Thursday, 30 June 2016

European Commission publishes final decision finding Luxembourg granted State aid in transfer pricing case

On 9 June 2016, the European Commission (the Commission) published its final decision in the State aid investigation case relating to Luxembourg, rendered on 21 October 2015. The Commission determined that Luxembourg granted illegal State aid to a Luxembourg-resident company, which forms part of a multinational company (MNC) group. The Commission found under the EU State aid rules that Luxembourg granted a selective tax advantage in agreeing to transfer prices that allegedly deviate from market practices. The Commission ordered Luxembourg to recover the alleged advantage from the taxpayer (consisting of the tax benefit that the taxpayer has received since 2012).
Luxembourg and the MNC have filed appeals.
The decision concerns an Advance Pricing Agreement (APA) issued by the Luxembourg tax authorities to a Luxembourg member of an MNC group. This company provided financial services, such as intra-group loans, as well as treasury services, including management of cash pools, to other group companies. In addition, the company held two participations in group companies. The activities of the company were financed with equity, third party debt and intra-group debt.
The Luxembourg entity’s fact pattern is very specific, in that it raises funds on the market, distinguishing the company from most of the Luxembourg group finance companies that provide intra-group loans out of funds provided by other group companies. In addition, the company’s method of calculating profitability based on a return on a certain amount of hypothetical regulatory capital is not a commonly used performance indicator in the financial sector.
The Commission agreed with Luxembourg that the activities of the MNC group company are comparable to those of a bank. The Commission also recognized the application of the Transactional Net Margin Method (TNMM) as the appropriate choice as well as the return on capital as an acceptable performance indicator for the financial industry.
However, the Commission goes into great detail in analyzing that the following choices and adjustments do not reflect market conditions considering the functions performed by the group company:

  • Use of the hypothetical regulatory capital as the profit level indicator as opposed to the group company´s accounting equity
  • Inconsistent application of the Basel II framework to calculate that capital
  • Inappropriate deductions from the capital to be remunerated 
  • The level of required return applied to the capital to be remunerated

Accordingly, the Commission found that the APA under investigation endorsed a methodology for determining the taxable profits of the Luxembourg company that, in the Commission’s view, did not approximate a marketbased outcome in line with the arm’s length principle. The Commission found the APA granted by Luxembourg unduly reduced the company’s tax burden by €20 to €30 million
since 2012. The Commission provided guidelines on what it sees as an appropriate arm´s length price considering the concrete facts and circumstances, i.e., functions performed by the group financial intermediary company.
The Commission dismissed arguments brought forward that the reference system to determine whether the Luxembourg company had received a selective advantage included the Luxembourg transfer pricing provisions and practice. Instead, it applied a more generic arm’s length principle. According to the Commission, the arm’s length principle necessarily forms part of the Commission’s State aid analysis, independently of whether a Member State has incorporated this principle in its national legal system or, in the case of Luxembourg, how this principle is applied in practice. It is therefore not relevant, in the view of the Commission, whether other companies in comparable facts and circumstances would have obtained a similar APA. Nevertheless, in a secondary line of reasoning, the Commission also concluded that there was no evidence that the contested APA was comparable to APAs granted to other companies in similar facts and circumstances.
Source: EY