Taking The Taxman To Court

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As a business venture, the expansion into Continental Europe by British retailer Marks & Spencer, which accelerated in the mid-1990s, was an expensive failure. In 2001, the company shut down or sold its stores in Belgium, France and Germany after incurring losses of $186 million. But the ultimate cost, it now turns out, is likely to be far, far higher — not for the firm itself, but for the British Treasury and governments across the European Union. The reason: Marks & Spencer is on the verge of setting a precedent in European tax law, one that directly challenges national tax policies in many E.U. member states. Thanks to a preliminary decision issued last week by the European Court of Justice (E.C.J.), many E.U. governments could face billions of dollars in back-tax claims, and will probably have to overhaul significant parts of their corporate tax codes.

How did a struggling groceries-and-underwear retailer cause such upheaval? Marks & Spencer wanted to use the losses incurred in its disastrous European foray to offset profits from operations in Britain. Firms in most E.U. nations commonly make use of losses in this way, but primarily to offset profits made in the same country as the losses. In 2001, the company cited Britain's "group relief" rules that allow firms to cluster different business units for tax purposes; if successful, the argument would have gained Marks & Spencer tax relief of about $56 million. But that same year, Britain's Inland Revenue said no, declaring that Marks & Spencer had no right to deduct its Continental losses because they hadn't been incurred in Britain. The retailer appealed the decision to the E.C.J., and last week E.C.J. advocate general Miguel Poiares Maduro weighed in on its side. He said the British ruling was a violation of the E.U.'s founding Treaty of Rome, which enshrines the freedom of establishment and outlaws any form of discrimination based on nationality. He said the British law "imposes a specific disadvantage on operators desirous of moving or establishing themselves within the Community." While the full Court of Justice won't issue a final opinion before the fall, governments are quaking over the ruling's potential effects. "This is pretty strong stuff," says Fred de Hosson, a tax partner at Baker & McKenzie in Amsterdam. "It's another wake-up call for member states" to bring their tax systems closer in line.

But it's a wake-up call that could have been anticipated. Tax has long been the odd man out of European integration. While E.U. states have largely coordinated their policies on value-added tax and custom duties to smooth the workings of the single market, national governments continue to jealously guard the right to set their own direct taxation of companies and individuals. The very notion of tax "harmonization" is vigorously opposed by some governments, particularly Britain and the new member states in Eastern Europe where rates are lowest; the latter see harmonization as a code word for higher taxes. The result is a patchwork of sometimes widely divergent policies that tend to treat domestic operations differently from international ones for corporate tax purposes.

For the past few years, the E.C.J. has consistently ruled against any tax treatment that differentiates between domestic and E.U.-based affairs. De Hosson, for example, represented a Dutch auto-parts company named Bosal Holding that in 2003 won a tax victory at the E.C.J., at that time against the Dutch government, which had refused to allow the firm to deduct interest and other costs incurred by its subsidiaries in other E.U. countries. The Dutch government estimated the decision would cost its national budget more than €2 billion if other companies followed suit, and quickly set about revamping its tax legislation to lessen the discrimination between national and E.U.-based transactions.