State aid and its characteristics

State aid is a concept that is defined within European competition law, and it is aimed at preserving a level playing field for businesses across the Internal Market of the European Union (EU). State aid is defined as any form of public measure (action by a member state) that satisfies a particular set of criterions. For a public measure to be deemed state aid, and hence illegal and incompatible with the internal market, the public measure must involve a transfer of state resources from the public body to an undertaking. An undertaking is defined as any form of enterprise engaged in economic activity.

Specifically for a public measure to be deemed State aid and hence, illegal under European Union law, the measure needs to satisfy all of the following five criteria:

• The measure must involve the use of state resources.
• The measure must confer an advantage to the undertaking.
• The advantage must be selective.
• The measure must distort competition.
• The measure must affect trade between member states.

In connection with transfer pricing, state aid usually comes up in the form of tax rulings that have been provided by national tax authorities of EU member states. These tax rulings permit transfer pricing arrangements that do not conform to the arm’s length principle or in effect confer a selective advantage on to the recipient undertaking.

Luxembourg v commission and Fiat Chrysler Finance Europe v Commission

Commission decision and facts

The European Commission concluded in 2015 that Luxembourg had granted selective tax advantage to one of Fiat’s European group companies. This selective advantage was in the form of a tax ruling that was issued by the Luxembourg tax authorities to one of Fiat’s European group companies. This tax ruling (referred to as further as the contested tax ruling) endorsed the use of a transfer pricing arrangement that artificial reduction this Fiat subsidiary’s tax liability.

Tax rulings, in general, are not illegal and are provided by national tax authorities to provide assurances to enterprises surrounding the application of tax laws. The tax ruling in question was provided by the Luxembourg tax authority to Fiat Chrysler Finance Europe (FFT) on September 03, 2012.

FFT, as the commission explained was a key component of Fiat’s global structure and functioned as the centralized financing and treasury arm for Fiat. FFT was providing intercompany loans to other Fiat group companies located in other countries. The commission’s decision was based on how the contested tax ruling endorsed the use of a transfer pricing arrangement which determined the remuneration due to FFT for the role it played within Fiat and the risks it bore. The remuneration due to FFT according to the transfer pricing arrangement was established using the Transactional Net Margin Method (TNMM) and was based on the remuneration rate (rate of return) applied to the amount of the capital given out to other Fiat group entities. The European Commissions’ challenged the TP arrangement by highlighting that an arm’s length transfer pricing arrangement would ensure FFT’s taxable profits are determined similar to how a bank’s taxable profits are determined; it noted that the TP arrangement in question did not do that and hence the remunerations earned by FFT were not arm’s length. Specifically, the European Commission’s concerns can be laid out as follows:

1. The use of the Transactional Net Margin Method (TNMM) – The European commission contested here that the Comparable Uncontrolled Price (CUP) TP method was a more appropriate method to use in determining the fair market value of the remuneration due to FFT since it allows for the determination of the arm’s length value of transactions entered into between associated enterprises.
2. Non-arm’s length remunerations – According to the TP arrangement, the remunerations due to FFT were a function of the following:
   1. The total loaned amount is given out by FFT (Capital at risk).
   1. The comparable market rate of return on the loaned amount FFT were to earn was it to provide these loans to market participants in recognition of its return on equity as well as for the risk it bore.

The European Commission stated that the transfer pricing arrangement used an amount for the equity at risk that didn’t encompass the total population of the monies loaned out by FFT to Fiat’s group entities. Additionally, the European Commission concluded that the rate of return applied to this already understated capital at risk was lower than the market rate that FFT would have been able to earn was it to engage in similar transactions with arm’s length market participants.

Decision challenges and the Court’s judgment

Both FFT and the Grand Duchy of Luxembourg brought an action before the General Court of the European Union for the annulment of the commission’s decision. The action was based on the following facets of the commission’s decision:

1. The commissions analysis was tax harmonization in disguise – The courts, however, ruled that the commission’s analysis was simply an analysis performed to determine if the rules on state aid were compiled with, (i.e. whether or not the tax ruling at hand conferred a selective advantage on the beneficiary), and therefore, this was not tax harmonization in disguise.  
2. Contrary to the Commission’s conclusion, the contested tax ruling did not confer state aid on the beneficiary undertaking – The Court concluded that:
   1. The application of the Transactional net margin method was inappropriate
   1. The TP arrangement (when attempting to calculate FFT’s remuneration on its treasury and financing function) did not take into account the whole of FFT’s capital at risk.
   1. The rate of return applied under the TP arrangement on this capital at risk was below the rate that FFT would have expected to earn under an arm’s length transactions.

The Court argued that by virtue of issuing the tax ruling endorsing the TP arrangement, the national tax authority of Luxembourg conferred an advantage on FFT. The court also established that this advantage was selective by the very nature that it was endorsed by way of a tax ruling provided specifically to Fiat. The Court also rejected Fiat’s and Luxembourg’s statement that the commission failed to establish that there was a restriction on competition.

Therefore, the court aired on the side of the Commission and concluded this contested tax ruling was a state aid issued by the national tax authority of Luxembourg and hence was not compatible with the internal market of the EU.

Netherlands v commission and Starbucks and Starbucks Manufacturing EMEA v Commission

Commission decision and facts

In 2015, The European Commission released its decision in connection with a contested advanced pricing arrangement (contested APA referred to as in the future) that was provided by the Dutch tax authority to Starbucks Manufacturing EMEA BV (SMBV) in 2008. The contested APA allowed for Starbucks to reduce its tax burden by €20 – €30 million and in effect conferred an advantage on Starbucks, something that was incompatible with the internal market.

SMBV is the only coffee roasting company in the Starbucks group in Europe. It sells and distributes roasted coffee and coffee-related products (e.g. cups, packaged food, pastries) to Starbucks outlets in Europe, the Middle East, and Africa.

The Commission’s claim of a reduction in tax burden was grounded on the following aspects of the contested APA:

1. SMBV pays a substantial royalty to a UK based Starbucks entity for the IP related to the coffee roasting know-how. This royalty reduces the taxable profits of SMBV and transfers it over to Alki, which is not subject to UK or Dutch tax. The Commission contended that the royalty did not exhibit arm’s length principles, specifically citing the following:
   1. SMBV does not appear to gain any business advantage from the use of intellectual property in the area of roasting coffee. An independent company, the commission argued, would not pay for such a royalty if it were not able to earn the royalties back. Therefore, SMBV should not have been making royalty payments to Alki since it does not reflect market value.
   1. The royalties were not required to be paid by any of the other Starbucks groups of companies nor were they required to be paid by other independent roasters to whom the roasting process had been outsourced by Starbucks. Therefore, this specific royalty arrangement between Alki and SMBV was not arm’s length.
   1. The commission indicated that instead of using the Transactional Net Margin Method (TNMM), the Comparable Uncontrolled Price method was a more appropriate method to be used. Additionally, it concluded that had Starbucks used the CUP method, the royalty amount payable by SMBV to Alki would have been equal to €0.

• SMBV pays an inflated price for green coffee beans it purchases from Switzerland-based Starbucks coffee trading SARL (SCTC referred to as in the future). The commission contends that:
  • The inflated price of the coffee beans eroded SMBV’s taxable profit base (especially considering that the margin on these green coffee beans more than tripled since 2011). Moreover, the commission argued that the increased mark-up can be connected directly to the losses incurred by SMBV’s coffee roasting activities since 2010, which highlights the non-arm’s length relationship of this mark-up.
  • Additionally, the commission also argued that Starbucks by way of incurring operating losses from its roasting activities, transferred to Alki (by way of the substantial royalty) SMBV’s profit generated from the sales of coffee-related products (cups, packaged food and pastries) to Starbucks group of companies in Europe, the Middle East and Africa.  

Decision challenges and the Court’s judgment

Both the Dutch government and Starbucks brought an action before the General Court of the European Union for the annulment of the Commission’s decision. The challenge was based upon the following aspects of the Commission’s decision:

1. The appropriateness of the use of TNMM
   1. The Dutch tax authority claimed that the application of the TNMM was accurate given the circumstances of Starbucks since TNMM requires a member of multinational enterprises to be treated as independently operating national enterprises. Additionally, TNMM enables profits to be taxed where the value is created, and since the Intellectual property or the know-how of the coffee roasting process was owned by Alki, the royalty was justified. The Dutch Tax authority concluded that the use of the CUP method was not suitable because of the absence of comparable data to the situation of Starbucks’ operation and value-creating activities and assets.
   1. The Courts in this situation concluded that the commission had failed to demonstrate that the level of the royalty should have been zero or that it resulted in an advantage within the meaning of the Treaty.
2. Price of the green beans
   1. The General Court of the European Union concluded on this by stating that the price of the coffee beans was outside the scope of the contested APA and also that the commission had not able to demonstrate the existence of an advantage given to Starbucks.