Transfer Pricing in the Light of State Aid: A Matter of Domestic Law

On November 8, 2022, the European Court of Justice (ECJ) rendered the first final decision in the recent wave of state aid investigations by the European Commission into the application of specific tax measures to companies belonging to multinational groups. The commission’s investigations, which started in 2015, have caused a good deal of uncertainty, and the ECJ decision provides a welcome clarification, introducing more balance to state aid considerations in the European Union. The decision is final and cannot be appealed.

The European Commission decided in 2015 that Luxembourg had unlawfully granted state aid to a financing company—part of a multinational enterprise group—by allowing the company, through an advance pricing agreement (APA), to determine the taxable spread on its intragroup financing activities on the basis of a methodology that departed from the arm’s-length principle. The commission’s conclusions were largely confirmed by the General Court of the European Union, which in 2019 dismissed the actions for annulment of the commission’s decision.

What started as a transfer-pricing dispute focused on all of the technicalities endemic to this topic ended in a judgment focused on how to correctly apply the EU state aid rules and, more specifically, on the correct determination of the “reference system” (that is, the rules that would normally apply in the member state that has allegedly granted the illegal state aid) to be used in assessing whether a company paid too little tax.

One of the conditions required for a domestic measure to be classified as state aid is that its beneficiary must have been granted a selective advantage. The starting point for assessing selectivity is to determine the reference system, in order to subsequently analyze whether the given tax measure derogates from this system so as to create differentiation between taxpayers that are in comparable situations.

The ECJ recalled that in taxation matters not harmonized in EU law, member states have sovereignty in the area of direct taxation. The principle of legality of taxation requires each member state to adopt domestic laws that lay down the features and rules according to which tax will be levied. This principle also applies in transfer-pricing matters: although it is generally acknowledged, at the EU and international levels, that transactions between related parties should be assessed for tax purposes under the same conditions as if they were carried out between independent parties (by applying the arm’s-length principle), it is at the discretion of each member state to define the methods and criteria for determining whether a transaction is to be considered an arm’s-length transaction.

In the case at hand, the APA was issued to the financing company in 2012, at a time when Luxembourg law did not yet provide detailed transfer-pricing rules; it included only a general provision requiring the tax base to be adjusted for benefits granted to related parties. That provision is quite broad and left some room for interpretation. Further guidance on the tax treatment of intragroup financing activities was provided, however, in a circular issued by the director of the Luxembourg direct tax administration, which detailed the methodology to be used in determining the arm’s-length remuneration for such activities. Those two measures formed the legal basis on which the Luxembourg tax authorities granted the APA.

The European Commission, however, did not consider the circular to constitute the reference system and instead argued that the relevant reference system was the general Luxembourg corporate income tax system, which, according to the commission, has as its objective the taxation of the profits of all companies subject to tax in Luxembourg, whether the companies are part of a group or not. According to the commission, the arm’s-length principle forms part of the commission’s assessment under the EU state aid rules, independently of whether a member state has incorporated this principle into its national legal system. The commission therefore analyzed the APA by applying its own arm’s-length standard—which is based on the OECD interpretation of this concept—without considering the specific Luxembourg provisions or the specific Luxembourg interpretation and application of the arm’s-length principle.

The ECJ dismissed this approach. It recalled that in order to determine whether a tax measure has conferred a selective advantage on an undertaking, the commission must carry out a comparison with the tax system normally applicable in the member state concerned, following an objective examination of the content, interaction, and concrete effects of the rules applicable under the national law of that state. In the court’s opinion, the commission cannot substitute its own arm’s-length principle, which is not an EU-harmonized concept, for the provisions on the arm’s-length principle that are anchored in the domestic tax system at issue. In a determination of the existence of a selective tax advantage, parameters and rules external to the tax system of a state can be taken into account, according to the court, only if that tax system makes explicit reference to them.

The ECJ therefore concluded that the General Court had been wrong to confirm the reference system that the commission had used to apply the arm’s-length principle, and, in consequence, the ECJ annulled the commission’s decision that Luxembourg had granted illegal state aid.

The ECJ’s conclusions in this case are significant because they are likely to affect other transfer-pricing cases that the commission is or has been investigating. Although the court has confirmed member states’ autonomy to interpret the arm’s-length principle and to determine the application of transfer-pricing methods, it acknowledges that the commission may continue to question the application of the arm’s-length principle. In doing so, however, the commission cannot apply its own arm’s-length principle; it must consider the relevant member state’s transfer-pricing provisions.

Anja Taferner and Katia Agazzini
EY Luxembourg