EC v Apple:
and the collusion of powers
Parts One and Two of this article queried the EC’s use of state aid legislation to attack “harmful tax competition”. The legislation as it stands involves retrospective penalties, and this violates legitimate expectations. Applying it to taxation was a questionable development, widening the area of legal uncertainty.
In this final part, we consider the most recent creative use of the state aid provisions: attacking transfer pricing arrangements and tax rulings. We also consider the role of the European Court of Justice in the process of competence creep, and in determining the future of the EU.
In the Apple/Ireland case, the European Commission is making dubious use of the state aid legislation to intrude into transfer pricing, an area of tax law which is often highly subjective. This is apparently being done for the purpose of attacking what the Commission regards as tax avoidance.
The fact that the case has little to do with promoting competition in the conventional sense should surprise no one, given that the Commission’s objectives long ago broadened beyond economics into general social policy. The question remains: granted the EC wants to achieve some social policy objective, why does it consider it acceptable to misuse Community law in this way?
A cynical possible answer is: the EC is trying to expand its sphere of action. If it can get the Apple case passed by the European Court of Justice, various precedents will have been established. Among other things, transfer pricing will henceforth have to be regarded as an area subject to EU jurisdiction.
A case of competence leap rather than competence creep.
A more charitable interpretation might be: the EC believes that frustrating the use of Apple-type corporate structures for tax minimisation is the right thing to do. The EC’s concept of “right thing” may be in terms of what citizens want but national governments are unable or unwilling to grant. Or it may simply be in terms of what the EC regards as morally correct, irrespective of popular opinion.
Both the more cynical and the more charitable interpretations, however, point to the same implication: the EC considers itself to be a superior source of power compared to that of national governments.
This is not just in the sense that EU law is said to have primacy over national law. Any collection of states with a central authority must give some primacy to the law of the central authority, if that law is not to be ineffectual.
The crucial question is: does the central authority have the power to change the law, whether formally or in practice, without the agreement of member states? If it does, it holds the trump card. The jurisdictional boundaries between itself and member states can then be shifted at its whim. Individual states become, to some extent, passive recipients of the central authority’s preferences.
“Creative accounting” is the exploitation of loopholes in accountancy rules to achieve objectives that deviate significantly from acceptable practice.
There is an analogous type of behaviour in matters of law, sometimes called legal opportunism. This involves exploiting areas where the law is vague or ambiguous, or where it has unintentionally left gaps. Imperfections in the law are used to facilitate actions that were not intended to be sanctioned.
It is not only private individuals and corporations who can indulge in legal opportunism. Government may in theory do so, by applying the law in unexpected ways. For example, a national government may occasionally resuscitate an ancient statute not used for centuries, or apply a loosely worded law in an innovative way to target some unenvisaged menace.
By and large, however, Western governments do not engage in this kind of action. One reason is that, since they have the power to create statute, they do not need to resort to opportunism. There is always the risk that a senior court may rule an opportunistic application of a law to be invalid. A new law does not carry that risk.
Another reason is that Western states generally try to maintain a reputation for neutrality vis-à-vis the law. A government with a cavalier attitude to the law as it stands tends to be one that is not held in high regard by world opinion.
For purposes of illustration, take the case of a corporate merger being considered by a national competition authority. The authority typically invites interested parties to submit their comments on the case. In reaching its conclusions, the authority is likely to make an effort to interpret prevailing laws and principles impartially — or at least to be seen to do so.
On the other hand, parties who submit opinions about the merger, whether for or against, are not expected to be neutral. Their arguments may involve mainstream economic analysis, but if the approach is slanted in the interests of one side or the other, no one is going to be very surprised, or necessarily think less of them.
By contrast, a government that gets openly creative or partisan in its interpretation of the law, in order to further its own agenda, loses its claim to neutrality and ceases to be trustworthy.
Courts: independent or otherwise
In jurisdictions where the state structure includes an independent judiciary, the government’s attempts at legal opportunism can in theory be held in check by the courts.
The notion that the state should be modelled so as to incorporate sources of internal opposition — often referred to as “separation of powers” — is a relatively modern idea. It depends on taking a sophisticated view about what government should be: not just a device for achieving what is desirable, but one with built-in restraints which on the face of it make its job more difficult.
The courts acting as a check on government requires the presence of a legal system that is autonomous enough, and self-confident enough, to be capable of critically comparing what the government tries to do with what the rule of law demands.
Notional autonomy may be a necessary condition for the role of constraint-on-government but is probably not a sufficient one. Opposing the government means regarding something other than government as your master; adherence to abstract legal principles, for example. If your primary commitment is to an agenda which happens to be the same as that of the government, you are likely to have little motive for resisting the government when it tries to bend the rules.
The legal system of what is now the European Union was created from scratch along with the corresponding governmental entity (the forerunner of the European Commission). The whole structure was aimed at achieving a particular objective, namely European integration. A system of this kind is likely to be compromised from the outset with regard to judicial independence. The unspoken purpose of the legal apparatus will be to assist in moving towards the objective, not merely to enforce the prevailing set of rules.
The European Court of Justice is the ultimate forum for appeal in matters of European law. Among its other functions, it supposedly plays a checks-and-balances role, acting as a constraint against possible abuses of power by the Commission and other EU government agencies.
With regard to the Commission, there is a particular need for a body to provide independent review. Many of the Commission’s actions combine functions that ideally should be distinct. Its case teams not only investigate possible violations of EU law, they propose a verdict and argue for a particular penalty. As The Economist points out, this process “is polluted by a prosecutorial bias”.
For some time, however, there has been a question mark over whether the European Court of Justice adequately meets the separation-of-powers requirement. The ECJ has been described as being too enmeshed with EU policy-making to act as a constraint on EU institutions, and has been accused of functioning as a mere rubber-stamping body. Professor Damian Chalmers has argued that the Court “has too much institutional investment in the development of the European Union to discharge its checks and balances role successfully”.
In 2012, Chalmers pointed to the one-sided nature of the Court’s judgments when ruling on the legitimacy of EU actions.
In over thirty-five years of EU fundamental rights law, there is not one instance, to my knowledge, of the Court of Justice striking down a Directive (the central legislative instrument of the EU) because it violates fundamental rights. [...]
By contrast, the Court has been quick to annul measures if they touch on its own institutional prerogatives [...]
When member states disagree with the lawfulness of EC actions against them, as in the Apple/Ireland case, the ECJ functions in theory as a neutral adjudicator. In practice, as Chalmers points out, judgments against the Commission are rare.
Of the [cases] reaching the Court of Justice between 2006 and 2010, the Commission won in 91 per cent of cases. This is an astonishing statistic when one considers that when it did lose, the Commission often did so only because it had not followed procedure properly.
It has been suggested that, far from acting as a check on EU state behaviour, the ECJ is in fact the primary agent in bringing about European political integration. A paper by Jean-Michel Josselin and Alain Marciano argues that, while the explicit project of political integration was seemingly abandoned in the 1950s, in reality the job was tacitly passed over to the ECJ.
Judges and courts [of the EU] are granted (and even grant themselves) the right to make political decisions in the sense that those decisions and their implementation convey quasi constitutional consequences [...]
The above considerations suggest that when the Commission engages in legal opportunism, we are likely to see less resistance from the ECJ than we should expect from a genuinely impartial court.
This appears to be borne out by the creeping expansion of EU power that has taken place over the last forty or fifty years. Loosely worded legislation is interpreted ever more widely. And there appears to be a kind of double act between the EC and ECJ. The Commission ‘tries on’ an innovative application of the law; the ECJ decides to allow it, making incidental arguments to support the case; the Commission is henceforth able to use the ECJ’s judgment as a precedent. Furthermore, the Court’s incidental arguments may then be seized on by the Commission to justify yet further legal opportunism, as we shall see below.
The Commission’s legal creativity
A court that fails to resist a government’s legal creativity is, in effect, a court that aids such creativity.
We have already considered several examples of creativity on the part of the EU state. In Part 1, we saw that the EC began in the 1970s to interpret Article 107’s reference to “abolishing or altering” aid as meaning that the relevant subsidy, grant or tax benefit had to be reversed, not merely stopped. This interpretation was supported by the ECJ, despite the fact that the reversal remedy violates the legitimate‑expectations and no‑retrospection principles, both aspects of legal certainty — one of the key planks of the rule of law.
In Part 2, we saw that around the same time, the EC began to apply the state aid provisions to tax law, although this conflicted with the principle that member states have fiscal autonomy. This extension in the violation of legal certainty was sanctioned by the ECJ, despite there being no strong case for a corresponding benefit to European competition. Since member states have the right to set different tax rules and rates, this already departs from the competitive ideal; it is not clear that member states tweaking the rules for particular companies or sectors necessarily makes things worse — it may in some cases even improve competition.
Finally, it was noted that the EC decided in the late 1990s to exploit the vagueness of the state aid definition to attack “harmful” tax competition, in spite of this contravening the principle that direct taxation policy was outside EU jurisdiction, and in spite of the fact that attacking tax competition has little do with promoting competition in the conventional sense. Again, the EU court system has put up little resistance to this creative extension.
Reviewing past decades, we can see a gradual process of transferring jurisdiction from member state governments to the EC in many policy areas. The process may be slow, or even static some of the time, but it appears to be in one direction only. The final result, which can sometimes appear remote, may nevertheless be inevitable. Taxation appears to be no exception to this rule, though it may currently seem as if we are still far from a situation where EU tax law is primary.
Having succeeded in establishing that taxation can become subject to EU law via the state aid rules, one way for the EC to move the process forward would be to widen the applicability of this. State aid law can be applied whenever a business is given a “selective” advantage, meaning an advantage not available to all businesses in a “comparable legal and factual position”. Hence if the definition of “selective” could be expanded, this would serve to increase EU jurisdiction.
A definitional expansion of this kind may well be what the Apple/Ireland case is designed to achieve. Understanding how this works requires some knowledge of transfer pricing, which I try to provide below.
Transfer pricing is an issue that arises for multinationals, i.e. corporate groups with a presence in more than one tax jurisdiction. Total group profits have to be allocated between the individual companies, and this is achieved by the group setting internal prices for goods or services transferred between one group company and another.
Consider a company which makes motor cars in country A and then sells them via its subsidiary in country B. The profit which the B‑company reports for its selling operation will depend on the amount it is charged per car transferred to it. The lower this transfer price, the more of the overall profit will be allocated to the B‑company. (See figure below for an example.)
Some groups may try to bias profit allocation towards countries with a lower tax rate by adjusting the transfer price. If country B has a higher tax rate than A, it is in the group’s interests to minimise profits in B by setting a relatively high transfer price per car.
Governments are of course aware of this ruse. B’s tax authority is likely to query the company’s calculation of profit if it considers the transfer price unreasonably high. Conversely, country A may object if it considers the price to be artificially low, so that too little of the profit is taxed in A. Disagreement about whether transfer prices are reasonable can result in long-drawn-out disputes.
The principle which guides authorities’ decisions about whether a transfer price is reasonable is the arm’s length rule. This states that transfer prices should approximate to what would happen in a “market outcome”, i.e. in transactions between unconnected parties. However, the interpretation of this is often anything but straightforward. There may be little or no market data to help answer the hypothetical question: what price would be set if the two divisions were independent?
In the case of relatively homogeneous industries like motor cars it may be possible to look at percentage mark-ups on cost charged by rival manufacturers to independent retailers, take an average, and adjust for any special factors; thus generating what may be a suitable mark-up percentage for the group to use. Alternatively one can look at the profit margins of independent retailers, and argue that the transfer price should leave retail companies within a group with a similar level of profit to that of independents. These are two rough and ready methods used in simple cases.
At the other end of the spectrum, if what is being ‘transferred’ within the group is the use of intellectual property (“IP”), say from a technology company to one of its subsidiaries, there may be little or no basis for calculating an arm’s length price.
A method often used in market transactions is to charge the IP user a percentage of the revenue he obtains from selling products that make use of the IP; in other words, a royalty. This suggests that a group company which owns IP should, analogously, charge a royalty to other group companies which use the IP. But this leaves the question of what royalty rate to charge. Rates used in market transactions range from less than 1 percent to more than 20 percent, so we are not much nearer to an answer. Royalty rates depend partly on the market power of the IP holder, which in turn depends on how substitutable the IP is (i.e. how readily an alternative can be found). The latter is impossible to quantify with any degree of accuracy.
Transfer pricing, then, is not an area where precision is to be expected. It generates questions that require a single answer but which rarely have a single ‘right’ answer. In the words of tax specialists, transfer pricing is “more of an art than a science”.
Putting it more bluntly, application of the arm’s length principle often amounts to little more than a fudge. This is partly because the notion of “market outcome” on which the principle depends is simplistic. It relies on a model of markets taken from classical economics, in which the forces of competition invariably generate a single ‘sensible’ result.
Transfer pricing guidelines often refer to the functions and risks of an enterprise in determining what its remuneration ought to be, as though transactions in the market always generated results that conformed to simple analysis of this kind. Those with experience of business know that market outcomes do not necessarily comply with what is deemed rational. The terms on which companies transact may only imperfectly reflect the distribution of functions or risks, to the extent it is possible to pin those down. Negotiations between a supermarket chain and a small farmer may generate a very different division of profits from those between the same chain and a multinational food company, even if functions and risks are similar in the two scenarios.
The fact that transfer pricing is an art rather than a science generates a good deal of uncertainty for multinational groups with regard to their future tax liabilities. A group may decide on a transfer pricing methodology which it considers reasonable, and which its tax advisers agree is acceptable. But the risk remains that a national tax authority will disallow it, possibly years after the event.
One way for a group to reduce this uncertainty is to try to obtain a tax ruling. This is a written clarification, issued by a tax authority to a taxpayer, about how taxation provisions will be applied in a specific situation. Such rulings often last for a number of years, protecting taxpayers from the risk that an authority will unexpectedly change its interpretation.
Tax rulings are used in areas such as transfer pricing where there is uncertainty about how authorities will interpret the law. They facilitate businesses’ efforts to engage in long-term planning, and so tend to promote economic efficiency.
According to the EC, tax rulings could be used to provide covert subsidies to businesses, by providing abnormally favourable interpretations of tax law. However, even if in principle tax rulings fall under the remit of state aid law, there are obvious reasons why the Commission should stay clear of this area. State aid legislation is already at odds with the rule of law:
• it violates legitimate expectations by allowing one government authority to overrule the prior commitment of another government authority, to the detriment of individuals; and
• it requires such overruling to have retrospective effect.
To extend application of this to areas where there is already uncertainty about interpretation of the law is to compound existing wrongs. Whenever a tax ruling is issued, there would be the possibility that the Commission subsequently argues in favour of a different interpretation of the law, and demands retrospective adjustment of tax liabilities. Apart from violating the rule of law, this destroys the purpose of rulings: to reduce uncertainty.
In areas which make use of tax rulings because of inherent ambiguities in the law, such as transfer pricing, it seems a priori implausible that one could in general demonstrate selectivity (i.e. preferential treatment) with sufficient confidence. Tax rulings are typically aimed at complex, idiosyncratic situations, making comparison difficult if not impossible.
If one had a number of tax rulings issued by a member state, to multinationals with similar corporate structures, and one of the rulings differed significantly from the others, it might be possible to argue that preferential treatment had been given. But this is rarely the case in practice.
Apple/Ireland: massive tax avoidance?
Much of the publicity about the Apple/Ireland case has focused on the allegation that Apple avoided tax, using an esoteric corporate structure. This structure, combined with a profit allocation mechanism endorsed by Irish tax rulings, meant (in the words of the Financial Times) that
almost all profit was allocated to a “head office” which had no employees or premises and existed only on paper.
Since the head office was regarded as non-resident for Irish tax purposes, the effect was to shelter a significant proportion of Apple’s profits from Irish corporate tax. The head office was in fact not tax-resident in any jurisdiction, so its profits escaped corporate taxes altogether — at least temporarily, while they are parked offshore. “Temporarily” because such profits will no doubt eventually be repatriated, at which point they are likely to be subject to taxation by the USA or some other jurisdiction, a point that is usually omitted in discussions.
If the FT is correct then Apple avoided billions in Irish tax by means of a highly artificial legal structure. This kind of avoidance is banned by some jurisdictions, though in Ireland it appears to have been legal.
For many commentators, the idea that Apple avoided tax seems to be the main or only point at issue.
However, in civilised countries the mere fact that something is regarded as unacceptable by a large number of people is not sufficient to render it unlawful. The rule of law requires that there be specific legislation against an action if that action is to be held illegal. It also requires that the legislation was already in place at the time of the action, i.e. that the law is not applied retrospectively.
The question whether Apple avoided tax is, in itself, irrelevant in deciding whether EU law was breached. The correct question is: was there a “sweetheart” deal, as has been alleged; in other words, was Apple offered a specially favourable deal, one not offered to companies in general?
The primary criterion for a tax provision to be identified as state aid is that it must be “selective”, i.e. it must give a special tax advantage to the company or companies supposedly receiving aid.
By contrast, a member state could decide to introduce a general corporate tax rate of only 5 percent (significantly lower than the average EU rate of about 20 percent), an action which would prima facie represent a more serious distortion of European competition than merely offering a low rate to one particular company. Equally, a member state could permit companies to shelter their profits from tax altogether. Provided the tax regime does not discriminate between different companies, there is no “aid” in either case.
What then is the EC’s argument that the Apple/Ireland scenario is state aid? There is no clue in the Commission’s Press Release on the case. The latter merely seems to imply that permitting tax avoidance schemes automatically entails state aid because it means companies that make use of them pay “less tax” than those who do not:
[We] concluded that the tax rulings issued by Ireland endorsed an artificial allocation of Apple Sales International and Apple Operations Europe’s sales profits to their “head offices”, where they were not taxed. As a result, the tax rulings enabled Apple to pay substantially less tax than other companies [...]
If Apple’s corporate structure allowed it to legally shelter profits from Irish tax, and other companies could in principle do the same, this is not state aid. Was the Commission able to substantiate its claim of a connection between “less tax” and selectivity? Let us turn to the published Decision.
An obvious starting point would be to look at other tax rulings on transfer pricing, or profit allocation, granted by Ireland to multinational companies. The Commission did indeed request, and receive, a sizeable sample of other rulings issued by the Irish Revenue. To test the claim of selectivity, one could look at whether the rulings showed a pattern in which the majority were similar, while Apple’s deviated significantly in favour of the taxpayer.
This test appears to have yielded a negative result. The EC’s main comment on the rulings is to note their heterogeneity and apparent haphazardness, complaining that “the choice of methods is not systematic”.
An impartial investigator might have considered the possibility that the rulings’ heterogeneity arose from the difficulties inherent in transfer pricing, implying a corresponding difficulty of establishing selectivity. For the Commission, they are evidence of “discretion”, which they say is a bad sign because it creates a presumption of selectivity. This argument makes little sense in an area like transfer pricing, where discretion is unavoidable.
To support a claim of selectivity, it is normally necessary to consider whether a tax measure deviates from what is referred to as the “reference system”, i.e the tax regime applying to companies generally. The Commission notes that the Irish Revenue’s tax ruling practice
is too inconsistent to constitute an appropriate reference system against which the contested tax rulings could be examined for determining whether [Apple companies] received a selective advantage as a result of the rulings.
A prudent and impartial Commission might have concluded that the difficulty of ascertaining the “reference system” as a basis for making comparisons was a good reason for not pursuing the issue in this case. A Commission determined to win its case, however, is not so easily deflected.
One source of comparable data for Apple’s transfer pricing seems to have been ignored by the Commission, unless they considered it best not to mention it. Apple’s tax scheme is remarkably similar to the “Double Irish” arrangement, a tax minimisation device apparently used by a number of US multinationals, including (allegedly) Facebook, Google, IBM and Microsoft.
It seems reasonable to suppose, based on the information publicly available, that it was Irish tax policy to permit the Double Irish for any multinational group that sought to avail itself of it. It is odd that this source of data for settling the question of selectivity — potentially pointing to the answer that the Apple rulings were not anomalous, but reflected standard practice — is not mentioned in the EC Decision. It is difficult to imagine that Commission investigators were not aware of it.
The EC’s trick
Judging by the published text of the Decision, the EC’s attempts to find hard evidence of selectivity proved unsuccessful.
Instead, its case against Apple/Ireland rests on a piece of legal creativity, a kind of trick. The EC asserts that any deviation from the arm’s length principle automatically violates the state aid rules, even if there is no requirement in national tax law to apply the principle. In other words, regardless of the transfer pricing of other companies, if in any single case it can be argued that a transfer price accepted by a tax authority was not arm’s length, then this is a prima facie instance of state aid. (See Note 2 below for an explanation of the supposed logic behind this argument.)
The EC then tries to demonstrate that Apple’s profit allocation method did not comply with the arm’s length principle. Their arguments in this respect seem persuasive. On the other hand, so do Apple’s and Ireland’s counterarguments. Given that neither side shows much sign of impartiality, the ‘right’ answer may be somewhere between the two extremes. Where precisely may be a meaningless question, given the inherent indeterminacy of the arm’s length concept.
The merit of the original solution to Apple’s transfer pricing problem is that it was agreed by the Irish tax authority — the first port of call — and gave a degree of certainty to both sides.
Revisiting the problem retrospectively, with a view to a different answer, not only violates Apple’s legitimate expectations. It creates a precedent which generates uncertainty for all multinational companies into the indefinite future — not just in relation to Ireland, but EU-wide. On the other side of the ledger, the revisiting seems unlikely to have significant benefits for competition, though it may reduce the future incidence of tax avoidance.
The implications of accepting the EC’s trick argument are potentially enormous. Jurisdiction over transfer pricing will effectively move out of the hands of national tax authorities, and over to the competition division of the Commission. In future, whenever the Commission becomes aware of a company’s transfer pricing methodology, it can demand information about it, announce that the arm’s length rule produces a different answer from that endorsed by the tax authority, and demand a retrospective increase in the company’s past tax bills. No comparison with other transfer prices endorsed by the tax authority will be required to substantiate the claim of selectivity.
Carrying this development to its logical conclusion, the Commission could become a kind of substitute revenue authority for member states. The Irish Revenue, and analogous bodies in other member states, would be relegated to the role of preliminary adviser. They may give provisional agreement to companies’ tax calculations, but real approval could only be given by the Commission, and only when it investigates a case, years later. It would not be possible to request an advance ruling from the Commission as there is no procedure for doing so.
The EC’s innovative trick solution to the problem of establishing selectivity, without having to refer to the transfer prices of other companies, can be admired as a clever device. An ambitious lawyer or economic consultant could be proud of it. As a strategy adopted by what is effectively the European government, it is highly questionable, for two main reasons.
First, it creatively and unexpectedly extends the application of state aid law. If this unexpected adaptation of the law is to be considered valid at all it should only be prospectively, not retrospectively as in the Apple case.
Second, even as a prospective development it seems extremely dubious. The need to make a comparison with a hypothetical outcome (“what would have happened if the parties had been unconnected?”) means applying the law to an area where there may be no basis at all for generating a reliably correct answer. Where two jurisdictional agencies — a national tax authority, and the Commission’s competition division — are in potential conflict over the law, entering into such an ambiguous area not only falls foul of legal certainty, it raises the potential for endless legal wrangling.
Trying to apply the arm’s length rule is a little like asking “what would have happened if the companies had been based on Mars instead of Earth?” It may be unavoidable to have one judicial sphere that has to determine the answer to such questions. Two potentially conflicting judicial spheres, each with a right to determine the answer, is likely to create havoc and is hardly efficient.
Bringing the law into disrepute
Reviewing the wording of past EC decisions, and of judgments issued by the European Court of Justice, one gets the impression that both bodies, while working hard to appear fair and impartial, have a covert agenda which is — at least on occasion — allowed to override the fair-and-impartial objective. This is certainly the impression given by the Decision on Apple/Ireland, which shows clear signs of being tainted by prosecutorial bias, and seems at least partially driven by the desire to establish a precedent that will allow the EC to clamp down on tax avoidance using state aid law.
The EU state’s covert agenda may seem laudable, depending on one’s viewpoint. It may derive from the drive to full European integration, a goal which some consider desirable while others do not. Specific applications of the agenda, for example tax harmonisation, or Europe-wide prevention of tax avoidance, may seem less controversial, from the point of view of attaining the idealised goal of the “single market”.
Regardless of the underlying intentions, when an influential government or supreme court changes the law without having a mandate to do so, and engages in judicial activism, the rule of law is undermined. Furthermore, to the extent the activism is tolerated, the character of law generally is liable to change, not just in the local jurisdiction but globally. This is perhaps particularly the case if the activism is hidden behind a veneer of neutrality.
If big-league governments and courts are subliminally perceived to be behaving opportunistically, attitudes to the law are liable to be shifted — in the direction of favouring expediency over principle, thus weakening the rule of law still further.
A double act
One means by which EU jurisdictional expansion can be achieved surreptitiously is if the Commission claims that an extension of the law has already been legitimated and is therefore not an extension at all.
If the Commission can refer to an ECJ decision which supposedly shows the Court endorsing the principle behind an extension, then — provided no one scrutinises the logic of this too closely — it will seem like the Commission is merely following the Court, not creating new law. All that is needed to ‘seal the deal’ is subsequent confirmation by the Court when a case in which the extension is employed goes to appeal. Once the Court has approved the extension explicitly (which, given the track record of EC/ECJ cases, is likely), EU law will effectively have been changed. A new principle or application will have been established by precedent, and is unlikely ever to be reversed, given that the ECJ is hardly likely to overrule itself.
The Apple case will generate an interesting test of this thesis as it provides a potential illustration of it. The Commission would like to claim that the argument they use to import the arm’s length principle into state aid law (what I called the “trick argument” above) derives legitimacy from having been formulated by the ECJ itself, in a case from 2006 involving Belgium, though the basis for this claim is weak. (See Note 3 below.) It will be interesting to see whether the ECJ endorses the claim when it pronounces on the Apple case, possibly later this year.
Federalisation: overt or covert
Whether the EU is moving towards federalism, and whether this is desirable, has been one of the most debated political issues of the past fifty years.
The European Community started life as a confederacy, i.e. a loose federation of states in which the supranational authority was viewed as having a limited mandate and limited autonomy. Many of the key figures associated with its development, however, have favoured a federalist model, and there is little doubt that it has been gradually moving in this direction. The meaning of the term “federalism” is disputed, but may be understood as a system in which — as in Germany and the USA — the greater share of political and legal power rests with the central government and not with member states.
It has been argued, including by those opposed to federalism, that a federal EU is unavoidable because a confederacy is a relatively inefficient system, particularly once there is a unified currency. If this argument is correct, member states appear to have two main options for the future: help to accelerate the move towards full federalism, or leave the Union.
Many of Europe’s citizens would like to see deeper integration. Many others are opposed to it. This conflict in preferences needs to be resolved by democratic means. That in turn requires (a) the electorate being given full information about the options, (b) politicians being willing to put the preferences of the electorate above their own. It also requires any moves towards deeper integration to be conducted in a clearly visible and transparent manner.
The speed of progress from confederacy to federalism is highly sensitive to whether changes in policy require unanimous agreement by member states or mere majority voting.
The unanimity requirement has often been regarded, by those who favour European integration, as an unnecessary hindrance to progress. The list of EU policy areas in which unanimity is required has grown dramatically shorter with time, as more and more issues have been switched to qualified majority voting. However, taxation is still on the unanimity list.
Faced with the difficulty of obtaining unanimous agreement to changes in taxation policy, the EU state appears to be resorting to back-door methods. These include exploiting the ambiguity of existing laws to the full, or resorting to novel legal arguments. Such methods appear only to require a single endorsement by the European Court of Justice to be subsequently regarded as irreversibly binding.
Fuller integration is a goal many in the EU consider desirable. Movement towards this involves the transfer of powers from member states to the EU state. Such transfers must be authorised by prior member state approval. Authorisation should be explicit and unambiguous, and should limit itself clearly to a specified area.
Movement towards fuller integration is impeded by the bureaucratic processes involved in obtaining such authorisation, and the fact that member states may be resistant to surrendering their powers in certain areas. Taxation in particular is an area where the concept of member state sovereignty still holds sway.
Faced with the difficulties of progressing the EU project, including the time delays involved, those at the highest levels of the EU state may be tempted to push their existing powers as far as they can be made to go. At the margins, this can mean things such as:
• applying a law to areas that were not envisaged when member states signed up to it;
• interpreting ambiguities in the law creatively and in a partisan manner;
• overriding legal principles such as legal certainty;
• redefining concepts such as legitimate expectations in a biased way.
These methods may aid progress towards integration, but at the cost of undermining the rule of law.
There are at least two reasons why the European Commission should use the law with more caution than national jurisdictions, rather than less. First, the EU proclaims support for the rule of law to be among its key values. It has recently decided to sanction Hungary for alleged failings in this area. For its support to be effective, it must ensure that its own actions cannot be accused of deficiencies in this respect.
Second, when a national jurisdiction threatens to deviate from generally accepted legal principles, there is usually an abundance of journalists, experts and commentators ready to cry foul. In relation to the EU, by contrast, there is a relative dearth of critical reporting and commentary. For purposes of democratic accountability, public domain discussion and analysis are arguably at least as important as citizens’ supposed control via the European Parliament.
When the US President proposes to appoint a Supreme Court judge with conservative leanings, the entire global commentariat pores over the issues at stake. When the European Commission proposes to extend state aid law to cover tax avoidance, few eyebrows are raised. Rather than exploiting this relative lack of scrutiny, the EU should consider it a reason to avoid using the law in any way that is potentially controversial.
In particular, the European Commission should refrain from using its powers to overturn rulings that provide an interpretation of national law, since this destroys the purpose of such rulings — to provide certainty and facilitate forward planning.
The charade of a supreme court supposedly interpreting the law impartially, while providing de facto assistance with the EU’s political agenda, should be abandoned. Even if the ECJ occasionally rejects the Commission’s findings, the Court’s tacit complicity in the process of competence creep means the legitimacy it ostensibly confers on the EU state is largely spurious.
Accepting the latest creative extension of state aid law implicit in the Commission’s Apple/Ireland decision will create uncertainty for companies in relation to their tax liabilities which is likely to have negative repercussions for European economic activity. It will also create uncertainty in a wider sense, in relation both to the EU and globally. With regard to the EU, it will reinforce the notions that the Commission may:
a) unexpectedly use innovative methods to extend the application of law, and with retrospective effects;
b) intrude into relatively subjective areas such as transfer pricing.
In a global context, it will reinforce the notions that:
a) it is acceptable for government to be creative in interpreting the law;
b) it is acceptable to violate the rule of law, provided the ends are justifiable.
A European Union that wished to give genuine weight to the principles of legal certainty and legitimate expectations — as opposed to paying them mere lip service — would need to do one of three things in relation to state aid:
• take over the taxation policy of member states altogether, so that it was clear that authority in matters of tax rested with the EC, not with national courts (this would currently require the unanimous consent of member states); or
• change the remedy for breach of state aid law, from (a) repayment of aid by recipients to (b) penalties payable by member state governments; or
• cease applying the state aid rules to taxation.
Ireland was right to appeal against the Commission’s order to collect €13 billion of additional tax from Apple. In doing so, it is taking a financial risk but sticking up for the rule of law.
EU Commissioner for economic and tax affairs, Pierre Moscovici, described Ireland’s decision to appeal as “strange”.
It is a strange decision, in a way, to say ĎI donít want your €13 billioní when you could have some social programmes or economic programmes in a country that has been damaged by a crisis, but thatís their own will.
Mr Moscovici also said that the EC is “a political commission with a political will, and this political will is clearly to fight [...] aggressive tax planning”.
If Commissioners had more respect for the rule of law, the EC might itself refrain from using the law aggressively, and from undermining long-established legal principles such as legitimate expectations and no‑retrospection.
The writer has worked in transfer pricing and international tax.
© Fabian Tassano
published 28 October 2018
1. EC Decision: Commission Decision of 30.8.2016 on State aid implemented by Ireland to Apple. Quotations are from paragraphs 383 and 397.
2. The EC’s “trick argument” goes as follows. If a tax authority fails to apply the arm’s length rule properly, and permits (say) a multinational manufacturing company to charge too low a transfer price to its overseas subsidiary, then this constitutes state aid even if the tax authority applies the same treatment to all other multinational manufacturers. This is (the EC argues) because permitting it puts that manufacturer in a better position than rival manufacturers that sell their products to unconnected customers. But doesn’t charging too low a price make the manufacturing company worse off? The argument goes: although the company’s profits are lower, so is its tax bill; hence it is made ‘better off’ by the actions of the tax authority, compared to non-multinational companies.
The argument is highly abstract. Perhaps the Commission hopes that its opaqueness will deter potential critics. The logic, however, is flawed. For purposes of establishing selectivity, we should compare like with like. We should therefore be comparing a stand-alone manufacturer with the manufacturing company that is part of a multinational group, and not with the group as a whole. What is the effect on that company of a member state permitting a relatively low transfer price, compared to a higher price? In terms of net financial effect on the company, it makes the company worse off, not better.
3. According to the Commission (Ireland/Apple Decision paragraph 251), in the 2006 case of Belgium and Forum 187 v Commission the ECJ “accepted”
that a tax measure which results in an integrated group company charging transfer prices that do not reflect those which would be charged in conditions of free competition [...] confers a selective advantage on that company [...]
However, as KPMG tax specialist Han Verhagen among others has pointed out, in the Belgium case the Court invoked the arm’s length principle when reviewing a set of circumstances quite different from the usual transfer pricing scenario. The Court had been asked to consider the validity of a profit calculation formula applicable only to special companies called “coordination centres”. The Court argued that in coming up with a formula, Belgium should have had regard for the way company profits are normally calculated, i.e. by subtracting total costs from total revenues. Belgium allegedly failed to do so, rendering the formula it employed artificial and inappropriate. It was in that context that the Court complained that “the transfer prices do not resemble those which would be charged in conditions of free competition”.
For the Commission to jump from (a) this single oblique allusion to the arm’s length principle in an unusual set of circumstances, to (b) the thesis that the Court established a requirement for all transfer prices to be arm’s length, seems like legal creativity at its finest.
The Commission used the same argument in its 2016 ‘Notice on the notion of State aid’, which predated the Apple decision.
4. Re separation of powers. The Roman Republic provides an early example, power being split between Assemblies, Senate and magistrates. The modern version of the concept is usually attributed to Montesquieu’s The Spirit of the Laws and Locke’s Two Treatises of Government.
5. Re the creation of a governmental entity along with the ECJ. From 1952 to 1957 the entity in question was the High Authority of the European Coal and Steel Community, which in 1957 became the Commission of the European Economic Community, later the Commission of the European Communities, and finally the European Commission.
6. Re tax rulings on transfer pricing. These are often referred to as Advance Pricing Agreements (APAs). APAs have had a somewhat tarnished image since the “Lux Leaks” in 2014. Leaked documents allegedly revealed that the Luxembourg tax authorities had been using APAs to rubber-stamp complex tax avoidance schemes, designed to keep profits in Luxembourg, where they were liable to a low rate of tax. APAs may sometimes be exploited by low-tax jurisdictions to facilitate profit shifting, but they are more typically used for purposes of long-term business planning.
7. Re Apple and the Double Irish. Apple’s corporate structure in Ireland appears to have differed in one respect from the standard Double Irish structure. Instead of using two companies, Apple used a single company which was deemed split into (a) tax-resident branch and (b) non-resident head office. The EC Decision spends some time arguing (not in relation to the Double Irish question but a different issue) that a branch has to be treated differently than a company. It is doubtful whether this is correct in a transfer pricing context, where one generally has to treat a branch as if it were a distinct legal entity. However, even if using one company rather than two affects the net outcome, to omit any mention of the Double Irish in the Decision seems negligent.
My references above to a company with a branch/head-office structure should be understood as applying to two Apple companies: Apple Sales International and Apple Operations Europe. The Decision argues in the case of each company that the rights to the intellectual property used should have been allocated to the branch rather than the head office.
8. Re selectivity, and whether a tax provision gives favourable treatment to one or more businesses. There is a good deal of debate in the state aid literature on a supposed distinction between selective and advantage. It has become standard practice to apply a four-pronged test to determine the presence of state aid, of which these two criteria (whether the provision grants an advantage, and whether the advantage is selective) are regarded as distinct prongs. Confusingly, these two prongs are said to be “collapsed” in some cases (including the Apple/Ireland decision) into a single test of advantage.
The courts may consider the advantage/selective distinction helpful, but I respectfully suggest that for non-lawyers it is an unnecessary abstraction. The key question in assessing potential state aid is (or should be) straightforward: can one or more businesses be shown to be receiving favourable treatment, relative to other businesses in a “comparable legal and factual position”? If yes, there is prima facie state aid; if no, there is not.
9. Re transfer pricing being an area where a wide range of answers may be ‘correct’, and where it is therefore inadvisable to have two competing jurisdictional authorities. On the Apple case, at least two tax specialists have radically disagreed with the EC Decision. Pascal Saint-Amans, head of tax policy at the OECD and architect of the Base Erosion and Profit Shifting project, argues that in transfer pricing terms, “the bulk of [Apple’s] profit clearly belongs to the United States”. The head of international tax at law firm Sullivan & Worcester has commented that “the Commission’s decision that half the profits of the global Apple group belong in Ireland defies logic” (see Baker Tilly Insights, March 2017).
10. Re dearth of critical reporting on EU affairs. A notable exception is EUobserver.
11. For a defence by the EC against the accusation that its approach to competition cases is biased, and the claim that the approach used by other jurisdictions is no better, see for example here.
As a supranational body, the EC should surely have higher standards than individual nations.
12. Re the lack of impartiality of the ECJ. It could be argued that the EU state as a whole, and the ECJ in particular, have been given an implicit mandate to engage in judicial activism in order to achieve the long-term EU project. Andreas Grimmel, for example, has produced an apologia along these lines.
Any such mandate, if not to be regarded as merely theoretical, would have been given before many current EU citizens were born. From the point of view of the present, the systematic departure by the ECJ from judicial norms would require a new mandate, and a clear admission of the limits on the Court’s impartiality which that would imply.
13. There is a popular theory that the EU is run by Germany and/or France. Possibly it is dominated by a coalition of individuals having disproportionately German or French nationality, but the idea that the EU state is controlled by a subgroup of nations seems outdated.
A highly critical review of the EC’s approach to fiscal state aid by Germany’s Ministry of Finance pleads for restraint, referring somewhat hopefully to a “mutual understanding among member states [not to] distort trade” — rather as though the EU were still little more than a civilised club of countries.
However, the EU state has moved well past the stage of acting simply as supervisory authority. It is now a fully fledged state in its own right, with its own agenda and the power to order individual countries to change their behaviour; it is probably beyond control by any subgroup of nations, let alone any one nation.
14. Re the EC competition division’s history of prosecutorial bias. With regard to its 2009 case against Intel, for example, the Commission was accused of ignoring evidence from a meeting with an executive from Dell Inc. which might have weakened its case. The European Ombudsman found maladministration, on the grounds that the Commission “did not make a proper note of that meeting and that its investigation file did not include the agenda of the meeting”.
15. In their Decision, the Commission cites the ECJ from a 2013 case which supposedly established that the use of discretion by an authority creates a presumption of selectivity. In this case (C-16 P Oy), the Court held that:
[If] the competent authorities have a broad discretion to determine the beneficiaries or the conditions under which the financial assistance is provided [...] the exercise of that discretion must then be regarded as favouring [certain undertakings] in comparison with others [...]However, it is unlikely that the learned judge who asserted this was thinking of the type of discretion required when considering a company’s transfer pricing.
Damian Chalmers, ‘The European Court of Justice is now little more than a rubber stamp for the EU’, Europp Blog, London School of Economics, 8 March 2012
Andreas Grimmel, ‘The Court of Justice of the EU and the myth of judicial activism in the foundational period of integration through law’, European Journal of Legal Studies, Winter 2014, pp.56-76
Jean-Michel Josselin and Alain Marciano, ‘How the court made a federation of the EU’, Review of International Organizations, March 2007, pp.59-75
Han Verhagen, ‘State aid and tax rulings — an assessment of the selectivity criterion of Article 107(1) of the TFEU in relation to recent Commission transfer pricing decisions’, European Taxation, vol.57, 2017, pp.279-287
Tax benefits and EU state aid control, Federal Ministry of Finance, Germany, October 2017
‘Prosecutor, judge and jury’, The Economist, 18 February 2010
‘Apple tax deal: how it worked and what the EU ruling means’, Financial Times, 30 August 2016
‘Irish appeal of Apple ruling a “strange decision” says Moscovici’, Irish Times, 9 September 2016