Alternative tax regimes do not provide State aid as long as they raise the amount of tax paid and they are justified by the nature or general scheme of the normal system of taxation.
During the past three years, the Commission has been pursuing multinational companies that pay too little tax. Its main objection to the tax treatment of these companies is that the alternative methods of taxation, such as “advance tax rulings”, that are used to estimate their income do not result in an amount of tax that they would have paid under the “ordinary” tax system.
Hence, it was a bit surprising when recently the Commission approved an alternative method for taxing diamond traders and processors in Belgium. Antwerp is the largest diamond centre in Europe. A couple of years ago its turnover was estimated to have reached EUR 29 billion.
The Commission found, in decision SA.42007, that, although the alternative tax regime for the wholesale diamond sector was selective, the selectivity was justified by the objectives and nature of the Belgian tax system. Therefore, this alternative tax regime did not constitute State aid.
The reasons for an alternative method of calculating taxable income
Diamond traders and processors or manufacturers buy rough diamonds in bulk. Rough diamonds are not recorded individually. After they are bought in bulk, they are sorted by size and colour and re-sold or they are cut up and polished. It is impossible to trace a cut and polished diamond back to the original rough stone. This means that it is very difficult to check the inventories of diamond companies. In addition, there can be fraud as diamonds are taken out of the inventory. Valuation disputes between diamond companies and Belgian tax authorities have been a common occurrence, often leading to litigation.
For these reasons, the Belgian authorities proposed to simplify the calculation of costs and profit for tax purposes. The “gross profit margin” [GPM], on which the normal corporate tax rate will be levied, will in the future be defined as 2.1% of turnover. This means that their assumed “cost of goods sold” [COGS] will be 97.9%. In addition, the new system will fix a certain amount as the presumed remuneration of directors and will make the actual costs of processing diamonds ineligible for deduction from taxable income.
Therefore, the new tax system aims to eliminate disputes and introduce more certainty in tax valuations. Interestingly, the Belgian authorities also successfully argued that the new system would raise the amount of tax actually paid by diamond companies. This is examined in more detail below.
It should be noted that the greater the extent of processing, the larger the added value of the diamond operations and therefore, the larger the difference between the initial cost and the eventual sales price. Although, it will not be possible for diamond manufacturers to deduct their actual processing costs, the new system with its fixed profit margin will be more favourable to processors who add more value to the rough stones and therefore will in reality make more profit. It is likely, therefore, that the new regime will induce more diamond processors to locate in Antwerp and raise the amount of manufacturing that takes place there. The Commission did not comment on this likely outcome.
Existence of advantage
The Commission focused on two issues: whether the new tax regime conferred and advantage and whether it was selective. With respect to advantage, the Commission first recalled that “(36) according to the case-law of the Union Courts, […] an advantage may be granted through different types of reduction in a company’s tax burden and, in particular, through a reduction in the applicable tax rate, taxable base or in the amount of the tax due. Although a tax reduction measure does not involve a positive transfer of resources from the State, it gives rise to an advantage by virtue of the fact that it places the undertakings to which it applies in a more favourable financial position than other taxpayers and results in a loss of income to the State.”
Then it examined how Belgium defined 2.1% as being the appropriate gross profit margin. “(37) […] The percentage of 2.1% [of the gross profit margin] was established on the basis of a benchmarking study commissioned to a consultancy by Belgium. The benchmarking study covers 292 diamond traders out of the 928 registered traders, which represent approximately EUR 24.5 billion turnover (out of the total of EUR 28.7 billion), i.e. more than 85% of the whole diamond trade industry, which renders it statistically meaningful.”
“(38) The percentage of 2.1% corresponds to the weighted average of the upper quartile GPM of small, medium-sized and large traders in the sector for the period 2012-2014 (the median being 1.65 %). According to the study, this means that with the application of the 2.1 % GPM, at least 75% of the wholesale diamond traders covered by the study would have paid a higher amount of taxes than they did over the period 2012-2014 under the ordinary rules of income taxation. Belgium further observes that the 2.1 % of turnover to calculate the GPM is above the corrected GPM that was obtained by the Belgian tax authorities in the past when rejecting the evidential value of the accounts of diamond traders and taxing them under application of the tax inspection technique.”
Therefore, the Commission considered the rate of 2.1% to be set on the basis of an objective and credible method. Also, it considered positively that the large majority of diamond companies would pay more tax.
However, it also noted that “(39) this implies that, at individual taxpayer’s level, the use of the weighted average upper quartile GPM rate means that the tax due for some of the undertakings concerned would have been lower over the period 2012-2014 under the Diamond Regime, if it had been applied, than under the ordinary rules of income taxation.”
“(40) Furthermore, taking into account the fact that the Diamond Regime is based on a mere approximation of the real GPM of diamond traders, it does not exclude that some diamond traders would pay less taxes according to this regime than they would pay if their real GPM was taken into account.”
Hence, some traders would end up paying less, while, in general, taxable profit would be always fictitious rather than based on actual figures. On these grounds, the Commission concluded that “(43) […] the Diamond Regime may confer an economic advantage to certain traders in certain circumstances.”
The Commission recalled, first, the three-step test of selectivity. Then it proceeded to define the reference tax system. “(45) The reference system is the benchmark against which the selectivity of a measure is assessed. The reference system is composed of a consistent set of rules that generally apply – on the basis of objective criteria – to all undertakings falling within its scope as defined by its objective. The identification of the reference system therefore depends on elements such as the taxable persons, the taxable base, the taxable events and the applicable tax rates.”
It found that “(46) in the present case, the reference system is the ordinary rules of taxation of income under the Belgian income tax regime. Those rules have as their intrinsic objective the taxation of income of all taxpayers subject to tax in Belgium. […] The taxable income is calculated as income minus deductible expenses, which forms the starting point for calculating the total taxable profit under the Belgian income tax system.”
In my view, the reference tax system can be any tax that is applicable to any undertaking “falling within its scope as defined by its objective”. The starting point is the objective of the tax. If it applies to the undertaking(s) under consideration, then it is the reference system.
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Next, the Commission examined whether the new Belgian tax method would derogate from the reference system. “(49) Since the Diamond Regime introduces specific rules for the calculation of the income tax base for a selected group of undertakings, i.e. wholesale traders in rough and polished diamonds, which differentiate from the normal rules of income taxation in Belgium, the Commission considers that the scheme is prima facia selective.”
One cannot disagree with this finding. Any method or formula that does not apply to all tax payers who fall within the scope of application of a tax necessarily constitutes a derogation from that tax. Therefore, the Commission had to proceed to the third step of the three-step test to determine whether the new method was justified by the nature and general scheme of the tax system.
“(50) A measure which derogates from the reference system is non selective if it is justified by the nature or general scheme of that system. This is the case where it is the result of inherent mechanisms necessary for the functioning and effectiveness of the system. It is for the Member State to provide such justification.” [Emphasis added]
“(51) According to Belgium, the determination of the tax base under the ordinary rules of income taxation, based on the COGS registered in the accounts, heavily depends on the value of the inventory of diamonds. That value can easily be manipulated by the taxpayer and it is difficult for the tax administration to assess and correct that value through tax audits. As a consequence, the application of the ordinary rules to wholesale diamond traders would not ensure that they pay their fair share of taxes. By applying a fixed percentage of GPM, the tax inspection difficulty related to the assessment of the amount of the COGS would be avoided while addressing the fraud issue. The Diamond regime therefore removes the possibility to manipulate – and thus the need to check in detail – the value of the inventory.”
There is an element of exaggeration in the last sentence of paragraph 51. The diamond regime does not really address the fraud issue, nor does it remove the possibility to manipulate the value of the inventory. It simply makes it unnecessary for traders either to commit fraud or manipulate the inventory. They will be taxed on a fictitious profit margin regardless of what they do.
For sure, however, the fictitious profit margin will bring in more tax revenue, as compared to what was paid in the past. “(52) […] the application of the Diamond Regime is expected to bring a surplus tax contribution of the sector of at least EUR 50 million on an annual basis. Therefore, as a whole, the wholesale diamond sector would pay more than three times the taxes they used to pay under the normal income tax regime.” [Footnote 13: “Currently the sector pays around EUR 20 million and the expected tax revenue with the Diamond Regime is EUR 70 million.”]
“(53) The Diamond Regime is intended to increase the tax paid by wholesale diamond traders, with a special focus on those taxpayers who, with the application of the ordinary rules of income taxation, might not pay their fair share of tax.”
The Commission also addressed the issue of under-taxing certain diamond traders. “(54) The fact that, despite all safeguards, certain undertakings could be taxed less in a specific year because their true GPM would exceed 2.1%, is justified by the nature and general scheme of the tax system, i.e. the efficiency of tax audits and fight against fraud. Indeed, the Diamond Regime is a response to specific difficulties experienced by the tax administration in the diamond wholesale sector to verify and establish the correct income tax base.”
Again, there is an element of exaggeration in paragraph 54. The new regime will not make tax audits more efficient, nor will it fight fraud. It will simply make unnecessary any tax audit for the purpose of establishing the value of inventories. Audits will only have to focus on whether revenue is correctly recorded. Therefore, inventory fraud will be unnecessary too. Fraud may only occur with respect to the registration of revenue. But for sure, it will reduce waste of public resources in carrying out futile audits and in unproductive litigation.
It is also true that “(55) […] the provision of a fixed GPM rate ensures that the vast majority of diamond traders will pay more taxes than under the ordinary rules of income taxation, i.e. the reference system. It also saves the most cumbersome audit verifications – in particular, the valuation and follow-up of the diamond inventories – as well as the uncertainty linked to taxpayers challenging the tax bill. On the other hand, it implies that a few taxpayers may pay less tax if their actual GPM rate exceeded that fixed rate. The Commission considers that the advantage that could be granted in such situations is inherent to the functioning of the Diamond Regime and justified by the objectives pursued by the tax system.”
“(58) Consequently, the Commission considers the derogation from the reference system by the Diamond Regime to be justified by the nature or general scheme of that system.”
On these grounds the Commission concluded that the diamond regime did not constitute State aid.
Concluding thought: Comparison with the recent decisions on advance tax rulings
The decisions of the Commission of the past year or so on Apple, Fiat, Starbucks and the Belgian Excess Profit system have all grappled with the issue of advance tax rulings. The Commission accepts in principle that advance tax rulings are a legitimate tax method when they prevent disputes on tax valuation and result in a market-based outcome. Both the diamond regime and the tax rulings aim to prevent disputes, reduce uncertainty concerning tax liability and therefore reduce the waste of resources in avoidable litigation. They are also based on derived benchmarks. Lastly, they aim to raise the amount of tax actually paid.
However, there are also significant differences. First, the Belgian diamond regime establishes a benchmark of tax liability in relation to actual past liability. The decisions on tax rulings define liability in relation to a hypothetical benchmark derived from proxy prices of costs and output that companies should have charged.
Second, the diamond regime obtains the benchmark from figures in the diamond sector. The decisions on tax rulings set a benchmark on the basis of comparisons that extent beyond individual sectors.
Third, the diamond regime benchmark is simply the result of a choice of the cut-off point of the percentage of traders [75%] who will end up paying more tax. The benchmark of the tax rulings is an estimation of what individual companies ought to charge and the profit that they ought to earn. The calculation behind this estimate is much more subjective and can vary from company to company.
 The full text of the Commission decision can be accessed at: