David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: the state of state aid. On May 12 the EU General Court released its judgements in two tax cases: Amazon and Engie. In the first, the court annulled the European Commission's 2017 ruling that advanced pricing agreements approved by Luxembourg resulted in €250 million in state aid to Amazon. It held that the commission's transfer pricing analysis in the Amazon case was fundamentally flawed.
In the Engie case, the EU general court upheld the European Commission's finding that Luxembourg's tax rulings allowing the French fuel supplier to categorize transactions as both debt and equity violated state aid rules.
What do these judgements in both cases mean for the commission's efforts to reign in tax avoidance through state aid rules? Here to talk about it are Tax Notes legal reporters Ryan Finley and Kiarra Strocko. Ryan, Kiarra, welcome to the podcast.
Ryan Finley: Thanks for having me.
Kiarra Strocko: Thanks, Dave. I'm excited to be here discussing these two very important state aid cases.
David Stewart: All right. Well, Ryan, let's start off with you. Can you tell us a bit about the Amazon case and its journey to the EU General Court?
Ryan Finley: Sure. So the Amazon case is about an advanced pricing agreement, or APA, that was originally issued in 2003. The APA dealt with the license of Amazon's technology and other IP from a Luxembourg partnership, which was not subject to any entity level tax, to a Luxembourg operating company, which was a taxable corporation. And that corporation was the one that actually actively oversaw Amazon's EU business.
So under the APA, the royalty payable under this license was calculated indirectly using a method called the transactional net margin method, or TNMM. In this case, it gave the operating company a markup on its operating expenses and allocated all the residual profits from Amazon's EU operations to the partnership as a royalty.
So the commission thought this left the taxable operating company with too little profit and the non-taxable partnership, which in this case didn't even have any employees, with too much profit. The commission made a bunch of arguments as to why this represented illegal state aid, but its primary argument had to do with how the TNMM was applied. So the way the method works, it gives one of the parties called the tested party, some kind of fixed return based on a comparison with the profitability of functionally comparable companies. And as a one-sided method, any residual profit or loss remaining after that return goes to the other party by default.
So the commission's argument was that the partnership and not the operating company should have been the tested party. So it would have been the partnership that only received a kind of fixed routine return while all the residual would remain with the operating company. So under the OECD transfer pricing guidelines, which the EU courts have accepted as guidance in these state aid cases involving transfer pricing, the tested parties usually supposed to be the less complex entity. And that's because it's typically easier to find comparable companies for a less complex entity.
Owning unique IP or bearing IP development risk like the partnership did in this case generally means that that party can't be the tested party. The commission still argued that the partnerships should be the tested party because it should not be treated as the real owner of the IP. And it argued that this was the case because it was the operating company, not the partnership, that performed and controlled all the key functions and risks associated with IP.
Now, importantly, the commission had to cite concepts from OECD guidance that wasn't issued until years after the 2003 APA was issued to make this argument. Basically in the decision and the court didn't go for that. The decision says you can't judge a 2003 APA based on standards that came out years later, and that kind of killed the commission's main argument because there really isn't much in the 1995 version of the OECD transfer pricing guidelines that would support disregarding IP ownership in this way.
The commission also added some alternative arguments, including that the profit- split method and not the TNMM should have been applied, but the court rejected these on kind of burden of proof grounds. Basically the court said that the commission had to justify its own methodological choices and actually prove that the changes of method led to a tax advantage. And since the court said they didn't do that, the commission lost.
David Stewart: Well, Amazon and its Luxembourg subsidiary having transfer pricing issues, that rings fairly familiar. Are these the same entities that were involved in the dispute that was recently appealed in the U.S. courts?
Ryan Finley: Yes, it does actually. The partnership was a participant in a cost-sharing arrangement with its ultimate parent Amazon Inc. And that cost sharing arrangement was the exact issue in dispute in the U.S. case. That case was about whether the IP that the U.S. developed and partially transferred to that Luxembourg partnership was valued appropriately. And this case is about whether the royalty that the partnership charged for sublicensing that IP was valid.
David Stewart: OK. Well how did the parties in this case — Luxembourg, Amazon, and the European Commission — how did they react to this decision?
Ryan Finley: Well, as you'd expect Luxembourg and Amazon welcomed the decision. They both released statements to the effect that the decision proves that Amazon never received any selective tax benefit that would run afoul of EU state aid rules. The commission released a kind of cautious statement saying that it would study the judgment and consider its options, but it also added the commission remains committed to its overall goal of combating tax avoidance with state aid law.
David Stewart: All right. Kiarra, let's turn to you now. Can you tell us a bit about the Engie case?
Kiarra Strocko: Yes. So to simplify the seemingly complex facts of the case, basically the transactions involved a transfer of assets and liabilities in connection with Engie's intergroup financing structure. So sort of as you touched on before, the transactions between the group's subsidiaries were categorized as both debt and equity.
And in the end, the parent entities were essentially not taxed because they benefited from the participation exemption regime. Between 2008 and 2012 Luxembourg issued tax rulings that allowed these financing structures. But the commission ended up opening a formal investigation into the rulings in 2016 after the authorities requested information from the commission.
So basically the commission found that Luxembourg's rulings allowed the company to deduct interest owed to another Luxembourg group entity for payments that were never made and did not create any corresponding interest income. And formally in 2018 the commission decided that the tax ruling by Luxenberg violated state aid rules.
David Stewart: So what did the General Court decide?
Kiarra Strocko: So the General Court ultimately dismissed the appeals brought by both Luxembourg and the company, and ordered the recovery of the €120 million in taxes. But what's interesting about this decision is that it seemed to be a clear cut win for the commission.
In a handful of other CJEU or General Court decisions, the court will at least side with the other party on one aspect or another. But for the most part the court agreed with the commission's conclusions that the setup was just not justifiable.
To get more into the court's reasoning though, it backed its decision on the matter based on the nonapplication of Luxembourg's abusive law provisions. So the court reason that Engie is similarly situated to other Luxembourg taxpayers that cannot benefit from the nonapplication of the anti-abuse provision. So basically Luxembourg should've applied its general anti-abuse rule to reject the ruling request, but it didn't. So that alone seems to result in a clear selective advantage for Engie. And of course they found that the insanely wacky financing structure resulted in a reduction in the corporate tax rate that would have been payable by other similarly situated taxpayers.
David Stewart: Well, it seems to be a mixed bag for the European Commission's state aid enforcement here. So what are you hearing from the tax community on these decisions?
Kiarra Strocko: Yeah. So for Engie specifically there seemed to be an overwhelming amount of commentary about how these aggressive transfer pricing practices cannot be prevented simply by these EU state aid enforcements. However, this begs the question of what corporate tax reform measures need to be implemented to curb the prevalence of these practices.
I spoke with Raymond Luja, a tax professor at Maastricht University, who noted that the avoidance in the Engie case happened within one member state, therefore the transaction was easier to discover and address rather than other cross-border situations that have or may arise in the EU.
Regarding the general anti-abuse rule bit in the decision, it seems like the case introduces a new line of attack for the commission. Luja said that the decision will likely result in the commission testing against a member states anti-abuse rule standard practice when reviewing these fiscal aids in the future.
David Stewart: And Ryan, what sort of things are you hearing about the Amazon case?
Ryan Finley: Well, one theme that I picked up on from multiple observers was that the commission's loss kind of reflects a misplaced focus on transfer pricing when maybe there are other issues at play in these cases. I spoke to J. Clark Armitage of Caplin & Drysdale, and he specifically said that one of the commission's problems here in this case and in other cases like it is that transfer pricing wasn't the issue. In this case, it was the hybrid tax treatment of that Luxembourg partnership that was licensing the IP and participating in the cost-sharing arrangement.
According to Stephen Daly of King's College in London, the commission shouldn't have focused so much on these transfer pricing technicalities in cases where the real issue and the thing that triggered the commission's suspicion in the first place for these kind of blatantly inappropriate lax ruling practices of countries like Luxembourg that were exposed during Luxleaks. I think Professor Daly referred to the rulings as back-of-the-cigarette-box type stuff.
David Stewart: All right. So where do these cases go from here?
Kiarra Strocko: Yeah, so I think given the amount at stake in the Engie case, there's a significant chance for an appeal, which I've been hearing amongst practitioners. One hundred and twenty million euros is not a drop in the bucket. However, I will point to the fact that this case has already lasted over half a decade and an option for an appeal would simply drag it on even further.
I think it leaves open a lot of uncertainty for other multinational companies that may have similar tax arrangements. And frankly it poses the question of whether the commission will bring additional state aid cases on these arrangements moving forward.
David Stewart: And Ryan, is there something else to expect out of Amazon?
Ryan Finley: No one I spoke to had any kind of clear prediction and there hasn't really been any clear indication yet as to whether the commission will appeal this decision. There are a lot of considerations at play. But I would say that at least one practitioner I spoke to, Aisling Donohue of Anderson in Ireland, said it would have been a surprise if the General Court had decided otherwise in this case. And so the odds look like they're stacked against the commission even on appeal to the Court of Justice. So whether or not that will affect the commission's assessment of whether to appeal or not, we don't know yet. But it's certainly something we'll have to consider.
David Stewart: So these cases are happening while the European Commission has been attempting to go after tax avoidance arrangements through the state aid rules. Are there other cases out there that have major implications along the same lines that are still pending?
Ryan Finley: There are actually two very prominent, ongoing investigations involving very well-known multinationals. One involves Nike and the other involves Ikea. And interestingly, they both involve almost the same kind of argument on the part of the commission that this calculation of a royalty as the residual left, after applying the TNMM, basically should have been applied in reverse. The holding company that doesn't really do very much should be the tested party instead of the operating company that does all the important functions.
So, and in those cases as well, the commission had to rely on guidance issued after the APA at issue were granted. So it would seem that the recent decision in Amazon might affect the direction they go in with those cases.
David Stewart: All right. Well, those are definitely things we're going to have to keep an eye on, as well as the Amazon and Engie potential for appeal. Kiarra, Ryan, thank you for being here.
Kiarra Strocko: Thank you for having me, Dave.
Ryan Finley: Thanks.
David Stewart: And now, coming attractions. Each week, we highlight new and interesting commentary in our magazines. In Tax Notes State, Bruce Fort explores how several states came to include an obscure provision in their laws that has enabled multinationals to significantly reduce or eliminate their state tax liabilities. Jacqueline Laínez Flanagan examines tax challenges faced by immigrants and responds to myths about the undocumented taxpayer community. In Tax Notes International, Charlotte Tolman and Michael Molenaars examine two Dutch proposals that target hybrid mismatches. Kevin Brown examines the benefits and practical application of a moon tax. On the Opinions page, Roxanne Bland examines a subsection within the American Rescue Plan Act prohibiting states from using stimulus funds to finance tax cuts. Nana Ama Sarfo highlights that gross based taxation could become more prevalent.
And now for a closer look at what’s new and noteworthy in our magazines here is Tax Notes Federal Editor in Chief Ariel Greenblum.
Ariel Greenblum: I'm here with Alan Viard, a resident scholar at the American Enterprise Institute, to discuss his upcoming Tax Notes piece titled, “Notches in the Tax System: the Good, the Bad, and the Ugly.” Welcome to the podcast, Alan.
Alan Viard: Thanks, Ariel.
Ariel Greenblum: We're excited to publish your new article with Jason Saving on May 24. To begin, can you give listeners a preview of the article?
Alan Viard: Sure. What Jason and I look at our notches in the tax code, not just our provisions that cause significant abrupt changes in tax liability or tax treatment when there's a very small, say $1, change in your income or your expenses or your net worth or the size of a transaction. And so we try to explain a couple things about notches in the article.
The first is that although the tax brackets do not feature notches, there are more provisions than you might think that do feature notches. We looked at 45 code sections that have notches and there's many more that we did not include on our list.
The other point we make is that some of these notches actually are desirable or may be unavoidable. And the reason that that can happen is if you have to make an either-or binary choice between two different tax treatments. So the example that we use, which is in a lot of code sections, is being subject to a withholding or information reporting requirement. You're either subject to it or you're not. And so on the one hand, we don't want to impose those requirements on the tiny transactions. We do want to impose them on the large ones.
Well, there just about has to be a notch. You say above $600 you have to do information reporting. If you're below $600, you don't. And so moving from $599 to $600 is a notch that causes a discrete change, abrupt change in what your treatment is on the information reporting, but there's really no way to avoid it. And so it makes perfect sense there that there will be an abrupt change because you really have to have an abrupt change if there's only two options open to you.
But when it comes to figuring out how much you owe in income tax, well that can change smoothly and gradually. And that's what it should do. If your income goes up by $1 or your expenses go down by $1, there shouldn't be a $100 or $1,000 or $1 million change in your tax liability. I mean, that's unfair if people are kind of trapped by that. If they have the opportunity to avoid it, then they can avoid it, then they can get away from the unfairness.
But that's inefficient because people are changing their behavior to escape those notches. And we found 17 code sections, and again there's more out there, where there is a notch in your tax liability. I'll just mention two, and then readers can go to the article to find the others.
The stimulus law that was just passed in March excludes up to $10,200 of unemployment benefits from tax. If your adjusted gross income is below $150,000, classic notch. You go $1 above that amount, all your benefits are going to be taxable. Congress could and should have phased in that around $150,000 instead of just having it properly go away at $150,000. So that is one dramatic example.
Another example on the business side is the interest expense limitation. That applies to businesses that have gross receipts of $25 million or more. Once again, abrupt change as you go from $1 below up to $25 million. Suddenly this interest deduction limitation hits you with full force. Could have been phased in gradually, should have been phased in gradually. And so we would urge Congress to really take a look at the notches in the tax code, see which ones make sense and should be kept, and which ones should be scrapped.
Ariel Greenblum: Really fascinating. What led you and Jason to write about the code notches?
Alan Viard: So it was a Tax Court decision that we stumbled upon in 2020: Abrego v. Commissioner. And the taxpayers of that case were affected by a notch. It looked like when they filed their tax return that they were going to have to repay almost $9,000 of premium tax credits because their income was a little bit above 400 percent of adjusted gross income. And the code has a notch there at that level.
And so the commissioner did issue a deficiency notice because they didn't repay any of those premium credits. But then during the case, it developed that there was a deduction they had failed to claim and their income was actually just a little bit below 400 percent of adjusted gross income. And so that change just a few hundred dollars in their income ended up changing by almost $7,000 the amount of premium credits that they had to repay. Because their income was a few hundred dollars lower, they only had to repay $2,000 instead of close to $9,000.
And so we thought this is just a dramatic example of where a notch mattered in the real world. It wasn't just a theoretical curiosity, but you could actually see it playing out in this case. And so that spurred us to think that maybe we actually should write about this topic and call attention to these issues.
Ariel Greenblum: Thanks, Alan. Before you go, can you tell our listeners where they can find you online?
Alan Viard: So they should go to the American Enterprise Institute website at ww.aei.org. All the AEI scholars are there. And my scholar page has all the writings I've done, many of which of course have appeared in Tax Notes publications. And I'd be delighted if any viewers or listeners come to the website, look at any of that stuff, and if they have questions or thoughts or comments, my email address is there as well. Be happy to hear from anyone.
Ariel Greenblum: Thank you for coming on the podcast, Allan.
Alan Viard: Thanks, Ariel.
Ariel Greenblum: You can find Alan's upcoming article online at taxnotes.com. And be sure to subscribe to our YouTube channel Tax Analysts for more in-depth discussion on what's new and noteworthy and Tax Notes. Again, that's Tax Analysts with an S. Back to you, Dave.
David Stewart: You can read all that and a lot more in the pages of Tax Notes Federal, State, and International. That's it for this week. You can follow me online at @ TaxStew, that's S-T-E-W, and be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts .org . And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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