Manipulation of transfer pricing of intangibles: the role of the arm’s length principle, the EU State Aid and the BEPS Action Plan.

Name: Evgenia-Charikleia (Erika) Dimopoulou

Anr: 547817

Snr: 2007089

Supervisor: Dr. E.D.M. (Eveline) Gerrits

Academic Year: 2016-2017

Master thesis International Business Taxation / track: International Business Tax Law, Tilburg School of Law, Tilburg University

Title: “Manipulation of transfer pricing of intangibles: the role of the arm’s length principle, the EU State Aid and the BEPS Action Plan.”

Name: Evgenia-Charikleia (Erika) Dimopoulou Anr: 547817 Snr: 2007089 Supervisor: Dr. E.D.M. (Eveline) Gerrits Date: 08/08/2017

Table of Content

CHAPTER 1: Introduction

1.1 Motivation of study 1.2 Research question (including sub-questions) 1.3 Importance of the study 1.4 Research Methodology 1.5 Overview of the chapters

CHAPTER 2: The arm’s length principle & its (un)certainty

2.1 Transfer pricing as major international taxation issue

2.2 The arm’s length principle in the OECD & UN Models and the OECD guidelines

2.3 Advantages and disadvantages of the arm’s length principle

2.4 Formulary Apportionment as the predominant alternative

CHAPTER 3: Tax Treatment of Intangibles in the context of Transfer Pricing

3.1 Definitional and valuation issues regarding intangible property

3.2 Transfer Pricing methods for transactions involving intangibles

3.3 Comparative analysis of the preferred methods

3.4 Aggressive tax planning and tax avoidance by MNEs

CHAPTER 4: Advance pricing agreements and EU State Aid

4.1 State aid as is prescribed in TFEU: advantage and selectivity

4.2 Advance pricing agreements

4.3 Significant cases that triggered a public debate

4.4 The role of the European Commission

CHAPTER 5: The project of BEPS and its effectiveness

5.1 BEPS Action Plan

5.2 Actions 8-10 and transfer pricing of intangibles

5.3 BEPS and the EU

5.4 Observations on the BEPS project

CHAPTER 6: Conclusion

List of Abbreviations

ALKI: Alki Limited Partnership

AOE: Apple Operations Europe

AOI: Apple Operations International

APA: Advance Pricing Agreement

ASI: Apple Sales International

ATP: Aggressive Tax Planning

BEPS: Base Erosion and Profit Shifting

CJEU: Court of Justice of the European Union

CPM: Cost Plus Method

CUP: Comparable Uncontrolled Price

DG Comp: Directorate-General for Competition

EU: European Union

FFT: Fiat Finance and Trade

IP: Intellectual Property

MNE: Multinational Enterprise

OECD: The Organization for Economic Co-operation and Development

PSM: Profit Split Method

R&D: Research and Development

RPM: Resale Price Method

SCBV: Starbucks Coffee EMEA BV

SCTC: Starbucks Coffee Trading Company SARL

SMBV: Starbucks Manufacturing EMEA BV

TFEU: Treaty on the Functioning of the European Union

TNMM: Transactional Net Margin Method

U.S.: United States

UK: United Kingdom

UN: United Nations Abstract

In the era of economic globalization, MNEs tend to take advantage of their internal cross border transactions of intangibles. The application of the arm’s length principle in transfer pricing, the difficult identification and valuation of intangibles, as well as the selection of the right transfer pricing method are issues that make these transactions vulnerable. MNEs intend to reduce their tax burden through aggressive tax planning practices, which are encouraged by governments’ incentives and advance pricing agreements in order to attract investments in the EU. State Aid rules may apply in such cases. In order to fight against BEPS, caused by the foregoing practices of States and MNEs, the OECD launched an Action Plan and more than a 100 countries have willingness to cooperate.

CHAPTER 1: Introduction

1. Motivation of study

Nowadays, the globalizing economy is dominated by Multinational Enterprises1 (hereinafter MNEs). Due to the power of the MNEs2 and the intricate mechanisms that they adopt in order to escape taxation, transfer pricing techniques have become an additional tool for tax avoidance. Transfer pricing is defined as the setting of a price of goods and services in case of an internal transaction between related entities under the control of a single enterprise and it is based on the arm’s length principle which is an international standard. Albeit quite simple this mechanism seems, many corporations tend to adopt aggressive tax planning schemes, by adjusting their transfer prices in a way that income can flow from high-tax to jurisdictions of low-tax rates. In addition, tax arrangements with governments constitute a useful tool for the reduction of their tax burden.

In the past, transfer pricing concerned only transactions of physical goods, while now it involves rights in intangible goods, as well as, services. Intangible assets may include intellectual property such as patents, trademarks, designs, know-how, copyrights, licenses and literary or artistic compositions. In many cases, MNEs fail to estimate the price of these non- physical and non-financial assets in accordance with the market price of similar assets – as they would be sold to an arm’s length customer- especially when the entities concerned are located in different countries, with various tax rates, aiming at avoiding taxation. In recent years, case law, as for instance, “Starbucks case” or “Apple case”, proves that the way of moving profits through transfer pricing is common practice in this kind of corporations. Particularly, this is relevant for technology companies that deal with intellectual property (e.g. know-how), the value of which is deemed subjective and present difficulties in its calculation.

On the other hand, regarding the above mentioned “Starbucks case”, the role of the States in the application of the arm’s length principle appears to be crucial. Since the tax competition between the States is an element of the developed globalized economy, there are many cases of State Aid related to transfer pricing which reveal the States’ intention to improve their financial position using tax benefits. Thus, the tax authorities might be unexpectedly lenient and conciliatory. In some cases, they “misapply” the law in order to create incentives for foreign investments or to favor domestic companies instead of multinationals.

1 Maarten F. de Wilde,(2010), 'Some Thoughts on a Fair Allocation of Corporate Tax in a Globalizing Economy' , Intertax: international tax review , Volume 38 - Issue 5 p. 281- 305 2 The term MNE is not limited to very large organizations, but also includes smaller organizations with one or more subsidiaries or permanent establishments in countries other than where the parent is located, as it is clarified in the “Review into Australian Taxation Office’s management of transfer pricing matters”, (Australian Government, Inspector-General of Taxation).

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Taking into account the current situation, this study aims at investigating the application of the arm’s length principle in establishing transfer prices, especially in transactions between related enterprises involving intangible property. From an EU perspective, another significant aspect to be addressed is States’ intervention in the form of State aid through tax agreements with MNEs. Furthermore, the importance of the OECD BEPS Action Plan in order to tackle international aggressive tax practices must be examined.

2. Research question (including sub-questions)

The central research question of the thesis is:

What is the importance of the arm’s length principle and the role of BEPS Action Plan in tackling the use of transfer pricing, especially regarding intangible assets, by MNEs aiming at tax avoidance and which is the role of State Aid in this practice?

2.1 The application of the arm’s length principle & its (un)certainty.

How to comply with the arm’s length principle when establishing transfer pricing? - Examination of transactions between related enterprises which involve intangible property

2.2 Since the non-physical nature of intangibles imposes difficulties in estimating their value, taxpayers tend to take advantage of transfer pricing. Which issues may arise while using the existing transfer pricing methodologies? How do MNEs use these issues for tax planning purposes?

2.3 Which is the role of the State aid rules regarding APAs? Which cases of tax avoidance confirm the crucial role of State aid? Which is the role of the Commission?

2.4 What is the importance of the “OECD BEPS Action Plan” as an international framework aiming at combating aggressive tax planning and tax avoidance?

3. Importance of the study

Since the field of transactions (and their taxation) between entities under control of the same enterprise, especially concerning intangible property, is one of the darkest and at the same time most challenging issues of International Taxation, an investigation seems really interesting. In a world of new technologies and intellectual property, the difficulties in estimating the value of intangible assets involved in such transactions, create the ambition of MNEs to exploit this situation in order to obtain legal tax avoidance. Thus, an analysis of the different perspectives of transfer pricing, the application of the arm’s length principle as well as measures to restrict tax avoidance tend to be an intensive necessity. An analysis of State

[2] aid rules in the EU and the international BEPS project, which are deemed promising tools for reforming of the international tax system must follow.

4. Research Methodology

This research is going to be based on findings of current literature (books, journals, academic researches and opinions), European Union legislation, the OECD and the UN Model, the OECD transfer pricing guidelines, the BEPS action plan, relevant case law and notes from academic lectures.

5. Overview of the chapters

The thesis is composed of six chapters. The introductory chapter consists of the main research question including sub-research questions, the motivation and the importance of study, and the research methodology. The second chapter analyzes the notion and the application of the arm’s length principle regarding transactions between affiliated entities and presents the formulary apportionment as the predominant alternative. The third chapter reviews the transfer pricing rules, as presented in the OECD Guidelines, and the transfer pricing methodologies. Furthermore, it examines the definition, valuation and tax treatment of the intangible property. It, also, investigates the MNE’s tax planning strategies in order to support the argument that these companies take advantage of the issues concerning intangible assets in order to mitigate or avoid taxation. The fourth chapter presents the concept of State aid, examines APAs from a State aid perspective and cites relevant case law. The fifth chapter analyzes the BEPS project and questions its effectiveness. The sixth chapter concludes.

CHAPTER 2: The arm’s length principle & its (un)certainty

2.1 Transfer pricing as major international taxation issue

“Transfer pricing, source of income and determination of legal and economic ownership of group intangible assets represent the tax problem with which authorities around the world are now wrestling. Traditional methods of taxation, developed in a different technological era, will have to be adapted to take into account the changing nature of undertaking business in a virtually borderless world”.345

This apposite remark describes briefly the central question of this research and triggers a further analysis of the multidimensional topic of transfer pricing. The rapid development of

3 P. Anderson ‘Australia’ (1997) International Tax Review 4 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International 5 Wills, Michelle (1999) "The Tax Treatment of Intangibles in the Context of Transfer Pricing," Revenue Law Journal: Vol. 9 : Iss. 1, Article 2

[3] technology, communication and transportation6 increased dramatically the performance of MNEs in world trade. Since these companies have the flexibility to establish their enterprises and run their activities all over the world, in the 1990’s more than 40%7 of international transactions were intra-group, whereas now they are estimated at more than 60%89. This results in intricate taxation issues. An important issue is the setting of prices for this kind of transactions.

The general term, the rules and the methods for the pricing of intra-group, cross-border transactions between associated enterprises seems to be the most common definition of transfer pricing. However, since this topic is considered of great international tax concernment, plenty of definitions are established by representatives of different sectors, such as economists, lawyers, tax authorities, MNEs, etc. and demonstrate their diverse aims. For example, from a business perspective, the established transfer price for a controlled transaction is important in order to keep track of the performance of business units or individual entities in MNEs, as well as, to assess the efficiency of their managers.10 Moreover, transfer pricing is crucial as it could expose an MNE to a possible double taxation. On the other hand, for tax authorities, transfer pricing is relevant for the proper allocation of profits between various subsidiaries or PEs of a MNE11insofar as an artificial transfer price could lead to double non-taxation or tax minimization and thus, deprive governments of their fair share of taxes12 from MNEs.

Considering the difference between income tax rates on a global level, it seems possible for MNEs to use the relation between their individual enterprises to set transfer prices which may reduce their worldwide tax bill. Therefore, governments become more and more concerned with corporate tax base erosion as it is evident in the agenda of forums, as for example the G813 and the G2014, as well as, the OECD which introduced the BEPS project. However, the

6 United Nations, New York (2013), ‘Practical Manual of Transfer Pricing for Developing Countries’, Chapter 1. 7R.Y.W. Tang, (1993), Transfer pricing in the 1990’s, Tax and Management Perspectives, ABC-CLIO 8 http://www.taxjustice.net/topics/corporate-tax/transfer-pricing/

9 John Neighbour, “Transfer pricing: Keeping it at arm’s length”, OECD Center for Tax Policy and Administration, p.29 10 http://www.transferpricing.wiki/general-transfer-pricing-information/transfer-pricing-definition/

11 Ibid. 12 John Neighbour, “Transfer pricing: Keeping it at arm’s length”, OECD Center for Tax Policy and Administration,p.29, http://oecdobserver.org/news/archivestory.php/aid/670/Transfer_pricing:_Keeping_it_at_arms_length.h tml

13 The Group of Eight 14 The Group of Twenty Finance Ministers and Central Bank Governors

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OECD15 states in its 1979 and 1995 reports on Transfer pricing and MNEs that the term “transfer pricing” is neutral, it should not be confused with the problems of tax fraud or tax avoidance16 and it should not be automatically assumed that the related parties aimed to manipulate their profits. The United Nations also declared that this term is wrongly assumed as the transfer of taxable income from high to low taxing jurisdictions.1718

Hence, transfer pricing deals with the allocation of profit for tax or other purposes between parts of a multinational group. Transfer prices determine the income of the enterprises involved in the cross border transaction and also affects the tax base of the countries which have the right to tax the income of these enterprises. Thus, the valuation, the allocation of income and the jurisdiction of the countries concerned constitute crucial matters for the MNEs’ trading decisions. In order to avoid incorrect pricing or unjustified pricing most of the countries have adopted transfer pricing rules, based on the arm’s length principle for the evaluation of cross-border transactions between related parties. Nevertheless, the complexity of this standard causes difficulties regarding its application.

2.2 The arm’s length principle in the OECD & UN Models and the OECD guidelines

The term “at arm’s length” literally determines a distance equal to the length of a human's arm and it is originated from the army. In order to adapt this term to an economic transaction we deem that the parties involved have a distance between them, thus they are not related. This principle is a fiction as it assumes that the transfer price set in an internal transaction within a MNE is the same as if this transaction takes place between unrelated parties.19Hence, it equates affiliated and non-affiliated enterprises20 regarding the transfer price that they establish in case of a transaction.

The debut of the arm’s length dealing is placed around 187221. The phenomenon of over or under pricing of cross-border transactions between affiliated companies had become on the rise during World War I. The first transfer pricing regulation had been presented, with

15 The Organisation for Economic Co-operation and Development 16 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International 17 UN Secreteriat, Transfer pricing history (-State of the Art- Perspectives), Ad Hoc Group of Experts on International Cooperation in Tax Matters, Tenth meeting, Geneva, 10 - 14 September 2001 18 Supposing that during the transaction, one of the trading enterprises (MNE unit) is located in a country with a high tax jurisdiction and the other (unit of the same MNE) is located in a country with a low tax jurisdiction. 19 Maarten F. de Wilde, (2010), 'Some Thoughts on a Fair Allocation of Corporate Tax in a Globalizing Economy', Intertax: international tax review , Volume 38 - Issue 5 p. 281- 305 20 Which are not units of the same MNE and act completely independently 21 COMMENTS ON THE REVISED DISCUSSION DRAFT ON TRANSFER PRICING ASPECTS OF INTANGIBLES BY DR RAMON DWARKASING, ASSOCIATE PROFESSOR OF TRANSFER PRICING AT MAASTRICHT UNIVERSITY, THE NETHERLANDS, September 2013.

[5] international focus, in the United States and in the United Kingdom.22Particularly in the U.S. domestic legislation, the term “arm’s length” appeared for the first time in 1934, when it was included in the Revenue Act, although it had been already mentioned in the U.S. report to the League of Nations23 on the income allocation in 1932.24 Before that time, in 1928, this international organization, through a Fiscal Committee, had developed international principles and methodologies regarding the allocation of tax jurisdiction such as ‘separate accounting’25 which almost included the arm’s length concept. The Article 5 of the League of Nations which had been drafted in 1933, as well as, the Article IV of the treaty between France and the U.S. on income allocation between affiliated companies which entered into force in 1936 could be deemed the predecessors to Article 9 (1) of the OECD Model.26 The OECD promulgated the Draft Double Taxation Convention on Income and Capital in 1963 although the final Convention was published in 1977, apparently influenced by the U.S. regulation which was published in 196827, with several revisions in 1992, 2008 and 2010. The United Nations produced a UN Model Convention long after World War II, in 198028 and several updates have been done until the latest in 2011. The corresponding Article 9 was more or less identical with the current Article 9 (1) of the OECD Model Convention and it was used in order to ascertain whether a cross border transfer price is appropriate or not.

Nowadays, the legal basis of the arm’s length standard is the Article 9 of the OECD Model Tax Convention on Income and Capital, the UN Model Double Taxation Convention between Developed & Developing Countries29 respectively and should be considered in conjunction with Articles 25 and 2630. The article 9 (1) of the OECD Model Tax Convention, entitled

22 UN Secreteriat, Transfer pricing history (-State of the Art- Perspectives), Ad Hoc Group of Experts on International Cooperation in Tax Matters, Tenth meeting, Geneva, 10 - 14 September 2001 23The American Heritage New Dictionary of Cultural Literacy, (2005), Houghton Mifflin Company: “An international organization established after World War I under the provisions of the Treaty of Versailles. The League, the forerunner of the United Nations, brought about much international cooperation on health, labor problems, refugee affairs, and the like. It was too weak, however, to prevent the great powers from going to war in 1939.” 24 Jens Witterndorf, (2010), ‘Transfer Pricing and the Arm’s Length Principle in International Tax Law’, Kluwer Law International p.37-38 25 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International, p.15 26 Ibid. 27 Including additional explanation of the methods which should be used to arrive at an arm’s length price : Reuven S. Avi-Yonah, (2007), ‘The Rise and Fall of Arm’s Length: A Study in the evolution of U.S. International Taxation’, University of Michigan Law School. 28 http://www.un.org/esa/ffd/documents/ UN_Model_2011_Update.pdf 29 and the U.S. Model Income Tax Convention and other Model Convention worldwide 30United Nations, New York (2003), ‘ Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries’ p.86 “Article 9 should be considered in conjunction with article 25 on mutual agreement and article 26 on exchange of information, just as in the case of the OECD Model Convention” http://www.un.org/esa/ffd/wp-content/uploads/2014/09/UNPAN008579.pdf

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‘associated31 enterprises’32, is concerned with the taxation of profits of enterprises.33 It includes an alternative international definition of the arm’s length principle34in transfer pricing and it introduces an indirect restriction. In general, taking into account this provision, domestic tax law may refrain from enforcing any valuation standard that could result in more burdensome taxation than the application of the arm’s length standard would bring on.35As it is analyzed in the OECD and UN Commentaries on Article 936, it examines adjustments to profits made for tax purposes in case of transactions between associated enterprises on other than arm’s length terms. Although the provision does not address the principle directly, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations37, as well as, previous Reports. They are produced in order to provide, in considerable detail, guidance on the application of the “arm’s length principle”, to facilitate the interpretation and incorporation of Article 9 in domestic law of the OECD member or non-member countries and to minimize contingent disputes between tax administrations and MNEs. The principle is thoroughly investigated in Chapter I of the Guidelines.

2.3 Advantages and disadvantages of the arm’s length principle

31 Determined in Commentaries: “parent and subsidiary companies and companies under common control”. 32 1. “ Where a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.” 33 Jens Wittendorff, (2010), ‘The Object of Art. 9(1) of the OECD Model Convention: Commercial or Financial Relations’, IBFD 34 Jens Wittendorff, (2011), ‘The Arm’s-Length Principle and Fair Value: Identical Twins or Just Close Relatives?’, TAX NOTES INTERNATIONAL 35 Para. 2 of the Commentary on Article 9 of the OECD Model/ and Para. 1.6 of the OECD Guidelines. 36 Art 9 1. OECD Comm.2014 [scope]. K. van Raad, (2016/2017), ‘Materials on International, TP and EU Tax Law’, International Tax Center Leiden p.269 37 http://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational- enterprises-and-tax-administrations-20769717.htm : “Governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdictions and that the tax base reported by MNEs in their respective countries reflect the economic activity undertaken therein. For taxpayers, it is essential to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of an arm’s length remuneration for their cross-border transactions with associated enterprises. After having been originally published in 1979, the OECD Transfer Pricing Guidelines were approved by the OECD Council in their original version in 1995. A limited update was made in 2009, primarily to reflect the adoption, in the 2008 update of the Model Tax Convention.” The latest amendments have been introduced in 2016, while the OECD had already released the final reports on BEPS in 2015.

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Despite the plethora of advantages that forced OECD to base all its guidance on this standard and also convinced many non-OECD countries to apply it during all these years, the at arm’s length dealing encloses an ironic issue. In case of an internal transaction within a MNE, the separate entity approach with arm’s length pricing demands the calculation of separate tax base in each state, as if each enterprise involved was independent, thus not affiliated. In contrast, most of MNEs operate internationally aiming to avoid, in a legal way, needless transaction costs, to reduce their overall tax bills38, to internalize their costs and from an economic perspective, to carry out transactions more effectively, non-depended on the market conditions as if they were independent39. Thus, it is reasonable that this principle presents many difficulties in its worldwide application in spite of its ostensible perfection, as demonstrated by the OECD and many authors.

According to the OECD Guidelines, there are several reasons why the arm’s length principle is adopted by the OECD countries and many other countries. To begin with, it provides broad parity40. Both dependent and independent companies must be treated, for tax purposes, equally, hence the principle prevents tax advantages or disadvantages which could distort the competitive position of dependent either independent companies. Companies do not need to focus any more on taxation issues during the decision making41 process, resulting in the amplification of international trade.

Moreover, the arm’s length principle is an international doctrine or, in other words, an international consensus which governs the assessment of the transfer price among affiliated companies in the majority of countries being the favored approach among MNEs. Nowadays, it is established as the common code of communication between tax administrations and the majority of business operations and the potential for double taxation is minimized42. Thus, any exclusion or replacement by one of its alternatives would possibly lead to double taxation.

Furthermore, it has been proved that the arm’s length dealing works effectively from the very beginning, in the majority of cases. In transactions of tangible property or other transactions involving sale/purchase of commodities for example, it seems that the comparability analysis used to control the relevant transfer price functions adequately, as it simple to find a “comparable transaction entered into by comparable independent companies under

38 United Nations, New York (2013), ‘Practical Manual of Transfer Pricing for Developing Countries’, Chapter 1. 39 Jens Wittendorff, (2010), ‘Transfer Pricing and the Arm's Length Principle in International Tax Law’, Kluwer Law International - p.19 “Economies of Integration” 40 OECD, Transfer Pricing Guidelines 2016 B.1., 1.8 41 https://www.taxdose.com/significance-of-arms-length-principle-income-tax/ 42 Adjustments concerning the price in the one jurisdiction should be also made in the other corresponding jurisdiction in case of an intragroup cross-border transaction.

[8] comparable circumstances.”43Nevertheless, this analysis is not that simple, even sometimes impossible, regarding other kind of transactions, such as transfer of intangible property, which is going to be examined in this case, or provision of specialized services.

On the opposite shore, many critiques and reviews disclose the insufficiency of the standard, especially during the last few decades, in the era of technological inflation and intellectual property. The most discussed argument against the domination of the arm’s length principle and the separate entity approach is the ironic issue mentioned above; to put it simply, the principle does not mirror economic reality because of the different purposes of MNEs44. Through internalization and due to their relation, affiliated companies, units of MNEs, can obtain reduction of costs and more effective transactions compared to independent companies, taking advantage of market’s imperfections.45They are able to integrate functions in different jurisdictions which results in a reduction of costs, such as transaction costs, R&D costs or other costs through synergy that benefits from economics of scope and scale.46

From a theoretical perspective, it could also be argued that we cannot determine what exactly arm’s length means47, taking into consideration that not all the transactions have comparables. The concept of comparability between controlled and uncontrolled transactions is essential for the application of the principle, although associated enterprises may enter into transactions that independent companies would not undertake, by reason of facing diverse commercial circumstances than MNEs. While a transaction may not be available for comparability test, it cannot be assumed that it is not arm’s length, resulting in an uncertain situation.

Furthermore, taking into account the maximization of transferring of intangibles assets, there are significant cases in which the principle is extremely complicated to apply, due to lack of comparable intangible assets. For example, in case of highly specialized, unique and high value intangible assets, it is sometimes impossible to find concrete information on their nature and establish the ‘correct’ price.

43 OECD, Transfer Pricing Guidelines 2016 B.1., 1.9 44“ The essence of MNEs is the potential to act as one entity in the world market and so to get competitive advantages…Advantages of scale and synergy-effects which are inherent in MNEs cannot be divided amongst the group in an objective way via the arm’s length principle”: H.Hamaekers, (2001), ‘Arm’s Length - How long?’ 8 International Transfer Pricing Journal 45 Jens Wittendorff, (2010), ‘Transfer Pricing and the Arm's Length Principle in International Tax Law’, Kluwer Law International - p.19 “Economies of Integration” 46 Reuven S. Avi-Yonah & Ilan Benshalom, (2010), “Formulary Apportionment–Myths and Prospects”, University of Michigan Law School. http://www.law.umich.edu/centersandprograms/elsc/abstracts/pages/papers.aspx 47 J. McCormack, (1992), ‘Getting what you pay for: Transfer Pricing and Division 13’ (NSW Intensive seminar, Taxation Institute of Australia).

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Undoubtedly, applying the arm’s length standard in intra-group transactions and therefore evaluating the circumstances on a case-by-case basis, causes tremendous administrative costs for both taxpayers and tax authorities, considering the evaluation process of numerous and various transactions, which becomes even more difficult with the passage of time.48In addition, lack of information/documentation and extra compliance costs make the procedure more complex and onerous.

2.4 Formulary Apportionment as the predominant alternative

The application of transfer pricing rules based on the arm’s length principle is not that simple, is not always possible, due to lack of information and comparables, and it takes time, although there is uncertainty whether the result is worthwhile. But is there any alternative method superior or is the dominance of the arm’s length principle sustainable despite the criticism?

The example of countries that use transfer pricing rules based on formulary apportionment49, such as the U.S., Canada and Germany, at the subnational level50, has influenced the European Commission so as to report some options51 supporting the use of apportionment approach among Member States.

What is formulary apportionment? It is the most frequently advocated alternative which has been gathering support from many political parties, economists and academics over the years52. It is a method of allocation of MNEs’ worldwide income, other than the separate entity approach. However, the process may include two main stages; firstly, the enterprise consolidates the income of all its units and secondly, the enterprise using the relevant formula attempts to apportion the income to the jurisdiction where the business is carried out and the income produced. Hence, according to this approach, the profits of the entire MNE would be divided among its subsidiaries or PEs notwithstanding their location.53Further, each

48 OECD, Transfer Pricing Guidelines, 1.12 49 Actually they apply a unitary system, which is a way to allocate the corporate tax base between states (especially in federations). “MNEs file a consolidated report based on their entire earnings and then the consolidated net income is allocated among the jurisdiction where the MNEs operate through the formula”. Reuven S. Avi-Yonah & Ilan Benshalom, (2010), “Formulary Apportionment–Myths and Prospects”, University of Michigan Law School. University of Michigan Law School. 50 Emil M. Sunley, (2002), ‘ The pros and cons of formulary apportionment’, CESifo Forum 51 Ibid. “home state taxation, common consolidated based taxation, a European corporate income tax and compulsory harmonization of existing tax bases”, http://ec.europa.eu/taxation_customs/business/company-tax/conferences-other-events/towards-an- internal-market-without-corporate-tax-obstacles_en

52 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International, p.133 53http://oecdobserver.org/news/archivestory.php/aid/670/Transfer_pricing:_Keeping_it_at_arms_length .html

[10] jurisdiction where the profits are allocated may apply its income tax rate depending on the portion of the overall unit that resides there.54

According to the OECD Guidelines, there are three crucial components for the application of a global formulary apportionment. The determination of unit that is going to be taxed, such as the relevant branch or subsidiary of the MNE, the precise determination of the global profits of the MNE and then the establishment of the appropriate formula in order to allocate the global profits of the unit.55

The basic argument in favor of the formulary apportionment is the provision of greater administrative convenience and certainty for taxpayers. 56There are, also, many other arguments supporting the use of the formulary apportionment instead of the separate accounting based on the arm’s length principle, such as the elimination of allocation costs and the simplification of compliance costs for enterprises57, considering that there will be a consolidated corporate tax base for their worldwide or EU-wide58 activities59. Furthermore, it overlooks the ironic issue which is considered a disadvantage of the arm’s length dealing; it emphasizes more on the globalization and the technological development and does not impose a comparison between dependent and independent companies, taking into account the different objectives of the MNEs. Thus, it seems to be closer to economic reality. Diverging from the separate accounting, under a formulary apportionment system there is less manipulation of the tax base by enterprises through transfer pricing60, resulting in the mitigation of competition between the states by lowering their corporate tax base.61

The OECD member countries and many MNEs consider formulary apportionment inappropriate and unrealistic alternative to the arm’s length approach as it can potentially solve some problems but will cause many others. First of all, such method is inherently

54 https://www.europeanceo.com/business-and-management/transfer-pricing-arms-length-alternatives- needed/ 55OECD, Transfer Pricing Guidelines, C.1. 56 Ibid. C.2. 57 Only one set of accounts prepared for the group for domestic taxation purposes as the OECD clarifies. 58“The Commission, in the November 2003 communiqué indicated that, from a theoretical perspective, a worldwide apportionment mechanism could be preferable, in that any other choice would imply the co-existence of separate accounting and formulary apportionment.”: Antonio Russo, (2005), "Formulary Apportionment for Europe: An Analysis and A Proposal", INTERTAX, Volume 33, Issue 1, Kluwer Law International 59 Emil M. Sunley, (2002), ‘ The pros and cons of formulary apportionment’, CESifo Forum 60 In the recent years the expanded economic integration presses governments to lower their tax rates under separate accounting and this leads the states to be more tax competitive, although under formulary apportionment they are able to levy higher tax rates. 61 ‘race to the bottom’

[11] arbitrary62, usually disregarding market conditions and individual characteristics of enterprises and potentially allocating profits non-corresponding to economic reality. Over and above that, such system is difficult to be implemented since it protects against double taxation and at the same time guarantees single taxation, whereas there is not yet any established international consensus or common agreement on particular ‘predetermined’ formulae and the factors to be used. Potential disagreements would arise in case different countries wanted to include different factors in the formula depending on their traditional activities or aiming at predominate their jurisdiction. Thus, despite the protection, there is a possibility of double taxation as some countries may still apply the arm’s length principle and others the formulary apportionment and the countries applying the second may, also, use different formulae along each other. Moreover, the transaction to a formulary apportionment system would introduce administrative complexity and there are also a lot of details to be worked out before such system is to be adopted.63

Every alternative proposed constitutes a completely new basis for the MNEs and may result in their opposition. On the other hand, governments do not seem resolute so as to apply a new method. Especially, the OECD member countries tend to reject any non-arm’s length method and preserve their support for this international consensus64. Despite the insistence on the arm’s length dealing and further on its modernization as proposed by OECD BEPS Action plan, we cannot underestimate or overlook the idea of annihilating the consensus and replacing it by a formulary apportionment oriented system which ever more gathers momentum.

CHAPTER 3: Tax Treatment of Intangibles in the context of Transfer Pricing

3.1 Definitional and valuation issues regarding intangible property

Over several decades the rapid progress of new technologies constitutes an additional component which has affected the globalization of the economy and has led to the expansion of MNEs around the world. From the dawn of the new millennium, as the OECD and several authors have already ascertained, investments in intangible capital tend to become larger and more important than investments in tangible capital in many companies universally.65 The noticeably increased intra-group worldwide trade has become more intricate by virtue of the transformation of transactions of tangible assets into transactions of intangible assets. These

62 Reuven S. Avi-Yonah, (2010), ‘Between Formulary Apportionment and the OECD Guidelines: A Proposal for Reconciliation’, University of Michigan Law School. 63 for example, the apportionment factors involved and the multilateral agreement which seems unrealistic. 64 OECD, (2016),Transfer Pricing Guidelines, C.3., (1.32.) 65 Daniel Zéghal, Anis Maaloul, (2010), ‘The accounting treatment of intangibles – A critical review of the literature’, ELSEVIER – Accounting Forum

[12] transactions are now, more than ever, under discussion and susceptible of diverse argumentations. In a world based on digital economy,66the development and exploitation of intangible property67 seems to be a key feature influencing the value creation and the economic expansion of most companies.

While examining the transfer pricing of transactions involving intangible assets on an arm’s length basis, it seems indispensable to, initially, identify the intangible assets concerned. The term ‘intangible’ is not determined in Article 9 of the OECD Model. The definitions provided are often either overly narrow or broad68and tend to inflame disputes between taxpayers, particularly MNEs, and tax administrations. Neither Article 12 contains any definition69 but there is a sharp distinction between intellectual property and know-how (assets through which royalties can arise).70

Nevertheless, there is clear intention of the OECD to provide a definition of these assets in the Transfer pricing guidelines. Regarding the OECD Guidance during the last decades, there is an observable effort to further explicate Chapter VI, which dates back to 1995 and is in need of update. Although, a major revision of the Transfer Pricing Guidelines had been completed in 2010, there was still not established any clear definition of intangibles. In 2011, the Committee on Fiscal Affairs decided to run a new project on the transfer pricing aspects of intangibles71. In 2012, the Working Party No.6 published a Revised Discussion Draft including a specific definition of intangibles in the field of transfer pricing,72 modified by a second Draft in 2013, which was in line with the OECD BEPS Action Plan. Since, there was a strong interaction between the Action 8 of the OECD BEPS Action Plan referring to

66- “The digital economy is the result of a transformative process brought by information and communication technology (ICT)” -“The digital economy is characterized by an unparalleled reliance on intangibles, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs”: OECD/G20 Base Erosion and Profit Shifting Project, “Addressing the Tax Challenges of the Digital Economy”, Action 1 – 2015 Final Report. 67 Ibid. p.65 68 OECD, 2013, ‘ Revised Discussion Draft on the Transfer Pricing Aspects of Intangibles’, p.14 69 Isabel Verlinden and Yoko Mondelaers, (2010), Transfer Pricing of Intangibles: At the Crossroads between Legal, Valuation and Transfer Pricing Issues, IBFD 70 OECD, (2016), Transfer Pricing Guidelines, A.2. 71 OECD, 2011, ‘Transfer Pricing and intangibles: Scope of the OECD Project’ 72 Loek Helderman, Eduard Sporken and Rezan Okten, (2014), “The Revised OECD Discussion Draft on Transfer Pricing Aspects of Intangibles’, IBFD

[13] intangibles and other Action points the Organization postponed 73the finalization of its Guidance to 2015, when the Action Plan would be released.74

In substance, Chapter VI 75paragraph 6.6 of the OECD Guidelines gives the underlying definition of an intangible: “something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances”76. The definition distinguishes between two types of transactions involving intangibles; transfers of intangibles or rights in intangibles and use of intangibles connected with the sale of goods or services.

In addition, there is a distinction between legal and economic ownership implied in the definition and encompassed in the next paragraph of the Guidelines. This is the next step of the functional analysis, after identification of an intangible asset, intending to determine the arm’s length conditions when transferring intangibles. In particular, the assessment of the entity, within a group, which is entitled to report in the tax return income derived from transactions of intangibles, is crucial in order to avoid potential double taxation issues. As long as the owner of an intangible asset is entitled to the income stream flowing from this asset77, it is undoubtedly important to determine the ownership of the asset first. Despite the dominance of legal ownership in previous years, due to the essential economic changes, economic ownership tends to gain ground, as it is more in line with the economic reality. In general, legal ownership is a matter of form78 based on contractual terms, public records and communications among the parties involved. It serves as a reference point for identifying controlled transactions and for establishing the proper remuneration in respect of these transactions. Economic ownership is substantially determined through the intra-group relationships and is relied upon the contribution to the value of intangibles. Hence, economic owner is deemed to be the entity/entities of an MNE group which has ‘performed functions, assumed risks or used assets’79 and should be compensated for this contribution under the arm’s length standard. The OECD Guidelines do not clarify which kind of ownership must be applied for transfer pricing purposes.

73 The OECD had deferred dealing with challenging issues until 2015 such as: “the re-characterization of transactions, the treatment of unanticipated ex-post returns, the use of profit split method and guidance on hard-to-value intangibles”. ibid. 74 Eduard Sporken and Peter Visser, ( 2015), “BEPS Guidance on Transfer Pricing Aspects of Intangibles and the Need for Substance and Transfer Pricing Documentation”, IBFD 75 And additionally, Chapter I (intangibles vs. comparability factors) 76 OECD Transfer Pricing Guidelines 2016, paragraph 6.6. 77 Markham, Michelle (2005) Tax in a Changing World: The Transfer Pricing of Intangible Assets. Tax Notes International 40:pp. 895-906 78 Ibid. 79 For “the development, enhancement, maintenance, protection and exploitation of intangibles” as mentioned in the Guidelines.

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Considering the various issues related to intangibles, it is obvious that there may be diverse categorizations80and classifications81. In the current guidance, there is a clear classification of commercial intangibles into two main categories, trade82 and marketing83 intangibles.84Further, it includes other categories, such as soft and hard intangibles, routine or non-routine intangibles, as well as, ‘unique and valuable’ intangibles. There are also illustrations of some specific intangible assets85. On the other hand, economists and assessors, particularly in the U.S., influenced by the 482 regulations86, tend to classify intangible assets in many different categories in order to make their identification easier. Examples of these categories are: marketing, artistic-related, technology-related, data processing-related, engineering-related, location-related, goodwill-related, human capital-related, customer- related and contract-related intangible assets. 87 In practice, we may identify efficiently some commercial assets that constitute intellectual property, such as patents, trademarks, copyrights, literary/artistic compositions and many others. In general, these are hard assets, which embody information protected by law88. However, it seems difficult to recognize the so-called ‘soft’ intangibles, such as market power, workforce in place, effective supply chain, time and emotional assets, which are usually key value drivers of a company89.

The valuation of intangible assets could be defined as the estimation of the current value - at the time of the transaction - of the asset, taking into account future benefits that may arise

80 Some of them are clearly mentioned in the Guidelines, although others are only referred in literature. 81Blair M.M. & Wallman S.M.H., (2000), ‘Unseen wealth: Report of the Brookings task force on understanding intangibles sources of value.’, Washington DC, The Brookings Institution Press; Ibid. (Daniel Zéghal, Anis Maaloul) An interesting classification was made in 2000, in Blair and Wallman’s report, which has as decisive criterion the difficulties faced in order to establish the ownership and make an appropriate measurement. According to them, intangible assets are divided in three categories: a) Intangibles in which someone may have explicit property rights and which capable of being sold and acquired, such as patents or data bases. b) Intangibles controlled by a company, although without having legally protected property rights in them, such as business secrets or R&D in process. c) Intangibles connected with people working in a company, mainly uncontrolled, without markets existence, such as human assets – high skill workers. 82 “Commercial intangible other than marketing” Ibid., Glossary 83 “Used in commercial activities such as the production of good or the provision of a service as well as an intangible right that is itself a business asset transferred to customers or used in the operation of business” Ibid. Glossary 84 Ibid. (Eduard Sporken and Peter Visser) 85 OECD Transfer Pricing Guidelines 2016, paragraph 6.13- 6.21. (‘Patents’, ‘ Know-how and Trade Secrets’, ‘Trademarks, Trade Names and Brands’, ‘Rights under contracts and government licenses’, ‘Licenses and similar limited rights in intangibles’, ‘Goodwill and ongoing concern value’ etr. 86 Intangible is any asset falling into one of the six broad categories included in U.S. regulations of section 482. (not exhaustive list) 87 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International, p.39

88Australian Government Consultative Committee on Knowledge Capital (AGCCKC), paper on knowledge capital and the management of intangibles ,Chris Liell-Cock and Dr Ken Stanfield, referred to by Tamara Plakalo in 'Accounting for the uncountable' February 11 2005 http://ww.smh.com.au/technology 89 Ibid. (Isabel Verlinden and Yoko Mondelaers)

[15] from it90. When the valuation of an intangible asset appears highly uncertain, especially in case of hard-to-value intangibles, it is questionable how we should determine the arm’s length pricing.91 The OECD’s recommendations on this matter, included in the BEPS report, will be addressed in the next chapters.

Concisely, the three major methods of valuing intangibles are classified as cost based approach, market/transactional approach and income based approach92. According to the cost method, the actual expenditures that had been incurred for the development of the asset must be taken into account in order to establish the value of the asset. 93The market/transactional approach is based on comparison of transactions of almost identical/similar intangible assets in an open market.94The income approach constitutes the most preferable approach in practice as it takes into account future economic benefits derived from the intangible asset during its useful life. Thus, it measures the present value of foreseen future returns from the intangible.95

The main problem that arises, especially in case of soft intangibles, is that, regardless of the exorbitant investments in intangible assets globally, there is notable paucity of financial reporting.96Due to their heterogeneity, intangible assets cannot be compared to tangible assets and may hardly be compared to other intangibles, even classified in the same category. For example, when dealing with human capital intangibles, the measurement of an employee’s contribution and finding an ideal comparable seems almost impossible. Thus, lack of comparability, which is crucial for measuring and establishing a price when dealing at arm’s length, is detected between intangibles. It is, also, hard to compare between transactions involving intangibles, undertaken between associated and independent entities. Furthermore,

90 As income-based method requires. 91http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/aligning-transfer-pricing- outcomes-with-value-creation-actions-8-10-2015-final-reports_9789264241244- en#.WUqcgWg1_IU#page109

92 Jens Wittendorff, (2010), ‘Valuation of Intangibles under Income-Based Methods – Part I’, IBFD 93https://www.cgma.org/content/dam/cgma/resources/tools/downloadabledocuments/valuing- intangible-assets.pdf -reproduction cost new (current cost of identical property) -replacement cost new (current cost of similar property with the same utility) In practice it is insufficient for valuation of intangible assets (mostly used for real estate valuation) because the cost made for the assets are not straight related to the potential value creation from the asset. 94 This approach is also called ‘sales comparison approach’ as it uses actual sales information. We should notice that in practice, there is no active market for unique and other intangibles and comparable assets are hardly identified. For transfer pricing purposes the CUP method, analyzed below, is deemed to be a market approach, as it depends on the price of comparable assets. 95 Three common income approaches: excess earnings method, relief from royalty method, incremental method. Ibid. 96 Markham, Michelle (2005) Tax in a Changing World: The Transfer Pricing of Intangible Assets. Tax Notes International 40:pp. 895-906

[16] the potential value creation from the use of intangibles is unpredictable. An unsuccessful result in an R&D project, for example, is possible to bring in elements which are useful for the profitability of a company. Since investments in intangibles might depend on other investments in order to create value, from an accountant’s perspective, it might be inconsistent to record them. Moreover, in case of incorporation of an intangible asset in a tangible asset, such as software incorporated into a machine, the valuation of the intangible becomes even more complex. Isolating the impact of the intangible asset on the entity’s income and further on the MNE’s income in this case may be problematic.

3.2 Transfer Pricing methods for transactions involving intangibles

The transfer pricing methodologies provided by the OECD may be applicable when setting a price for any controlled transaction, including transactions involving intangibles. Their application is not always meticulous; many countries or companies do not follow explicitly the OECD guidance and others may apply their own methodologies97, depending on domestic circumstances, yet in accordance with the arm’s length principle. In practice, when trading in intangibles, certain of the five methods described in the Guidelines are mostly used, as they tend to provide a more accurate estimation of an arm’s length price98. The methods are classified in two main categories. The first one includes the traditional transaction methods, namely, the comparable uncontrolled price method, the resale price method and the cost plus method. Under the second category belong the transactional profit methods, namely, the transactional net margin method and the transactional profit split method. The OECD used to be cautious99 with applying the methods mentioned in the second category, because they rely on profits, although the methods based on transactions are deemed more certain and in line with the arm’s length principle. An important observation regarding the use of transfer pricing methods by entities entering into an intra-group transaction is that they can either be applied separately or cumulatively/combined.100The purpose of this combination is to reinforce the reliability of a transfer pricing analysis. In addition, there is a distinction between one-sided and two-sided methods101, depending on whether only one of the entities involved applies the method or both of them (or more). The choice of the ‘tested’ party follows from functional analysis of the transaction, which demonstrates the entity/entities that could apply the method

97 Monsenego J., (2013), “Introduction to transfer pricing”, Eurographic Danmark A/S 98 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International 99 OECD Guidelines until 2010: “In such cases of last resort, practical considerations may suggest application of a transactional profit method either in conjunction with traditional transaction methods or on its own” 100 OECD Transfer Pricing Guidelines 2016, paragraph 2.11. 101 Monsenego J., (2013), “Introduction to transfer pricing”, Eurographic Danmark A/S

[17] reliably.102Although there will be no extensive analysis of the methodologies, some observations regarding the case of intangibles are necessary.

The comparable uncontrolled price (CUP) method appears to be the most preferable method according to the OECD Guidelines. It is deemed the most reliable manner for the application of the arm’s length principle and, accordingly, the first to be chosen, if possible. It constitutes a two-sided method, which compares the price established in a controlled transaction of property to the price charged in a similar/comparable transaction between independent enterprises, under comparable circumstances. Thus, this method relies on a comparability analysis aiming at setting the closest price possible to an uncontrolled transaction. A distinction is drawn between internal CUP that is based on the price set between an entity which is part of a group and a third party and external CUP, which refers to the price set for a comparable good between independent entities. The high standard of comparability, differences in prices between controlled and uncontrolled transactions and the adversity to correct them through adjustment, could make this method inefficient. The rest of the methodologies have been prescribed in case there is no comparable uncontrolled price.

The resale price method (RPM) is one-sided and relies on the price charged to an independent party to whom the good is resold after the controlled transaction has taken place. In other words, in order to ascertain whether a controlled transaction is in line with the arm’s length principle, we examine the price charged to the next independent purchaser of that good after the reduction of a gross margin that must be earned by the reseller (group member).103The comparability issue here arises through the functional analysis of the transactions, which results in the gross margin; the functions carried out, the assets used and the risks taken by controlled and uncontrolled companies should be comparable.104

Conversely, the cost-plus method (CPM), that is also one-sided, takes as a starting point the costs realized by the supplier in a controlled transaction and then, adds the appropriate profit mark-up, which is harmonized with “the functions performed and the market conditions”.105The mark-up is set after taking into account the corresponding mark-up established in internal and external comparable transactions.

One of the profit based methods is the transactional net margin method (TNMM), which is a one-sided method and concentrates on the net profit margin106 realized by this tested party on an arm’s length basis. Further, the net profit earned by the tested taxpayer from a particular

102 OECD Transfer Pricing Guidelines 2016, paragraph A 3.3., 3.18. 103 OECD Transfer Pricing Guidelines 2016, 2.21. “resale price margin” 104 Monsenego J., (2013), “Introduction to transfer pricing”, Eurographic Danmark A/S 105 OECD Transfer Pricing Guidelines 2016, 2.39. 106 Relative to a suitable base (sales, costs, assets), as referred in the Guidelines.

[18] controlled transaction must be the same with the net profit realized in (internal and external) uncontrolled comparable transactions.

The second profit based method is the profit split method (PSM) which is a two-sided method, as profits and losses are split between the parties involved in a transaction. Regardless of the special conditions that usually are inherent in controlled transactions, this method aims to determine, in this kind of transactions, the same division of profits (or losses) that would have been expected in case of transactions between unrelated enterprises. The first step is the identification of the ‘combined’ profits to be split between the affiliated companies and the second step is the at arm’s length allocation of profits between the companies. Thus, an uncontrolled split constitutes the benchmark for a controlled split. The portion of profit to be split may depend on the value added to the underlying good, on the ownership of an intangible or on costs realized by the parties. When both parties of a transaction contribute unique and valuable assets, when there is a dearth of independent comparable transactions or when a transaction is highly intricate, profit split appears to be the most appropriate method to establish the transfer price107

3.3 Comparative analysis of the preferred methods

The selection of one or more transfer pricing methods is not predetermined for one kind of transactions; even if it is well known that, for example, the cost-plus method is commonly used for manufacturing, provision of services108, or, generally, low risk transactions, this is not always correct. There is, also, an obvious change in the selection of the right method over the last decades, particularly when transferring intangible assets. To put it simply, transactional profit methods have gained ground, while traditional methods which used to be the most preferable, are now deemed insufficient for specific transactions.

A transfer of intangibles or rights to use them through sale or license and an arm’s length remuneration received by the affiliated company constitute a transaction dependent on potential changes in facts and circumstances, such as the generation of significant profits or future cash flows attributable to intangibles. Thus, potential problems could arise during the functional109 and comparability analysis, which is necessary in order to determine the role of each party to the transaction, to select a method and establish an arm’s length price.

Furthermore, due to the sensitive nature of intangible property and of intra-group transactions where it is involved, it seems difficult to ascertain whether the transfer pricing method/s,

107 Monsenego J., (2013), “Introduction to transfer pricing”, Eurographic Danmark A/S 108 www.un.org/esa/ffd/tax/2011_TP/TP_Chapter5_Methods 109 Mostly, the functions performed (e.g. R&D activities) and the assumption of undertaken risks attributable to parties.

[19] which has been chosen in a certain case, is the most appropriate. For instance, in Starbucks case, where there was an intragroup cross-border transaction involving know-how, the royalties’ payment to the affiliated selling company was calculated using the transactional net margin method, although the European Commission argued that the comparable uncontrolled price method should have been used instead110.

In an attempt to assess the most useful methods regarding intangibles, we must examine the special nature of these assets in combination with the characteristics of the five transfer pricing methods. First, the special characteristics of intangibles cause lack of comparability, which, in most of cases, constitutes the main rule rather than an exception. Intangibles might be unique, non- routine, hard-to- value, highly valuable and profitable only under the control of the MNE.111Particularly marketing intangibles are in most cases solely created for the MNE’s purposes112 and for its own use. Taking into account all these different types of intangibles, it seems reasonable that there is not always enough information regarding comparable uncontrolled transactions. The problem becomes more intricate in case of transactions which include intangible assets along with tangible assets or/and services, so- called ‘package deals’,113 where even the identification of the intangibles is difficult and the payment is usually undifferentiated. Although different methods would apply for establishing the price of goods and services in case they had been sold /provided independently, the CUP method would not probably be the selected one. Therefore, this method might not be the most suitable for intangible asset transactions, as the required comparability standard cannot be applied when companies struggle to find valid data.

The resale price method is apparently concentrated on transactions involving tangible property (sales-distributions) without any addition of substantial value by the distributor. According to OECD Guidelines, this method is secondarily used in transactions including intangibles; particularly when the affiliated company sub-licenses such property to independent parties, RPM is only used for the analysis of the terms of the intragroup

110 The underlying case and the purposes of the selection will be analyzed in chapter 4. It was mentioned here in order to show that there may appear different arguments regarding the methods used and that the right method is not certain. 111 Thus, they would not be valuable in case they were sold to an independent company or they would be deemed useless. 112 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International 113 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International

[20] transaction.114The cost-plus method is, also, applicable for sales of tangible assets and rarely in case of intangible assets115.

In spite of the OECD’s unwillingness to embrace transactional profit methods in the past, these methods are no longer treated as the last resort. Transactional net margin method may be applied when an associated enterprise sells tangible and intangible goods or provides services. Since this method is more flexible regarding product and functional differences than the other transactional methods (i.e. CUP), it is usually applied in case of tangible property transactions. Nevertheless, its application seems difficult when the transactions involve unique and high-value intangibles due to comparability issues arisen.116 It is, also, remarkable that while this method does not seem to be an adequate method when dealing in the above mentioned intangibles, it is frequently used in order to check and verify the results of the traditional transactional methods.

Profit split method appears to be the most appropriate in the majority of transactions involving unique, non-routine, high-value intangibles or high interrelated transactions with significant economic risks, where CUP and one-sided methods might lead to scant results or cannot be applied at all. In this respect, when both of the associated enterprises own intangible property and both are tested parties to the transaction, this method is the only solution. Since it is deemed impossible to find comparables in such cases, the profit split method, which is concentrated on the allocation of actual profits made by MNEs - rather than focusing on the determination of a hypothetical arm’s length price-, takes precedence over the other methods. In addition, this method is the most reliable for the so-called ‘package deals’ 117as there is no need to examine separately the transactional items and it takes into account particular facts and circumstances that exist only in controlled transactions.

3.4 Aggressive tax planning by MNEs

By nature, MNEs have the ability to manipulate their complex configuration in order to minimize their tax risks and their tax debt. During the last decades, there are several examples of these corporations trying to adjust transfer prices and enter into ostensibly flawless intra- group transactions. In most cases, they use clearly unsuitable transfer pricing methods,

114 Wills, Michelle, (1999), "The Tax Treatment of Intangibles in the Context of Transfer Pricing," Revenue Law Journal: Vol. 9 : Iss. 1, Article 2. 115 It must be noticed that the resale price method, the cost plus method or the transactional net margin method (one-sided) are applied to the associated entity – party to the transaction – which is the least intricate/ the distributor. This tested party must not be the owner of highly valuable intangible assets. 116 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International p.112 In highly valuable or unique intangible property transactions even negligible transactional variations are capable of reducing comparability chances. 117 Markham M., (1995) “The transfer pricing of intangibles”, Kluwer Law International

[21] particularly when transferring intangible property, aiming at shifting profits in different tax jurisdictions and avoiding taxation. This behavior seems to be within the letter of law as tax planning constitutes an integral unit of business activity118; every company wants to mitigate its tax risks and intends to maximize the cash inflow and minimize costs such as tax debts. However, it is not, always, in the spirit of legislation.

Before analyzing in depth practices followed by MNEs, it seems prudent to point out some kinds of tax planning which lead to the characterization “aggressive”. A distinction should, first, come about between illegal, criminalized tax evasion, which is the exception, and legal tax avoidance and tax planning (mitigation). In most cases, MNEs seem to act legally, in other words, complying with the legal system of the countries where they are economically active. However, they tend to form a more sophisticated structuring119 regarding their cross border transactions and use the most propitious formalities in order to obtain tax advantages.

There is an obvious tendency to misuse the scheme of tax planning to cover their intention to avoid taxation. In other words, MNEs rename tax avoidance to tax planning in a way that the latter becomes aggressive and impermissible. As Pascal Saint-Amans has stated120, MNEs as, for instance, “Apple, Amazon, Facebook and Google have been extremely aggressive, pushing the boundaries of what is legal”. Despite the similarities between these legal regimes, there are significant differences that disclose the moral character of tax planning on the one hand, and the immoral character of tax avoidance on the other. For instance, their objective is different as tax planning aims at reducing tax liability by means of applying tax provisions and using advantages provided therein. Thus, it has a ‘bonafide’ motive. On the other hand, tax avoidance has the purpose to reduce tax liability but by means of exploiting shortcomings and loopholes of tax law and, thus, it has a ‘malafide’ motive. Moreover, they have different consequences; the first results in possible exemptions, deductions or allowances, whereas the second has as a result the least possible tax liability or nil taxation.

It does not seem absurd that all the above mentioned technology companies mostly deal with intangible property, such as intellectual property rights, which is involved in the majority of their transactions. In addition, they are MNEs that operate in many countries with different tax regulations and rates, and have more opportunities to shift profit. Hence, they are more interested in tax planning than other companies. Two forms of aggressive tax planning which

118 https://www.nob.net/cfe-forum-2013-tax-planning-what-unacceptable 119 https://www.nob.net/cfe-forum-2013-tax-planning-what-unacceptable 120 Director of the center of Tax Policy, OECD

[22] may eventually be impermissible and treated as tax avoidance are profit shifting and mismatches between tax systems121.

Profit shifting from a high-tax jurisdiction to a low-tax jurisdiction is one of the forms of aggressive tax planning which has been constantly on the rise due to the economic globalization. The hypothesis of profit shifting is strongly supported, since MNEs, which have presence in countries with lower tax rate tend to report lower profit than comparable companies which have no link with these countries. There are three main channels used by MNEs in order to shift their profits such as the transfer price manipulation on internal transactions, the location of intangible assets122 and income from such assets, and the position of intra-group debts123 (and the corresponding interest payment) usually in high tax jurisdictions. Taking advantage of mismatches between tax systems, namely, differences in tax treatment of enterprises (hybrid entities), transfers (hybrid transfers) or even financial instruments in different tax jurisdictions capable of reducing the corporate tax burden, constitutes the second form. This could, also, be achieved by MNEs, using a preferential tax treatment or a negotiated diminished tax rate.124

In case of intra-group transactions of intangible assets, tax planning and, particularly, profit shifting through manipulation of transfer prices or through strategic selection of intangibles’ location appear to be crucial. In general, transfer pricing is used by MNEs not only to avoid or minimize their tax burden, but also to improve their cross-border operation. Transfer price manipulation could be defined as the over or under-stating of prices set by MNEs for international, intra-firm transactions. Hence, a company over-states the price of imports in a high tax country while it under-states the price of exports, resulting in the reduction of its accounting profits.125Concerning the manipulation of transfer prices in this kind of transactions, as it is evident from the U.S. rulings 126and corresponding rulings of other high tax countries, there is an effort to tighten up transfer pricing rules and avoid the shift of taxable income to low tax jurisdictions.127

121 OECD, ECO/WKP(2016)79, https://www.oecd.org/eco/Tax-planning-by-multinational-firms-firm-level-evidence-from-a-cross- country-database.pdf 122 Mostly in low tax jurisdictions. 123 Vincent Vicard (Banque de France), (2014), “Profit shifting through transfer pricing: evidence from French firm level trade data” 124 OECD, ECO/WKP(2016)79 125 European Commission, Economic Papers (2006), ”International profit shifting within multinationals: a multi-country perspective” Harry Huizinga, Luc Laeven http://ec.europa.eu/economy_finance/publications/pages/publication590_en.pdf 126 Section 482 of the U.S. Income Tax Act 127 Ramy Elitzur, Jack Mintz, (1996), “Transfer pricing rules and corporate tax competition”, Elsevier - Journal of Public Economics 60, 401-422

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Taking into account that most of MNEs deal somehow with intangible property and that the valuation of this property is doubtful, it seems reasonable that exploiting the setting of a transfer price in this case is more convenient for MNEs. Thus, the mobile nature of these assets, such as intellectual property, patents or copyrights, and the difficulty to benchmark their price in accordance with the market price give possibilities for manipulation.

There is no doubt that intangibles are now, more than ever, the drivers of corporate profit. Regardless of the transfer price of intangibles in intra-group dealings, their location could play an important role for profit shifting purposes. Taking advantage of their mobility and their complicated valuation, MNEs tend to locate intangible assets in jurisdictions with preferential treatment for this kind of assets, or in lower tax rate countries in order to achieve taxation of profits derived from intangibles, such as royalties, therein.128As a general tendency, companies relocate considerable parts of valuable intangible property holdings from their home countries to subsidiaries located in low tax countries, such as Ireland, or found enterprises in tax havens and manage this property there.129 These strategies have become more common, since not only the MNEs intend to minimize their total tax liability, but also many countries have developed a tax friendly environment attempting to promote activities involving intangibles or R&D activities. Their objective is to take advantage from intellectual capital and increase their tax revenues. For instance, the adoption of intellectual property box regimes or patent boxes by many countries gives the opportunity to more MNEs to invest in R&D activities, as they benefit from a tax extenuation.130 The results of this approach regarding tax competition between the states will be addressed in the next chapter.

Even if the above mentioned arrangements are not constructed in an aggressive way, there is an important challenge for legislators, governments and policy makers to recognize the real intentions behind corporations’ activities and to provide the right means of prevention. Since, most of the countries face economic strains due to fiscal debt whereas they intend to generate tax revenues, there is a huge debate about the MNEs’ strategies. The OECD has created a forum for aggressive tax planning matters (ATP), based on the cooperation between member countries and the exchange of information on aggressive tax planning schemes131. In order to tackle base erosion and profit shifting the OECD introduced the BEPS Action

128 OECD, ECO/WKP(2016)79 129 Matthias Dischinger, Nadine Riedel, (2010), “Corporate assets and the location of intangible assets within multinational firms”, Elsevier – Journal “Famous examples are Pfizer, Bristol-Myers Squibb and Microsoft which have relocated a considerable part of their research and development (R&D) units and patents from their home countries to Ireland (see e.g. Simpson (2005) on Microsoft's R&D transfer).” 130 Joris Luts, (2014), “Comparability of IP Box Regimes with EU State Aid Rules and Code of Conduct”, EC Tax Review 2014-5, Kluwer Law International 131 http://www.oecd.org/ctp/aggressive/co-operation-and-exchange-of-information-on-atp.htm

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Plan.132Furthermore, the Anti-avoidance package published by the European Commission and the directives included therein demonstrate that the confrontation of these tax planning strategies is of great concernment to the EU Member States.

CHAPTER 4: Advance pricing agreements and EU State Aid

In the previous chapter, the phenomena of aggressive tax planning and tax avoidance had been analyzed in order to show how slight is the difference between them, to distinguish the techniques used and understand the purposes behind the current practices of MNEs. This analysis is deemed the necessary link in order to pass from the MNEs’ aggressive strategies to the role of the States, which constitute the other part of the tax mechanism. For this reason it took place in this part of the thesis.

In spite of MNEs’ intention to minimize their tax burden or, as a rule, to avoid taxation, these entities are not to be entirely blamed for this situation as they share liability with the states. It seems clear from the complex tax regulations and the high corporate tax rates in developed countries that the international tax system is outdated and has not been synchronized with the digital economy. On the other hand, many countries provide tax incentives in order to attract investments and improve their economies. Advance pricing agreements between certain States and powerful MNEs, for the sake of legal certainty, provide special tax treatment to these companies and improve the investment climate within the State133. But do these agreements (hereinafter APAs) constitute unlawful State aid, granted to MNEs by EU Member States?

From an EU point of view, any aid provided which meets the criteria included in Article 107 TFEU is illegal. APAs could aggravate tax avoidance as MNEs, take advantage from the aid provided by States, resulting in reduced or nil tax liability. State aid regulation (TFEU) is used by the European Commission as a mean to combat harmful tax competition between the States, as well as, tax avoidance by MNEs.

It does not seem to be just a coincidence or a random choice of MNEs the fact that most of the agreements cover transactions involving intangible assets. This is, also, clear from the examined case law, as the MNEs under investigation mostly trade intangibles. As already mentioned, these assets, due to their mobility, are easily transferred, through related transactions, to other countries. In particular, MNEs prefer to locate them in low tax jurisdictions or to EU Member States with which they have conducted APAs, providing both parties with legal certainty. Through these arrangements, MNEs have the possibility to

132 BEPS action plan will be analyzed in the 5th chapter, focusing on intangible assets (8). 133 R.H.C. Luja, (2015), “Will the EU State Aid Regime Survive BEPS?”, British Tax Review

[25] propose the transfer pricing method that they consider to be the most appropriate one for the transactions concerned. However, their proposal is not always correct.

In short, this chapter will include the determination of State aid as prescribed by the TFEU, placing great emphasis on the condition of selectivity which is the most important for tax purposes. Thereafter, a brief definition of rulings and, particularly, advance pricing agreements must take place, since they have been criticized as a mechanism used by tax authorities to provide advantages only to certain taxpayers.134Some remarkable cases – scandals will be discussed here as examples. Finally, the importance of the European Commission’s role towards these practices will be examined.

4.1 State aid as is prescribed in TFEU: advantage and selectivity

Although government interventions appear crucial for a stable and well-functioning economy, the use of State aid is generally prohibited as it violates EU law (Article 107 (1) TFEU). Only the lawful aid is not prohibited. The TFEU leaves room for a number of policy objectives which can be supported through State assistance and are considered compatible with the internal Market. In addition, the European Commission approves aid measures within the limits provided by the regulation (exceptions Article 107 (2)&(3) TFEU).

State aid is defined broadly as an advantage135 in any form granted by public authorities of a Member State or through State resources, -taxpayer-funded resources-, on a selective basis in order to provide assistance to certain undertakings/organizations or to the production of certain goods. This could potentially provoke distortion of competition and trade in the European Union. Therefore, in order for prohibited State Aid, as provided in Article 107 (1) TFEU, to be present, four criteria seem relevant and must be fulfilled cumulatively: aid that gives an advantage, selectivity, aid from State resources, distortion of competition and effect on trade between Member States.

From a tax law perspective, State aid subsists when a Member State, usually by means of tax agreements, unduly benefits only certain undertakings. Despite State’s initial intentions to create legal certainty and incentives for investments, the aid is, in most cases, unjustified and prohibited. The most important of the foregoing criteria to be met in order to verify fiscal State aid are advantage and selectivity. However, selectivity is the decisive criterion from a direct taxation perspective, since the other conditions of Article 107 (1) are usually satisfied.

134https://www.wu.ac.at/fileadmin/wu/d/i/taxlaw/institute/staff/publications/Lang_BritishTaxReview_Is sue3_2015_391.pdf 135 http://ec.europa.eu/competition/State_aid/overview/index_en.html

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In spite of the fact that, in practice, it seems difficult to distinguish between the criteria of advantage and selectivity, and both tests are often merged by the European Commission under a “selective advantage” test136, it is prudent to examine these criteria separately, according to the case law of the Court of Justice of the European Union (hereinafter CJEU). An advantage could be defined as an economic benefit which would not be granted to undertakings in normal market conditions, without State’s interference. The advantage might be of a positive nature, such as advantageous application of transfer pricing rules, or negative nature, such as a tax relief.137 . More often, the tax advantages granted by governments take various forms such as tax exemptions, tax deferrals, tax settlements, tax deductions, special tax rates and other preferential regimes.

O the other hand, selectivity138 is present when an advantage, here a tax measure, is granted to certain economic operators –taxpayers- over others or only for the production of some specific goods. Thus, the tax measure is not general and the beneficiaries-undertakings have an advantageous position compared to similar taxable enterprises, under similar legal and factual circumstances in the relevant Member State139. In other words, they may are relieved from taxes that comparable undertakings are still liable to pay, as the tax measure deviates from the common/normal tax policy applied by the Member State. Selectivity can be characterized as de jure and de facto; the latter is mostly found in practice.

In order to confirm the existence of a selective measure the selectivity test must be performed. This test consists of three steps140. Firstly, a system of reference must be identified. According to the European Commission’s decisions, the OECD Transfer Pricing Guidelines are deemed to constitute such a framework, although this set of rules is soft law, and thus non-binding. As it follows from the CJEU decision in Paint Graphos case, when dealing with direct taxation matters, the general corporate tax legislation of the underlying Member State could be deemed as a reference framework. 141Secondly, a comparability analysis must take place,

136 This confusion was visible in the judgement: “Case C-143/99 (Adria-Wien Pipeline GmbH) judgment of 8th November 2001, para 41 et seq.”

Wolfgang Schön, (2015), “Tax Legislation and the Notion of Fiscal Aid —A Review of Five Years of European Jurisprudence –“, Max Planck Institute for Tax Law and Public Finance Working Paper 2015 -14 137 S. Moreno González, (2017), ‘State aid, tax competition and BEPS: comments on the European Commission’s decisions on transfer pricing rulings’, University of Leicester School of Law Research Paper No. 17-00. 138 There are two categories of selectivity, geographic/regional and material, although only the second will be addressed. 139 M-A. Kronthaler and Y. Tzubery, (2013), “The State Aid Provisions of the TFEU in Tax Matters”, Introduction to European Tax Law: Direct Taxation, 3rd edition, Vienna, Spiramus 140 European Commission v World Duty Free Group SA (C-20/15 P) 141 Luc de Broe, (2015), “The State Aid Review against Aggressive Tax Planning: ‘Always Look a Gift Horse in the Mouth’”, EC Tax Review 2015-6, Kluwer Law International

[27] constituting the next step of the selectivity test. In this step, it should be clarified whether a tax measure derogates from the foregoing framework, inasmuch as there is a different treatment of economic operators “who are in a comparable legal and factual situation”.142143In case the measure concerned constitutes derogation, it may be classified as discriminatory in a later stage. The third step is to examine whether the measure that constitutes State aid might be justified by the nature or the general scheme of the reference tax system144. In order to be justified, a measure should be consistent with the principle of proportionality and the requirement of necessity; in case it turns out to be justified, the measure is non-selective and there is no illegal State aid as provided in Article 107 (1) TFEU.

4.2 Advance pricing agreements

Tax rulings are indicated as advance tax rulings, advance pricing agreements or other tax arrangements. In this sub-chapter of the thesis a brief review of advance pricing agreements will take place by virtue of their relation with the foregoing criteria, as well as, their important role in the transfer pricing cases that will be discussed later.

They are defined as tax rulings- agreements between certain taxpayers, in most cases MNEs, and tax authorities, aiming at the mitigation of legal uncertainty.145 They, usually, determine the application of tax law in forthcoming transactions in general and the adoption of the appropriate transfer pricing146 methodology in particular. APAs are crucial in cases of internal cross-border transactions of MNEs as they guarantee higher compliance with the transfer pricing regulation, they encourage the application of the arm’s length principle and they mitigate tax risks for both MNEs and the States involved. When more than two countries are involved (bilateral, multilateral) the agreement occurs only between the tax authorities, although unilateral APAs bind companies and tax authorities. In the latter case, the tax authorities, usually, confirm the transfer pricing estimation, as proposed by the MNE- taxpayer. These arrangements are more valuable when companies of the same group are

142 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) OJ C 262, 19 July 2016, p. 27-40. 143 Joined cases C-20/15 P and C21/15 P, Santander (2016) 144 “Exceptionally: boundaries of system of reference have been designed in a clearly arbitrary or biased way to favor certain undertakings which are comparable with regard to the underlying logic of the system in question.” Judgment of the Court of Justice of 15 November 2011, Commission and Spain v Government of Gibraltar and United Kingdom, Joined Cases C-106/09 P and C-107/09 P, ECLI:EU:C:2011:732 145 Alexander Vögele and Markus Brem, (December-January 2003), “Do APAs prevent disputes?”, www.internationaltaxreview.com 146 “An ‘advance pricing agreement’ determines (in accordance with the law and the OECD Guidelines) in advance if the transfer price between two related parties within a group is at arm’s length compared to the transfer price with an unrelated party.” Elly VAN DE VELDE, (2015), “‘Tax rulings’ in the EU Member States”, European Parliament - POLICY DEPARTMENT A: ECONOMIC AND SCIENTIFIC POLICY - IP/A/ECON/2015-08

[28] closely related and it is difficult to distribute the functions, risks, assets to either company; when dealing with intangible assets that have high value in the company; when it is impossible to find comparables and difficult to establish the needed method.147

APAs must be in accordance with European law, such as State Aid rules, and National law, as well as, with International law and policies. However, the recent formal investigations launched by the European Commission’s DG Competition into tax ruling practices, resulted in a problematic application of rulings, and particularly, APAs, from the EU State aid rules perspective.148The investigation has been focused on transfer pricing arrangements between MNEs and Member States. As described in the Working Paper, “The inquiry led, in mid- 2014, to the opening of three formal State aid investigations by the European Commission on tax rulings granted by Ireland (to Apple), Luxembourg (to Fiat) and the Netherlands (to Starbucks). Further investigations were opened by the European Commission later the same year and in 2015 on tax rulings granted by Luxembourg (to Amazon and to McDonald's) and by Belgium (the Excess Profit scheme).” An analysis of some of these cases will follow.

There is no specific guidance in order to recognize whether certain APA practices constitute illegal State aid and this becomes more difficult considering that these practices are created to provide legal certainty.149The European Commission alleges that the APAs are selective as long as they deviate from the arm’s length principle and there is incorrect application of the OECD Transfer Pricing Guidelines by the Member States150; it uses the same reasoning to examine the existence of the advantage criterion in the cases at hand. Hence, the European Commission blurs the divergence between these criteria and concurrently incorporates the arm’s length principle in the concept of State aid.151A review of the role of the institution and observations on its practices will follow.

4.3 Significant cases that triggered a public debate

147 Alexander Vögele and Markus Brem, (December-January 2003), “Do APAs prevent disputes?”, www.internationaltaxreview.com 148 EU Commission, DG Competition Working Paper on State Aid and Tax Rulings, 2016 (http://ec.europa.eu/competition/state_aid/legislation/working_paper_tax_rulings.pdf) 149 In case the application of tax provisions is complicated in practice (e.g. transfer pricing of intangibles). The draft Notice of the European Commission, published in 2014, states that the arm’s length principle, as provided in the OECD Transfer Pricing Guidelines, engenders legal uncertainty and the APAs rulings intend to turn it into certainty through the appropriate interpretation. -Draft Commission Notice of 2014 on the notion of state aid pursuant to Art. 107(1) TFEU, § 174–175 150Luc de Broe, (2015), “The State Aid Review against Aggressive Tax Planning: ‘Always Look a Gift Horse in the Mouth’”, EC Tax Review 2015-6, Kluwer Law International It should be noticed that the OECD Transfer Pricing Guidelines still constitute soft law and Member States are allowed to deviate and interpret them as they want. Potential disputes could be settled through the Mutual Agreement Procedure or the Arbitration Convention (in the EU). 151 S. Moreno González, (2017), ‘State aid, tax competition and BEPS: comments on the European Commission’s decisions on transfer pricing rulings’, University of Leicester School of Law Research Paper No. 17-00.

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Despite the effort made by many countries to combat aggressive tax planning and tax avoidance, there are still other countries which aggravate these phenomena. The latter countries aim at creating tax incentives in order to convince powerful companies to invest in their territory. Since this behavior has caused millions (euro) of tax revenue losses, people’s “outcry” against governments and MNEs was more than expected152. This situation reasonably brought out the reaction of the European Commission and Commission’s DG Comp, which, in summer 2014, launched formal State aid investigations into tax rulings and more precisely into APAs. The APAs obtained by mammoth group companies, namely, Starbucks, Fiat - Amazon - McDonalds , as well as, Apple from the Netherlands, Luxembourg and Ireland, respectively, will be briefly analyzed in this part. As this sub-chapter contains case law, it seems prudent not only to examine the cases involving APA practices but also to notice the intricate structure of MNEs, using transfer pricing for tax avoidance through additional examples.

Fiat constitutes a MNE that obtained APA from Luxembourg, into which the European Commission has launched formal investigations. The beneficiary is the FFT153, part of the Fiat group, which provides financing and treasury services to the group having its head-office in Luxembourg and branches in the UK and in Spain.154The FFT APA provides a method for profit allocation to FFT within the group and gives FFT the chance to determine its corporate income tax liability to Luxembourg per year. The European Commission expressed doubts, for instance, as to the fixed tax base for FFT’s activity in this State, or to the appropriateness of the transfer pricing method chosen (TNMM instead of CUP), and concluded that the ruling constituted an advantage. This advantage was granted in a selective way, favoring FFT over companies in comparable legal and factual position. Since the other conditions were satisfied, the FFT APA was considered to be illegal State aid granted to FFT and Fiat group.155

Starbucks is, also, one of the companies targeted by the European Commission’s inquiry, due to the improper implementation of the arm’s length principle, by this MNE, into its transfer pricing policy.156Before examining the European Commission’s investigation and decision, a description of Starbucks Corporation’s structure will occur. Starbucks Corporation, based in the U.S., has two Dutch subsidiaries, Starbucks Coffee EMEA BV (SCBV) and Starbucks Manufacturing EMEA BV (SMBV). SMBV has concluded two

152 Hans van den Hurk, (2014), “Starbucks versus the People”, BULLETIN FOR INTERNATIONAL TAXATION, IBFD 153 Commission Decision of 21.10.2015 on State Aid SA.38375 (2014/C ex 2014/NN) which Luxembourg granted to Fiat 154 http://ec.europa.eu/competition/state_aid/cases/253203/253203_1757564_318_2.pdf 155 In breach of Article 108(3) TFEU. 156 https://www.europeanceo.com/business-and-management/transfer-pricing-arms-length-alternatives- needed/

[30] agreements with ALKI LP based in the UK and SCTC based in Switzerland157. According to the first, roasting IP licensing agreement, ALKI sells know-how to SMBV and the latter pays royalties to the seller in exceptionally high price compared to the arm’s length price, for corresponding independent transactions, involving intangibles. Regarding the second, green coffee purchase agreement158, the increase in the price is notable and may justify the Commission’s doubts as to the Corporation’s purposes159. The structure is actually much more complex, although it is described here in brief, as an example.

“Structure of Starbucks based on the description in the transfer pricing report”160

Two APAs had been concluded in 2008 between the Dutch tax authorities and two subsidiaries of Starbucks Corporation, namely SMBV and SCBV based in Amsterdam.161 The European Commission opened an investigation into the SMBV APA in 2014 and decided that the Netherlands granted prohibited State aid to Starbucks through the APA between the company and the Dutch tax authorities, as all the conditions of 107 (1) are satisfied. Both of them appealed this decision but the CJEU decision is not available yet.

The concluded APA determines that the remuneration estimated by Starbucks for the functions performed (roasting/manufacturing) in the State by SMBV is in accordance with the arm’s length principle. The parties agreed upon the profit allocation to SMBV within the Starbucks Corporation which enables the BV to determine its corporate income tax liability in the State per year, for a period of ten years. The European Commission considers that some methodological choices should not have been accepted by the authorities as they reduce the

157 Eric C.C.M. Kemmeren, (11//2/1017- Lecture), The Netherlands: Fiscal unity, Groupe Steria’s per- element approach and currency losses relating to a non-resident subsidiary(C-399/16(X NV)); Starbucks and State aid (T-760/15 and T-636/16), available for Tilburg University students 158 SMBV buys green beans from SCTC and roast these beans in the Netherlands. 159 “The average mark-up on the costs of green beans was around 3% in the period from2006 up to and including 2010. In the period from 2011 up to and including2014, the mark-up was 18%.” 160 Commission Decision (EU) 2017/502 of 21 October 2015 on State aid SA.38374 (2014/C ex 2014/NN) implemented by the Netherlands to Starbucks 161 Commission Decision (EU) 2017/502 of 21 October 2015 on State aid SA.38374 (2014/C ex 2014/NN) implemented by the Netherlands to Starbucks

[31] tax liability of SMBV compared to non-integrated entities. For instance, the TNMM does not seem to be the most appropriate transfer pricing method for the transactions concerned. However, the less complex CUP method would be more in accordance with the arm’s length principle and the company has already concluded agreements with third parties, using the latter method. The European Commission, also, argues that the royalties’ payment to ALKI LP is questionable, as the latter has no employees in order to manage such a risk and its probable reason of existence is the royalties’ taxation in the UK.

Apple is deemed to be the largest company in the world, taking into account the market capitalization, 614.61$ billion in 2016162. After the formal investigation which started in June 2014, the European Commission concluded, in August 2016, that Ireland granted undue tax advantages163 to Apple, amounting 13€ billion. Acting contrary to the State aid rules164, resulted in Ireland’s liability to recover the aid. There are two agreements concluded between the Irish government and the Apple group, in 1991 and in 2007. The European Commission noted that the tax ruling, on profit allocation to Apple group’s Irish branches, obtained by Apple from Ireland in 1991165 had been negotiated without having as a starting point a set of comparable transactions, as it is customary. Moreover, it perceived that there was no transfer pricing report attached in the documents that the Irish tax authorities provided to defend the estimation of taxable profit, as confirmed in the ruling.166The Commission, also, criticized the transfer pricing method167 agreed in the 2007 ruling, namely, the transactional net margin method, as not the most appropriate one for the transactions concerned. In addition, there were inconsistencies in the application of this method. Regarding the duration of the ruling of 1991, which had been applied for 15 years without any revision, although rulings must be granted for fixed periods, it seems problematic to the European Commission.

162 Reuven Avi-Yonah and Gianluca Mazzoni, (2016), “Apple State Aid Ruling: A Wrong Way to Enforce the Benefits Principle?”, LAW AND ECONOMICS RESEARCH PAPER SERIES -PAPER NO. 16-024, University of Michigan 163 For instance, the company has arranged with the Irish government a special, extremely low, corporate income tax rate, which since 2003 has been 2% or less. 164 The other three criteria are also fulfilled as analyzed in the Commission’s assessment. (next ftn.) 165 Commission State aid case SA.38373 (2014/C) (ex 2014/NN) (ex 2014/CP), on alleged aid to Apple by Ireland 166 Reuven Avi-Yonah and Gianluca Mazzoni, (2016), “Apple State Aid Ruling: A Wrong Way to Enforce the Benefits Principle?”, LAW AND ECONOMICS RESEARCH PAPER SERIES -PAPER NO. 16-024, University of Michigan 167 http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv:OJ.C_.2014.369.01.0022.01.ENG “the Commission recalls that the OECD Guidelines set certain requirements for the choice of the appropriate transfer pricing method to comply with the arm’s length principle. The method proposed by the tax advisor and accepted by Irish Revenue in the 2007 ruling for profit allocation is in effect the TNMM, with operating costs […] as a net profit indicator. The choice of that particular net profit indicator is neither explained by the tax advisor nor by Irish Revenue, although that choice results in materially different outcomes in the present case. The 2007 ruling also fails to explain the choice of operating costs as net profit indicator rather than a larger cost basis, such as costs of goods sold.”

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A closer, albeit brief, examination of Apple group’s structure seems necessary. Firstly, as it is well known, the biggest part of this company’s profit derives from intangibles and particularly from intellectual property which is developed in the U.S., although the profit is shifted to its Irish affiliates: AOI (Shell Company), ASI, and AOE. Apple, also, manipulates the different rules between Ireland (place of effective management) and the U.S. (place of incorporation) for establishing the residence of a company in their territory, resulting in no residence and double non taxation. Moreover, ASI licenses IP rights and rights to use the company’s brand to global subsidiaries, receiving remuneration (royalties) and, consequently, profit back in Ireland. In addition to this ingenious strategy, and despite the fact that, generally, Ireland constitutes a low tax jurisdiction compared to the U.S., the company exploits the low corporate income tax rate (i.e. recently 0, 005 -2% on ASI profits) negotiated in the APAs with the Irish tax authorities.168

4.4 The role of the European Commission

MNEs tend to take advantage of governments’ wish for development and of the incentives that the latter provide in order to achieve it. However, the main purpose of the State aid doctrine is to launch fair competition between the States and the Article 107 TFEU is established to combat contrary practices. The role of the European Commission as the guardian of the internal market appears to be crucial. The European Commission is responsible for enforcing the EU State aid rules and is obliged to open a formal investigation under Article 108 (2) TFEU where it has serious doubts about the aid's compatibility with EU State aid rules. Thus, this supranational institution monitors State aid in all Member States and, in this way, it is allowed to control their tax practices169. Since 1958, the Member States must notify the European Commission in case they plan to confer State aid and the latter has the responsibility to determine whether the measures taken by the States constitute State aid and further, whether they are consistent with the internal market.170

From a tax perspective and despite the fiscal autonomy of the Member States, the European Commission is still competent to assess whether a measure in the area of direct business

168 Antony Ting, (2014), “ iTax—Apple’s International Tax Structure and the Double Non-Taxation Issue”, British Tax Review : “The double non-taxation of the profits booked in AOI and ASI was achieved primarily by the combined effect of the following: 1. Definitions of corporate residence in Ireland and the US; 2. Transfer pricing rules on intangibles; 3. Controlled foreign corporation (CFC) regime in the US; 4. Check-the-box regime in the US; and 5. Low-tax jurisdiction.” 169 R.H.C. Luja, (2015), “Will the EU State Aid Regime Survive BEPS?”, British Tax Review 170 EU Commission, DG Competition Working Paper on State Aid and Tax Rulings, 2016 (http://ec.europa.eu/competition/state_aid/legislation/working_paper_tax_rulings.pdf)

[33] taxation constitutes legal or illegal State aid, as mentioned in its 1998 Notice171. Since 2001, series of investigations have been conducted by the DG Comp into Member States’ direct tax measures, rulings and agreements. Nevertheless, since 2014, these investigations focus on tax rulings and, particularly, APA practices between the States and certain undertakings, where the agreed pricing is not in accordance with the arm’s length principle, resulting in the Commission’s negative decision.

On the other hand, many multinational companies, as well as, States have criticized or even have appealed such decisions by virtue of European Commission’s inconsistency in some cases. For instance, the European Commission seems to consider the Article 107 TFEU, which is directly applicable, without needing interpretation and transposition in the national law of the Member States, as the EU legal basis for the application of the arm’s length principle. To be more concrete, the institution applies the general principle of equal treatment between taxpayers and not the Article 9 of the OECD Model Convention172. Although, the institution refers to the OECD Guidelines in order to cover the international consensus, the interpretation of Article 107 under the Commentaries/Guidelines of OECD for Article 9 is problematic as it obliges the States to apply non-binding soft law. Furthermore, as some critics allege, the European Commission has merged the criteria of economic advantage and selectivity, as in some cases it assumes that an advantage to certain undertakings is presumably selective. Moreover, regarding the determination of selectivity criterion, the European Commission applies the above mentioned three-step test, but not systematically when investigating APAs. For example in Apple case, the determination of a reference framework, which is the first step, was ignored173. To summarize, its behavior must be in accordance with the TFEU174 and consistent with its previous decisions in order to satisfy the principle of legal certainty and the legitimate expectations of taxpayers175.

171 Luc de Broe, (2015), “The State Aid Review against Aggressive Tax Planning: ‘Always Look a Gift Horse in the Mouth’”, EC Tax Review 2015-6, Kluwer Law International 172 Commission Decision (EU) 2017/502 of 21 October 2015 on State aid SA.38374 (2014/C ex 2014/NN) implemented by the Netherlands to Starbucks “Thus, for any avoidance of doubt, the arm’s length principle that the Commission applies in its State aid assessment is not that derived from Article 9 of the OECD Model Tax Convention, which is a non- binding instrument, but is a general principle of equal treatment in taxation falling within the application of Article 107(1) of the Treaty, which binds the Member States and from whose scope the national tax rules are not excluded”. 173 Reuven Avi-Yonah and Gianluca Mazzoni, (2016), “Apple State Aid Ruling: A Wrong Way to Enforce the Benefits Principle?”, LAW AND ECONOMICS RESEARCH PAPER SERIES -PAPER NO. 16-024, University of Michigan 174 In May 2016, the Commission published a Notice on the notion of State aid, intending to provide some guidance on its key aspects and simplify its application. http://europa.eu/rapid/press-release_IP-16-1782_en.htm 175 Anna Gunn & Joris Luts, (2015), “Tax Rulings, APAs and State Aid: Legal Issues”, EC Tax Review 2015-2, Kluwer Law International

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The main tool that the European Commission uses when it verifies, after its investigation, that an aid granted is unlawful, is the recovery. Thus, the State is liable to find a way to recover the amount of aid accompanied with the interest charge176. In case of non-compliance with the recovery injunction, the European Commission shall be entitled to refer the matter directly to the Court of Justice.177

CHAPTER 5: The project of BEPS and its effectiveness

5.1 BEPS Action Plan

Numerous problems in the field of international income taxation such as the application of transfer pricing, the location of intangibles, the rise of the digital economy, mismatches and, mostly, the ineffectiveness of the existing anti-abuse rules, have created opportunities for tax avoidance. As analyzed in previous chapters, MNEs tend to exploit the existence of such issues in combination with shortcomings and loopholes of tax law in order to mitigate their tax liability through their tax planning. These issues have brought the reorganization of international taxation on the top of the political agenda. Tax authorities, taxpayers, legislators, international organizations and policymakers are seriously concerned by this situation and its future consequences, especially considering the financial and economic crisis of the last few years. The OECD, which has already released guidelines, models and comments aiming at confronting the foregoing situation, continues its reflection on the base erosion and profit shifting.

In order to tackle aggressive tax planning strategies, which result in base erosion and profit shifting, the OECD and the G20 decided, in 2012, to provide guidance in the form of an Action Plan. This project aims at updating international tax rules in a coordinated way. More than a hundred countries around the world, even if some of them are not Members of the OECD, as well as the European institutions, have agreed on the coordinated action in order to implement this BEPS project178. The release of the report “Addressing Base Erosion and Profit Shifting” followed in 2013, as well as, an Action Plan consisting of fifteen specific points. In short, the objectives of these points include the accomplishment of coherence of domestic law, particularly when it has effect on cross border transactions, the enhancement of

176 R.H.C. Luja, (2015), “ EU State Aid Law and National Tax Rulings”, European Parliament - POLICY DEPARTMENT A: ECONOMIC AND SCIENTIFIC POLICY 177 Council Regulation (EC) No 2015/1589 of 13 July 2015 laying down detailed rules for the application of Article 108 of the Treaty on the Functioning of the European Union (codification) – the Procedural Regulation - (Codification of Council Regulation (EC) 659/1999 as amended) 178 OECD, (Progress Report 2016-2017), About the Inclusive Framework on BEPS http://www.oecd.org/tax/beps/beps-about.htm

[35] substance requirements in international standards and the prevalence of transparency. 179In 2015, the final Action Plan was completed and released by the OECD.

The action points180 are, for simplicity sake, to be broken down into the following groups. The first group includes an action point which deals with the taxation of digital economy (Action 1). The second group (coherence) is mostly related to anti-abuse rules, aims at preventing double non-taxation and tackling strategies that distort tax competition (Actions 2, 3, 4, 5, 6). The third group (substance), which seems to be more relevant to the topic of this thesis, examines the alignment of taxation and economic activity of companies; particularly it deals with related transactions, high risk transactions, cross border transfer of intangibles and transfer pricing issues (Actions 7, 8, 9, 10). The fourth group (transparency) deals with procedural reforms, such as country by country report, and addresses the issues of transparency and disputes (Actions 11, 12, 13, 14). The final group (multilateral treaty) refers to the implementation of treaty measures for the prevention of BEPS (Action 15).181

5.2. Actions 8-10 and transfer pricing of intangibles

As described in the third chapter of this thesis, the identification of intangible assets, the transfer of intangibles among group members, the finding of comparable transactions, the selection of the right transfer pricing method, and generally the establishment of a price is not an easy task. Moreover, this uncertainty creates opportunities for manipulation by MNEs, which use sophisticated strategies aiming at reducing their tax liability. The current transfer pricing rules and guidelines are usually misapplied and the outcomes show that the allocation of profits is not in line with the business activity which generated them.182

179 Van Raad K., (2016/2017), “Materials on International, TP and EU Tax Law”, International Tax Center Leiden p. 2198 180 Before the attempt to classify the Actions in several categories, we must first mention the title of each Action, as provided in the final reports, in order to show the diversity of the issues addressed by the OECD and G20 : “Action 1: Addressing the Tax Challenges of the Digital Economy, Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements, Action 3: Designing Effective Controlled Foreign Company Rules, Action 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments Action 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status, Actions 8-10: Aligning Transfer Pricing Outcomes with Value Creation, Action 11: Measuring and Monitoring BEPS, Action 12: Mandatory Disclosure Rules Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting, Action 14: Making Dispute Resolution Mechanisms More Effective, Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties”. OECD, BEPS 2015 Final Reports http://www.oecd.org/ctp/beps-2015-final-reports.htm 181 Ault H.J., Schön W. and Shay S.E., (2014), “Base Erosion and Profit Shifting: A Roadmap for Reform”, BULLETIN FOR INTERNATIONAL TAXATION, IBFD 182 OECD/G20, 2015 Final Report, Base Erosion and Profit Shifting Project, Executive Summaries, https://www.oecd.org/ctp/beps-reports-2015-executive-summaries.pdf

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These practices are to be tackled by the OECD/G20 BEPS action points 8-10. The purpose of this group of action points is to “assure that transfer pricing outcomes are in line with the value creation.” Although the action points 8-10 are referred as independent points, they appear combined in a group for the sake of coherence. They advise countries to develop specific rules in order to combat BEPS through intra-group transactions involving intangibles (8), through the intra-group allocation of risks and excessive capital (9), or through high risk or solely dependent transactions (10)183.

Thus, the OECD’s recommendations for enacting new rules give emphasis on the requirement of substance for the allocation of profit to different locations. For instance, an intra-group transfer of intangibles to entities that add no value184 to these intangibles, although they report significant profits, seems problematic. Every entity of an MNE should be compensated in accordance with their contribution to value creation. An entity is deemed to create value through “functions performed, assets used, risks assumed”.

5.3. BEPS and the EU

The European Commission, aiming at answering to the OECD BEPS Project, decided to adopt, in January 2016, the EU Anti Tax Avoidance Package185. The latter is based on OECD recommendations to address BEPS and this proves that the institutions of the EU treat this effort seriously.186Their main intention is the increase of legal certainty to European taxpayers.

This package includes different measures which cover the majority of the issues addressed in BEPS Action Plan. The Anti Tax Avoidance Directive187, which contains five binding anti- abuse measures, the Commission’s Recommendation on tax treaties188, the Communication

183 http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/action-plan-on-base-erosion- and-profit-shifting_9789264202719-en#page5 184 “…legal entities that play little or no role in the development, enhancement, maintenance, protection and exploitation of those intangibles other than providing funding for the development of them.” Wright R.D., Keates A.H., Lewis J. and Auten L., (2016), “The BEPS Action 8 Final Report: Comments from Economists”, International Transfer Pricing Journal, IBFD 185 European Commission, (2016), Anti Tax Avoidance Package, http://ec.europa.eu/taxation_customs/business/company-tax/anti-tax-avoidance-package_en 186 Dourado A.P., (2016), “The EU Anti-Tax Avoidance Package: Moving Ahead of BEPS?”, INTERTAX, Volume 44, Issue 6 & 7, Kluwer Law International BV 187European Commission, (2016), The Anti Tax Avoidance Directive http://ec.europa.eu/taxation_customs/business/company-tax/anti-tax-avoidance-package/anti-tax- avoidance-directive_en 188 COMMISSION RECOMMENDATION of 28.1.2016 on the implementation of measures against tax treaty abuse, http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/company_tax/an ti_tax_avoidance/c_2016_271_en.pdf

[37] on an External Strategy for Effective Taxation189 and a Revision of the Administrative Cooperation Directive190constitute the four measures included in the package. There are, also, changes in the Parent-Subsidiary Directive, intending to follow the OECD BEPS project, which have created doubts concerning potential increase of tax competition in the EU, as well as, the alignment between the amendments and the EU Primary Law.191 Furthermore, remarkable is the proposal for modification of the Interest and Royalty Directive192with a view to curb BEPS in the EU.

The external strategy for effective taxation, which constitutes part of the Anti Tax Avoidance Package, aims at promoting tax good governance in a global level, at tackling BEPS practices and guaranteeing a level playing field for companies. For the latter purpose, agreements between EU countries and third countries appear to be necessary. The Commission in order to increase tax transparency and interdict harmful subsidies wants to introduce State aid provisions in bilateral agreements. However, this intention is criticized as it may have the opposite results on investments in the EU and may constitute indirect protectionism for the European companies193, although the BEPS project requires coordination.194

5.4. Observations on the BEPS project

The release of the OECD BEPS Action Plan constitutes a coordinated effort to reinforce the international tax system by means of restricting opportunities for tax avoidance by MNEs. The implementation of this project was never meant to be an easy task. This Action Plan, which envisages action in fifteen areas, is meant to limit disparities and gaps. However, when it is implemented unilaterally, by each country and different national rules are enacted, these disparities cannot be avoided195. Moreover, the timelines established in the BEPS Action Plan make it even more difficult to proceed with comprehensive changes whereas the process of adopting these recommendations in countries’ tax rules requires more time.

189COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL on an External Strategy for Effective Taxation 28.1.2016, http://eur- lex.europa.eu/legal-content/EN/TXT/?qid=1454056581340&uri=COM:2016:24:FIN 190Proposal for COUNCIL DIRECTIVE amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation, http://eur-lex.europa.eu/legal- content/EN/TXT/?qid=1454056899435&uri=COM:2016:25:FIN 191 Cécile Brokelind, 'Legal Issues in Respect of the Changes to the Parent-Subsidiary Directive as a Follow-Up of the BEPS Project' (2015) 43 Intertax, Issue 12, pp. 816–824 192 COUNCIL DIRECTIVE 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:02003L0049-20130701 193 Dourado A.P., (2016), “The EU Anti-Tax Avoidance Package: Moving Ahead of BEPS?”, INTERTAX, Volume 44, Issue 6 & 7, Kluwer Law International BV 194 The use of the State aid doctrine as a tool for transparency purposes seems to be an effort to indirectly incorporate BEPS Actions 5-6 to the EU law, although this treatment is questionable. The reference of this subject took place here as it is deemed to be linked with the fourth chapter. 195 Ibid (Dourado A.P.).

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An important aspect to be addressed is the position of developing countries in this BEPS era. According to the OECD, BEPS is of great concernment for these countries as they basically count on corporate income taxation of MNE’s in order to satisfy their needs. Thus, they may be more vulnerable to corporate tax base erosion196 than developed countries, which are often partly responsible for this erosion. It seems important to engage developing countries in the international agenda.197As the OECD states, these countries have been extensively engaged through different mechanisms such as participation in the CFA198, regional tax organizations and international organizations.

Despite the differences between the countries involved in this effort and the difficulties to incorporate the Action Plan’s recommendations to various national tax legislations, this is the first international project which fights against aggressive tax planning, tax avoidance and base erosion. Although there are going to be many obstacles to its consistent application due to political and economic interests of countries and MNEs, it is deemed an important coordinated effort and could constitute a promising starting point for reforming the international tax system.

CHAPTER 6: Conclusion

The main purpose of this thesis was to analyze the current exploitation of transfer pricing of intangibles by MNEs, which also take advantage of incentives provided by governments in order to avoid taxation, and the tools provided by the European Union and the OECD, namely the binding State aid rules and the recommended BEPS Action Plan respectively, aiming at combating aggressive tax planning and harmful tax competition. This thesis has been constructed on the basis of tree distinct, albeit interconnected pillars. More specifically, in the first two chapters the transfer pricing of intangibles in accordance with the arm’s length principle and the issues arising, which lead to aggressive tax planning practices and tax avoidance by MNEs have been investigated. Then, some problematic advance pricing agreements in the EU, which aggravate the foregoing practices, as well as, their detection by the European Commission through the State aid rules have been described, with supporting case law. Finally, the international and promising BEPS Action Plan launched by the

196Crivelli E., De Mooij R.and Keen M., (2015), “Base Erosion, Profit Shifting and Developing Countries”, International Monetary Fund – Working Paper, WP/15/118 “…the possibility of mutual harm from the attempts of each country to make its tax system more attractive than those of others. These concerns with current international corporate tax arrangements have arisen most prominently in advanced economies. And it is they that drive the BEPS.” 197 OECD, (Progress Report 2016-2017), About the Inclusive Framework on BEPS http://www.oecd.org/tax/beps/beps-about.htm . 198 Committee on Fiscal Affairs

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OECD/G20 in order to tackle all the above mentioned aggressive practices has been presented, followed by certain observations.

In a globalized economy, cross border associated transactions within MNEs are increased. The transfer pricing system which is created in order to estimate the price in these transactions is based on the arm’s length principle, requiring the same treatment of related and unrelated transactions. Most MNEs fail, not by chance, to implement this standard into their transfer pricing policies and the provided legal framework is not sufficient in order to restrict this situation. It is questionable whether this principle and the separate entity approach must be replaced by another more concrete approach, such as formulary apportionment. Due to the rapid development of technology, most of related transactions involve intangible property. The definition and valuation of this property are problematic issues which make the determination of a price more difficult. All these issues leave room to MNEs to exploit the absence of legal scrutiny and to adopt aggressive tax planning practices aiming at producing favorable tax outcomes. The main consequence is base erosion and profit shifting and double non-taxation.

From an EU perspective, opportunities for BEPS are provided by Member States, which intend to increase investment in their territories, through tax measures granted to certain MNEs Since MNEs’ practices constitute only the one side of the coin, the aggressive tax planning by MNEs would be ineffective without States’ intervention through tax rulings and particularly advance pricing agreements. As the European Commission’s investigations have proven, these agreements do not always constitute lawful aid as they result in tax avoidance by MNEs and harmful tax competition between the Member States. The State aid rules provided in Articles 107-109 of the TFEU constitute an effective instrument managed by the European Commission, which is able to tackle harmful tax competition and abusive tax planning –through recovery- and consequently BEPS.

Finally, the OECD has launched, in 2015, the BEPS Action Plan, which is an international project having as a purpose the combat of base erosion and profit shifting through coordination between the countries involved. The OECD provides some recommendations to countries in order to develop ‘uniform’ rules, the previous absence of which has created BEPS. For instance, some action points included in the Action Plan provide guidance on transfer pricing of intangibles which has never existed before. Although the OECD’s plan seems promising, we are concerned about difficulties in its implementation in more than a hundred different legislations.

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