To apply the Arm’s Length Principle to transactions between two related companies, the Commission must identify the less complex company of the two and compare it to a similar independent company.
Methodological errors in the application of the Arm’s Length Principle by national authorities does not necessarily prove the existence of advantage.
On 12 May 2021 the Commission suffered its fourth defeat in its campaign against advance tax rulings that artificially lower the tax liability of multinational companies.
The General Court in joint cases T-816/17, Luxembourg v European Commission, and T-318/18, Amazon v European Commission, annulled Commission Decision 2018/859 that ordered Luxembourg to recover EUR 283 million from Amazon.
Amazon Inc, in the United States, had established a holding company in Luxembourg [“LuxSCS”]. The latter was granted licence to use intellectual property developed by Amazon Inc. In turn LuxSCS entered into an agreement with another Amazon company, also established in Luxembourg [“LuxOpCo”], for the purpose of allowing the latter to use the intellectual property and other intangible assets. The advance tax ruling concerned the royalties paid by LuxOpCo to LuxSCS for the use of that intellectual property and confirmed that they did constitute an “appropriate and acceptable profit”.
The view of the Commission, in a nutshell, was that LuxSCS, which had no physical presence or employees in Luxembourg obtained most of the profit made by LuxOpCo through the royalty payments. Such an arrangement would not have been agreed by two independent companies because LuxOpCo did all the work that generated profits, while LuxSCS carried out only routine functions. It was not a reliable approximation of a market-based outcome, contrary to the arm’s length principle [ALP]. The Commission inferred that the purpose of the agreement between the two companies was to minimise the profit of LuxOpCo and therefore the tax paid by LuxOpCo.
Applicability of State aid law
“ (112) While direct taxation, as EU law currently stands, falls within the competence of the Member States, they must nonetheless exercise that competence consistently with EU law […] Thus, intervention by the Member States in matters of direct taxation, even if it relates to issues that have not been harmonised in the European Union, is not excluded from the scope of the rules on the monitoring of State aid”.
“(113) Member States must exercise their competence in respect of taxation in accordance with EU law […] Accordingly, they must refrain from adopting any measure, in that context, liable to constitute State aid incompatible with the internal market”.
Then the Court reiterated the standard method for determining the existence of State aid in tax measures.
“(114) A measure by which the public authorities grant certain undertakings favorable tax treatment which, although not involving a transfer of State resources, places the recipients in a more favorable financial situation than that of other taxpayers constitutes State aid for the purposes of Article 107(1) TFEU”. “(115) In the case of tax measures, the very existence of an advantage may be established only when compared with ‘normal’ taxation […] Accordingly, such a measure confers an economic advantage on its recipient if it mitigates the burdens normally included in the budget of an undertaking and, as a result, without being a subsidy in the strict meaning of the word, is similar in character and has the same effect”. “(116) Consequently, in order to determine whether there is a tax advantage, the position of the recipient as a result of the application of the measure at issue must be compared with his or her position in the absence of the measure at issue”.
Then the Court explained how the above principles applied to related companies [group companies].
“(117) In determining the fiscal position of an integrated company which is part of a group of undertakings, it must be noted at the outset that the pricing of intra-group transactions carried out by that company is not determined under market conditions. That pricing is agreed to by companies belonging to the same group, and is therefore not subject to market forces”. “(118) Where national tax law does not make a distinction between integrated undertakings and stand-alone undertakings for the purposes of their liability to corporate income tax, that law is intended to tax the profit arising from the economic activity of such an integrated undertaking as though it had arisen from transactions carried out at market prices. In those circumstances, it must be held that, when examining, pursuant to the power conferred on it by Article 107(1) TFEU, a fiscal measure granted to such an integrated company, the Commission may compare the fiscal burden of such an integrated undertaking resulting from the application of that fiscal measure with the fiscal burden resulting from the application of the normal rules of taxation under national law of an undertaking, placed in a comparable factual situation, carrying on its activities under market conditions”.
“(121) It should also be noted that when the Commission uses the arm’s length principle to check whether the taxable profit of an integrated undertaking pursuant to a tax measure corresponds to a reliable approximation of a taxable profit generated under market conditions, the Commission can identify an advantage within the meaning of Article 107(1) TFEU only if the variation between the two comparables goes beyond the inaccuracies inherent in the methodology used to obtain that approximation”.
“(123) If the Commission detects a methodological error in the tax measure under consideration, it cannot be concluded that mere non-compliance with methodological requirements necessarily leads to a reduction in the tax burden. It is further necessary for the Commission to demonstrate that the methodological errors that it identified in the tax ruling concerned do not allow a reliable approximation of an arm’s length outcome to be reached and that they led to a reduction in the taxable profit compared with the tax burden resulting from the application of normal taxation rules under national law to an undertaking placed in a comparable factual situation to the company concerned and carrying out its activities under market conditions. Thus, the mere finding of a methodological error does not in itself suffice, in principle, to demonstrate that a tax ruling conferred an advantage on a specific company and, thus, to establish that there is State aid within the meaning of Article 107 TFEU”.
Then the Court considered who had the burden of proof.
“(126) It is for the Commission to show, in the contested decision, that the requirements for a finding of State aid, within the meaning of Article 107(1) TFEU, were met. In that regard, it must be held that, while it is common ground that the Member State has a margin of appreciation in the approval of transfer pricing, that margin of appreciation cannot lead to the Commission being deprived of its power to check that the transfer pricing in question does not lead to the grant of a selective advantage within the meaning of Article 107(1) TFEU. In that context, the Commission must take into account the fact that the arm’s length principle allows it to verify whether the transfer pricing accepted by a Member State corresponds to a reliable approximation of a market-based outcome and whether any variation that may be identified in the course of that examination does not go beyond the inaccuracies inherent in the methodology used to obtain that approximation”.
As the Court explained later on in its judgment, “(281) the relevant question in the context of the present action is therefore not whether LuxSCS was created purely for tax purposes, nor whether the income which it generated was actually taxed in the United States in the hands of its partners, but rather whether LuxOpCo paid a royalty which was overpriced and whether, as a result, LuxOpCo’s remuneration and, therefore, its taxable base were artificially reduced.”
Calculation of the market price that should have been paid by LuxOpCo according to the ALP
Next the General Court examined how the Commission applied the ALP to determine whether the prices agreed between LuxSCS and LuxOpCo corresponded to market-based rates.
The Commission chose the transactional net margin method [TNMM] to assess the reliability of the transfer pricing between LuxSCS and LuxOpCo. The TNMM determines the net profit, in an appropriate base, made by a taxpayer in a controlled transaction. The appropriate base is the base to which a profit indicator is applied, such as costs, sales or assets. The profit indicator is determined by reference to the profit earned by an independent undertaking in comparable uncontrolled transactions.
In addition, the TNMM requires the identification of the party to the transaction to which the profit indicator is applied or tested whether it conforms with the ALP. As a general rule, the tested party is the party to which a transfer pricing method can be applied in the most reliable manner and for which the most comparables can be found. For this reason, the tested party most often is the party which has the less complex functions because it is easier to identify independent parties with similar operations. Moreover, the tested party is the one that makes no unique or valuable contributions to a transaction because, again, it is easier to find similar companies to act as comparators.
Luxembourg and Amazon did not dispute that Commission was wrong to choose the TNMM. They argued instead that the Commission applied that method incorrectly. They disagreed with the Commission’s choice of LuxSCS as the tested party with the least complex functions, the calculation of LuxSCS’s remuneration, and the reliability of the results.
Over a long a detailed analysis, the General Court concluded in paragraphs 190-196 that the LuxSCS managed Amazon’s technology and know which were “unique” and “valuable” assets and for which no comparator could be found. In addition, the Court found that LuxSCS exploited those assets by licensing them to LuxOpCo [paragraphs 204 & 215]. LuxSCS also incurred risk in managing those assets [paragraphs 235-236]. Consequently, the Court held that “(251) the Commission should have accepted, when seeking to determine the appropriate mark-up for the royalty, that there were no comparables for LuxSCS” and that “(291) the absence of comparables should have led the Commission not to apply the TNMM to LuxSCS.”
Consequently, the General Court upheld the pleas of Luxembourg and Amazon on the grounds that “(296) first, the Commission wrongly considered that LuxSCS should be used as the tested party. Secondly, the Commission’s calculation of LuxSCS’s ‘remuneration’, on the basis that LuxSCS had to be the tested entity, is vitiated by numerous errors and cannot be regarded as sufficiently reliable or capable of achieving an arm’s length outcome. Since the calculation method used by the Commission must be rejected, that method cannot serve as a basis for the Commission’s finding that the royalty paid by LuxOpCo to LuxSCS should have been lower than the royalty actually received, pursuant to the tax ruling at issue, during the relevant period. The elements set out in the primary finding of an advantage therefore do not establish that LuxOpCo’s tax burden was artificially reduced as a result of an over-pricing of the royalty.”
Then the General Court examined the pleas against the subsidiary reasoning of the Commission on the existence of advantage in favour of Amazon through reduction of its taxable income.
The Court began its analysis by recalling the relevant points in the judgment of 24 September 2019 in case T-760/15, Netherlands v European Commission (Starbucks).
“(307 ) First of all, in paragraph 152 of the judgment of 24 September 2019, Netherlands and Others v Commission (T‑760/15 and T‑636/16, EU:T:2019:669), the Court stated that, when the Commission applies the arm’s length principle to check whether the taxable profit of an integrated undertaking pursuant to a tax measure (first comparable) corresponds to a reliable approximation of a taxable profit generated under market conditions (second comparable), the Commission can identify an advantage within the meaning of Article 107(1) TFEU only if the variation between the two comparables goes beyond the inaccuracies in the methodology used to obtain that approximation.”
“(308) It follows that, to demonstrate that an advance tax ruling used to calculate an undertaking’s remuneration confers an economic advantage, the Commission must prove that that remuneration deviates from an arm’s length outcome to such an extent that it cannot be regarded as remuneration that would have been received on the market under competitive conditions.”
“(309) Next, in paragraphs 201 and 211 of the judgment of 24 September 2019, Netherlands and Others v Commission (T‑760/15 and T‑636/16, EU:T:2019:669), the Court stated that mere non-compliance with methodological requirements does not necessarily lead to a reduction in the tax burden. It is further necessary for the Commission to demonstrate that the methodological errors in the advance tax ruling that it identified do not allow a reliable approximation of an arm’s length outcome to be reached and that they led to a reduction in taxable profit. The Court thus concluded that the mere finding of errors in the choice or application of the transfer pricing method does not, in itself, suffice to demonstrate the existence of an advantage and, therefore, to establish that there is State aid within the meaning of Article 107 TFEU.”
“(312) In the light of the foregoing, and in the absence of a comparison in the contested decision between, on the one hand, the result that would have been obtained using the transfer pricing method advocated by the Commission and, on the other, the result obtained pursuant to the tax ruling at issue, the Commission’s approach, set out in recital 564 of the contested decision, at the end of which the Commission merely identifies errors in the transfer pricing analysis, is, in principle, insufficient to establish that there was in fact a reduction in LuxOpCo’s tax burden.”
“(313) Nevertheless, it is necessary to ascertain whether, despite the assertion in recital 564 of the contested decision, the Commission’s subsidiary line of reasoning relating to the advantage contains specific evidence establishing that the errors in the transfer pricing analysis identified by the Commission led to a genuine reduction in LuxOpCo’s tax burden.”
Once more, the General Court examined the calculations of the Commission and once more it concluded that they were either wrong or insufficient to prove that Amazon’s tax burden was artificially reduced.
“(516) The Commission should have compared LuxOpCo’s remuneration obtained using the method endorsed in the tax ruling at issue with the arm’s length remuneration that should have been received in the light of LuxOpCo’s functions identified by the Commission itself in its own functional analysis. […], the Commission should at least have identified a number of factors from which it could be concluded that LuxOpCo’s remuneration calculated pursuant to the tax ruling at issue was necessarily lower than the remuneration that a company operating on the free market would have received had that company performed functions comparable to those identified by the Commission in its functional analysis. Specifically, […], instead of making mere unverified assumptions of the result that would have been obtained […], it should have examined whether, on the free market, taking account of functions and risks comparable to those assumed by LuxOpCo under the controlled transaction (in particular its functions and risks as an online retailer) did in fact result in a share of profits (for an online retailer comparable to LuxOpCo) that would have been greater than that to which LuxOpCo was entitled under the calculation method referred to in the tax ruling at issue. Although the Commission did not have to give precise figures, it was required, at the very least, to provide verifiable evidence in that regard.”
“(517) In the present case, the Commission merely found in the contested decision that, had the profit split method on the basis of the contribution analysis been used, LuxOpCo would have received greater remuneration, without seeking to apply that method. However, the Commission cannot make assumptions about what the result of applying a particular method would be or what remuneration would have been awarded to a particular function. By contrast, […], the Commission must establish that the remuneration endorsed in the tax ruling at issue was lower than the reliable approximation of arm’s length remuneration that would have been received using the profit split method with the contribution analysis.”
“(520) In those circumstances, it must be held that the Commission has not demonstrated the existence of an advantage, but has, at most, demonstrated the probability of the existence of an advantage.”
As in previous cases in which the General Court quashed Commission decisions [Starbucks, Apple], the Court endorsed the principles which the Commission used to detect the presence of advantage but rejected the Commission’s actual calculation methods. The Court has set a pretty high standard of proof for these methods. It is not enough that the Commission identifies mistakes in advance tax rulings or that it shows that prices charged between related companies could be different. The Commission must prove that prices actually charged between similar but independent companies are significantly different.
 The full text of the judgment can be accessed at: