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By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC
Many U.S. international tax advisors have treated the European Commission's (the Commission's) state aid cases against U.S. multinationals like establishment Republicans have treated the Trump campaign for President: ignore it and it will eventually go away — a victim of its inherent absurdity. Unfortunately, the Commission's state aid cases are not going away soon and may have potential implications for some of the standard structures used by U.S. multinational enterprises (MNEs) in Europe.
The Commission has announced1 that Luxembourg and Netherlands tax rulings "artificially reduced" taxes paid by two MNEs, and therefore constitute illegal state aid. Final Commission decisions regarding an Ireland ruling and another Luxembourg ruling are yet to come, and another inquiry concerning Luxembourg was recently announced.2 If upheld, the decisions could require the impacted countries to collect over a decade's worth of additional taxes from the affected taxpayers, plus interest.3
The Commission's unfavorable decisions are widely expected to be appealed to the Court of Justice of the European Union (CJEU). There are also indications that the Commission attacks may not be limited to rulings but might extend to enforcement actions (or lack thereof) by the involved countries, a possibility that observers outside the EU may not fully appreciate. At bottom, this attack is as much a political one as a legal one, and the most recent media coverage, statements, and actions from the Commission indicate that the politics do not seem to have abated in recent months.
For a measure to constitute state aid it must confer an advantage on its recipient that is "selective." Most American tax advisors have been surprised by the Commission's decisions on this element since it is widely understood that any MNE with roughly similar facts could obtain a ruling similar to those at issue. The materials published by the Commission to date provided the Commission's rather strained arguments why it thinks this is not a defense. First, the Commission asserted that a benefit can be selective in application if only MNEs can use it. If a country allows what the Commission considers to be non-arm's-length pricing between related companies, the Commission claims that that discriminates against a single-entity enterprise which, per se, deals at arm's-length with its suppliers. While some have suggested that this theory finds support in the CJEU's decision in Commission v. Gibraltar,4 concerning a tax exemption for passive interest and royalties, to this commentator this Commission argument seems so overbroad as to gut the selectivity requirement. In Gibraltar the selectivity was that only foreign MNEs used the challenged system. In the current cases, the same transfer pricing rules and interpretations at issue apply to any foreign or domestic company.
Second (though essentially just a different slant on the first argument), the Commission has asserted that any allowance of an intercompany transfer price that differs from what would obtain under "market conditions" provides a selective advantage to the company concerned. In other words, if a tax authority's application of the arm's-length principle in a case differs from the Commission's interpretation of the arm's-length standard, the tax authority has granted a selective benefit in that case, even if it applies the same interpretation of arm's-length in all cases governed by the relevant country's laws. That seems ridiculous on its face.
More than Rulings
Another requirement for a measure to constitute state aid is that the measure "must be imputable to the State and financed through State resources." A tax ruling that reduces income tax meets this requirement, but the Commission may apply its thinking more broadly.
While it is possible that some rulings may reach results that could rightly be questioned under accepted international transfer pricing principles, the challenged rulings considered by the Commission to date appear to have been supported by transfer pricing studies applying arm's-length principles in a manner fully consistent with most practitioners' (and tax administrations') understanding of the OECD Guidelines. It would not be at all surprising that local country advisors would be willing to opine that similar structures with similar transfer pricing would be valid under these countries' laws. So, taxpayers would appear to be justified in continuing to use or establish similar structures with similar transfer pricing, but without a ruling.
The Commission, however, has suggested their attack may go beyond rulings. This is based on their position that if a tax authority simply accepted a method of taxation based on prices that departed from conditions that would prevail under market conditions, there would also be state aid, even without a ruling.
What the Commission means by "acceptance of a method of taxation" is not clear, but it seems potentially quite broad. Even where a taxpayer is not examined by a tax authority, so long as a structure and its transfer pricing results constitute the basis of a taxpayer's unchallenged tax reporting position and remittance to a country's tax authority, that could be subject to Commission attack as a case where a tax authority has "simply accepted a method of taxation." Thus, the lack of overt State action may be capable of constituting illegal State aid — a sin of omission rather than one of commission. This suggests a set of concerns perhaps broader than most tax advisors outside the EU may appreciate.
How will the Commission uncover specific cases of such illegal inaction? Can the Commission gain access to the BEPS-generated, country-by-country (CbC) reporting as it is implemented by EU countries? If so, that is a reason to be very careful in filing the CbC reports.
Relevance of Structures Used
Another troubling aspect of some of the cases brought by the Commission is their apparent focus on the multi-jurisdictional structures used — the taxation not simply of the entities tax resident in the countries examined, but the taxation of non-EU tax residents by the residence country of the ultimate corporate parent. Indeed, given the selection of cases so far, one could accuse the Commission of being most concerned with the clearly permissible tax results arising under applicable non-EU law with respect to hybrid entity structures, as opposed to the application of the arm's-length standard. The Commission has made extended comments about such parent-country tax results, notwithstanding the complete irrelevance of those issues to the proper application of the arm's-length standard to the transactions that the Commission was analyzing. This suggests that the Commission is stretching the transfer pricing rules in an attempt to address other tax issues clearly beyond the Commission's jurisdiction, presumably based on political interest in those issues. This is another area of concern noted by the U.S. Treasury Department in recent Senate testimony:[W]e are greatly concerned that the EU Commission is reaching out to tax income that no member state had the right to tax under internationally accepted standards. Rather, from all appearances they are seeking to tax the income of U.S. multinational enterprises that, under current U.S. tax rules, is deferred until such time as the amounts are repatriated to the United States. The mere fact that the U.S. system has left these amounts untaxed until repatriated does not provide under international tax standards a right for another jurisdiction to tax those amounts.5
"Tested Party" and Other Transfer Pricing Heresies
Because the facts are somewhat obscure in the publicly available documents, it is impossible to divine precisely how the Commission is interpreting OECD transfer pricing principles applicable in the years at issue. There are a few aspects of the Commission's thinking, however, that appear extremely aggressive and virtually unprecedented, particularly since the Commission seeks to impose its thinking retroactively on Member States and taxpayers.
First, it appears that the Commission rejects the idea that the commercial functions and risks should be analyzed as they are contractually and operationally established between the parties. Instead, for example, the Commission challenges the "economic rationality" of contractual and operational allocations of relevant functions and risks.
Second, the Commission rejects accepted gospel of treating a toll or contract manufacturer that licenses in proprietary and hard-to-value IP as the "tested party." Instead, because a manufacturer may perform several functions and assume certain risks, the Commission appears to say it cannot be the tested party where the principal company is seen as carrying out a more limited range of functions (even though the principal owns and has incurred costs and risks of developing critical IP). Using a residual profit method for pricing hard-to-value IP royalties, therefore, is not acceptable in such a case. The notion that only "people functions" and not investments, no matter how early they're made and how risky, can earn the return on innovation is still very controversial and certainly wasn't a part of the transfer pricing framework a decade ago.
Third, the Commission appears to reject the widely accepted concept that an arm's-length transfer price can fall within a moderately broad range, rather than consisting of a single number.
The Commission and the CJEU as Final Arbiters of Arm's Length
Another troubling aspect of these cases is that the Commission's competition policy bureaucrats have set themselves up as the final arbiter (subject to the CJEU's review) of what transfer pricing rules mean and how they should be applied. As all readers know, the transfer pricing practice of most tax administrations is no paragon of simplicity, clarity, and fairness. Certainly, the area is fraught with challenges. And when disputes are litigated, even tax-experienced tribunals like the U.S. Tax Court don't relish the task of deciding these cases. But whatever the flaws of the current system, at least there are economists, tax lawyers, accountants, and judges who have worked with these rules and guidelines who are the chief decision-makers. Adding a new level of politically-motivated review by unelected bureaucrats with no relevant experience cannot bode well for making the system function better than it has in the past.
Competent Authority Relief
As noted above, several of these cases appear to involve royalties paid by/to CFCs ultimately owned by U.S. shareholders. A vastly reduced amount of royalty could vastly increase the foreign tax payable by the CFC paying the royalty. This gives the U.S. tax authorities a very large interest in these cases, since, via foreign tax credits, the U.S. tax on distributions from CFCs could be significantly reduced. As the U.S. Treasury Department recently noted, it is possible that the U.S. fisc would wind up footing the bill for these State aid settlements when the affected U.S. taxpayers either repatriate amounts voluntarily or Congress requires a deemed repatriation as part of tax reform (and less U.S. taxes are paid on the repatriated amounts as a result of the higher creditable foreign income taxes).6
Where, for a variety of reasons,7 the foreign tax credit might be limited, however, the result could be that both the United States and the EU country will tax the same dollar of income. Competent Authority relief ought to be available to address this problem. Although the U.S. tax is not assessable until a distribution is made, and, when it is, the tax will be assessed on a different item of income (the distribution rather than the royalty), these circumstances should not be a bar to Competent Authority relief. Competent Authority relief is available for issues raising "difficulties or doubts" as to the interpretation or application of treaties (Article 25(3), U.S. Model). Given the apparent U.S.-focus, Competent Authority discussions also may be appropriate to address a possible violation of the letter, or at least the spirit, of treaty-based non-discrimination principles. The U.S. Treasury Department has expressed concern about the tax treaty implications of the Commission's actions:The United States has a network of income tax treaties with the member states and has no income tax treaty with the EU because income tax is a matter of member state competence under EU law. While these cases are being billed as cases of illegal state subsidies under EU law (state aid), we are concerned that the EU Commission is in effect telling member states how they should have applied their own tax laws over a ten-year period. Plainly, the assertion of such broad power with respect to an income tax matter calls into question the finality of U.S. taxpayers' dealings with member states, as well as the U.S. Government's treaties with member states in the area of income taxation.8
* * *
It seems to this commentator that, unless overturned by the CJEU, these cases have the potential for making a much bigger mess of transfer pricing practice (and common business structures in Europe to which transfer pricing is relevant) than already exists. A taxpayer should be entitled to rely on a country's ability to administer its tax laws, subject only to existing tax treaties. Moreover, the approaches taken and arguments made by the Commission in retroactively second-guessing these tax rulings seem plainly wrong — politically expedient but legally flawed. At a minimum, it is clearly improper for these new approaches and arguments to be imposed retroactively, given that no one reasonably could have expected such action by the Commission.9 Because of this, all EU countries, not just Luxembourg, Ireland, and the Netherlands, should intervene in these cases when they reach the CJEU. Otherwise, the more-than-two-decades struggle to reach a multilateral consensus on transfer pricing rules may have been wasted.
This commentary also appears in the February 2016 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Gleicher 892 T.M., Transfer Pricing: Competent Authority Consideration, Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶3600, Section 482 -- Allocations of Income and Deductions Between Related Taxpayers, ¶7150, U.S. Persons – Worldwide Taxation, ¶7160, U.S. Income Tax Treaties.
Copyright©2016 by The Bureau of National Affairs, Inc.
2 According to press reports, the Commission has requested additional information with respect to the Ireland case and may be pursuing a different tack than that generally taken, or expected to be taken, in the others.
3 The lengthy retroactivity of the Commission's asserted approach in and of itself is an issue of serious concern, including to the U.S. Treasury Department. See Testimony of Robert B. Stack, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, Before the Senate Finance Committee, Dec. 1, 2015 ("The retroactive application of a novel interpretation of EU law calls into question the basic fairness of the proceedings.") (the "Stack Testimony").
9 See, e.g., Parker and Bell, Treasury Official: EU State Aid Cases Raise Questions for U.S., 231 Daily Tax Rep. G-6 ( Dec. 1, 2015) (reporting the comments of Treasury official Robert Stack: "We also have a concern that these taxes are being imposed retroactively, under circumstances in which I do not believe countries, companies, tax advisers or auditors ever expected the state aid analysis of the type that is emerging from this work" and "when a novel approach to law is taken, that is precisely the situation in which a prospective remedy would be appropriate").
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