Jeremy Warner's Outlook: Europe's tax ruling deals new blow to Brown

Marks & Spencer hasn't been getting much right in recent years, so it should be congratulated on finally managing to stick one of the Treasury with a landmark judgment which besides yielding a handy little £30m tax rebate forces the Government finally to recognise the reality of the single European market and reform its tax laws appropriately.

Marks & Spencer hasn't been getting much right in recent years, so it should be congratulated on finally managing to stick one of the Treasury with a landmark judgment which besides yielding a handy little £30m tax rebate forces the Government finally to recognise the reality of the single European market and reform its tax laws appropriately.

The Chancellor has for years been burying his head in the sand over so-called "group tax relief", not least because he doesn't want his precious golden rule further endangered by another blow to the corporation tax base. Provided the European Court of Justice upholds the Advocate General's view, which it nearly always does in such cases, the UK's tax laws on group relief are about to be judged illegal and Mr Brown, or who ever succeeds him as Chancellor, will have to make root and branch changes.

Yet although the Advocate General's opinion was widely being described by tax specialists yesterday as of huge significance, it may not be quite as bad for the Government as it seems, provided ministers act swiftly and appropriately. On the point of principle, the Advocate General, Miguel Poiares Maduro, judged unambiguously against the Treasury, but he also appears to have left open a number of escape hatches.

Group relief allows companies to offset losses from one subsidiary against the profits of another. In common with a number of other European countries, including Germany, Britain allows offset on its own home turf but not the losses of subsidiaries based abroad. M&S, which clocked up quite considerable losses on operations in France, Belgium and Germany before closing them or pulling out in 2001, has been arguing in a test case that this is a breach of the EU treaty because it penalises overseas investment and therefore interferes with the proper functioning of the single European market.

The Treasury's case boils down to two not unreasonable arguments. One is that British companies shouldn't be allowed to offset the losses of overseas subsidiaries because the British revenue doesn't benefit from any subsequent profits they might make. These would he taxed overseas. What's more, the effect would be to distort the internal market as companies would offset losses in low tax countries such as the accession nations against those in higher tax countries. Actually this would only be a form of tax competition, the merits of which the Chancellor is generally keen to stress in his various other battles with Europe, but we'll let that one pass.

Of course, none of these distortions would occur if the rate of corporation tax were the same everywhere, as the European Commission is prone to point out. Yet few nations these days share the Commission's harmonising instincts, so how should Britain respond? Until the final judgment it is not entirely clear either what the damage to the Exchequer might be or how the law should be reformed.

Claims already lodged in respect of legacy losses on foreign subsidiaries amount to £768m, according to a recent circular from Morgan Stanley. But some of the biggest potential claimants, such as Vodafone with more than £7bn of accumulated overseas trading losses to offset, have yet to demand a rebate. The eventual bill could be very considerable indeed, further upsetting the Chancellor's already heroic assumptions about likely corporation tax receipts.

As for the future, the Government has three options. The draconian one would be to abolish group relief altogether, which for the Chancellor at least would have the merit of raising more tax. It would also make the UK extraordinarily uncompetitive from a tax perspective, and in any case, companies could get round it by for instance collapsing all their subsidiaries into a single entity.

A second option would be the approach used in Denmark and Italy, where companies that offset foreign losses also have to pay Danish or Italian tax on their foreign profits. Yet the most obvious lifeline is the one thrown by the Advocate General himself. The implication is that only in cases where local tax rules disallow the carrying forward of tax losses should it be possible to offset the losses of overseas subsidiaries. If this is upheld, then the implications for the Treasury are bad, but not that bad since hardly any European countries forbid the accumulation of tax losses.

The root cause of this extraordinarily protracted case is the Treasury's refusal to bring its tax rules into compliance with European law. Britain is not alone in this. Few countries permit global consolidation of company profits. The Treasury's position is shared by Germany, France and Sweden among others. Yet its intransigence is indicative of quite how far Europe still has to go before it achieves a free and open internal market to compare with the United States. National interest still reigns supreme, and as long as it does, Europe's ambition of becoming the most competitive economic region in the world will remain just a pipe dream.

Boots the Chemist

It's surprising how quickly a once core business suddenly becomes non core, but then Richard Baker, chief executive of Boots, needed to do something to detract attention from his constantly shrinking profits. Flogging off Boots Healthcare International must have seemed as good a way as any. If that was the intention, it didn't work.

An early rise in the share price on the promise that the proceeds would be substantially returned to shareholders was fast reversed as investors realised that Mr Baker is actually disposing of his most successful business. Profits from this over-the-counter healthcare products company are still rising fast, whereas they are falling sharply in the main retail chain.

One of Mr Baker's primary tasks since becoming chief executive two years ago has been to bring City expectations of Boots into line with a diminished reality. This has not been particularly well managed. There have been three profit warnings since Mr Baker began, and investors reasonably complain of never being properly briefed as the seriousness of the task in hand. Yet in other respects, Mr Baker seems to have done most of the right things and occasional calls for his head seem both harsh and premature.

The beast he inherited was charging too much and investing too little, as Mr Baker pointed out in a surprisingly candid statement yesterday. "It has been tough for both our people and shareholders to face the reality that Boots the Chemist was operating an unsustainable model. Re-investment was minimal and profits were inflated by unrealistic pricing".

Mr Baker should, perhaps, have said this right at the beginning, but then this is not the sort of thing investors want to hear from the man they've just anointed to rescue the show. Instead they wanted a miracle worker capable of reforming the business while sustaining the profits. In truth, that was never going to be possible given the near 20 per cent reduction in prices Mr Baker has needed to push through to make them competitive with the main supermarket chains.

On top of everything else, he's now hit a soft patch in consumer spending, so that although for the first time in years he's now holding his own in terms of market share, like-for-like sales growth has disappeared down the Swanee. So how big have the unsustainable profits turned out to be? In round terms about £100m. This is the difference between where profits were when Mr Baker started and where they are likely to bottom out, assuming nothing else goes wrong. Tough indeed.

Boots still has plenty going for it, particularly in pharmacies, where sales growth remains strong. But no one can live on pills alone and Mr Baker still has big issues to address on availability and what in my view remains a faintly old fashioned and tired format. In the meantime, price cutting by the supermarkets, which has to be answered penny for penny by Boots, shows little sign of easing. As Mr Baker says, the letdown has been painful for all concerned. The worry is that it may not yet be over.

jeremy.warner@independent.co.uk