News Update EU State Aid & Tax Special

17 July 2020

On 15 July 2020, the General Court (the "Court") annulled the European Commission's (the "Commission") decision that Ireland granted tax benefits to Apple that constitute unlawful State aid. In the Commission's view, Apple paid substantially less tax than other businesses, which distorted competition. Consequently, Ireland was ordered to recover the illegal aid amounting to EUR 13 billion before interest. Both Ireland and Apple appealed the Commission's decision to the Court, which ruled that the Commission had not sufficiently demonstrated that Ireland gave Apple a more favourable tax treatment than other businesses subject to Irish tax law.

The decision follows the earlier judgments in the Fiat and Starbucks cases in which the Court confirmed the application of the State aid rules to tax rulings, while at the same time placing a heavy burden of proof on the Commission.

Please see the appendix for a summary of the main arguments the Court ruled in favour and against the Commission.

The Commission's investigation

In its investigation, the Commission focused on two tax rulings that Ireland granted to Apple in 1991 and 2007. These rulings endorsed an internal profit allocation method which established the taxable profits of two Apple group companies in Ireland: Apple Sales International ("ASI") and Apple Operations Europe ("AOE").

In the Commission's view, the tax rulings endorsed an allocation of profits that substantially and artificially lowered taxes paid by Apple in Ireland since 1991. This did not correspond to a reliable approximation of a market-based outcome in line with the arm’s length principle. The Commission considered that this was due to the fact that a great deal of ASI's and AOE's profits were allocated to their non-resident head offices, which existed only on paper. According to the Commission, only the ASI's and AOE's Irish branches had the capacity to generate income from distribution activities and the profits should have been allocated to them in line with the Authorised OECD Approach ("AOA") and the arm's length principle. In addition, the Commission established that ASI and AOE made payments to Apple in the USA to fund research and development initiatives in exchange for intellectual property ("IP") rights. These payments – which amounted to USD 2 billion in 2011 – were deducted annually from the profits of the two Apple companies in Ireland. The Commission argued that the IP rights held by ASI and AOE should have been allocated to the Irish branches instead.

The Court's judgment

As in the Starbucks and Fiat judgments, the Court confirmed the Commission's competence to assess the compatibility of tax rulings with the State aid rules. Subsequently, the Court assessed the Commission's considerations in its three lines of reasoning.

Commission's primary line of reasoning
The Court agreed with the Commission's view that the relevant reference framework was the ordinary corporate profit taxation rules under the Irish corporate tax system, which have as their objective the taxation of profit of all companies subject to tax. The Court also confirmed the application of the arm's length principle as a benchmark to assess whether the level of profit allocated to the branches, as accepted by the national tax authorities, corresponds to the level of profit that would have been obtained under market conditions by a stand-alone company. The Court agreed with the Commission that the value of activities of Irish branches should be determined according to market prices. This was mainly on the basis of Section 25 of the Irish Taxes Consolidation Act 1997, various case law, and the double taxation treaty between Ireland and the US which allowed Ireland to apply the arm's length principle to avoid double taxation.

Next, the Court confirmed that the Commission was entitled to rely on the AOA, since the AOA reflects a broad international consensus on profit allocation to permanent establishments. However, it also pointed out that this approach requires an analysis of the functions actually performed within the permanent establishments, which the Commission failed to carry out. Consequently, the Commission also failed to demonstrate that the profits derived from the IP licenses (which represented the most substantial part of the profits of ASI and AOE) should have been allocated to the Irish branches for taxation according to the 'normal' Irish tax rules. Despite its burden of proof, the Commission had not performed a detailed functional analysis and so did not succeed in showing that ASI's and AOE's branches had in fact controlled the IP licenses. Hence, the Court concluded that the Commission's factual assessment lacked decisive substantiation and, therefore, the Court rejected the Commission's argument that there was a selective advantage.

Commission's subsidiary line of reasoning
The Commission argued that – even if the IP licenses should have been allocated to ASI and AOE (contrary to its primary line of reasoning) – the endorsed profit allocation methods were not in line with the arm's length principle, leading to an erosion of the Irish tax base.

The Commission contended that the profit allocation methods established in the challenged tax rulings constituted one-sided profit allocation methods, in line with the transactional net margin method ("TNMM"). During the administrative procedure, Ireland and Apple submitted ad hoc transfer pricing reports which relied on the TNMM to make their case. The Court, therefore, agreed that the TNMM could be used to assess the profit allocation method established by the tax rulings.

We note that a proper and extensive functional analysis of the Irish branches and the other parties involved (which the Commission did not successfully provide in its first line of reasoning), could possibly have led to the conclusion that another – two-sided – transfer pricing method (e.g. the profit split method) would have been more appropriate. This could have been the case if the Commission had been able to successfully demonstrate that the Irish branches performed important functions with respect to Apple's IP. For example, in the case of the Apple brand, this could have been done by indicating that the branches directly bore the marketing costs to perform important marketing activities which contributed to maintaining the Apple brand. If the Commission had substantiated the appropriateness of the profit split method, the analysis would have to be extended to all parties involved in the value chain, including the other European and non-European group companies (including the head offices of ASI and AOE), and Apple Inc. Consequently, part of the profits could have been attributed to those entities outside Ireland, while the remaining part could have been attributed to the Irish branches.

The Commission implicitly builds the case for applying the profit split method when presenting its subsidiary line of reasoning. It questions the comparability of third party companies, considering the high-quality branded products offered by the Apple group. The presence of a unique intangible in transactions that the Irish branches engaged in could suggest that it might be more appropriate to apply the profit split method than the TNMM.

Since the Commission assumed and accepted Apple's transfer pricing methodology to be comparable to the TNMM, it built its remaining arguments by contending that the TNMM was applied incorrectly. In this respect, the Commission argued that Apple and Ireland had made three methodological errors in light of the TNMM, which we set out below.

i) The choice of the Irish branches as the tested parties

Contrary to the Commission's plea, the Court ruled that there was no evidence indicating that the choice of the Irish branches as the tested parties was incorrect. In line with earlier observations, a proper functional analysis could have helped to prove otherwise. If the Commission had been able to successfully demonstrate that the branches were responsible for complex and unique functions within the Apple group (e.g. the important functions and key decision-making for Apple's IP), as well as that those branches controlled the associated economically significant risks, it would have been less likely that the Irish branches could be upheld as tested parties.

ii) The choice of the profit level indicator

Although the Commission challenged the choice of the branches as the tested parties, it continued to challenge the profit level indicators used for remunerating the branches, considering them as the tested parties. This is a weakness in the Commission's analysis because if the branches were incorrectly chosen as the tested parties, the rest of the analysis was also likely to be flawed. Also on this point, the Court concluded that the Commission did not successfully show that the operating costs could not serve as the proper base for the profit level indicator.

The profits of the Irish branches were calculated as a margin of the operating costs. The Commission argued that the operating margin (based on sales) instead of the Berry ratio (based on operating costs) would have been a more appropriate profit level indicator for ASI's Irish branch. As for the Irish branch of AOE, the Commission considered that a profit level indicator based on the total costs would have been more appropriate than a profit level indicator based on the operating costs. To succeed in defending their claim in the case of ASI's Irish branch, the Commission should have demonstrated that the functional and risk profile of the Irish branch was in line with that of a sales distribution company which performs important sales and marketing functions, including key decision-making in relation to the activities of sales entities across Europe. In addition, it should have demonstrated that ASI's branch had control over associated economically significant risks, such as the market, credit, and inventory risk.

iii) The substantiation of the level of the remuneration

Since the Commission did not agree with the choice of the profit level indicators, it challenged Ireland on the level of the remuneration by reproducing the comparability data used by Apple using its new profit level indicators (i.e. return on sales for ASI and mark-up on total costs for AOE). Furthermore, even though the Commission challenged the comparability of the companies that Apple selected in their ad hoc benchmark study, it continued to calculate the arm's length remuneration of the Irish branches based on those selected companies. The Court rejected the Commission's challenges with respect to the levels of return of the Irish branches. The Court ruled that the Commission did not perform its analysis in a way that demonstrated that, as a result of that calculation, the tax actually paid by ASI and AOE on the basis of the contested tax rulings was unjustifiably low. If the Commission had succeeded in demonstrating a different functional and risk profile for the branches, it could possibly have successfully defended a two-sided transfer pricing method or, if not, at least a different choice of profit level indicators which would have likely required a different set of comparables and also a higher level of remuneration.

The Court's decision for all three alleged methodological errors in light of the subsidiary line of reasoning is unambiguous. Merely stating that a methodological error has been made is not sufficient. The Commission should have also demonstrated that the methodological errors had led to an unjustifiable reduction in the taxable profit and, thus, in the tax burden borne by the Irish branches of ASI and AOE.

Commission's alternative line of reasoning
As part of its alternative line of reasoning, the Commission argued that, amongst others, the contested tax rulings had been issued by the Irish tax authorities on a discretionary basis, in the absence of objective criteria related to the Irish tax system. The Court ruled that the Commission cannot rely on its alternative line of reasoning in order to conclude that a selective advantage had been granted.

Conclusion

The Court's judgment confirm the Commission's policy as a matter of principle, but nevertheless is a blow for the Commission, especially given the pending investigations into the IKEA, Nike and Huhtamäki tax treatments. In terms of outcome, the Court's position and associated arguments are rather similar to those of the Starbucks case. The Court has given a clear message as to the heavy burden of proof that the Commission must satisfy in tax ruling cases. This burden of proof in State aid cases is not a new standard, but follows from established case law. This standard has recently led to a series of annulments of Commission decisions in both fiscal and non-fiscal State aid cases (e.g. Real Madrid, FC Barcelona, Belgian excess profit and Elche). The key message from all these cases is that a thorough and detailed analysis is required to prove a selective tax advantage. In order to be more successful, it remains to be seen whether the Commission will take this message seriously in its pending investigations, for instance the Nike case, which is similar to both the Starbucks and Apple cases in terms of its transfer pricing aspects. The recently published extension of the formal investigation into the tax treatment of IKEA could be a sign that the Commission has taken this message to heart.

The Commission may decide to appeal the Court's judgment to the Court of Justice of the EU. However, since it seems as if a more substantive transfer pricing analysis (and in particular, starting with a detailed functional analysis) is needed, it is doubtful that an appeal will be successful. The Commission may also decide to re-open the investigation in order to be able to adopt a new decision if it is able to provide the required evidence that the Irish branches benefitted from a more favourable tax treatment than other non-integrated businesses. If the Commission is able to provide this evidence without a further investigation, it could also adopt a new recovery decision with improved reasoning. Depending on its analysis of its chances of success in either approach, the Commission may also decide not to pursue the case, as happened in the Starbucks case. In the meantime, Vice-President Vestager has anticipated that the Commission will continue scrutinising aggressive tax planning measures to assess whether they result in illegal State aid. Companies operating at an international level must thus remain alert to the State aid consequences of their tax planning and the consecutive recovery obligations as they may have a substantial negative financial impact on international business groups.