What Constitutes State Aid? Important Factors Companies Should Consider

The investigations regarding fiscal state aid that the European Commission has opened in recent years have raised several questions that seem new and unprecedented. The majority of the commission’s decisions in these recent cases — specifically, cases involving large multinational enterprises in which tax rulings are at the center of the debate — are under appeal before the Court of Justice of the European Union.¹ Hopefully, the courts will shed light on these matters, although it may be some time before they are finally settled.

In the interim, what issues should MNEs consider when evaluating fiscal state aid? It is clear that companies cannot ignore the topic as they proceed with the ordinary course of business. State aid may pose a reputational and financial risk for these companies, and the international business community now considers assessing and managing fiscal state aid to be a best practice. However, it is not always clear how MNEs should carry out a state aid assessment and what they should take into consideration when doing so.

This article will focus on the issues that MNEs should keep in mind when dealing with fiscal state aid in light of the recent cases that the European Commission has brought forward and CJEU case law. In particular, it will analyze the two most decisive criteria for MNEs in a state aid context: advantage and selectivity. Concerning the selectivity criterion, this article will argue that a key element of any state aid analysis is the identification of the correct comparable undertakings. However, one can only perform that task after first considering the reference system — that is, the rules applicable to the case — and then determining the reference system’s objective. Only in relation to a measure’s objective can one determine which companies to compare when assessing whether there is a differentiation in the treatment between the undertaking at issue and the other companies.

This analysis can be quite complex, and therefore companies should not jump to conclusions when dealing with state aid. A thorough — and often not obvious — analysis should be carried out to assess the state aid position of a company. This article will also briefly consider the context behind these recent cases and the fundamental role that state aid rules play in the internal market.

Background: The Internal Market

When the Treaty of Rome created the European Economic Community in 1957, its main objective was to establish and then protect a common market among its members by eliminating most trade barriers and establishing a common external trade policy. The Maastricht Treaty (formally known as the Treaty on European Union) entered into force November 1, 1993, renamed that body the European Community, and embedded it in the EU as the first of three pillars, with the second being a common foreign and security policy and the third being cooperation by police and judicial forces in criminal matters. Together, the member states worked to achieve an internal market, a concept that the Single European Act of 1986 defined as “an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured.” The internal market remains a key element in the EU: a common European space where people, goods, services, and capital should circulate freely, and fair competition among member states should govern.

State aid rules, together with the fundamental freedoms, have played an instrumental role in achieving and protecting the internal market. However, after achieving the internal market, the commission’s focus shifted from its establishment to its functioning and, some scholars argue, the state aid rules became an expression of this change.² According to these commentators, the commission began to see the state aid rules more as competition tools and less as internal market tools — that is, as tools for competition between undertakings instead of rules about competition among the economies of the member states. Put another way, the commission shifted from a macroeconomic approach, in comparison to other member states, to a microeconomic perspective that targeted the beneficiaries of the aid in relation to their competitors.³

One can read the recent cases involving MNEs as part of this larger evolution in the approach to fiscal state aid. The commission has shifted its attention to individual tax cases and their effect on competition between undertakings, rather than tax schemes implemented by the member states — a shift from a macroeconomic perspective to a microeconomic one in the field of taxation.

Fiscal State Aid

It is established case law that member states, while retaining their sovereignty in fiscal matters, must exercise their power in conformity with EU law including the state aid provisions.⁴ Nonetheless, it is not always easy to identify the proper balance between the right of the member states to define (and implement) their own tax policy and the obligation to remain compliant with state aid rules.

Part of the challenge is that there is no clear definition of state aid in the Treaty on the Functioning of the European Union. Instead of restricting the notion of aid to a particular definition, article 107(1) TFEU states:

According to the CJEU,⁵ a measure must meet the following four conditions to be considered as state aid:

• it constitutes an intervention by the state or through state resources;

• it is liable to affect trade between member states;

• it confers a selective advantage on the recipient; and

• it distorts or threatens to distort competition.

If a measure in any form whatsoever satisfies these conditions, it constitutes state aid. The commission has repeatedly stated that tax rulings are not a problem per se⁶: A ruling does not automatically entail a state aid risk. The problem, from a state aid perspective, arises when a ruling fulfills the conditions of article 107(1) TFEU. MNEs should also note that a state aid risk could arise without a ruling if all the conditions of article 107(1) TFEU are met.⁷

The CJEU has defined and developed various concepts in the fiscal state aid arena. Commission v. Government of Gibraltar and United Kingdom, joined cases C-106/09 P and C-107/09 (CJEU 2011) (the Gibraltar case), is one of many decisions noting that the definition of aid is more general than that of a subsidy, given that it includes not only positive benefits, such as subsidies themselves, but also state measures that, in various forms, mitigate the liabilities of undertakings. Germany v. Commission, C-156/98 (CJEU 2000), clarifies that the lack of taxation can also be interpreted as a transfer of state resources because the state is renouncing tax revenues that it would have otherwise collected.

In the case of tax rulings that member states grant to MNEs, despite the lack of a positive transfer of resources such as with subsidies, the undertaking benefits from a mitigation of the tax charge to which it would otherwise be subject, and other undertakings in a similar legal and factual situation are not granted. Therefore, while some measures that tax administrations grant — like the rulings at issue in the recent cases — are not subsidies in the strict sense of the word, if they ultimately reduce the tax liability associated with a given undertaking then they are similar in character to and could have the same effect as direct aid. As the CJEU explains in Belgium and Forum 187 ASBL v. Commission, joined cases C-182/03 and C-217/03 (CJEU 2006):

These measures are, in essence, indirect transfers of resources from the state to the beneficiary.

Key Elements of State Aid for MNEs

The existence of a selective advantage is the key factor in a state aid analysis concerning MNEs. This is because the other criteria of article 107(1) TFEU are generally met in cases involving MNEs.⁸ Therefore, for MNEs, the presence of selective advantage is likely to determine whether there may be a potential state aid risk.⁹

The two elements of this criterion — that is, advantage and selectivity — should be analyzed separately. In practice, each requires an independent and thorough analysis. The commission recognizes this in the recent cases, treating advantage and selectivity separately and clarifying that they are two distinct criteria. As the commission’s second Luxembourg decision states:

The analysis should start by examining the advantage: If there is no advantage, there is no state aid. For a measure to be state aid, all the criteria must be met cumulatively. If the measure does not grant an advantage to the beneficiary, one of the state aid conditions is missing and it would not be necessary to proceed with the (more complex) analysis concerning selectivity.

Advantage: The CJEU on Transfer Pricing

CJEU case law clearly establishes that an advantage within fiscal state aid may take different forms such as an exemption, a tax reduction, or even the permission to delay a payment of the tax normally due.¹¹ Indeed, under state aid rules, it is sufficient that the measure places the beneficiary in a better financial situation than other comparable undertakings.¹² In the recent cases, the commission generally cites as the advantage the fact that the taxpayer incurred a tax liability that was lower than the liability that other undertakings in a similar legal and factual situation would have faced. This argument is in line with the case law of the CJEU.

However, the commission goes a step further, identifying the reason why the tax liability of the specified beneficiary is inferior to the tax liability of other comparable taxpayers. According to the commission, in most of these cases, this is a result of transfer pricing arrangements that do not reflect a market-based outcome. The arrangements, which the commission asserts do not respect the arm’s-length principle, reduce the tax base of the beneficiary and therefore affect its tax liability.

In so holding, not only does the commission suggest that the arm’s-length principle is embedded in article 107 TFEU, it ultimately argues that the arm’s-length principle is an expression of the principle of equal treatment¹³ — that is, the prohibition against different treatments for undertakings that are in a similar factual and legal situation.¹⁴

Article 107 TFEU and Equal Treatment

At first, these assertions created a level of uncertainty among taxpayers and practitioners alike. The question is: To whom should the principle of equal treatment, as the commission defines it, apply?

In the commission’s first Luxembourg decision, it claims that the objective of the arm’s-length principle is:

The comparison that the commission makes in all of the recent cases is between the MNEs and standalone companies. The commission is attempting to ensure that member states will not treat standalone companies less favorably than MNEs.

Consequently, a key question underlying all these cases is whether standalone companies and MNEs are really comparable. Indeed, it is a very old principle that like cases should be treated alike¹⁵ — hence, different cases should be treated differently. Without going into the philosophical debate around this concept, it is logical that if standalone companies and MNEs are not comparable, then the favorable treatment allegedly given to the MNEs under scrutiny should be assessed by comparing them to other MNEs and not standalone companies.

In a nutshell, this is what both the member states accused of granting aid and the alleged beneficiaries argue in the recent cases: The comparable undertakings should be other MNEs, not standalone companies. Put another way, can a bakery shop be considered comparable to a company carrying out intragroup financing activities? At first glance, this seems like comparing apples and pears.

Consequently, if it is demonstrated that standalone companies and MNEs are not comparable, and if the transfer pricing arrangements that the MNEs obtained in the cases at issue are in a range in line with market practice, then there should be no state aid.

Given these considerations, it becomes clear that the criterion of selectivity will play a crucial role in all of these cases. However, selectivity is currently the most controversial of the criteria, and it will probably cause quite a few headaches for taxpayers and practitioners in the future.

The Question of Selectivity

When can a measure be considered selective? As World Duty Free and other decisions explain, the CJEU has established a three-step test to ascertain whether a measure is selective:

• First, identify the normal tax system applicable in the member state concerned (that is, the reference system).

• Second, assess whether the measure constitutes a derogation from that reference system. In other words, determine if the measure distinguishes between operators that are in a comparable factual and legal situation given the reference system’s objectives.

• Third, if a derogation exists, determine if it can be justified by the nature or general scheme of the system of which it is part. If so, the measure would not be selective.

Notably, the commission argues that the tax rulings involved in the recent cases are individual measures and therefore, based on the interpretation of the CJEU’s decision in Commission v. MOL, C-15/14 P (2015), there is a presumption of selectivity. Therefore, if an advantage has been granted, the measures would entail state aid and there would be no need to analyze if the selectivity criterion has been met. However, the commission also applies the three-step test as a secondary line of reasoning in these recent cases. This article will focus on the selectivity criterion itself and will not examine whether rulings should carry a presumption of selectivity.

Even with the three steps identified, it is still challenging to assess whether a measure is selective or not. The crucial point is often the identification of the reference system. As the CJEU recently affirmed,¹⁶ an error in the identification of the reference system vitiates the entire analysis.

The Identification of the Reference System

Identifying the correct reference system is not always straightforward. It largely depends on the type of measures under review — an intellectual property regime, an environmental tax, and a tax ruling are different types of measures that can bring different types of issues.

In the recent cases, the commission has argued that the reference system should be the ordinary rules for the taxation of corporate profits in the relevant member state. The commission contends that standalone companies and MNEs are both subject to corporate income tax and that they therefore are comparable, because both pay corporate income tax.

The importance of the identification of the correct reference system is particularly evident in the first Luxembourg decision. In that case, the commission argues that the reference system against which the ruling granted to the company should be examined is the general corporate income tax code. The company, on the contrary, argues that the correct reference system should be the Luxembourg circular governing intragroup financing activities.¹⁷ Thus, in the company’s view, the comparison should be carried out among those companies that apply the circular, which it contends are the undertakings in a comparable situation. Clearly, applying two different reference systems can cause the result to vary as well.

Moreover, one cannot assume a priori that a specific measure is selective. In Ministero dell’Economia e delle Finanze and Agenzia delle Entrate v. 3M Italia SpA, C-417/10 (CJEU 2012), the Court argued that:

On the other hand, one should not only consider the legislative technique used, but also the effects of the measures. Only if the implementation of the measure results in distinguishing undertakings that are in a comparable legal and factual situation can the measure be considered selective. The Gibraltar case is helpful in understanding this concept. In that case, the Court deemed the whole general system of taxation of Gibraltar to be selective because it discriminated between companies that were in a comparable situation and, de facto, favored offshore companies despite its apparent general nature.

The Identification of Comparable Undertakings

Assuming that the correct reference system for the recent cases is the corporate tax code, the next question becomes: Are MNEs and standalone companies comparable in light of the objective of the system?¹⁸

The identification of the reference system in itself is not sufficient. One must also identify the objective of that system to support the comparative analysis. As World Duty Free and Paint Graphos confirm, it is the objective of the provision that determines the identity of the comparable undertakings. While this is well-established case law, it requires careful and considered application.

In Adria-Wien Pipeline GmbH et Wietersdorfer & Peggauer Zementwerke GmbH v. Finanzlandesdirektion für Kärnten, C-143/99 (CJEU 2001), the issue involved an Austrian energy tax that allowed a rebate for undertakings engaged in the production of goods, but not for undertakings that provided services. The CJEU found that the objective of the measure was to limit the ecological impact of the energy consumption involved in the undertakings. After analyzing the objectives of the measure, the Court found that the energy consumed by undertakings that supplied services and that consumed by undertakings that produced goods were equally bad for the environment. Therefore, it deemed the measure selective. Notably, the Court did not limit itself to considering undertakings affected by the measure. Instead, it drew a comparison between those entities and undertakings that did not benefit from the measure — that is, comparing undertakings producing goods and those supplying services — and found that they were in a comparable situation in light of the measure’s objective — namely, environmental protection.

The CJEU applied the same line of reasoning in Asociación Nacional de Grandes Empresas de Distribución (ANGED) v. Consejería de Economía y Hacienda del Principado de Asturias, Consejo de Gobierno del Principado de Asturias, joined cases C-234/16 and C-235/16 (CJEU 2018). The case involved a Spanish tax that targeted large distribution establishments;¹⁹ the tax did not apply to establishments that had a sales area smaller than the specified thresholds. The tax was intended to help protect the environment and enable town and country planning. The Court examined these purposes and then considered whether the taxable establishments and retail establishments — that is, undertakings that carried out the same activities as the taxable entities, but with smaller sales areas — were in a comparable situation regarding the objectives.

According to the Court, it was not disputed that the environmental impact of a business depends on its size: The larger the business, the worse the impact. Hence, the Court found that the introduction of a size threshold made sense in relation to the environmental purpose of the levy. In reaching this determination, the Court compared two types of undertakings that were carrying out the same business activity but varied in size. The determination of the specific threshold in itself was a matter for the national legislature, with the CJEU having only limited power to review the threshold. Since the Court found that large and small retail businesses were not comparable for the purpose of the disputed tax, the measure at issue in ANGED did not constitute state aid.

Turning to the recent cases, the European Commission focuses on the ordinary tax rules and argues that their objective is to tax all the profits of the corporations that are subject to tax in that member state. However, this approach may be too general. The position does not consider the specific rules that normally govern the computation of the companies’ tax bases and their subsequent taxation. Moreover, the reasoning behind the identification of the reference system’s objective is not well elaborated in the commission’s recent decisions.

However, the CJEU case law demonstrates that the objective is a fundamental element in the comparability analysis and the application of the three-step test. In other words, a correct analysis of the selectivity criterion not only entails identifying the reference system, but also identifying its objective. It is based on the objective that comparable undertakings can be identified and, ultimately, that it can be determined whether there is a derogation from the reference system. This may put pressure on legislatures since, for state aid purposes, not only is the way the laws and regulations are written relevant, but the policy objectives behind the measures are also relevant.

To conclude, recall the initial question: Is a single bakery comparable to a company engaged in an intragroup financing activity? Following the analysis above, the answer depends on the measure that is applicable in the specific situation. If the applicable measure is specific (for example, the Luxembourg circular) and if the measure itself is not a derogation from the ordinary taxation system, then the two undertakings might not be comparable. This is because the comparability analysis would examine whether the undertakings are comparable in light of the objective of that measure. However, if the applicable measure is generic (such as the corporate income tax code) then it is possible that two or more undertakings — even undertakings as different in size, activity, and industry as an MNE and a bakery — may be comparable.

Conclusion

The latest cases concerning state aid that EU member states allegedly provided to MNEs using tax rulings took the business world by surprise and have generated uncertainty. Nonetheless, one might read the recent cases as an evolution stemming from the development and achievement of the internal market itself. Once the internal market was established, the European Commission shifted its attention to its functioning. In this respect, the recent state aid cases may be the first step in a new period, perhaps one that will lead to greater harmonization in the field of direct taxation.²⁰

All this considered, MNEs should consider fiscal state aid in the ordinary course of business, since it may represent both a financial and a reputational risk. The two criteria that are most important for MNEs in state aid analyses are advantage and selectivity. The recent cases show that one of the key elements is the criterion of selectivity, and evaluating selectivity requires conducting a comparability analysis between undertakings. In particular, the identification of the correct reference system and the objective of that reference system are crucial.

The CJEU’s case law shows that at least under some circumstances, even companies that carry out the same activity might not be deemed comparable in the light of the objective of the system.²¹ That ruling, however, involved a reference system that was largely a standalone measure, making the identification of the reference system and its objective relatively straightforward. In the recent cases, the identification of these elements may be less evident. Taxpayers will surely welcome the CJEU’s guidance in these cases, and its decisions will advance the understanding of state aid.