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Widely publicised profit-shifting cases in the European Union (EU) investigated by the European Commission against multinationals such as Apple, Starbucks, Fiat, Nike and Amazon have caught the attention of scholars and tax authorities worldwide including those in Australia. A submission to the Australian Parliament, for example, estimates that 90 per cent of the profits realised by an Apple subsidiary in Australia in 2015 were shifted to Ireland by way of transfer pricing arrangements. The profit-shifting arrangements in question are all based on favourable private rulings from tax authorities in a select group of EU member states.

Under European treaties, income tax policy is a prerogative of member states. However, the EU is empowered to act against the tax measures of member states that directly impact the functioning of the European single market. However, to date, the European initiatives to attack profit-shifting schemes have primarily focused on the treaty prohibition against state aid. The experience to date reveals the limitations on the ability of the EU to curb profit-shifting arrangements as long as the global system of profit allocation rests on a conceptual foundation of fictional transactions between parts of a single economic entity.

There are at least three implicit routes that the EU can use to modify tax behaviour of member states for the purpose of protecting the single market.

European anti-tax avoidance legislation

First, the EU can adopt directives, a form of EU-wide law, to in effect override national laws or administrative practices inconsistent with the single market. Relying on these powers, the EU to date has adopted discrete directives, limited in character and application, addressing administrative cooperation in tax matters, parent-subsidiary tax rules, mergers, interest and royalty payments, tax avoidance, and disputes over double taxation.

Of these discrete measures, the anti-tax avoidance directive (ATAD) and certain amendments to the administrative cooperation directive are the key EU-level initiatives that seek to tackle the pricing-induced tax rulings. However, the drafters of the  anti-tax avoidance directiveseem to have been motivated by a desire to design a very vague and broad anti-abuse rule’ to deter multinationals from tax minimisation arrangements. Along with the rest of the directive, this measure lacks any detailed rules that would specifically address the arrangements exposed in recent EU cases. The EU therefore requires more targeted tax legislation to combat the nature and scale of profit shifting that took place under concessional tax rulings.

The adoption of such a targeted directive however has twofold challenges. The first is the difficulty the Commission would encounter trying to construct a rule that prevents bespoke concessional rulings on the basis of its obligation to protect the single market. The second challenge is that its adoption will require unanimous consensus of all member states including those that have been part of the group issuing concessional tax rulings.

European company tax reform and formulary apportionment

A second, and alternative, option for the EU would be to attack the underlying problem directly by removing the benefit of profit shifting within Europe. To that end, a model EU-wide company income tax law could allocate shares of group profits to members of the group for tax purposes in a way that ignored intra-group transactions (and transfer pricing). A regime of this sort has already been adopted in the United States where the states have separate income tax systems. In this system, profits of enterprises with subsidiaries in multiple jurisdictions are allocated for tax purposes using a formula based on the actual economic source of profits looking at inputs (labour and capital) and outputs (sales) in each jurisdiction.

For this purpose, the EU would require a company tax reform based on a broader piece of legislation. In fact, a similar draft proposed in 2011 by the European Commission on a Common Consolidated Corporate Tax Base (CCCTB) law failed to obtain unanimous consensus in the Council of EU (represented by finance minister of each member state). The Commission withdrew the draft legislation in 2016 and proposed two-phased legislation: first to establish a common corporate tax base and then to consolidate that base. Both draft laws have since then stuck in the Council of EU. With little progress on these proposals since 2016, the European Commission has recently announced plans to abandon both drafts and replace them with a new legislative proposal, likely to be revealed in 2023, Business in Europe: Framework for Income Taxation or BEFIT, based on the formulary apportionment.

EU prohibition on state aid

When other remedies proved ineffective, the European Commission turned to a third strategy to combat profit shifting, this time attacking the bespoke rulings behind the arrangements, using the prohibition against state aid in the EU treaty as the foundation for its assault. The treaty provision prohibits illegal national subsidies to undertakings. In principle, the provision can also apply to a subsidy or aid by way of selective reduction of a tax burden of an industry or enterprise. Thus, if there was evidence that member states were using selective tax measures to subsidise in effect an industry or enterprise, the Commission would be empowered to intervene and seek an end to the practice.

Although there are difficulties in applying the state aid prohibition against transfer pricing arrangements, it seems the European Commission has concluded this path is its best bet for the present. The Commission scrutinised a number of national measures and held bespoke tax rulings issued by tax authorities of certain member states to Apple, Starbucks, Fiat, Amazon, Nike and Engie (the French energy company that owns Simple Energy in Australia) confer selective benefits to the companies within the meaning of state aid rules. The companies and the issuing authorities contested the decisions before the General Court of EU and the court has issued verdicts.

In the Apple, Starbucks and Amazon cases, the General Court of EU accepted the European Commission’s competence to investigate the bespoke tax rulings but annulled the Commission’s decisions holding that the European Commission was unable to prove selectivity in the advance tax rulings. The European Commission has contested the Apple judgment before the apex EU court, and is preparing to challenge the Amazon judgment. In Fiat and Engie, the European Commission was victorious in proving the tax rulings issued to the companies were preferential within the meaning of state aid rules. Fiat had appealed the Fiat judgment before the apex court and it is yet to be seen whether Engie follows suit.

The prospects

At this point, the prospects for tackling intra-EU profit shifting schemes through directives aimed directly at profit shifting or a directive implementing the Common Consolidated Corporate Tax Base seem limited, both paths thwarted by the unanimous voting rule. The European Commission’s third option, the state aid approach, has to date proved only marginally more successful than its predecessors. To be successful, the Commission must demonstrate that the profit allocation rules or transfer pricing methodology used to calculate the profits of a subsidiary are concessional compared to those used for other firms in factually and legally comparable positions.

To show that a state aid ruling involving royalty payments is concessional, the European Commission would have to show the ruling did not correctly quantify the arm’s length value of intellectual property acquired as a result of the payments. This is a near impossible task. By definition, there can be no comparable arm’s length price for the use of intellectual property developed by and applied exclusively in multinational firms. To show that a ruling incorrectly segregated the value of supplies based on a component attributable to the supplier’s operation and a component attributable to the intellectual property content in the supplies, the European Commission would have to dispute the proposition implied by the ruling that it is possible to dissect supplies made by an arm of a wholly integrated business into elements attributable to different aspects of the single business. While the idea that the elements of a business can be divided in this way may be counterintuitive in terms of economic reality, it is the cornerstone on which the fiction of arm’s length pricing is built.

Change may be on the horizon, however. Internationally, the first cracks have appeared in the dogmatic adherence to the traditional arm’s length standard by OECD members, with proposals to shift to a formulary apportionment system for profits of digital service enterprises. Time will tell if this foreshadows broader debate on alternative systems for the allocation of profits of multinational enterprises.


Further reading

Khan Niazi, Shafi and Krever, Richard (2021), ‘Bespoke tax rulings and profit shifting in the European Union: assessing the EU’s options’ 36(3) Australian Tax Forum (forthcoming).

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