On November 27, 2008 the European Court of Justice ("ECJ") issued its judgment in Ministry of Finance v. Société Papillon (C-418/07). The questions referred to the Court was whether the French national tax laws, which do not allow a French parent company to form a French consolidated tax group with its French subsidiaries (and reduce its tax liability by offsetting its profits with the losses of other members of the group and disregarding intra-group transactions), when the French subsidiaries are owned indirectly through an EU holding company (in the case, a Dutch BV) not subject to tax in France, violates Article 43 of the EC Treaty.
The Court ruled that such restriction is discriminatory and constitutes a violation of the freedom of establishment, because a French parent company that exercises its freedom of establishment by incorporating a holding company in another EU Member State through which it owns stock in its French subsidiaries is subject to a less favorable tax treatment in France than a French parent company that owns stock in its French subsidiaries directly or through other French intermediate holding companies. Indeed, the latter is able to offset its profits with the losses of the French subsidiaries while the former is not.
Contrary to the Advocate General’s opinion, the Court refused to apply the coherence of tax system justification to sustain the restriction, on the ground that the restriction goes beyond what is strictly necessary for that purposes and fails the proportionality test.
Société Papillon provides legal support to taxpayers who intend to challenge national tax laws that restrict access to consolidated tax regimes in EU cross border situations.
Italy permits consolidation of foreign subsidiaries, but sets more restrictive requirements that those that apply to consolidation of domestic subsidiaries. The ECJ ruling in Société Papillon puts in doubt the validity of those restrictions under EU Law.
French law at Issue
Section 223 A of the French Tax Code provides for an elective group tax regime that allows French companies to file a consolidated tax return with their at least 95-per-cent owned direct or indirect subsidiaries. Profits and losses of group members are combined and intra group transactions are ignored. Only French parent and French affiliates directly or indirectly owned by other French companies (or foreign companies taxable in France) can be members of the tax group. A foreign company not subject to tax in France, and a French parent owning stock in French subsidiaries through a foreign holding not subject to tax in France, cannot be part of the group.
Facts of the case
A French parent company had set up a consolidated tax group including several French companies which it indirectly held through a Dutch wholly owned intermediate holding company. The Dutch company, an NV, was not subject to tax in France, having no French permanent establishment, so it could not be included in the consolidated group. Because the NV was not French, the consolidated group had to exclude also the NV’s French parent.As a result, the French parent’s income was recalculated, and the French parent was subject to tax on its own profits, with no offset with the losses of other French subsidiaries in the integrated group.
The French parent company disputed the tax assessment by arguing in Court that the restriction in section 223 A of the French Tax Code was incompatible with the EU freedom of establishment. The lower court and the Court of Appeal of Paris rejected the claim, and the parent company appealed the judgment to the Conseil d’Etat (French Supreme Court).
The Conseil d’Etat referred the case to the ECJ for a preliminary ruling on two questions of EU law: (1) was the freedom of establishment of at least one member of the group (the French parent) restricted by the tax consequences of the parent company’s decision to hold its French subsidiaries through a EU holding company, rather than a French company, that being the inability for the French parent to be part of a tax group with its French subsidiaries and offset its profits with the losses of the other members of the group and reduce its tax liability; (2) may the restriction be justified by the need to preserve the coherence of the tax system or avoid tax evasion.
Ruling of the Court.
On the first issue, the Court noted that the tax integration regime reduces the tax liability of the parent company, by allowing it to combine its profits with the profits and and losses of all the companies in the fiscally integrated group. As a consequence, the tax integration regime constitutes a favorable tax treatment, because the offsetting allows the group to deduct the losses of certain of its members immediately thereby reducing the combined tax liability of the group.
Under French law, a parent company can benefit from the integration regime only if it holds its subsidiaries directly or through another company that is liable to tax in France and is itself member of the integrated group, that is, a French company or a foreign company that does business in France through a French permanent establishment and is subject to tax in France. If the parent holds the stock in the subsidiaries indirectly through a EU company that is not taxable in France, it cannot benefit from the tax integration regime.
The ECJ found the different treatment, which puts a Community situation at a disadvantage compared to purely domestic situation, while the two situations are otherwise similar, discriminatory and in violation of the freedom of establishment.
On the second issue, the Court refused to apply the tax evasion justification and distinguished the case from Marks & Spencer on the ground that, unlike Marks & Spencer, the problem is not the risk that the same losses are used twice (by the French subsidiary and the foreign holding company), but the ability of the French parent to offset its profits with the losses and profits of its French subsidiaries in the tax group.
With regard to the coherence of the tax system argument, the Court recognized that in case of consolidation of French taxable entities, all profits and losses of the entities are combined within the group and all intra-group transactions are neutralized, which avoids the possibility to use the same losses twice at the level of the resident companies falling under the tax consolidation regime.
Instead, in case of an intermediate holding which is not taxable in France and is not member of the tax group, the losses recorded by the French sub-subsidiary may be taken into account twice, first in form of direct losses by the sub-subsidiary, and then in the form of a write down recognized by the French parent company for the depreciation of its holding in the intermediate holding, and the losses of the sub-subsidiary and the write down of the parent would not be neutralized internal transaction would not be neutralized because the intermediate holding is not subject to the tax integration regime.
In such circumstances, a resident parent would achieve the benefits of the tax consolidation regime, by immediately taking into account the losses of the companies subject to the tax integration, without the losses of the sub-subsidiary and the write-down of the parent in the stock of the foreign holding being neutralized.
As a consequence, the restriction might be justified with the need to preserve the coherence of the tax system.
However, according to the Court, the restriction goes beyond what is necessary and fails to meet the proportionality test. According to the Court, it is not always possible to identify the origin of a write down and trace it to the losses of a subsidiary, and the risk of double use of losses can be addressed with the recourse to the exchange of information system granted under the Council Directive 77/799/EEC and by asking the proper documentation and information to the resident parent.
As a result, the ECJ struck down the French rules as incompatible with the EC Treaty.
Implications under Italian Law
Under Italian worldwide consolidation rules, foreign subsidiaries can be consolidated, but under stricter rules and standards than those that applies to domestic consolidation, and taxpayers cannot benefit from the use of foreign losses to the same extent as they can use domestic losses in the domestic consolidation regime.
The main differences from domestic consolidation are as follows:
- Only the ultimate Italian parent company can consolidate foreign subsidiaries. Ultimate Italian parent company means the domestic resident company at the top of the group, whose stock is publicly traded or owned by Italian resident individuals who do not control other resident or nonresident companies. The permanent establishment in Italy of a foreign company, and the Italian intermediate holding company of a foreign group, cannot consolidate foreign affiliates owned by the Italian holding company for Italian tax purposes.
- The election for consolidation is binding for five years.
- The requirement for consolidating is more than 50 percent of stock (by value), voting power, and profits share.
- All foreign affiliates must be included in the consolidation ("all in all out" rule, which contrasts to the "pick and choose" rules that applies to domestic consolidation).
- Only a proportionate share of the foreign affiliates’ profits and losses is combined in the
computation of the consolidated income or loss (as opposed to the entire amount of profits and losses that are offset in domestic consolidation).
- Independent auditors must audit the financial statements of foreign affiliates.
- An advance ruling that certifies that all requirements are met is required to be able to
elect for worldwide consolidation.
In light of the above, from the perspective of foreign taxpayers investing in Italy, consolidation of
lower-tier foreign subsidiaries controlled by a foreign-owned Italian company is not permitted.
From the perspective of Italian investors, although consolidation of foreign subsidiaries (through the
ultimate Italian parent) is permitted, it is subject to stricter limitations compared with domestic consolidation, which makes it less advantageous in many respects.
To the extent that the foreign subsidiaries are based in a EU member states, the restrictions to worldwide consolidation might be in contracts with the freedom of establishment and non discrimination principles of the EC Treaty.
Indeed, pursuant to the ECJ ruling in Société Papillon, any restrictions to the access to the tax consolidation regime in cross-border EU situations are illegal.
The restriction may be justified under the need to combat tax evasion, but only if they are narrowly tailored to target excusively tax abusive situations (see Cadbury Schweppes), or to avoid double dipping, provided that there is any real risk or possibility that the losses are usable also in the foreign country (see Marks & Spencer), or to preserve the coherence of the tax system, but only if they do not exceed what is strictly necessary for this purpose.
Taxpayers who can benefit from tax consolidation of foreign subsidiaries in the EU but do not meet any of the standards required for this purpose should test the validity of the law under EU law principles and assess any chances of challenging them before the ECJ.