European Union law and state fiscal aid
Week 5 presents the actions taken within the European Union to neutralise the effects of international tax planning by multinationals. It also discusses how EU law and rulings from the European Court of Justice may limit domestic and international initiatives for countering tax planning practices.
The stated goals of EU policy include acheiving the “four freedoms”: free movement of goods, services, persons and capital within the internal market. It also aims to produce a level playing field within that market and harmonise national laws.
Some of the European institutions are particularly relevant to the intended analysis. To quote the brief presentation made on the first lecture:
First, the Council of the European Union, or EU Council, is the institution representing governments of the EU member states. In the EU council, national ministers from each country within the EU meet to adopt laws and coordinate policies. The EU council is divided into several different configurations, based on policy areas. For our purposes, the Economic and Financial Affairs Configuration (Ecofin) is most important. Ecofin is composed of the Economic/Finance Ministers of the EU member states.
The European Commission is the EU executive body:
The European Commission represents and upholds the interests of the European Union as a whole. It’s responsible for proposing and drafting legislation and manages the day-to-day business of implementing EU policies and spending EU funds. The members of the European Commission are 28 in total, one from each member state. For purposes of this course, the commissioners for taxation and competition are particularly important.
And the Court of Justice of the European Union is the highest EU court in matters of EU law.
Each country has its own tax policies, which fall within two categories:
- indirect taxation, which is mostly harmonised already; and
- direct taxation, which has been left mostly to the designs of member states.
The ultimate EU goal, as pointed in lecture 1, would be to implement a consolidated corporate tax base. The creation of directives and regulations on direct taxation, however, requires unanimous approval of all member states, as stated in article 114, paragraph 2, and article 115 of the Treaty on the Functioning of the European Union.
Even with such limitations, the EU has adopted some measures of positive integration on direct taxation, such as
- the parent-subsidiary directive, which seeks to abolish withholding facts of outgoing payments, and to prevent economic double taxation within an EU-based corporate group structure;
- the merger directive, which seeks seeks to facilitate tax-neutral corporate mergers, divisions, transfers of shares and exchanges of shares between EU-based companies; and
- the interest and royalty directive, which seeks to abolish withholding tax on those kinds of intra-group payments;
The EU Court of Justice tries to fill the gaps left by the absence of positive integration measures through negative integration, ruling against national tax provisions that go against the economic principles of the European Union, especially the four freedoms.
Tax competition & tax planning
Corporate income taxes have not been harmonised within the European Union, and that may lead to distortions on investment and employment decisions. Cross-border economic activities may be subject to double taxation and legal discrimination through protectionist tax measures (which have mostly been removed by the EU Court of Justice). As the EU countries retain their fiscal sovereignty, they may shape their internal tax regimes to attract and retain investment, and the differences between tax regimes may benefit companies or negatively impact their activities based on their choices of countries of operation.
This scenario of tax competition between countries opens opportunities for corporate tax planning and may ultimately erode the tax bases of involved countries. In the absence of binding directives, the EU has established a Code of Conduct for Business Taxation, which was adopted in December 1st, 1997 as a non-binding document by the EU countries. The Code of Conduct group has identified measures that could lead to harmful tax competition, and EU countries have adjusted their laws to close those opportunities. Since then, the group has extended its scope to topics such as hybrid mismatches (2009), cross-border exchange of tax rulings (2010), and review of the substance requirement (2013).
The European Commission has also launched initiatives of its own, such as their 2004 “Communication on Preventing and Combating Financial and Corporate Malpractice”, and their 2009 communication proposing more transparency and data exchange between EU countries, allowing national structures to cope better with complex multinational strucutres. In 2012, the EC recommended that EU states adopt the same general stance over the subject of aggressive tax planning, coordinating their actions to address such practices and avoid double taxation and not-taxation.
So, while few binding directives have been emmitted on the subject of tax competition, European countries have managed to close some of the possible exploits through coordinated action and acceptance of non-binding guidances. Yet, those instruments alone are not enough to fully harmonise the tax laws of member states.
State aid law
State aid is defined on Article 107, paragraph 1, of the Treaty on the Functioning of the European Union (TFEU) as:
- Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.
Some exceptions to this definition are provided in paragraphs 2 and 3 of the same article. The “favouring certain undertakings” part, referred to as the selectivity requirements, must be understood in comparison to the ordinary tax regime of a country. For this purpose, the notion of advantage should be understood as going beyond stricto sensu subsidies and including any measures that mitigate costs associated with a given business operation.
If the aid establishes any selectivity distinction to its recipients, the criteria must be legitimate and proportional to the intended goals. To quote Lecture 3:
In the case of Paint Graphos, a case about the abuse of the legal form of a cooperative society for tax purposes, the EU could have just added that tax exemptions or other tax advantages may be justified by the nature or general scheme of the tax system of the member state concerned. In such a case, this however still necessary to ensure that those exemptions are consistent with the principle of proportionality and do not go beyond what is necessary and that the legitimate objective being pursued cannot be obtained by less far-reaching measures.
Article 108, paragraph 3, of the TFEU establishes that the European Commission must be informed before any plans to grant or alter aid. If it deems that the plan is not compatible with the internal market, or if it finds that allowed aid has been misused, the Commission shall decide that the State concerned shall abolish or alter the aid conceded. If the State does not comply, the Commission or any other interested State may refer the matter to the Court of Justice of the European Union, unless the Council of Europe, after application by a Member State, unanimously decides that the aid is compatible with the internal market.
The Commission, upon determining that state aid has been given in an unlawful fashion, shall require the recovery of all aid given in the last 10 years before the investigation, plus interest. According to article 14 of Council Regulation number 659/1999, the so-called procedural regulation, recovery is not required if this would be contrary to a general principle of EU law. One of those principles is the principle of legitimate expectations, which applies only in a very narrow case: when expectation of aid has been generated through communications from EU institutions such as the Commission itself, under very specific circumstances the concession of aid may be reasonably expected even without official notification, but the EU Court of Justice interprets this principle in a very narrow way.
In practical cases, the EC has identified unlawful state aid by distinguishing the extrinsic objectives attributed to a tax scheme and the mechanisms inherent to the system itself to achieve its goals. Unlawful aid may be identified through extrinsic objectives of a tax aid scheme or through the unintended spilling of intrinsic mechanisms of a lawful model. An example is the use of IP boxes — special tax regimes intended to stimulate research and development through tax reductions on income from patents — which the EC understand not to be unlawful aid in the general case. However, a specific IP box might cause a spill-over effect that is not necessary to achieve the intended research and development object, thus unfairly favouring highly mobile business.
Tax rulings may also be interpreted as unfair tax aid. Based on investigations started from 2014 on, the European Commission has stated that
where a tax ruling concerns transfer pricing arrangements between related companies within a corporate group, that arrangement should not depart from the arrangement or remuneration that a prudent independent operator acting under normal market conditions would have accepted, end of quote.
This prudent independent operator principle reflects what is stated in the Draft Notice on the Notion of Aid (2014), where the European Commission stated that rulings should only aim to provide legal certainty to the fiscal treatment of certain transactions, as opposed to ensuring lower taxation. Guided by that principle, the EC has investigated operations of companies such as Fiat and Starbucks and their use of favourable tax rulings by authorities from Luxembourg and the Netherlands, respectively.
Adjustment P/S Directive
The Parent-Subsidiary Directive is a measure of the European Union, adopted in 1990, which seeks to abolish withholding tax from outgoing payments and to prevent economic double taxation within an EU-based corporate group structure. As an EU directive, it expresses policy goals, leaving the specific implementation details to each country; member states need to adapt their laws to follow the directive, but are free to choose the best way to do so within their legal systems.
[t]he Parent-Subsidiary Directive provides that intra-group cross-border payments of dividends should be exempt from withholding tax, and the member state of the parent company that is the entity receiving the dividend must either exempt the income or provide for a credit on underlying taxes.
This directive applies to companies resident within the EU, where the parent company holds a qualifying interest in the subsidiary (as of 2009, that interest should be of at least 10%) and both companies have the adequate legal forms and are subject to corporate income tax. To avoid double non-taxation, the European Commission made in 2013 a proposal to amend the Parent-Subsidiary Directive and close some perceived loopholes. This proposal introduces a rule according to which a country shall deny tax exemption from hybrid loan arrangements whenever the arrangement results in a deduction in another country.
The 2013 proposal also introduces a general anti-abuse rule that prevents the benefits of the directive from being granted whenever a corporate structure change is adopted with the main purpose of obtaining artificial tax benefits. EU member states had until the end of 2015 to put in place both the hybrid loan rule and the general anti-abuse rules, and that may have required changes to their tax legislations.
EU free movement law
As previously discussed, the TFEU establishes four fundamental freedoms:
- free movement of goods (mostly in arts. 28, 34 and 25, 110 and 111);
- free movement of persons, including the freedom of workers (art. 45);
- freedom to provide services (art. 56); and
- free movement of capital and payments (art. 63), the only one that also extends to investments from and towards non-member countries.
Natural persons also enjoy the freedom to move and reside freely in the EU, defined in the article 21 of the TFEU. Any measure adopted by EU member states must preserve those freedoms, and that constraint limits national approaches to restrict tax planning, especially those undertaken in an unilateral fashion. Restrictions to those liberties must meet a series of conditions, as presented in the course lectures:
Does the situation of the taxpayer come within the personal, material and territorial scope of one or more of the free movement provisions, or is the situation wholly internal to a member state?
Does the situation in question discriminate on grounds of nationality or prohibit, impede, or make less attractive the exercise of the right to free movement?
Does the legislation in question not discriminate directly on the grounds of nationality and is it pursuing a legitimate objective compatible with EU law and justified by imperative requirements in the public interest?
Test of suitability: is the legislation in question suitable for obtaining the objective pursued?
Test of necessity: does the legislation in question go beyond what is necessary in order to attain the objective pursued? That is, is there no less restrictive measure available?
Test of balance: is the objective pursued by the legislation in question proportionate to the restriction on the right to free movement?
Those standards are used by the EU Court of Justice when it evaluates cases related to direct taxation and state aid. An example can be seen on the court’s ruling on Cadbury Schweppes, based on an UK attempt to apply its Controlled Foreign Company (CFC) rules to that company. Quoting from the lecture discussion:
The court, however, said that the need to prevent the reduction of tax revenue is not a matter of overriding general interest, which would justify a restriction on a fundamental freedom. Also, the mere fact that the resident company establishes a secondary establishment, such as a subsidiary, in another member state cannot set up a general presumption of tax evasion.
On the other hand, a national measure restricting freedom of establishment may be justified where its specifically relates to wholly artificial arrangements aimed at circumventing the application of the legislation of the member state. Here it is necessary to take particular account of the objective pursued by the freedom of establishment.
The EU Court of Justice has ruled that countries may only apply CFC regimes to artificial arrangements, designed for tax allocation between countries. Otherwise, such measures may discriminate against companies operating in other member states, unduly constraining the four freedoms. A similar logic was applied by that court on cases of interest deduction (Thin Cap Group Litigation and SIAT) and transfer pricing (SGI), establishing that any limitations imposed by countries must be based on precise and clear rules, respect the principle of legal certainty and should not result in a further denial of interest deduction than which the arm’s length principle will justify, while allowing companies to provide commercial justification for not meeting the at arm’s length principle.