UK: Marks & Spencer: A win for the taxpayer or a win for the Government?

Last Updated: 15 December 2005
Article by Mark Nichols, Michael Boutell and Steven Sieff

The European Court of Justice has handed down its decision in the Marks & Spencer case. Since the Advocate General gave his opinion on 7 April 2005 the Court’s decision has been eagerly awaited particularly as some of the more recent decisions of the ECJ (such as the decision in the "D" case) have suggested that in relation to direct tax cases that are being referred to the Court on the grounds of inconsistency with the fundamental freedoms contained in the EC Treaty there might be a shift in the direction that the Court is taking. Prior to the opinion of the Advocate General many commentators felt that the Marks & Spencer case would result in an unqualified defeat for the Revenue. However, both the opinion of the Advocate General and now the decision of the ECJ suggest that the Court might be at least slowing down (if not holding or reversing) its propensity to bring about harmonisation of corporate tax through the back door.

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The European Court's decision

Marks & Spencer established subsidiaries in France, Germany and Belgium. In the late 1990's and early 2000's these subsidiaries incurred significant losses. Marks & Spencer ceased to trade in Germany and Belgium and sold its French business to a third party. It also sought to set the losses of the foreign subsidiaries against the profits made by the UK parent. UK group relief rules do not permit the surrender of losses of foreign subsidiaries. The case was concerned with the extent to which the UK group relief rules contravened Article 43 (as extended to companies by Article 48) EC Treaty (the freedom of establishment for businesses). If you would like to read the article that we produced following the Advocate General's opinion please click on ‘next page’ button at the end of this article.

The ECJ has held that restricting the availability of group relief to UK companies constitutes a restriction on the freedom of establishment under Articles 43 and 48 EC Treaty in that it applies different treatment for tax purposes to losses incurred by a resident subsidiary and losses incurred by a non-resident subsidiary, thereby providing a disincentive to the establishment of a subsidiary in another member state.

However, the ECJ has accepted that a restriction is permissible where it pursues a legitimate objective, which is compatible with the treaty and which can be justified as being for the public interest. In particular, the Court accepted that the following three justifications put forward by the UK Government could provide a legitimate basis for the restrictions:

(a) to preserve a balanced allocation of the power to impose taxes as between the different member states (so that in principle where the profits of the subsidiary were not taxed in the UK, the relief of losses against UK profits would not represent a balanced allocation of the power to tax);

(b) to avoid the risk of the double use of losses which would exist if losses were taken into account in both the member state of the parent and the member state of the subsidiary (in other words, UK group relief rules that deny relief to the UK parent for losses of its foreign subsidiary can be justified where those losses are able to be used in the member state of the subsidiary); and

(c) to avoid the risk of tax avoidance which would exist if the losses were not taken into account in the member state of the subsidiary (here, the Court was concerned with the possibility of a foreign subsidiary in a low tax jurisdiction electing to surrender losses to a parent based in a jurisdiction with a higher tax rate; the motive for surrendering the losses to the jurisdiction with higher tax rates is for tax avoidance rather than simple utilisation of the losses).

Therefore, the Court held that the UK group relief rules that place restrictions on the ability of a subsidiary resident in another member state to surrender losses to its UK parent are permissible. However, the Court also went on to make clear that provisions that are in principle discriminatory could only be justified (on the grounds of overriding public interest) where they are proportionate. In other words, the UK group relief rules that restrict a foreign subsidiary's ability to surrender its losses to its UK parent will only be upheld as legitimate to the extent that they are necessary to satisfy the public interest objective.

The Court set out the tests that need to be applied to determine whether or not the restrictions can be regarded as proportionate. Where the following two conditions are fulfilled, the restrictions on the ability of the foreign subsidiary to surrender its losses cannot be justified so that the UK would be in breach of Article 48 if it fails to provide relief for the losses:

(a) "the non resident subsidiary has exhausted the possibilities available in its State of residence of having the losses taken into account for the accounting period concerned by the claim for relief and also for previous accounting periods, if necessary by transferring those losses to a third party or by offsetting the losses against the profits made by the subsidiary in previous periods, and

(b) there is no possibility for the foreign subsidiary's losses to be taken into account in its State of residence 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."

The meaning of these two conditions holds the key to determining the extent to which losses arising in a foreign subsidiary resident in another member state can be surrendered to its UK parent. This is true not only for Marks & Spencer but for any other group that has loss making subsidiaries.

Under the first condition the foreign subsidiary must have exhausted its ability to use the losses in its state of residence either in the accounting period in which they arose or any previous accounting period (by carrying back and setting against prior year profits) and whether by setting the losses against its own profits or the profits of a third party (eg. another group company resident in the same state). If it could have, but did not, then the group relief rules can be justified (even if the losses are instead carried forward and for whatever reason cannot be used in the future).

This condition would seem to be relatively clear. Where the member state of the foreign subsidiary does not permit the carry forward of losses, the surrender of losses to a third party (eg. another group company) or either does not permit the carry back of losses or as a matter of fact the foreign subsidiary has no prior year's profits against which to set the losses then this condition will be satisfied.

The second condition, that also needs to be satisfied, is that the foreign subsidiary is unable to preserve the losses for use in a future period. What this condition means is not so clear. If the loss is carried forward but in a subsequent accounting period it becomes clear that those losses will never in fact be used (either because the period for which the losses can be carried forward has expired or the company ceases trading, or the company is sold but due to the application of specific provisions the foreign subsidiary cannot use losses accumulated prior to the sale) are the restrictions contained in the UK group relief rules justified? On the face of it the Court is saying that the group relief rules would not be proportionate in these circumstances (assuming also that the foreign subsidiary was unable to use the losses under the first condition).

However, one important issue that the Court failed to address was that of time limits. If the foreign subsidiary carries forward losses, as it would do if it were able to (and cannot use the losses in the year they arise or carry them back or surrender them to a third party in the foreign jurisdiction) what happens if, say, 7 years later the foreign subsidiary ceases trading. If the parent wishes to make a group relief claim it will be out of time. If it wishes to pursue a remedy through the courts it may be barred from doing so under the Limitation Act. Generally, the ECJ has upheld the application of time limits in the name of certainty.

Did Marks & Spencer win?

For the German and Belgian subsidiaries that ceased trading it seems likely that there is no longer any possibility of those losses being used in the state of residence. Accordingly, Marks & Spencer should have a remedy assuming that it has never been in a position to use the losses in the local jurisdiction although this might depend on the subsidiaries being liquidated if, under local laws, the losses could be revived by a re-commencement of trading. For the French subsidiary, which was sold, the availability of a remedy will depend upon whether the losses may continue to be carried forward or, indeed, whether they can be surrendered to the purchaser. If not, Marks & Spencer should also have a remedy in respect of those losses as well.

But does this mean the Revenue lost?

In the narrow sense it may have done. However, the Revenue will be more concerned with the bigger picture and in this sense the Revenue may look upon the result as a victory. Although the group relief system will have to be extended to cover some losses of foreign subsidiaries (namely, those that cannot be used in the local country of the subsidiary) this is much more limited than it might have been and should not have the financial impact on the Exchequer that was originally feared.

The case still needs to be referred back to the English court for it to be applied to the specific facts. No doubt a lot of thought will be given to how this case applies to all of the other claims that have been made under the Group Relief GLO as well as those that have arisen more recently or those that may arise before we see any changes to the UK group relief rules. It is quite possible that we will see further references made to the ECJ for additional clarification and it will be interesting to see what view the Revenue take in relation to time limits and whether the English court makes any mention of this issue when the case is referred back.

Other implications

It now seems clear that the "nuclear option" of abolishing group relief is unlikely. The cost to the Exchequer of making the necessary amendments to the group relief rules should be manageable. Indeed the changes would be relatively minor albeit that they may be more difficult to apply in practice. The residence conditions would have to be made subject to a number of conditions: that the surrendering company has (a) exhausted the possibilities available in its state of residence of having the losses taken into account for the accounting period in which they arose; and (b) exhausted the possibilities in its state of residence for carry back to previous accounting periods; and (c) that there is no possibility for those losses to be used in its state of residence for future periods either by the subsidiary itself or by a third party. We could see these amendments introduced in next year's Finance Bill.

It also seems likely that this decision will add an additional layer of complexity for groups managing losses within the EU. It is also conceivable that we could see certain member states restricting the extent to which losses can be used locally thereby shifting the fiscal burden for losses from the local state to the parent's state of residence.

It also provides an insight into the direction that we may be seeing the Court move over the coming years. The judgment may mark a significant step away from the previous line taken by the Court of finding every measure referred to it as a restriction and finding that the restrictions could hardly ever be justified. The acceptance of three separate grounds that could justify discriminatory measures (which could be described as territoriality, cohesion and tax avoidance) is remarkable in the light of the dismissive statements that have been made about these defences in a host of previous cases. The Court has said that while these defences may justify discriminatory measures such measures would only be EU law compliant if they were "proportionate" (that is to say that the measures were no more than was necessary to satisfy the territoriality, cohesion or tax avoidance public interest aim). If the Court follows this line in future cases it is likely to make the outcome of future ECJ cases much harder to predict. Although proportionality is not a new concept for the Court its use in this way in corporate tax cases is likely to give the Court more flexibility in determining what domestic law measures are EU law compliant and what measures are not.

The revival of the justifications of territoriality and cohesion is interesting because the defences were thought to be more or less dead, but the acknowledgement in a direct tax case of the tax avoidance justification – also known as 'abus de droit' – may be even more significant, especially in the light of the Cadbury Schweppes case concerning the UK's controlled foreign companies legislation which, coincidentally was heard by the ECJ immediately after the release of the judgment in Marks & Spencer.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 14/12/2005.

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