Transfer Pricing In EU Law:
In light of Case Law by Court of Justice
Master Thesis
Supervisor: dhr. prof. dr. H.G. (Hein) de Haas
Author: Xiaonong Zhou
Faculty of Law
LL.M, International Tax Law
Date of Submission: 29
thJuly, 2016
Abstract
With emphasis of BEPS on transfer pricing, lack of coordination in Union transfer pricing is brought up again. Limited extend of direct taxation harmonization,
unexpected directives on transfer pricing and the complexity of transfer pricing makes the Court’s opinions in transfer pricing important. But the engagement of the Court is limited in transfer pricing fields. The purpose of the thesis is to discuss the Union’s efforts after publication BEPS final package and retrospect main ECJ case law with regards to transfer pricing. After finding out the changes of the Court’s opinions and discuss extended questions, such as comparisons between the opinions in judgments with transfer pricing in OECD guidance, equal treatment of all taxpayers and treaty abuse in other case law. The method used in the thesis is the historical and
comparative research of existing case law and literature. The research of the thesis stresses the existing importance of ECJ case law on transfer pricing issue, finds some inconsistency in the judgments and court’s tolerance of discriminative treatment for anti tax-avoidance measures.
Abbreviations
ALP Arm’s length principle
ATAD Anti Tax-Avoidance Directive CBCR Country-by-Country reporting
CCCTB Common Consolidated Corporate Tax Base
ECOFIN the European Union's Economic and Financial Affairs Council ECJ European Court of Justice
EC Treaty Treaty establishing the European Community G20 Group of Twenty
PE permanent establishment
OECD the Organization for Economic Co-operation and Development TEC the Treaty Establishing the European Community
TEU the Treaty on European Union
TFEU the Treaty on the Functioning of the European Union as amended by the
Treaty of Lisbon (2007)
TPG OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax
Contents
Chapter 1 Introduction... 4
1.1. Nature and relevance of the research...4
1.1.1 BEPS development and transfer pricing...4
1.1.2 EU response to BEPS and its jurisprudence in transfer pricing...5
1.2. Definition of the problem and the objective of the research...9
1.2.1 State of the art of literature...9
1.2.2 Identification of the problem...11
1.3. Objective of the research... 12
1.4. Scope of the research... 13
1.5 Research question... 14
1.5.1 Research Question... 14
1.5.2 Sub-questions... 14
1.6 Research method... 14
1.7 Key terminology... 14
Chapter 2 EU law on transfer pricing... 15
2.1 General scene of harmonization in direct taxation...15
2.1.1 Competences of the Union in direct tax and direct tax harmonization...15
2.1.2 A further guarantee of fundamental freedom: prohibition of discrimination...16
2.1.3 Exceptions of harmonization: state aid and disparities...17
2.1.4 Summary: “negative integration” and importance of ECJ...18
2.2 Case law in transfer pricing... 19
2.2.1 Lankhorst-Hohorst Case...20
2.2.2 Thin Cap Case... 22
2.2.3 SGI Case... 25
2.2.4 Other related case law...27
2.3 Summary... 27
Chapter 3 Indications of EU transfer pricing rules on intangibles...30
3.1 Is transfer pricing in ECJ’s understanding identical to OECD guidance?...30
3.1.2 Functions of transfer pricing...32
3.1.3 Comparability analysis and transfer pricing methods...33
3.1.4 Documentation requirements...33
3.2 Does case law require applying identical transfer pricing rules to cross-border taxpayers and domestic taxpayers?...33
3.3 Variety of sources of unequal treatments...34
3.4 The peculiarity of current case law: concerning deduction of related interest...34
Chapter 4 Conclusion... 35
Chapter 1 Introduction
1.1. Nature and relevance of the research
1.1.1 BEPS development and transfer pricing
During the 2008 financial crisis, the attention of the world was turned to combating tax avoidance and to discussions about the equitable taxation of companies. As demanded by the G20 in 2013, the OECD set up the BEPS Project to combat double non-taxation and keep tax rules up to date with changing situations of global economy1 on a widely-cooperated basis in fifteen key areas. In October 2015, the final BEPS package was published and approved by the OECD and the G20, after consolidating interim report and extensive engagement of OECD and non-OECD states. The outputs of BEPS still await (part or whole) implementation by the states in a complete and coherent manner, which will restructure international tax rules. These implementations can consist of statute law adopted by parliament, or of regulations, rulings or notes published by the tax authorities.
Assuming that multinationals are frequently employing transfer pricing strategies for intra-group transaction, transfer pricing is very important from a BEPS point of view. With their high mobility, intangibles are easily transferred; with their complexity, they are hard to value and price.2 These two features of intangibles make possible an even wider use of differences between national tax regimes, that is, of low-tax jurisdictions and privileged or preferential tax regimes. Multinationals now have more approaches other than tax havens to reduce tax burden. This is Ownership of intangibles can be transferred to low-tax jurisdictions and the right to use can be licensed to related companies in high-tax jurisdictions. In this way, profits are shifted and tax revenue eclipses. Similarly, since multinationals have high discretion of intra-group contracts and arrangements, risks and returns can be artificially separated by
1 “global corporations, fluid movement of capital, and the rise of the digital economy”, http://www.oecd.org/ctp/beps-about.htm
them. That is to say, decisions to undertake risks, control exercised on controlling risks and capability to undertake risks are not corresponding. These strategies can be utilized by multinationals to shift profit without being caught by existing OECD transfer pricing guidance. Illustrations are management fees or head office expenses, paid by a subsidiary/PE to the headquarters.3 In a word, actual backgrounds and facts indicate that transfer pricing is, or is regarded as, a main factor causing “profit shifting”. Improving transfer pricing is an urgent need to solve “profit shifting”. BEPS final reports 8, 9 and 10 provide suggestions in the form of revision of existing standards4, and clarification and strengthening of OECD transfer pricing guidelines5, while debates in academia are still heated on whether the arm’s length principle can adapt itself to the BEPS era or whether global formulary appointment is a better alternative.6 New focus on “real activities” and “value creation” is presented as a mere modification of the existing ALP.7
1.1.2 EU response to BEPS and its jurisprudence in transfer pricing8
As mentioned above, BEPS initiatives need states’ implementations to fulfill its mission. Regarding the large number of overlapping members between the OECD and
3 Page 29, OECD/G20 BEPS Project 2015 Final Reports, Executive Summaries.
4 In final reports, 15 BEPS initiatives are in forms of minimum standard, revision of existing standard, common approach and best practice, see Paragraph 11, OECD/G20 BEPS Explanatory Statement, see
https://www.oecd.org/ctp/beps-explanatory-statement-2015.pdf. Transfer pricing have been updated and will be implemented, although not all BEPS participants endorse the underlying standards.
5 Page 15, OECD/G20 BEPS Project 2015 Final Reports, Executive Summaries.
6 Discussion of arm’s length principle after BEPS, see Transfer Pricing in a BEPS Era: Rethinking the Arm’s Length Principle – Part I &II, International Transfer Pricing Journal, 2015 (Volume 22), No 3 and No 4.
7 Wolfgang Schon, Transfer Pricing Issues of BEPS in the Light of EU Law.
8 Before the formal action against BEPS by OECD, i.e. 2013, EU also has actions with similar objectives. Firstly, in 2008, ECOFIN agreed in its conclusions that a tax good governance clause should be introduced into all relevant agreements between the EU and third countries and regions. Secondly, during 2012 the Commission issued a Recommendation to the EU Parliament and EU Council on measures to encourage third countries to apply minimum standards of tax good governance. In addition Member States are encouraged to use transparency, information exchange and fair tax competition as the three criteria for assessing purposes and taking appropriate counter-measures. Thirdly, in 2013, two Directives are launched introducing CBC reporting obligation for the EU-based banking and financial sector as well as for the logging and extractive industries under the Accounting Directive. In the 2015 ‘Trade for All’ strategy the EU Commission confirmed that it would ensure that trade agreements support the promotion of international standards of transparency and good governance which address aggressive corporate profit shifting and tax avoidance strategies. See
http://www.tpa- global.com/news/2016/01/28/eu-coordinates-beps-implementation-triggering-substantial-impact-for-mnes-in-2016.
EU9, EU law’s binding effect, and state aid cases’ engagement in transfer pricing, it is meaningful to research how BEPS initiatives on transfer pricing are implemented within EU in light of EU law. Unique elements of the single market and fundamental freedoms are tailoring current reforms to be implemented in a consistent manner among the Union. Thus, EU has the advantage of making coordinated legislation. The Commission also attaches itself “an important role in continuing to support BEPS, by pushing for its smooth and timely implementation – in the Single Market and internationally”.10
EU Commission’s responses to BEPS are wide. Concerning good functioning of the single market and effective corporate taxation, the Council recalls and confirms its conclusions in 2014 that “the urgent need to advance efforts in the fight against tax avoidance and aggressive tax planning”. 11
In the middle 2015, the Commission proposed to create “a fair and efficient corporate tax system in the European Union” 12 in five key areas, i.e. mandatory and staged CCCTB , enabling cross-border loss offset and improving double taxation dispute mechanism, further progress on tax transparency, and EU tools on coordination.13 The Commission is headed for reforming the corporate tax framework in order to combat tax abuses, ensure sustainable revenue and support an improved environment for business in the single market.14
Transfer pricing is not a separate issue in that proposal, however, but a part of ensuring effective taxation where profits are generated. The Commission promised to build coordinated and more concrete implementations with member states and 9 22 states, almost 70%, out of 28 EU member states and 3 EEA member states are also OECD members. Austria, Belgium, Czech, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxembourg, Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, and United Kingdom are EU member states which are also OECD members. Iceland and Norway are EEA member states which are also OECD members. See list of EU and EEA member states at http://europa.eu/about-eu/countries/index_en.htm and see list of OECD member states at http://www.oecd.org/about/membersandpartners/list-oecd-member-countries.htm.
10 Communication from the Commission to the Parliament and the Council on an External Strategy for Effective Taxation,COM/2016/024 final, see http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52016DC0024 11 Para 1, 2 and 3 in press release of “Council Conclusions on corporate taxation – base erosion and profit shifting ”, available at http://www.consilium.europa.eu/en/press/press-releases/2015/12/08-ecofin-conclusions-corporate-taxation/
12 Action Plan On Corporate Taxation, see at
http://ec.europa.eu/taxation_customs/taxation/company_tax/fairer_corporate_taxation/index_en.htm 13 http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52015DC0302
14 Direct Taxation: Personal and Company Taxation, see at
business, but no specific actions were mentioned. Only transparency is illustrated as a tool for tax administrations to investigate intra-group transactions.
Later on, after BEPS final reports were published, ECOFIN initially agreed on some of BEPS recommendations in December 2015. On transfer pricing, the recognition only went as far as inviting the Code of Conduct group to prepare guidance on BEPS Action 8-10 (aligning transfer pricing outcomes with value creation) and Action 13 (transfer pricing documentation) with support from the Commission and EU Joint Transfer Pricing Forum15, while other initiatives of BEPS, i.e. Actions 2 (hybrid mismatches), 3 (Controlled Foreign Company rules), Action 4 (interest limitation rules), Action 6 (general anti-abuse rule), Action 7 (permanent establishment status) and Action 13 (country-by-country reporting), were under the Council’s discussion for a legislative proposal such as anti-BEPS package, CCCTB and anti-abuse rule in the Interest and Royalty Directive.16
The Parliament took a similar stance. In calling for corporate tax makeover, it did not require the Commission to propose any further rules on transfer pricing, but kept emphasis on the Country-by-country Reporting. It showed an even more radical opinion that compulsory EU-wide CCCTB would be the best way to solve preferential regimes, mismatches and most BEPS.17
As a compulsory response to that recommendation of Parliament on legal steps to respond BEPS18, in January 2016, the Commission released the Anti Tax Avoidance Package19 comprised of four parts, a proposed European Union (EU) Anti-Tax Avoidance Directive (the ATAD)20, a proposed Directive implementing the automatic exchange of country-by-country (CbC) reports (CbCR Directive)21, a communication
15 This is also the conclusion of the Council, see http://www.consilium.europa.eu/en/press/press-releases/2015/12/08-ecofin-conclusions-corporate-taxation/.
16 EU Ministries Agree Initial EU BEPS Response, see http://www.bakertillyinternational.com/web/insights/eu-ministers-agree-initial-eu-beps-response.aspx.
17 Parliament Calls for Corporate Tax Makeover, see http://www.europarl.europa.eu/news/en/news-room/20151120IPR03607/Parliament-calls-for-corporate-tax-makeover.
18 EP spells out legal steps to fight against aggressive corporate tax planning and evasion, see
http://www.europarl.europa.eu/news/en/news-room/20151210IPR06812/EP-spells-out-legal-steps-to-fight-aggressive-corporate-tax-planning-and-evasion. 19 http://europa.eu/rapid/press-release_IP-16-159_en.htm. 20 http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_tax/anti_tax_avoidance/com_2 016_26_en.pdf . 21
proposing a framework for a new EU external strategy for effective taxation (the external strategy communication)22, and a recommendation on the implementation of measures against tax treaty abuse23. Although ATAD, addressing BEPS Action 2, 3 and 424, goes much wider and deeper than BEPS initiatives as commented by practitioners, it does not contain specific terms on transfer pricing. “Wider and deeper” refers to inclusion of some topics unrelated to BEPS, i.e. switch-over clause, GAAR and consistent exit tax regimes. It results from the harmonization of the Union, just as the Commission itself concludes that the priority of EU is to promote sustainable growth and investment within a fairer and deeper Single Market.25
In June, ATAD was passed by the Parliament and adopted by the Council at the time of writing the thesis26. MEPs called for definitions of terms like “permanent establishment”, “tax havens”, “minimum economic substance” “transfer prices”, “royalty costs”, “patent boxes”, “letterbox companies” and other terms27.
From above information, two points can be concluded:
a) The Commission, the Council and the Parliament hesitate to put any legally binding provisions on transfer pricing, let alone systematic ones based on OECD guidance as international consensus. The Commission tends to solve transfer pricing issue along with harmful tax practice related to it with CCCTB, a formulary apportionment. The Union still keeps harmonization as its first priority in creating fair and effective corporate taxation. Once they can (and they already think they do with CCCTB) find a better solution to BEPS nowadays, transfer pricing is taken into consideration. http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_tax/anti_tax_avoidance/com_2 016_25_en.pdf . 22 http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_tax/anti_tax_avoidance/com_2 016_24_en.pdf . 23 http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_tax/anti_tax_avoidance/c_2016 _271_en.pdf . 24 http://www.bakertillyinternational.com/web/insights/eu-sets-out-response-to-each-beps-action-item.aspx 25 http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52015DC0302 26 See http://www.europarl.europa.eu/news/en/news-room/20160603IPR30204/Parliament-calls-for-crackdown-on-corporate-tax-avoidance, https://epthinktank.eu/2016/06/06/anti-tax-avoidance-directive-legislation-in-progress/
27 Direct Taxation: Personal and Company Taxation, see at
b) Although OECD transfer pricing guidance is not going to be the future of EU transfer pricing, the Commission show recognition of the arm’s length principle in CCCTB Proposal, the Arbitration Convention and JTPF, and, BEPS initiatives in ATAD, CBCR directive and state aid investigations on tax rulings.28 Differences exist such tax should be paid where profits are generated according to the Commission while BEPS argues that transfer pricing results should be in accordance with value creation.
Besides such direct response to BEPS, state aid investigations have been extended in respect of transfer pricing. Advanced pricing arrangement, tax deferral, tax exemption and, more ordinarily, tax expenditures, have been qualified as state aid by commission. In latest notice of Article 107(1), the Commission achieved to take specific consideration of tax measures and used BEPS and OECD transfer pricing guidance as a reference.29 Arm’s length profits will be used to justify the tax rulings.
1.2. Definition of the problem and the objective of the research
1.2.1 State of the art of literature
Previous literature has been abundant on discussion of following issues:
- transfer pricing rules and EU case law on discrimination (mainly focused on SGI), e.g. Adolfo Martín Jiménez , Transfer pricing and EU law following ECJ judgement in SGI: some thoughts on controversial issues (2010)30; Moritz Glahe, Transfer pricing
and EU fundamental freedoms (2013)31; Wolfgang Schön, transfer pricing, the arm’s
length standard and European Union law (2011)32.
- comparative study of transfer pricing between OECD (and BEPS initiatives) with
EU law, e.g.
28 See Chapter 2.3 of this thesis.
29 Commission Notice on the notion of State aid as referred to in Article 107(1) of the Treaty on the Functioning of the European Union (2016/C 262/01), http://eur-lex.europa.eu/legal-content/EN/TXT/?
uri=uriserv:OJ.C_.2016.262.01.0001.01.ENG&toc=OJ:C:2016:262:TOC.
30 Adolfo Martín Jiménez, Transfer pricing and EU law following ECJ judgement in SGI: some thoughts on controversial issues, 2010,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2391838.
31 Moritz Glahe, Transfer pricing and EU fundamental freedoms, 2013, see https://www.kluwerlawonline.com/abstract.php?area=Journals&id=ECTA2013025.
32 Wolfgang Schön, transfer pricing, the arm’s length standard and European Union law 2011, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1930237.
Wolfgang Schön, Transfer pricing issues of BEPS in the light of EU law (2015)33;
Christiana HJI Panayi, The compatibility of the OECD/G20 base erosion and profit shifting proposals with EU law (2015)34; Maria João da Cruz Maurício, Transfer
pricing and the arm’s length principle in the European Union law and domestic law (2013).35
Other literature on member states’ implementation to be in accordance with BEPS is also found, such as E. Sporken; P. Visser, Intangibles in a BEPS World and How the
Netherlands Is Complying with OECD Rules (2015).36
Literature on transfer pricing rules and EU latest state aid cases are also found, but this topic will only be introduced a bit in this section, so the list of literature will be put in the appendix.
According to literature, addressing transfer pricing issues, in two cases, it can be derived that member states’ domestic transfer pricing regime can violate EU law. The first one is where member states treat cross-border taxpayers worse than domestic ones, as infringement of fundamental freedoms, especially the one of establishment, as the provisions at issue “typically tend to limit the application of transfer pricing rules to cross-border related party transactions only”3738. The second one is where member states give benefits to selected taxpayers, i.e. state aid involving tax matters, currently, mainly focused on tax rulings.
A common view is that the SGI Case, along with previous Lankhorst-Hohorst Case and Thin Cap Case, confirms that the ECJ recognized the arm’s length principle but 33 Wolfgang Schön, Transfer pricing issues of BEPS in the light of EU law, 2015, see
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2657998.
34 Christiana HJI Panayi, The compatibility of the OECD/G20 base erosion and profit shifting proposals with EU law, 2015, see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2697511.
35 Maria João da Cruz Maurício, Transfer pricing and the arm’s length principle in the European Union law and domestic law, 2013, Master thesis of Universidade do Minho.
36 E. Sporken; P. Visser, Intangibles in a BEPS World and How the Netherlands Is Complying with OECD Rules, 2015, IBFD International Transfer Pricing Journal, 2016 (Volume 23), No 1, see https://www.ibfd.org/IBFD-Products/Journal-Articles/International-Transfer-Pricing-Journal/collections/itpj/html/itpj_2016_01_nl_2.html. 37 The Arm’s length Comparable in transfer pricing: a search for an “actual” or a “hypothetical” transaction, Dr Amir Pichhadze, World Tax Journal, 2015 (Volume 7), No.3, http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=2642902.
38 In this sense, Wolfgang Schön also argues that “This (disadvantageous treatment of cross-border transactions by a member state when compared to internal situations) is a common element of transfer pricing provisions as these are regularly targeted at international situations”. And he also gives reasonable motives for that “while a domestic group the profits of both involved companies are subject to domestic corporate tax. Self-dealing between domestic entities does not shift the underlying tax base abroad”. See Wolfgang Schön, 2011, Transfer Pricing, the Arm’s Length Standard and European Union Law.
case law does not solve problems once and for all. The discussion focuses on fundamental freedom influenced, wholly/purely artificial arrangement, and commercial/economic rationality in case law and justifications of domestic transfer pricing with restrictive effects. Further discussions include whether current case law require identical treatment of domestic and cross-border taxpayers, differences between the arm’s length principle in OECD transfer pricing guidelines and in the ECJ understanding, how to find a comparable for rule of reason, how to distinguish the disparity from discrimination, i.e. seeing from a group perspective or an entity perspective. Common criticism is observed that ECJ exposed more to be settled on EU transfer pricing after SGI Case and OECD transfer pricing guidance have been diluted into case law, but the Commission or the ECJ have not provided systematic solutions to that.
In respect of state aid, transfer pricing is regarded as not a direct factor in state aid cases, because state aid concerns selectivity. Issues discussed most frequently include state aid rules applied in transfer pricing (four elements), what is regarded the arm’s length principle and “right” transfer prices in the Commission and the Council’ view, how much of OECD TPG is used or recognized by the Commission, procedures and other potential aid.
1.2.2 Identification of the problem
Trying to conclude information above, a picture of member states’ environment in regard of transfer pricing can be drawn as the diagram (see Diagram 1).
Diagram 1
From this chart, the obvious fact is that member states today face a very complicated environment. They made commitments in participation of BEPS; they are bound by EU law; and they are faced with challenges of coordinating domestic legislation and changes described in Section 1.1. Even if domestic legislation has not been presented before ECJ or investigated by the Commission, they have the risk of being incompatible with EU law.
1.3. Objective of the research
At the Union level, guidance is hidden in currently effective law and expressed in prospective reform the Commission is trying to conduct. The objective of research is trying to draw a picture of transfer pricing rules in light of EU law mainly based on case law by ECJ.
Chapter 2 will analyze transfer pricing rules in light of EU law, mainly based on negative harmonization and further interpreted by ECJ.
1.4. Scope of the research
The thesis is discussing cross-border transfer pricing issues for corporation taxation existing in EU law.
It is necessary to limit the scope of research by classifying which part of EU law and transfer pricing to be discussed.
Firstly, this thesis will not discuss all of EU law sources. EU law sources which are included in Chapter 2 analysis are: TFEU, TEU, case law from ECJ, general principles of union law.39 Some open decisions of the Commission is mentioned but not introduced in detail.
EU law sources which are excluded from Chapter 2 analysis are international agreements among member states, i.e. Code of Conduct on transfer pricing documentation, advance pricing agreements and arbitration convention40; secondary law, i.e. directives, regulations, decisions and recommendations; and supplementary law except for case law.
Secondly, it is necessary to settle a scope of transfer pricing rules discussed. Transfer pricing is defined as “the area of tax law and economics that is concerned with ensuring that prices charged between associated enterprises for the transfer of goods, services and intangible property accord with the arm’s length principle”41. It may also be applied in transactions or dealings among different parts of a single enterprise, e.g.
39 See http://eur-lex.europa.eu/legal-content/EN/AUTO/?uri=uriserv:l14534. According to EUR-Lex summary, EU law sources are primary law (whose sources are Treaty on European Union (TEU), Treaty on the Functioning of the European Union (TFEU), and their protocols, and treaties on new member states’ accession to the EU), secondary legislation (whose sources are unilateral acts, i.e. those listed in Article 288 TFEU, regulations, directions, decisions, opinions and recommendations, and those not listed in Article 288TFEU; and agreements, i.e. international agreements, agreements between member states and inter-institutional agreements) and supplementary law (case law, international law and the general principles of law). Also see page on legal order http://www.europarl.europa.eu/ftu/pdf/en/FTU_1.2.1.pdf.
40 Despite the exclusion list, in 2009, EU Council published Revised Code of Conduct for the effective
implementation of the Convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises (2009/C 322/01), in which arm’s length principle is required in the scope of Arbitration Convention, EU triangular cases and thin capital. Further, in mutual agreement part, it explicitly states that “The arm's length principle will be applied, as advocated by the OECD, without regard to the immediate tax consequences for any particular Member State”. Although the Code of Conduct is only a political commitment without affecting member states’ rights, obligations or the sphere of competence, I personally regard this partly reflect EU Commission’s view. Available at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX
%3A42009X1230(01)
between a head office and PE or between different PEs of the same enterprise.42 This definition mentions “rules and procedures applicable to transfer pricing”. It entails that transfer pricing is a broad area and at least contain rules and procedures.
But this thesis will not cover that broadly. Documentation requirements, settlement of dispute, procedure and administrative aspects will be totally fall out of the scope of thesis. This is to say, the arm’s length principle, comparability analysis and possibly transfer pricing methods will be the main part to be checked of a member state’s transfer pricing regime.
1.5 Research question
1.5.1 Research Question
Which ECJ court cases can be identified that involve TP and what lessons can be learned from them?
1.5.2 Sub-questions
a) What is the basis for EU transfer pricing rules?
b) What kind of national legislation of member states can be incompatible with EU law under current ECJ case law?
1.6 Research method
The research will be of a qualitative nature. The following will be conducted: - analysis of case law, literature and regulations
1.7 Key terminology
More terminologies used, as abbreviations at the beginning of the thesis, are quite commonly understood ones. There is not much to be defined here, but the first term needed to be clarified before description research is EU transfer pricing rules.
42 Available at
http://online.ibfd.org/kbase/#topic=doc&url=/highlight/collections/itg/html/itg_transfer_pricing.html&q=transfe r+pricing+pricings+transfers&WT.z_nav=Search&colid=4949
EU transfer pricing rules discussed below indicates all the relating references in case law by ECJ, decisions and proposals by the Commission and any legally binding aspects on the arm’s length principle, comparability analysis, transfer pricing methods and any other rules on determining transfer prices between associated companies.
Chapter 2 EU law on transfer pricing
2.1 General scene of harmonization in direct taxation
In Chapter 1, the scope of research is limited to transfer pricing in direct tax, so it is necessary to examine that the Union has competences in terms of direct taxation. In TFEU, there are three points that make it possible and legal.
2.1.1 Competences of the Union in direct tax and direct tax harmonization
Article 4(2) TFEU claims shared competence between the Union and member states with Union’s “preemption”43. Direct taxation is caught by subparagraph (a) of this article, with heading of “Internal market”. Whenever the Union has exercised its competence to regulate a tax matter by way of a Regulation or a Directive, member states have to that extent lost their individual competences to regulate that tax matter.44
Although direct tax harmonization is seemingly reasonable for enhancing the internal market, the legal basis provided for that in TFEU is not as explicit as the harmonization of indirect taxation, i.e. Article 113 TFEU. The harmonization of direct taxation follows the harmonization rules indicated by Article 114 and 115. While Article 114(2) excludes taxation from applying “ordinary legislative procedure”, Article 115 calls for directives with a view to approximation of national rules which
43 Chpater 2, European Tax Law, Sixth Edition, Ben J.M. Terra & Peter J. Wattel. 44 Id. at Chapter 2.
directly affect the establishment or the function of the internal market.45 And that is also the only legally binding instrument for (direct tax) integration, on a unanimous basis.
However, this provision does not stop the Commission from issuing recommendations and communications which often follow the reading of the Commission of related case law. These forms help member states to conform to the Commission’s understanding.
Besides, the Council can take appropriate measures to attain the objective of enhancing internal market according to Article 352 TFEU.
2.1.2 A further guarantee of fundamental freedom: prohibition of discrimination
Firstly, a general provision forbidding discrimination based on nationality is set under Article 18 TFEU (ex Article 12 EC Treaty). Furthermore, fundamental freedoms of capital, persons, goods and services are regulated in the treaty.
Article 63 TFEU prohibits restrictions on capital and payments between member states and between member states and third states while Article 65 TFEU asserts such prohibition does not apply to national measures of member states to distinguish taxpayers in different situations and to necessarily prevent infringements of national law, in particular in the field of taxation. Article 45 TFEU, indicated in the Finanzamt Köln-Altstadt v Schumacker Case (Case C-279/93), has direct effect with regards to tax and social security, which stipulates the freedom of movement for workers with prohibiting “discrimination based on nationality [...] as regards employment, remuneration and other conditions of work and employment”. 46
Article 49 TFEU prohibits restrictions of establishment of nationals of a member state in the territory of another member state and Article 55 TFEU forbids discrimination between the nationals of Member States “as regards participation in the capital of companies”. Article 56 TFEU protects providing of services from discriminative treatment and the definition of “services” is defined in Article 57 TFEU.
45 Framework for the Approximation of National Legal Systems with the European Union’s Acquis, Uroš Ćemalović,2015. On Page 247 the article discussed the function of Article 95 TEC, i.e Article 115 TFEU. 46 http://www.europarl.europa.eu/atyourservice/en/displayFtu.html?ftuId=FTU_5.11.2.html
Although not expressly mentioned direct taxation, these provisions on the protection of freedoms can be and are actually used in protecting taxpayers from the prejudice of restrictive and discriminating provisions. Concerning the relatively modest direct harmonization introduced in 2.1.1, the ECJ is required to be the guardian of interpretation of TFEU to develop systems of treaty freedoms47 and is continuing its intervention in direct taxation from 1980s, in both direct taxation and direct taxation.48 In indirect taxation where highly harmonization and legally binding rules are realized, case law mainly concerns the technical and detailed interpretation of tax law rather than EU law, while in direct taxation, case law are more EU law than tax law and treaty freedom is of extreme significance. The freedom of establishment, providing services and capital are what ECJ concerns most.
These features are also found in transfer pricing case law.
2.1.3 Exceptions of harmonization: state aid and disparities49
From efforts of integration in direct taxation above, there are two potential exceptions.50
TFEU Article 107 regulates that member states are forbidden to grant state aid to taxpayers except narrowly defined situations offered by Article 107 (3) TFEU. Because favoring certain undertakings will distort or threatens to distort competition and harm internal market and EU integration, state aid is incompatible with EU law. This logic also applies to tax measures member states may have. According to Article 108(3), EU member states shall inform EU Commission before they grant or alter aid
47 http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv%3Aa10000
48 Articles 110-113 TFEU regards tax provisions and require Member States to ‘enter into negotiations’ on the abolition of double taxation within the Community, but is usually thought to concern indirect taxation, so they does not include in the discussion.
49 There are two exceptions. The other one is under Article 116 TFEU, disparities between national laws or practices leading to market distortions allow qualified majority adoption of directives necessary for the elimination of such market distortions.
50 Exceptions of state aid and disparities here are different from European Tax Law by Peter Wattel. In the book, two exceptions are addressed as deviations from the ordinarily unanimous requirements in direct tax matters. State aid is exceptional as the Commission holds the alone authority of deciding state aid, and disparities are exceptional as the directives for elimination of market distortions caused by disparities can be adopted with consents of majority. Here, the exceptions are compared with 2.1.2 where taxpayers are protected from less favorable treatment, while 2.1.3 forbids some (selected) taxpayers are treated more favorably (state aid), or allows unfavorable treatments of some taxpayers to exist (for disparities).
ahead of sufficient time and wait for its comments. Otherwise, the Commission can start investigations on those aids implemented without informing and accepting it. The Commission is the only authority to assess whether a national rule constitutes state aid and whether it should be prohibited or approved. This different authority – compared with the function performed by ECJ introduced in 2.1.2 – inevitably leads to some discontinuation in the Union’s expressed opinion in some harmful tax practice.
The other exception is disparities of national tax systems. Although ECJ acts as guardian of prohibiting discrimination, disparities fall out of the scope of ECJ authority as a “two-country problem” (Peter Wattel) and can be solved only by making jurisdictional priority choices, i.e. political choices instead of a purely application of tax principle or EU law. With case law such as the Gilly Case and the Van Hilten Case, a consistent view is held by ECJ that “Articles [12, 43 and 49 EC] are not concerned with any disparities in treatment which may result, between Member States, from differences existing between the laws of the various Member States, so long as they affect all persons subject to them in accordance with objective criteria and without regard to their nationality”.51If no relief from double taxation at all is available and neither of the two States involved discriminates against non-residents or against foreign source income (‘exercise in parallel’), then taxpayers will have to wait for positive integration.
2.1.4 Summary: “negative integration” and importance of ECJ
To update, substantive positive integration in direct taxation includes four Directives on the basis of Article 115 TFEU (the Parent-Subsidiary Directive52, the Tax Merger Directive53, the Interest and Royalty Directive54 and the Anti Tax-Avoidance Directive; CCCTB Directive is re-launched and pending55), as well as one
51 ECJ, 1 February 1996, Case C-177/94, Criminal proceedings against Gianfranco Perfili [1996] ECR I-161.
52 Council Directive of 23 July 1990 on the common system of taxation applicable in the case of parent companies and
subsidiaries of different Member States (90/435/EEC).
53 Council Directive of 23 July 1990 on the common system of taxation applicable to mergers, divisions, transfers of assets
and exchanges of shares concerning companies of different Member States (90/434/EEC).
54 Council Directive of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (2003/49/EC).
multinational Arbitration Convention on the basis of deleted Article 293 TEC. Starting from the Report of the Fiscal and Financial Committee in the ECC Reports on tax Harmonization in 1963, proposals for direct tax harmonization have always been discussed but ended up without a realized outcome. So the ECJ plays a more important role in direct tax field than indirect tax field. On transfer pricing matters in cross-border cases it is the same.
With lack of positive integration in direct tax matters, the ECJ has to deal with increasing amount of corporate taxation cases in situations involving the exercise of fundamental freedoms granted by the TFEU56, protecting fundamental freedoms over the attempts of national tax authorities to protect their corporate tax bases. Hereby, with the growing importance, the Court builds a complex and indistinct composition of a picture of negative harmonization and leaves more to be fulfilled for successors.
2.2 Case law in transfer pricing
Within the scene of direct tax harmonization, transfer pricing is concerned with the second point (2.1.2) and the third point (2.1.3). In the general context of international taxation, transfer pricing (in cross-border scenarios) concerns (i) the right allocation of profits between permanent establishment/subsidiary and parent, and (ii) thus the allocation of taxing rights of states. It induces all four issues in international tax law, (i) taxation of foreign income of residents, (ii) taxation of domestically sourced income of nonresidents, (ii) prevention of the double taxation ensuing from the parallel exercise of taxing jurisdiction by two member states on the same tax base of the same person, and (iv) prevention of international tax avoidance. Taking a two-sided view, profits taxable in a member state might well be expenses deductible in the other member state. So trying to imagine in EU law, less favorable tax treatment can be higher transfer prices to be taxed on and less transfer prices allowed to be deductible for cross-border taxpayers. Extra documentation requirements can also be “less favorable” when ECJ does not think the Arbitration Convention can be a solid
remedy. Here three cases will be introduced relatively in detail, Lankhorst-Hohorst GmbH v Finanzamt Steinfurt （ Lankhorst-Hohorst ） (Case C-324/00)57, Test Claimants in the Thin Cap Group Litigation v IRC (Thin Cap) (Case C-524/04)58, and Societe de Gestion Industrielle (SGI) v Belgian State (SGI) (Case C-311/08)59. Other case law, i.e. National Grid Indus BV 371/10) P61 and Deutsche Shell GmbH (C-293/06) P43 will be briefly discussed.
2.2.1 Lankhorst-Hohorst Case
In the Lankhorst-Hohorst Case, the compatibility of a German domestic provision on thin capitalization with the freedom of establishment was at stake.60 Under the heading of “capital borrowed from shareholders” in national legislation, interest payments by a German subsidiary to its German parent company were fully deductible for computing the corporate income taxes of the subsidiary, while interest payments by a German subsidiary to a foreign parent company above a certain threshold (thin capitalization rule) were regarded as non-deductible profit distributions, stated as “not entitled to tax credit”.
In the judgment of ECJ, the German tax provisions impaired the freedom of establishment. The governments tried to justify provisions at issue with three justifications.
Firstly, German government provided justification that national provisions at issue were “intended to combat tax evasion in the form of ‘thin capitalization’ or ‘hidden equity capitalization’”.61 In this respect, the ECJ agreed with the government’s opinion by mentioning Head 2 of the provision at issue which allowed an exception in case that company proved that it could have obtained the loan capital from the third 57 Lankhorst-Hohorst GmbH v Finanzamt Steinfurt (C-324/00) (judgment of December 12, 2002) [2002] ECR I-11779.
58Test Claimants in the Thin Cap Group Litigation v IRC (C-524/04) (judgment of March 13, 2007) [2007] ECRI-02107.
59 Société de Gestion Industrielle (SGI) v Belgian State (C-311/08) (judgment of January 21, 2010) [2010] ECR I-487.
60 Supra n. 30.
party and the amount of loan capital was permissible compared to equity capital. However, the ECJ required that in realization of anti tax-avoidance, that the proportionality principle needed to be upheld. The denial of this justification was confirmed and enhanced in Opinion of Advocate General by referring to ICI judgment that “diminution of tax revenue cannot be regarded as a matter of overriding general interest which may be relied upon in order to justify a measure which is, in principle, contrary to a fundamental freedom”.62
Despite its approval of adopting proportionate anti tax-avoidance provisions, the ECJ noted that German tax provisions at issue was not one of them. Paragraph 8(a) was applied generally to any situations with non-domestic parent companies while these situations did not themselves constitute tax evasion, instead of “have the specific purpose of preventing wholly artificially arrangements”.63 Moreover, specifically in this case, a German subsidiary’s tax due did not reduce no matter whether the loan capital was obtained from parent company, so tax evasion was not established.
The second justification was that Paragraph 8(a) Head 2 ensured the coherence of tax systems by applying the arm’s length principle. ECJ, referring to previous case law, held that this justification may justify a restriction on the free movement of persons. But no direct link for the same and one taxperson, German subsidiary, existed between the less favorable tax treatment and tax advantage to offset such treatment. So this justification was also denied. The Advocate General, in the Opinion, noted that being in accordance with OECD Model does not make a national provision in accordance with EU law64, even where the arm’s length principle indicated by Article 9 of OECD Model is regarded as fair allocation of taxing right.
The third justification was effectiveness of fiscal supervision, which was rejected with no arguments put to ECJ that rules at issue were of such a nature of fiscal supervision. Thus, ECJ found that the German provision violated Article 43 EC and was not justified. The (rather weak) argument put forward by the German and the British Government, that the respective rules on “thin capitalization” for intra-group loans 62 Paragraph 78, the Opinion of the Lankhorst-Hohorst Case.
63 Supra n. 60, Paragraph 37. 64 Supra n. 61, Paragraph 80.
were fully in line with the arm’s length standard under Art.9 OECD model, was rejected both by Advocate General Mischo and the Court itself. The presumed compatibility of those rules with the OECD Model does not make rules compatible with European tax law.
2.2.2 Thin Cap Case
According to the Lankhorst-Hohorst Case, Article 43 TEC is interpreted as forbidding a member state to restrict a resident company from deducting interest for tax purposes on the loan granted by a non-resident parent company. In the Thin Cap Case, a number of cases are presented by a UK national court as a test for UK thin capitalization rules. According to these rules, cross-border taxpayers are treated differently from domestic ones. Until 1995, two rules were applied to the interest paid cross border between related parties: firstly, interest paid by a UK resident company to non-resident company will be treated as dividends to the extent that it exceeds “commercial reasonable return”; secondly, if not dealt with the first rule interest paid by a UK resident company to non-resident company belonging to the same group would be wholly as distribution without distinction of “commercial reasonable return”. 1995 amendment replaced the second rule with limiting recharacterizaiton to the part exceeding commercial reasonable return. Along with changing the limit of interest deduction, the scope of the rules above was also changed to “common control”, which was wider than 1995 definition of 75% holding.
As the inevitable consequences of restriction on freedom of establishment, Article 49 and 56 EC Treaty indicating restrictive effects of freedom to provide services and free movement of capital is not examined by ECJ for legislation at issue. Apparently the questioned provisions, no matter which period is examined, give a less favorable tax treatment for the interest on the loan granted by non-resident parent company by recharaterizing it as dividend, the amount of which was different depending on the legislation then. It is a restriction of freedom of establishment, also in accordance with judgment of the Lankhorst-Hohorst Case.
The ECJ confirmed its opinion on elimination of double taxation and allocation of taxing right with referring to previous case that “member states retain the power to define, by treaty or unilaterally, the criteria for allocating their powers of taxation, particularly with view to eliminate double taxation”.65 However, provisions at issue are not for allocation of profits and taxing right by using internationally recognized methods, but designed in the way of preventing profits from being untaxed.66 The unilateral nature of them is confirmed by the judgment and the Advocate General67 even if the internationally-recognized principles are used or UK sought to prevent or mitigate double taxation by DTCs with some states. Even if in some cases the provisions are implemented within the scope of allocating taxing right, they still must comply with EU law.
In the judgment, the ECJ clearly announces that it is sufficient to constitute a restriction if the tax legislation under examination is capable of restricting a non-resident company from exercising freedom of establishment, and acquiring, creating or maintaining a subsidiary in its jurisdiction, while effect of doing so is not necessary.68 The difference in treatment which applies to resident borrowing companies by virtue of the national provisions relating to thin capitalization at issue on the basis of the registered office of the related lending company constitutes a restriction on freedom of establishment.69
The UK government and the German government provided justifications of ensuring the cohesion of the national tax system and preventing tax avoidance according to the same objective to ensure fair and coherent tax treatment.70
In the first justification, a DTC is accepted as part of member state’s legislation in finding out direct link between the tax advantage and disadvantage. However, even then, the lending company with residence in another state will not get a concrete tax advantage with UK legislation of recharacterization and DTC corresponding adjustments. Its taxable profits will not get downwards after recharacterization. 65 Paragraph 49, Judgment of Thin Cap Case.
66 Supra n.64, Paragraph 52.
67 Paragraph 55 and 56, Opinion of Thin Cap Case.c 68 Supra n.64, Paragraph 62.
69 Supra n.64, Paragraph 63. 70 Supra n.64, Paragraph 65.
The second justification is preventing tax avoidance. The ECJ points out that such justification can be accepted as long as national measure is specifically targeted at wholly artificial arrangements. “Wholly artificial arrangements” do not reflect economic reality and escape tax normally due on the profits generated by activities carried out on national territory. The type of conduct described in the preceding sentence is such as to undermine the right of the Member States to exercise their tax jurisdiction in relation to the activities carried out in their territory and thus to jeopardise a balanced allocation between Member States of the power to impose taxes.71 ECJ accepts UK legislation on its objective and then examines whether it is in accordance with proportionality.
UK legislation at issue will recharacterize the interest payments only if the payments and the loan agreement deriving it did not comply with the arm’s length principle. And depending on time (after 2004), only the part that exceed what independent parties will agree under similar circumstances will be recharacterized. Compensating adjustments is allowed based on UK’s treaty network to eliminate double taxation. That is to say, in the residence states of the parent company, through treaty compensation double taxation will be relieved. That was regarded as proportionate by the Court.
In a word, although both Advocate General and the Court emphasized that rules at issue were discriminating against cross-border groups, the application of the arm’s length test as such can be justified by overriding public requirements. Member states is allowed to issue domestic rules to combat tax abuse, and especially, with reference to previous case law, disregard “artificial arrangements” with no business rationale and aiming at lowering or avoid tax. Comparisons with independent parties’ transactions can be accepted as a way to make sure the business rationale justifications provided by companies are real.
2.2.3 The SGI Case
According to literature, the SGI case is the first “full-fledged” transfer pricing case and one that undoubtedly lays down ECJ’s recognition of the arm’s length principle. In this case, the dispute is on an interest-free loan granted by Belgian holding company SGI to French subsidiary and a “disproportionate” director’s remuneration paid to the Luxembourg parent company, which constitute “unusual and gratuitous advantage” under the national legislation at issue. Those provisions will add back unusual and gratuitous advantage back to the profits of domestic company for tax purposes.
The fundamental freedom related can be freedom of establishment, under Article 43 TFE interpreted with Article 48 TFE, forbidding discrimination based on nationality. Free movement of capital under Article 56, and general rule under Article 12 is not used regarding the “interdependence” characterized by “definite influence” referring to previous case law. This stance is inherited from the Lankhorst-Hohorst Case’s opinion that restrictions of free movement of capital will be inevitable results of restrictions of freedom of establishment.
The judgment highly follows Advocate General’s Opinion on whether restrictions are constituted. Still inherited from previous case law, restrictive effects are constituted when provisions at issue deter companies from acquiring, creating or maintaining a subsidiary in another member state because Belgium tax law makes advantage granted to such foreign subsidiary less favorably. The provisions at issue meet that standard and are even worse. Non-resident companies can be deterred from acquiring, creating or maintaining a subsidiary in Belgium due to “tax burden imposed there on the grant of advantages at which the legislation is directed to”.72 Even the Arbitration Convention can resolve the extra tax burden, it will be invoked only at taxpayers’ request and thus imposes additional administrative burden. The process to solve double taxation by that way takes years long and then the taxpayer already is damaged in that time.
Furthermore, ECJ denied Belgium and German governments’ contentions that the tax disadvantages result from, not tax assessment, but risk of double taxation, and that the Arbitration Convention73 is possible to be used to diminish that risk. It is enough to constitute a restriction when the provision is capable, instead of in effect, to restrict. The governments involved provide justifications of balanced allocation of the right to tax, fear of tax avoidance, and combat against abusive practices.
The Advocate General made a new point that the justification of combating tax avoidance to some extent falls in the justification of allocation of taxing rights. And the justification of balanced allocation of the right to tax is accepted by ECJ this time when ECJ is convinced by German’s statements that provisions at issue is taxing the profits which German should tax and does not exceed the proportionate part.
The arm’s length principle can be defended as a means to fight abusive arrangements. The judges stated74:
“Article 43 EC, read in conjunction with Article 48 EC, must be interpreted as not precluding, in principle, legislation of a Member State, such as that at issue in the main proceedings, under which a resident company is taxed in respect of an unusual or gratuitous advantage where the advantage has been granted to accompany established in another Member State with which it has, directly or indirectly, a relationship of interdependence, whereas a resident company cannot be taxed on such an advantage where the advantage has been granted to another resident company with which it has such a relationship. However, it is for the referring court to verify whether the legislation at issue in the main proceedings goes beyond what is necessary to attain the objectives pursued by the legislation, taken together.”
As a result of accepting the justification, Belgian tax provisions are in accordance with EU law. An opinion to the result of the case reads that reconcilidation between treaty law and European tax law is possible because, in the judgment, relief from treaty is taken into consideration by the Court and the arm’s length principle is recognized as an effective approach to determine unusual and gratuitous advantage. It 73 Convention 90/436/EEC of 23 July 1990 on the elimination of double taxation in connection with the
adjustment of profits of associated enterprises (OJ 1990 L 225, p. 10). 74 Supra n.64 Paragraph 3.
seems to shed light on whether transfer pricing can be incorporated into ECJ case law.
2.2.4 Other related case law
Hein Vermeulen (2016) provides that National Grid Indus BV Case and Deutsche Shell GmbH Case are also related in transfer pricing.
National Grid Indus BV Case (C-371/10) is indirectly concerned with transfer pricing in regard of once again expressing ECJ’s view on exempting member states from the duty of changing national taxation to remove disparities (Paragraph 61). This case is about transferring a company’s effective management to another member state which it is not incorporated in and declares in the judgment that the state of origin is not obliged to take into account the decrease in value after the transfer of effective management.
Deutsche Shell GmbH Case (C-293/06) reiterates on disparity that a member state (the origin) is not obliged to provide a corresponding (decreasing) adjustment for capital gain/loss when the other state (the host) revalues (Paragraph 43). Wolfgang Schon also refers to Société d’investissement pour l’agriculture tropicale SA (SIAT) v Belgian State (SIAT) (C-318/10) and Itelcar - Automóveis de Aluguer Lda v Fazenda Pública (Itelcar) (C-282/12) as related.
2.3 Summary
As the Advocate General said in the Lankhorst-Hohorst Case, irrespective of anything that the provisions of the OECD model convention may permit, member states should never give rise to discrimination when they tax profits generated in their territories and exercise their jurisdictions on fiscal policy.75 Starting from freedom of establishment, ECJ has always attained its rule of reason on discriminate treatment on cross-border taxpayers.
According to case law discussed, there are several instructive points in checking member states’ national legislation. Following the rule of reason:
a) Fundamental freedom involved in transfer pricing cases: Usually in these cases, freedom of establishment is the only fundamental freedom to be checked. Being in compatible with the arm’s length principle is not sufficient for examined provisions to constitute infringement of fundamental freedom.
b) How to constitute a discrimination: examined provisions is required to be capable of creating extra burden for cross-border transactions. The existing actual harm is not required. “Extra burden” or “less favorable treatment”, in other cases, are confirmed to exist by comparing with domestic taxpayers in same table situations. But in here, comparable case, as the Lankhorst-Hohorst Case, domestic and cross-border is not comparable. However, the comparability analysis is strictly required in discrimination test (Thin Cap Case).
c) Justifications
- anti tax-avoidance: to meet the requirement of this justification, provisions at issue need to be specifically applied to wholly/purely artificial arrangements. Though some descriptions such as “lack of economic rationality” are made, no situations explicit enough are included in the Judgment or the Opinion to act as guidance for taxpayers. Before SGI Case, ECJ has never accepted such a justification in transfer pricing cases (similar expression is risk of tax evasion in Lankhorst-Hohorst Case). But in SGI Case, with the norm “fear of tax avoidance” and putting it partly under fair allocation of taxing right.
- allocation of taxing rights: complying with global standard such as OECD transfer pricing guidance or the arm’s length principle does not necessarily release national legislation from the doubt of discrimination. But here ECJ in SGI case ignored the point that allocation of taxing right requires the direct link between the less favorable tax treatment and tax advantage, i.e. the increasing taxable income must be compensated by increasing deductions (in the group perspective).
- other justifications which are denied include: cohension of national tax system in Lankhorst-Hohorst Case and coherence of the tax system in Thin Cap Case.
concern with the protection of tax revenues76. ECJ seems to take a more flexible attitude recently when in SGI Case it gives up the standards of the tax burden exercised and the tax benefits must be directly linked which was reconfirmed in Thin Cap Case. But it is unclear whether this test will be applied again in later case.
d) Proportionality
Although ECJ contends that national courts have discretion to design the test of “fully artificial arrangements”, there are two rules member states must obey:
- Give taxpayers an opportunity, without being subject to undue administrative burden, to provide evidence of any commercial justification that there may have been for that transaction.
- Profit adjustments have to comply with the arm’s length principle and should not exceed what would have been agreed between independent parties.
In conclusion, ECJ has confirmed compatibility of transfer pricing adjustments under the arm’s length standard”.77 Their understanding of arm’s length principle is not what it is in international consensus but only keep a half of it as a anti-avoidance test by limiting acceptable national legislation to those manifestly proportionately aimed at wholly artificial arrangements. One step further, by asking national tax authorities to allow taxpayers to provide justifications of commercial reasons, the ECJ forces tax authorities to accept non-arm’s length transactions if the legislation is treating cross-border non-arm’s length transactions differently from domestic ones and taxpayers can provide commercial justifications. But non-arm’s length transactions with commercial reasons does not mean independent party in comparable situations would do the same. It is true in accordance with the negative integration introduced in 2.1 that ECJ in transfer pricing case law still keeps high relation with EU law and transfer pricing rule is diluted into it. And All in all, Peter Wattel’s observations are right again in transfer pricing case law as ECJ disapproved German recharaterisation of interest at first, ending up with approval of SGI Case and forgetting the consistency of some points:
76 Supra n. 47. 77 Supra n. 30.
The Court’s direct tax case law shows a cyclical pattern: hesitance at first, followed by a decade of outright free movement activism in direct tax matters, producing many erroneous judgments, and in the last decade showing more awareness of its own limitations and more reverence for legitimate tax base protection interests of the Member States.
Chapter 3 Indications of EU transfer pricing rules on intangibles
In Chapter 3, discussions will be made following case law above, trying to shed some light in gains and loss of judgments and discuss in combination with international tax law and other EU practice.
3.1 Is transfer pricing in ECJ’s understanding identical to OECD guidance?
The answer is apparently no. The ECJ ‘s case law shows different understanding of the arm’s length principle, functions of transfer pricing, comparability analysis, transfer pricing methods, and documentation requirements.
3.1.1 Arm’ length Principle
As concluded in the last part of Chapter 2, the ECJ takes a one-sided approach to understand the arm’s length principle and makes the scope of its application smaller than OECD guidance. It even explicitly says that being in accordance with international consensus, i.e. the arm’s length principle, does not indicate any compatibility with EU law.
To dig further, the ECJ asserts in the Thin Cap Case, “national legislation which provides for a consideration of objective and verifiable elements in order to determine whether a transaction represents a purely artificial arrangement, entered into for tax reasons alone, is to be considered as not going beyond what is necessary to prevent abusive practices where, in the first place, on each occasion on which the existence of
such an arrangement cannot be ruled out, the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that arrangement”.78
That is to say, three conditions need to be fulfilled to regard thin capitalization rules as proportionate: (1) they should be based on an objective arm’s length test and (2) the taxpayer should be given the opportunity to prove, without excessive administrative burdens, that the transaction was commercially justified; (3) the recharacterization of interest should only affect the proportion that exceeds what would have been agreed between independent parties79.
The first and the third reason seems to regard arm’s length principle as standards, but read with the Lankhorst-Hohorst Case, the problems arise from “commercial justification”. Recalling the Lankhorst-Hohorst Case, parent company lending money to highly defective subsidiary defended itself by reason of reducing financial cost of subsidiary. If that is commercial justification which the ECJ means, it is deviating from OECD guidance. OECD transfer pricing guidance advises to use objective test to evaluate what is arm’s length principle and defines it by five comparability factors. “Contractual terms”, “economic circumstances” and “commercial strategies” in comparability analysis which read similar are different from commercial justification because their objectivity is realized by comparison with independent parties while commercial justification is to some extent subjective without that comparison. So in this regard the ECJ does not understand OECD TPG in the right way.
ECJ’s misunderstanding goes further when use group-level reasons to justify a single transaction between two group companies which is separately examined under thin capitalization rules. Reducing financing cost for a subsidiary is a justification deriving from arrangements of the whole group and cannot justify separately for the interest. If that justification is used, then the determination of subsidiary’s profits/losses should be considered together. OECD TPG takes a subsidiary perspective instead of a group one when performing comparability analysis. In this regard, ECJ does not understand
78 Supra note 65, Paragraph 82. 79 Supra note 65, Paragraph 83.
right.
In SGI Case, the ECJ expressed very briefly when accepting the anti-avoidance justification and failed to clear the confusion caused by previous case law.
3.1.2 Functions of transfer pricing
Generally, in checking transfer pricing rules from states and international organizations (the UN and the OECD), transfer pricing is used in two aspects, preventing potential tax avoidance and allocating/dividing of taxing right.80 There is no use to singly address the anti avoidance aspect of transfer pricing, as many other tax provisions can be used for that. But that is what ECJ did.
However, in rethinking arm’s length principle, it is too early to accuse the Court of misunderstanding transfer pricing. Arm’s length principle dates back the decades where cross-border trade was just starting and the initial efforts to allocate profits between different parts of a group. With assumptions of “market conditions” and “competition conditions” were very valid standards to find out “right” prices and taxes. But nowadays multinationals are running in a different logic from domestic companies. They are achieving business which purely domestic companies cannot do with help of control of highly integrated hierarchies. Also, studies show that intra-firm optimal transfer pricing is based on “marginal cost” instead of “market price”.81 Thus, contractual relationship between group members may not follow what governs the transaction between separate parties and fully application of “competitive conditions” or “market conditions” does not reflect all the economics in multinational.82 Transfer pricing is partly setting incentive for internal transactions. If all the differences between market transactions and related transactions are ideally wholly eliminated, then the superiority of form of multinational would be eliminated, too. This is not in accordance with internal market and optimal resource allocation in the Union. In this
80 Supra note 6.
81 Eugen Schmalenbach, “Über Verrechnungspreise”, 3 Zeitschrift fürhandelswissenschaftliche Forschung (1908/09) pp.165 – 185; and Jack Hirshleifer, “On the Economics of Transfer Pricing“, Journal of Business 1956, pp.172 – 184.
