The Treasury is changing UK company tax law to fall incline with a landmark European court ruling today.
In a victory for Marks & Spencer, judges in Luxembourg said the Inland Revenue's refusal to allow companies to use their losses in one EU country to reduce their UK tax bill was a violation of EU rules.
Now multinational companies based in Britain could be queuing up for tax rebates in a move which could cost the Treasury hundreds of millions of pounds.
Treasury officials flatly denied claims that the cost of the ruling would run into billions - because the European Court of Justice (ECJ) said companies could only seek to offset "foreign" losses against UK profits when they could not do so in the country where they incurred the losses.
The Treasury refused to put figures on the costs of the verdict today, but officials are believed to be working on the assumption that Chancellor Gordon Brown could lose out to the tune of £50 million a year.
Marks & Spencer went to court when it found it was unable to lower its UK tax bill by offsetting heavy losses incurred in the 1990s in German, French and Spanish subsidiaries against its UK profits.
The company, resident for tax purposes in the UK, sought "group relief" under UK tax laws.
But the claim was refused on the grounds that "group relief" only applied to losses incurred in the UK. The High Court sent the company's appeal to the European Court of Justice.
Under current UK tax legislation, a multinational company resident in the UK can only claim UK tax relief on UK-incurred losses: if the losses occur in a company subsidiary elsewhere in the EU, they cannot be offset against UK profits.
Lawyers for Marks & Spencer argued in court that differences in tax treatment between domestic and foreign branches of the same company violate EU laws on "freedom of establishment".
This afternoon the Treasury said the current system of "group relief" under domestic tax laws could be preserved - with "very limited" exceptions to comply with the European court ruling.
A Treasury statement said: "We believe that the judgment means that the UK's existing system of group relief can be preserved, broadly as it is now.
"The court's judgment emphasises that the UK's rules are in principle compatible with EU law, but we accept that in a very small number of very limited circumstances the UK may have to allow relief for losses of the foreign subsidiaries of UK companies, where there is no possibility of those losses being relieved in the EU country the foreign subsidiary is based in."
The statement added: "The Government will bring forward detailed proposals in due course, and our intention is to consult with business on the detail of how the group relief should be amended to bring it fully in line with EU law."
Eurosceptics said the verdict proved that domestic tax policy was now in the hands of the EU.
The "Bruges Group" - honorary president Baroness Thatcher - claimed the judgment would cost British taxpayers "billions of pounds."
A statement went on: "The decision today shows that the EU has usurped the right to make UK tax laws. The ECJ has struck out well-established UK rules in pursuing the Brussels goal of tax harmonisation. This will cause uncertainty for business and government funding. The government has known about this risk since at least 1999, and should now act to bring back control of the UK's tax affairs."
The judgment declared: "The Court reiterates, first of all, that although direct taxation is within the competence of the member states, the latter must exercise that competence with respect for Community law."
Robert Oulds, director of the Bruges Group, commented: "Gordon Brown must be incensed. The European Court of Justice will cost the British taxpayer an untold sum and force Mr Brown to raise taxes to fund his budget deficit."
The European Federation of Accountants (FEE) is already campaigning for for new EU Commission proposals specifically to tackle the problem of equal company tax treatment across Europe of foreign losses.
The organisation argues that the ability to offset losses against profits for assessing the tax liability of a domestic group of companies is a basic feature of any company tax system.
However, the fact that arrangements vary widely in different countries means that foreign investment receives less favourable treatment than domestic investment.
"The issue is particularly relevant for European business - the range of different domestic provisions on loss compensation for tax purposes is detrimental to the efficient functioning of the single market, and is an obstacle to cross-border activity" said FEE president David Devlin.
Today's case was the latest in a series referred to Luxembourg by UK courts questioning the compatibility of UK tax law with EU rules.
Even as the M &S verdict was being delivered, a separate case brought by Cadbury Schweppes was beginning in the same court concerning UK tax penalties against multinationals trying to benefit from lower taxes in other EU countries.
A spokesman for London Chartered Accountants Blick Rothenberg said the M& S ruling would have limited effect, because the court made clear losses abroad could only be offset against UK profits where those losses could not be offset in the country where they occurred.
But he said a bigger headache for the Treasury could lurk in the separate case being heard today on the compatibility of UK tax law with EU rules, brought by Cadbury Schweppes.
According to Blick Rothenberg, a ruling in favour of Cadbury Schweppes would have far bigger repercussions for the Treasury because far more companies currently benefit from low foreign taxes than from offsetting foreign losses against UK profits.