By Dimitrios Kyriazis
Oddly enough, state aid has recently been making headlines. In June, the Commission decided to open three in-depth investigations into tax rulings issued by Ireland, Luxembourg and the Netherlands in relation to Apple, Fiat and Starbucks respectively. In October, the Commission announced that it will also be examining whether the tax treatment of Amazon by Luxembourg is in line with EU state aid rules. These decisions are the spearhead of a recent clampdown on sweetheart tax deals between Member States and big multinationals that Commissioner Almunia says will ensure that they pay “their fair share of taxes”.
This post will focus on the rulings issued by the Irish tax authorities on the calculation of the taxable profit allocated to the Irish branches of the Apple group. The tax rulings under scrutiny were granted in favour of Apple Sales International (ASI) and Apple Operations Europe (AOE), first in 1991 and then in 2007. Both these companies are incorporated in Ireland but are not tax resident there. Tax rulings, in essence, are “comfort letters” by tax authorities, giving a certain company clarity on how its corporate tax will be calculated. As the Commission keeps repeating in its press releases, tax rulings are not problematic per se. In its view, “rulings that merely interpret the tax provisions without deviating from relevant case law and administrative practice do not give rise to state aid. However, a ruling that departs from the general tax rules and benefits individual undertakings leads in principle to a presumption of State aid and must be analysed in detail.” This is what the Commission has doubts about, and this what prompted it to open the in-depth investigation.
Transfer pricing agreements
How exactly can a tax ruling benefit a company? It can do so in many ways, one of which is by validating transfer pricing agreements, also known as advanced pricing agreements (APAs). An APA is a contract between a tax authority and a taxpayer stipulating the pricing method the latter will apply to its affiliated-company transactions when calculating its taxes. If this method is not agreed, or if it is misapplied, then a multinational can manipulate the prices of transactions between its subsidiaries, thus moving profits to low (or no) tax jurisdictions. In order to combat this form of tax avoidance, the most popular standard for setting commercial conditions between related companies is the “arm’s length principle” as defined in Article 9 of the OECD Model Tax Convention, which requires that they don’t differ from conditions between unrelated companies. Moreover, the OECD Transfer Pricing Guidelines provide five different methods of applying the arm’s length principle to intra-group transactions. All these documents are important because the Commission has retained them as “appropriate guidance” (paragraph 56 of the decision), thus giving these soft law instruments a hard edge.
The applicability of state aid rules
In order to constitute state aid, a measure has to fulfill four conditions: it must confer an advantage on an undertaking, this advantage must be selective, it must be granted by the state and through state resources, and it must distort competition and affect intra-Union trade. The fulfillment of the two final conditions is, according to the Commission, “relatively straightforward”. The rulings were issued by the Irish tax authorities and the reduction in tax they allegedly entailed resulted in a loss of tax revenue, and thus of state resources. Furthermore, Apple is active across the EU, and any state support is bound to strengthen its position in relation to its competitors.
Establishing the rulings’ selective character isn’t too hard either. If the Commission manages to prove that the Irish authorities used their large discretion to deviate from the arm’s length principle as regards Apple, and that such preferential treatment was not given to all comparable undertakings, then this condition is also fulfilled. Given the fact that Apple seems to have negotiated the tax rulings with Ireland, the conditions included therein are “custom-made”, and thus exclusively reserved for it.
The conferral of an advantage: misstating the test
Let us now come to the most problematic part of the decision in question, namely the Commission’s analysis as to whether an advantage has been conferred to Apple. The Commission’s reasoning is quite confusing here, since in paragraphs 9, 54 and 56 it seems to misstate the private investor test. More specifically, it focuses on what kind of tax arrangements a private operator, here a taxpayer, would declare, and not on what a private operator, here the Irish authorities, would accept. From a profit maximization point of view, it is only logical that a private operator like Apple would seek to minimize its taxes – although it is questionable whether consumers would accept such practices without protest (see e.g. the Starbucks boycott here). However, the market economy operator test is not used to compare the actions of the aid recipient with a market operator, but the actions of a Member State with a market operator of a comparable status operating in normal conditions of market economy (see e.g. para 29 here; for the test’s applicability to fiscal state aid see paras 89-92 here). Thus, whenever the Commission talks about what a private operator would “declare”, we must read this as meaning “what tax declaration a private operator would accept”, and then compare that with the arrangements Ireland accepted in its contested rulings (see its correct comments in para 53).
The Commission’s reasoning
The nub of the Commission’s reasoning is to be found in paragraphs 54 to 70 of its decision. In order for the tax rulings not to confer an advantage on Apple, the APAs they validate must not depart from market conditions when setting the acceptable conditions of intra-group transactions. This will be the case if the agreed transfer pricing methods comply with the arm’s length principle, for the application of which the OECD documents provide suitable guidance. Still, not all OECD methods respect this principle in any given case: a tax authority must aim at finding the ad hoc most appropriate method. A formalistic approach to compliance is consequently not enough – the circumvention of these rules is not to be tolerated.
The Commission then went on to claim that these requirements were not met. The agreed transfer pricing methods were not the most suitable ones, but were instead chosen arbitrarily and lacked an economic basis. In fact, the Commission claims they were “reverse-engineered” so as to arrive at a taxable income that Apple would accept! These are strong words, but the minutes from the rulings’ negotiations seem to vindicate the Commission. Moreover, the duration of the 1991 ruling (16 years) was too long, much longer that rulings in most Member States (3-5 years). This lack of adjustment resulted into a more favourable agreement for Apple, which had by that time become one of the most valuable companies in history, and has continued to grow exponentially (ASI increased its sales revenues by 415% from 2009 to 2012).
Since the agreed transfer pricing methods were both inappropriate and lasted too long, the Irish tax rulings did not respect the arm’s length principle, thus they did not reflect market conditions and consequently, since they also led to an inferior taxable base than would have otherwise been the case, they conferred an advantage to Apple. This is the gist of the Commission’s case against Apple, and this is what Apple needs to disprove in order to avoid repaying millions of euros.
Tax predictability and legal certainty
Following this short analysis, two more observations seem apposite before concluding. First, there needs to be more guidance from the Commission regarding tax rulings and their compatibility with Article 107 TFEU. Tax predictability is crucial for companies: they need to know whether they can participate in a tax scheme or negotiate a tax ruling without getting in trouble. Accordingly, more detailed comments on tax rulings must be included in the final version of the draft notice on the notion of state aid, especially if the OECD guidelines are to be regarded as appropriate guidance in all cases. Second, the Commission’s effectiveness in ensuring compliance with state aid rules is at stake. If the reach of these rules does not become clear, the Commission risks being inundated with thousands of notifications from Member States in relation to individual tax rulings which the Commission will be practically unable to assess. Legal certainty and tax predictability are thus crucial when it comes to fiscal state aid.
The Apple, Amazon, Fiat and Starbucks investigations seem to be Commissioner Almunia’s parting shots, and their echo is loud. In her confirmation hearing, Competition Commissioner-designate Vestager stressed that these cases constitute a “high priority”. The Commission’s determination is evident, as is Apple’s and Ireland’s obstinacy in denying the accusations; litigation will thus surely ensue. Stay tuned: it seems that fiscal state aid will finally be getting its 15 minutes of fame.