When tax attacks! Corporate tax arrangements under EU state aid scrutiny

The objective of state aid control is to prevent the distortion of competition when governments grant advantages or incentives to particular companies. The Commission’s investigations are focusing on whether the tax base of certain companies has been calculated in a favourable way. If the tax arrangements are found to constitute aid that is incompatible with EU rules, the beneficiary must pay back the aid (with interest) to the relevant member state, subject to a limitation period of ten years.

According to the Commission, any tax ruling that departs from general tax rules, and thereby benefits individual companies, may, in principle, constitute state aid:

Every decision by the administration that departs from the general tax rules and benefits individual undertakings leads in principle to the presumption of state aid and must be analysed in detail.[1]

As well as investigating international household names including Amazon, Apple, Starbucks, and Fiat Finance and Trade,[2] the Commission is scrutinising the tax affairs of a larger number of European companies.[3] As the state aid remit is potentially far-reaching, and given that the new President of the Commission has stated that ‘the EU and all its Member States should step up their efforts to combat tax evasion and tax fraud’, the investigations could have significant consequences for European companies and their tax authorities.[4] This article explores why the Commission is investigating the tax arrangements of these companies, and considers the investigations’ potential repercussions.

Why are corporate tax arrangements under scrutiny?

The Commission’s state aid investigations focus on the prices charged for transactions between different subsidiaries of the same corporate group (known as transfer pricing arrangements), and the corresponding calculation of the taxable bases of the subsidiaries. Transfer pricing influences the allocation of taxable profit between subsidiaries of a corporate group located in different countries.

In the case of Apple, Starbucks and Fiat Finance and Trade, the focus is on tax rulings that validated Advance Pricing Agreements (APAs). An APA sets out the pricing methodology that applies to all subsidiaries of the same corporate group when calculating taxes.

If the tax base of a company is calculated in a ‘favourable’ way, this may give the company a selective advantage; indeed, the Commission has stated that:

National authorities must not allow selected companies to understate their taxable profits by using favourable calculation methods. It is only fair that subsidiaries of multinational companies pay their share of taxes and do not receive preferential treatment which could amount to hidden subsidies.[5] [emphasis added]

State aid exists if the following four criteria are all met:[6]

• the state has some involvement in the measure, which is financed through state resources;
• the measure confers an advantage on its recipient;
• the advantage is selective;
• the measure distorts or threatens to distort competition, and has the potential to affect trade between member states.

State aid is illegal unless it can be demonstrated that the aid is compatible with EU rules (‘good aid’). As set out by the Commission, good aid is ‘well-designed, targeted at identified market failures and objectives of common interest and least distortive’.[7] Examples include aid that stimulates innovation or green technologies, avoids environmental harm, and promotes growth within the EU.

According to the Commission’s Opening Decisions in the tax rulings cases, it is relatively straightforward to demonstrate that the first and last criteria for state aid are met, as follows.[8]

• As the tax rulings have been issued by the tax authorities of the relevant member state, and the rulings have resulted in lower tax revenues than would otherwise have been available to that member state, the first criterion is deemed to be met.
• In terms of the fourth criterion, as the investigations focus on global companies that operate across a number of European countries, any aid is deemed to distort or threaten to distort competition, and has the potential to affect intra-EU trade.

The most contentious question is therefore whether the tax rulings confer a selective economic advantage on the companies concerned by lowering their tax liabilities in certain jurisidictions. This question about whether tax rulings confer an economic advantage is explored below.

Corporate tax arrangements: is there a selective economic advantage?

The Commission applies the market economy operator principle (MEOP; see the box below) to assess whether the tax arrangements confer an economic advantage on the company concerned. This approach is in line with the General Court’s ruling in the 2012 EDF case:

an economic advantage must—even where it has been granted through fiscal means—be assessed inter alia in the light of the private investor test.[9]

To apply the MEOP test, the methodology used to calculate the taxable basis, as validated by the tax rulings by the member state, needs to be compared with the ‘prudent behaviour of a hypothetical market operator’.[10] According to the Commission, the tax rulings should not lead to the subsidiaries concerned paying lower tax than other undertakings in a ‘similar legal and factual situation’.[11]

OECD member states have adopted the ‘arm’s-length principle’ to establish commercial conditions between subsidiaries within the same corporate group. According to this principle, commercial and financial relations between associated subsidiaries should not differ from relations between independent companies. The arm’s-length principle forms the benchmark for the application of the MEOP test.

The OECD’s Transfer Pricing Guidelines provide internationally accepted guidance for establishing the arm’s-length principle.[12] The OECD distinguishes between traditional methods and transactional profit methods, and regards the former as the most appropriate basis for establishing whether commercial and financial relations between associated subsidiaries are at arm’s length. This is shown in Figure 1.

Figure 1   How does the OECD recommend that arm’s-length pricing is established?

Source: Oxera, based on OECD (2010), ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’, 22 July.

Although the OECD’s guidelines are accepted internationally, there are many practical difficulties associated with their application, which complicates the application of the MEOP test. Indeed, the Commission has noted that ‘depending on the facts and circumstances of the taxpayer, not all methods approximate a market outcome in a correct way.’[13] For example, in the case of Apple, Starbucks and Fiat Finance and Trade, the tax authorities did apply one of the methods from the OECD’s Transfer Pricing Guidelines—the transaction net margin method—yet the companies’ tax rulings are nonetheless under investigation by the Commission.[14] There may also be problems associated with other methods; for example, based on the Commission’s decisional practice in tax state aid cases, which dates back to the early 2000s, rulings allowing taxpayers to use fixed margins for a cost-plus or resale-minus method may also involve state aid.[15]

The box below provides an overview of the Commission’s investigation of Apple’s Irish subsidiary.

Under the Commission’s approach, if the method of taxation leads to a taxable base that is lower than the level that would result from the application of the arm’s-length principle, this is deemed to provide an economic advantage to the company concerned. However, as illustrated by a recent judgment from the General Court in relation to Spanish tax cases, as described in the box below, the assessment of whether an economic advantage is selective can be contentious.

This example illustrates that tax measures that could, in principle, be received by any company are unlikely to be selective unless it can be shown that, in practice, the measures are available only to certain categories of firms. However, there is no clear dividing line to determine when a tax measure is considered to be open to only a limited category of firms. Therefore, as recently highlighted by the new President of the Commission, there is likely to be significant focus on the question of whether the tax arrangements are selective.[16]

What economic and financial analysis is required in order to apply the MEOP test?

Detailed economic and financial analysis is central to the application of the MEOP test in order to assess whether the tax arrangements confer an economic advantage. The areas of analysis include:

• benchmarking the price of intra-group transactions over time with prices for similar transactions between independent companies (i.e. companies not operating within the same corporate group);
• a comparison of the profitability of the subsidiaries under investigation over time with benchmark profitability metrics.[17] The analysis would consider how the profitability of the subsidiaries has evolved over time, including the drivers of any changes in profitability. The benchmark profitability metrics could include measures of the appropriate return for the subsidiaries in question, taking into account their risk exposure and/or profitability metrics for comparable independent companies that are exposed to similar risks and are operating in a similar geographical area;
• a comparison of the approach to calculating the taxable base of the subsidiaries over time with methods used by comparable independent companies to determine the taxable base and/or comparable corporate groups not under investigation. For example, if the APA stipulates a mark-up above costs, this could include an assessment of the relevant cost base for the application of the mark-up. The assessment would consider how the taxable base of the subsidiaries under investigation has evolved over time, focusing on the relationship between the evolution of revenues, costs, profits and tax payments of the subsidiaries under investigation. This analysis would identify any material divergences in the trends of key financial metrics of the subsidiaries under investigation relative to those of comparable independent companies or corporate groups not under investigation;
• an assessment of the cost-reflectivity of the transfer prices, by comparing the price of intra-group transactions over time with the costs associated with the transaction, including an appropriate allocation of group overheads, financing costs and profit allowance;
• an examination of the profitability of the subsidiaries within the same corporate group under alternative allocation drivers (including an economic assessment of the most appropriate driver(s) to allocate profit in each case).

Robust economic analysis will therefore be required in order to apply the MEOP test and thereby determine whether the tax arrangements confer an economic advantage.

What are the likely implications of the ongoing tax investigations?

The Court’s Decision in Lufthansa Hahn set a precedent for a national court to order the recovery of ‘aid’ at the stage when the Commission starts a formal investigation (i.e. prior to the Commission reaching a Decision about whether a measure constitutes illegal state aid). In light of the Commission’s scrutiny on corporate tax arrangements, and the precedent from Lufthansa Hahn, this could lead to a higher number of private actions in front of national courts.[18]

If the Commission concludes that the tax arrangements constitute illegal state aid, valuing the advantage for the purposes of recovering the aid is likely to be highly contentious, since the arrangements do not involve an explicit transfer of state resources.

The Commission’s decisions could have implications for any multinational company whose applicable tax rate in any EU country has been reduced by a tax ruling. As the OECD Guidelines allow taxpayers to select the transfer pricing method, provided it results in arm’s-length pricing, it may be more challenging for companies to be confident that the tax rulings received will not be subject to state aid challenge without a robust economic assessment.

With recent reports that the tax affairs of an additional 300 multinationals could potentially come under the Commission’s scrutiny, ensuring compliance with state aid rules is likely to become increasingly important in corporate tax planning.[19]

Contact: James Kavanagh