Last month’s decision by Europe’s General Court to reject the European Commission’s attempt to recover €13 billion in back taxes from Apple was the third such defeat that the EC suffered at the hands of the General Court. Following this massive defeat, the inevitable question is where this leaves the European Commission’s tax agenda going forward.
Last month, Europe’s General Court crushed the European Commission’s decision ordering Ireland to recover €13 billion (plus interest) in back taxes from Apple. This was the Commission’s third defeat before the General Court using the state aid framework against tax measures of (mostly) American corporations operating in Europe.
To understand why the EC lost the Apple state aid case, it’s important to take a minute to explain Apple’s corporate structure. Apple Inc. is based in Cupertino, California, in the United States. Its subsidiary, Apple Operations International, owns Apple Operations Europe (‘AOE’), which in turn owns Apple Sales International (‘ASI’). AOE and ASI are both companies incorporated in Ireland but are not tax resident in Ireland.
In 2014, the European Commission opened an investigation against Ireland. It alleged that the Irish tax authorities had issued two tax rulings to AOE and ASI in 1991 and 2007, respectively, both of which allegedly gave the Apple subsidiaries preferable tax treatment amounting to illegal state aid under the European Treaty. Both Ireland and Apple appealed the Commission’s decision and won before the General Court.
Following this massive defeat, the inevitable question is where this leaves the European Commission’s tax agenda going forward. Europe doesn’t have a federal tax system, and it is up to each of the EU’s Member States to decide its own corporate tax rate. In some Member States, the corporate tax rate is 12.5 percent, and in others, it is 35 percent. This is possible because the Member States have exclusive competence within the area of direct taxation.
For some time, the European Commission has tried—and failed—to create a common, consolidated corporate tax base through legislation both in 2011 and 2016. So far, however, there has been little political will amongst the EU states to do this. In light of these repeated failures, the EC tried to advance its tax agenda through the judicial system, which so far has not proven to be very successful.
Tax Rulings and State Aid
Many of the European Union’s Member States operate with a national tax ruling system. Such a system may be set up because taxpayers require support in their own assessments, or because there exists a desire to foster a level of cooperation between taxpayers and the taxation authorities, or because authorities view a rulings system as a means of identifying important information at an earlier stage. These justifications underpin the overarching notion that tax rulings can often, through increased certainty and clarity, produce a better taxation environment.
However, Member States cannot give financial support to selective companies in the form of a favorable tax ruling in order to protect or boost certain sectors of their national economies. That is considered illegal state aid. It has a distortive effect on competition and can prejudice the interests of more-efficient competitors in other Member States, which harms both economies and consumers.
Without any form of state aid control, the EU’s Member States could be tempted to enter into a wasteful subsidies race, with each state giving more and more support to its own national industries at the expense of taxpayers. It is therefore essential to the effective running of the European single market that companies are able to compete with each other at a level playing field, and that Member States are not allowed to distort competition by giving state aid to companies in the form of sweetheart deals.
It is settled case law in the EU that the Commission is allowed to investigate whether certain national tax rulings infringe on the European Treaty. However, the European Commission has no powers of its own on issues of direct taxation. While the Member States have exclusive competence within the area of direct taxation, they must exercise their sovereignty in accordance with EU law.
Under the state aid rules of the European Treaty, the Commission must demonstrate that the company in question—in this case, Apple—has been given a selective advantage as a result of the national tax ruling.
To examine whether Apple’s subsidiaries, ASI and AOE, had been given a selective advantage by the Irish tax authorities, the European Commission had to determine the proportion of overall profits allocated to ASI and AOE for taxation purposes. This involved identifying the assets, functions, and risks allocated to those branches on the basis of the activities actually performed by those branches. The European Commission relied on the Authorized OECD Approach to make that decision. Like previous cases, the General Court confirmed that the Commission is entitled to rely on that approach.
The General Court also confirmed that the Commission was allowed to rely on the arm’s length principle (ALP) when analyzing the level of profit that has been accepted by the Irish tax authority (also known as the Revenue). The purpose of the ALP is to determine whether the chargeable profits of non-resident companies correspond to the level of profit that would have been obtained if that activity had been carried on under market conditions.
The ALP is a well-known principle that forms part of many double taxation treaties around the world. Such treaties are put in place to avoid the double taxation of companies carrying out trade in another country than the country where it has its permanent establishment.
Not all EU Member States operate with an ALP, as it is not a principle incorporated in all national tax frameworks. Thus, the General Court had to decide whether the European Commission was allowed to rely on the principle. The General Court accepted that the ALP is a tool that enables the Commission to exercise its powers under the state aid framework but did not accept that there is a freestanding obligation to apply the ALP principle horizontally and in all areas of national tax law.
The Commission’s Reasoning for Finding Illegal State Aid
The Commission argued that the Irish tax authorities had accepted that the Apple Group’s IP licenses—from its development and innovations of technological products—which were held by ASI and AOE had to be allocated outside Ireland. Allocating the IP licenses outside Ireland meant that ASI and AOE’s annual chargeable profits in Ireland were not consistent with a market-based outcome in line with the ALP.
Consequently, the Irish tax authorities had conferred an advantage on ASI and AOE that is illegal under the state aid framework, in the form of a reduction in their respective annual chargeable profits.
The European Commission’s argument relied on an “exclusion approach.” Meaning, it assumed that since the head offices of ASI and AOE had no presence or employees, they could not have controlled the relevant IP, and therefore all associated profits must be allocated by default to the ASI and AOE Irish branches.
Ireland argued that the European Commission was wrong to conclude that the profits related to the Apple Group’s IP licenses held by ASI and AOE should have been allocated to their Irish branches. Both Ireland and Apple argued that the Commission not only failed to examine the functions actually performed within the Irish branches of ASI and AOE, but it also misapplied the Authorized OECD Approach.
The General Court concurred and held that the “exclusion approach” was inconsistent with the Authorized OECD Approach. Moreover, it held that the European Commission should have analyzed the actual activities of ASI and AOE, including intangibles such as IP, the related risks that they assume, and the value of the activities actually carried out by the branches themselves.
The General Court found that the European Commission had failed to prove with specific evidence that ASI and AOE had performed the functions and assumed the risks that were allocated to those branches. It stressed that the analysis “cannot be carried out in an abstract manner that ignores the activities and functions performed within the company as a whole.” It criticized the Commission for not trying to show that the Irish branches of ASI and AOE had in fact controlled the Apple Group’s IP licenses when it concluded that the Irish tax authorities should have allocated the Apple Group’s IP licenses to those branches.
The Commission also argued that even if the Irish tax authorities had been correct in accepting that the Apple IP licenses could be allocated outside Ireland, the methods used by the Irish tax authorities to allocate profits had nonetheless resulted in an annual chargeable profit for ASI and AOE in Ireland, which departed from a market-based outcome in line with the ALP.
In other words, the EC argued that the Irish tax authorities had used the wrong methodology to calculate the allocated profit. The General Court disagreed. It held that even if the Irish tax authorities had chosen the wrong methodology to calculate the profit, it is not enough to establish that ASI and AOE had been given an advantage: the Commission must demonstrate that the wrongly applied methodology led to a reduction in chargeable profit. The court acknowledged that calculating the chargeable profit of ASI and AOE demonstrates the incomplete and occasionally inconsistent nature of the contested tax rulings.
However, a wrong methodology is not sufficient to prove the existence of an advantage for the purposes of state aid. This must be correct as even a wrong methodology can lead to the right result and vice versa a correct methodology can lead to the wrong result.
Using an alternative line of reasoning, the Commission argued that the tax rulings issued by Irish tax authorities were given on a discretionary basis. It had not relied on objective criteria related to the Irish tax system, and as a result, they had conferred a selective advantage on ASI and AOE. The court rejected this line of reasoning fairly swiftly. The court held that even if “it were established that the tax authorities had discretion, the existence of such discretion does not necessarily mean that it was used to reduce the tax liability of the recipient of the tax ruling as compared with the liability to which that recipient would normally have been subject.”
So where does this defeat leave the Commission going forward? It is clear that the General Court has not closed the door on the European Commission bringing judicial action against national tax authorities if they issue sweetheart deals to corporations in form of lower tax compared to their competitors.
However, the loss is a reminder of what it takes to lift the legal burden of proof in cases involving state aid and tax rulings. In this case, it was not enough for the European Commission to simply rely on a number of presumptions and exclusions. The European Commission must carry out a more meticulous and thorough factual assessment.
One would hope that this defeat—as well as previous defeats—has made the Commission realize what it takes to bring state aid action against national tax authorities.
The General Court also reminded us of the European Commission’s limitations/lack of competence within areas of direct taxation such as corporate taxation. While the European Commission can continue to use the state aid framework to hold national tax authorities accountable for any tax ruling that gives any company a selective advantage in form of a lower tax burden, it is a slow and resource-intensive exercise.
Thus, the European Commission is currently looking for another way of creating a single EU-wide system for computing taxable income. The Commission has suggested using a provision of the European Treaty in order to eliminate competition distortions that may exist due to different national tax rules. It requires the European Commission to establish that the different national rules—whether tax or otherwise— create a distortion of competition in the internal market, which needs to be eliminated.
Unlike a change in direct taxation, which requires unanimity from the EU’s Member States, this change can be made by qualified majority i.e. if two-thirds of the Member States agree. It remains to be seen whether the Commission will be successful in utilizing this little-used provision.