After almost 10 years of litigation, the European Court of Justice (ECJ) has finally settled the Fiat state aid case, clarifying an essential aspect of TP in the EU. The highest court concluded that only the domestic law of the relevant EU member state must be considered as a reference system when assessing whether an advantage constitutes an unjustified and hence selective derogation, which may lead to the recognition of an illegal state aid. The ECJ dismissed accordingly the Commission’s concept of a harmonised EU arm’s length principle, distinct from the OECD’s TP guidance and binding on the EU member states, irrespective of any domestic implementation.
In the beginning
The facts of the case date back to 2012, when a Luxembourg affiliate of the Fiat group – Fiat Chrysler Finance Europe (FFT) – filed an application for an advance pricing agreement (APA) with the Luxembourg tax authorities (LTA). The APA sought confirmation that FFT’s remuneration in respect of its financing and treasury activities was compliant with the arm’s length principle. The remuneration was determined by a TP analysis using the transactional net margin method (TNMM). The analysis estimated the remuneration by reference to the appropriate level of equity at risk and the relevant functions performed with respect to the financing and treasury activities only (excluding the equity supporting other functions and the other financial investments, e.g., shareholdings). The remuneration of the equity at risk was computed by using the capital asset pricing model (CAPM) (Commission Decision (EU) 2016/2326 of 21 October 2015 on State aid SA.38375 (2014/C ex 2014/NN) which Luxembourg granted to Fiat, section (57)).
In September 2012, the LTA issued an APA to FFT confirming that the TP analysis complied with Luxembourg’s TP regulations and the arm’s length principle.
It must be noted that at that time, Luxembourg’s TP framework was set in its income tax law (ITL) and in a number of circular letters. Amongst these was a circular letter issued in 2011 by the LTA on the tax treatment of companies engaged in intra-group financing activities (the Circular). In addition, the general tax law (GTL) included documentation requirements:
Article 56 of the ITL (as drafted at that time) allowed the LTA to readjust the profit of an enterprise if a transfer of such profit was made possible because the enterprise maintained, directly or indirectly, particular economic relations with a non-resident;
Article 164(3) of the ITL (which is still effective today) requalifies as a hidden profit distribution any advantage that a shareholder, member or other interested party receives directly or indirectly from a company or an association that they would normally not have received in the absence of their status as an interested party;
The Circular (which has since been replaced), referred explicitly to the OECD’s arm’s length principle and required that the financing company maintained sufficient capital to cover its credit risk (equity at risk), realised an arm’s length remuneration, and maintained a sufficient taxable presence in Luxembourg to be considered a resident; and
Paragraph 171 of the GTL requires that, upon request, taxpayers must provide evidence of the accuracy of their tax return and provide clarifications, including the relevant documentation.
Although the wording of Article 56 of the ITL differed from Article 9 of the OECD’s Model Tax Convention, legal scholars understood that Article 56 of the ITL referred to the OECD’s arm’s length principle and therefore the OECD’s TP Guidelines are applicable in Luxembourg. A subsequent amendment of Article 56 of the ITL in 2016 to replicate Article 9 of the OECD Model Tax Convention appears to confirm this position. Similarly, Luxembourg case law has further confirmed on several occasions that the OECD’s arm’s length principle is embedded in Article 164 (3) of the ITL.
The Commission’s investigation
Within the framework of a much broader review of Luxembourg’s APA practice, the Commission came to analyse FFT’s APA. In 2014 the Commission opened a formal investigation procedure for incompatible state aid under 108(1) of the Treaty on the Functioning of the EU (TFEU), which concluded in 2015 that said APA constitutes an illegal state aid within the meaning of Article 107(1) of the TFEU.
For a measure to be categorised as state aid within the meaning of article 107(1) of the TFEU, the following four conditions must be met:
There must be an intervention by the state or through state resources;
The intervention must be liable to affect trade between EU member states;
A selective advantage on an undertaking must be granted; and
Such advantage must distort or threaten to distort competition.
In this case, the selectivity criterion must be analysed in more detail. It requires that the purported advantage derogates from the common or ‘reference’ system, which is applied consistently to all comparable undertakings within its scope, and that any such derogation is not justified by such reference system. The Commission acknowledged that the Luxembourg corporate income tax system constituted the reference system and that it had to verify whether the APA constituted an unjustified derogation therefrom, potentially leading to unequal treatment between companies that are in a similar situation. However, instead of testing the APA against the TP rules contained in the Luxembourg corporate income tax system, the Commission decided that its assessment should be based on an arm's length principle, independently of whether said principle had been incorporated into an EU member state’s national legal system (Commission Decision (EU) 2016/2326, section (228)).
Said arm’s length principle should be used to establish whether the taxable profits of a group company for corporate income tax purposes have been determined by a methodology that approximates market conditions. This is so the company is not treated favourably under the general corporate income tax system as compared to non-integrated companies whose taxable profit is determined by the market forces. The Commission further decreed that the arm's length principle it refers to is not the one derived from Article 9 of the OECD Model Tax Convention but a general principle of equal treatment in taxation falling within the application of Article 107(1) of the TFEU, binding the EU member states. It further dismissed Article 164 of the ITL and the Circular as a reference system, the first being too limited and the second too broad (Commission Decision (EU) 2016/2326, section (316) and section (7.2.5.1.)).
It finally concluded that the methodology accepted by the APA was not compliant with its arm’s length principle, in particular the approach of remunerating only the equity at risk of FFT and disregarding the capital used for its shareholdings and other functions (Commission Decision (EU) 2016/2326, section (134)). Incidentally, it also challenged the application of the CAPM and the values chosen, concluding that the level of capital and the respective remuneration “were set at a too low level” (Commission Decision (EU) 2016/2326, section (133)).
The decision was heavily criticised for imposing an arm’s length principle through EU law in breach of the fiscal autonomy of the EU member states – noting that fiscal harmonisation still requires the unanimity of all EU Member States and such arm’s length principle being different from the OECD’s arm’s length principle foreseen by Article 9 of the OECD Model Tax Convention. The wording of Article 56 of the ITL was further amended to replicate Article 9 of the OECD Model Tax Convention, clarifying the inclusion of the OECD’s arm’s length principle in its TP rules.
The General Court’s decision
In 2016, Luxembourg and FFT applied for an annulment of the Commission’s decision before the EU General Court, while Ireland intervened to support the applicants. Three years later, in September 2019, the General Court ruled in favour of the Commission, adopting its argument that the arm’s length principle is a general principle within the application of Article 107(1) of the TFEU which is binding on the EU member states regardless of the presence of local implementation. The General Court went further by labelling it as a tool (Judgment of the General Court in Cases T-755/15 and T-759/15, 24 September 2019, section (143)) for determining market conditions as part of the powers of the Commission under Article 107(1) of the TFEU.
By endorsing the decision of the Commission, the General Court effectively agreed with the arguments against the TP methodology applied by FFT and accepted by the Luxembourg tax authorities in their ruling, namely the denied capital segmentation approach. Such a position seems erroneous because it disregards the economic reality of the different functions and activities of an undertaking, as well as the effective use of equity.
The ECJ’s decision
FFT and Ireland appealed before the Court of Justice of the European Union, which rendered its long-awaited decision in November 2022. It set aside the General Court’s judgment and annulled the Commission’s decision on the grounds that the Commission committed an error in identifying the appropriate reference system. By considering the Luxembourg corporate income tax system as the reference system, the Commission and the General Court failed to failed to consider the arm’s length principle as provided in Article 164(3) of the Luxembourg Income Tax Law and specified in the related Circular when defining the reference system as part of the selective advantage examination carried out under Article 107(1) TFEU (Judgment of the General Court in Cases T-755/15 and T-759/15, 24 September 2019, section (105)). The highest court confirmed that only national law applicable in the EU member states should be considered in identifying the reference system and criticised the Commission for disregarding the importance of the specific provisions of the Luxembourg domestic law while relying on the general objective of the tax system to tax profits of companies irrespective of their level of integration.
In the end
The ECJ’s decision is justified in several aspects. Firstly, it correctly protects the fiscal sovereignty of the EU member states and pushes back on the Commission’s attempt to interfere in tax matters through state aid investigations, keeping in mind that tax harmonisation still requires the unanimity of all member states.
Secondly, it has also the merit to dismiss the Commission’s standalone concept of an arm’s length principle which is not based on the OECD’s guidance. The arm’s length principle has a commonly accepted definition as per Article 9 of the OECD Model Tax Convention, which represents an international consensus that is applied by most OECD member states in their domestic legislation. Hence, it would be detrimental for the EU member states to have another layer of TP rules based on a different arm’s length principle for EU transactions, while applying the OECD’s guidance on transactions with non-EU States.
As regards FTT’s APA, it seems that the Commission must test it again, but this time against the correct reference system - Luxembourg’s domestic corporate income tax and TP rules, which refer to the OECD’s arm’s length principle. As both the TNMM and the CAPM have been endorsed by the OECD (Transfer Pricing Guidance on Financial Transactions, OECD February 2020, C.1.2.5.), it would be inconsistent if the Commission dismissed the methodology of the FFT APA a second time.
The Commission’s attempt to harmonise the arms’ length principle in EU member states could be a positive initiative if it would help to avoid conflicting TP positions between EU member states. Indeed, the various local implementations of EU member states may require lengthy multilateral APA negotiations or mutual agreement procedures that may still lead to double taxation. However, it seems doubtful whether such a result could ever be achieved in practice, given that TP is always based on valuations and comparisons that leave room for interpretation. Any such attempt should nevertheless follow the legal path foreseen by the TFEU and preferably rely on the OECD’s arm’s length principle with which OECD member states are already familiar.
