Marks & Spencer vs UK Government - and the winner is…

7 April 2005 may well go down in the annals of UK tax history as a very significant day. It was the day the (first) Finance Act of 2005 received Royal Assent. It was also the day that Advocate General Poiares Maduro delivered not one but two important and much awaited opinions concerning references from the UK courts. This article concerns one of those opinions – Marks & Spencer plc v David Halsey (HM Inspector of Taxes) Case C-446/03.

The very brief facts of the appeal are that M&S operated in several European jurisdictions through local subsidiaries. These subsidiaries were owned by the M&S UK parent company. The subsidiaries were loss making, but the parent was profitable. M&S made a group relief claim to the Inland Revenue to allow it to set the losses of its foreign subsidiaries against the profits of the UK parent. It is relevant that at the time of the claims M&S was in the process of either selling off or discontinuing the operations of its loss making foreign subsidiaries. The Inland Revenue refused the group relief claim on the grounds that relief is not available for subsidiaries, which are neither resident nor trade in the UK.

To say that the reaction of the ECJ has been keenly awaited is something of an understatement. If M&S win, the estimated cost to the Treasury of tax refunds runs to hundreds of millions or even billions of pounds and the UK group relief system will have to be changed or even scrapped. As befits such an important case, the 84 paragraph opinion of the AG is fairly weighty.

So who won?

The reaction of many commentators has been that the AG found in favour of M&S, but our view is that the governments of the member states are the real winners. The reason for this is that while M&S won their argument that the group relief rules are discriminatory, the AG found that discrimination could be justified for the majority of M&S' losses.

The AG achieved this result by agreeing with the taxpayer that the current group relief system was discriminatory, but concluding that the system would be acceptable if it provided that group relief was only to be disallowed where the foreign subsidiary was able either to transfer the losses to another legal person or carry them forward to other financial years in the state of establishment. This suggests that only fairly minor changes are required to the UK's existing legislation in order to make it EU compliant.

The reasoning of the AG is extremely interesting and a few points should be noted:

1. When analysing the grounds on which discrimination can be justified the AG found the state of the court's case law to be regrettably unclear. The AG cited the well reasoned opinion in Danner (C136/00) where AG Jacobs argued that it is inappropriate to have different grounds of justification depending on whether the measure is directly or indirectly discriminatory. This would be a sensible simplification.
2. The freedom of establishment does not preclude discrimination between subsidiaries and permanent establishments where this difference in treatment applies domestically. Cases such as Commission v France, Royal Bank of Scotland and Saint Gobain are distinguished as actually relating to place of residence.
3. The territoriality principle in Futura does not apply here because the UK exercises an unlimited right to tax the global profits of the UK parent. Consequently the UK cannot limit the UK parent's right to a tax advantage connected with the transfer of losses. This is an expected reading of Futura by the AG, but nonetheless many readers will justifiably find it puzzling that in Futura the Luxembourg authorities were permitted to refuse loss relief on the grounds that they did not tax the corresponding profits, whereas in this case the UK cannot refuse loss relief notwithstanding that any profits of the subsidiaries would have been outside the scope of UK tax.
4. The approach to the Bachmann doctrine is unexpected. The defence of cohesion has been narrowed and eroded by previous ECJ case law to the point where most commentators expected the AG to dismiss it here. However, although the UK did not succeed in justifying the existing group relief rules on Bachmann grounds, the AG did accept firstly that Bachmann should not be limited to situations where the issues involve the same tax and the same taxpayer. Secondly, and more importantly in this case, the AG actually found that a restriction of the group relief rules (to situations where the losses of foreign subsidiaries cannot receive advantageous tax treatment in the state of establishment) was justified on cohesion grounds. This use of Bachmann to justify a restriction of the fundamental freedoms could be a significant step and will give hope to governments and their advocates who are currently engaged in ECJ proceedings.
5. The Abus de Droit doctrine appears to be gradually creeping into the direct tax sphere. The AG made it clear that a taxpayer cannot rely on the fundamental freedoms for the sole purpose of evading national laws or exploiting differences between those laws (see para 67 of the opinion). It will be interesting to see how this doctrine is developed and used by the court. If the chamber wishes to follow the AG's conclusion but is unwilling to take the AG's approach to Bachmmann, then Abus de Droit may become a central plank of the reasoning of the court. Even if the judges in M&S do not feel the need to consider Abus de Droit any further, it is almost inevitable that the court will have to consider the merits of this approach in the pending Cadbury Schweppes case.
6. It will surprise few people that the AG found the group relief rules as they presently stand to be discriminatory, however it is worth asking the question as to why this should be so. The opinion begins its interpretation by citing the principle in Schumacker that while direct taxation does not fall within the purview of the Community, the powers of the Member States must still be exercised consistently with Community law. The effect of the Schumacker principle is to allow the ECJ to interfere in matters, which Member States had expressly reserved as being outside of the Community's jurisdiction. If the ECJ follows the AG it will claim that it is interpreting the provisions of the treaty, but surely this interpretation must be called into question when numerous governments have intervened unanimously against a part of the interpretation that the ECJ takes. In this case the Commission even proposed in 1990 a directive, which would have allowed the taxpayer's claim – only to see it shelved for lack of support. Surely this is the best possible evidence that the fundamental freedoms are not intended to have the effect that the ECJ insists on.

There are still a number of questions that remain unanswered by the AG's opinion. It is unlikely that the Revenue will make a statement about its interpretation of the decision before the ECJ hands down its decision in the next few months. One issue, which we will return to when the ECJ gives its decision, is whether those claims within the Group Litigation Order that relate to EU loss making subsidiaries that theoretically may be able to utilise losses in the state of establishment (for example, by carry forward) will be successful. Even for M&S and those companies in a similar position (i.e. the business has been brought to an end) the Revenue might say that only losses in the year that business ceases may be group relieved since prior year losses (where they have been able to carry them forward in the state of establishment) have received equivalent treatment in the state of establishment. The fact that prior year losses cannot now be utilised is the same as it is for UK subsidiaries that carry forward losses; only current year losses can be group relieved. Companies who have not yet filed a protective claim should consider their position carefully in the light of the AG's precise reasoning. We would be happy to assist any potential claimants assess the likely outcome of their specific case.

For the future, it would not be surprising to see amendments to the group relief legislation included in the next Finance Bill, which is likely to be published in May. Any such amendments are likely to seize upon the AG's approval of limitations to the right of an EU subsidiary to surrender losses where the subsidiary may obtain equivalent treatment in the state of establishment (through carry forward of the losses or surrender to another person in that state). It would also be surprising given the sums of money at stake if we do not see further litigation to clarify the scope of the AG's comments (assuming the ECJ sheds no further light on them).

For further information, please contact Mark Nichols on 020 7637 2051 or at [email protected], Simon Meredith on 020 7367 2959 or at [email protected] or Steven Sieff on 020 7367 3452 or at [email protected].