European Commission Targets Member States’ Tax Rulings as Prohibited State Aid: Where Will it Lead?

This article was published on January 25, 2018 by the Bureau of National Affairs, Inc., Bloomberg Tax. We obtained consent of the Bureau of National Affairs, Inc., Bloomberg Tax to publish this article on our blog.

This article explores whether the EU’s attempt to extend its accepted powers to limit various forms of market distorting state aids within the common market to cover member States’ tax rulings, including advance pricing agreements, as providing selective, hence unfair competitive advances, is technically supportable.

A fight has been slowly intensifying over the past several years between the U.S. and the European Union (EU) over the European Commission’s targeting of member states’ tax rulings, especially those involving U.S. multinationals, as ‘‘prohibited’’ under the EU’s competition policy rules. The EU initiated its tax ruling inquiries in 2013 setting up a dedicated tax force to address tax fairness issues related to the tax planning practices of multinationals and subsequently announced in October 2015 the first of its conclusions deciding that certain tax rulings, including advance price agreements (APAs), provided selective, unfair competitive advantages, hence were determined to be a form of prohibited state aid.

Since June 2014, the European Commission initiated at least four procedures against different member states: Ireland (Apple APA), the Netherlands (Starbucks APA), Luxembourg (Fiat Finance & Trade APA), and Belgium (“excess profit ruling’’). On October 21, 2015 the Commission found that Luxembourg and the Netherlands have granted state aid respectively Fiat Finance and Trade (decision SA.38375) and Starbucks (decision SA.38374). Actions before the Court of the European Union have already been commenced by Fiat and Luxembourg (T-759/15 and T-755/15) and the Netherlands (T-760/15).

To date applying EU competition rules the Commission has investigated and concluded five cases involving four Member States—Luxembourg, Ireland, Belgium and the Netherlands—with an additional three cases open (State Aid Procedures viewed 12/7/2018).

One of the more publicized of the Commission’s determinations involves Apple and Ireland. In August, 2016, the Commission announced it had concluded that Ireland had granted undue tax benefits valued up to 13 billion euros and recently in October 2017 the Commission referred Ireland to the European Court of Justice (ECJ) due to Ireland’s failure to recover the alleged tax benefits from Apple.

The U.S. Treasury reacted negatively—and increasingly strongly—against these actions. In December 2015, in testimony before Congress, Deputy Assistant Secretary of Treasury for International Tax Affairs, Robert Stack, explained Treasury’s four principal U.S. concerns with the EU’s approach, including that the Commission appeared to be disproportionately targeting U.S. companies and its determinations potentially undermined U.S. tax treaty rights. One particularly important concern Stack mentioned was that the EU’s ability applying its State aid rules to retroactively claw back or recover illegal State aid (including interest) for up to 10-years and that ‘‘…[the] retroactive application of a novel interpretation of EU law calls into question the basic fairness of the proceedings’’ (Written statement of Robert B. Stack, Deputy Assistant Secretary (International Tax Affairs) U.S. Department of the Treasury before the Senate Finance Committee December 1, 2015, page 7.)

The U.S. Congress then expressed its concerns to Secretary of the Treasury Lew in a letter of January, 2016 indicating the ‘‘…United States has a stake in the [EU] cases and has serious concerns about their fairness and potential impact on the U.S. fisc’’ and further also indicated its concerns about the retroactive application of the EU state aid rules to issues of international taxation (“Finance Comittee Members Push for Fairness in EU State Aid Investigations” viewed 12/7/2018).

In February 2016, U.S. Treasury Secretary Lew in a letter to EU Commissioner Vestager, head of the EU’s competition policy unit—referencing Stack’s testimony of the previous December—emphasized U.S. concerns regarding the EU’s unilateral approach and indicating the U.S. view that the recently completed G20/ Organization for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) project was the preferred, multilateral vehicle to address tax fairness concerns. Lew’s letter stated that ‘‘[w]hile we recognize that State aid is a longstanding concept, pursuing civil investigations–predominately against U.S. companies–under this new interpretation creates disturbing international tax policy precedents. We respectfully urge you to reconsider this approach’’ (“Letter State Aid Investigations” viewed 12/7/2018).

The EU head of Directorate-General for Competition (DG COMP), Margrethe Vestager, quickly replied to the Lew letter and rejected out of hand the U.S. view saying the Commission’s actions were fully appropriate and warranted, adding, “… [T]he Commission’s State aid investigations into tax rulings… are part of the Commission’s enforcement of fair competition within the EU’s Single Market, which is the Commission’s responsibility under the EU Treaties. State aid is clearly specific to the EU and has no direct equivalent in the United States. I would, nonetheless, hope we agree that if a national tax authority gives certain companies a more advantageous tax treatment than other undertakings in the same country, this can be extremely distortive of fair competition.’’

“…For the purpose of determining a group company’s taxable profits, the price of transactions between that company and other companies of the group have to be established at market terms, in line with the socalled ‘arm’s length principle.’

’’ DG COMP on June 3, 2016 issued a working paper ‘‘DG Competition Working Paper on State Aid and Tax Rulings’’ (DG COMP working paper) which laid out the Commission’s arguments for using its authority over state aid to regulate tax rulings, concluding: ‘‘State aid control in tax rulings follows from the Commission’s competence in the field of State aid as set out in the EU Treaties to investigate cases under State aid rules with the objective to prevent distortions of competition through the granting of special tax advantages that are not available to all similarly situated taxpayers in a given Member State’’ (para. 24).

In August, 2016, Treasury responded to the DG COMP working paper by issuing a white paper that elaborated on Treasury’s concerns that the Commission’s actions based on applying the EU’s state aid rules ‘‘…have considerable implications for the United States—for the U.S. government directly and for U.S. companies…’’ (U.S. Department of the Treasury, ‘‘The European Commission’s Recent State Aid Investigations of Transfer Pricing Rulings,’’ August 24, 2016, page 1; referred herein as the ‘‘Treasury White Paper’’).

Importantly, the Treasury White Paper pinpointed a key problem in DG COMP’s economic analysis in the public cases where it has ruled that tax rulings constitute illegal state aid. The DG COMP Working Paper claimed it focused on ‘‘. . .cases where there is a manifest breach of the arm’s length principle’’ (DG COMP Working Paper, para. 23). Yet, as the Treasury White Paper pointed out, the Commission’s working paper failed to explain what it means by the ‘‘arm’s length principle’’ since the paper made no reference what so ever to the OECD transfer pricing guidelines to frame its analysis but instead only to some notion of ‘‘the market’’ (Treasury White Paper, page 20).

What is at the core of this dispute is whether the EU’s reliance on its authority to regulate state aid within the EU can and should be applied to regulate international tax matters.

Since its inception the EU has considered member states picking winners or supporting national champions through selectively granting benefits to be contrary to the proper functioning of the European single market. A typical example of a prohibited form of state aid would be the government of France granting a loan to a private company, say France Telecom, on terms that no private party would ever consider to be economic.

But, as the Commission seeks to extend its reach beyond its traditional one into regulating tax policy through the application of EU state aid rules, the Commission has moved onto far less favorable grounds. The heart of the argument against the validity of the EU’s use of competition rules to discipline intra-EU tax rulings is the following view: If a member state such as Luxembourg decides to grant tax rulings deemed especially favorable to companies conducting business in its territory, this form of tax competition is not selective by its very nature—whether or not the tax benefit granted is economically rational is another question (in terms of the net benefits generated relative to the underlying costs of the incentives provided). No one industry or product or company is being singled out to receive preferential treatment as a national champion.

The U.S. analogue to intra-EU tax competition is the use of tax incentives by individual states and local taxing jurisdictions. In the past there have been challenges to the states and local jurisdictions use of tax incentives from a purely legal perspective. For instance the state of Ohio’s and the city of Toledo’s offer to DaimlerChrysler to subsidize the company’s expansion of a plant by offering local property tax exemptions and a state franchise tax credit was challenged by a group alleging these tax incentives violated the commerce clause of the U.S. Constitution (United States Constitution, Article I, Section 8, Clause 3, which states that the United States Congress shall have power ‘‘To regulate Commerce with foreign Nations, and among the several States…”)

In 2005 the U.S. Sixth Circuit Court of Appeal’s agreed, but on appeal the Supreme Court overturned the decision. While the cost versus economic benefits generated by these tax incentives continues to be questioned in the U.S., intra-state tax incentives competition rages on in the U.S. pretty much unabated by reason as witnessed by the recent willingness of the state of Wisconsin to provide tax incentives to an Apple supplier, Foxconn, reported to be in the order of $250 million per year in refundable state tax credits for 15 years (Washington Post, September 18, 2017. The Post article reports that one group analyzed the Foxconn deal with the state and determined that it would take over 25 years for the state of Wisconsin to gain a positive return on the value of the incentives granted.) Thus, in the case of the U.S., state, and local tax incentives are essentially unregulated and continue to be viewed by politicians as a constructive tool to help foster state and local economic development objectives.

State and local tax incentives, together with some forms of U.S. federal tax incentives, have been challenged in a different forum, the World Trade Organization, as prohibited export subsidies conveying unfair economic benefits on U.S. exporters, for example, Boeing. The U.S. federal government lacks the authority to remove or modify state and local tax incentives.

Whether unfettered tax competition in the case of the U.S. states and local governments is tending to drive a sort of ‘‘race to the bottom’’ has been debated in the U.S. with recent empirical evidence suggesting otherwise. (On this point, see Robert Chirinko, Daniel Wilson, ‘‘Tax Competition among U.S. States: Racing to the Bottom or Riding the Seesaw,’’ March, 2017, Federal Reserve Bank of San Francisco Working Paper 2008-03.)

This article explores whether the EU’s attempt to extend its accepted powers to limit various forms of market distorting state aids within the common market to cover member states’ tax rulings, including APAs, as providing selective, hence unfair competitive advantages, is technically supportable. Here we want to stress that a distinction should be made between the Commission’s legitimate objective of reforming the tax system, both within the EU as well as internationally, and the particular means the Commission has chosen to apply, relying upon its powers to regulate state aids, to allow it to have a stronger role in regulating and reforming intra-EU tax policy.

Why Did the Commission Choose to Apply State Aid Rules to Address Tax Fairness Concerns?

The European Commission has quite narrow, limited powers in relation to matters of taxation within the EU, unlike the Commission’s well defined, broad authority over other areas of EU affairs such as international trade and customs rules and more recently foreign affairs. This limited power in the area of taxation is a direct consequence of the EU member states’ general unwillingness to delegate their taxing powers to a supranational institution like the Commission. Essentially, the Commission’s power is limited to indirect taxation (art. 113 Treaty on the Functioning of the European Union or TFEU). When it comes to direct taxes, the Commission’s role is limited to proposing directives concerning direct taxes that are likely to affect the functioning of the internal EU market (art. 114 TFEU) or when they are designed in a discriminatory manner (art. 110 TFEU). In all cases, any decision on direct taxation must be unanimously agreed by EU’s Council of Ministers.

Starting with the publication of the Ruding Report in 1992, the Commission has progressively shown an interest in trying to rein in tax optimization schemes frequently used by multinationals, most notably ones relying on transfer pricing (Commission Europeenne, 1992. ‘‘Conclusions and Recommendations of the Committee of Independent Experts on Company Taxation’’, or the ‘‘Ruding Report’’).

The Commission has considered these tax optimization schemes to generally be ‘‘harmful’’ at the EU level since they fostered intra-EU tax competition beyond what the Commission deemed to be reasonable and fair tax competition. Seeking to restrain these ‘‘harmful’’ practices, the Commission first tried a ‘‘soft law’’ approach. In 1998, the Commission circulated a sort of EU code of conduct to promote non-binding principles of ‘‘fair competition’’ in taxation among the member states (See document 98/C 2/01 ‘‘Conclusions of the Ecofin Council meeting concerning taxation policy’’).

Since it was a purely voluntary, not surprisingly, this approach completely failed. Ignoring the Commission’s concerns regarding the negative consequences for the collective member states’ interests, most member states continued unabated to allow what the Commission’s guidance had deemed to be harmful tax competition policies.

Seeing its goal of fair tax competition basically frustrated by member states’ actions—or more correctly inaction in terms of not applying the non-binding principles—in 2011 the Commission turned next to issuing a draft directive (Council of the European Union, 26 October 2011 ‘‘Proposal for a Council directive on a Common Consolidated Corporate Tax Base (CCCTB)’’).

A directive is the only legally binding instrument at the Commission’s disposal. In this case the Commission’s draft directive had a very ambitious objective. Essentially it sought to establish within the EU rules regarding sharing the EU tax base of multinational corporations (regardless of headquarters location). Had it been adopted, the draft directive would have effectively resolved the issue of intra-EU tax competition by replacing the arm’s-length principle, as explained by the OECD’s guidance on transfer pricing, with a form of intra-EU formulary apportionment. The Commission’s draft faced strong opposition from a number of the member states and was never put to a vote and ultimately was shelved.

Then in 2013 the political situation started changing due to the combination of the public finance crisis which hit many EU member states together with the accompanying media attention questioning the fairness of tax optimization strategies frequently applied by multinationals operating in the EU. This mounting political pressure moved the EU’s discussion of the fairness of the international tax regime out of the realm of the purely arcane and highly technical internal forum inside the Commission where it had been taking place into a more public political arena.

Faced with public pressure to address the inherent unfair outcomes seemingly allowed by existing international tax rules, the Commission felt it must react and publicly stated its commitment to fight for greater tax fairness by strongly pushing back against continuing to allow what it deemed to be unfair tax optimization schemes relied upon by multinationals.

Numerous public statements were made around this time reflecting the need to address tax fairness. Some examples: ‘‘Moreover, when public budget are tight and citizens are asked to make effort to deal with the consequences of the crisis, it cannot be accepted that large multinationals do not pay their fair share of taxes’’ (Statement of Joaquin Almunia, June 11, 2014 at the time the Commission initiated its investigations on state aid to Apple, Fiat Finance and Trade, and Starbucks).

‘‘It is time to ensure fairness and transparency in corporate taxation in Europe (…) it is time for everyone to pay their fair share … Too often, countries do not have knowledge of decisions taken by tax authorities of other Member States of the Union even though such decisions may have a direct impact on their own tax revenues. In a single European market designed to ensure economic efficiency and social equity, this type of unfair tax competition is unacceptable’’ (Pierre Moscovici former French Minister of the Economy, Finance and Industry later European Commissioner for Economic and Financial Affairs, Taxation and Customs, quoted in the French journal l’Opinion March 18, 2015 (translated)).

‘‘We are in a situation today where some companies are engaging in aggressive tax planning, made possible by lack of fiscal harmonization in the EU and loopholes in national taxation systems (…) Especially in challenging economic times, with many EU citizens having had to tighten their belts, it is even more important that large companies pay their fair share of tax’’ (Margrethe Vestager and Pierre Moscovici in the Irish Times, January 17, 2015).

The pressure to respond on the tax fairness question led the Commission to establish a task force in June 2013—called the ‘‘Task Force Tax Planning Practices’’—to start investigating certain forms of member states’ tax rulings and then in late 2014 it broadened the inquiry to cover all forms tax rulings, including APAs.

At the European Union political level, despite continuing public pressure for action on tax fairness, there was still no consensus reached among the member states on what actions should be taken. Unanimity among member states was and remains the requirement for the Commission to gain the necessary authority to act in the area of taxation. European Commissioner for Economic and Financial Affairs, Taxation and Customs, Pierre Moscovici—former French minister of Finance named to his post in September 2014— did announce certain measures, including the return of the consolidated tax base or CCCTB draft directive for consideration (Pierre Moscovici’s speech, September 17 2015). But the Commission knew there was little likelihood this resuscitated proposal would gain sufficient support among the member states and therefore no substantive actions were taken.

Thus, as of 2015 the inability to gain member states’ consensus on meaningfully addressing tax equity issues left as the only effective instrument in the Commission’s regulatory arsenal its undisputed control over state aid. At this juncture, this was the fork in the road the Commission elected to take to address international tax fairness concerns.

Origins of the EU’s Authority to Regulate State Aid

One facet of the EU’s competition policy seeks to regulate potentially harmful competitive outcomes from certain forms of member states’ state aid. The legitimacy of the EU Commission with regard to this traditional, widely accepted application of the EU’s competition laws and regulations is not at issue here. But are the principles that underpin this traditional, accepted form of EU regulation of state aid for competition purposes applicable to evaluating member state’s granting of tax rulings, particularly in the case of member states who have entered into an APA? The Treasury White Paper highlighted the central issue: what precisely constitutes a ‘‘manifest breach’’ of the arm’s-length principle in the context of determining whether a tax ruling grants a benefit in contradiction to what would be considered an appropriate ‘‘market outcome’’?

We first explain the origin of state aid regulations in the EU and what EU jurisprudence and practice have defined to be ‘‘prohibited’’ forms of state aid.

Commission’s Regulation of State Aid

The Commission’s oversight and regulation of state aid is rooted in origins of the European Union, and, importantly, consistent with the notion of forming a ‘‘common market’’ (or an ‘‘internal market”). Language expressly banning state aid first appeared in Article 4c of the European Coal and Steel Community (ECSC) of April 18, 1951—that is, at the very origins of the post war European Community project. The ECSC was then followed by the pivotal Treaty of Rome of March 25, 1957 which established the European Economic Community (EEC), the predecessor to the current European Union. The Treaty of Rome like the ECSC ‘‘prohibits’’ state aids at Article 92, and, except as otherwise provided in the Treaty, especially any form of state aid affecting cross border trade between member states that would distort or threaten to distort competition within the EEC. This same formulation was later adopted, without change, into the Amsterdam Treaty (October 2, 1997), which further clarified the rights of the member states vis-a`- vis the EEC, at Article 87. Likewise it appears in Article 107 of the 2007 Treaty on the Functioning of the European Union. Thus, from its very outset starting with the ECSC Treaty in the 1950s continuing up to the present, the legal underpinnings of the EU’s authority to explicitly regulate state aid was quite clear and unambiguous.

What Constitutes a ‘‘Prohibited’’ Form of State Aid?

State aid is prohibited by the EU if four factors are deemed to be present when a member state provides a form of economic assistance to a company or an industry within the EU:

  1.  a benefit granted …
  2.  … by the State or through State resources …
  3.  … affecting competition and trade between Member States … 
  4. … and having a specific or selective in favoring ‘certain undertakings or certain products.’

Any state aid ‘‘in any form whatsoever’’ which is determined to meet all of these criteria is deemed to be trade distorting State aid and hence is ‘‘prohibited’’ (Emphasis added. Art. 107 of Treaty on the Functioning of the European Union provides that: ‘‘Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.’’).

The analytically important part to the analysis is whether a benefit is conveyed in whatever form by a Member State’s economic assistance, criteria one and two, and is selective, criteria number four, and hence would affect terms of competition within the EU, criteria number three.

Also of importance is the Commission’s authority in state aid inquiries to claw back illegal state aid, including interest, for a recovery period of ten years starting from the point at which the unlawful aid was awarded (EU Council Regulation 2015/1589, see Article 16 ‘‘Recovery of Aid’’ and Article 17 ‘‘Limitation period for the recovery of aid.’’).

In the context of international taxation, especially where an APA ruling has been granted years earlier, this claw back authority obviously creates major uncertainties for taxpayers.

The vast majority of state aid cases reviewed by the Commission are circumstances where a member state supports an EU firm with some form of a financial assistance such as a loan on non-market terms or infrastructure support. To determine if state aid is selective and thereby favors a specific company or industry or product, the Commission applies the ‘‘market economy operator test’’ (also referred to as the ‘‘private market operator test’’). For a discussion, see B. Slocock, ‘‘The Market Economy Investor Principle,’’ 2002, Competition Policy Newsletter Vol 2: 23-26. In the Commission Decision involving Ireland’s state aid to Apple, this test is referred to as the latter form.

Using our example of the French government loan made on below market terms to France Telecom, the market economy operator test considers if the French government’s loan would have been made by a private party lender under the same terms and with the same market conditions applying. The market economy operator test is a central element of all of the Commission’s state aid inquiries. This test applies to considering the circumstances where a government is on one side of the transaction and, most often, a single firm on the other side—though entire industries are sometimes favored with the targeted assistance.

Are the Commission’s Actions Against Tax Rulings Well-grounded in EU Competition Law?

Since the DG COM task force was established in 2013 to examine tax ruling practices of the EU member states, the Commission has initiated at least eight publically known procedures against different Member States (of which five have been completed). On October 21, 2015 the Commission announced its first findings relying upon its authority to regulate state aid in two cases finding that Luxembourg and the Netherlands granted prohibited state aid to Fiat Finance and Trade (decision SA.38375) and Starbucks (decision SA.38374), respectively. In January 2016, the Commission ruled against Belgium’s excess profit exemption. In August 2016 it made its highly publicized decision involving Ireland’s tax rulings issued for Apple’s companies operating in Ireland, concluding that Ireland’s tax rulings did: “…confer a selective advantage that is imputable to Ireland and financed through State resources, which distorts or threatens to distort competition and which is liable to affect trade between Member States. The contested tax rulings therefore constitute State aid within the meaning of Article 107(1) of the Treaty.’’

‘‘Since the contested tax rulings give rise to a reduction of charges that should normally be borne by [the Apple affiliates] in the course of their business operations, the contested tax ruling should be considered as granting operating aid to [the Apple affiliates].’’ (European Commission Decision of 30.8.2016, ‘‘On State Aid SA.38373,’’ Conclusions on the existence of aid, paragraphs 414 and 415, herein after ‘‘Apple Decision.’’)

The last decided case was in November, 2017 involving Luxembourg; no public version of this decision has been released yet. There are at least another three cases pending in the DC COM case pipeline, two involving Luxembourg and one involving the U.K.

Without going into the details of each case, the Commission’s published analyses in the documents made public to date, including the decision regarding Ireland and Apple, indicate that the Commission based its determination each time on the selectivity of aid (the fourth factor on the list above). The publically available information suggests that the Commission simply assumed that the three factors were present in the case of a tax ruling and only the fourth criteria, selectivity, required them to make a detailed examination.

In order to demonstrate that an APA meets the fourth criteria, ‘‘selectivity,’’ and hence constituted prohibited state aid, the Commission’s analysis seemed to follow a two-stage approach. First, DG COM has to identify the standard set of rules applicable for setting transfer prices in the concerned member state. Second, DG COM then has to evaluate whether the transfer pricing results as validated by the APA are consistent with the local standard for evaluating transfer pricing. The underlying reasoning of the Commission seems to be that if APA validates a transfer pricing result that deviates from the local standard it is deemed to be selective and therefore constitutes a form of prohibited state aid. As the DG COM Working Paper explained: ‘‘The Commission does not call into question the granting of tax rulings by the tax administrations of the Member States. It recognises the importance of advance rulings as a tool to provide legal certainty to taxpayers. Provided they do not grant a selective advantage to specific economic operators, tax rulings do not raise issues under EU State aid law. Since 2013, the Commission’s Directorate- General for Competition (DG Competition) has been carrying out an inquiry into tax ruling practices from this perspective of EU State aid rules.’’

Importantly, the Commission generally seems to suggest in the decisions released to date and in the 2016 DG COM Working Paper as well that the applicable standard to be applied is based upon the OECD’s arm’slength principle—the standard long promoted and defended by the OECD as the global standard to be applied for transfer pricing purposes. Thus the way the second step is being applied—asking whether the transfer pricing policy complies with the arm’s-length standard or not – is quite troublesome since the Commission has not clearly stated what criteria it will apply in making this determination. This is the same criticism the Treasury White Paper makes.

The Commission, perhaps seeking to avoid head-on the types of concerns raised by the U.S., seems to have decided to adopt a sort of blended approach that bolts on to the prudent independent market operator test the OECD’s arm’s-length principle to evaluate if a tax ruling or an APA should be deemed a prohibitive form of state aid. The Commission’s claims its newly constructed form of the traditional market operator test aims to assess whether the terms of a tax ruling or an APA would have been accepted by both parties assuming the parties had been independent companies and ‘‘conservative.’’ But the Commission’s claim that its analysis of tax rulings is based on a ‘‘market approach’’ that is consistent with the arm’s-length standard is simply wrong. This is made evident by going through each of the four factors of what constitutes prohibited state aid.

Benefit granted

No APA brings a financial benefit to a company since it only concerns the tax base, not the tax paid. The potential benefit should be assessed by comparing the tax paid by the company globally under the APA system and the counterfactual tax it would have paid without the APA arrangement. In essence, aid is not likely to be granted to a company if state A agrees to sign an APA that reduces its tax base in favor of state B with a lower rate of taxation, otherwise, the company pays more tax by concluding the APA and it is therefore impossible to conclude there is any subsidy, hence aid. This analysis of the potential advantage enjoyed by the company should also be performed dynamically, considering the various risks that can affect a company’s profits. For instance, the APA might confirm a transfer pricing policy which grants a subsidiary a low but stable return. In the boom years for the group this agreement can lead to a reduction of the tax base in the country concerned (compared to the situation without APA), in contrast, in years of low return or losses the APA might increase the tax base of the subsidiary. An analysis of this nature should be performed to assess the existence and amount of the alleged aid to the company signing the APA.

State resources

The only likely state aid issues are indeed those in which a state agrees to reduce its tax base to attract private investment. (In the U.S., this is one of the powerful drivers behind U.S. states and local jurisdictions granting tax incentives to attract new investment.) The logic followed by a state likely to conclude such an APA is clearly economic: the expected benefits of the investment of the multinational (job creation and thus reducing unemployment benefits, positive externalities on the creation of local businesses, increase wages and payroll taxes, increased consumption and payment of additional VAT, etc.) must outweigh the costs (reduced tax), otherwise the APA would not be signed. If one considers an APA whose record in terms of public finances is positive, one is entitled to wonder if it really verifies or confirms this second criterion.

Affecting competition and trade between Member States.

The Commission emphasizes that some APAs are likely to create distortions of competition within Europe, favoring large corporations over small businesses. It is also settled law that a tax relief for a multinational company is deemed to affect trade between member states. Automatic validation of the competitive distortion criterion may, however, be re-examined in the case of granting of an APA. It would first be helpful if the Commission specified the nature of the distortion of competition that it believes is created by the granting of the APA. A public subsidy to a business on the verge of bankruptcy or unable to grow exports (intra-EU) absent a subsidy can indeed cause a distortion of the internal market. But a member state agreeing to reduce the tax paid by a highly profitable multinational company does not have a clear effect on competition within the EU. Even if the classical results on the neutrality of corporate income tax on investment are not necessarily true in the real world, it is highly dubious that a lower corporate income tax rate could give a competitive advantage to a multinational firm. (See for instance: Stiglitz, J.E. ‘‘Taxation, corporate financial policy, and the cost of capital’’, Journal of Public Economics 2, 1973, 1-34.) Such an effect, if it ever existed, would only be observed under very specific circumstances. In the most general cases, the reduction of tax would probably be retroceded to shareholders, creating an effect on the international distribution of wealth but no direct effect on competition, especially if only the effects within the EU are considered. Similarly, in sectors where international competition exists only between a small numbers of large multinational companies that have all the same access to the APA process, the effect of such measures on competition is far from clear.

Provides the recipient with an advantage on a specific or selective basis.

Regarding this last, and probably the most important criterion, the Commission’s reasoning deserves to be more closely considered. As we have seen, there are two steps in the Commission’s analysis regarding determining whether a specific or selection advantage is being conveyed by a member state granted APA:

  • If the APA states or defines a transfer pricing policy that in inconsistent with the arm’s-length principle, it is deemed to be selective. Though one may first wonder if the Commission is really that attached to applying the arm’s-length principle as this principle was criticized in the CCCTB Directive (‘‘A key obstacle in the single market today involves the high cost of complying with transfer pricing formalities using the arm’s length approach. Further, the way that closely integrated groups tend to organize themselves strongly indicates that transaction-by-transaction pricing based on the ‘arm’s length’ principle may no longer be the most appropriate method for profit allocation.’’ COM(2011) 121/4, page 4)
  • The proper application of the principle of competition can be measured using the ‘‘market operator test.’’

Both legs of the Commission’s analytical framework underpinning its approach are highly questionable. First one could imagine that the tax authority of a member state adopts a particular interpretation of the arm’s length standard and applies it consistently in all the tax ruling (APAs) it negotiates. This measure would then no longer be selective. Importantly here, while the OECD’s arm’s-length principle can be difficult to apply in practice—as is frequently noted practically applying the arm’s-length standard tends to be more of an art than science—it is still a widely accepted standard. Judgement is required in its application and taxpayers and taxing authorities can disagree on what constitutes the most reliable best method. A review of major tax disputes relating to transfer pricing shows that the application of the arm’s-length principle may lend itself to differing interpretations. In the case of the Commission’s state aid inquiry related to Apple, this difference of view is on full display where Apple relies on the results of applying the transactional net margin method while the Commission rejects that approach and makes a general assertion that a one-sided testing approach is not appropriate considering Apple’s facts and circumstances. The DG COM Working Paper discusses different methods applied under the OECD transfer pricing guidelines at para. 17 – 22. What is not done in the working paper is to explain how the test applied by the Commission fits with the market operator test that is typically applied in state aid cases. Thus the Commission’s interpretation that the Apple APA was somehow ‘‘selective’’ seems to ignore the reality that transfer price analyses typically yield a range for an arm’slength result.

More critically, the Commission has yet to detail or explain the criteria it applies to determine whether a specific transfer pricing policy derogates from the principle of full competition. This problem appears, for example, both in Commissioner Vestager’s letter to Secretary Lew previously cited, as well in the more detailed explanation provided by the DG COM White Paper. The test as proposed by the Commission to validate the compliance of a transfer price with the arm’s-length principle is at least strange. It refers to the application of the ‘‘market operator test’’ yet that test was conceived with a quite different objective namely to check if an investment by a member state would also have been made by a private actor. If the Commission’s approach is considered through the lens of the OECD’s transfer pricing guidance, the Commission’s test seems to approach being a form of the comparable uncontrolled price (CUP) method, which is only one of the multiple methods proposed by the OECD to calculate or validate prices between related parties as arm’s-length (which the DG COM working paper acknowledges). Thus, the approach of the Commission to rely only on one method leads it to conclude a regime such as the Starbucks’ APA’s acceptance of applying a variable rate fee is contrary to the principle of full competition. Yet the same Starbucks’ regime was generally accepted as an arm’s-length result by the tax authorities (who presumably subjected Starbucks’ results to additional verification). As the Treasury White Paper notes ‘‘The Commission’s new approach therefore reduces a state aid inquiry to whether the Commission believes a transfer pricing ruling satisfies its view of the arm’s-length principle’’ (Treasury White Paper, page 9).

If the Commission, as the Vestager letter suggests, is to now sit in judgment on the proper application of the arm’s-length standard by the EU member states, it seems that it should at least specify in a more coherent way the criteria it intends to use to make that determination and ensure that its criteria are consistent with the member states’ tax authorities’ practices. The failure to do so by considering the OECD transfer pricing guidelines, which frame the practical application of the arm’s-length standard for multinational taxpayers, is an important, if not fatal, shortcoming with the Commission’s prudent independent market operator test applied to transfer pricing.

This concern about the absence of clear principles in the EU’s approach was echoed by Michel Danilack, who formerly served as U.S. competent authority: ‘‘In the near term, experience suggests that what governments will do quickly is seek to collect more revenue through enforcement actions against foreign-based businesses. Without clear principles to guide these enforcement actions, the result will be more disputes that will be more difficult to resolve’’ (Written statement of Michael Danilack before the Senate Finance Committee, December 1, 2015).

What Limits the Power of the Commission?

Admitting the possibility for the Commission to assess the regularity of tax rulings in terms of state aid opens the door for the Commission to have virtually limitless oversight over direct taxation matters. Any decision (whether express or not) of a member state in direct tax matters could be challenged, whether in the form of a tax ruling or specifically an APA ruling, or a tax audit result leading to a settlement between a member state taxing authority and the taxpayer, or even a decision of the national court could be fair game for review and challenge.

The Commission would then gain the authority to become a sort of supra EU tax authority overseeing the member states, able to challenge all prior or subsequent agreements and able to overturn national prescription rules. Such an outcome is certainly not one that is sought or desired by the EU’s member states. Most observers would believe that such oversight prerogative would exceed the powers that the member states intended to confer on the Commission through the Treaties where national sovereignty in direct tax matters was and remains solely the prerogative of the member states. This point has been explicitly underlined by Advocate General Kokott in the case of Finanzamt Linz which raises the risk that extensive use of state aid for fiscal devices endangers the division of powers between member states and the European Union (See CJUE Oct. 6, 2015. Case 66/14.)


The underlying question we addressed is whether the EU’s reliance on its authority to regulate state aid is compatible with the international consensus of the OECD regarding the practical application of the arm’slength principle for transfer pricing purposes. Can the EU legitimately use its authority (and its analytical methods) designed to police EU member states’ state aids to now deal with trying to limit and discipline direct tax competition within the European Union deemed to be ‘‘unfair’’? Ultimately the answer to this question will be determined by the European Court of Justice. If the court determines that the Commission has overreached its authority and/or if it decides that the Commission’s particular application of state aid rules to international taxation is not appropriate, then the EU’s attempt to regulate member states’ direct tax competition within the EU will come to an end. Many in the U.S. certainly hope this is the outcome.

But if this does not happen, then the EU will very likely find itself faced with a pyrrhic victory as it tries to explain and defend its policies to international taxpayers and OECD member countries, and not simply just the U.S., who follow and seek to sustain the OECD’s interpretation of the arm’s-length standard globally. These concerns are especially important in the era of BEPS when more and more taxpayers want the certainty gained through the APA ruling process and thereby avoiding protracted disputes over double taxation. Whether this form of certainty can continue to be obtained would be problematic when an APA involves an EU member state and where the Commission has gained the ability to second guess and overrule a member state on what constitutes an acceptable APA result. And, adding to the uncertainty this situation would create would be the Commission’s ability to retroactively second guess a taxpayer’s results for the past 10-years. This outcome should be a real concern both to taxpayers as well as the EU’s member states.

And, of course, the U.S. Congress will not take lightly to seeing the U.S. tax base tapped to make refunds to Apple and others as the Commission presses ahead (and assuming the European Court of Justice allows it). This would be the nightmare scenario with frictions between the EU and the U.S. growing as the number of these state aid tax ruling cases multiply with no clear exit and with multinational corporations faced with increasing uncertainty and potential double taxation even in circumstances where they have successfully concluded an APA with an EU member State. Perhaps the one clear winner under this morass scenario might be the U.K. as it heads out of the European Union, no longer subject to Brussels’ authority.


Julien Pellefigue

Julien Pellefigue, Partner, is an Economist in the Transfer Pricing department of Deloitte Société d’Avocats. He has more than 13 years of consulting experience both in economic consulting (transfer pricing […]