The Increasing Uncertainty of EU Corporate Tax Rules

The arm's-length principle has been the gold standard by which all intragroup transactions within multinational enterprises (MNEs) have been evaluated since the introduction of the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995. In recent years, however, the European Commission (EC) has revived a long-dormant provision called "state aid" to challenge transfer-pricing arrangements. This raises the question whether the arm's-length principle still prevails or whether a new standard is evolving in the European Union. The use of state aid to disregard transfer-pricing arrangements also calls into question the legal and ethical parameters of the EC's power, since these same transactions could not be challenged under conventional transfer-pricing provisions or the international tax treaty network.

State-aid rules were formally introduced in the EU statute law by the 1957 Treaty of Rome to ensure the uniform treatment of all businesses operating within the European Union. Article 107 of the 2007 Treaty on the Functioning of the European Union governs the legality of state aid granted by member states. In recent years, the EC has enforced state-aid rules by determining whether a selective advantage was provided by member states to enterprises, resulting in a reduced tax liability for the relevant companies.

According to EC administrative practices, the EC will follow a three-step rule for determining whether a tax ruling provides a selective advantage (Notice 98/C 384/03 and Commission Notice on the Notion of State Aid as Referred to in Article 107(1) of the Treaty on the Functioning of the European Union):
  • examine the applicable tax reference system;

  • decide whether the measure constitutes an exception to the reference system; and

  • decide whether the deviation is justified by the general scheme of the reference system.

Recently, however, the EC has expanded the use of the state-aid principle beyond tax rulings to invalidate tax legislation, tax settlements, and tax amnesties if it determines that a beneficial tax measure is being provided that has not been specifically approved by the EC and that is not generally available to all types of businesses.

There were at least four state-aid decisions in 2015-16 (two involving transfer-pricing policies of MNEs) in which the EC concluded that member states (Ireland, Luxembourg, and the Netherlands) had granted a selective tax advantage to MNEs (Apple, Fiat, and Starbucks, respectively); two more cases (Amazon and McDonald's) are currently being investigated.

The primary issue that the EC appears to be targeting is that of income not taxed in any jurisdiction (commonly referred to in the international tax community as "double non-taxation"). For example, in the McDonald's case, the EC has suggested that the company was granted selective tax treatment that allowed it to pay no corporate income tax in either the United States or Luxembourg on royalty income originating from Europe. Also, as noted above, it appears that the EC is moving toward its own standard for transfer-pricing arrangements between associated enterprises (disputes about tax rulings in the Amazon, Fiat, and Starbucks cases), which diverges significantly from the arm's-length principle articulated by the OECD guidelines.

The consequence of state-aid recoveries can be significant: recoveries can be applied retroactively subject to a period of limitation of 10 years, which is significantly longer than the relevant statute of limitations under domestic tax laws and tax treaties. Member states are responsible for recovering state-aid tax savings from beneficiaries (that is, the amount payable under normal tax rules less tax paid plus interest), even if they do not want to. (A member state can appeal the EC's decision.)

Interestingly, the recent state-aid decisions involve US MNEs; thus, the recoveries ordered by the EC could effectively transfer a significant portion of taxable income from the United States to EU member states. It is important to note that MNEs are at a significant disadvantage with respect to adjustments under state aid as compared with conventional transfer-pricing adjustments pursuant to an income tax audit. The key disadvantages are the lack of an effective dispute resolution mechanism (such as the competent authority) and the real potential for double taxation.

Another potential disadvantage of state-aid adjustments compared with conventional transfer-pricing adjustments relates to foreign tax credits. The US Treasury's white paper, The European Commission's Recent State Aid Investigations of Transfer Pricing Rulings, indicates that foreign tax credits will be available; however, other sources have suggested that relief will be capped and that double taxation will occur on the income over the threshold. This outcome will result in extremely high effective tax rates in most state-aid cases.

The EC's decisions on the Fiat and Starbucks cases have been appealed, and the appeal process is expected to take several years. The EC's decisions can be appealed to the EU General Court in the first instance and to the European Court of Justice to review legal issues only. During the appeal, any amounts recovered will be held in an escrow account pending the outcome of the appeal.

In an era when the behaviour of MNEs is under careful scrutiny by domestic tax authorities and regulators, both under current rules and pursuant to the OECD BEPS initiatives, it is becoming increasingly difficult to provide tax certainty to the capital markets. The EC's use of state aid is a new challenge, and it is one that is very difficult to anticipate and plan for. With all of these forces at play, we expect the next several years to be a tumultuous period for MNEs, especially those operating in Europe. Only time will tell whether the arm's-length principle will prevail in the end.

Surya Banerjee
Ernst & Young LLP, Vancouver

Canadian Tax Focus
Volume 7, Number 1, February 2017
©2017, Canadian Tax Foundation