Recovery of Incompatible Aid and the Application of General Provisions for the Avoidance of Double Taxation

The amount of incompatible State aid that has to be recovered can be reduced by any credit the aid recipient could have legally obtained from the application of general provisions of national law.

Introduction

The recovery of incompatible State aid has to be carried out immediately and effectively. The Commission gives guidance to the Member State concerned how to calculate the amount of aid to be recovered, but it is ultimately the responsibility of the granting Member State determine as accurately as possible that amount.

When the aid is in the form of a grant, the amount of aid to be recovered is easy to calculate: it is the grant plus interest. When the aid is in the form of a tax exemption, it becomes a bit more difficult to calculate the precise amount because it is necessary first to determine the taxable profit and then apply the rate of tax that corresponds to each tranche of profit.

On 15 September 2022, in case C-705/20, Fossil (Gibraltar) Ltd v Commissioner of Income Tax, the Court of Justice held that the calculation of the amount to be recovered must also take into account the possible application of general rules for the avoidance of doubt taxation that existed at the time the aid was granted.[1]

A Gibraltar court asked the Court of Justice for a preliminary ruling concerning the interpretation of Commission decision 2019/700 on the Gibraltar corporate income tax Regime and, in particular, the implementation of the obligation to recover the State aid referred to in Article 1 of that decision.

Fossil (Gibraltar), a company established in Gibraltar, is a wholly owned subsidiary of Fossil Group, a US company. Fossil (Gibraltar) receives royalty income from the worldwide use of a number of trade marks owned by Fossil Group.

Fossil (Gibraltar) obtained royalty income which was not taxed in Gibraltar. However, Fossil (Gibraltar) did declare all of that income to the US tax authorities. The US levied a tax of 35%. Fossil (Gibraltar) claimed that the amount of aid to be recovered had to be reduced by the amount of tax it has already paid in the US.

Decision 2019/700

After a formal investigation, the Commission concluded in December 2018 that, first, the exemption of passive interest and royalty income in the Gibraltar income tax act [ITA] of 2010 constituted State aid that was incompatible with the internal market. Second, the decision also concluded that the advance tax ruling granted to the Mead Johnson Nutrition companies constituted incompatible aid. Both types of aid had to be recovered.

However, on appeal, the General Court upheld the first part of the decision with respect to passive interest and royalties and annulled the second part with respect to the advance tax ruling [see case T-508/19, Mead Johnson Nutrition and others v European Commission]. Neither the Commission, nor the UK or any company appealed the judgment of the General Court. Therefore, the first part of the Commission decision became final.

During the process of recovering the incompatible aid that had been granted through the exemption of passive interest and royalties, the Gibraltar Tax Commissioner proposed to the Commission an adjustment of the amount of aid to be recovered from Fossil. The proposed adjustment would take into account tax that had been paid in the US by Fossil Group following the application of the US rules on controlled foreign companies. In other words, by applying the rule for avoidance of double taxation, the proposed adjustment would reduce the amount of aid to be recovered.

DG Competition of the European Commission rejected that proposal on the grounds that the recovery of incompatible aid could not take account of tax paid by Fossil in the US. The Tax Commissioner then increased the amount that had to be repaid by Fossil and informed it accordingly. However, Fossil contested the new amount before the referring Gibraltar court.

Fossil argued that the tax code of Gibraltar contained a provision – in section 37 – that allowed deduction from the tax due in Gibraltar of taxes paid abroad.

The question of the referring court was whether the calculation of Fossil’s tax liability and, therefore the amount that it had to repay, could take into account the tax that it had already paid in the US, as was provided by section 37, had Fossil been taxed in Gibraltar.

Applicability of section 37

The Court of Justice, first, noted that “(35) the question, as formulated by the referring court and to which the Court is asked to provide an answer, is based on the premiss that section 37 of the ITA 2010, which prescribes a mechanism for the set-off of tax paid in a third State with a view to avoiding double taxation, is applicable in the case in the main proceedings.”

In this regard the Court of Justice stressed that “(37) it is for the referring court alone, and not for the Court of Justice, to determine whether that assessment of domestic law is well founded. In that regard, Article 267 TFEU establishes a procedure for direct cooperation between the Court and the courts of the Member States. In that procedure, which is based on a clear separation of functions between the national courts and the Court, any assessment of the facts in the case is a matter for the national court, which must determine, in the light of the particular circumstances of the case, both the need for a preliminary ruling in order to enable it to deliver judgment and the relevance of the questions which it submits to the Court, whilst the Court is empowered to give rulings on the interpretation or the validity of an EU provision only on the basis of the facts which the national court puts before it”.

“(38) In the present case, and taking as a basis the premiss that section 37 of the ITA 2010 is applicable in the case in the main proceedings, it is necessary to determine whether the grant of a reduction in the amount of aid to be recovered from Fossil (Gibraltar) based on that provision, is liable to compromise the effective enforcement of the recovery order contained in Decision 2019/700.”

Purpose and process of recovery of incompatible aid

Then the Court of Justice examined the purpose of the recovery of incompatible State aid. It recalled that “(39) recovery of unlawful aid is the logical consequence of the finding that it is unlawful. Consequently, the Member State to which a decision requiring recovery of illegal aid is addressed is obliged under Article 288 TFEU to take all measures necessary to ensure implementation of that decision. This must result in the actual recovery of the sums owed in order to eliminate the distortion of competition caused by the competitive advantage procured by the unlawful aid […] By repaying, the recipient forfeits the advantage which it had enjoyed over its competitors on the market, and the situation prior to payment of the aid is restored”.

“(40) Under Article 16(3) of Regulation 2015/1589, the recovery of aid declared unlawful and incompatible with the internal market by a decision of the Commission must, as is also apparent from recital 25 of that regulation, be effected without delay and in accordance with the procedures under the national law of the Member State concerned, provided that they allow the immediate and effective execution of that decision, a condition which reflects the requirements of the principle of effectiveness laid down by the case-law of the Court”.

Quantification of the amount that has to be repaid

Since the Commission is not obliged to calculate the precise amount that has to be recovered, it falls on Member States to determine the amount that they must obtain from the recipient of the incompatible aid.

“(41) For the purposes of quantifying the amount of aid to be recovered, the national court must take into account all the relevant information of which it has been made aware. It cannot be excluded that, having regard to all those factors, that calculation made by the national court may result in an amount of aid lower than that resulting from taking into account, in isolation, the Commission decision ordering the recovery of the aid declared incompatible with the internal market, or even an amount equal to zero”.

“(42) The Court has accordingly stated that re-establishing the status quo ante means returning, as far as possible, to the situation which would have prevailed if the operations at issue had been carried out without the aid measure in question having been granted”.

What is status quo ante?

In cases where the aid is given in the form of a grant, the status quo ante is easy to define. It is the situation without the grant. But, in the case of aid granted in the form of a tax exemption, how much tax would the aid recipient pay without the tax exemption? The amount of tax depends on the amount of taxable income. So what would have been the taxable income without the tax exemption?

In a recent case concerning the free economic zone of Madeira, Portugal argued that companies would choose not to establish there and, therefore, would not be liable for tax, in the absence of the tax incentives that the Commission had considered to constitute State aid. That is, Portugal claimed that the counterfactual was a situation of no tax liability. The Commission rejected that argument outright. [See Commission decision 2022/1414 on Zona Franca da Madeira, paragraphs 127-130. The decision was reviewed here on 6 September 2022: Special Economic Zones – (lexxion.eu)

In the case of Gibraltar the Court of Justice, first, explained that “(43) the amounts to be repaid cannot be determined in the light of various hypothetical operations which could have been implemented by the undertakings if they had not opted for the type of operation coupled with the aid”. And, then continued that, nevertheless, “the beneficiaries may of an aid scheme may, at the recovery stage, rely on the deductions and reliefs provided for by domestic law if it is established, having regard to the operations actually carried out, that they were in fact entitled to benefit from them. Re-establishing the status quo ante merely enables account to be taken, at the stage of recovery of the aid by the national authorities, of tax treatment which may be more favourable than the ordinary treatment which, in the absence of unlawful aid and in accordance with domestic rules which are compatible with EU law, would have been granted on the basis of the operation actually carried out”.

“(44) That being said, as regards, in the first place, the question whether Decision 2019/700 precludes, as such, the relief sought under section 37 of the ITA 2010, it must be recalled that, by that decision, the Commission declared to be unlawful and incompatible with the internal market, first, the scheme granted in the form of non-taxation of passive interest income and royalty income and, second, the individual aid measures consisting of five tax rulings out of the 165 referred to in the Commission Decision of 1 October 2014 to extend the formal examination procedure under Article108(2) TFEU, as referred to in paragraph 6 of the present judgment.”

“(45) As regards the measures taken in the form of non-taxation of passive interest income and royalty income, which are the only measures at issue in the main proceedings, it is apparent from Decision 2019/700 that those measures were classified as State aid prohibited by Article 107(1) TFEU, in particular on the ground that they conferred a selective advantage.”

“(46) In particular, account was taken of the fact that that non-taxation contradicted the general principle that corporate income tax is collected from all taxable persons which receive income derived from or accruing in Gibraltar. Therefore, according to the Commission, ‘passive interest and royalty income should normally fall within the scope of taxation’ (recital 82 of Decision 2019/700). The mitigation of a charge which companies would otherwise have to bear gives rise to an advantage (recital 83 of that decision) which is a priori selective in so far as it primarily benefits multinational groups (recitals 103 and 104 of that decision). The Commission stated in recital 107 of that decision, as regards non-taxation, that the argument based on the need to prevent double taxation does not hold up ‘as the (foreign) paying entity is generally allowed to deduct the interest or royalties for tax purposes’.”

“(47) It follows from those considerations that Decision 2019/700 relates only to the finding that certain categories of income, in the present case those generated by passive interest and royalties, are not subject to corporate income tax in Gibraltar.”

“(48) While Decision 2019/700 requires, therefore, the competent national authorities to recover the tax which should have been levied in the absence of the exemption for passive interest and royalty income (recital 223 of that decision), it does not however address the possible discretion to rely on deductions and reliefs laid down in Gibraltar legislation, which could have been applied when calculating the tax due. That decision, and in particular recital 226 thereof, therefore do not preclude, in accordance with the principle laid down in the case-law cited in paragraph 43 of the present judgment, reliance on a mechanism such as that laid down in section 37 of the ITA 2010. Consequently, it also does not call into question the possibility, for the Gibraltar tax authorities pursuant to that mechanism to set-off taxes relating to royalty income paid abroad against the tax relating to those royalties to be paid in Gibraltar.”

The legal validity of letters of Commission services

As mentioned earlier, the Gibraltar Tax Commissioner had proposed to the Commission the adjustment provided by section 37, but the Commission services rejected that proposal. The Court of Justice held that the views of Commission services could not supplement or modify decision 2019/700. “(49) As regards the statements of position apparent from the letters sent by the Commission to the national authorities in the context of exchanges seeking to ensure the immediate and effective execution of Decision 2019/700, as referred to in paragraphs 26 to 28 of the present judgment, they are not acts which can be adopted on the basis of Regulation 2015/1589, they cannot have the effect of supplementing or amending the content of that decision and must be regarded as devoid of any binding effect”.

Recovery must not leave the aid recipient in a more advantageous position than if it had not received any aid

The Court of Justice also considered it necessary to examine whether taking into account, at the stage of recovery of the aid, a tax credit granted on the basis of section 37 would undermine the effectiveness of decision 2019/700 be leaving Fossil in a more advantageous position than it would have been if it had not received State aid in the form of tax exemption.

“(52) The Member State in question must actually recover the sums owed in order to eliminate the distortion of competition caused by the competitive advantage procured by the unlawful aid. While it is true that such a requirement necessarily implies that a Member State cannot circumvent the scope of a Commission decision by adopting compensatory measures intended to render ineffective the consequences of that decision, it cannot prevent the recipients of the aid in question from relying, at the recovery stage, on the deductions and reliefs provided for by domestic law if it is established, having regard to the operations actually carried out, that they were in fact entitled to benefit from them on the date of those operations.”

Was section 37 a general provision that in itself did not constitute State aid and therefore could be used to reduce the amount that had to be repaid?

The Court of Justice held that it was necessary “(54) to examine whether Decision 2019/700 – which classifies the system of non-taxation of passive interest and royalty income as State aid in so far as it, inter alia, deviates from the principle of territoriality laid down in Gibraltar’s tax legislation – implies, by extension, that section 37 of the ITA 2010, on which Fossil (Gibraltar) relies in the main proceedings, must be treated in the same way as such a regime and, consequently, must be regarded as prohibited State aid for the purpose of Article 107(1) TFEU.”

“(55) Accordingly, where, at the date of the operations in question, Fossil (Gibraltar) was in fact able to rely on the application of section 37 of the ITA 2010, which it is for the referring court to ascertain, it is necessary to examine whether the set-off of a tax paid abroad relating to royalty income, as provided for by that provision, is capable of constituting prohibited State aid for the purpose of Article 107(1) TFEU.”

“(59) Outside the spheres in which EU tax law has been harmonised, the determination of the characteristics constituting each tax falls within the discretion of the Member States, in accordance with their fiscal autonomy, that discretion having, in any event, to be exercised in accordance with EU law. This includes, in particular, the determination of the basis of assessment and the taxable event”.

“(60) Deciding which foreign taxes may be set off against domestic tax liability and under which conditions such set-off is possible is a decision of a general nature which falls within the discretion of the Member States in determining the characteristics constituting the tax.”

“(61) A measure such as that referred to in section 37 of the ITA 2010, which seeks to avoid double taxation by prescribing a mechanism for the set-off of tax paid by a taxpayer abroad against taxes for which such taxpayer is liable in Gibraltar, falls, in principle, within the scope of the fiscal autonomy of the Member States and cannot, unless it is established that it is based on discriminatory parameters, be classified as prohibited State aid within the meaning of Article 107(1) TFEU. In that context, it should be recalled that EU law on that matter seeks only to remove the selective advantages from which certain undertakings might benefit to the detriment of others which are placed in a comparable situation”.

Conclusion: The answer of the Court of Justice

On the basis of the foregoing analysis, “(62) the answer to the question referred is that Decision 2019/700 must be interpreted as meaning that it does not preclude the national authorities responsible for the recovery from the beneficiary of aid which is unlawful and incompatible with the internal market from applying a domestic provision which prescribes a mechanism for the set-off of taxes paid by that beneficiary abroad against taxes for which it is liable in Gibraltar, where it appears that that provision was applicable on the date of the operations in question.”

It seems to me that this answer presumes that Fossil would have applied for double tax relief. Although in this case it is likely that Fossil would have used that Gibraltar tax provision to reduce its tax liability, in other cases involving other companies it may not be so obvious. Since this answer of the Court of Justice has wider applicability it would have been more useful if the Court had also qualified the likelihood of that provision being used by the aid recipients. Otherwise we enter into a situation of guessing the “hypothetical operations” of the aid recipients, which is something that we are not supposed to do when identifying the status quo ante. In other words, there are two elements at play: the existence of a general provision and whether it is likely to used by the aid recipient.

[1] The full text of the judgment can be accessed at:

CURIA – Documents (europa.eu)

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About

Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He is professor at the University of Maastricht and the University of Nicosia. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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