Tuesday, December 13, 2005

Heads we win, tails you lose

The European Court of Justice has just issued an opinion in the Marks & Spencer case, affirming an earlier opinion by its Advocate General, under which England (and other members of the European Economic Community) must allow resident companies to deduct the losses of their foreign subsidiaries, even though the resident companies are not required to include net income from their foreign subsidiaries.

The ruling is limited to cases where the subsidiary's losses can't be deducted in the country where it was resident. But this is a trivial limit. Given the universal nonrefundability of overall tax losses, all a European company has to do, in order to satisfy this requirement, is sell its foreign loss subsidiary.

This is going to be great fun for European tax planners. For a company that is resident in a high-tax country, one simple thing to do is establish a foreign sub in a low-tax country. If it's profitable, pay tax at the low rate. If it loses money, sell and get the loss deduction at the high rate. Companies can also probably gin up the losses, where they like, through inter-group games such as transfer pricing (have the foreign subsidiary pay too much and charge too little in inter-group transactions) and leverage (put lots of debt into the sub).

The ECJ was warned about this, but chose to disregard all such problems as mere concern about revenue loss, which can't carry the day since countries would never allow any deductions if this were all that mattered.

While supposedly charged with creating a single European market and preventing protectionism within the community, the ECJ is acting as if it wants to obstruct national revenue authorities and create open season for tax planners. But perhaps what it really wants to do is grab as much turf as possible. Reducing revenue while increasing economic distortion is evidently a small price (for someone else) to pay.

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