Federal Tax Court rules on cross-border loss relief for losses from EU permanent establishments

The German Federal Tax Court (BFH) issued two decisions on 9 June 2010 in cases where the taxpayers claimed cross-border loss compensation for losses incurred in a permanent establishment (PE) in an EU Member State (cases references I R 100/09 and I R 107/09).

According to settled case law, losses incurred in a foreign PE will not reduce a taxpayer’s German tax base if an applicable tax treaty provides for exemption of the PE profits. In its decision in Lidl Belgium (case reference C- 414/06), the European Court of Justice (ECJ) held that such an approach is in line with the freedom of establishment principle, but that losses that cannot be used by the EU PE in previous or future accounting periods (i.e. “final losses”) must be taken into account by the country of residence of the taxpayer. In another case (Wannsee, case reference C-157/07), the ECJ further elaborated that a Member State is not required to compensate negative results arising from specific features of the legislation of another Member State.

The first case involved a German entity operating a PE in France. The tax loss carryforwards resulted from losses incurred in 1999 and which were forfeited in 2004 due to a five-year restriction on tax loss carryforwards under French tax law. The PE was liquidated in 2005. The BFH did not characterize the losses as “final losses” because it viewed the five-year limitation of tax loss carryforwards as a specific feature of another Member State’s tax law which need not to be compensated by Germany as the taxpayer’s country of residence. The BFH therefore rejected the plaintiff’s appeal. The fact that the PE was closed down in 2005 was not a sufficient reason for the BFH to reach a different conclusion since the losses became final as a result of a timing restriction rather than the termination of the PE.

In the second case, however, the taxpayer, after having incurred losses in a French PE, terminated its business in 2001 and argued that PE losses incurred in 2000 and 2001 became final in 2001. The BFH ruled that closing a PE leads to final losses under the Lidl principles, even if a tax loss carryforward would later have been forfeited under general timing restrictions for loss carryforwards in the PE state and that a forfeiture of tax loss carryforwards upon a conversion of a PE into a subsidiary or a transfer to another person (either by way of a sale or without consideration) should be treated in the same way.

The BFH further held that final PE losses are to be taken into account in the fiscal year the losses became final and not in the year in which the losses were incurred. Notably, different results were reached in previous local tax court decisions (see in Deloitte Tax-News).

Finally, the BFH ruled on the question whether such final losses are deductible for German trade tax purposes. Trade tax is levied on income from a trade or business in Germany, so business profits derived through a foreign PE are generally excluded from the trade tax base. Nevertheless, the BFH ruled in favor of the taxpayer stating that the restriction of the tax base to domestic income is to be considered analogous to the foreign income exemption under a tax treaty. 

It is unclear how the German tax authorities will respond to these decisions. A non-application decree is possible since the BFH conclusions on the qualification of losses as final under the Lidl principle conflict with the position taken by the tax authorities in a circular letter on the BFH decision in Lidl. In addition, the court’s position on the relevance of final losses for trade tax purposes may not find consensus within the tax authorities. The decisions are relevant only in cases in which the PE is situated in an EU Member State -- losses incurred in a PE located outside the EU do not qualify for loss relief under EU law (see Stahlwerke Ergste Westig, case reference C-415/06).

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