In the case of Lidl Belgium, decided on 15 May 2008, the European Court of Justice (“ECJ”) held that the freedom of establishment ensured by the Treaty of Rome does not preclude a Member State from disallowing the deduction by a taxpayer in that state of losses incurred by a permanent establishment of that taxpayer in another Member State. This decision applies to cases in which, by virtue of a double taxation convention, the income of the permanent establishment is taxed in the latter Member State and its losses cannot be used to reduce the taxation of the permanent establishment’s income in later fiscal years.

The ECJ noted that while such a tax treatment is a restriction on the freedom of establishment, since the company would be allowed to deduct the losses of a permanent establishment located in the same Member State as the company itself, it can, however, be justified in light of the need to safeguard the allocation of the taxation power between the Member States and the need to prevent a double use of the losses. The ECJ therefore concluded that these interests, taken together, pursue legitimate objectives compatible with the Treaty and thus constitute overriding reasons in the public interest which justify the restriction of the freedom of establishment, provided that the tax treatment is proportionate to these objectives.

However, the ECJ also stated that it is contrary to the freedom of establishment to disallow a company located in one Member State from deducting the losses incurred by its non-resident permanent establishment if the permanent establishment has exhausted the possibilities for deducting the losses incurred in the Member State where it is situated in the accounting period concerned and in previous accounting periods and there is “no possibility for that subsidiary’s losses to be taken into account in that State” in future periods.

Following this ECJ decision, the German Federal Fiscal Court stated in a decision of 17 July 2008 that, by way of exception, a company can deduct losses relating to a permanent establishment belonging to it and situated in another Member State if and to the extent that the company can prove that the losses can under no circumstances be utilized in the Member State in which the permanent establishment is located. The deduction must, however, be made from the company’s income generated in the same fiscal year in which the permanent establishment’s losses were incurred.

On 13 July 2009 the German Federal Ministry of Finance published a decree in which it declared that the Federal Fiscal Court’s decision will not apply to cases other than the one decided. While, in general, there is no rule that Federal Fiscal Court decisions are binding on the German tax authorities, it is nevertheless necessary to the principle of the separation of powers that the tax authorities may not ignore the Court’s decisions without reason. In this regard, the Ministry of Finance named the following reasons for its decree.

- the ECJ’s “no possibility for that subsidiary’s losses to be taken into account in that State” wording includes only legal possibilities for loss deduction regardless of whether the deduction is actually taken or not.

- In the Lidl Belgium case, the loss actually could be deducted from income generated by the permanent establishment in subsequent years and, therefore, the Federal Fiscal Court’s decision was not a decision on the merits of the case and its statement regarding the loss deduction can only be regarded as dictum.

Given these considerations, it will now be up to taxpayers to bring another case to court which will cause the German Federal Fiscal Court or the ECJ to clearly state the preconditions for inter-European deduction of permanent establishment losses.