On 5 and 14 December 2023 respectively, the Court of Justice of the European Union issued two milestone judgments in the Engie and Amazon cases related to State aid in tax matters. These judgments clarify the relevant conditions for determining whether a tax measure constitutes unlawful State aid. The cornerstone of the discussion is the “selectivity” criterion, which can only be assessed if the so-called “reference system” has been correctly established. The Court of Justice has now shed more light on this subject. The highest EU Court’s main message to the EU Commission is that the Commission is not entitled to rewrite domestic law or to substitute an interpretation it considers more appropriate for the national authority’s interpretation of and national practice related to domestic law.
Introduction
According to settled case-law of the Court of Justice, the classification of a national measure as “State aid” within the meaning of Article 107(1) TFEU requires all the following conditions to be fulfilled:
- there has been an intervention by the State or through State resources;
- the intervention confers on the beneficiary an advantage on a selective basis;
- the intervention distorts or threatens to distort competition on the internal market; and
- the intervention is liable to affect trade between Member States.
Most of the cases still being investigated by the Commission or currently pending before the General Court or the Court of Justice concern the existence of an advantage and its selective nature.
In order to classify a national tax measure as “selective”, the Commission must identify the reference system, namely the normal tax regime applicable in the Member State concerned, and demonstrate that the tax measure at issue departs from this reference system to the extent that it introduces differentiations between operators in a comparable factual and legal situation. The determination of this reference framework is therefore an essential prerequisite for assessing not only the existence of an advantage but also its potentially selective nature.
The Engie case
Engie used an intra-group financing structure in Luxembourg and obtained tax rulings from the Luxembourg tax authorities confirming its tax treatment. The main feature of the tax planning consisted in a qualification mismatch. In short, the rulings basically confirmed the debt nature of a convertible zero-coupon loan (ZORA) in the hands of the borrower and its equity nature in the hands of the lender. The tax rulings confirmed the deductibility of accrued but unpaid interest under the ZORA in the hands of the borrower, whereas the taxable income at the level of the lender was not impacted. Following the conversion of the loan into shares (where the accrued value of the ZORA was, apparently, taken into account), the former lender could benefit from the participation exemption regime in respect of the income from the shares received upon conversion.
The Luxembourg tax authorities, in their tax rulings, did not apply the general anti-abuse rule (GAAR) under Luxembourg law.
According to the Commission, the deduction of expenses under the ZORA, without corresponding income inclusion in the hands of the lender, constituted a selective advantage under Article 107(1) TFEU. The Commission considered that Luxembourg had misapplied its own tax legislation with respect to the participation exemption and had also omitted to apply the GAAR.
The Amazon case
Amazon also obtained tax rulings from the Luxembourg tax authorities, approving the tax treatment of two subsidiaries (LuxOpCo and LuxSCS) in connection with the restructuring within the Amazon group.
Specifically, the tax ruling confirmed that a royalty paid by LuxOpCo to the partnership LuxSCS (whose partners were US group entities) for the use of certain intangible assets was “appropriate and acceptable” within the meaning of the relevant provision of the corporate income tax rules and in line with the transfer pricing policy applicable in Luxembourg. LuxSCS, which was a tax-transparent entity in Luxembourg, was not subject to income taxes in Luxembourg.
The Commission considered that LuxOpCo’s tax base was unduly reduced by royalty payments to LuxSCS under the licensing agreement. The Commission made its own calculation of an arm’s length royalty (referring to its own interpretation of the arm’s length principle and OECD guidelines) and considered the taxes reduced according to any excess paid by LuxOpCo as a selective and, hence, unlawful advantage.
The General Court’s judgments (first instance)
Amazon, Engie and the State of Luxembourg brought actions before the General Court of the European Union.
In a judgment dated 12 May 2021, the General Court upheld the Commission’s decision in the Engie case and confirmed that Engie’s financial structure should have been considered as abusive by the Luxembourg tax administration under the GAAR.
In the Amazon case, the General Court, in its judgment on the same day, rejected the Commission’s reasoning as to the existence of a selective advantage and annulled the Commission’s decision. The General Court found that the Commission had committed several errors in its application of the arm’s length principle. Hence, the Commission was not able to demonstrate that LuxOpCo had effectively received an advantage.
The Court of Justice’s judgments (last instance)
Both cases were submitted to the Court of Justice, which reformed the two judgments of the General Court due to fundamental errors in the identification of the reference system and annulled the Commission’s decisions in both cases.
In the Engie case, the Grand Chamber of the Court of Justice emphasised that classifying a tax measure as “selective” presupposes a clear determination of the content of the provisions of national law and also requires examination of their scope on the basis of the administrative and judicial practice of the Member State concerned.
In that respect, the Court of Justice stressed that the Commission had failed to correctly identify the reference system by exclusively referring to the general purpose of the Luxembourg corporate tax law which consists of taxing all resident companies, without adequate appreciation of its wording or the applicable administrative and judicial practice. The Commission must, in principle, respect and apply the interpretation of provisions of national law given by the Member State if such interpretation is compatible with the wording of those provisions. In the Engie case, the Commission had not presented any convincing argument that would invalidate the interpretation of the Luxembourg law as defended by Luxembourg and Engie. Furthermore, the General Court and the Commission had made an error of assessment by dismissing the administrative and judicial practice in Luxembourg in applying the GAAR. Indeed, the existence of the alleged abuse of law should have been assessed in the light of such practice, and not on the basis of the Commission’s own interpretation in abstracto of the criteria for abuse. The Court of Justice re-assessed the legality of the Commission’s decision and decided to annul it directly.
In the Amazon case, the Court of Justice confirmed, in line with the Fiat case, that the arm’s length principle has no autonomous existence in EU law. The Court of Justice also confirmed that the OECD transfer pricing guidelines and the arm’s length principle cannot be considered in the examination of the reference system under Luxembourg law, unless the Luxembourg tax system makes explicit reference to them. Hence, the Commission had erred in law when determining the reference system by taking into account parameters and rules external to the national tax system in question, such as the OECD transfer pricing guidelines that aim to clarify the arm’s length principle – which was not even part of Luxembourg tax law at the time when the rulings were issued. Neither the Commission nor the General Court should have analysed the rulings from the perspective of OECD transfer pricing guidelines and an arm’s length principle that was not part of Luxembourg tax law.
Although the General Court had relied on a wrong reference system, the Court of Justice still considered that the operative part of the judgment annulling the Commission’s decision could be justified on other grounds. The Court of Justice therefore decided to make a substitution of grounds and directly rule in last instance by annulling the Commission’s decision.
Conclusion
In both judgments, the Court of Justice followed the opinion of Advocate General Kokott, who had explicitly warned that the Commission and the Courts of the EU should not become the highest tax judges judging how a Member State should interpret and/or apply its own tax rules. Such interpretation should be taken as a starting point when determining the relevant reference system. These judgments obviously limit the Commission’s action radius, but they do not give the Member States carte blanche when enacting or applying tax incentives either.
Given the financial risks associated with the characterisation of a tax advantage as State aid (which can be recovered, with interest, within a period of 10 years), companies benefitting from specific tax advantages or sweetheart deals with tax authorities should consider running sanity checks with respect to the existing structures to assess the scope of potential exposure under the State aid rules. Prudent legislators should pay serious attention to State aid considerations when enacting legislation that might result in tax benefits without prior consultation with and submission to the Commission.
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