The continuing EU Tax and State Aid Saga

The EU investigation into state aid and taxation continues to expand.  In a speech late last year the European Competition Commissioner, Margrethe Vestager, confirmed that their investigation continues to grow.  Following the well-publicised decisions against Amazon, Apple, Fiat and Starbucks, the investigation now stems well beyond technology. She said "We've looked at more than 1,000 tax rulings as part of [our] work. We've found the Fiat, Starbucks and a whole series of multinationals got illegal state aid".

In late June, the EU General Court heard the cases of Fiat, Starbucks and the Belgian Excess Profits Ruling and as at publication these judgments are yet to be published. It is hoped that the decision of the Court will provide more clarity as to the ambit of the state aid rules and narrow the scope of the European Commission's investigation. However if the General Court decides these cases in favour of the Commission this may well prompt the Commission to widen the scope of its investigation to include other tax payers.

In the meantime, this article considers three of the developments since we last reported on this topic - the Amazon and Inter IKEA decisions published earlier this year and the consequences of the European Commission's (the "Commission") investigation into the UK's CFC regime.

Amazon

The Amazon decision (published by the Commission on 26 February 2018) is another decision concerning the transfer pricing methodology.  This was in respect of certain licence fee payments made by Amazon's Luxembourg Operating Company (Lux OpCo) to another Luxembourg entity (Lux SCS) which was a tax transparent partnership for tax purposes.  In consideration for the payments, Lux OpCo was permitted to run Amazon's European websites.  The licence fee chargeable under the agreement was calculated on the basis that Lux OpCo obtained a return equal to the lesser of (i) 4%-6% of its expenses or (ii) the total operating profit. The basis for this was that Lux OpCo was said to be undertaking 'routine' management functions over the intellectual property rights.  Lux SCS also entered into licence and assignment agreements' and a 'cost-sharing agreement' with Amazon's parent companies in the US.  The Luxembourg tax authorities gave a ruling at the time that the payments and mark up were in line with Luxembourg's transfer pricing rules (the "Luxembourg Tax Ruling").  However, the Commission argued that they were far below the value that would have been determined on an arm's length basis.

This decision followed the format of previous cases in assessing whether State Aid existed by reference to four factors:

1. whether there was an Intervention by the State;
2. whether any such intervention affected trade between member states;
3. whether it conferred a selective advantage on Amazon; and
4. whether it distorted or threatened competition.

In Tax State Aid cases the key consideration is whether the relevant measure conferred a selective advantage.   The three other factors were held to be self-evidently satisfied here.

Selectivity

The Commission's approach to selectivity analysis was twofold. Following previous case law, the Commission considered that the existence of any economic advantage is in principle sufficient to support a presumption of selectivity.

However, for completeness it also approached the test by considering a three step process, namely:

1. identify the reference system or benchmark;
2. determine whether the State Intervention is a derogation from the reference system; and
3. determine whether the intervention is justified.

The Commission first identified Luxembourg's general corporate income tax system as the reference system.  Whilst Amazon and Luxembourg argued that the reference system should only be restricted to 'multinational corporate groups', the Commission instead expanded it to all corporate taxpayers as being in a similar situation.  The Luxembourg Tax Ruling, therefore, granted a favourable tax treatment to Lux OpCo which was not available to other corporate taxpayers in Luxembourg whose taxable profits reflected prices negotiated at arm's length on the market, thereby derogating from the reference system.  Finally, the Commission could not find any reason that the tax ruling was justified by the nature of Luxembourg's tax system.  

Advantage 

Regarding the existence of an advantage, the Commission held that this existed on two separate grounds. Firstly, there was an inaccurate analysis of the assets used, functions performed and risks assumed by Lux SCS and Lux OpCo in the Luxembourg Tax Ruling and Amazon's transfer pricing report. Secondly, even if such an analysis was accurate and correct, Amazon and Luxembourg did not follow the OECD's arm's length methodology. This resulted in a reduction in the amount of tax due from Amazon, amounting to an economic advantage.

The Commission differed from the Luxembourg Tax Ruling in concluding that Lux SCS performed no active and critical functions in relation to the development, enhancement, management and exploitation of the intellectual property rights ("TP Use"). It was merely a basic legal owner; Lux OpCo, which Amazon had argued only carried out 'routine' management functions, completed all of such functions relating to the rights.  For example, Lux OpCo had oversight of the technology and data to customise Amazon's websites to specific markets and link Amazon's inventories on a pan-European basis.  The licence agreement was essentially irrevocable and did not allow Lux SCS to use, manage or control such rights. Finally, Lux SCS never had the capability (operational capacity) or financial means (financial capacity) to respectively control or undertake any risks connected with the TP Use. Any liability or expenditure that Lux SCS may have had under the cost-sharing agreement was met by income received from Lux OpCo. Lux SCS's only associated cost related to the maintenance of legal ownership of the rights.  Therefore, the mark-up arrangement on the basis of Lux OpCo performing solely 'routine' functions was not correct and should have been set higher to reflect its key role in the TP Use.  

The Commission concluded that the choice of the transactional net margin method ("TNMM") as the correct transfer pricing methodology, instead of the comparable uncontrolled price method, was appropriate, as only one of the parties to the licensing agreement performed unique and valuable contributions.  Nevertheless, the TNMM requires the tested party to be the one undertaking the less complex functions to ensure the broadest scope of comparables. In the Commission's view Lux SCS should have been the tested party, not Lux OpCo as stated in the transfer pricing report.  In addition, when using the TNMM, the Commission determined that the profit level indicator needs to indicate the value of the functions performed by the tested party.  Since Lux SCS did not perform any of the key functions relating to the rights, the mark-up should have only applied to the operating costs in relation to Lux SCS's legal ownership maintenance.  The effect of this analysis was that, the arm's length remuneration for Lux SCS was dramatically lower than stated in the Luxembourg Tax Ruling.  Whilst it is common for transfer pricing arrangements to be disputed, the Commission's critique of these arrangements goes far beyond a criticism of the comparable used or aspects of the methodology and proposes almost a diametrically opposite analysis as being more appropriate.

Inter IKEA

The Commission's opening decision on Inter IKEA bears many similar similarities to the Amazon one.

The decision concerns two advanced pricing agreements ("APAs") obtained in 2006 and 2011 by IKEA Systems BV ("Systems"). The 2006 APA had set out and endorsed the transfer pricing treatment of a licensing fee paid by Systems to a Luxembourg company ("Holding").  Holding was exempt from taxation on its income under a special tax scheme. Holding held the proprietary rights to exploit the IKEA franchise business, to which Systems had full entitlement under the licensing agreement.  

In July 2006, the Commission held that the special tax scheme was illegal under EU State Aid rule and Holding would incur corporate tax liabilities from 2011 onwards. Consequently, Inter IKEA restructured to ensure that the 2006 APA was no longer applicable.  Systems acquired the proprietary rights (formerly held by Holding) from its Lichtenstein-based parent entity, Interogo Foundation (the "Foundation") for EUR 9 billion under a Sale Purchase Agreement ("SPA"). This was done in two parts – the Foundation contributed to Systems 40% of the beneficial interest in the rights as share premium reserves.  Systems purchased the remaining 60% for a price of EUR 5.4 billion, which was converted into a loan granted by the Foundation to Systems. This loan, which had a 12-year maturity period, was unamortised and had a 6% yearly interest rate. The SPA also contained a price adjustment mechanism – if the fair market value of the rights was different to EUR 9 billion on 31 December 2023, the amount of debt owed to the Foundation will change so that it still represented 60% of the rights' value. The Netherlands government issued the second APA which endorsed the adjustment mechanism, the acquisition price, the interest payable under the loan and the deductions of the interest payments from Systems' taxable profit in the Netherlands.

Selectivity

The Commission reviewed both APAs and found that they constituted unlawful state aid. It believed that there was an economic advantage granted to Systems under both APAs, which raised the presumption that they were selective in nature.  It also applied the three-step process (discussed in the Amazon case above) and reached the same conclusion. Again, the Commission applied a wide scope for the 'reference system', considering it to be the general corporate income tax system with the objective of taxing all companies subject to tax in the Netherlands, with no distinction between group companies and standalone companies. The APAs derogated from the reference system – they allowed Systems to lower its taxable profit by departing from a reliable approximation of a market-based outcome in line with the arm's length principle. Finally, there appeared to be no justification in the reference system for this derogation, whether in the intrinsic, basic or guiding principles or as a result of inherent mechanisms necessary for the functioning and effectiveness of the system.

Advantage - 2006 APA

The Commission held that the 2006 APA incorrectly assumed that Systems was a party which carried out simple functions and was therefore the less complex (i.e. tested) party for TNMM purposes. Rather, Systems appeared to be responsible for the legal protection over the rights, managed the relationships with franchisees and third party providers and had the final say over the design of products and definition of the product range. Similar to Lux OpCo in the Amazon case, Systems was the primary party for the commercial, marketing, strategic and planning activities of the franchising business. Holding had a rather limited role – in fact, it was considered an exempt 1929 holding company under Luxembourg law and so was prevented from 'carrying on any industrial or commercial activity or providing any kind of service' or 'having direct involvement in the affairs of its subsidiaries', amongst other restrictions. As such, the Commission did not consider the profit allocation between Systems and Holding under the licensing agreement to reflect the economic reality. There was a reduction in the corporate tax liability which did not reflect a reliable approximation of a market-based outcome with the arm's length principle. 

Even if the above assumption was correct, the Commission held that Inter IKEA still did not apply the correct methodology.The APA based the decision on a 5% margin applied to the franchise revenue plus net catalogue revenue minus marketing support contributions to franchises. This margin was calculated on the individual operating profits arising from three different functions (catalogue operation, franchise contract management and IKEA Franchise Concept maintenance). The Commission considered parts of the calculation to be either unidentified or incorrect, as it did not agree that a single margin should have applied to all these activities and considered that no mark-up should have been applied where there was a pass through of expenses. A transfer pricing report produced also assumed that Systems incurred no or very limited market risk but at the same time included loss-making comparables. The inclusion of loss-making comparables contradicted the earlier analysis – if Systems was performing complex functions and could incur losses the use of TNMM would be questionable. Finally, Systems' operating profit did not include net financial and net extraordinary results, further reducing the operating profit figure.

Advantage - 2011 APA 

The Commission considered two main aspects of the 2011 APA to be wrong. The first aspect concerned the valuation of the EUR 9 billion figure.The Commission considered the purchase price to be higher than what would have been agreed between two undertakings on an arm's length basis. As discussed earlier, Systems had performed a range of vital functions in relation to the rights – Systems' remuneration for its roles should have been subtracted from the value of the rights. Systems had also owned a particular right (the IKEA Franchise Concept) at this point and so profits attributable to it should have been subtracted from the purchase price.  The Commission found there were only documents showing a limited discounted cash-flow model with no explanation. By endorsing the deduction of interest payments based on this inflated purchase price, the Netherlands tax authority had departed from a reliable approximation of a market-based outcome in line with the arm's length principle.

The Commission also did not consider that an independent lender would have granted a loan on such terms outlined above. It analysed Systems' financial reports and found it unlikely that Systems had the capability to repay more than EUR 4 billion of principal over eight years, whilst there was correspondence between one of the banks and Inter IKEA's chief financial officer expressing doubt over Systems ability to raise EUR 5 billion of external financing given the contemporary economic circumstances.

The second aspect considered by the Commission was the price adjustment mechanism – again, it did not find it would have been agreed on such terms between independent undertakings negotiating at arm's length under comparable circumstances. Furthermore, there were deductions of provisions for future interest related to the mechanism which did not seem to comply with Dutch tax law. Permitting such a mechanism meant that Systems ultimately benefited from a lower tax liability which was not available to other taxpayers in similar situations.

UK Controlled Foreign Companies ("CFC") Regime 

The Commission has also opened an investigation into the UK's CFC regime.  More specifically, the Commission was to look at the group financing exemption ("GFE"), which exempts from UK taxation financing income received by an offshore subsidiary from another foreign group company. The EU subsequently published a decision letter on 24 November 2017 elaborating on the reasons behind the investigation.

The GFE is not defined or specified in UK legislation, but the Commission clarified that it was targeting the differential treatment between companies with CFCs receiving non-trading finance profits ("NTFPs") falling within Chapter 5 of Taxation (International and Other Provisions) Act 2010 and those receiving NTFPS under Chapter 9. Two exemptions are provided for under Chapter 9: (i) the qualifying loan relationship exemption, which results in a 75% reduction in the CFC charge for finance income arising from group loans between non-UK members of a UK headquartered company, and (ii) the qualifying resources exemption which provides complete exemption for financing income where the CFC was not funded by debt finance from the UK and that they were entirely funded by local assets or a new group equity capital. 

Applying the three-step selectivity process, the Commission considered the entire CFC regime to be the relevant reference system. The derogation arose, in its view, from the rules treating certain companies (who carried out financing transactions with certain related foreign debtors – Chapter 9) better than other companies (carrying out the same transactions involving related UK or third party debtors – Chapter 5), since the latter cannot benefit from the GFE. Essentially, the UK CFC rules seem inconsistent – interest income earned by a qualifying CFC from loans under Chapter 9 should be considered artificially diverted under the regime, but nevertheless benefits from the two aforementioned exemptions. These two sets of companies, according to the Commission, are in factually and legally comparable positions under the regime. 

Finally, there was no justification in the Commission's view as to the differing treatment between the two sets of companies. The UK authorities argued otherwise.  Regarding the partial exemption, as it is often difficult to precisely establish the extent to which an equity investment in a CFC is sourced from UK borrowings, the exemption presupposes a 'deemed' debt-to-equity ratio of 25:75 to avoid the need to maintain complex cash flow records. The Commission did not find this convincing, since in reality, almost all CFCs are always fully equity financed – so this 75% exemption would apply to such CFCs regardless of how they are capitalised. The UK also argued that the use of fixed ratios was commonplace, for example under the Anti-Tax Avoidance Directive which exempts a CFC from the CFC rules if one third or less of its income concerns high risk income (i.e. income at risk of avoidance/diversion). The Commission countered by saying, in its opinion, the GFE does the exact opposite – it exempts a fixed ratio of a CFC's income which has the highest risk of diversion. In addition, this deemed ratio does not apply when determining whether UK companies are excessively debt-financed.  Regarding the full exemption, the Commission saw this as being inconsistent with the approach under Chapter 5, where the conditions for the exemption did not regime a relation between the NTFPs a tax deduction in the UK. Furthermore, there was no equivalent exemption available to UK companies with NTFPs.

If the Commission concludes that the GFE constitutes unlawful state aid, there may be substantial tax penalties, since the UK government will need to recover an amount equal to the amount that would have been paid if the profits were not exempted by the GFE. Furthermore, it is unclear if Brexit will absolve such liabilities since the EU's negotiation guidelines specified that the UK must ensure a level playing field, notably in terms of competition and state aid. If a Brexit deal is achieved the acceptance of the ECJ's jurisdiction over any UK decisions until 31 December 2020 in the draft transitional agreement will likely compel compliance with any pre-Brexit state aid decisions.

Where Does This Leave Multinational Groups?

It is clear from the comments of Margrethe Vestager that EU State Aid investigations will continue, with the Commission becoming more aggressive in challenging transfer issues and rulings. Indeed, the Amazon and later IKEA case demonstrates how the Commission is willing to critically analyse transfer pricing rulings to the extent as to whether the methodology applied was correct or not.  Multinational companies which have obtained tax rulings similar to those in the Amazon, Inter IKEA or the earlier cases should review the transfer pricing analysis and robustness of the methodology applied and consider the potential exposure in the case of an EU investigation of their position. 

In addition, any group relying on the UK's Group Finance Exemption under the CFC rules would be well-advised to consider the potential impact if the EU's investigation gives rise to a determination that such rules breach its State Aid provisions. Multinational groups who may be affected should review the decisions of the General Court of the CJEU in relation to the June hearings and will be hoping that they will bring greater clarity as to the scope of these rules.