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Update on the Deductibility of Foreign Losses

26 Jul 2010

Recently, the German tax authorities (ie the Bavarian State Tax Office) issued an administrative decree concerning the deductibility of losses incurred through a foreign permanent establishment (branch) located in an EU or EEA member state of a German resident entrepreneur referring to the judgment of the ECJ in the case C-414/06 (Lidl Belgium). Taxand Germany reviews the decree and related cases to provide an update on the deductibility of foreign losses.

The decree focuses on losses of the foreign branch which are subject to the exemption method according to the relevant double taxation treaty (DTT). The decree indicates that generally the member state, where the permanent establishment is situated, has to consider the losses for tax purposes. Only if the losses are final the possibilities are exhausted for deducting the losses in the state of the permanent establishment in past, present or future periods (ie tax loss carry back and tax loss carry forward), the German tax authorities would allow these losses to be deducted from the German tax base. However, the Bavarian State Tax Office stressed that foreign losses are not final if they do not have any effect on the foreign tax assessment or if they have just expired. The Bavarian State Tax Office refers for this interpretation of the Lidl case to a further ECJ case from 23 October 2008 (C-157/07, Krankenheim Ruhesitz am Wannsee-Seniorenheim). From this case the tax authorities took the general thought that implications of the tax system of a member state are of no concern for another EU member state (i.e. Germany). Though this interpretation of the case is considered a doubtful generalisation, it is supported by a recently issued judgment of the German Federal Fiscal Court (from 3 February 2010, I R 23/09), at least concerning foreign losses expired subsequent to foreign tax law.

Taxand Germany considers the Krankenheim case to be referring a special legal situation which led the ECJ to its judgment. In this case, Germany initially considered the foreign losses incurred by an Austrian Permanent Establishment ("PE"). However, German tax law provided that, despite a DTT, later profits from the Austrian PE are subject to German taxation to the extent Austrian losses were deducted in Germany. In the Krankenheim case the ECJ held that this taxation does not violate EU law even if there was no tax loss carry forwards provided according to Austrian tax law for Austrian permanent establishments belonging to foreign companies. However, there was a tax loss carry forward available regarding Austrian PEs of Austrian companies. This different taxation of losses may have caused a restriction of the freedom of establishment for foreign companies in setting-up a permanent establishment in Austria.

The situation is different if foreign losses expire subsequent to the tax law of a member state which is applicable without consideration of the nationality or domicile of the owner of the PE. Under these conditions the foreign country does not violate EU law. Under these circumstances these foreign losses should be considered final according to the Lidl case and therefore, deductible in Germany.

There is currently the first German "Marks & Spencer" case pending before the German Federal Fiscal Court concerning losses incurred through Italian subsidiaries (corporations) of a German parent company (corporation). As the subsidiaries were liquidated, their losses became final. The claimant's supporting argument in this case is that among a parent company and its subsidiary both domiciled in Germany a fiscal unity (Organschaft) could be established whereas between a German parent company and its foreign subsidiary such fiscal unity is not feasible. As a fiscal unity would lead to a netting of profit and losses between parent and subsidiary even for tax purposes, it would be a restriction of the basic freedoms granted by EU law if this advantage is denied regarding cross-border relationships.

As the claim for deduction of the Italian losses was rejected by the Local Fiscal Court the case is now pending before the Federal Fiscal Court.

Taxand's Take

The tax burden could be significantly reduced if final losses incurred in a foreign country which could not be used in future tax years become deductible in the tax assessment of the home country of the company. Therefore, it is quite attractive for German taxpayers to get final foreign losses deducted for domestic tax purposes. Without doubt the tax authorities will find it very hard to argue against such deductions.

However, for losses that are final through expiration according to foreign tax law, the chance for deduction is significantly reduced. The Federal Fiscal Court decided on 3 February 2010 against such a transfer without a preliminary ruling from the ECJ. Therefore a preliminary ruling in a similar case brought before the Federal Fiscal Court is not likely at present.

The chance to get foreign losses deducted in domestic taxation could be considered much better if they are final on other grounds of expiration of time (e.g. winding-up of the subsidiary). This applies even for a deduction of losses of foreign subsidiaries as there is currently no final decision of the Federal Fiscal Court or even the ECJ regarding the German rules on fiscal unity (Organschaft).

Consequently, it remains worthwhile for German resident companies to apply for a deduction of foreign losses considered final where they were incurred in EU and EEA member states. However, lengthy proceedings before German tax authorities and tax courts could be expected. Costs may be reduced in some cases by an application for suspension on proceedings with reference to similar pending cases.

Your Taxand contact for further queries is:
Jens R?hrbein
T. +49 511 5458 20129

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