The “Arm’s Length Principle” and the Taxation of Transactions between Related Companies

The arm’s length principle is not an autonomous principle that can be applied to any advance tax ruling. It must be provided in the national tax system.

Furthermore, the arm’s length principle must be applied, if it exists in the national tax system, in the form that is defined by that tax system.

Introduction

In a series of decisions beginning in 2015 on advance tax rulings [ATRs] concerning transactions between related multinational companies, the Commission used the arm’s length principle [ALP] to determine whether those transactions were priced below or above the level of similar transactions between independent companies. It was the first time it used the ALP to establish whether ATRs treated more favourably multinational companies and whether, as a result, the ATRs constituted State aid.

Although, on appeal, the General Court in several cases faulted the Commission on specificities, it nonetheless endorsed the use of the ALP as an instrument of detecting favourable tax treatment and the existence of State aid. However, in later judgments in the landmark cases of Apple and Amazon, the General Court also held that in order to compare transactions between group companies and transactions between independent companies, group companies and independent companies had to be treated equally in the national tax system.

On 8 November 2022, the Court of Justice, had its first opportunity, in joined cases C885/19 P, Fiat Chrysler Finance Europe v European Commission and C898/19 P, Ireland v European Commission, to pronounce on the use of the ALP as a means of determining the presence of selective tax treatment and whether it had to be provided in the national tax system.

Fiat Chrysler Finance Europe (C885/19 P) and Ireland (C898/19 P) had appealed against the judgment of the General Court in joined cases T755/15, Luxembourg v European Commission and T759/15, Fiat Chrysler Finance Europe v European Commission. In that judgment the General Court dismissed their actions for annulment of Commission decision 2016/2326 on State aid SA.38375 granted by Luxembourg to Fiat in the form of an advance tax ruling.

Background

In September 2012, the Luxembourg tax authorities issued an ATR in favour of Fiat whose subsidiary in Luxembourg at the time was known as Fiat Finance and Trade [FFT]. The ruling confirmed that the transfer pricing analysis that had been submitted by Fiat respected the ALP.

After an investigation, the Commission adopted in October 2015 the decision at issue. It found that the ATR constituted State aid that was incompatible with the internal market. On appeal, the General Court upheld the Commission decision.

The Court of Justice examined, first, the arguments put forth by Ireland in case C898/19 P. It upheld the appeal of Ireland and, for this reason it considered unnecessary to examine the arguments of Fiat Chrysler Finance Europe in case C885/19 P.

The need to define the reference system

Ireland argued that the reference tax system must be based on the national tax system at issue and not on a hypothetical tax system. Indeed, the Court of Justice has already said so, for example, in its recent rulings on the Polish and Hungarian progressive turnover taxes. Ireland further argued that the ALP may be applied to verify the existence of a selective advantage only if that principle is incorporated as such into the national tax system constituting normal taxation.

This is an important argument because, as noted above, the General Court had accepted in its rulings on Fiat and other multinationals such as Starbucks, Apple and Amazon, that the Commission could use the ALP to determine whether transactions between related companies were priced at normal prices. These are the prices that would be charged in transactions between independent companies. However, as also noted above, in later judgments the General Court ruled that whether transactions between related companies and independent companies could be treated similarly from a State aid perspective depended on whether the national tax law made no distinction between them. Therefore, Ireland took that finding of the General Court to its logical conclusion and contended that for the ALP to be applicable, it had to be explicitly provided in the national legislation.

It should be recalled that the Commission was inspired to apply the ALP to transactions between related companies from the judgment in case C-182/03, Belgium and Forum 187 v Commission in which the Court of Justice held that “the transfer prices do not resemble those which would be charged in conditions of free competition” [paragraph 96]. According to Ireland, that judgment did not support the Commission’s conclusion that the ALP derives from Article 107(1) TFEU irrespective of whether or not it is incorporated into national law. In the Forum 187 case the ALP had been incorporated into the Belgian law.

First, the Court of Justice reminded us that the fact that Member States have discretion to determine their tax systems is irrelevant. “(65) Action by Member States in areas that are not subject to harmonisation by EU law is not excluded from the scope of the provisions of the FEU Treaty on monitoring State aid. The Member States must thus refrain from adopting any tax measure liable to constitute State aid that is incompatible with the internal market”.

With respect to the criterion of selectivity which is one of the constituent elements of State aid, the Court held that “(68) in order to classify a national tax measure as ‘selective’, the Commission must begin by identifying the reference system, that is the ‘normal’ tax system applicable in the Member State concerned, and demonstrate, as a second step, that the tax measure at issue is a derogation from that reference system, in so far as it differentiates between operators who, in the light of the objective pursued by that system, are in a comparable factual and legal situation. The concept of ‘State aid’ does not, however, cover measures that differentiate between undertakings which, in the light of the objective pursued by the legal regime concerned, are in a comparable factual and legal situation, and are, therefore, a priori selective, where the Member State concerned is able to demonstrate, as a third step, that that differentiation is justified, in the sense that it flows from the nature or general structure of the system of which those measures form part”.

“(69) In that regard, it must be recalled that the determination of the reference framework is of particular importance in the case of tax measures, since the existence of an economic advantage for the purposes of Article 107(1) TFEU may be established only when compared with ‘normal’ taxation. Thus, determination of the set of undertakings which are in a comparable factual and legal situation depends on the prior definition of the legal regime in the light of whose objective it is necessary, where applicable, to examine whether the factual and legal situation of the undertakings favoured by the measure in question is comparable with that of those which are not”.

“(70) It must nevertheless be stated that regulatory technique cannot be decisive in order to determine whether a tax measure is selective, so that it is not always necessary for that technique to derogate from a common or normal tax system. […] even a measure which is not formally a derogation and founded on criteria that are in themselves of a general nature may be selective, if it in practice discriminates between companies which are in a comparable situation in the light of the objective of the tax system concerned”. [Here the Court cited the landmark case of World Duty Free concerning the difference in tax treatment of acquisition of foreign companies and domestic companies in Spain.]

“(71) For the purposes of assessing the selective nature of a tax measure, it is, therefore, necessary that the common tax regime or the reference system applicable in the Member State concerned be correctly identified in the Commission decision and examined by the court hearing a dispute concerning that identification. Since the determination of the reference system constitutes the starting point for the comparative examination to be carried out in the context of the assessment of selectivity, an error made in that determination necessarily vitiates the whole of the analysis of the condition relating to selectivity”.

“(72) The determination of the reference framework, […], must follow from an objective examination of the content, the structure and the specific effects of the applicable rules under the national law of that State”.

This definition does not really help us to understand how the reference system should be defined. In other case the Court has said that the reference system can be applied “autonomously”, meaning that the reference system contains all those rules that do not depend on any other rule for the application.

“(73) Outside the spheres in which EU tax law has been harmonised, it is the Member State concerned which determines, by exercising its own competence in the matter of direct taxation and with due regard for its fiscal autonomy, the characteristics constituting the tax, which define, in principle, the reference system or the ‘normal’ tax regime, from which it is necessary to analyse the condition relating to selectivity. This includes, in particular, the determination of the basis of assessment and the taxable event”.

“(74) It follows that only the national law applicable in the Member State concerned must be taken into account in order to identify the reference system for direct taxation, that identification being itself an essential prerequisite for assessing not only the existence of an advantage, but also whether it is selective in nature.”

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The status of the ALP

The Court noted that “(76) the Commission found that the arm’s length principle necessarily formed part of its assessment, under Article 107(1) TFEU, of tax measures granted to group companies, irrespective of whether a Member State had incorporated that principle into its national legal system.”

Then the Court referred to the reasoning of the Commission which had stated that the “(77) arm’s length principle is used to establish whether the taxable profits of a group company for corporate income tax purposes has been determined on the basis of a methodology that approximates market conditions, so that that company is not treated favourably under the general corporate income tax system as compared to non-integrated companies whose taxable profit is determined by the market.”

“(78) It is apparent, moreover, from the general scheme of the decision at issue, […], that the Commission took account of the fact that the general corporate income tax system in Luxembourg does not distinguish between integrated companies and non-integrated companies, since the objective of that system is to tax all resident companies.”

“(79) It is in the light of those considerations that the General Court, […], specified, […] that the arm’s length principle is a general principle of equal treatment in taxation which falls within the scope of Article 107(1) TFEU must not be taken out of context and could not be interpreted as meaning that the Commission had asserted that there was a general principle of equal treatment in relation to tax inherent in Article 107(1) TFEU.”

“(80) The General Court found that the arm’s length principle applies where the relevant 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, since, in such a case, that law would be 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. That legal basis having been identified, the General Court considered, […], that that principle was applicable in the present case in so far as the objective of the Tax Code was to tax integrated and stand-alone companies in the same way with regard to corporate income tax.”

The ALP and specific rules on transfer pricing

Then the Court of Justice pointed out that “(83) in the present case, […], Ireland does not seek to call into question the General Court’s interpretation of national law, but invites the Court of Justice to determine whether it was without error of law that the General Court adopted the delimitation of the relevant reference framework as the decisive parameter for the purposes of examining the existence of a selective advantage, without taking into account the specific transfer pricing rules provided for by the Luxembourg law applicable to integrated companies.”

“(85) The question whether the General Court adequately defined the relevant reference system and, by extension, correctly applied a legal test, such as the arm’s length principle, is a question of law which can be reviewed by the Court of Justice on appeal.”

“(89) It is apparent […] that the General Court endorsed the Commission’s methodology which consisted, in essence, in considering that, in the case of a tax system which pursues the objective of taxing the profits of all resident companies, whether integrated or not, the application of the arm’s length principle for the purposes of applying Article 107(1) TFEU is justified independently of whether that principle has been incorporated into national law.”

Then the Court of Justice observed that the ALP was in fact incorporated in a different form in the Luxembourg tax law. “(91) In that regard, in dismissing the relevance of Article 164(3) of the Tax Code and Circular No 164/2, the Commission applied an arm’s length principle different from that defined by Luxembourg law. It thus confined itself to identifying, in the objective pursued by the general corporate income tax system in Luxembourg, the abstract expression of that principle and to examining the tax ruling at issue without taking into account the way in which the said principle has actually been incorporated into that law with regard to integrated companies in particular.”

“(92) By endorsing such an approach, the General Court failed to take account of the requirement arising from the case-law […], according to which, in order to determine whether a tax measure has conferred a selective advantage on an undertaking, it is for the Commission to carry out a comparison with the tax system normally applicable in the Member State concerned, following an objective examination of the content, interaction and concrete effects of the rules applicable under the national law of that State. In so doing, it erred in law in the application of Article 107(1) TFEU.”

“(93) It is true, […], that the national law applicable to companies in Luxembourg is intended, as regards the taxation of integrated companies, to bring about a reliable approximation of the market price. While that objective corresponds, in general terms, to that of the arm’s length principle, the fact remains that, in the absence of harmonisation in EU law, the specific detailed rules for the application of that principle are defined by national law and must be taken into account in order to identify the reference framework for the purposes of determining the existence of a selective advantage.”

“(94) In addition, by accepting, […], that the Commission may rely on rules which were not part of Luxembourg law, even though it recalled, […], that that institution did not, at that stage of development of EU law, have the power autonomously to define the ‘normal’ taxation of an integrated company, disregarding national tax rules, the General Court infringed the provisions of the FEU Treaty relating to the adoption by the European Union of measures for the approximation of Member State legislation relating to direct taxation, in particular Article 114(2) TFEU and Article 115 TFEU. The autonomy of a Member State in the field of direct taxation, […], cannot be fully ensured if, in the absence of any such approximation measure, the examination carried out under Article 107(1) TFEU is not based exclusively on the normal tax rules laid down by the legislature of the Member State concerned.”

“(95) In that regard, it should be noted, in the first place, that, without harmonisation in that regard, any fixing of the methods and criteria for determining an ‘arm’s length’ outcome falls within the discretion of the Member States. Although the member States of the OECD recognise the merits of using the arm’s length principle in order to establish the correct allocation of company profits between different countries, there are significant differences between those States in the detailed application of transfer pricing methods. As the Commission itself mentioned […], the OECD Guidelines provide for several methods for approximating an arm’s length pricing of transactions and profit allocation between companies of the same corporate group.”

“(96) Moreover, even assuming that there is a certain consensus in the field of international taxation that transactions between economically linked companies, in particular intra-group transactions, must be assessed for tax purposes as if they had been concluded between economically independent companies, and that, therefore, many national tax authorities are guided by the OECD Guidelines in the preparation and control of transfer prices, […], it is only the national provisions that are relevant for the purposes of analysing whether particular transactions must be examined in the light of the arm’s length principle and, if so, whether or not transfer prices, which form the basis of a taxpayer’s taxable income and its allocation among the States concerned, deviate from an arm’s length outcome. Parameters and rules external to the national tax system at issue cannot therefore be taken into account in the examination of the existence of a selective tax advantage within the meaning of Article 107(1) TFEU and for the purposes of establishing the tax burden that should normally be borne by an undertaking, unless that national tax system makes explicit reference to them.”

Then the Court of Justice noted how the specific Luxembourg rules on transfer pricing were defined. “(98) Circular No 164/2 interpreting Article 164(3) of the Tax Code lays down specific rules on the calculation of transfer prices in the case of group financing companies, such as FFT, implying that activities related to the holding of participations should not be taken into account for the calculation of those prices.”

“(99) However, the Commission’s analysis of the reference system and, by extension, of the existence of a selective advantage granted to FFT, as validated by the General Court, does not take account of those legislative choices, aimed at clarifying the scope of the arm’s length principle and its implementation in Luxembourg law.”

“(102) The judgment of 22 June 2006, Belgium and Forum 187 v Commission (C-182/03 and C217/03, EU:C:2006:416), does not support the position that the arm’s length principle is applicable where national tax law is intended to tax integrated companies and stand-alone companies in the same way, irrespective of whether, and in what way, that principle has been incorporated into that law.”

“(103) In that judgment, the Court of Justice held that, once a Member State has chosen to incorporate into its national law a method for determining the taxable profits of integrated companies that is analogous to the OECD ‘cost-plus’ method, and therefore has the objective of taxing such companies on a basis comparable to that on which they would be taxed under the ordinary regime, that State confers an economic advantage on such companies if it includes, within that method, provisions which have the effect of reducing the tax burden that those companies would normally have to bear under that regime.”

“(104) Thus, in the said judgment, it was in the light of the rules on taxation laid down in the relevant national law, namely Belgian law, which provided for a mechanism for taxing profits according to an OECD ‘cost-plus’ method, that the Court concluded that it was appropriate to use the arm’s length principle. It cannot therefore be inferred from the same judgment that the Court intended to establish an autonomous arm’s length principle that applied independently of the incorporation of that principle into national law for the purposes of examining tax measures in the context of the application of Article 107(1) TFEU.”

Having found that the General Court made an error of law, the Court of Justice proceeded to assess itself the arguments of applicants at first instance. This is because if a decision of the General Court is set aside, the Court of Justice may itself give final judgment in the matter.

Final judgment of the case before the General Court

The Court of Justice noted that “(117) the decision at issue must be annulled in so far as the Commission erred in law in finding that there was a selective advantage in the light of a reference framework comprising an arm’s length principle which does not derive from a full examination of the relevant national tax law, […], and that, in so doing, it also infringed the provisions of the FEU Treaty relating to the adoption by the European Union of measures for the approximation of Member State legislation relating to direct taxation, in particular Article 114(2) TFEU and Article 115 TFEU.”

“(118) Such an error in determining the rules actually applicable under the relevant national law and, therefore, in identifying the ‘normal’ taxation in the light of which the tax ruling at issue had to be assessed necessarily invalidates the entirety of the reasoning relating to the existence of a selective advantage.”

“(119) Such a finding does not, however, rule out the possibility that direct tax measures, such as tax rulings granted by the Member States, may be classified as State aid provided that all the conditions for the application of Article 107(1) TFEU […] have been fulfilled.”

“(120) After all, […], action by Member States in areas that are not subject to harmonisation by EU law is not excluded from the scope of the provisions of the FEU Treaty on monitoring State aid.”

“(121) Thus, the Member States must exercise their competence in the field of direct taxation, such as that which they hold in the area of the adoption of tax rulings, in compliance with EU law and, in particular, the rules established by the FEU Treaty on State aid. They must therefore refrain, in the exercise of that competence, from adopting measures which may constitute State aid incompatible with the internal market within the meaning of Article 107 TFEU”.

“(122) In particular, after having observed that a Member State has chosen to apply the arm’s length principle in order to establish the transfer prices of integrated companies, the Commission must, […], be able to establish that the parameters laid down by national law are manifestly inconsistent with the objective of non-discriminatory taxation of all resident companies, whether integrated or not, pursued by the national tax system, by systematically leading to an undervaluation of the transfer prices applicable to integrated companies or to certain of them, such as finance companies, as compared to market prices for comparable transactions carried out by non-integrated companies.”

“(123) In the present case, […], the Commission did not carry out such an examination in the decision at issue, since its analytical framework did not include all the relevant norms implementing the arm’s length principle under Luxembourg law.”

“(124) Consequently, the decision at issue must be annulled, without it being necessary to examine the other pleas of the actions for annulment.”

Conclusions

This ruling is a major setback for the Commission’s attack on favourable taxation of multinational companies. The ALP is not an autonomous principle that can be applied to any ATR. It must be provided in the national tax system. Furthermore, the ALP must be applied, if it exists in the national tax system, in the form that is defined by that tax system.

Both of these conclusions imply that Member States have significant leeway in how they tax transactions between related companies. In this respect, it seems that the discretion of the Member States is strengthened by the use by the Court of the word “systematically” in paragraph 122 of the judgment. As may be recalled, the General Court stated in its judgments on Apple and Amazon that the identification by the Commission of mistakes in ATRs does not constitute proof that they contain State aid. It appears now that even if a mistake can confer a selective advantage, for ATRs to constitute State aid the mistake or mistakes must be systematic. It is not easy to understand what the Court intended to achieve with that word, but it is perhaps safe to assume that random mistakes or mistakes limited to certain transactions or certain companies could fall outside the scope of Article 107(1) TFEU.

The full text of the judgment can be accessed at:

https://curia.europa.eu/juris/document/document.jsf?text=&docid=268045&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=291194

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