The EU State Aid Tax Puzzle

For a while, the European Union state aid investigations into the tax practices of large, (mostly) U.S. tech companies seemed like the whole world to me.

Back in the circa-2015 era, it competed for attention with other big developments–the Organization for Economic Cooperation and Development’s first Base Erosion and Profit-Shifting Project, the U.S. rules on earnings stripping and inversions, as well as the long-simmering tax reform initiatives in Congress.

But there was a time when the European Commission seemed to grab the spotlight in the international tax world. While lawmakers dawdled and the U.S. Internal Revenue Service seemed outmatched, finally someone was doing something about these large, extravagant tax structures that seemed to put so many billions of dollars outside of any tax authority’s reach.

Except, the European Commission doesn’t even have jurisdiction over income taxes, as the case was made as part of the EU rules on fair competition. And the Obama Administration’s Treasury Department strongly objected to the logic behind the proceedings, setting up a conflict between ostensible allies. Even worse, if the Commission were successful, the companies could potentially recoup their lost tax advantage through foreign tax credits, ultimately putting the cost on American taxpayers.

So, there were a lot of reasons that this became a high-profile thing.

The cases, along with other initiatives involving antitrust and tech, elevated EC Competition Commissioner Margrethe Vestager into superstar status, at least in the EU bureaucratic realm, ultimately leading to her claiming a newly created role, Executive Vice President of the European Commission for A Europe Fit for the Digital Age. (She will leave the office this year.)

You didn’t hear a ton about it since that 2015/16 peak, though. Partly because the Commission suffered some high-profile court losses, and partly because the 2017 Tax Cuts and Jobs Act’s deemed repatriation withdrew those enticing billions of dollars from Europe. (Even though this shouldn’t have affected the legality of the case.)

But, just as Vestager packs her bags to leave Brussels, the Commission has picked up an unexpected win. The EU Court of Justice overruled the EU’s General Court, finding that Apple Inc. did indeed benefit from unlawful state aid, when Ireland agreed not to challenge the company’s legal structure in two separate tax rulings, which led to billions of dollars being untaxed. The Commission estimates that Apple will need to pay Ireland 13 billion euros ($14.5 billion) in back taxes. (This whole saga put the Irish government in the odd position of pushing back against a revenue windfall imposed from above.)

I’m not even going to pretend to try to do an overview of the details of the case, or the logic behind the CJEU’s 400+-paragraph opinion. (Oxford's Richard Collier has a good run-down, albeit one that's highly critical of the Commission.) Apple had a variation of the Double Irish structure, where its money was somehow simultaneously on the Emerald Isle and elsewhere. (Tax experts often speak of “stateless income,” but that normally refers to income held in a zero-tax jurisdiction. In this case it was almost literally stateless, not recognized as being taxable income in any of the jurisdictions where Apple operated.) As far as Ireland was concerned it wasn’t Irish taxable income, and it was happy to provide the company assurances of that in 1991 and 2007 rulings.

The EC argued that this violated the basic pact behind the EU’s common market, that the member states not use selective state benefits to lure investment. That Ireland wanted to be perceived as the most business-friendly country in the EU was no secret, and a handshake deal granting Apple the ability to leave billions untaxed was surely a clear example of the state luring investment away from competing nations with the promise of dollars. Is it materially different than if the Irish government had handed them a fat check?

Ireland and Apple–and the U.S., for that matter–responded that the EC had way overstepped its bounds. Tax authorities make deals with taxpayers all the time. The tax code would be impossible to administer otherwise–the government must allocate resources to where it believes the biggest risks of noncompliance are, and to make calculated compromises where the tax code is ambiguous. Did the EC want to put itself in the position of second-guessing countries’ administrative choices, effectively becoming the EU’s tax super-authority? The case got wrapped up in the whole debate about what the EU is, exactly.

Bob Stack, then the deputy assistant Treasury secretary for international tax affairs, memorably likened it to plumbers taking on electrical work.

The European Commission also pointed to the arm’s-length standard, the global benchmark that income be allocated based on what independent parties would have paid. They used this to question the legal arrangements that Apple used to create its Irish tax structure, especially rights to its valuable intellectual property.

The problem is, while the arm’s-length standard is international tax’s Golden Rule, it wasn’t ratified through some multilateral agreement with enforcement mechanisms. In fact, many countries–including the U.S. and Ireland–never explicitly incorporated it into their national laws. It’s largely a product of bilateral tax treaties, which the European Commission isn’t a party to. (In many of these cases, even the other EU member states weren't parties to the relevant treaties.)

The Commission claimed that the arm’s-length standard goes beyond its literal legal definitions, and should be understood as a global norm–customary law that can be used as a standard to see if tax authorities are behaving appropriately.

It is true that the arm’s-length standard is supposed to be a universal norm, something that virtually all countries have bought into as the basis for international taxation. But part of the idea behind this is that it’s self-reinforcing. It’s a tool for countries to use to protect their own tax base, regardless of what other countries do. If something doesn’t seem right–there's not enough revenue or too many deductions in the calculation of income in the jurisdiction–the arm’s-length standard is how a country can try to get to the right amount. And if things are right, what’s the difference what the country on the other end of the transaction does?

That’s the theory. In practice, of course it does end up mattering. International taxes are often done on the margin, in the grey areas of legality and accounting, and low or zero-tax jurisdictions can be a powerful lure. That creates strong political incentives to look beyond the traditional tax tools to try to influence other countries’ behavior. This is especially true in Europe, where countries are often performing a two-step dance (Irish jig?) to crack down on alleged corporate malfeasance while also presenting to be as business-friendly and open to investment as possible.

In any event, the General Court found that the Commission had indeed overstepped its role. In somewhat of a surprise, the CJEU overruled them and found that the Commission does have the right, in this case, to overturn Ireland’s tax authority.

It’s a potentially important precedent, with one caveat. Almost all of this is out of date. Ireland closed down the avenues for the Double Irish years ago, and Apple’s structure would not be possible today, as Vestager noted in her response to the CJEU decision. Furthermore, both the TCJA and the OECD’s in-progress Pillar Two attempt to make these kind of arrangements impossible or unnecessary. Now that the U.S. has a quasi-territorial tax system, there isn’t the same overwhelming urge to let income pile up in zero-tax havens.

That doesn’t mean it’s altogether stopped, but it may mean those eye-popping dollar amounts no longer apply.

This raises the question, what will the European Commission do with its new-found, court-sanctioned authority over taxation now?

Will it look to new potential areas to enforce global tax norms? One possibility that comes to mind are the OECD’s rules on the transfer pricing of hard-to-value intangibles, updated in the 2015 BEPS project. Those include analysis of which corporate entities are involved in “development, enhancement, maintenance, protection and exploitation” of valuable intangible assets–the so-called DEMPE functions. This is exactly the kind of factual analysis that the Commission, and later the CJEU, used while assessing Apple’s legal arrangements.

Except these cases will involve a new level of mind-numbing complexity–often comparing real on-the-ground operations with remuneration for IP, something that can be close to inscrutable when it comes to giant tech and pharmaceutical firms.

The European Commission may eventually decide this is one power it wishes it had never won.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• The OECD last week held a long-awaited signing ceremony for a multilateral treaty to implement the Subject to Tax Rule–basically, a treaty-based version of the undertaxed profits rule, that is meant to appeal to developing countries. (It’s something I’ve neglected to write about much, which was probably a mistake on my part.) So far, nine countries have signed on, including Indonesia and Turkey, although an additional 10 have “expressed their intent to sign,” according to the OECD. As the rubber hits the road for the Pillar Two project, this is another example of how the rules are being carried out–and if the treaty-based model works, the developed world may be interested in taking some pointers from it.
• Would you believe there’s a part of the United States. that is implementing Pillar Two? It’s just not part of the 50 states. Puerto Rico, a U.S. territory with quasi-autonomy in its tax system, announced yesterday a public consultation over proposed Pillar Two rules. How the territory will fit into the Two-Pillar project, given its somewhat unique status, has been an ongoing saga that has attracted the attention of tax experts. Most of the time, P.R. is considered an independent jurisdiction when it comes to international taxes, although the U.S. Treasury has been pushing for the territory to count as part of the U.S. for the purposes of Pillar One. Given the complex status of its tax regime, including significant R&D incentives for the territory enacted by the U.S. Congress, this could get very interesting.
• The United Nations General Assembly is currently convening in New York for its 79th session–but as far as I know, it’s not going to involve the UN special committee on taxes, which will meet in October. There are quite a few other issues going on in the world to keep the U.N. occupied, if you haven’t noticed. But that doesn’t mean the issue of international taxes won’t come up. For instance, Volker Türk, the U.N. high commissioner for human rights, last week made a statement strongly urging a new U.N. tax framework. So something to keep an eye on.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

The Black Owl, appearing first in Prize Comics #1 in 1940. No particular origin story for this one, he was just a wealthy playboy he created a costume to fight crime, first as "K the Unknown" and then the Black Owl. He would eventually pass off the mask to a new hero, who mostly fought Nazis overseas.

Contact the author at amparkerdc@gmail.com.