Cross-Border Loss Relief: The Portuguese Rules and the Case for Harmonisation

Tiago Pedro Rodrigues.

2009 The Offshore & International Taxation Review, n.º 1

I - The Portuguese legislation current situation on cross-border loss relief

Article 47 of the Portuguese Company Income Tax Code (“CIRC”) sets forward the possibility of loss relief in corporate taxation, stating tax losses incurred in a given tax year can be deducted on the taxable profits from one or more of the following tax years. However, losses can only be deducted from the taxable profits of the same company which incurred the losses. This provision, a general rule on loss relief within the same company, establishes a time limit of six tax years to deduct the losses.

Furthermore, Portuguese legislation on cross border double taxation relief is based on the credit system. This means Portuguese resident companies are taxed on their worldwide income but are able to deduct the foreign tax paid in other Member-States[1]. With regard to cross border relief, the use of the credit system breaks up the cross-border loss relief analysis into two categories.

The first category is a Portuguese resident company with a permanent establishment (“PE”) in other Member-State. In this situation the head office in Portugal is taxed for its worldwide profits and deducts the tax paid in other Member-States on the income connected with the PE.  However, if any losses arise in the same PE they are deductible from the head office profits, which means in most situations cross border loss relief is available to Portuguese resident companies with PEs in other Member-States.

The second category is a Portuguese resident parent company with a subsidiary established in another Member-State. In this case the first paragraph article 7(1) of the OECD Model[2], in which the Portuguese DTT are based, requires the use of the exemption method[3]. This means that profits obtained by subsidiaries of Portuguese resident parent companies are exempt from tax in Portugal. Given that this income is exempt in Portugal, if the same subsidiaries incur in losses they will not be able to offset them against profits earned by the Portuguese resident parent company. Thus, cross-border loss relief is not available to Portuguese resident parent companies with subsidiaries in other Member-States. However, when comparing this scenario with a purely domestic situation comprising a Portuguese resident parent company with a Portuguese resident subsidiary, the results may be different.

This difference arises from the possibility of using the Portuguese special regime for tax groups (“PT Group regime”).

The PT Group regime consists of a tax consolidation system in which the results from the companies that form part of the group are consolidated at the level of the groups’ dominant company.

Under article 64(1) of the CIRC, the taxable profit of the group is assessed by the dominant company through a algebraic sum of the taxable profits and tax losses assessed in the individual tax returns of each of the companies part of the group.

 In the Portuguese case, a company may be included in a tax consolidation group if it holds or is held, directly or indirectly, at least 90% of the capital of one or more companies, called dominated, provided that such participation confers more than 50% of the voting rights (article 63(2) CIRC).

However, under article 63(3) of the CIRC, other cumulative requirements will also have to be met:

(i)     The companies making part of the group must all have registered office and central management in Portuguese territory and all their income must be subject to the Portuguese Corporate Income Tax general tax regime at the highest normal rate foreseen;

(ii)     The dominant company must have held the participation in the dominated company at least for one year from the date in which the application of the PT Group regime starts;

(iii)    The dominant company must not be considered dominated by any other Portuguese resident company which meets the requirements to qualify as a dominant company;

(iv)    The dominant company must not have renounced to the application of the PT Group regime in the three years prior to the date in which the application of the PT Group regime starts; 

Additionally, the Portuguese rules on the PT Group regime also foresee that companies where the required participation percentage, of at least 90%, is obtained indirectly through an entity which fails to meet the legal requirements referred above may not be included in the tax group (article 63 (4) (f) CIRC).

From the analysis of the Portuguese provisions we can safely conclude that, in a purely domestic situation of a Portuguese resident parent company with a Portuguese resident subsidiary using this regime, the parent company will be able to offset the losses suffered by the subsidiary from its taxable income.

The same advantage is not possible in a cross-border situation because non-resident subsidiaries (even if EU resident companies) are not allowed to join the tax group. This situation, in practice, renders the possibility of cross-border loss relief impossible for Portuguese parent companies even in the case of final losses.

Thus, because the PT Group regime is available only to Portuguese companies, there is no possibility of cross border deduction of losses incurred by subsidiaries located in other Member-States.

In the next chapter I will explain why the present situation is incompatible with the EC Treaty.


II - Incompatibility of the Portuguese rule with the EC Treaty

A discrimination on freedom of establishment arises only if there is a difference of treatment between two comparable situations, or, if the same treatment is given to two non-comparable situations[4].

In this situation, in order to reach the conclusion on the existence of a restriction on freedom of establishment we have to start by comparing the cross-border and the purely domestic situations, so as to check if they are in a comparable situation. Hence, a Portuguese resident parent company with a subsidiary in another Member-State and a Portuguese resident parent company with a subsidiary in Portugal.

In both cases the subsidiaries are subject to corporate tax. However, the Portuguese subsidiary is subject to corporate tax in Portugal while the second is subject to corporate tax in the UK[5]. Both Member-States have allocated their taxing rights so as to exempt the income of foreign subsidiaries according to Article 7 of the OECD Model. This means that Portugal is not allowed to tax the worldwide profits of a UK subsidiary unless those profits arise in Portugal [6].

However, according to the ECJ approach, it is important to check the purpose of the domestic rules in order to assess if the same purpose could not be fulfilled in cross-border situations. The Portuguese rules have the purpose of taking into consideration the economic circumstances of a group of companies by allowing them to be considered, for taxing purposes, as a single economic unit. Nevertheless, this benefit is given to the group in the assumption that all companies in the group are subject to Portuguese corporate tax given that, according to the allocation of taxing rights in article 7 of the DTT, Portugal is able to tax foreign subsidiaries and, thus, does not have to take into consideration the losses incurred by the same subsidiaries.

Allowing companies established in other Member-States to offset their losses in their Portuguese parent companies would mean Portugal was waiving its taxing rights on profits earned by Portuguese resident parent companies to the Member-State where the subsidiary is established. This would open the tax avoidance “door" to companies wanting to shift their profits to lower tax jurisdictions. Thus, the conclusion may only be that the cross-border and purely domestic situation are not in a comparable position, seeing as, the foreign subsidiary is not subject to Portuguese tax.

However, an advantage granted to a purely domestic situation can still constitute a restriction to freedom of establishment according to the ECT[7]. The PT Group regime and its exclusion of non-Portuguese companies can hinder Portuguese companies from establishing themselves abroad by granting a less favourable treatment in relation to the offsetting of losses.

In fact, by applying a migrant/non-migrant test, the conclusion is that an enterprise which chooses to take its business cross-border suffers a cash flow disadvantage on the offsetting of losses when compared to an enterprise which chooses to remain in Portugal. Additionally,  when the loss is “final” it suffers the disadvantage of losing the possibility to offset the loss completely.

This is a valid point because, when establishing abroad, companies are undertaking a large investment and may suffer large losses in the first years of the company’s activity. Thus, when taking a decision to open a subsidiary, companies are discouraged to do so in other Member-state, because of the disadvantage given by the PT Group regime. However, because this advantage to purely domestic situations only occurs when companies apply for the PT group regime doubts could arise on the possibility of this voluntary benefit constituting an obstacle on freedom of establishment.

I believe it does. This view is supported by an example from the past ECJ’s jurisprudence. In fact, the Metallgesellschaft[8] judgment showed us that in situations where, by being able to form a group, resident companies are at an advantage in comparison with other EU companies, which are unable to join the same group, a restriction to the fundamental freedom is found to exist.


III - The Metallgesellschaft decision

The Metallgesellschaft[9] judgment concerned the obligation imposed on companies resident in the UK to pay advance corporation tax with respect to dividends paid to their parent companies. In this case there were several subsidiaries resident in the United Kingdom distributing dividends to their parent companies resident in Germany. According to UK rules at the time (section 247 ICTA) two companies resident in the UK, one of which holds at least 51% of the other, may make a group income election. This group income election resulted among other things in the possibility of the subsidiary not paying ACT on the dividends which were paid to its parent company.

Non-resident companies were not allowed to make a group income election which was only for UK resident companies. The German parent companies considered that this difference in treatment amounted to unjustified discrimination between parent companies resident in different Member-States, contrary to the EC Treaty, because it was impossible for non-UK residents and their UK subsidiaries to form a group income election enabling the subsidiaries to avoid payment of ACT.

Notwithstanding the fact that the ACT paid by subsidiaries resident in the UK could later be deducted against the mainstream corporation tax, the possibility of making a group income election constituted a cash-flow disadvantage to subsidiaries of parent companies resident outside the UK. This cash-flow disadvantage comes from the fact that in a purely domestic situation subsidiaries were able to retain, until the date when the mainstream corporation tax was due, the sums which they would otherwise have had to pay, as ACT, on the distribution of dividends to their parent companies.

The ECJ concluded as follows:

“to afford resident subsidiaries of non-resident companies the possibility of making a group income election would do no more than allow them to retain the sums which would otherwise be payable by way of ACT until such time as MCT falls due. They would thus enjoy the same cash flow advantage as resident subsidiaries of resident parent companies (... ) the difference in the tax treatment of parent companies depending on whether or not they are resident cannot justify denial of a tax advantage to subsidiaries, resident in the United Kingdom, of parent companies having their seat in another Member State where that advantage is available to subsidiaries, resident in the United Kingdom, of parent companies also resident in the United Kingdom, since all those subsidiaries are liable to MCT on their profits irrespective of the place of residence of their parent companies”[10].

Also, with regard to justification:

“the refusal to allow subsidiaries, resident in the United Kingdom, of parent companies resident in another Member State to make a group income election cannot be justified on grounds relating to the need to preserve the cohesion of the United Kingdom's tax system”[11].

Therefore, the Court found the different treatment of a purely domestic situation and a cross-border situation, consisting of a cash-flow advantage given to the purely domestic situation, contrary to Article 52 of the EC Treaty mainly because non-resident parent companies could not make a group income election.

The parallel with the Portuguese situation on cross-border loss relief is immediately identifiable. Considering that a non-resident company is not allowed to make a tax consolidation group with a Portuguese resident company, a purely domestic situation is given a cash-flow advantage consisting on the possibility of immediately deducting their losses on profits earned on other group companies.

Thus, the cross-border situation is disadvantaged in comparison to a purely Portuguese situation because the latter will be able pay less tax immediately while the former will have to wait until the company sustaining the losses is profitable in order to deduct the losses accumulated.


IV - Justification

After laying down the existence of a restriction on freedom of establishment it is still necessary to determine whether the Portuguese domestic rules can be considered justified by imperative reasons of public interest and, if that is the case, whether the Portuguese domestic rules are proportional.

The requirements to consider on this matter come from the jurisprudence in Gebhard[12] and Kraus[13]: (i) the application of the rule in a non-discriminatory way; (ii) the need to meet a general public interest; (iii) to be adequate and necessary to attain its purpose; and (iv) it cannot go beyond what is necessary to attain the said purpose.

With regard to the first requirement referred above it is my contention that the different treatment given to a purely domestic situation and a cross border situation (migrant/non-migrant) was not discriminatory. This conclusion was made on the basis that the two situations are not in a comparable position because the foreign subsidiary is not subject to tax in Portugal on its business profits. Thus, I can safely assume that Portuguese domestic rules which deny the possibility of cross-border loss relief are discriminatory, seeing as they treat different situations differently, in tune with the jurisprudence established in the Schumacker[14] judgment.

To check the remaining requirements of the Gebhard jurisprudence, it is necessary to analyse the recent justification used by Member-State on these types of rules. The balance achieved by the allocation of taxing rights between Portugal and other Member-States on the taxation of profits. As shown above, allowing the cross-border loss relief from foreign subsidiaries would jeopardize Portugal’s tax sovereignty, seeing as, it would mean Portugal was waiving its taxing rights on business profits of companies residing in Portugal.

Also, by allowing the cross-border loss relief, Portugal would be “opening the doors” to a major tax avoidance opportunity. In fact, Portugal has one of the highest corporate tax rates in the EU, especially after new members joined the EU. Thus, it safe to assume that companies would try to shift the taxation of profits to lower tax jurisdictions in the EU and save a significant amount of tax by transferring losses to Portugal. This possibility makes the cross-border loss relief a very difficult system to implement in the EU without some form of harmonization between Member-States.

The third argument of the justification used in Marks & Spencer[15] was the possibility of double deduction of losses. In the transfer of losses between companies from one Member-State to the other, opportunities could arise where losses would be used twice, once in the host state and again in the origin state. I believe the instruments in place in the EU, specifically the mutual assistance for the recovery of tax directives, allow Member-States to combat this possibility by merely asking Member-States for information allowing them to control the double dipping possibility.

In Marks & Spencer, the Court did not agree with this view and considered this risk to be relevant in the analysis of the justification, accepting it as an argument to maintain the UK domestic rules. Nevertheless, the Court has already accepted this justification in Lidl Belgium[16] where only two of the three arguments were used.

The conclusion is that the ECJ will accept domestic rules on cross-border loss relief that can be justified by two of the three arguments presented in Marks & Spencer, and also sustains that rules disallowing the possibility of offsetting cross-border loss relief are adequate to attain the purpose of avoiding disrupting the balanced allocation of taxing rights and the risk of tax avoidance which would arise.


V - Proportionality

Finally, it is necessary to determine if Portuguese domestic rules are in any way disproportionate. In order to make this analysis we must check if the requirements established in Marks & Spencer (and later confirmed in Oy AA[17] and Lidl Belgium) are fulfilled. The ECJ described two situations where the cross border loss relief must be allowed in order for the domestic rules to be considered proportional.[18]

By establishing these two requirements the ECJ clearly stated that loss relief regimes that do not allow the cross-border loss relief in situations where the possibilities of offsetting the losses in the state of residence have been exhausted do not pass the proportionality test and fail to meet the last requirement established in the Kraus and Gebhard judgment.


VI - Conclusion

Looking at the Portuguese domestic rules analyzed above, it is clear that the Portuguese domestic rules do not allow cross-border loss relief by means of the tax consolidation group, even in situations where the foreign subsidiary has exhausted all possibilities of deducting the losses in their residence state.

This includes situations where the (i) time limit for loss relief is surpassed, and (ii) companies have sold its facilities or ceased trading. The Portuguese domestic rules exclude, without exception, all possibilities of a foreign subsidiary becoming part of a tax consolidation group, given that, the special regime can only be chosen by Portuguese resident companies.

The conclusion is also fairly simple: according to the ECJ jurisprudence in the area of cross-border loss relief, the Portuguese domestic rules are justified but not proportional. Thus, the rules must be altered in order to become compatible with freedom of establishment and the ECT.


VII - Possible solutions to the present incompatibility

When trying to deal with the incompatibility found in the Portuguese domestic rules on loss relief several solutions can be found. The first, and more obvious solution, would be to end the PT Group regime for all companies. By ending the regime Portugal would be avoiding the disadvantage given to cross-border situations. However, this solution brings two sorts of problems. The first is that Portugal would still be responsible for situations which had already occurred during the time the regime was in place. The second problem is Portugal would be ending the regime for the wrong reasons; the Portuguese economic groups would see their present situation disadvantaged only so the benefit would not be extend to cross border subsidiaries in final losses scenarios.

Additionally, this does not seem to be the way in which the EU wants to progress. In December 2006, the European Commission released a communication to the Council, the European Parliament and the European Economic and Social Committee on the Tax Treatment of Losses in Cross-Border Situations[19]. In this communication the Commission stressed that allowing cross-border relief is one step further toward achieving the Lisbon Strategy and suggested three possible ways in which Member-States could change their domestic rules in order to allow the cross-border loss relief.

The first alternative is the definitive loss transfer or intra-group loss transfer. This possibility would allow a definitive transfer of losses within a domestic group income election scheme without any later recapture of future profits. This solution implies loss of tax revenue by the Member-State of the company that absorbs the losses, which would otherwise tax if the cross-border loss relief was not granted. To avoid the loss of tax revenue the Commission suggests a clearing system where the Member-State of the company absorbing the losses would be compensated by the Member-State of the company surrendering the loss in case the company was systematically offsetting losses from one Member-State to the other.

This solution is questionable, not only because it would require harmonization between Member-States in an area in which Member-States are still not prepared to bring harmonization, but would also create a complex compensation regime which as the Commission states “would need to take account of any significant differences between applicable tax rates and tax accounting rules”.

The second alternative suggested by the Commission was the temporary loss transfer or deduction and recapture method[20]. According to this solution a loss suffered by a subsidiary in one Member-State could be deducted from the results of a parent company resident in another Member-State but would subsequently be recaptured in future years as soon as the subsidiary obtained profits. The recapture of the losses would be done by a corresponding additional tax burden at the level of the parent company which would have to pay the tax whose payment was avoided when the losses suffered by the subsidiary were immediately offset in the results of the parent company.

This mechanism would avoid the cash flow disadvantage seen in Lidl Belgium in situations involving subsidiaries, seeing as, by allowing immediate temporary relief for the cross-border losses, companies would not have to wait for the subsidiaries to become profitable before offsetting the losses. The results of the whole economic group would be considered and taken into account. This solution was the approach chosen by the Commission in their proposal for a Directive submitted in 1990 but which was not brought forward by Member-States.  

The third alternative was the current taxation of subsidiary’s results or system of consolidated profits. The main idea behind this solution is to apply the credit system instead of the exemption system to subsidiaries and treat them as if they were PEs.

Thus, as in a situation between a head office and its PE, parent and subsidiaries would have consolidated results which meant profits and losses for a given tax year of the group (subsidiary and parent company) would be taken into account at the level of the parent company. To avoid double taxation the Member-State would apply the credit method and allow the subsidiary to deduct, from the tax payable in the Member-State of the parent company, the tax already paid in the Member-State of the subsidiary relating to the latter’s income. Also, profit distributions between group members would not be taken into account for taxing purposes.

This solution would obviously solve the cross-border loss relief problem. The losses would immediately be taken into consideration at the level of the parent company. Additionally, this solution was intended to work as a voluntary regime in which companies would elect to participate for a certain period in the same way as the current PT Group regime.

The Commission suggests two different schemes in this system of consolidated profits: (i) a selective scheme where groups could choose which companies would form the group, or (ii) a comprehensive scheme where, if the group chose to be taxed according to this regime, all subsidiaries of the group were automatically elected.

In our opinion, the main problem with this solution is that it constitutes a deviation to article 7 of the OECD model. According to the allocation of taxing rights in article 7, the business profits of foreign subsidiaries can only be taxed in the State of residence of the subsidiary. This problem can be surpassed by making it an elective and voluntary scheme. However, there is still doubt whether situations of final losses in companies which chose not to elect the scheme (and thus could not offset the losses) would still constitute a restriction on freedom of establishment.

Other problems with this option include the large compliance costs with documentation given that groups would have to recalculate the income of the group members under the rules of two different sets of rules (i) the Member-State of the parent company, and (ii) the Member-State of the subsidiary. Also, this regime would be vulnerable to aggressive tax planning techniques involving concentrating costs in subsidiaries chosen for consolidation.[21]

I would suggest another solution: to change the Portuguese domestic rules in order to only accommodate the decision of the Court in Marks & Spencer. This could be done by changing the provisions in CIRC so as to allow subsidiaries with final losses to enter the group and offset their losses at the level of the parent company. However, this solution would require further study so as to find a way to accommodate the Marks & Spencer decision without making the Portuguese regime incoherent. Additionally, this solution would not allow Portugal to recapture future profits of the subsidiary in situations where the subsidiary had ceased trading, meaning that Portugal would be, in some situations, effectively waiving taxing rights on profits of a resident parent company.

The current Portuguese domestic rules do not respect this balance and do not allow for final losses to be offset on a Portuguese parent company part of a tax consolidation group. However, the ECJ decision in Marks & Spencer is very clear, Portugal is required to accept final losses of a foreign subsidiary held by a Portuguese resident parent company.

With respect to possible solutions to the present incompatibility of Portuguese domestic rules, although the simplest solution would be ending the PT Group regime, and thus, avoiding foreign subsidiaries from deducting final losses in Portuguese resident parent companies, I believe this would be a step in the wrong direction.

If the EU wants to become the most powerful economy in the world it must continue to push forward in the area of direct taxation and keep forcing the harmonization of the rules between Member-States. However, because harmonization in the area of direct taxation is still a Member-states competence, Portugal is not required to bring forward rules which require harmonization.[22]

Furthermore, it is not up to the ECJ to enforce this harmonization on Member-states. In fact, the role of the ECJ is to, through its decisions, enforce negative integration deciding whether Member-States’ domestic rules are compatible with the fundamental freedoms. However, the ECJ is not competent to enforce Member-States to introduce provisions into their domestic laws.

The introduction of new rules or harmonized rules by way of positive integration is a role reserved for the Commission and other institutions of the EU. However, the fact that the Commission has not proposed any harmonization rules in this area does not mean Member-States can disregards the effects that a judgment by the ECJ has on the rules of all Member-States. In the AMID[23], Marks & Spencer and Lidl Belgium judgments the Court defined the requisites which Member-States’ domestic rules must meet in order to be considered compatible with the freedom of establishment.

In conclusion, although Portugal is not required to bring forward rules which would allow the cross-border loss relief of temporary losses, it will have to choose one of the solutions proposed above in order to allow final losses of foreign subsidiaries to be offset at the level of the Portuguese resident company. Otherwise, companies in a situation of final losses can make their right prevail in Court.

[1] The only exception among Member-States is Austria because of the double tax treaty (“DTT”) negotiated between both States, which establishes the exemption method.

[2] According to this widely used provision “The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein”.

[3] See comments to article 7 in Philip Baker  “Double Taxation Conventions - A Manual on the OECD Model Double Taxation Convention, ed. Sweet & Maxwell, Londres 2007.


[4] Firma A. Racke v Hauptzollamt Mainz (C-283/83). Also check joined Cases 17/61 and 20/61 Klöckner-Werke AG and Hoesch AG v High Authority of the European Coal and Steel Community and Case C-279/93 Schumacker.

[5] Except when the income arises in the host country’s territory.

[6] As we saw in the Deutsche Shell judgment the allocation of taxing rights concerning profits means that states have also allocated the losses and are not obliged to take into consideration losses suffered by foreign subsidiaries (paragraph 42).

[7] As we saw in the analysis of the Deutsche Shell judgment even if the cross-border and purely domestic examples are not comparable the domestic rules can still hinder the freedom of establishment.

[8]  Metallgesellschaft Ltd v Inland Revenue Commissioners (C-397/98), [2001] S.T.C. 452.

[9] [2001] STC 452.

[10] Paragraph 54.

[11] Paragraph 73.

[12] Case C-55/94 [1995] ECR I-4165.

[13] Case C-1992 Kraus v Baden-Wuerttemberg [1993] ECR I-1663.

[14] Case C-279/93 Finanzamt Koln-Altstadt v Roland Schumacker  [1995] ECR I-00225.

[15] Case C-446/03 Marks & Spencer plc v Commissioners of Custom and Excise [ECR I-10837].

[16] Case C-414/06 Lidl Belgium GmbH & Co. KG v Finanzamt Heilbronn [2008] ECR I-03601 Paragraph 42.

[17] C-231/05 [2007] ECR I-06373

[18] As we said above in our analysis of Marks & Spencer the two situations are “- the non-resident subsidiary has exhausted the possibilities available in its State of residence of having the losses taken into account for the accounting period concerned by the claim for relief and also for previous accounting periods, if necessary by transferring those losses to a third party or by offsetting the losses against the profits made by the subsidiary in previous periods, and (…) - there is no possibility for the foreign subsidiary’s losses to be taken into account in its State of residence for future periods either by the subsidiary itself or by a third party, in particular where the subsidiary has been sold to that third party”. (paragraph 55).

[19] COM (2006) 824 final {SEC(2006) 1690}.

[20] This was also the method which was in place in Germany until 1990 and which Advocate General Sharpston used to try to demonstrate German domestic rules could set forward less restrictive measures and, therefore, were not proportional according to the Gebhard jurisprudence. This alternative has the advantage to be relatively easy to operate and implement.

[21] This regime would be something similar to the check-the-box regime adopted by the USA. This regime allows a foreign entity taxed as corporation or as transparent for US tax purposes. For more information on this regime see Jesper Barenfeld book “Taxation of Cross-Border Partnerships: Double Tax Relief in Hybrid and Reverse Hybrid Situations” - Doctoral Series: Vol. 9.

[22] The Court stated this in the Marks & Spencer judgment when it said: “Furthermore, in so far as it may be possible to identify other, less restrictive measures, such measures in any event require harmonisation rules adopted by the Community legislature”. (paragraph 58).

[23] C-141/99 Algemene Maatschappij voor Investering en Dienstverlening NV (AMID) v Belgische Staat [2000] ECR I-11619