International juridical double non-taxation and state aid. D.S. Smit

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1 International juridical double non-taxation and state aid D.S. Smit

2 ec TAX REVIEW Forum International Juridical Double Non-taxation and State Aid Daniel S. Smit * 1 INTRODUCTION On 3 December 2015, the European Commission (EC) reported in a press release that it has opened a formal probe into Luxembourg s tax treatment of McDonald s. 1 Following the press release, the EC is currently investigating whether two consecutive tax rulings issued by the Luxembourg tax authorities in 2009 have granted McDonald s an advantageous tax treatment in breach of EU State aid rules. In this contribution, I will examine the EC s concerns in more detail. To this end, I will firstly elaborate on the content of the rulings insofar the content can be derived from the press release (section 2). Next, I will briefly recall the applicable European legal framework on state aid (section 3). On that basis I will subsequently provide a preliminary assessment of the EC s formal probe (section 4), concluded by a couple of final remarks (section 5). 2 THE COMMISSION S PRESS RELEASE IN THE MCDONALD S CASE From the press release one can infer the following circumstances. McDonald s Europe Franchising Sàrl (McDonald s) derived profits from royalties paid by franchisees operating restaurants in Europe and Russia for the right to use the McDonald s brand and associated services. Internally, McDonald s had transferred these royalties to one of its branches located in the United States (US). From the perspective of the US, however, this branch did not undertake sufficient business or trade in order to qualify as a permanent establishment under US law. In the absence of taxable presence under US law, the royalty income was therefore not subject to tax in the US. In 2009, McDonald s concluded two consecutive tax rulings with the Luxembourg tax authorities concerning the Luxembourg tax treatment of the royalty payments. Both rulings confirmed that the royalty payments were exempt from Luxembourg corporate income taxation based on the tax treaty between Luxembourg and the US. The first ruling made this exemption conditional on the requirement that the royalties were subject to tax in the US. The second ruling, however, no longer imposed this requirement, following McDonald s submission that Luxembourg was in any case required under the tax treaty to exempt the royalty payments, despite the fact that these profits were not subject to tax in the US. On balance, the outcome was that Luxembourg fully exempted the royalty income from Luxembourg corporate income taxation based on the tax treaty, whereas at the same time the US did not tax this income on the basis that there was no sufficient taxable presence in the US under US law. 3 THE SUBSTANTIVE STATE AID FRAMEWORK IN A NUTSHELL The Treaty on the Functioning of the European Union (TFEU) provides for a prohibition on unlawful state aid. This prohibition aims at removing or abolishing state aid incompatible with the European internal market. The EC is the exclusive administrative body competent to assess whether a state aid measure is incompatible with the European internal market, subject to legal supervision by the General Court and the Court of Justice of the European Union (CJEU). The EU state aid provisions also aim at restoring to a situation where state aid has not been granted. To that end, the beneficiary of the aid is, in principle, required to repay the aid received, including interest. The recovery of the aid is subject to a limitation period of ten years. A tax measure constitutes state aid when the following four criteria are met. First of all, there must be an advantage to the recipient. This test not only governs positive benefits, such as subsidies but also carries advantages in the form of a reduction in the tax burden of a taxpayer. 2 Second, the advantage must be granted by the intervention of a state or through state resources. * 1 LLM, Associate professor, Tilburg University, Tax advisor EY Amsterdam, the Netherlands. See < 2 For example, ECJ 10 Jan. 2006, C-222/04, Cassa di Risparmio di Firenze and others [2006] ECR I-289, para. 113 and the case law cited there. EC TAX REVIEW 2016/ Kluwer Law International BV, The Netherlands

3 INTERNATIONAL JURIDICAL DOUBLE NON-TAXATION AND STATE AID An actual transfer of state resources is, however, not required. Also a loss of tax revenue by a Member State qualifies. 3 Third, the advantage is liable to affect trade between the Member States. This requirement is generally met if the beneficiary carries on an economic activity involving trade between Member States. 4 Finally, the advantage distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods. Tax measures that are effectively open to all economic agents operating within a Member State are regarded as general measures and are therefore not selective. 5 A tax measure is selective if it deviates from the common tax system applied by a Member State. To this end, it must be examined whether a tax measure favours certain undertakings in comparison with other undertakings which are in a legal and factual comparable situation. Whether undertakings are in a comparable situation must be examined in the light of the objective pursued by the measure in question. 6 Essentially, the selectivity test therefore boils down to a question of discrimination and comparability. 7 A measure constituting state aid may be justified, but only on the basis of the limited grounds listed in the TFEU or by the nature or general scheme of the tax system. 8 In the latter respect, a distinction must be made between the objectives attributed to a particular tax scheme which are extrinsic to it, on the one hand, and the mechanisms inherent in the tax system which are necessary for the achievement of such objectives, on the other. In any event, derogatory measures must be consistent with the principle of proportionality and must not go beyond what is necessary, in that the legitimate objective being pursued could not be attained by less far-reaching measures. 9 4 A PRELIMINARY ASSESSMENT 4.1 Introduction How should one assess the EC s preliminary findings in the light of the legal state aid framework? It is firstly acknowledged that the EC s full preliminary analysis has For example, 2006/269/EC: Commission Decision of 8 Feb State aid C 22/2004 (ex N 648/2001) on tax deductions for professional fishermen (Sweden), OJ 2006 L 99, 21 et seq., para. 30. See Commission Notice on the application of the State aid rules to measures relating to direct business taxation, OJ 1998 C 384, 3 et seq., para. 11 with further references. Commission Notice (1998), para. 13. See for example, ECJ 8 Nov. 2001, C-143/99, Adria-Wien Pipeline [2001] ECR I-8365, para. 41; ECJ 6 Sep. 2006, C-88/03, Portugal v. Commission [2006] ECR I-7115, para. 54. See also, for example, M. Lang, Selectivity as a Criterion to Determine Whether a Tax Measure Constitutes State Aid, inlegal Remedies in European Tax Law 270 (P. Pistone ed., Amsterdam: IBFD Publications, 2009). For example, ECJ 29 Apr. 2004, C-308/01, GIL-Insurance [2004] ECR I-4777, para. 78. CJEU 8 Sep. 2011, Joined Cases C-78/08 to C-80/08 Paint Graphos and others [2011] ECR I-7611, para. 75. not yet been disclosed. Automatically, therefore, only a preliminary assessment of the EC s analysis is possible. This being said, it is clear that the non-taxation of the royalty payments (nor in Luxembourg neither in the US) boils down to a tax benefit for McDonald s. For state aid purposes, however, the core question is whether this benefit is selectively granted by Luxembourg. In order to answer this question affirmatively, there must be a deviation from the main rule. From the press release it does not become clear, however, where the EC sees such a deviation. I see three possible ways of reasoning that the EC may be applying. I will discuss them below. 4.2 The Traditional Deviation Approach First, the EC may be arguing that there is a deviation in the ruling from the permanent establishment (PE) definition as laid down in the US-Luxembourg tax treaty. This could be the case if the US branch would not qualify as a PE based on the tax treaty definition, e.g., because its activities would be of a mere preparatory or auxiliary nature, whereas the ruling nonetheless would accept that a PE exists in the US. Also in case there would be a PE based on the tax treaty definition, selectivity could still arise if under a proper interpretation of that tax treaty, the profit to be attributed to that PE would be lower than the amount of profit that was accepted under the ruling. It is submitted that in both cases, the mere fact that there is no PE and no taxable income from a US domestic law perspective should, by itself, play little or no role when determining whether Luxembourg deviates from tax treaty definitions. Although this traditional deviation approach seems rather straightforward in the abstract, it is recognized that the proper interpretation of the tax treaty in Luxembourg may not necessarily be obvious. For example, Luxembourg case law on the PE concept may perhaps 10 not be conclusive and the right methodology for profit attribution has perhaps not fully materialized yet under Luxembourg law. In other words, it cannot be excluded that the main rule itself is not clear under Luxembourg law. And if such would be the case, it may become a more difficult task for the EC to detect an actual deviation on the Luxembourg main rule. 11 Nonetheless, what in my opinion the EC should avoid in such case is deciding what the main rule (e.g., PE-definition, profit attribution) under the US- Luxembourg tax treaty should be. This is because essentially the EC would then start creating rules of international tax law, something which would go beyond the EC s competence It is noted that the author has not further analysed the relevant Luxembourg tax law provisions for purposes of this contribution. See on the issue of missing benchmark also W. Schön, Tax Legislation and the Notion of Fiscal Aid A Review of Five Years of European Jurisprudence, Max Planck Institute for Tax Law and Public Finance Working Paper (2015) 14, EC TAX REVIEW 2016/2

4 INTERNATIONAL JURIDICAL DOUBLE NON-TAXATION AND STATE AID 4.3 The Comparability-Approach A second approach that the EC may be following (and the wording of the press release gives support that the EC is actually doing so) is that the selectivity lies in the fact that the Luxembourg authorities exempted the profits from taxation in Luxembourg, despite knowing that they in fact were not subject to tax in the US. Clearly, there is an overall benefit for McDonald s as a result, but how could the EC subsequently come to the conclusion that this would be a selective benefit granted by Luxembourg? After all, the US-Luxembourg tax treaty does not contain a rule that says that Luxembourg should not give an exemption if foreign PE-income is not subject to tax in the US. As stated above, the selectivity test boils down to a question of discrimination and comparability. I would submit that under this comparability approach there can be no selectivity. All Luxembourg resident companies that fall under the scope of the business profit provision of the US-Luxembourg tax treaty are treated the same. They are all entitled to an exemption for US PE-income without being required that the exempt income is actually subject to tax in the US. In other words, the treaty merely allocates taxation powers between Luxembourg and the US, but does not require income to be actually taxed in the US before Luxembourg should grant an exemption. The fact that Luxembourg domestically operating companies do not fall under the treaty and therefore are not entitled to relief is not selective since these companies are based on the objective of the tax treaty not in a comparable situation. After all, there is no need to allocate taxation powers in a purely domestic situation. I would not be surprised, however, if the EC would take the view that the reference group within which the comparison must be made is formed by all Luxembourg resident taxpayers subject to unlimited corporate income tax liability in Luxembourg. Hence, the corporate income tax in general would then constitute the reference framework and the fact that not all Luxembourg resident taxpayers are treated the same (as a result of tax treaty relief available to some) would then constitute a selective advantage that needs to be justified. Although typically provisions to prevent double taxation can be justified by the nature or general scheme of the tax system, there is still an important difference between the selectivity (i.e., comparability) test and the justification test. This is because the justification test is subject to the requirements of proportionality and necessity whereas the selectivity test is not. This means that the EC could take the view that providing relief for double taxation in cases where there is actually no double taxation boils down to unjustified state aid under reference to the proportionality and necessity test. Based on what has been officially published so far in the case concerning the Belgium excess profit tax ruling system, 12 and the press release in the McDonald s case itself, this seems indeed to be the path the EC is currently following in other cases. I think, however, that this approach is not without problems. Essentially it means that the EC would decide how tax treaty provisions for relief of double taxation should look like (e.g., no relief if there is no double taxation). Again one could wonder if it should be up to the EC to make such a decision. 4.4 The Rossi-Approach Finally, perhaps the EC is taking another (and more radical) approach what I would call the Rossi-approach. Under this approach, selectivity could still arise even if there would be no deviation from the US-Luxembourg tax treaty definitions and no discrimination between Luxembourg resident companies. This is because in exceptional cases, the mere application of the general tax system may still result in selectivity. This can be inferred from the Gibraltar case. 13 In brief, this case regarded the proposed Gibraltar corporate tax regime. The main contemplated criteria for corporate tax liability, however, did not consist of income, but of premises and employees. The CJEU concluded that offshore companies would not be taxed under the proposed regime, which was not a random consequence of the regime at issue, but followed precisely from the contemplated criteria for corporate tax liability. 14 The CJEU consequently ruled that although the reference system as defined by Gibraltar was founded on criteria that were of a general nature, it nonetheless discriminated factually between companies that were in a comparable situation, resulting in a selective advantage being given to offshore companies. 15 Apparently, the benchmark for selectivity in this case no longer was whether there was an exception to the main rule. The mere application of the main rule factually resulted in selectivity. Although intuitively one could endorse the CJEU s decision given the peculiarities of this case, the CJEU s approach nonetheless raises important conceptual difficulties. After all, how should one calculate the advantage (difference between main rule and deviation) if it is already the main rule that results in selectivity? This decision implies that the EC could set its own benchmark in such a case, e.g., a (minimum) norm as to how a corporate income tax system should at least look like. This means that selectivity might arise not only in cases of a deviation from the domestic general system, but also in case of a EC 3 Feb (2015/C ex 2015/NN), State aid SA Belgium Excess profit tax ruling, para. 58. The text of the final decision was not yet available at the time of finalizing this article. CJEU 15 Nov. 2011, Joined Cases C-106/09 P and C-107/09 P Commission and Spain v. Government of Gibraltar and United Kingdom [2011] ECR I Ibid., para Ibid., para EC TAX REVIEW 2016/2 111

5 INTERNATIONAL JURIDICAL DOUBLE NON-TAXATION AND STATE AID deviation from certain higher international or European norms (which norms are currently unknown). Although in my view the Gibraltar case must be seen as an exceptional case, and should therefore not be generalized, in literature Rossi has submitted (inter alia based on the Gibraltar case) that cross-border tax planning and arbitrage techniques are only available to multinationals and therefore by nature selective. 16 And indeed, Rossi subsequently introduces certain higher international norms (e.g., substance over form, territoriality principle, arm s-length principle) against which he starts assessing a number of concrete international tax planning structures. Although this approach has been criticized in literature, 17 it nonetheless seems that the EC has actually adopted this approach in its recent decision in the Starbucks case. In this case, the EC seems to assess a domestic tax ruling against a European arm s-length standard and not against the domestic (Dutch) standard. 18 Likewise, the EC could perhaps take the view in the McDonald s case that a higher (European) norm exists stating that income should be taxed in the residence state if it is not subject to tax in the other tax treaty state. Again, in my view such would mean, however, that the EC would start See for example, P. Rossi-Maccanico, Fiscal Aid, Tax Competition, and BEPS, Tax Notes Intl. 857 et seq. (2014). For example, R.H.C. Luja, Will the EU s State Aid Regime Survive BEPS?, British Tax Rev. 3, (2015). See the press release < 80_en.htm>. See on this matter also A. Gunn & J. Lutz, Tax Rulings, APAs and State Aid: Legal Issues, EC Tax Rev. 4, (2015). creating rules of international tax law on the basis of the EU state aid rules. 5 FINAL REMARKS The current McDonald s case is the latest example to date that the EC is trying to combat international mismatches through application of the European state aid rules. Although the preliminary analysis of the EC has not been released yet, I have discussed three possible ways of reasoning that the EC may apply which (in increasing order) raise concerns of legal certainty. I think the crucial point here is that bilateral benefits flowing from international tax planning are not imputable to an individual state. They exist simply because different rules of different state do not always match. And in fact, in 2009, the EC accepted in its decision in the Dutch group interest box investigation that any advantage resulting from an international context owing to a low taxation rate in the Netherlands which is not mirrored by a low rate of deduction in the Netherlands but instead corresponds to a normal deduction rate abroad, is not imputable to the Netherlands. 19 In my opinion, there is nothing wrong with removing international disparities. For the sake of legal certainty, however, this should in my view be done through legislation instead of through application of the European state aid rules. 19 Commission Decision of 8 Jul on the Groepsrentebox scheme C 4/2007 (ex N 465/2006), para EC TAX REVIEW 2016/2

Ernst & Young LLP Accountancy Belastingen Transacties Advies Over Ernst & Young Daniel Smit is verbonden aan Ernst & Young Belastingadviseurs LLP Tel: 088-4078499 E-mail: daniel.smit@nl.ey.

6 Ernst & Young LLP Accountancy Belastingen Transacties Advies Over Ernst & Young Daniel Smit is verbonden aan Ernst & Young Belastingadviseurs LLP Tel: Verschenen in: EC Tax Review 2016 nr. 2 april p , een uitgave van Kluwer Law International te Den Haag Ernst & Young is wereldwijd toonaangevend op het gebied van accountancy, belastingen, transacties en advies. Onze mensen delen wereldwijd dezelfde waarden en staan voor kwaliteit. Wij maken het verschil door onze mensen, onze cliënten en de samenleving te helpen hun mogelijkheden optimaal te benutten. Voor meer informatie: Disclaimer Dit bericht is met grote zorgvuldigheid samengesteld. Voor mogelijke onjuistheid en/of onvolledigheid van de hierin verstrekte informatie aanvaardt Ernst & Young geen aansprakelijkheid, evenmin kunnen aan de inhoud van dit bericht rechten worden ontleend. Ernst & Young International juridical double non-taxation and state aid / D.S. Smit. - ECTAXREV 2016/IC-ECTA

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