Is the European Commission Using the Apple Case to Rewrite International Tax?
Is the European Commission’s extension of state aid to multinational groups’ tax strategies designed to (covertly) implement the Common Consolidated Corporate Tax Base across the single market?
The spotlight has been shining on the tax strategies of large multinational groups (“MNGs”) that exploit tax arbitrage opportunities that typically arise when trading across borders. This typically arises:
- as a result of two or more jurisdictions’ domestic tax laws clashing in a way that can be exploited to provide a tax advantage;
- through the use of double tax treaties to limit or remove taxes in either the source state (i.e., the country in which the income or gains arise) or the recipient state (i.e., the country in which the MNG has a tax presence through, for example, a company or branch) or both;
- from the use of hybrid instruments or entities to change the nature of income or gains such that they are not taxed in any country; or
- through the subjective nature of the transfer pricing landscape that governs how companies within a multinational group must interact with one another—on an arm’s length basis (i.e., as if they were wholly independent parties), allowing payments to be made from high tax jurisdictions for the use of royalties, provision of services etc., to low or no tax group companies (known as base erosion and profit shifting).
The Organisation for Economic Cooperation and Development (“OECD”) has led the way in curtailing such behavior of MNGs through its Base Erosion and Profit Shifting (“BEPS”) initiative. This has resulted in changes to:
- the OECD’s Transfer Pricing Guidelines;
- the OECD’s Model Tax Convention (to prevent tax treaty abuse); and
- domestic laws of countries that have introduced the BEPS recommendations, such as anti-hybrid legislation, changes to the definition of a permanent establishment (i.e., when a taxable presence is created) or introduction of new anti-avoidance rules to prevent such abuses (e.g., the U.K.’s Diverted Profits Tax).
It is evident that the European Commission (“EC”) does not consider the OECD’s BEPS initiative to have gone far enough. The EC, as part of its “fair taxation agenda” has, since the completion of the BEPS project, introduced its Anti-Tax Avoidance Directive (“ATAD”), that makes it compulsory for certain BEPS recommendations to be implemented by Member States (such as controlled foreign company rules, anti-hybrid legislation, etc.); the effect being that ATAD extends the BEPS recommendations in ways that the OECD, through extensive public consultation, considered damaging to MNGs and trade.
Another example of tension between the OECD and the EC is in respect of the digital economy. The OECD is to release, in early 2018, its interim report on the taxation of the digital economy. Notwithstanding this, the EC announced on September 27, 2017 that it will develop its own solutions to be implemented within the single market to tax digital businesses if it considers the OECD’s approach falls short.
Since 2013 the EC has launched investigations into the tax rulings granted by various Member States (Ireland, Luxembourg and the Netherlands) to MNGs such as Amazon, Apple, Starbucks, Fiat, McDonalds and Engie.
State aid is broadly defined as an advantage, in any form whatsoever, conferred on a selective basis to undertakings (e.g., businesses, companies, branches etc.) by national public authorities. In 2014, the EC stated that tax rulings that provide more “favorable” discretionary tax treatment to particular businesses compared with other taxpayers in a similar factual and legal situation would be regarded as state aid. The EC’s actions come under the guise of a “fair taxation agenda”, but the real motive is, in the authors’ opinion, to create a European superstate through the harmonization of tax and accounting laws and principles (the single currency of tax and accounting), with the introduction of a Common Consolidated Corporate Tax Base (“CCCTB”).
The CCCTB is a single set of rules to calculate companies’ taxable profits in the EU. With the CCCTB, MNGs will administer a single system for computing their taxable profit, file one tax return for their EU activities and share their consolidated taxable profits between the Member States in which the group is active, using an apportionment formula (disregarding the arm’s length principle). For now, it is proposed that each Member State will tax its share of the profits at its own national tax rate.
The CCCTB will rewrite the international tax landscape by amending the definition of a permanent establishment and using the formulary apportionment method (based on assets, labor and sales) to override the OECD’s traditional transfer pricing (“TP”) methodologies and arm’s length principle. It is questionable whether such EU measures will adequately address the problems and perceived tax abuse of MNGs, or simply increase complexity, uncertainty, cost and compliance.
The use of state aid investigations to challenge the TP arrangements granted by sovereign Member States to MNGs is creating significant uncertainty for businesses generally (not just the large well-known MNGs). It is also changing the nature and scope of state aid, whcih will have ramifications beyond taxation.
This article provides a high level consideration of the merits and repercussions of the EC’s state aid claim against Ireland in relation to Apple (Case T-892/16: http://src.bna.com/vE4).
In 2013, the EC brought a case against the Irish government for providing illegal state aid to Apple. A state aid claim has a window of limitation of 10 years, meaning that the EC’s assessment goes back to 2003/4. On August 30, 2016, the EC concluded that the tax benefits afforded to Apple by Ireland amounted to illegal state aid, on the basis that it allowed Apple to pay substantially less tax than other businesses. As a matter of principle, EU state aid rules require that illegal state aid is recovered in order to remove the distortion of competition created by the aid, with the EC assessing that Apple owes Ireland circa 13 billion euros.
By way of background, in 1991, Apple obtained rulings from the Irish government in relation to its TP strategy (i.e., its strategy to allocate revenue and expenses to its Irish operations on an arm’s length basis) that allowed it to allocate a significant proportion of the profits of two Irish companies, Apple Sales International and Apple Operations Europe, to a head office that was not subject to tax in any country. As a result of the rulings, Apple paid a far lower effective corporate tax rate on its European profits than other businesses. The EC has estimated the effective tax rates as being 1 percent in 2003, declining to 0.005 percent in 2014 on the profits of Apple Sales International.
Most countries operate TP rules. These dictate that transactions between connected parties (e.g., entities within an MNG) must be undertaken on the same terms that would have existed had the transaction been between wholly independent parties (i.e., no common ownership/control). The OECD published TP Guidelines in 1979, which have been substantially updated over the past 39 years, and that establish the methods to be used to identify such arm’s length terms. Most countries now have TP rules based on the OECD Guidelines.
At the time the rulings were issued, Ireland did not have TP rules. Apple nonetheless operated in many countries that did have TP rules, and thus had a strategy that was potentially compliant with the TP rules of those countries. The absence of TP rules in Ireland, however, created uncertainty and it was therefore sensible and normal practice to obtain a ruling on the allocation of profits to Ireland, a system that was available to all undertakings, not just Apple.
Most countries that have a TP regime also offer taxpayers the possibility of entering into an advance pricing agreement (“APA”), arguably not that different to the Irish ruling system. A ruling is merely a method by which a taxpayer can obtain certainty over its tax position.
The Basis of the EC’s Claim in Apple
The EC asserted that the method used to determine the profit allocation to Ireland is wrong and that instead of using the transactional net margin method (“TNMM”), the comparable uncontrolled price method (“CUP”) should have been applied. This is a case against the Irish government and such a claim is at odds with the fact that, until 2010, Ireland did not have TP rules within its domestic legislation. In the absence of any domestic TP rules, the state in question, Ireland, was presumably at liberty to select the methodology that best suited it and the taxpayer (Apple).
Issues with the Application of State Aid to Tax Matters
EC competition law specialists ordinarily deal with matters of state aid. Their remit also extends to state aid matters pertaining to tax, despite the fact that their primary area of expertise is not taxation. Consequently, a unique interpretation of the “arm’s length principle” that is inconsistent with the OECD TP Guidelines (and therefore the TP regimes of a significant number of countries both within and without the EU) has been developed (as discussed below).
When Will a Measure Constitute State Aid?
For a measure to constitute state aid it must have the following hallmarks, as prescribed by case law of the Court of Justice of the European Union (“CJEU”) and the General Court:
- it is provided by a Member State and financed through state resources (i.e., intervention by the Member State that departs from the norm);
- an economic advantage is provided to an undertaking;
- it is selective in favor of a particular undertaking, category of undertakings or category of goods; and
- it distorts or threatens to distort competition and affects trade between Member States—this is assumed to be the result where intervention, economic advantage and selection exist).
Application of State Aid Principles to the Ireland/Apple Case
Intervention: has there been an Intervention by the Irish Government?
In this case a ruling was granted to give certainty over the taxpayer’s tax position in the absence of specific TP legislation. The EC has asserted (in its state aid case against Luxembourg in respect of Amazon), that any tax assessment that results in a tax benefit by virtue of the EC’s application and interpretation of the arm’s length price will constitute “intervention”. This, in our opinion, has to be wrong. Ireland had very limited TP rules at the time it entered into the Apple rulings. It included the concept of the arm’s length principle, but not the methodologies and how to apply them in determining an arm’s length price for the transactions and, as such, there appear very few cases in which the arm’s length principle was applied. Consequently, up until the introduction of its TP regime in 2010, Ireland would have had no real basis to challenge or make an adjustment to Apple’s TP policy, regardless of whether a ruling was granted or not. In which case, we would argue that there can be no tax benefit conferred upon Apple for most of the period to which the state aid case applies (2003–2010).
However, the EC argue that Ireland did not need domestic TP law, because Article 107 of the Treaty on the Functioning of the European Union (“TFEU”) provides that where a state provides aid that distorts competition, it will be illegal and incompatible with the single market. In respect of tax cases, it allows the Member State to make an adjustment to a taxpayer’s liability to prevent such illegal state aid.
To suggest that Article 107 allows (or forces) a Member State to levy tax in the absence of domestic rules would create incomprehensible uncertainty for taxpayers and undermines established domestic parliamentary and legislative process (i.e., the rule of law). An attempt to redesign Ireland’s corporate tax system exceeds the EC’s power granted by Article 107 (one of Apple’s appeal arguments), a notion echoed by the Irish Department of Finance in its press release of August 30, 2016:
It is not appropriate that EU state aid competition rules are being used in this new and unprecedented way in the area of taxation, which is a member state competence and a fundamental matter of sovereignty.
Economic Advantage: Is there an Economic Advantage to Apple?
The EC seeks to rely on case law from the CJEU that establishes an “economic advantage” as an economic benefit that an undertaking would not have obtained under normal market conditions (C-39/94, SFEI: http://src.bna.com/vE5 ).
This disregards the fact that transactions between connected parties do not reflect market conditions. Instead, the arm’s length principle is applied as a mechanism to substitute market conditions. To identify market conditions would not be comparative and it is necessary to apply the OECD TP Guidelines as to how to determine an arm’s length price and thus whether an economic advantage has arisen.
In each of the recent fiscal state aid cases referred to above, the EC’s preliminary finding has been that the respective tax rulings diverged from the “arm’s length principle” and this provided the selective economic advantage.
The EC held, in an Italian non-tax state aid case that policy measures do not automatically constitute state aid, and that it is necessary to look at the effect(s) of the measure. It appears that, as a result of this decision, the EC gives more weight to the effect of a policy or measure than the established conditions for state aid. For instance, whether there has been an economic benefit to the taxpayer is secondary to whether there is a disadvantage to others. This approach was extended further by the CJEU in World Duty Free Group (C-20/15P: http://src.bna.com/vE6), where it was broadly held that a measure that is merely discriminatory (i.e., not necessarily causing an advantage to the taxpayer or a disadvantage to other undertakings) against other undertakings will constitute state aid. It seems the “economic advantage condition” required to be present for state aid to arise has been completely rewritten.
In TP cases, it is likely that there will always be a difference in the treatment of a related party transaction as against transactions between independent parties. Whether this difference means that independent parties are discriminated against, and whether this is sufficient for illegal state aid, remains to be seen. The risk for MNGs is that any ruling or APA approving an MNG’s pricing policy is now potentially subject to a state aid claim.
Selective: has Apple Benefited from a Measure that Other Businesses can’t Benefit from?
The “measure” in question is the granting of a ruling by Ireland to Apple agreeing the profits that would be allocated to Apple’s Irish operations (i.e., a transaction between connected parties). However, to answer the question of whether the measure was “selective”, one would need to consider all undertakings, including those that have no connected party transactions. In our view, the only way to answer this question would be to consider whether the transactions between Apple’s non-Irish entities and its Irish entity were arm’s length—the price that would have been charged had the entities not been connected.
The EC’s response has been to develop and apply its own version of the arm’s length principle:
A reduction in the taxable base that results from a tax measure that enables a taxpayer to employ transfer prices in intra-group transactions that do not resemble prices that would be charged in conditions of free competition between independent undertakings negotiating under comparable circumstances at arm’s length considers a selective advantage. This is because that taxpayer’s tax liability determined under ordinary rules of taxation of corporate profit is reduced as compared to independent undertakings whose taxable profit reflects prices determined on the market negotiated at arm’s length.
In other words, if a tax authority accepts a taxpayer’s use of a method other than the CUP, this results in the state aid “selective” condition always being met since the EC is suggesting that only market prices actually negotiated between independent parties would be acceptable prices to use.
However, use of the CUP method in accordance with OECD standards is only possible where the taxpayer makes sales or provides services to an unrelated third party in the same ways as it does internally (i.e., there is a direct comparative price for the sales or services provided internally) or where there is market data available showing the price between independent parties for such sales or services. It is noted that such data is almost never available.
The EC’s approach again undermines standard domestic parliamentary or legislative process, since no tax authority applying the arm’s length principle can adjust a taxpayer’s pricing of a related party transaction to the market price had the taxpayer been structured differently, organized itself more or less efficiently, etc. A tax authority can only make adjustments where it considers a transaction is not arm’s length. To determine this, the tax authority will apply the arm’s length principle (i.e., the substitution mechanism for market value/price) using methods prescribed by domestic law or those set down in the OECD TP Guidelines.
Ireland and Apple have appealed the EC’s decision and we strongly expect either or both appeals to be successful. Ireland and/or Apple have alleged that the EC has:
- breached the principle of fiscal autonomy of Member States in attempting to substitute its interpretation of state aid rules for Ireland’s own view of the geographic scope and extent of its tax jurisdiction;
- violated the principles of legal certainty and non-retroactivity by ordering recovery of the alleged aid;
- failed to conduct a diligent and impartial investigation; and
- breached Article 296 of the TFEU by failing to fulfil its obligation to provide “good administration”.
We would strongly agree with this line of argument.
In the meantime, to fend off separate proceedings from the EC for the collection of the 13 billion euros, Ireland and Apple mutually agreed to hold the disputed tax in an escrow account, meaning that Ireland have not actually collected and Apple have not actually paid any additional tax. If Ireland wins its appeal the funds are released back to Apple.
It seems that the EC is actively taking steps to undermine the OECD, the arm’s length principle and established international tax standards. The only conclusion that we can draw is that this is part of the EC’s wider aim of introducing the CCCTB and, in particular, its preferred alternative to the arm’s length principle —formulary apportionment method—for pricing connected party transactions.
This article was published in Bloomberg BNA
Reproduced with permission from Copyright 2018 The Bureau of National Affairs, Inc. (800-372-1033) www.bna.com