The European Commission’s fight against BEPS

and how it relates to state aid

The fight against base erosion and profit shifting (BEPS) appears to turn into an all-out war. The European Commission recently launched three separate in-depth investigations to examine whether decisions by tax authorities in Ireland, the Netherlands and Luxembourg with regard to the corporate income tax paid by Apple (Ireland), Starbucks (Netherlands) and Fiat Finance and Trade (Luxembourg) comply with the EU rules on state aid (European Commission – IP/14/663). 

The EU can hardly be accused of complacency when it comes to addressing BEPS. The EU’s Action Plan published in December 2012 contained a plethora of initiatives targeted at limiting tax evasion as well as tax avoidance. The comparatively swift implementation of the initiatives illustrates the strong political momentum prevailing in the EU in respect to stricter tax regulations and enhanced harmonization (European Commission – Memo 13/1096).

Among others, the EU overhauled the Parent-Subsidiary Directive (addressing hybrid fiscal mismatches) and stepped up the efforts to establish the automatic exchange of information process (OECD – Global Standard for AEOI). Together with the comprehensive reform package of the OECD – including, most notably, country-by-country reporting – the reforms enacted by the EU amount to a significant overhaul of international taxation. In addition to these reforms focused on the short- and medium-term, the common consolidated corporate tax base (CCCTB) remains lurking on the political agenda of the EU (as discussed in the 2Q/2014 issue of the Cayman Financial Review).

The Commission explicitly puts the investigation of the “[…] compliance with EU state aid rules in the context of aggressive tax planning by multinationals […].” Considering the rhetoric adopted by Joaquin Almunia, it is rather evident that the investigations are envisioned to complement the existing initiatives against BEPS: “In the current context of tight public budgets, it is particularly important that large multinationals pay their fair share of taxes. Under the EU’s state aid rules, national authorities cannot take measures allowing certain companies to pay less tax than they should if the tax rules of the Member States were applied in a fair and non-discriminatory way” (European Commission – IP/14/663).

What sets the state aid investigations apart from other initiatives related to BEPS is that they are not, at least not directly, targeted at overhauling international tax regulations in order to curb tax avoidance schemes adopted by MNEs. The state aid investigations are instead targeted at overruling discretionary decisions made by national governments within the framework of existing regulations. The Commission does not regard tax rulings, specifically so-called advanced pricing agreements (APAs), to be problematic as a general concept and the investigations are not intended to reform the respective regulatory framework.

The underlying argument of the investigations is rather that Ireland, the Netherlands and Luxembourg have failed to correctly apply the existing transfer pricing regulations, namely the arm’s length principle, and that their failure to comply was premeditated. In other words, the EU Commission apparently considers these governments to have colluded with specific MNEs, by granting selective tax advantages, in an effort to broaden their own tax bases at the expense of other EU member states.

By prosecuting the accomplices of the MNEs, the Commission has ostensibly addressed another substantial loophole for aggressive tax avoidance schemes. Hence, one may be tempted to interpret the investigations of the tax rulings as merely another measure against BEPS which sensibly complements the existing initiatives. Such an interpretation, however, underestimates the potential ramifications. In case the Commission determines the tax rulings constitute illegal state aid and directs the member states to revise their rulings and (possibly) to recover any illegal state aid from the respective companies, it would set a rather worrisome precedent.

Preserving the integrity of the Single Market – the Commission acting as an “APA Watchdog”?

According to Algirdas Semeta, Commissioner for Taxation, “Fair tax competition is essential for the integrity of the Single Market, for the fiscal sustainability of our Member States, and for a level-playing field between our businesses. Our social and economic model relies on it, so we must do all we can to defend it.” The investigation by the Commission is based on Article 107 of the Treaty on the Functioning of the European Union (TFEU), according to which “any aid granted by a member state or through state resources in any form whatsoever which distorts or threatens to distort competition by favoring certain undertakings … in so far as it affects trade between Member States, be incompatible with the internal market.”

The immediate question to be addressed is whether a tax ruling, specifically an APA, may be deemed to constitute state aid. The Commission correctly points out that tax rulings are used in particular to confirm transfer pricing arrangements and that the allocation of taxable profit between subsidiaries of a MNE located in different countries are thus influenced by the agreed transfer prices. The Commission asserts that if the transfer pricing arrangement confirmed in an APA “… is not based on market terms, it could imply a more favorable treatment of the company compared to the treatment other taxpayers would normally receive …. This may constitute state aid.”

An APA covers a fixed period of time and defines various elements (e.g. an appropriate transfer pricing method and a range of profit ratios that is considered to constitute an arm’s length remuneration for the functions performed by an entity) which are subject to so-called “critical assumptions” as to future events (for details, please refer to the OECD Transfer Pricing Guidelines, Chapter IV). Provided that the MNE adheres to the agreement, its compliance with the arm’s length principle will not be challenged.

To illustrate this by a (highly simplified) example: Starbucks and the Netherlands may agree that the remuneration of the Starbucks subsidiary located in the Netherlands shall be determined by applying the cost-plus method and that a full cost mark-up of 2 percent is to be considered an arm’s length remuneration. According to the Commission, this exemplary agreement would constitute state aid in case the market terms for the remuneration of the local Starbucks subsidiary are found to be higher than the one agreed in the APA (i.e., 5 percent). In order to eliminate the effect of the state aid granted to Starbucks, the remuneration of the subsidiary would have to be increased to cost-plus 5 percent and the illegal state aid (i.e., the 3 percent differential) that has been received by Starbucks in the past would have to be recovered by the Netherlands.

Two aspects merit some further thoughts:

First, while it is rather easy to claim that transfer pricing arrangements agreed within an APA deviate from market terms, it may prove to be quite difficult to determine the relevant market terms. In practice, it is frequently challenging to identify uncontrolled transactions that may be utilized as a benchmark to determine an arm’s length remuneration for an intercompany transaction.

As pointed out by the OECD, “transfer pricing is not an exact science but does require the exercise of judgment on the part of both the tax administration and taxpayer.” As a result, arm’s length transfer prices are frequently determined within a sufficiently broad bandwidth which is assumed to constitute a plausible approximation of prevailing market terms. Mr. Almunia and Mr. Semeta, however, suggest that ensuring “fair” taxation is a rather straightforward task, as if relevant market terms were readily available.

It is not clear how the Commission actually intends to establish market terms. In regards to three separate in-depth investigations, the Commission merely stated that, based on a preliminary analysis, it has concerns that the APAs underestimate the taxable profits and thereby grant an advantage to the respective companies. It appears likely that the outcome of the investigation will heavily depend on the discretion and judgment exercised by the Commission – which could well consist in just applying CCCTB through the backdoor.

Second, it should be noted that the APAs under investigation are unilateral APAs. Unilateral agreements, however, only cover one leg of a cross-border transaction. Thus, coming back to our exemplary agreement, the APA concluded between Starbucks and the Netherlands does not prevent other countries from challenging the arm’s length nature of the agreed conditions. In case other states find that the Starbucks subsidiaries located in their jurisdiction do not receive an arm’s length remuneration for their services, they may challenge respective transfer pricing arrangements. Led by the Public Accounts Committee, the HMRC has started to challenge tax schemes of Starbucks and other MNEs. Tax administration in other member states are also becoming more aggressive in transfer pricing audits and build up administrative capacity targeted at BEPS. The additional benefit from the EU Commission acting as an APA watchdog should thus not be overestimated.

To be clear, the Single Market can be regarded as one of the most remarkable achievements of the EU. While there may be room for improvement, it doubtless contributed to enhancing efficiency and stimulating competition by allowing people, as well as money, goods and services to interact freely. Devoting substantial efforts in order to preserve the integrity of the Single Market, as called for by Mr. Semeta, is thus generally sensible. It may, however, be worthwhile to briefly contemplate the relevant tradeoffs. The following points are intended to provide some further food for thought:
There is only circumstantial evidence regarding the scale and economic impact of BEPS, as illustrated by the recent request for input regarding methodology and data analysis (on Action Plan 11) published by the OECD in August.

According to the statistics on APAs published by the European Commission in August 2013 (JTPF/013/2013/EN), 222 APAs (EU) were in force as of 2012 (46 thereof being bi- or multilateral) – excluding the Netherlands, which received by far the most APA applications in 2012. In Germany, a total of 9 APAs (EU) were in force and the numbers in the U.K. (15), France (20), Ireland (3) and other countries are also far from overwhelming, which may be explained by the fact that applying for an APA is a rather burdensome process (with average negotiation taking up to 49 months in Germany). How much BEPS is supposed to be based on APAs? Is the social and economic model of the EU really at stake here – has there been any impact assessment?

Will the EU Commission also challenge bi- or multilateral APAs in the future? Or will the Commission extend challenges to reviewing tax audits relating to international taxation in general? Considering that governments colluding with taxpayers may not always be as straightforward and document their agreement in a formal APA, extending the scope of challenges based on TFEU 107 seems only logical. Maybe some of you lawyers out there could shed some light on the boundaries of the competencies of EU in this area.


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Oliver Treidler

Oliver Treidler works as a senior consultant in the transfer pricing department of a mid-sized auditing firm in Berlin. Previously, he worked for two of the Big Four in Frankfurt and Hamburg. Oliver specializes in economic policy issues within the EU and has recently published his Ph.D. thesis on the Lisbon Strategy and Europe 2020. He frequently publishes working papers and brief articles for the think tank Open Europe in Berlin. Oliver holds master’s degree in international economics and European studies from the Corvinus University of Budapest (MSc.) and a Ph.D. in economics from the University of Würzburg.

Oliver Treidler

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