UK resident subsidiary) to be surrendered to its UK parent and not losses incurred by a foreign subsidiary without a UK permanent establishment. This is as you would expect from a territorial-based system of taxation, under which UK residents are taxed on their worldwide profits, but non-UK residents are taxed only on UK source profits. Marks & Spencer argued that these rules were in contravention of paragraph two of Article 43 of the EC Treaty, in that by preventing the loss-surrender of a non-UK resident subsidiary, they constituted a barrier to the exercise of the freedom of establishment and made it less attractive to set up a subsidiary outside the UK.
Will Marks & Spencer win? To do so it will need to show that there has been discrimination based on grounds of nationality – something it failed to achieve in front of the Special Commissioners of Income Tax. Discrimination requires the application of the same tax rules to objectively different situations, or the application of different tax rules to objectively similar situations. Indeed, Article 58 of the EC Treaty specifically provides for member states to apply tax laws that distinguish between taxpayers which are not in the same situation as regards their place of residence, or with regard to where their capital is invested. The Schumacker case similarly makes it clear that, in relation to direct taxes, the circumstances of residents and non-residents are not, as a rule, comparable. The critical issue for the ECJ will be to determine what the correct comparison is.
The defence likely to be advanced by the UK Government is that a UK parent with a French subsidiary is not in the same objectively comparable position as a UK parent with a UK subsidiary because, in accordance with the principle of territoriality, the UK taxes the French subsidiary and the UK subsidiary differently. The French subsidiary’s profits are not taxed in the UK and thus neither should its losses be relieved within the UK tax system.
Support for this contention derives from the ECJ itself in the Futura Participation case, which concerned the carry-forward of Luxembourg branch losses by a French company and the need to show that the losses of the company were economically linked to the branch. In that case, the court ruled that “such a system, which is in conformity with the fiscal principle of territoriality, cannot be regarded as entailing any discrimination, overt or covert, prohibited by the EC Treaty”.
Notwithstanding what may be a well-argued defence, the ECJ has itself demonstrated a voracious appetite for striking out member states’ tax systems on a more purposive and simplistic view of what is meant by discrimination, and by limiting the effectiveness of the defences to differentiated tax treatment in Article 58.
If Marks & Spencer gets a favourable ruling from the ECJ then we can expect the Government to consider changes to its group relief provisions, as it has had to change the thin capitalisation legislation following the ECJ decision in Lankhorst-Hohorst. One possibility is to allow both UK and non-UK resident subsidiaries to surrender losses, but only insofar as they derive from operations in the UK. While this would treat UK and non-UK residents alike, it would prevent UK residents from using losses in the UK that arise from overseas branch operations.
There will also be a potentially significant loss to the Exchequer, as a large number of multinationals are party to a group litigation order seeking restitution or repayment of tax on the same basis as Marks & Spencer.
Corporate tax approximation
What these cases demonstrate is the destructive power of the ECJ. As guardian of the EC Treaty in the tax field, it can make great swathes of tax legislation in member states unlawful, but it cannot replace it with anything. Member states then react unilaterally, and invariably inconsistently, to an ECJ decision.
The response to the Lankhorst-Hohorst decision is a case in point. Some member states, including the UK and Germany, provided that thin capitalisation legislation would also apply to purely domestic lending relationships; others, such as Spain, decided that there would be no thin capitalisation legislation at all. This generates the sort of internal tax competition that the EC is trying to avoid and the numerous ECJ decisions in favour of the taxpayer are counter-productive. Member states look less to harmonising corporate taxation and more to protecting their own revenues through unilateral measures, some of which are barely disguised attempts to attract business from other member states. Ironically, such measures are likely to reduce EU tax revenues.
What is really required now, both from an EU tax policy perspective and to reduce the uncertainty caused by the ECJ, is a move towards some form of corporate tax approximation among member states.
One hesitates to use the dreaded word ‘harmonisation’, which even the Commission shies away from. The Commission recognised this in its 2001 working paper ‘Company taxation in the internal market’, and Fritz Bolkestein, the EU Tax Commissioner, has gone on record to say that major changes to corporate taxation in the EU are inevitable.
The suggested approach is two-pronged. First, targeted tax measures to deal with specific hindrances to the single market, such as the Parent/Subsidiary Directive and the Interest/Royalty Directive, both of which facilitate cross-border payment flows without withholding tax. Second, and more interestingly, is the wider technical approach of introducing one of two options. One possibility is ‘home-state’ taxation, under which a multinational would be taxed in the member state in which it was headquartered and under that member state’s rules for all its operations in the EU. There would be a formula to divide the resulting tax among the member states in which there were operations. Another option is a consolidated common base of taxation. Under this proposal, a multinational would compute the profits for all of its EU operations on a consolidated basis according to a common tax code applicable across the EU. The computed profits would then be allocated on a formulary basis between member states.
Both of these proposals have attractive features. Member states would be free to set their own tax rates and, in the case of home-state taxation, would be free to continue to set their own tax bases, subject to complying with the EC Treaty. In the current political climate in the UK, this would be an easier sell than a consolidated common base system, although the latter is the preferred route of the Commission.
As both proposals require formulary apportionment, on which unanimous member state consent is required, such radical reform may be some way off. In the meantime, the judgment of the ECJ in Mark & Spencer is awaited with interest.
Richard Palmer is a tax partner at Ashurt