EU State Aid and Tax Rulings - The Net Widens

Multi-National Enterprises (MNEs) that have received favourable tax rulings from EU Member State tax authorities (notably the tax authorities in Luxembourg and the Netherlands) continue to be within the scope of the European Commission’s investigation into whether such rulings constitute unlawful State Aid with the risk that substantial amounts of tax ‘saved’ may have to be repaid.

EU Commission decisions in the cases of Fiat, Starbucks, the Belgian Excess Profit Rulings Exemption regime (BEPE) and, most recently, the Irish case of Apple, together with comments from the EU Competition Commissioner (Margrethe Vestager) suggest that more State Aid investigations may be forthcoming and we understand that the Commission is currently investigating up to 100 Unilateral Advance Pricing Agreements.

The Apple decision was announced only three days before we went to press and the full reasoned decision has not yet been released. We will therefore provide a full analysis in the next edition of this publication. It does seem from the announcement, however, that the technical basis for the decision may not be particularly robust – in particular the selectivity condition which is at the heart of the concept of State Aid has not obviously been addressed. The Irish government and Apple have both indicated their intention to appeal. 

Key points

•  Tax Rulings which comply with OECD transfer pricing guidelines may not necessarily prevent the existence of unlawful State Aid.

• MNEs with tax rulings granted by EU Member State tax authorities should review those tax rulings.
• MNEs (particularly US based MNEs) should consider whether the established existence of State Aid on facts similar to their own tax rulings requires disclosure in financial statements.

Background

In October 2015, the European Commission issued final decisions confirming that the Governments of the Netherlands and Luxembourg conferred unlawful State Aid of at least EUR 20 million on both Starbucks’ Dutch manufacturing company and Fiat’s Luxembourg group finance company by granting tax rulings regarding the amount of profit to be shown and tax required to be paid in those jurisdictions.

Both Member States and Fiat (as one of the beneficiaries of the State Aid) have now made pleas for annulment of these decisions at the European Court of Justice.

Given that many MNEs will have tax rulings regarding the amount of profits and tax to be reported in the Netherlands and Luxembourg similar to those issued to Starbucks and Fiat, it is important to consider what these two State Aid decisions might mean for those MNEs.

The Fiat decision will be of particular interest for two reasons:

• the use of group treasury and finance companies amongst MNEs, as in Fiat, is perhaps more common than the use of toll or contract manufacturing companies seen in Starbucks; and
• Margrethe Vestager’s comments to the European Parliaments TAXE 2 Committee in January suggest that Advance Pricing Agreements (APAs) issued by Member States to group financing companies may be subject to ongoing investigation.

The BEPE decision may also be relevant as it concerns what is effectively a profit allocation agreement which is similar to the unilateral APAs agreed with Tax Authorities to determine the level of profit to be reported by a group company in a jurisdiction.

What is State Aid?

The four criteria for State Aid

1               The existence of an advantage.

2               The advantage is selectively granted to certain undertakings.

3               The use of State Resources.

4               The creation of a distortion of trade between Member States.

State Aid can arise where the use of state resources results in an advantage being given to some over others in circumstances where the four criteria for State Aid are satisfied. Member States are prohibited from providing aid without the prior authorisation of the EU Commission; their intent being to safeguard fair competition within the EU.

While the EU Commission does not generally have competence over a Member State’s system of direct taxation, it can intervene by opening investigations if a Member State’s tax arrangements (usually in the form of tax rulings and tax incentives) breach State Aid rules. EU State Aid rules therefore apply to undertakings with business activities in Member States.

State Aid rules typically manifest themselves in one of two ways in respect of a Member State’s tax arrangements:

• a tax regime or a specific tax measure provides a ‘selective advantage’ (e.g. a tax reduction or deferral) to a taxpayer or class of taxpayers; or
• a specific arrangement with a taxpayer (e.g. a ruling or APA) provides a selective advantage to that taxpayer.

Although four criteria need to be satisfied to find the existence of State Aid, in practice and under case law, the criteria listed as 1, 3 and 4 above are generally satisfied in relation to these tax arrangements.

Establishing a selective advantage

The courts generally adopt the following three-step analysis to decide whether a tax measure confers a selective advantage:

• identify the common or normal tax regime applicable in the relevant Member State (the 'reference system');         

• determine whether the particular tax measure (e.g. the legislation, ruling or APA), constitutes a derogation from the reference system, insofar as it differentiates between economic operators who, in light of the objectives intrinsic to the system, are in a comparable legal and factual situation; an

• determine whether the measure is justified by the nature or general scheme of the reference system if the particular measures does differentiate.

The BEPE and Fiat decisions allow us to predict how this analysis will play out in a group finance context.

The BEPE and Fiat decisions

What is BEPE?

Pursuant to BEPE, Belgian resident companies that are part of a multi-national group were able to reduce their tax base in Belgium by deducting an amount of “excess profit” from their actual recorded profit. The “excess profit” is the actual amount recorded less the hypothetical average profit that a stand-alone Belgian company carrying out comparable activities could be expected to make in comparable circumstances. The rationale behind BEPE was to ensure that a Belgian group entity was not taxed on profits in excess of its arm’s length profit, i.e. it was not taxed on any profits derived from benefitting from being within a multi-national group.

A company had to obtain an advance ruling to benefit from the BEPE.

The Fiat APA

Fiat Finance and Trade (FFT) obtained an APA from the Luxembourg authorities confirming the transfer pricing methodology to be applied to FFT’s intra-group activities. The remuneration payable to FFT was determined by reference to the capital needed by FFT to perform its functions and to bear its risks, in relation to assets in use, and effectively allowed FFT to pre-determine its taxable profit in Luxembourg on a yearly basis on the basis of a level of capital which the Commission considered to be unjustifiably low. This, therefore, pre-determined the amount of corporate income tax payable in Luxembourg on the basis of that level of capital.

The reference system

In both the BEPE State Aid Scheme and the FIAT decision, the Commission was clear that a reference system must be a consistent set of rules applied on the basis of objective criteria to all undertakings within its scope as defined by its objective, i.e. the ordinary system of taxation of corporate profits under the Belgian Corporate tax system and Luxembourg Corporate tax system respectively, the objective of which is to tax standalone or group companies on their profits.

BEPE was neither an inherent part of nor an application of this reference system; it was a derogation from that reference system since it was available only to companies that are part of a multinational group.

Similarly, in the Fiat decision the Commission rejected FFT and Luxembourg’s assertions that the reference system should be restricted to companies subject to transfer pricing rules which had obtained APAs, as the reference system was the taxation of both standalone and group companies, and that they could not assess by reference to taxpayers who had obtained APAs as the APAs provided to the Commission were too inconsistent to constitute an appropriate reference system.

The selective advantage

The Commission considered that BEPE conferred a selective advantage on Belgian companies for three main reasons:

• it was only available to Belgian members of multinational groups;
• the rulings were effectively advance rulings in respect of future operations; and
• as BEPE only exempts profits which result from synergies and economies of scale related to being part of a multinational group, only those entities forming part of such a multinational group have an incentive to obtain a ruling under the BEPE.

In Fiat, the tax rulings constituted a derogation from the reference system leading to unequal treatment between Fiat and a stand-alone Luxembourg company. FFT’s activities were similar to those of a bank, and therefore the taxable profits could be determined in a similar way to a bank. However, the parameters and calculations applied under the tax ruling to determine the arm’s length remuneration were challenged by the Commission as artificial and inappropriate for the calculation of taxable profits reflecting market conditions. In particular a selective advantage arose due to remuneration being calculated by reference to an estimation of capital much lower than actual capital (due to a number of economically unjustifiable assumptions and downwards adjustments), and the rate of remuneration on the capital being lower than market rates.

Deviation from the arm’s length principle

The essence of the Commission’s decisions was that the methodology accepted by the Belgian and Luxembourg tax authorities, respectively, for determining the adjusted arm’s length profit departs from a methodology that leads to a reliable approximation of a market-based outcome, and thus from the arm’s length principle. The BEPE/ methodology agreed under the Luxembourg APA therefore lowered the taxpayer’s tax liability under the corporate tax system as compared to undertakings in a comparable factual and legal situation.

The phrase ‘reliable approximation of a market-based outcome’ which is used throughout the decision seems to be the Commissions view of the arm’s length principle and insofar as the Commission did not like the transfer pricing methodology used (in this case application of the TNMM) it decided that that amounted to a selective advantage and thus unlawful State Aid.

In the Fiat decision the Commission accepted that the remuneration based on the TNMM was an appropriate transfer pricing method to use, but held that the assumptions, parameters and calculations applied were not, because the capital to be rewarded is understated and the functions are not correctly stated. Similarly, the Commission did not object to the use of TNMM itself in the BEPE but rather that it was applied to both Belgian and non-Belgian parties at different stages of the process.

Many finance company rulings will undoubtedly have used TNMM, and will therefore need to consider, in light of the detailed comments by the Commission in the decisions as to the methodology and calculations used, whether that correct method has been used and whether that method has been applied to reflect a “reliable approximation of a ‘market-based outcome’.

The Consequence of Finding Unlawful State Aid As there was found to be no justification (for example to ensure the functioning and effectiveness of the tax system or to prevent double taxation) in BEPE, Fiat or Starbucks, the consequence of finding unlawful State Aid is for Member States to fully recover the amount of the State Aid for a period of up to 10 years.

It is a requirement of the Commissions State Aid decisions that they must set out either:

• exactly the State Aid granted; or
• a methodology for determining the amount of State Aid.

The BEPE decision sets out a methodology with the State Aid being the excess profit that was previously deducted from the BEPE calculation multiplied by the corporate tax rate in the relevant years together with compound interest.

However in the Fiat decision, the Commission states that, per previous decisions of the Court, it is not required to state the exact amount of aid to be recovered, and that Union law requires the recovery to “restore the position to the status quo ante and that repayment to be made in accordance with the rules of national law”. The Commission therefore leaves it to the Luxembourg authorities to calculate the exact amount of aid to be repaid.

Companies resident in an EU jurisdiction (particularly Luxembourg, the Netherlands and Ireland) will need to consider the impact of the State Aid rulings whether or not they themselves are the subject of a specific State Aid investigation. The specific areas where the Commission appears keen to consider further investigations are:

• where there is 'stateless' income - typically with US based multinationals using hybrid vehicles such that the effect of the EU ruling is to leave passive income (such as IP income) taxed at very low rates in the EU jurisdiction and untaxed in the US until repatriated; and
• group finance rulings.

Companies should review their existing rulings to ensure that, from a transfer pricing perspective the rulings comply with the arm’s length principles (as seen through the Commissions definition).

In June 2016 the EU Commission issued a working paper on State Aid and Tax Rulings, which addressed the differences in tax ruling practices of Member States and summarised the transfer pricing methods described in the OECD guidelines. This followed the Commission’s Competition Directorate review of over 1,000 tax rulings issued by Member States. It appears that a considerable number of these tax rulings relate to transfer pricing based rulings that do reflect a reliable approximation of a market based outcome and cover intra-group transactions within Member States. Those are unlikely to lead to investigations. The paper, although not explicitly, gives an indication of where future State Aid investigations may go.

We consider that the focus going forward is very much likely to be on rulings that relate to:

• group financing and IP licensing activities within a group where a uniform ruling is applied regardless of the economic analysis; and
• unilateral tax rulings where only one party to the transaction requests a ruling endorsing transfer pricing approach that will typically TNMM based. Often the residual profit accrues to a company or entity that is untaxed or the residual income is stateless.

The overriding impression however is the confluence of State Aid as purely a transfer pricing issue so that if the basis of the ruling can be justified as a reliable approximation of a market based outcome (or only a limited deviation therefrom which is proportionate to the uncertainty in the transfer pricing method chosen), State Aid will not be present.

Many of the affected multinationals are US based, a point explicitly made in a letter from the US Department of the Treasury to the European Commission that pulled its punches in its disappointment at the ongoing actions of the Commission’s State Aid enquiry arm. Those multinationals will need to consider whether they should be making disclosure in their financial statements for ‘uncertain taxes’, in accordance with Financial Accounting Standards Board Statement No.109. Where the tax benefits of EU rulings have been taken through financial statements, the recognition threshold requests that the tax position be more likely than not (i.e. greater than 50%) to be sustained based on its technical merit under applicable tax laws and based on a presumption that the tax position will be examined by the relevant taxing authority with full knowledge of all information and circumstances.

We expect to see a great many multinationals look to their advisors for opinions on the position.