The end of fiscal sovereignty in the UK?

The end of fiscal sovereignty in the UK? - at Moneyweek.co.uk - the best of the week's international financial media.

A preliminary EU judgment has ruled that Marks & Spencer should be allowed to offset European losses against its UK tax bill. This has radical implications, says Simon Wilson.

Why did M&S go to court?

Between 1998 and 2001, M&S made a loss of around £100m from its ill-fated and now-abandoned expansion into Belgium, France and Germany. When the Inland Revenue refused to let the retailer cut its tax bill by offsetting these losses against its UK profits, M&S went to the High Court. Its case, subsequently referred to the European Court of Justice (ECJ) in Luxembourg, was that British tax law in effect penalises investment in other EU states, thus breaching EU law. If M&S wins, as now seems highly likely after a senior court official gave a preliminary recommendation in its favour earlier this month, it stands to gain about £30m in back-dated tax relief from the Government.

What is the Government's case?

Britain's tax system does allow what's known as "group relief", which lets companies offset losses from one UK-based subsidiary against profits from another. But the Treasury does not let firms offset losses from foreign subsidiaries, because the tax revenue from any subsequent profits would flow not into British coffers, but into those of foreign governments. Moreover, letting companies deduct losses made abroad would have the effect of distorting the EU's single market, since companies could start offsetting losses made in low-tax regimes (Estonia, for example) against profits in higher-tax nations.

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What has the European Court of Justice ruled?

Nothing yet. The judgment given on 7 April is a preliminary opinion given by its Advocate General, Poiares Maduro. He has found unambiguously in favour of M&S on the grounds that Britain's current rules "impose a specific disadvantage on operators desirous of moving or establishing themselves within the community". In other words, it amounts to discrimination based on nationality and thus breaches a core principle of the EU's founding Treaty of Rome. The ECJ's final ruling is not expected until autumn - but the Court follows the Advocate's advice in 80% of cases.

Does this just affect M&S?

Absolutely not. Potentially, it affects every EU business with operations in more than one country - and nearly every member-state government. They could now face massive shortfalls in corporation tax as well as loss of their fiscal sovereignty to the EU. That's why representatives from seven national governments, including France, Germany, and the Netherlands, lined up behind Britain at the hearing in Luxembourg to argue against M&S. Only the European Commission backed the firm.

Are other firms following M&S?

Yes, lots. Dozens of big companies - including the BT Group, BNP Paribas and US firms Caterpillar, PepsiCo and HJ Heinz - have filed for tax relief in the UK, using the same criteria as M&S. And Simon Whitehead of solicitors Dorsey & Whitney, who represents M&S, says that 70 multinationals have signed up to a group action organised by his firm.

How much money are we talking?

Enough to upset government tax and spending plans, not just in Britain but across the EU. A recent report from Morgan Stanley puts the possible cost to the Treasury at £768m, with BT Group alone looking for £404m back from the Government. But estimates vary widely - some running into billions of pounds - in part because it is not yet clear whether the judgment (when it comes) will be made retroactive, or whether it will only apply to profits/losses made after the ruling is given. Isabelle Kronawitter, an economist with the German bank HVB, puts the chances of retroactive claims being permitted at fifty-fifty. If they are, then German finance minister Hans Eichel believes his government could lose a ruinously large e50 billion, or 1.5% of GDP. Adam Craig, head of European tax practice at Deloitte Touche, believes that companies that have already made claims are very likely to be awarded retroactive compensation. He thinks the UK Treasury faces a bill of up to £1bn.

How will the Government respond?

It could simply abolish group tax relief altogether, which would raise more tax for the Government, but would make the UK highly unattractive for big companies. That looks unlikely. A second option would be to follow the example of Denmark and Italy, who are unaffected by the M&S case because companies that offset foreign losses also have to pay domestic tax on foreign profits. That route is possible. But the Government will also be taking comfort from a significant caveat in the Advocate General's statement - the suggestion that firms shouldn't be able to offset foreign losses in countries where the tax laws let them carry losses forwards into subsequent tax years.In this sense, the ruling is bad news for the Treasury, but not as bad as it might have been.