May 24, 2021
EU General Court annuls Commission's decision on Luxembourg transfer pricing state aid case
On May 12, 2021, in Luxembourg v. Commission, the General Court of the European Union (Court) found that the European Commission (Commission) erred in concluding that a Luxembourg company of a multinational group (MNC) had received illegal state aid and therefore had to pay €250 million plus interest to Luxembourg (consisting of the tax benefit that the taxpayer received between 2006 and 2014, when the company changed its operating structure).1 According to the Court, the Commission failed to prove that a transfer pricing methodology, which had been endorsed in a tax ruling, resulted in an undue reduction of the Luxembourg company's tax burden, amounting to state aid.
The decision provides important clarifications regarding the Commission's burden of proof in establishing state aid in the context of the application of transfer pricing rules.
The decision may be appealed to the Court of Justice of the European Union (EU).
The case focuses on two Luxembourg entities of Amazon.com, Inc. (the MNC). LuxOpCo (the Operating Company) is a capital company incorporated and residing in Luxembourg. It is in charge of the MNC's retail business in Europe. It is wholly owned by LuxSCS (the Holding Company), a Luxembourg limited partnership. LuxSCS held the intangible assets for the group in Europe through a cost-sharing arrangement (CSA) with a US group company. LuxOpCo paid royalties to LuxSCS for the right to use the intangible assets under an irrevocable exclusive license. Based on Luxembourg tax law, the Holding Company, being a limited partnership, was not subject to tax in Luxembourg, as partnership profits are taxable at the level of the partners, who in this case were US tax residents. The Operating Company was subject to Luxembourg taxes.
In 2003, the Luxembourg tax authorities confirmed in a tax ruling that LuxSCS was not subject to Luxembourg corporate income tax and endorsed the transactional net margin method (TNMM) as the method of calculating the annual royalty to be paid by LuxOpCo to LuxSCS, using LuxOpCo as the "tested party." The tested party is generally the least complex of the controlled parties, and the controlled party for which reliable data on uncontrolled comparables can be located.
In October 2014, the Commission launched a state aid investigation that concluded in 2017. The Commission found the tax ruling, as well as its annual implementation (acceptance of tax returns), from 2006—2014 constituted state aid under Article 107 TFEU, which is incompatible with the internal market.2 On the issue of an advantage, the Commission argued that the royalty paid by LuxOpCo to LuxSCS did not correspond to market conditions and had the effect of reducing LuxOpCo's taxable basis.
Luxembourg and the MNC appealed the decision. The Court annulled the Commission's decision and concluded that the Commission based its 2017 decision on a flawed assessment.
In annulling the Commission's decision, the Court found that the Commission's main finding that LuxOpCo's tax burden was artificially reduced as a result of overpricing the royalties was based on an incorrect transfer pricing analysis. The Court stated that the mere finding of methodological errors in the transfer pricing analysis cannot lead to the automatic conclusion that tax liability was reduced and resulted in a selective advantage.
Incorrect transfer pricing analysis
The Court based its finding that the Commission's analysis was incorrect on three reasons.
First, according to the Court, the Commission did not establish that the Luxembourg tax authorities erred in choosing LuxOpCo as the tested party. In support of its conclusion, the Court said the Commission was incorrect in finding that LuxSCS was "merely a passive holder of the intangible assets" because the Commission did not properly consider all of LuxSCS's functions.
Referring to the 1995 version of the OECD Guidelines, the Court rejected the distinction between "active" and "passive" functions made by the Commission. The Court found LuxSCS contributed to the development of the intangibles by making financial contributions under the CSA. The Court elaborated that it is not apparent from the 1995 version of the OECD Guidelines that financial participation in a CSA cannot be considered genuine participation in the development of assets. Conversely, a financial contribution to such a CSA may indeed be a valid and valuable contribution and sometimes may be the sole enabler of the (commercial) success of the transaction. The fact that LuxSCS made the intangible asset available to the LuxOpCo by granting the license in itself constitutes exploitation of the intangible. The Court also disagreed with the Commission's view that all risks had been transferred to LuxOpCo, finding that LuxSCS bore the risks associated with the ownership and development of the intangible assets, including the financial risks associated with the exploitation of those intangible assets.
In view of these functions, the Court concluded that LuxSCS cannot be regarded as the less-complex entity, so LuxSCS cannot be the tested party for the application of the TNMM. The Commission had not demonstrated that it was easier to find undertakings comparable to LuxSCS than undertakings comparable to LuxOpCo, or that choosing LuxSCS as the tested entity would have made it possible to obtain more reliable comparison data.
Second, even if the royalty should have been calculated using LuxSCS as the tested party, the Commission should have taken into account the increase in value of the intangible assets resulting from the CSA.
Third, the functions necessary to maintain the intangible assets should not have been treated as supplying "low value adding" services; thus, the Commission underestimated the value of remuneration LuxSCS should have received for those services.
In analyzing the Commission's subsidiary findings, the Court found that the Commission failed to establish that LuxOpCo received an advantage.
Profit split method
The Court rejected the Commission's finding that the profit split method with a contribution analysis was the more appropriate transfer pricing method in the case at hand. In applying the profit split method, the Court stated, both parties must perform unique and valuable functions; the Commission's analysis of LuxOpCo's functions, however, showed no evidence of that.
While the Commission may choose a transfer pricing method that it considers appropriate in a given case, it must still justify its choice of methodology, which it failed to do in this case. Even if the profit split method with a contribution analysis had been applied, the Court ruled, the Commission failed to establish that the remuneration of LuxOpCo would have been higher.
For the same reason, the Court also rejected the Commission's finding that the choice of a profit level indicator based on operating expenses was inappropriate. The Court noted that the Commission departed from its qualification of LuxOpCo as a company "with management functions" and applied total costs as a profit-level indicator to remunerate LuxOpCo as a retailer. Still, the Court argued, LuxOpCo was a marketplace administrator that acted as an intermediary in its relations with third parties, not only a retailer.
Accordingly, the Court concluded, it is not apparent from the 1995 version of the OECD Guidelines that total costs were the appropriate profit-level indicator.
The Court agreed that accepting a ceiling (according to which LuxOpCo's remuneration could not exceed a low percentage of its annual sales) could be a methodological error in applying the TNMM to determine LuxOpCo's remuneration. Nonetheless, it concluded, this finding alone is not sufficient to establish an advantage, or to establish that LuxOpCo's remuneration for the years in question was not at arm's length.
For these reasons, the Court concluded that the Commission failed to demonstrate, to the requisite legal standard, the existence of state aid. Accordingly, it annulled the contested decision in its entirety.
Taxpayers should continue to carefully analyze and contemporaneously document their transfer pricing methodology. The Commission has the onus of providing conclusive evidence that the application of a transfer pricing methodology reduced the taxpayer's tax liability through intra-group prices that did not correspond to market outcomes. Interestingly, the Court held that subsequent OECD Transfer Pricing guidelines cannot be used to examine the arm's-length nature of a transaction to the extent that they change or enlarge the previous guidelines.
While the case concerned a tax ruling, as stated by the Court, any aid would only manifest itself in the acceptance of the annual tax returns by the Luxembourg tax authorities. As a result, not only tax rulings may result in state aid investigations, so taxpayers should maintain appropriate documentation of transfer prices used in tax returns.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Tax Advisory Services Sarl, Luxembourg City
Ernst & Young LLP (United States), Luxembourg Tax Desk, New York
Ernst & Young LLP (United States), Luxembourg Tax Desk, Chicago
Ernst & Young Belastingadviseurs LLP, Rotterdam
Ernst & Young LLP (United States), Transfer Pricing
Ernst & Young LLP (United States), International Tax and Transaction Services
1 Luxembourg v. Commission, Cases T-816/17 and T-318/18
2 Commission Decision (EU) 2018/859 of 4 October 2017 on State aid SA.38944 (2014/C) (ex 2014/NN).