By Dr. Patricia Lampreave, EU tax and state aid expert, Professor, Instituto de Estudios Bursátiles, Madrid
A few weeks after the European Commission issued its highly controversial final decision about Gibraltar’s tax system, the same service opened, on 10 January, an in-depth investigation to examine whether five tax rulings granted by the Dutch tax authorities to two Nike group companies based in the Netherlands (Nike European Operations Netherlands BV and Converse Netherlands BV) between 2006 and 2015 gave the company an unfair advantage over its competitors, potentially in breach of EU State aid rules.
Nike was among the companies highlighted in the so-called Paradise Papers. The company´s chief tax officer, Patti Johnson, answered last June questions from the EU Parliament’s special TAXE committee looking into tax evasion and tax avoidance. Following the Paradise Papers leaks, the Commission intensified its investigation and requested additional information from the Netherlands.
Nike also faces a separate EU antitrust case into its sales practices within the Directorate-General for Competition. The antitrust directorate examines whether the company illegally restricts traders selling licensed merchandise outside one country or online.
How Nike operated
As can be read in the press release, Nike European Operations Netherlands BV and Converse Netherlands BV obtained licenses to use intellectual property rights relating to, respectively, Nike and Converse products in Europe, Middle East, and region. The two companies obtained the licenses in return for a tax-deductible royalty payment from two Nike group companies that are transparent for tax purpose (i.e., not taxable in the Netherlands). The Nike group companies receiving the royalties “had no employees and did not carry out any economic activity”.
From 2006 to 2015, the Dutch tax authorities issued five tax rulings, two of which are still in force, endorsing a method to calculate the royalty to be paid by Nike European Operations Netherlands and Converse Netherlands for the use of the intellectual property.
The European Commission added in its statement that the royalty payments endorsed by the tax rulings seem to not reflect economic reality. The aim of the payments was to reduce the taxable base in the Netherlands of Nike European Operations Netherlands BV and Converse Netherlands BV since 2006.
As a result of the rulings, Nike European Operations Netherlands BV and Converse Netherlands BV were only taxed in the Netherlands “on a limited operating margin based on sales” which it appears to be in contradiction with the arm’s length principle (payments between companies should be in line with the arrangements that take place under commercial conditions between independent businessmen).
State of play
This opening is an investigation; it, therefore, does not directly imply that the Commission has already reached a verdict. It means that the Commission doubts specific rulings granted by the Netherlands that could contain state aid elements, in particular, the European Commission concerns focus on whether the method used to calculate royalty payments endorsed in the tax rulings is contrary to the arm´s length principle
Responding to news of the Nike investigation, the company said: “We believe the European Commission’s investigation is without merit.” It added that Nike was “subject to, and rigorously ensures that it complies with, all the same tax laws as other companies operating in the Netherlands.”
The Dutch finance ministry said it would cooperate with the Commission’s investigation. In the following months, DG Competition will need to prove the aid element in the tax ruling investigated and the Dutch authorities will need to prove that the tax rulings granted are not selective or, if so, the derogation from the reference system can be justified. Nike needs to prove that they paid fair taxes. After the investigation the Commission can issue a negative decision with recovery or a decision of no state aid.
Tax ruling practice and state aid
In 2014, the Directorate-General for Competition, Commissioner J. Almunia, announced the EU Commission’s first investigation into member state tax ruling practices, examining rulings issued by Cyprus, Malta, UK, Netherlands, Ireland, and Luxembourg.
In December 2014 the investigation extended its information inquiry on tax rulings practice to all member states (Bulgaria, Croatia, Greece, Latvia, and Slovenia were excluded).
This work continues with the current Directorate-General for Competition, Commissioner M. Vestager, whose mandate is a crusade against potentially selective tax rulings and considers that a state aid review of business tax measures appears to be an appropriate instrument under EU law to counter alterations of the level playing field.
The Directorate-General for Competition clarified the relation of tax rulings and state aid in a 2016 Communication on the notion of aid. According to the communication, the function of a tax ruling is to establish in advance the application of the ordinary tax system to a particular case in view of its specific facts and circumstances and therefore it can create certainty and predictability on the application of general tax rules, which is relevant for the taxpayers, but state aid rules have to always be respected.
Concretely, it has identified certain elements considered selective in tax rulings:
- The tax authority accepts a transfer pricing arrangement which is not at arm’s length because the methodology endorsed by that ruling produces an outcome that departs from a reliable approximation of a market-based outcome.
- The same applies if the ruling allows its addressee to use alternative, more indirect methods for calculating taxable profits, for example, the use of fixed margins for a cost-plus or resale-minus method for determining an appropriate transfer pricing, while more direct ones are available.
- The ruling clearly proves that the taxable basis has been freely negotiated with the tax authorities without any reference to other comparable transactions,
- The tax authorities merely accepted in the ruling the company’s proposals without an ex ante verification that the company is reflecting economic reality (which is easily meet if the ruling contains a clause saying that the ruling is in force until the situation of the company changes) or even ex-post control (e.g., a tax audit).
- The financial parameters (the use of debt instruments) of the ruling lack substance and are not substantiated by any generally accepted methodology.
- The profit allocation factors or the costs attributable to a given entity recognized by the ruling don´t have any economic basis and are not consistent throughout the company’s organization.
According to the Communication, an economic advantage in the case of tax rulings exists if, in the absence of the state intervention, an undertaking recognized in the tax ruling would not have been obtained under normal market conditions.
An aid measure, like a tax ruling, gives rise to an advantage for a beneficiary where, as a result of the measure in question, the beneficiary gains a financial advantage which it would not have gained but for the adoption of the measure.
The key element is to determine if a tax ruling applies the ordinary tax rule or misapplies the tax rules. Where a tax ruling endorses a result that does not reflect in a reliable manner that would result from a normal application of the ordinary tax system, that ruling may confer a selective advantage upon the addressee in so far as that selective treatment results in a lowering of that addressee’s tax liability in the member state as compared to companies in a similar factual and legal situation.
- This investigation is derived from the Commission efforts to penalize tax rulings containing transfer pricing methods in contradiction with the arm´s length principle.
- DG Competition has pushed to tighten tax rules in accordance to state aid regulation, but we have to bear in mind that they have not been named as a supra tax authority which can oblige member states to change the corporate income tax (fiscal policy is an element of the sovereignty of Member States that depends on tax collection) but they can push for changes in the tax code in accordance with state aid regulation.
- This investigation concerns individual tax rulings and as such should not directly impact other taxpayers.
- Tax rulings should be examined for potential selective elements to quantify the risk. Tax adjustments, due to a recovery decision, will cause serious economic damage to a company, without mentioning the administrative burden.