M&S tax case victory to cost Treasury tens of millions

A landmark European court judgment allowing Marks & Spencer to offset foreign losses against UK profits is set to change the rules of the game for British companies operating throughout the Continent at a cost of millions of pounds to the Exchequer.

Judges in Luxembourg ruled yesterday that the UK Government had violated fundamental European rights to freedom by refusing to let M&S claim tax relief for about £100m of losses sustained in France, Germany and Belgium in the late 1990s.

But in a partial victory for the Treasury, the European Court of Justice (ECJ) sought to shut the floodgate of copycat claims by ruling that before a company can automatically offset its losses, it must first "exhaust" all possibilities of claiming some sort of tax relief locally. This was a narrower interpretation of the advice put forward in April by the ECJ's advocate-general than some tax experts had expected.

M&S, which has since shut or sold its European subsidiaries, sought a rebate of more than £30m from the Inland Revenue. It took the case to the High Court when this was refused, ending up in Luxembourg in 2003 after the UK courts had washed their hands of it.

The ruling from the Europe's top court is expected to cost Gordon Brown £200m in claims for back taxes, plus about £50m a year, putting further pressure on the public finances.

Estimates of how many companies are queuing up to pursue similar claims vary wildly, but there are more than 100 cases already lodged with the High Court and probably double that number sitting on tax assessment forms within the Revenue. BT, Gap, Nissan, Sony, Carphone Warehouse, JP Morgan, Lunn Poly and Asda are all part of an existing group litigation order. Cadbury Schweppes took a separate case against the Inland Revenue to Luxembourg yesterday, claiming that UK tax law illegally restricts it from setting up operations abroad.

Tax lawyers predicted the Government would be forced to re-write the rulebook on so-called "group relief", which allows UK companies to offset losses only for subsidiaries operating in the UK. Fiona Walkinshaw, a partner at Reynold Porter Chamberlain, said: "The Government will have to change the legislation so that it expressly incorporates the effect of the judgment."

Crucially for businesses and the UK Government, the judgment was not the nuclear catalyst that some tax experts had feared. It fell far short of the worst case scenarios that had threatened to force the Revenue to rip up the existing rules on group relief and abolish it altogether.

Mark Persoff, senior tax lawyer at Clifford Chance, said: "The judgment is a balance between protecting the single market and protecting national tax systems. It is helpful in most of the cases against the Treasury and will not be a cash payout day for the taxpayers."

Around Europe's capitals there was relief that the judgment was not as sweeping in its implications as had been feared. The stakes were high. The former German finance minister Hans Eichel had estimated that a negative judgment could ultimately force his government to repay up to €50bn to its companies if a finding in favour of the retailer set a precedent. In addition to Germany, Greece, France, Ireland, Sweden, Finland and the Netherlands had submitted "observations" in support of the British Government. All feared that the ruling would hit their Treasuries hard and could have had an impact on public finances.

One EU diplomat described the court's ruling as a "judgment of Solomon". Another added: "It was more nuanced, more balanced than predicted. It may not have the impact feared because the court put certain conditions on where companies are allowed to have relief."

The European Commission said it was impossible to estimate the financial impact, Europe-wide, though diplomats believe it will fall well short of the billions some had predicted.

Yesterday's ruling in effect enshrines the principle that subsidiaries should claim tax relief first and foremost in the country in which the losses arose. Only once the non-resident subsidiary "has exhausted all possibilities available in the state of its residence" should it be able to seek relief in its parent company's member state. Possibilities include rolling up each year's losses until the business eventually makes a profit to offset them against in that country, or simply selling the loss-making business on to a third party.

Mr Persoff said: "The Treasury will fight tooth and nail when this comes back to the UK courts. Is a theoretical possibility of using those losses enough or does it have to be a real, practical possibility? The real question is what if there is no realistic possibility of utilising those losses?"

Kevin Phillips, corporate tax partner at the accountants Baker Tilly, said: "In nearly every single case there will be the possibility of overseas relief."

Although M&S declined to comment on the implications of yesterday's ruling until its lawyers had finished poring over the lengthy document, experts said it differentiated between the situation in the different countries in which the retailer operated. In Belgium and Germany, M&S could not offset its losses because there its subsidiaries never traded in profit before closing. But the French situation is different because the business was sold to a third party, which may have been eligible to offset the losses in France.

For that reason the judgment does not indicate how much M&S can recoup and the claim in relation to France is likely to be decided by the High Court.

More broadly, the judgment ruled that the UK had pursued "legitimate objectives" in seeking to prevent the double use of losses in two different EU states, and in its bid to deflect tax "shopping". The latter refers to the transfer of losses within a group to the nation whose tax regime would best advantage the firm.

The Treasury said it would consult businesses on how it intended to amend group relief but insisted it could be preserved "broadly as it is now".

John Cridland, the deputy director general of the CBI, welcomed the judgment. "This allows the UK's existing systems to be adapted to comply with the Treaty of Rome, therefore there are no grounds for abolishing group tax relief - to do so would be very damaging to the UK's global competitiveness." UNICE, which represents business across the EU, said the ruling "constitutes a step in the right direction towards better functioning of the internal market".

Maria Assimakopoulou, a European Commission spokeswoman, said: "This kind of ruling gives the hint to the member states that they had better co-operate on tax systems in order to avoid cases like this." The Commission is due to produce a communication next year on cross-border loss relief, though the ECJ's decision may mean that this will be of limited scope.

Simon Airey, a barrister for Dorsey and Whitney, the law firm representing M&S and a clutch of other companies also pursuing claims, predicted that in the UK, "we are likely to see increased scrutiny of the big corporates' tax affairs". He added: "There is a possibility the Government will be fairly innovative in how it seeks to recover those funds."