The function of tax incentives and their potential risk of being incompatible State aid

Bosîi Ana ANR. 384386

Supervisor Dr. Cihat Öner

Academic year 2018/19

The function of tax incentives and their potential risk of being incompatible State aid

Master Thesis International Business Taxation Track: International Business Tax Law

Tilburg School of Law, Tilburg University

Bosîi Ana ANR. 384386

Supervisor Dr. Cihat Öner

Date of completion of the thesis 17.06.2019

Acknowledgements

The present thesis analyses the question of tax incentives, their design and the risks they entail in a world where tax competition is strictly controlled and regulated, while also looking into their interaction with the State aid regime of the European Union. The research and the completion of the thesis happened between January and June 2019.

I would like to express my gratitude to my supervisor dr. Cihat Öner, who has been patiently guiding me with the best advice through the entire writing process of the thesis. I have learned a lot from him during this period.

I am grateful for the friends I made in Tilburg, Karmen and Dora, with whom preparation for the exams was like a celebration.

In addition, I would like to thank my family for their patience and confidence in me.

Finally, I would like to thank Lukas for his unconditional support.

Tilburg, June 2019

Ana Bosîi

Abstract

Tax incentives are granted by states in order to stay competitive on the market. Whether their use is the best solution to attract long-lasting investment is debatable by many. Therefore, tax incentives will be analysed in the light of the recent developments aiming at finding durable solutions for base erosion and profit shifting and the developments in the area of the State aid regime. The importance of design of incentives will be equally discussed, but also the interrelationship between tax incentives and Stat aid. The subject of tax rulings will also be touched upon briefly.

TABLE OF CONTENTS

1. INTRODUCTION ...... 1

1.1. DISCUSSION OF THE TOPIC ...... 1 1.2. PRESENTATION OF THE RESEARCH AND SUB-RESEARCH QUESTIONS ...... 2 1.3. INTERRELATIONSHIP WITH BUSINESS TAXATION ...... 3 1.4. RESEARCH METHOD AND ITS LIMITATIONS ...... 3 1.5. STANDARD OUTLINE OF THE PAPER ...... 4

2. TAX INCENTIVES ...... 5

2.1. THE NOTION OF TAX INCENTIVES ...... 6 2.2. RELEVANT TYPES OF INCENTIVES ...... 8

3. STATE AID ...... 11

3.1. BRIEF HISTORICAL CONTEXT ...... 11 3.2. DEFINITION AND PURPOSE OF STATE AID ...... 12 3.3. BRIEF OVERVIEW OF THE STATE AID CONDITIONS ...... 14 3.3.1. Aid granted through state resources ...... 14 3.3.2. The advantage criterion ...... 15 3.3.3. The selectivity criterion ...... 15 3.3.4. Aid affecting trade between Member States...... 18

4. EFFECTIVELY DESIGNED INCENTIVES AND PREVENTION OF ABUSE ...... 20

4.1. THE ADVANTAGES AND DISADVANTAGES OF ADOPTING TAX INCENTIVES ...... 20 4.2. THE IMPORTANCE OF DESIGN OF TAX INCENTIVES ...... 25 4.3. THE USE AND ABUSE OF TAX INCENTIVES ...... 29 4.4. THE IMPACT OF TAX INCENTIVES ON CIN AND CEN...... 31

5. THE INTERRELATIONSHIP BETWEEN TAX INCENTIVES AND STATE AID ...... 34

5.1. TAX INCENTIVES BECOMING STATE AID ...... 34 5.2. THE PARTICULARITY OF TAX RULINGS ...... 36 5.3. TACKLING HARMFUL TAX COMPETITION AT EUROPEAN UNION LEVEL ...... 40 5.4. CERTAIN INCENTIVE PRACTICES IN THE EUROPEAN UNION ...... 41 5.4.1. The Gibraltar case ...... 41 5.4.2. Belgium’s excess profit rulings ...... 43

6. CONCLUSION ...... 45

7. BIBLIOGRAPHY ...... 47

1. INTRODUCTION

1.1. Discussion of the topic

It is of particular importance for countries to remain competitive on the market. In doing so, they strive towards modernizing their tax systems and bringing their economies to such a level as to be fit for the race. This applies especially for countries joining the European Union (EU), which have to make sure their tax system is competitive to the point of enabling them to be active on the European market in line with other developed economies. The same is true for the “older” economies, who have the same drive for remaining competitive on the market, desiring just as much to attract businesses to their jurisdictions. This ongoing race is said to be desirable up until the moment it turns into a race to the bottom1.

A “desirable” tax system requires the existence of a certain balance between the need to be competitive and the limits that come with it. In order to be in conformity with EU law, Member States (MSs) have to make sure they abide by the EU rules on State aid, which are an integral part of primary EU law. Equally, they have to make sure their tax systems are in conformity with secondary law of the EU like the Anti-Tax Avoidance Directive or the General Block Exemption Regulation.

This means that MSs have to find the right balance between setting viable tax rules and keeping low tax rates in the country, while at the same time avoiding an excessive loss of revenue due to these low rates, which would be prejudicial to their budgets.

In times of such a globalized economy as we have nowadays, jurisdictions cannot be said to exercise their taxation powers in a completely independent matter. Their decisions are inevitably influenced by those of their neighbours, with whom they are in constant competition2. Which country has the lowest tax rates, the most attractive tax incentives or the most stable political arena – these factors, amongst others, are being considered by companies when deciding whether the investment climate of a certain country is convenient for their business and budget.

When it comes to tax incentives and the EU, there is an ambiguous relation between the two. This impression stems from the general idea that tax incentives are actually preferential treatment for

1 “The race to the bottom refers to a competitive state where a company, state or nations attempts to undercut the competition's prices by sacrificing quality standards or worker safety, defying regulations, or paying low wages.”, Investopedia.com. 2 A. Bal, Tax Incentives: Ill-Advised Tax Policy or Growth Catalysts?, European Taxation, February/March 2014, p. 63.

1 economic and non-economic actors in an attempt to enhance their economic performance and generally attract investment to the MSs designing the incentive. This idea of preferential treatment is, at least in appearance, contrary to the concept of “open market economy with free competition, favouring an efficient allocation of resources” found in art. 120 of the TFEU.3 This is the reason why there is a general prohibition for MSs to adopt measures constituting illegal State aid. The case law of the CJEU has shown that, in some cases, there is a fine line between what represents incompatible and compatible State aid at EU level.

The problem of tax incentives risking being considered incompatible State aid is indeed a very topical issue. It is also a matter of practical importance for businesses, which have to take these risks into account when accepting and implementing State aid, in order to avoid having to pay it back (plus interest) to the MS grating it.

As the focus of the European Commission (EC) on State aid has been significantly growing, this subject has created much of controversy among scholars and practitioners. The general idea that dominates the discussion around tax incentives and the recent State aid decisions is the potential lack of legal certainty. Moreover, tax incentives themselves have been put under severe scrutiny, many discussions pointing to them as being, in some cases, “quick fixes” for problems that stem deeper than the apparent visible surface (unsolved economic issues, political instability, unskilled labour force and other commercial concerns), but also an instrument that can create tax competition between states which can lead to a “race to the bottom”.4

1.2. Presentation of the research and sub-research questions

With regard to the above-mentioned issues, it is of particular importance to make use of tax incentives in a way that proves to be effective in attracting foreign direct investment (FDI) and encouraging local investment, but also that is according to the standards and principles of EU law, more precisely the State aid regime. The following sub-research questions can therefore be asked:

i. How should tax incentives be designed to create a desirable tax system? ii. How effectively could this system be used? Do tax incentives really work? iii. What are the opportunities in the system for taxpayers to use but also abuse the system? iv. What is the impact of the State aid regime on tax competition through tax incentives?

3 E. Traversa, Tax Incentives and Territoriality within the European Union: Balancing the Internal Market with the Tax Sovereignty of Member States, World Tax Journal, October 2014, p. 320. 4 A. Bal, supra n. 2, p. 65.

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1.3. Interrelationship with business taxation

It is without a doubt that tax incentives can play a crucial role in stimulating investment decisions and influencing taxpayers’ behaviour, since it is only natural and of sound business practice for businesses to strive for tax optimization. However, what happens when the notion of “optimization” gains a negative understanding, it being associated with income purposely being shifted to low tax jurisdictions?

It is of particular interest what is the role of tax incentives in this matter and how can a MS make sure that, when granting one, it will not be granting illegal State aid.

The subjects of tax incentives and State aid are at the core of the taxation discussion of the past years. They represent important topics on which there is still no clear consensus. The importance and consequences of tax incentives, be they positive or negative, is probably a subject that is going to be debated for a long time in the future, as they are so diverse in terms of design and their true impact on the economy of a particular country is still not entirely clear. State aid is also a subject that doesn’t cease to surprise every time the EC brings a new investigation or the CJEU deliberates on a new case.

The combination of these two areas of taxation is a particularly interesting topic to look into, as it would be of great practical importance for businesses to have more clarity on it.

1.4. Research method and its limitations

The research for the present thesis will be conducted from the perspective of analysing the existing doctrine on certain tax incentives and State aid in the EU. The legal framework, EC’s decisions and investigations, but also reports and press-releases of the EC will be used as support for illustrative purposes. Furthermore, reference will be made to the 1997 Code of Conduct for Business Taxation, but also to the OECD BEPS Actions Plan. Although the present work will focus solely on tax incentives and State aid in the EU, it is undeniable that the BEPS Project has a particular impact and is being considered by the policy-makers both at national and Union level, hence the references to the OECD tax policies.

The present study has been narrowed down only to certain tax incentives discretionarily selected, that being due to the limits imposed by time and resources. Also, due to the vast amount of diversely designed incentives across the EU, have been selected only the tax incentives that are relevant to the business taxation environment, but also the ones that have been considered to constitute illegal State aid or are in

3 the process of evaluation by the CJEU. For illustrative purposes, the relevant case law of the CJEU, but also investigations and decisions of the EC will be briefly analysed.

1.5. Standard outline of the paper

The two chapters following the introduction (Chapter 2 and Chapter 3) will be dealing with the definition of tax incentives and the motivations behind MSs’ decision to design and adopt them. This will be followed by a brief historical context of State aid, the definition and its cumulative conditions, with a particular focus on the selectivity criterion.

The fourth chapter will look into the advantages and disadvantages of granting tax incentives, but also into understanding what precisely is being expected of MSs in terms of design of tax incentives for a more desirable tax system. The doctrine on this matter will equally be analysed and commented on, in an attempt to put down the main elements of what makes a tax incentive successfully designed. It will equally be pointed out that no matter the design, there will most likely be ways of using and abusing the system. Before proceeding to the conclusion, the impact of tax incentives on tax neutrality will also be shortly analysed.

The fifth chapter will analyse the interrelationship between tax incentives and State aid. It will be shown, in relatively general and theoretical terms that, if implemented improperly or poorly designed, tax incentives may qualify as incompatible or unlawful State aid. The question of tax rulings will equally be discussed, in an attempt to show that the practice of offering legal certainty to MNEs can turn into selectively granting preferential treatment as an incentive for investment.

The conclusion will be formulated as a brief attempt to answer the research question and sub-research questions presented above, specifically whether it is advisable for states to offer tax incentives to attract or retain investment, whether they are the ultimate solution to maintain or build the welfare state, but also whether such incentives can still be discretionarily offered in the light of the latest developments of the State aid regime.

4 2. TAX INCENTIVES

In such a competitive world as nowadays, countries are competing with each other on every single possible aspect. Tax incentives are one of the instruments that states, or regions of a state are putting in place in order to be more competitive compared to their neighbours. When it comes to developing countries in particular, attracting FDI is a particularly important for their economy. Tax incentives are therefore employed as a tool to attract MNEs to a certain territory as FDI, but also the spill-over effects this may bring.5 Other states, however, choose to use tax incentives in order to encourage the development of an activity in particular (for ex. R&D, protection of the environment, etc.).6

The need for tax incentives has increased when the importance of FDI has been comprehended by most developing countries in the 1980s. Before this moment, until the middle of 1970s, most developing countries were sceptical of FDI, associating it with post-colonialism. The change of perspective regarding FDI has occurred due to the radical political and economic changes that have occurred in the last couple of decades of the 20th century. Socialism has mainly been abandoned in favour of the market economy. The mass of privatizations that occurred were dependent on foreign-originating funds.7

Another reason for accepting a more liberalized flow of FDI was the need for countries to abide to the rules of the international organisations they chose to be part of, like the WTO or the OECD which demand a certain level of liberalization.8

Nevertheless, studies of the UN have shown that countries have unilaterally and independently embraced more liberalization, competing with each other in order to create a more beneficial investment environment for investors: over the period of 1991-1999, 94% of a total of 1,034 changes in policy in 63 countries were linked to more liberalization. 9

Therefore, countries compete with each other in creating the most favourable investment environment through offering tax incentives, amongst other things. When deciding to invest in a particular part of the world as the EU, for instance, MNEs will also pay attention to the MS that has, amongst other factors, the most favourable tax incentives. However, whether tax incentives play an essential role in their

5 A. Miller, L. Oats, Principles of International Taxation, 3rd ed., Ch. 20 (Haywards Heath Bloomsbury Professional), 2012. 6 A. Bal, supra n. 2, p. 63. 7 A. Easson, Tax Incentives for Foreign Direct Investment, Part I: Recent Trends and Countertrends, IBFD, July 2001, p. 267. 8 Ibid. 9 United Nations, World Investment Report 2000: Cross-Border Mergers and Acquisitions and Development (New York: UNCTAD, 2000); United Nations, World Investments Report 1998: Trends and Determinants (New York: UNCTAD, 1998), at. 57.

5 decision-making and whether they are indispensable in attracting investment to a country is debated by many.

2.1. The notion of tax incentives

The OECD Glossary of Tax Terms defines investment incentives as “financial and tax incentives used to attract local or foreign investment capital to certain activities or particular areas in a country”.10 Other sources define tax incentives like “departures from the benchmark system that are granted only to those investors or investments that satisfy prescribed conditions”11 or “special provisions that allow for exclusions, credits, preferential tax rates or deferral of tax liability”12.

Tax incentives can also be defined as “a special tax provision granted to qualified investment projects (however determined) that represents a statutorily favourable deviation from a corresponding provision applicable to investment projects in general”13. Speaking in practical terms, tax incentives are a loss in revenue for the state granting the incentive and a drop in the tax liability for the beneficiary.14

These investment incentives can be found in a variety of forms, but generally they are classified as financial and fiscal incentives, which are “direct” in the case of the former and “indirect” in the case of the latter.15

Tax incentives, in particular, have as a purpose to attract FDI to a particular jurisdiction or to stimulate that jurisdiction’s residents to undertake economic or non-economic activities.16 Having as a purpose to influence taxpayer’s decision on where to invest, they can be seen as a recompense for the decision to invest in a particular place or to behave in a certain way.17 They have as a common feature the fact that they are rather a derogation from the general system than normality.

Taxation can equally be seen as an instrument of influence of human behaviour in a particular direction desired by governmental policies, by increasing or decreasing the subjects’ tax liability depending on

10 Definition of “investment incentives”, Glossary of Tax Terms, OECD.org 11 A. Easson, E. Zolt, Tax incentives, World Bank Institute, 2002, p. 15. 12 E. Zolt, Tax Incentives; Protecting the Tax Base, in Selected Topics in Protecting the Tax Base of Developing Countries, Draft paper No. 3, 2014, p. 5. 13 H.H. Zee, J.G. Stotsky and E. Ley, Tax Incentives for Business Investment: A Primer for Policy Makers in Developing Countries (Washington, D.C. 2002: International Monetary Fund), p. 14. 14 A. Bal, supra n. 2, p. 64. 15 A. Easson, Tax Incentives for Foreign Direct Investment, Kluwer Law International, 2004, p. 2. 16 A. Bal, supra n. 2, p. 63. 17 R. W. Grant, The Ethics of Incentives: Historical Origin and Contemporary Understanding, 18 Economics and Philosophy 1, 2002, p. 111.

6 their compliance level. In doing so, the government exercises a direct influence on its residents or on residents of other countries deciding to invest there.

Research in behavioural economics with a focus on tax compliance tends to suggest that tax incentives do play a role in the behaviour of taxpayers.18 It concludes that when it comes to companies, in particular, tax incentives are only perceived positively by the rest of the taxpayers if they are well designed, consistent and are followed by efficient enforcement. In case an incentive is poorly designed and is perceived as highly selective by the beneficiaries19, it is capable to decrease the government’s credibility on the long run – therefore it can have an impact on tax compliance.

Trust in the government is said to attract investment. The OECD 2015 report on Policy Framework for Investment mentions that “high levels of trust can facilitate compliance with laws and regulations, strengthen investor confidence and reduce risk aversion.”20 Therefore, a well-established framework of tax incentives can also have an impact on how the general legal framework of a particular country is perceived by the investors, but also by its residents. The same OECD report mentions that a lack of compliance can occur if the tax system is characterized by “excessive complexity, a lack of transparency and unpredictability”21 but also by a lack of monitoring of the incentives.

An example of non-compliance could arise at the level of the local residents if the incentives are poorly designed. If they are to benefit only to foreign investors, local taxpayers might engage in the practice of “round-tripping”22 by moving the funds abroad to establish foreign or offshore entities and furthermore invest in their country as “new” investors.

Put in very simplistic terms, some believe tax incentives definitely play a crucial role in influencing taxpayers’ behaviour and present it as a general truth in a more or less humorous way: “To believe incentives do not influence behaviour is to believe the inserts in your newspaper about the upcoming Black Friday sales events are an irrational waste of time and money”23 – J.D. Foster. The above comparison was made in the context that taxes play a decisive role in the MNEs decision- making process when considering investing or moving their activities in more “business-friendly” environments.

18 T.O. Weber, J. Fooken, Behavioural Economics and Taxation, Working Paper no. 41, EU Taxation Papers, 2014, p. 5. 19 Although selectivity in itself is not a problem if the incentive is correctly designed. 20 OECD, Policy Framework for Investment, 2015, p. 19. 21 Ibid., p. 57. 22 A. Easson, E. Zolt, supra n. 11, p. 32. 23 J.D. Foster, You Can’t Sugarcoat the Facts: Taxes Influence Behavior, U.S. Chamber of Commerce (uschamber.com), November 19, 2015.

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Others uphold, however, that the role of tax incentives as a general solution for attracting durable, long- term investment is limited, but not insignificant.24 While it is undeniable that tax incentives per se are capable of influencing taxpayers’ behaviour and that they represent a burning topic at policy-making level, it is argued nevertheless that they should be considered only after the actual root of the problem is tackled, such as underdeveloped infrastructure, lacking administrative capacity or an unfit labour policy.25 Therefore, when granting incentives, a state needs to determine as precisely as possible what exactly are those incentives supposed to compensate for. If the answer is one of the issues mentioned above, then perhaps tax incentives should not be advised.

The above-mentioned OECD 2015 report upholds that “the key pre-requisites for investment policy include respect for the rule of law, quality regulation, transparency and openness and integrity.”26

A more detailed presentation of the different views on the function of tax incentives as perceived by the doctrine can be found in the fifth Chapter of this work, which focuses on the advantages and disadvantages of adopting tax incentives.

2.2. Relevant types of incentives

With regard to tax incentives, in particular, their operating mechanism works by conferring a benefit to the taxpayer through an effective reduction of the tax otherwise normally due. Tax incentives can be proposed in order to pursue different policy objectives, such as environmental, social or economic ones.

The tax incentives that will be focused upon in this work are the ones related to business taxation, while also falling in the scope of the OECD Base Erosion and Profit Shifting (BEPS) Project.27

When choosing the desired incentives, there is a relatively large number of possibilities that countries have at their disposal in order to attract more FDI or to stimulate local research and development activities (R&D). Among the vast number of the said possibilities, some are more relevant than others for taxing business-related income. Some of the most popular incentives are to be listed below, together with their respective short description.

24 C.E. McLure, Jr., Tax Holidays and Investment Incentives: A Comparative Analysis, 53 Bulletin for International Fiscal Documentation 8/9, 1999, p. 326. 25 A. Bal, supra n. 2, p. 70. 26 OECD, supra. n. 20, p. 19. 27 M. Cotrut, K. Munyandi et al., Tax Incentives in the BEPS Era, 2018, IBFD, p. 3.

8 Amongst the most popular business-related tax incentives used by states are the ones relating to the corporate income tax (CIT). It is a profit-based tax and its success depends on whether the business is profitable in the host country.28 It can either be implemented through the reduction of the rate (a complete exemption or a concessionary rate) or through the exclusion of certain income from the tax base. However, if a country generally offers a low rate to the companies present on its territory, the said low rate cannot qualify as an incentive, but rather as a general regime providing low CIT.29

The tax holiday is, perhaps, the most frequently employed method by the developing states in their incentive policymaking. It is also the method that is at the centre of the numerous debates concerning the effectiveness of tax incentives. It is defined as a “fiscal policy measure often found in developing countries (which) offers a period of exemption from income tax for new industries in order to develop or diversify domestic industries.”30 It is a policy measure that is characterized by its limited duration, lasting from one year to twenty years.31 It is directly linked to a state’s policy strategies, thus its characteristics vary from on country to another.

The following three incentives mentioned below can be put in the category of “capital investment incentives”. They are normally offered to active investments, as opposed to portfolio investments, thus being made available to foreign investors in order to help increase FDI.32 Investment allowances are sometimes presented as an alternative to tax holidays by the doctrine.33 The difference between them and tax holidays is that the latter applies to new investors, whereas the former applies to new investment. The investment allowance is defined as “an allowance with respect to a qualifying depreciable asset (which) adds a certain percentage of the asset's initial cost to the full depreciation write-off and is usually given in the year of acquisition or as soon as possible thereafter.”34 If an investment allowance aims at diminishing taxable income, “an investment tax credit is set against the tax payable”35. Besides investment allowances, there are incentives relating to R&D and intellectual property – front- end incentives (like R&D tax credits) and back-end incentives (like IP box regimes).36 Front-end, or more commonly ‘input-related’ R&D tax incentives vary in their forms, the most common being tax deductions of capital expenditures (costs of R&D equipment), current expenditures (costs of R&D

28 A. Easson, supra n. 7, p. 133. 29 M. Cotrut, K. Munyandi et al., supra n. 27, p. 5. 30 Definition of “tax holiday”, Glossary of Tax Terms, (OECD.org) 31 A. Easson, supra n. 7., p. 135. 32 M. Cotrut, K. Munyandi et al., supra n. 27, p. 5. 33 C.E. McLure, Jr., supra n. 24, p. 326. 34 Definition of “investment allowance”, Glossary of Tax Terms, (OECD.org) 35 A. Easson, supra n. 7, p. 144. 36 M. Cotrut, K. Munyandi et al., supra n. 27, p. 70.

9 labour). Back-end or ‘output-related’ incentives concern mobile income – the IP-related income. The latter incentives are meant to provide relief on income sourcing from the commercialization of the IP.

Capital investment incentives are crucial for developed countries, as they promote certain industry sectors or activities that are vital for the development of a country (like R&D). They are equally important for developing countries, because they promote transfer of technology which is an important factor that has enormous spill over effects, thus helping the said countries be more visible on the global competitive market.37 Despite their numerous benefits for the countries adopting them, they have also given rise to countless abusive tax planning structures which the OECD BEPS Project tries to tackle.

Finally, there is also the possibility for the outermost regions of the EU to have special economic zones (SEZ), which is a regional aid scheme providing assistance to companies established in that region. The OECD paper on tracking SEZs in the Western Balkans defines them as “designated geographical areas within an economy, where business activity is subject to different rules from those prevailing in the rest of the economy. Those rules can pertain to investment conditions, trade, customs and taxes, etc.”38 They are also commonly called “tax-free zones”, “export processing zones”, “free economic zones” or “free zones”.39

As mentioned above, countries may implement a variety of tax incentives depending on their policy goals. Listing them all in this section would be fruitless, since the present work focuses exclusively on tax incentives relating to the corporate income tax regime, or more generally - to the business environment. Consequently, the tax incentives which are meant to attract FDI discussed in the present work are reduced rate incentives, tax holidays, capital investment incentives and SEZs.

Since the present work tries to relate tax incentives to the subject of State aid, tax rulings will also be discussed and analysed under the light of tax incentives.

37 United Nations Conference on Trade and Development (UNCTAD), Tax Incentives and Foreign Direct Investment: A Global Survey (2000), p. 11-12. 38 OECD paper, “Tracking Special Economic Zones in the Western Balkans: Objectives, Features and Key Challenges”, OECD 2017, p. 14. 39 M. Cotrut, K. Munyandi et al., supra n. 27, p. 5.

10 3. STATE AID

3.1. Brief historical context

The European Union as it is nowadays is the product of a number of core values and principles which have been expressed through the EU fundamental freedoms. Amongst other essential functions, they make sure that, for instance, the exchange of goods and services between MSs happens in an unhindered manner, or that companies can freely establish themselves within the MS of their choice without experiencing any limitations whatsoever. It is an ongoing process that strives to effectively harmonize the practices and legislation amongst the EU MSs.

One of the aims of the EU is to safeguard free competition and free trade between MSs, and State aid has been considered to be an instrument capable of disrupting the economic balance the EU is striving for.40 With the idea of preserving the progress of the EU Single Market, a legal framework has been implemented, whose aim is to control the State aid mechanism efficiently.

The EC was entrusted with great investigative powers to make sure that countries do not grant incompatible State aid to local businesses, which would jeopardize the proper functioning of the internal market.41 It has been pointed out that the EC began having a stronger stance on MSs’ tax incentives at the moment an agreement has been reached between the MSs’ representatives in the Council and the EC itself, having as its principal focus the tackling of certain behaviours which have been labelled at the time as “harmful tax competition within the EU”42. This commitment has been materialized in the adoption on the 1st of December 1997 of a “Code of Conduct for Business Taxation”43 and a “Package to tackle harmful tax competition in the EU”.44

These initiatives have received a strong reconfirmation in 2012, when the EC has come up with the project of State aid modernisation (SAM) through a communication to the other European institutions45, which has been backed up with support by the European Parliament through a resolution on the matter46. In the context of the SAM initiative, the EC has adopted the revised General Block Exemption

40 E. Fort, EU State Aid and Tax: An Evolutionary Approach, European Taxation, September 2017, IBFD, p. 370. 41 Ibid., p. 370. 42 C. Pinto, EC State Aid Rules and Tax Incentives: A U-Turn in Commission Policy? (Part I), European Taxation, August 1999, IBFD, p. 295. 43 Resolution of the Council and the Representatives of the Governments of the Member States, meeting within the Council of 1 December 1997 on a Code of Conduct for Business Taxation. 44 C. Pinto, supra n. 42., ibid. 45 EU State Aid Modernisation (SAM), COM/2012/0209. 46 European Parliament resolution of 17 January 2013 on state aid modernisation, 2012/2920 (RSP).

11 Regulation (GBER) under which MSs are able to grant more aid without needing to notify it to the EC.47 The legal basis for the GBER are articles 108§4 and 109 of the TFEU which empower the EC and the Council to adopt modifications to the allowed exemptions.48

On the one hand, this has given more freedom to the MSs to judge on their own whether their State aid measures are within the thresholds prescribed by the regulation, while on the other hand, the EC has started focusing its attention on more significant cases, which could potentially have more impact on the single market. Therefore, this initiative has naturally caused the EC to come up with more elaborate mechanisms meant to preserve competition, implicitly through enhanced ex-post controls49 - which explains the recent activity of the EC in State aid and direct taxation matters that started around 2013.

3.2. Definition and purpose of State aid

Generally, State aid is defined as “an advantage in the form of assistance provided by a public entity, or a publicly-funded entity, to selected undertakings (any corporate entity selling goods or services in a market) with the potential to distort competition and affect trade between MSs”50- meaning that there has to be a transfer of public resources to particular entities, thus creating a disbalance in the trade between MSs and competition in general.

Initially, the State aid provisions were to be found under article 87(1) of the EC Treaty51, whereas today the mechanism lays in the articles 107 to 109 of the Treaty on the Functioning of the European Union (TFEU). The first paragraph of article 107 TFEU lays down the cumulative conditions for a measure to qualify as State aid:

“1. Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring

47 Commission Regulation (EU) No 651/2014, 17 June 2014, declaring certain categories of aid compatible with the internal market application of Articles 107 and 108 of the Treaty. 48 Art. 108§4 TFEU: “The Commission may adopt regulations relating to the categories of State aid that the Council has, pursuant to Article 109, determined may be exempted from the procedure provided for by paragraph 3 of this Article”; Art. 109 TFEU: “The Council, on a proposal from the Commission and after consulting the European Parliament, may make any appropriate regulations for the application of Articles 107 and 108 and may in particular determine the conditions in which Article 108(3) shall apply and the categories of aid exempted from this procedure. 49 EC press release, State aid: Commission exempts more aid measures from prior notification, 21 May 2014. 50 E. Fort, supra n. 40, p. 371. 51 Treaty Establishing the European Community, 25 March 1957, EU Law IBFD.

12 certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.” 52

A distinction has to be made between incompatible aid and unlawful (or non-notified) aid. The former (incompatible aid) means that the aid has been found in breach of EU law rules after a formal investigation procedure and has to be paid back to the MS granting it, whereas the latter (unlawful aid) does not necessarily have to be in breach of the internal market rules, but it rather means that the procedural rules prescribed by art. 108§3 TFEU have not been respected – the stand-still obligation.53 While, according to the GBER54, some aid does not have to be notified, the amount of aid that goes over the mentioned thresholds in the regulation does have to be notified and the outcome of the EC investigation has to be awaited before its implementation. 55

When it comes to the purpose of the State aid instrument, there are both economic and political reasons behind the decision of granting aid. Some policy reasons for granting aid could involve the desire to stimulate economic development at national or regional level or even promote the development of new sectors of the economy. Other reasons could be to avoid bankruptcy of certain operators and preserve employment.56 Another reason for providing aid, which is less justifiable, may be the desire to increase certain politicians’ chances of re-election “by signalling their commitment to supplying public goods”.57

There is a general understanding that the States should have a limited involvement in the economy and that market forces should be allowed to run their natural course. Similarly, the general principles behind the establishment of the single market at EU level make it clear that unhindered competition and the four freedoms should be the rule, while State aid, if compatible - the exception.

When the single market was created, certain rules had to be rewritten. Customs and all sorts of barriers to entry were not acceptable anymore, just like MSs creating unfair circumstances by giving their support to local industries was perceived as a hinderance to free competition.58

Nevertheless, the intervention of a State can be considered acceptable and not against free competition, as mentioned in the exceptions of art. 107§2 and §3 TFEU. Also, State aid can be considered compatible with the single market if, after notification by the MSs, the Council concludes that its implementation

52 Treaty on the Functioning of the European Union (TFEU), 13 December 2007, EU Law IBFD. 53 H.C.H. Hoffman, C. Micheau, State Aid Law of The European Union, 2016, Oxford University Press, p. 348. 54 Commission Regulation (EU) No 651/2014, supra n. 47. 55 EC Report on the Recovery of unlawful aid, 12 July 2016. 56 H.C.H. Hoffman, C. Micheau, supra n. 53, p. 3. 57 M. Dewatripont, P. Seabright, “Wasteful” Public Spending and State Aid Control, 2006, Journal of the European Economic Association 514. 58 H.C.H. Hoffman, C. Micheau, supra n. 53, p. 4.

13 cannot hinder free competition in the EU. This notification procedure and its steps are to be found under art. 108 TFEU.59 Also, as mentioned above, if the aid is within certain regulatory thresholds and criteria, it is considered to be an exemption and it can be implemented without notification.

3.3. Brief overview of the State aid conditions

3.3.1. Aid granted through state resources

The first condition of article 107(1) TFEU is that in order for a measure to constitute State aid, it has to be granted through State resources. The CJEU has held in the Bouygues case that “only advantages granted directly or indirectly through State resources or consuming additional burdens on the State are to be regarded as aid within the meaning of art. 107§1 TFEU.”60 This ruling was a reconfirmation of the Court’s PreussenElektra case.61

In its 27th Report on Competition Policy (1997), the European Commission defines “aid” as “any measure representing a cost or a loss of revenue to the public authorities and a benefit to the recipient”.62 MSs can grant State aid in various forms, hence the EC and the CJEU being alert to any kind of tax incentive that could, in fact, be an aid in disguise. Therefore, it has been made clear by the Court in 1961 that State aid can take many shapes and forms and the qualification of “aid” will not be limited only to subsidies: “The concept of aid is nevertheless wider than that of a subsidy because it embraces not only positive benefits, such as subsidies themselves, but also interventions which, in various forms, mitigate the charges which are normally included in the budget of an undertaking and which, therefore, without, being subsidies in the strict meaning of the word, are similar in character and have the same effect.”63

The above position has been reconfirmed in 2003 in the GEMO case, where the Court said that an advantage can mean both a positive and a negative benefit.64

The advantage can be granted directly by the government itself (central or local) or by a public/private entity controlled by the State (directly or indirectly). In some cases, it may be harder to determine whether the alleged aid has been granted through state resources, but in any case, the Court has

59 Treaty on the Functioning of the European Union, art. 108, 13 December 2007, EU Law IBFD. 60 ECJ, 19 March 2013, joined cases (C-399/10 P and 401-10 P) Bouygues SA and Bouygues Telecom SA v. EC and Others, para. 99. 61 ECJ, 13 March 2001, C-379/98, PreussenElektra AG and Schleswag AG. 62 EC, Competition Law in the European Communities, Brussels 1997, Vol. II. 63 ECJ, 23 Feb. 1961, Case C-30/59, De Gezamenlijke Steenkolenmijnen in Limburg v. High Authority; ECJ, 8 Nov. 2001 Adria-Wien Pipeline (C-143/99), para. 38. 64 ECJ, 2003, Case C-126/01, Ministère de l'Économie, des Finances et de l'Industrie v GEMO SA.

14 established that the inaction of a MS to enforce its legislation can be perceived as a transfer through state resources.65

3.3.2. The advantage criterion

Furthermore, for a measure to qualify as State aid, it has to be established that an advantage has been granted to an undertaking. It is the second of the four cumulative conditions of art. 107§1 TFEU. The Court stated in the SFEI case: “In order to determine whether a State measure constitutes aid for the purposes of Article 92 of the Treaty (now Article 107 TFEU), it is necessary to establish whether the recipient undertaking receives an economic advantage which it would not have obtained under normal market conditions.”66

In its 1998 Notice on the application of the State Aid Rules to Measures relating to Direct Business Taxation, the Commission tried to define a tax advantage by stating that “the measure must confer on recipients an advantage which relieves them of charges that are normally borne from their budget”.67

The Court made it clear in the Altmark judgment that an advantage can be granted through measures ‘in any form whatsoever’ and that will be perceived as advantageous those measures “which, whatever their form, are likely directly or indirectly to favour certain undertakings”.68

To establish whether an advantage has been granted, it is required to do a comparison between the tax treatment of the recipient of the advantageous measure and the tax treatment that it would have received under the standard system of taxation. The general tax system of a MS is the relevant comparability benchmark against which any “deviation” will have to be compared and analysed.69 This matter is directly linked to the selectivity criterion discussed below.

3.3.3. The selectivity criterion

The third criterion for a measure to constitute State aid is selectivity. The selectivity criterion is an extension of the advantage criterion seen above. After it has been established that an advantage has been granted by the State, it has to be verified that the said advantage is selective in nature. The measure must “favour certain undertakings or the production of certain goods”70 compared to the situation of other

65 C. Pinto, supra n. 42, p. 299. 66 ECJ, 1996, Case C-39/94 Syndicat Français de l’Express international (SFEI) et al v. La Poste et al., para 60. 67 EC Notice on the application of the State aid rules to measures relating to Direct Business Taxation, para. 12 (98/C 384/03), OJ C 383/2 (10 Dec. 1998), EU Law IBFD (hereinafter ‘the 1998 Notice’). 68 ECJ, 2003, Case C-280/00 Altmark Trans GmbH and Regierungspräsidium Magdeburg v Nahverkehrsgesellschaft Altmark GmbH, para. 84. 69 C. Micheau, State Aid, Subsidy and Tax Incentives under EU and WTO Law, Kluwer Law International, p. 196. 70 Art. 107§1 TFEU, 13 December 2007, EU Law IBFD.

15 enterprises in similar situations. The selectivity criterion has proven to be the most challenging and complicated amongst the four cumulative conditions of State aid, therefore it deserves special attention.

It is important to make a distinction between individual aid and aid schemes.71 Measures that are “open to all economic operators in similar legal and factual circumstances in the light of the objectives pursued by the ordinary tax system”72 are normally considered to be general measures, part of the general reference system. In its 1998 Notice, the EC has pointed out that if a measure applies to all undertakings equally, it can potentially escape the selectivity criterion.73 Whereas when it comes to individual aid measures, the presumption of selectivity appears in a more obvious way due to the probable identification of economic advantage. In reality, this doesn’t necessarily have to be the case, but it is understandable why the presumption of selectivity would be more obvious in the case of individual aid measures than it would be in the case of aid schemes.

Assessing selectivity has proven to be particularly difficult when it comes to fiscal matters. While the MSs still have exclusive competence in shaping their tax systems, they also have to take EU law into account. Therefore, the State aid prohibition applies when it comes to fiscal matters as well.74 Due to a lack of harmonization of the taxation field at EU level, assessing whether a measure is selective has proven to be particularly difficult. This is the reason why a three-step test has been elaborated by the EU Court, which has proven to be particularly effective when assessing the material selectivity (as opposed to regional selectivity75) of a measure.76

As mentioned above, when assessing the material selectivity of a measure, the first step would be to determine the general tax system of the MS in cause (including the tax base, tax rates, taxable persons and events77), which would also represent the benchmark against which all the derogations will be compared. This has been pointed out by the Court in the Gibraltar and in the Italian Cooperatives (Paint Graphos) cases:

71 ECJ, 4 June 2015, Case C-15/14, European Commission v. MOL Magyar Olaj-és Gázipari Nyrt, para. 60. 72 H. Verhagen, State Aid and Tax Rulings – An Assessment of the Selectivity Criterion of Article 107(1) of the TFEU in Relation to Recent Commission Transfer Pricing Decisions, European Taxation, IBFD, July 2017, p. 279. 73 EC 1998 Notice, supra 67, para. 17. 74 H.C.H. Hoffman, C. Micheau, supra n. 53, p. 130. 75 European Commission, Commission Notice on the notion of State aid as referred to in Article 107(1) of the TFEU, 19 July 2016, OJ C 262 (hereinafter the ‘2016 Notice’) – where the EC makes a distinction between material selectivity and regional selectivity. 76 H.C.H. Hoffman, C. Micheau, supra n. 53, p. 133. 77 A. Taferner, Tax Rulings: In Line with OECD Transfer Pricing Guidelines, but Contrary to EU State Aid Rules?, European Taxation, IBFD, April 2016, p. 135.

16 “to classify a domestic tax measure as ‘selective’, it is necessary to begin by identifying […] the common or ‘normal’ regime applicable in the Member State concerned.” 78

The second step would be to actually prove that the tax measure analysed is in derogation from the ordinary system, resulting in a different treatment of companies in comparable factual and legal situations – meaning that one them of would get an advantage at the expense of the other: “it differentiates between economic operators who, in light of the objective assigned to the tax system of the Member State concerned, are in a comparable factual and legal situation.”79

The third and last step of the test would be to determine whether the derogation, if found under the previous step, can be justified by the “nature or general scheme of the system of reference”, as held by the Court in Netherlands v. Commission case in 200480. The Court had the same reasoning in the Paint Graphos case: “a measure which creates an exception to the application of the general tax system may be justified if it results directly from the basic or guiding principles of that tax system. […] a distinction must be made between, on the one hand, the objectives attributed to a particular tax regime and which are extrinsic to it and, on the other, the mechanisms inherent in the tax system itself which are necessary for the achievement of such objectives.”81

This justification for a certain derogation has to be interpreted in a restrictive manner.82 In its 2016 Notice, the EC mentioned that: “The basis for a possible justification could, for instance, be the need to fight fraud or tax evasion, the need to take into account specific accounting requirements, administrative manageability, the principle of tax neutrality, the progressive nature of income tax and its redistributive purpose, the need to avoid double taxation, or the objective of optimising the recovery of fiscal debts.”.83

Once the EC has established that a different tax treatment is given to subjects in comparable factual and legal situations, it has met its burden of proof obligation. Therefore, it is up to the MS in cause to prove that the differential treatment is justified “by the nature and the general scheme of the system in question”.84

78 ECJ, 8 September 2011, Case C-78/08, Paint Graphos; Joined Cases Commission and Spain v Government of Gibraltar and United Kingdom, 15 November 2011, (C-106 and 107/09 P). 79 ECJ, 8 September 2011, Case C-78/08, Paint Graphos; Joined Cases Commission and Spain v Government of Gibraltar and United Kingdom, 15 November 2011, (C-106 and 107/09 P). 80 ECJ, 29 April 2004, Case C-159/01, Netherlands v. Commission of the European Communities, para. 43. 81 ECJ, 8 September 2011, Case C-78/08, Paint Graphos, para 69. 82 E. Fort, supra n. 40, p. 378. 83 EC, 2016 Notice, supra n. 75, para. 139. 84 H.C.H. Hoffman, C. Micheau, supra n. 53, p. 140.

17 Moreover, besides checking whether the measure is in line with the nature and general scheme of the system, the Court also pays attention to the actual correct implementation of the said system, in order to avoid any possible inconsistencies or even to prevent tax avoidance.85

In addition, the Court also proceeds to its usual proportionality test that it generally applies in cases related to the fundamental freedoms: it checks whether the derogatory measure goes beyond what is necessary to achieve the objective pursued and whether a less far-reaching measure exists.86 Although the application of the proportionality test is not as popular in tax related matters, its first application in Paint Graphos has been subject to criticism from the doctrine, some saying “it provides a good tool to understand whether an exception to a national system is genuine in the terms laid down by the case law of the CJEU”87 while others believing that “the proportionality test is just an intruder in the ambit of Article 107§1”88.

Since taxation is still in the exclusive competence of MSs, the only benchmark of comparison is their own general tax system. If the Court is to exert any kind of control in MSs’ taxation matters, it can only compare derogatory measures to the general tax system of that MS, and not to the general principles of the EU. Using the proportionality test in the comparison of derogatory measures to the system of which they are a part doesn’t seem out of place, as long as the Court does not start incorporating its own principles in the domestic law of the MSs.89

3.3.4. Aid affecting trade between Member States

Finally, the last cumulative condition for State aid is the fact that the measure must affect trade between MSs. In its 1998 Notice the EC pointed out that under settled case law, the recipient of the benefit must be carrying out an economic activity which involves trade between MSs.90

Both the EC and the CJEU operate with a broad interpretation of the affectation on trade and the distortion of competition. These two elements are usually assessed together as they are perceived to be interconnected. The case law of the Court does not require an in-depth analysis of these elements.

85 ECJ, 8 September 2011, Case C-78/08, Paint Graphos, para. 74. 86 ECJ, 8 September 2011, Case C-78/08, Paint Graphos, para 75. 87 H.C.H. Hoffman, C. Micheau, supra n. 53, p. 141. 88 A. Biondi, State aid is falling down, falling down: An analysis of the case-law on the notion of state aid, 50 Common Market Law Review, Issue 6, p. 1723. 89 Action brought on 23 December 2015 — Netherlands v Commission (Case T-760/15). The EC Decision is being contested by the Netherlands for assessing the existence of an advantage by reference to an EU law arm’s length principle (ALP), when in reality, such a principle is not part of the State aid control. The EC is criticized for the appropriation of the ALP into the list of EU principles as a “general European legal principle of equal treatment” and for presenting it as an inherent element of the State aid control. 90 EC 1998 Notice, supra 67, para. 11.

18 The sole fact that a company benefitting from the aid has a strengthened position on the market in comparison to the undertakings it is competing with is enough for the measure to result in intra- Community trade being affected.

This position of the EC has been reconfirmed in the Starbucks, Apple and Fiat investigations - especially when “the aid recipients are MNEs operating in sectors open to competition”91. The fact that the aid has been granted to “a globally active firm, operating in the various Member States […]” it is believed that “any aid in its favour distorts or threatens to distort competition and has the potential to affect intra- Union trade”92.

The condition of trade being affected is satisfied even though there is no in-depth analysis of the situation between the entities involved. It is thus a condition that is believed to be relatively easy to satisfy.93

91 EC, Report on the Implementation of the Commission Notice on the Application of the State Aid Rules to Measures Relating to Direct Business Taxation p. 17, C (2004) 434 (2004) (9 Feb. 2004). 92 EC Decision of 30 August 2016 on State aid SA.38373 (2014/C) (ex 2014/NN) (ex 2014/CP) – Ireland: Alleged aid to Apple C (2014) 3606 final, para. 51; EC of 21 Oct. 2015 on State aid SA.38374 (2014/C) (ex 2014/NN) (ex 2014/CP) – Netherlands: Alleged aid to Starbucks C (2014) 3626 final, para. 71 and EC of 21 Oct. 2015 on State aid SA. 38375 (2014/NN) (ex 2014/CP) – Luxembourg: Alleged Illegal State Aid regarding Fiat, C (2014) 3627 final, para. 58. 93 Opinion of Advocate General Jacobs delivered on 23 March 1994, Kingdom of Spain v. Commission of the European Communities, Joined cases C-278/92 and C-280/92, §33.

19 4. EFFECTIVELY DESIGNED INCENTIVES AND PREVENTION OF ABUSE

4.1. The advantages and disadvantages of adopting tax incentives

When it comes to tax incentives related to the corporate environment, each of the tax incentives mentioned in the second Chapter of the present work will be shortly analysed from an analytical and comparative perspective, in an attempt to identify some general advantages and disadvantages relating to their adoption.

It has to be stated from the outset that studies have shown that corporate decision-making is less likely to be influenced exclusively by tax incentives.94 While there certainly is a multitude of strategies focused on tailoring tax incentive legislation to the growing needs of businesses, policymakers need to keep in mind that according to the United Nations Industrial Development Organization (UNIDO) (2010), political and economic stability are just as important factors to attract investment, just like the cost of raw materials, the local markets or the transparency of the legal framework.95 Also, the OECD Policy Framework for Investment report mentions that “critically important to potential investors are questions over costs and risks associated with macroeconomic and business conditions, the cost of compliance with laws, regulations and administrative practices, market size, labour-force conditions, and above all, location-specific profit opportunities.”96

The commonly expressed view regarding the adoption of tax incentives in general is that they more often than not erode the tax base of the countries offering them, without having a significant effect on the investment level.97 The World Bank and the IMF are usually advising against their use.98 The same cautious position is expressed by the EC in its 2014 Occasional Paper on tax expenditures in the EU99.

Nevertheless, this negative opinion on incentives is not shared by all tax advisors or policymakers. Some are arguing that tax incentives can correct market failure in its many forms. They could be helpful to some smaller entities desiring to enter a market that is dominated only by a few big companies. Moreover, increased competition can benefit not only the new entities, but also the consumers through an increase of the general welfare.100

94 D. Holland, R. J. Vann, Income Tax Incentives for Investment, in Tax Law Design and Drafting, p. 1009, Kluwer 2000. 95 M. Cotrut, K. Munyandi et al., supra n. 27, p. 151. 96 OECD, supra n. 20, p. 58. 97 OECD, Taxation and Foreign Direct Investment: The Experience of the Economies in Transition, 1995. 98 Chua, Tax Incentives, in Tax Policy Handbook, 1995, p. 165-68. 99 EC, Directorate-General for Economic and Financial Affairs, Tax expenditures in direct taxation in EU Member States, Occasional Papers, 2014, p. 4. 100 C. Micheau, supra n. 69, p. 25.

20

Others are upholding that certain well-designed incentives directed at investment in R&D and new machinery can prove to be useful in increasing investment.101 This could lead to a transfer of technology, know-how and capital but could also increase employment, improve workers’ skills and generally ameliorate the situation of less-developed regions.102

Generally speaking, when MNEs choose between countries with similar infrastructure, legal framework and general costs, a set of tax incentives can happen to be the decisive factor that would shift the balance in favour of a country or another. Therefore, it is understandable that countries in the same region start feeling competitively threatened by the incentives offered by their neighbours, especially if the non-tax- related factors mentioned above are more or less comparable in the competing states.103 This may be the reason why some states believe that an enticing tax incentive framework would make the difference. Whether or not their reasoning is justified is certainly debatable.

There are downsides to this competitive approach regarding incentives and the first one to be mentioned is the so-called effect of the “winner’s course”. When a particular type of investment is deeply sought, there will probably be fierce competition and bidding wars around it, therefore making the incentive most likely inefficient – its potential future benefit will be exceeded by its cost.104 An example of this situation was described by Kolesar with regard to the inter-state competition concerning the Toyota investment in the US (1985): “political pressure and state pride caused Kentucky to adopt a win at all costs approach, which Toyota deftly exploited.”105

There is also the evermore feared effect of the “race to the bottom” where countries compete against each other with excessively generous tax incentives until their tax base suffers, therefore either the welfare standards are affected or their cost is assumed by other sectors of the economy (e.g. the less mobile taxpayers having to pay higher consumption taxes or labour taxes).106 This can make governments unable to fund social programs for their citizens or have good infrastructure, therefore unjustifiably benefitting the mobile capital.107 Some argue that this is the phenomenon of “fiscal

101 A. Easson, E. Zolt, supra n. 11, p. 6. 102 Ibid., p. 10. 103 Ibid., p. 9. 104 A. Easson, supra n. 15, p. 103. 105 A. Kolesar, Can State and Local Tax Incentives and Other Contributions Stimulate Economic Development, 1990, 44 Tax Lawyer, p. 286. 106 R.S. Avi-Yonah, Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, 2000, 113 Harvard Law Review 1573, p. 1645. 107 A. Bal, supra n. 2, p. 66.

21 degradation”108 – one of the main reasons the EU is actively involved in restricting “harmful” tax competition.

Moreover, there is a clear effort in the EU to harmonize and moderate the effects of “harmful” tax competition, in order to create a harmonious level playing field both for SMEs and MNEs established there. As discussed in the chapter above, tax incentives have the potential of becoming State aid when the four cumulative conditions of the State aid regime are reunited. This could be the case when governments consider some activities to be more useful or worthier of support than others, therefore making the incentive accessible only to certain types of activities or companies.

This selectivity issue raises two particular concerns. A certain part of the doctrine argues that politicians’ ability to artificially create distortions in the economy is questionable, suggesting that the market forces are possibly more suitable for this task.109 Furthermore, this could make other sectors of the economy ask for similar treatment, therefore putting significant pressure on policymakers and on their capacity to explain why certain sectors deserve State’s support and others not as much. Since the adoption of incentives has to pass through legislation, this could have as a consequence the fact that “existing tax incentives breed new tax incentives”110.

Another problem with tax incentives in general is that their costs are harder to evaluate than those of direct government spending programs. There is no real predictability or stability in their regard. It cannot be predicted in advance how many taxpayers will benefit out of them, therefore it is hard to make a reliable cost-benefit analysis.111

When analysed separately, several advantages and disadvantages can be noticed in each of the incentives enumerated in Chapter 2.

Tax holidays, for instance, have the advantage of simplicity when it comes to administrative obligations. The companies granted tax holidays are in most cases exempt from some compliance obligations, like filing tax returns. However, this could also be perceived as a disadvantage from the perspective that countries can no longer follow the effects of the tax holiday, but also it can prove to be difficult to check whether the beneficiary of the incentive still qualifies for receiving it.112

108 “Monti Memorandm”, Taxation in the European Community, discussion document for the meeting of the ECOFIN ministers: Verona, April 12-13, 1996. 109 C.E. McLure, Jr., supra n. 24, 326. 110A. Bal, supra n. 2, p. 65. 111 Ibid., p. 65. 112 M. Cotrut, K. Munyandi et al., supra n. 27, p. 35.

22 Essentially, tax holidays are believed to be more effective in the cases where companies make profits immediately as they start operating on a market, as tax holidays are usually limited in time, and they would turn out to be useless for companies starting to be profitable at a later point in time.113 However, there is no guarantee that when the holiday period is over, companies would stay in the same country offering them the incentive. This is the moment in time when the other important factors mentioned above make an impact on the investors decision to continue investing in a country. Therefore, if the system is lacking other essential components of a good investment climate, tax holidays may not be the most appropriate way of attracting long lasting FDI.

When it comes to incentives for capital investment, IP box regimes in particular have the advantage of retaining IP assets in the country providing the incentive, therefore preventing them from being shifted to another low-tax jurisdiction. Companies are therefore incentivized to continue to commercialize the IP and develop new innovative products, by being offered reduced rates on royalty income or other income sourcing from the IP.114

If compared to R&D-related incentives, IP box regimes provide more incentives for commercialization of the IP in that particular jurisdiction, whereas R&D-related incentives take care of the incipient phase of the investment – the development of the product.115 It is indeed debatable what exactly is more efficient for companies developing IP – having the support of the host country in the incipient phase or rather at the end when the IP is being exploited.

From an international tax perspective, some capital investment incentives like IP box regimes may be perceived as harmful tax practices falling in the scope of the prohibitions of harmful tax competition of the OECD and the EU.116 Despite the advantages brought by capital investment incentives like boosting technological innovation and economic development through foreign investment, there are several things to consider before accepting such incentives. The OECD BEPS Project has adopted a more severe stance on tax planning structures (especially regarding IP structures), by giving priority to the economic reality over artificial legal arrangements.

When it comes to reduced tax rates for specific companies, activities or sectors of the economy, countries have to be mindful when adopting them, especially if they are MSs of the EU. Firstly, they have to be

113 United Nations Conference on Trade and Development (UNCTAD), Tax Incentives and Foreign Direct Investment: A Global Survey, 2000, p. 11-12. 114 B. Perez Bernabeu, R&D&I Tax Incentives in the European Union and State Aid Rules, 2014, European Taxation, Journals IBFD, p.81. 115 L. Evers, H. Miller, C. Spengel, Intellectual property box regimes: effective tax rates and tax policy considerations, EW Discussion Paper no. 13-070, 2013, p. 8-10. 116 M. Cotrut, K. Munyandi et al., supra n. 27, p. 88.

23 aware of the State aid regime which prohibits offering a selective advantage to companies in similar factual or legal situations, as seen above.117 Secondly, they have to abstain from engaging in harmful tax competition proscribed by the OECD in its Action 5 of the BEPS Project.

While the OECD does not automatically consider as harmful all reduced tax rates, nor does it intend to “promote the harmonization of income taxes or tax structures generally, (…) nor is it about dictating to any country what should be the appropriate level of tax rates”118, it is clear that states are expected to abstain from competing through abnormally low tax rates in order to avoid a race to the bottom and a degradation of the welfare state.

There is a set of criteria proposed by the OECD in order to determine whether a reduced tax rate regime could be regarded as actually harmful, but there is no consensus or guidance on the concept of ‘substantial activity’ required to be present when a reduced tax rate is granted.119 Therefore, since a re- characterization of the reduced tax rate from potentially harmful to actually harmful seems to be rather complex in reality, countries will most likely continue to exercise their sovereignty in respect of tax rates from an international perspective.120

Finally, concerning special economic zones (SEZs), studies have shown that there are both advantages and disadvantages in adopting them. They have been and still are effective in attracting FDI to some countries, helping them to develop new industries and the general economy.121 However, SEZs are traditionally used by mobile industries like the electronics or the textile ones, meaning that there is an increased risk of the business leaving at the moment a better opportunity has been found abroad (similar to tax holidays).122 The generally recognized benefits of SEZs for the host country are creation of employment, economic development of certain remote areas and the areas around it, but also forcing infrastructure development in those areas. However, in the majority of cases it’s the SEZ or the host country that has to pay for the development of the said infrastructure.123 When it comes to the benefits brought directly to the MNEs, SEZs provide markets, cheap labour but also a lenient and convenient tax environment.124

117 European Commission, 2016 Notice, supra n. 75, where the EC makes a distinction between material selectivity and regional selectivity. 118 OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance – Action 5: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. 119 Ibid., p. 24-36. 120 L. Hsieh, Disparate tax rates ensure tax competition despite OECD action plan to combat base erosion and profit shifting, The Economist Intelligence Unit, 2015, Journals IBFD. 121 V. Tanzi, P. Shome, The Role of Taxation in the Development of East Asian Economies, in The Political Economy of Tax Reform, Vol. 1, T. Ito & A.O. Krueger eds., U. of Chicago Press. 122 M. Cotrut, K. Munyandi et al., supra n. 27, p. 153. 123 Ibid., p. 155. 124 Ibid., p. 158.

24

4.2. The importance of design of tax incentives

A balance has to be struck between the following two issues. One the one hand, there are the investment promotion agencies whose intention is, through their investment attraction tactics, to offer compelling incentives that would appeal to new investors. On the other hand, policymakers in charge of taxation stand strong on the position that tax revenue is vital for a country in order to provide the necessary pillars that are also at the base of an attractive investment climate such as healthcare, an educated workforce, infrastructure, etc. Therefore, actual co-ordination between policymakers, public bodies and organizations is crucial in order to ensure an efficiently designed tax policy framework that is consistent and duly followed at all levels – a “whole-of-government approach”.125

A sound tax policy framework requires states to mind some essential considerations before offering incentives. The first factor to consider is whether the incentives are beneficial to the creation of public goods, which is ultimately the general goal of taxation.

The second factor to consider is whether the incentives serve a small group of entities or are beneficial to everybody. Even if assisting a precise activity can sometimes be useful and necessary (especially when there are very few players on the market and their absence is felt in terms of general welfare), this State intervention has to be duly supervised and thought through.126

The third question to be asked by policymakers is whether such intervention has to happen through the tax system of the state or rather through other more specialized agencies of public or private order, or even through the provision of subsidies. The Ministry of Finance is usually the public body responsible for the implementation of the incentives, whereas subsidies are managed by different ministries who have their share of expertise and executive powers in the different domains for which the subsidies may be allocated.

Therefore, in the case of subsidies, the management of aid would successfully happen through a decentralisation of competencies and expertise. Otherwise, the risk of taking the responsibility to make a significant change in the general welfare system of the society solely through taxation-related methods is that policymakers might lose the understanding of what the main purpose of incentives is, therefore also stripping them of their efficiency.127

125 OECD, supra n. 20, p. 57. 126 M. Cotrut, K. Munyandi et al., supra n. 27, p. 263. 127 Ibid., p. 263.

25 Furthermore, there are several characteristics than an effectively designed incentive has to reunite. For instance, two important factors in designing incentives are its transparency in the legislation and the consistency of the legislation granting it in order to avoid arbitrary practices.128 Simplicity is another feature that the incentive framework should not lack, as it would help reduce compliance costs and would make the framework more accessible for taxpayers.129

Another important element that needs to be taken care of in order to grant a proper functioning of the incentive is adopting agreements on exchange of information between the jurisdictions concerned. International compatibility is an important characteristic that tax incentives need to have.130 Although the issue of communication between jurisdictions does not concern directly the design of tax incentives, it is something that needs to be carefully considered by governments, as it can have just as much impact on the effectiveness of incentives as the design itself.

Transparency and disclosure of information make sure that home countries can be more aware of what is actually happening in the host countries granting the incentive, thus not fearing double non-taxation of income or artificial holding structures - therefore not feeling the need to recur to more severe measures like CFC rules.131

Another crucial factor is the need for a constant monitoring of the incentive by the host country granting it. This will ensure that some abuses are dealt with from the inside of the host country by applying local anti-abuse legislation. Combined with an effective exchange of information agreement, this will decrease the chances that the home country will apply their anti-abuse rules to income resulting from the incentive.

Tax incentives have in common the fact that they are to be found in the domestic laws of the states granting them. In some cases, this can prove to be problematic when it comes to the actual effectiveness of the incentives for the investor. The procedures applied to tax incentives may vary from country to country and when a cross-border element is added to the equation, it certainly doesn’t make things easier.132 Therefore, the role of tax treaties in matters of design of tax incentives can prove to be very useful.

128 R. Musgrave & P. Musgrave, Public Finance in Theory and Practice, McGraw-Hill Education 2004, p. 235. 129 M.H.J. Alink & V. van Kommer, Handbook on Tax Administration (Second Revised Edition), IBFD 2016, Online Books IBFD, 109 130 Ibid. 131 M. Cotrut, K. Munyandi et al., supra n. 27, p. 60. 132 Ibid., p. 173.

26 When adopting tax holidays, for instance, a host country should be mindful of the tax treatment of the profits when they are repatriated in the home country to the parent company. If the parent company applies a full participation exemption, the profits will not be taxed in either of the two countries and the advantages of the tax holiday will be effective. This is not true if, for instance, the home country applies a foreign tax credit system to tax profit repatriated from abroad, thus only allowing a credit for the tax effectively paid in the state granting the incentive. Since the host country foregoes taxation entirely, the profits will be fully taxed in the home country, reducing the advantages of the tax incentive to zero.133 Thus, it could be very discouraging for taxpayers to invest in the tax holiday country, since the promised benefit of the tax holiday would be indirectly eliminated.134

This nullifying effect of credit systems on tax incentive benefits135 could be avoided if a tax sparing credit provision would be included in the tax treaties, thus ensuring that the tax incentive effectively reaches the investor. A tax sparing credit would deem the income earned in the host country as taxed, thus the home country would not be applying the credit method in a classical way. This fiction would allow the investor to be the real beneficiary of the tax incentive, and not the home country. It would also avoid an unjustified transfer of income from the host country to the home country. 136

There can be abuse with regard to the tax sparing credit mechanism through treaty shopping. However, this type of abuse is in the scope of the BEPS Project, namely Action 6 on “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances” under which countries have to include in their tax treaties either a specific anti-abuse rule – limitation on benefits (LOB) or a more general anti-abuse rule – principal purpose test (PPT) under which the tax treaty benefits may be refused to a taxpayer if it is established that the sole purpose of a transaction has happened purely for tax related reasons, meaning that the effects of the tax sparing mechanism could be denied in cases where tax incentives are being abused.137

The LOB and PPT rules also cover situations of treaty shopping with regard to other tax incentives like IP box regimes, whereby a parent company transfers IP ownership to another company in a country with

133 M. Cotrut, K. Munyandi et al., supra n. 27, p. 41. 134 Ibid. 135 Recognition by the OECD of the nullifying effect of the credit method on domestic tax incentives, OECD, Income and Capital Draft Model Convention and Commentary: Commentary on Articles 23A and 23B, para 47 (30 July 1963), Models IBFD; OECD Report, Tax Sparing: A Reconsideration, p. R(14)-6, 1998, International Organizations’ Documentation IBFD. 136 C. Azémar, A. Delios, The Tax Sparing Provision Influence: A Credit versus Exempt Investors Analysis (July 2007), available at https://www.semanticscholar.org/paper/The-Tax-Sparing-Provision-Influence-%3A-A-Credit- Azémar-Delios/691e961b23a1666c7c115e0adc6a1f019881a36f (accessed 17 May 2019). 137 OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, October 2015, International Organizations’ Documentation IBFD.

27 a beneficial IP regime. The anti-abuse provisions act by excluding conduit or intermediary entities which are not actively performing a business activity.138

When deciding to design reduced tax rates, policymakers need to make sure they are offering them in the right circumstances and for the right activities. Reduced rates should not target location-specific activities, since a physical presence is necessary to perform the business. These kinds of activities can include infrastructure and utilities investment, provisions of hotel services or the extraction of natural resources.139 A combination between a variety of location-specific activities and a stable macroeconomic framework, a trained and skilled labour force and regulatory certainty allows policymakers to offer higher tax rates and it is more acceptable by the investors.

However, if the profit is not location-specific, then a lower tax burden may be considered by the policymakers, as businesses will most likely compare between the neighbouring jurisdictions’ tax systems in order to choose the ones that offers them the lowest effective tax burden. Nevertheless, policymakers should consider the above-discussed risk of engaging into a race to the bottom that does not benefit anybody and results in countries being collectively in a worse situation.140 It is an issue that cannot be tackled independently, but which needs increased co-operation between the involved jurisdictions.

When it comes to the correct design of SEZs, governments should provide sufficient information about the legislation, regulations and operational practices surrounding them. This way, any comparison to tax havens is less likely to occur. Therefore, this will provide a more transparent and administratively attractive environment for businesses to want to establish themselves there, but will also make sure the host country with the SEZ is compliant with the OECD recommendations on SEZs, more specifically regarding mobile businesses and intangibles.141

While the terms “substantial activity” are rather subjective and can be disputable, a SEZ has to aim at being visible. The presence of factories, warehouses, ports, employees and equipment shows substantial activity more clearly than a shelf or a mailbox company. Whereas a mailbox can definitely show some substantial economic activity (to be distinguished from substantial activity), it does not necessarily contribute to the development of the country hosting it – which is ultimately the main goal of SEZs.142

138 M. Cotrut, K. Munyandi et al., supra n. 27, p. 105. 139 OECD, supra n. 20, p. 59. 140 OECD, supra n. 20, p. 59. 141 OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, October 2015, International Organizations’ Documentation IBFD. 142 M. Cotrut, K. Munyandi et al., supra n. 27, p. 164.

28 4.3. The use and abuse of tax incentives

As countries are competing to attract more FDI, they may be tempted to adopt tax holidays as a way of luring MNEs to invest on their territory. But the true effectiveness of this particular incentive is indeed questionable, as mentioned above. Moreover, some MNEs may see an opportunity for abuse in tax holidays, deciding to explore the possibility of benefitting from such incentive in one country, only to leave it when the incentive period expires and pursue the same type of incentive in another country.143 Also, if the tax holiday is available only for foreign investors, some local investors may feel discriminated and may actually try to circumvent the system by ‘round-tripping’. This would involve routing the funds abroad by establishing a new entity and then investing the funds in the tax holiday company as if it would be “foreign” investment. 144

Another abuse opportunity regarding tax holidays would be when the tax holiday country grants the incentive only for a certain type of activity like manufacturing. The investor might take advantage and do other non-qualifying activities (like sales, distribution or financing) while benefitting from the tax holiday for the whole amount of profits generated by all the activities, whether they are qualifying for the tax incentive or not. This is a consequence of a poor monitoring of the incentive. 145

Countless abuses have been identified in the area of capital investment incentives, specifically R&D tax credits or IP box regimes. Some companies may, by means of IP tax planning, take advantage of the best of both worlds. On one side, enjoying a favourable research environment in a jurisdiction, and on the other, benefitting from low rates on IP exploitation in another jurisdiction.146 The main point of the scheme is to shift the profits related to the commercialization of the IP to a low taxed company or IP branch, without actually relocating the research activities.147 This is possible through a license agreement or a cost contribution agreement (CCA).148

When adopting capital investment incentives, countries have to mind the fact that the types of IP tax planning structures described above have been covered by the OECD BEPS Project in Action 5 that introduced the modified nexus approach. Under this new approach, it would be possible for companies to benefit from IP box regimes and their reduced effective tax rates only if a significant part of the R&D

143 Ibid., p. 39. 144 A. Easson, E. Zolt, supra n. 6, at 32. 145 M. Cotrut, K. Munyandi et al., supra n. 27, p. 43. 146 Ibid., p. 92. 147 See Figure 1 in Annex. 148 H. Grubert, J.H. Mutti, The Effect of Taxes on Royalties and the Migration of Intangible Assets Abroad, NBER Working Paper no. 13248 (2007), p. 3.

29 is done by the qualifying partners themselves.149 Therefore, expenses relating to R&D activities will no longer be deductible if the R&D activities will be outsourced to another entity through a contract R&D. This will most likely lead to restructurings and to more centralized R&D models.150

When adopting structures that involve separating the IP ownership from the decision making and other functions, companies have to make sure that their structure is in accordance with the OECD Transfer Pricing (TP) Guidelines but also OECD BEPS Project Actions 8-10, where it puts a special emphasis on the substance behind structures involving intangible assets.151 In the mentioned report and guidelines it is made clear that economic reality will prevail over any contractual arrangements – the substance over form approach, meaning that the legal owner of the IP will not necessarily be entitled to all or any of the return attributable to the intangible.152 When outsourcing the IP or its development to another country, companies need to make sure the functions with regard to the IP are accomplished – the DEMPE153 functions. IP holding companies will need to have enough substance behind them, thus involving an adequate number of people working there, assets, liabilities, risks but also financial resources – a true functional ownership of the IP.154

This can involve contract R&D arrangements and CCAs155, where the IP would be transferred from the legal owner to a tax haven through buy-in payments for pre-existing IP and IP from the new R&D (CCA) which, in turn, will sublicense the IP rights to a subsidiary, who will again sublicense the rights to a European company. This is the kind of structure that has been adopted by Google in the past, but which has been changed later on.

The scheme involved the US, Bermuda, Ireland and the Netherlands.156 For US tax purposes, the place of incorporation of a company determinates residence and gives taxation rights. For Irish tax purposes, it is rather the real seat of the company (management and control) that determinates residence and gives taxation rights. In this case, the subsidiary was incorporated under Irish law but managed and controlled in Bermuda. Under Dutch law, there were no withholding taxes on royalty payments to several tax havens (Bermuda included). Google managed to escape US CFC rules thanks to the ‘check-the-box’

149 OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance – Action 5: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. 150 R. Dannon, C. Schelling, Switzerland in a Post-BEPS World, 69 Bulletin International Taxation 4/5, 2015, Journals IBFD, p. 197. 151 OECD, Aligning Transfer Pricing Outcomes with Value Creation – Actions 8-10: 2015 Final Report (OECD 2015), International Organisations’ Documentation IBFD. 152 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 153 Development, enhancement, maintenance, protection and exploitation of the intangible. 154 M. Cotrut, K. Munyandi et al., supra n. 27, p. 118. 155 See Figure 2 in Annex. 156 See Figure 3 in Annex.

30 rules, which allowed it to be seen as a transparent entity, thus the CFC income could not be attributed to it. This has given rise to the famous so-called “Double Irish Dutch sandwich”.

Regarding abuse linked to SEZs, it has to be established from the outset that they are different from tax havens. SEZs are focused on manufacturing and other business activities which are meant to develop the region itself and the surrounding area, whereas tax havens usually focus on wealth management business, asset holding, banking and tax avoidance – everything that aims at drastically reducing the tax burden of MNEs.157 However, if not appropriately documented and transparent, the advantages received from a SEZ can be mistaken for those received from a tax haven. Therefore, transparency and legal certainty are crucial with regard to SEZs.

Since the BEPS Project is aiming at eradicating artificial arrangements and the obtaining of undeserved benefits, MNEs will be put into the situation to prove that their relocation to the SEZ has other reasons besides obtaining the tax benefits, but also that they are pursuing a substantial business activity. This is relevant specifically because SEZs are particularly popular destinations for R&D activities. As mentioned above, if a jurisdiction aims at being compliant with the OECD nexus approach, the R&D centres do not have to be separated from the IP generated by them.

4.4. The impact of tax incentives on CIN and CEN

Some members of the doctrine argue that economic inefficiency, distortion of competition and misallocation of capital are due to a lack of harmonization of tax systems around the world.158 However, identical tax systems around the world or even in Europe are not likely to happen159 due to the different economic policies adopted by each country according to their interests and needs. Fiscal policy is also a matter that belongs almost entirely to the competency of each state and is thus part of their sovereignty, therefore is very hard to harmonize unless there is global consensus.

Nevertheless, a certain balance in the global allocation of income and taxing rights is aimed at by the OECD, the UN and other international organizations, but also by the policies of the EU. International double taxation is one of the main risks that is trying to be avoided through double tax conventions and exchange of information between the states. However, it is equally important to make sure income and capital are allocated in a balance manner, therefore contributing to inter-nation equity. It is believed in economic theory that tax neutrality can contribute to higher welfare gains on a global level. Therefore,

157 A. Laukkanen, The Development Aspects of Special Tax Zones, 70 Bull. Intl. Taxn. 3 (2016), Journals IBFD, 152. 158 N.T.T. Nguyen, Corporate Taxation: CIN and CEN, Helvidius, Journal of Politics and Society, 1998, p. 101. 159 J. Kay and M. King, The British Tax System, 5th ed., New York: Oxford, 1990, 126.

31 a system can be considered tax-neutral when business investment, the allocation of capital, is not influenced by taxation, but rather by other economic merits.160

However, full tax neutrality on a global level appears to be realistically unattainable at the moment. When it comes to the global allocation of production factors, there are two criteria that are traditionally being referred to in order to measure the efficiency of such allocation: capital import neutrality (CIN) and capital export neutrality (CEN), originally introduced in the 60s.161 For instance, CIN entails that both foreign and resident companies only incur tax in the state where they source their income, at that state’s rates but also that foreign-sourced income is being exempt.162 Conversely, a state has CEN if it taxes its resident companies the same whether they invest at home or abroad. It taxes its residents on a worldwide basis. Therefore, it should not matter for a company where they invest, as taxation is always according to the rules of their state of residence.163

Ideally, both situations of capital neutrality could be achieved simultaneously by a country if tax rates would be the same everywhere.164 However, a different application by countries of CIN or CEN policies, different methods of double taxation relief, but also all the different tax rates around the world make this harmonization impossible. Moreover, by interfering in the market in their attempt to “correct” some “market failures” through tax incentives, states influence the global income allocation even more.

Therefore, all of these artificial interventions of the state, whether made in good conscience or ill- advised, are capable of distorting competition between investors and certainly have an impact on their investment decisions. As seen above, investment decisions in developing countries motivated solely by tax incentives are usually not long-lasting.165 Therefore, besides weakening their general tax framework, poorly designed and excessively offered tax incentives also have the potential of stripping developing countries of their much-needed tax base. Consequently, this results in the impossibility for them to establish any kind of elementary form of welfare state.166

When less developed countries are adopting tax incentives like tax holidays that favour inbound investment over local investment, besides deviating from tax neutrality, they are also encouraging “ring-

160 R. Mason, Tax Discrimination and Capital Neutrality, World Tax Journal, June 2010, p. 126. 161 P. B. Musgrave, United States Taxation of Foreign Investment Income: Issues and Arguments (1969). 162 N.T.T. Nguyen, Corporate Taxation: CIN and CEN, Helvidius, Journal of Politics and Society, 1998, p. 101. 163 R. Mason, supra n. 160, p. 130. 164 T. Horst, A Note on the Optimal Taxation of International Investment Income, 84 Q.J. ECON. 793 (1980). 165 A. Bal, supra n. 2, p. 66. 166 Avi-Yonah, Reuven S., Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, Harv. L. Rev. 113, no. 7 (2000):1573-676.

32 fencing” practices that are not tolerated (unless justified) under the State aid regime or by the BEPS Project and its fight on harmful tax competition.167

Interactions between CIN and CEN policy elements can result in the tax incentive being effectively nullified, unless there is a close co-operation between the two jurisdictions. As seen in the sub-chapter above, investments coming from countries that have CEN are not likely to fully benefit from foreign tax incentives as they are being taxed according to the residence principle on their worldwide income and double taxation is relieved under the credit system. Unless mechanisms like tax sparing credits are adopted, this can impact MNEs tax burden at the moment the income is repatriated back to the residence country. Moreover, this would ultimately result in giving the taxing rights to the residence state on items of income sourced in the host state, all the while unjustly impoverishing the latter’s budget.

In the context of nowadays globalized economy, where the costs of transportation and communication have decreased due to technological developments and skilled workers have become more mobile, the importance of location specific economic rents168 are diminishing compared to company specific economic rents. The focus has shifted on how to run a company efficiently rather than on the place to invest. 169

If ideally there would be a shift from CEN to CIN and taxation would happen according to the origin- based interpretation of source instead of favouring residence-based taxation170, carefully designed and monitored tax incentives offered in moderation (their framework ideally harmonized at EU level) would indeed be more effective for developing countries. Perhaps there would be no need for tax incentives anymore, as “capital importing” countries would be given tax jurisdiction on the income sourced on their territories, gained due to the resources, the presence of a cheaper labour force, cheaper markets, public goods and services situated there. This would ultimately contribute to reduce the economic gap between developing and developed countries.

167 R. Mason, supra n. 160, p. 127. 168 An economic rent is the excess amount of money earned compared to what it is economically or socially acceptable by a business, http://investopedia.com/terms/e/economicrent.asp (accessed on June 14 2019). 169 N.T.T. Nguyen, supra n. 162, p. 102. 170 E.C.C.M. Kemmeren, Source of Income in Globalizing Economies: Overview of the Issues and a Plea for an Origin-Based Approach, Bulletin November 2006, IBFD, p. 451.

33 5. THE INTERRELATIONSHIP BETWEEN TAX INCENTIVES AND STATE AID

As seen in the chapters above, both tax incentives and State aid have the characteristics of an advantage/benefit. Both their natures stem from closely related roots, their purpose being to mitigate in a way or another the fiscal or financial burden of their subjects. Whereas their purposes may seem related, they are considered two different mechanisms.

Both their existence in a certain legal system needs to be justified by several different principles like, for instance, the necessity principle, the non-discrimination principle or the principle of equal treatment. Especially in the EU, if a MS adopts incentives without minding the respect of the above enumerated principles, the said incentives can become incompatible State aid.

The below sub-sections will discuss the consequence of tax incentives risking to become State aid if certain conditions are not respected, but also the particular case of tax rulings and why they could ultimately be perceived as “tax incentives in disguise”.

5.1. Tax incentives becoming State aid

Tax incentives are part of the direct taxation matters of a MS, over which it detains full sovereignty. They are free to build their tax policy strategies depending on their needs, while at the same time doing it in accordance with EU law.171 In their desire to stay competitive, MSs are introducing tax incentives. However, as seen above, incompatible State aid is prohibited in the EU and it is becoming a limitation to their freedom to provide incentives but also a filter that MSs are being faced to deal with, especially in the past years.

When it comes precisely to the criteria for a measure to constitute incompatible State aid under EU law, it seems that the first three criteria can generally be fulfilled by the majority of tax incentives. All tax incentives provide a tax advantage – they are a derogation from the general tax system (1). By foregoing to collect a certain amount of tax as part of the incentive, the MSs are using their resources for it (2). The recipients of the incentive are inevitably in a better situation compared to their other competitors on the EU market – thus, the measure is affecting trade between MSs (3). Up until this point, the three conditions of State aid are in principle reunited in all the cases.172

171 EC, 2016 Notice, supra n. 75. 172 M. Cotrut, K. Munyandi et al., supra n. 27, p. 210.

34 Regarding selectivity, the tax measure has to favour certain companies, the production of particular goods or the provision of particular services (4). As previously seen above, selectivity is more challenging to assess and to justify. A tax incentive could be materially selective if it distinguishes companies based on their size, on the amount of job creation or investment.173 However regional or geographical selectivity can occur if the aid is available only if the company is established in a certain region, which is the case of SEZs, for instance.

In case selectivity is established, the tax-tailored three-step test of the CJEU will be applied consequently to determine if the measure is justified. The complexities of this test have shown that it can be almost impossible to predict if the selectivity of a tax measure will be justified in the eyes of the Court. This is true especially when it comes to the third step of the test, which is supposed to check if the derogation is justifiable in the light of the nature and general framework of the whole tax system. The tax policy goals of a MS have to be analysed and it could be determined that the aim of the incentive is unrelated to the general purpose of the tax system of that particular jurisdiction (e.g. maintain employment in a particular sector). If it is established by the Court that the justifications for the incentives are external to the reference system, they could be indeed considered invalid.174

There is currently an open discussion regarding the potential justifications that could be considered acceptable by the Court for an incentive to escape the selectivity criterion.175 The need for such a discussion is obviously imminent, as it appears that tax incentives are under high risk under the State aid regime, especially if they target specific sectors or entities.

Departing from the assumption that some tax incentives are providing differential treatment for certain types of activities or entities in a particular jurisdiction, does this imply that MSs have to notify the EC before implementing tax incentives in their internal systems? If the answer to this question is affirmative, there is a high chance that a big part of tax incentives adopted in the EU so far may fall in the category of unlawful aid, since the stand-still obligation under art. 108§3 TFEU has probably not been respected.176

This brings up a number of issues like the obligation for the MSs to recover the aid, even if it can potentially be considered compatible by the EC at a later stage of the investigation, but also the difficulty of identifying all the beneficiaries of the aid.

173 EC, 2016 Notice, supra n. 75 174 M. Cotrut, K. Munyandi et al., supra n. 27, p. 212. 175 Ibid., p. 213. 176 Treaty on the Functioning of the European Union (TFEU), 13 December 2007, EU Law IBFD.

35 An example of this difficulty is the Commission v. France case177, where an incentive was granted in France to companies created with the purpose of taking over the activities of industrial firms in difficulty. The incentive provided a two-year long exemption from CIT. Even though it was established that over 200 companies were involved in this matter, despite its recognized efforts, France only succeeded to recover the aid from 27 entities.

An obstacle to the recovery of unlawful or incompatible aid can also be the reorganization of entities over the 10-year period during which the EC is still entitled to ask the MSs to retroactively recover the aid. Therefore, after the reorganization, the entity who allegedly benefited from the aid may not exist anymore.178 This situation can interact negatively with the tax legislations of the EU MSs. In domestic law, the statute of limitation periods are usually shorter than 10 years, thus the taxpayer cannot be fully protected by them, since the longer period provided by the EU Regulation prevails179.

Even though taxpayers, as diligent businessmen, are expected to be aware whether the MS followed the notification procedure of art. 108 TFEU180, the reality is that, in some situations, the information does not always reach the recipients or is not even available to them, and there could effectively be a misbalance in information between the MSs and the taxpayers.

State aid legislation is not meant to prohibit MSs from adopting tax incentives, but they have to be drafted in a way as to be general enough and available to all the entities. Moreover, if MSs want to stay on the safe side, compliance with art. 108 TFEU is desirable. MSs have to take all the due measures in their power to protect the interests of the taxpayers, as they are those who ultimately end up suffering the consequences of unlawful or incompatible State aid, having to return it back with interest. Bizarrely, due to the payment of interest, the MS that granted the aid actually ends up in a better situation after the recovery of the aid.

5.2. The particularity of tax rulings

Being amongst the most controversial topics in international tax law in the past years and despite EC’s recent decisions on the matter, tax rulings are still a popular instrument of obtaining legal certainty by the taxpayers. Tax rulings have been defined as “a more or less binding statement from the Revenue

177 ECJ, 13 Nov. 2008, C-214/07 Commission v. France. 178 A. Maitrot de la Motte, The recovery of the illegal fiscal state aids: Tax Less to Tax More, 26 EC Tax Review 2, 2017, p. 82. 179 Council Regulation (EU) 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. 180 ECJ, 14 January 2004, Case T-109/01, Fleuren Compost BV v. Commission of the EC, para. 135.

36 authorities upon the voluntary request of a private person, concerning the treatment and consequences of one or a series of contemplated future actions or transactions”.181

The Final Report on Action 5 of the BEPS Project has equally discussed tax rulings, giving a similar definition of what they represent182, also making a distinction between advance tax rulings (ATRs) and advance pricing agreements (APA). The first category refers to taxpayer-specific rulings which are meant to provide clarification on the consequences of a particular transaction entered into by the taxpayer, whereas the latter refers to transfer pricing methods and calculations, based on an appropriate set of criteria.

As tax law is getting progressively more complicated, there are a lot of benefits that tax rulings can grant their recipients like, for instance, legal certainty, the avoidance of litigation and a better communication with the tax authorities. The latter have the chance to know in advance of taxpayers’ intentions, which is certainly beneficial as it is allowing them to propose legislation that would cover potential loopholes in the system183.

Some characteristics of tax rulings are that they are specific to every single taxpayer and they are not available to everybody for the simple reason that they are not made public. There are two reasons for keeping tax rulings private. First, it is important for taxpayers to keep their business matters secret. Second, a favourable ruling gives companies a competitive advantage and tax authorities have an interest in keeping tax rulings secret because more taxpayers will be willing to receiving the same kind of advantage and this would be detrimental for the country’s budget.184

The secrecy surrounding tax rulings raises several problems in international taxation. Some of the problems regarding tax planning through tax rulings are currently being dealt with both at international185 and at EU level186 by asking for more transparency and an improved framework on exchange of information between states. Another problem with tax rulings is their secrecy itself. The reason why secrecy can be problematic is the fact that it can put in danger the principle of equal treatment. The fact that not all taxpayers are aware

181 M.J. Ellis, General Report, IFA Cahiers de Droit Fiscal International (1999), Online Books IBFD. 182 OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance – Action 5: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. 183 M. Cotrut, K. Munyandi et al., supra n. 27, p. 237. 184 M. Lang, Tax Rulings and State Aid Law, 3 British Tax Review, p. 391 (2015). 185 OECD framework for the compulsory spontaneous exchange of information in respect of rulings in Action 5: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. 186 Council Directive (EU) 2015/2376 of 8 December amending Directive 2011/16/EU with regard to the mandatory automatic exchange of information in the field of taxation.

37 of the preferential treatment given to others implies the fact that they cannot ask for the same kind of treatment, and therefore cannot ask for the reinforcement of their right to equal treatment.187 Also, since tax rulings are offered privately and by different representatives of the tax authorities, there is no way of finding out whether a certain taxpayer’s request was rejected, whereas another one’s was accepted – both being in comparable legal and factual situations.188

Before concluding on the above situation, it has to be stated from the outset that there is a clear difference between tax rulings and tax incentives. Although it may appear that the two have some common characteristics, they are two fundamentally different mechanisms. Tax incentives are used to determine tax liability - they are part of the substantive law. Tax rulings are used to help the taxpayer understand what his tax liability will be and how the rules will be applied to his situation – they are part of procedural law.189

Technically, the theory that the granting itself of tax rulings can appear as a tax incentive practice seems to be wrong from the start, since both mechanisms are part of different legislative categories. However, even if this idea may be weak from a technical/legal point of view, taking a closer look at the investigations of the EC, one can notice that MNEs were attracted to particular jurisdictions precisely because such favourable tax rulings were systematically granted. Attracting investment is the main purpose of tax incentives and this purpose was successfully achieved through the mechanism of tax rulings. Therefore, from a strictly logical point of view, tax rulings as a phenomenon could have been perceived by certain MNEs as an incentive for investment in some countries.

It is not being upheld that all tax ruling systems from all the jurisdictions can be perceived by MNEs as an incentive to invest. Tax ruling systems differ from country to country, but it is certain that companies could be attracted by the availability of a particular jurisdiction to provide them with legal certainty – which is a feature of a good investment environment.190 However, legal certainty differs drastically from preferential treatment. It is undeniable that certain jurisdictions have indirectly given signs to MNEs that they are open to giving preferential treatment through tax rulings. Some jurisdictions have done it more than others, therefore creating a reputation for themselves as being open to offer a little more than just legal certainty in exchange for MNEs’ investment. The journalistic investigation known as ‘LuxLeaks’ has proven the fact that Luxembourg has given preferential treatment to more than three hundred companies based there191. The choice by

187 M.J. Ellis, supra n. 181, p. 34. 188 M. Cotrut, K. Munyandi et al., supra n. 27, p. 236. 189 Ibid., p. 238. 190 M.J. Ellis, supra n. 181, p. 26. 191 International Consortium of Investigative Journalists, Luxembourg Leaks investigation, See https://www.icij.org/investigations/luxembourg-leaks/ (accessed 28 May 2019).

38 companies of Luxembourg as their place of establishment has not been incidental and this choice has most certainly been fuelled by the country’s self-made (but also relatively secret) reputation in offering generous tax rulings.

It is not being upheld that the mechanism of tax rulings constitutes a harmful tax practice in itself. If correctly implemented, (preferably) harmonized at EU level and their framework known and easily accessible for everyone - they could prove to be of extreme use for taxpayers who most certainly get lost at times in the massive amount of legislation and practices.192

Moreover, this would increase the chances of having the State aid qualification avoided. Whether or not the qualification of incompatible State aid given by the EC in such situations of abuse is appropriate and whether abuse should be fought with special anti-abuse legislation is not part of the scope of the present work. Nonetheless, it is a fact that State aid can be granted through tax rulings - the EC has confirmed it in its well-known decisions193 involving big MNEs like Apple, Starbucks, Amazon, etc.

Consequently, it is hard to deny that in some jurisdictions, although technically it is not part of their purpose, tax rulings have acted as an incentive for MNEs to invest or establish there, therefore attracting FDI to the jurisdictions offering them. The secrecy surrounding them has equally contributed to the present theory, therefore enforcing even more the fact that, in some cases, tax rulings do resemble tax incentives incompatible with the rules on State aid. The fact that only certain types of companies can benefit from them and that the outcomes of the understandings remain behind closed doors fulfils the criteria of an advantage given selectively.

In theory, the taxpayer could be involved in a miscellaneous legal mechanism that is at the same time a ruling and an incentive, which can, on top of everything, qualify as incompatible State aid.

192 M. Cotrut, K. Munyandi et al., supra n. 27, p. 237. 193 Commission Decision of 30 August 2016 on State aid SA.38373 (2014/C) (ex 2014/NN) (ex 2014/CP) – Ireland: Alleged aid to Apple C (2014) 3606 final, para. 51; Commission Decision of 21 Oct. 2015 on State aid SA.38374 (2014/C) (ex 2014/NN) (ex 2014/CP) – Netherlands: Alleged aid to Starbucks C (2014) 3626 final, para. 71 and Commission Decision of 21 Oct. 2015 on State aid SA. 38375 (2014/NN) (ex 2014/CP) – Luxembourg: Alleged Illegal State Aid regarding Fiat, C (2014) 3627 final, para. 58.

39 5.3. Tackling harmful tax competition at European Union level194

The MSs of the EU have to bear in mind that when it comes to tax competition and incentives in particular, they have reached an agreement on a Code of Conduct on Business Taxation in 1997, the reason being that “coordinated action at European level is needed in order to reduce continuing distortions in the single market, prevent significant losses of tax revenue and help tax structures develop in a more employment-friendly way”195 therefore acknowledging “the need for a code of conduct for business taxation designed to curb harmful tax measures.”196

The work on harmful tax competition at EU level is very similar to the work done by the OECD Guidelines on the same matter. Just like the OECD’s BEPS Action Plan, the Code of Conduct on Business Taxation is an instrument that is not legally binding. It is nevertheless a political commitment entered into by the MSs. Despite not being legally binding, the MSs have agreed on some compromises regarding their tax legislation. Firstly, there is a standstill clause according to which MSs should not include new harmful measures, and secondly, there is a rollback provision obliging them to abolish the existing ones.197

Therefore, the Code of Conduct Working Group (WGCC) was later established, concluding a report (the Primarolo Report198) in 1999 and including an initial list of 271 tax measures deemed potentially harmful. The list was later reduced to 66 measures, out of which the EC decided that 31 should be abolished.199 Their work actively continues up to the present day through similar reports which target tax measures that could potentially fall in the scope of the Code of Conduct. The Council believes the work of the WGCC should be more visible200, therefore giving it a mandate201 through which the extension of the scope of the Code of Conduct could be possible, but also the updating of its criteria.

194 The term “harmful tax competition” is used by the author in the same context as employed by the EU institutions and the OECD in their work. The debate over the appropriateness of the use of the term “harmful” in the context of tax competition is not part of the present work. 195 Resolution of the Council and the Representatives of the Governments of the Member States, meeting within the Council of 1 December 1997 on a Code of Conduct for Business Taxation. 196 Ibid. 197 J. Malherbe, Harmful Tax Competition and the European Code of Conduct, 2000, 21 Tax Notes Intl. 2, p. 151. 198 Report from the Code of Conduct Group (Business Taxation) to the ECOFIN Council on 29 November 1999, SN 4901/99. 199 P. Lampreave, Harmful Tax Competition and Fiscal State Aid: Two Sides of the Same Coin?, May 2019, European Taxation, IBFD, p. 199. 200 Council, Reports by the Code of Conduct Group to the Council of 11 June 2015, doc 9620/15 and 8 Dec. 2015, doc. 15148/15. 201 Council, Report by the Code of Conduct Group to the Council of 8 Mar. 2016, Doc 6900/16.

40 The EU Code of Conduct, despite not being legally binding, is also a document that points out the risk for tax incentives to fall under the scope of the State aid rules202 which they indeed are binding - according to the Costa v. ENEL case of the CJEU203 due to the fact that they are part of EU primary law. Therefore, it is important to see that there is a direct link between the EU Code of Conduct and the application of the State aid rules. Some uphold that these mechanisms are interdependently used as tools to harmonize tax law at EU level204 while others affirm that State aid is used as “backdoor” legislation to tackle harmful tax competition205.

It is therefore interesting to see how the principle of fiscal sovereignty of the EU MSs interacts with the EU Code of Conduct and with the EU rules on fiscal State aid. In the light of the EC investigations and of the matters discussed in the sections above, it is hard to say whether the MSs can still take their fiscal sovereignty for granted in matters of selectively provided tax incentives. When including incentives in their legislations (but also selectively providing them through rulings), MSs should probably consider all the possible consequences that such legislation may entail, both at national and EU level.

More legal certainty is definitely expected in matters of application of the State aid regime to tax incentives, but before such a point is reached, MSs could refrain from adopting tax incentives that could put at risk the situation of the taxpayers.

5.4. Certain incentive practices in the European Union

As analysed above, tax incentives can be offered in various forms. They can be offered through legislation, but they can also be offered indirectly as tax rulings. The following two examples will illustrate certain tax practices that had as a goal to diminish the tax liability of their subjects, but which ultimately came under the scrutiny of the EC and the CJEU because of the State aid regime.

5.4.1. The Gibraltar case

The first example of an incentive practice conflicting with the State aid regime is the Gibraltar case. The issue in the Gibraltar case206 was a new reform that intended to replace the old tax system by three new

202 Resolution of the Council and the Representatives of the Governments of the Member States, meeting within the Council of 1 December 1997 on a Code of Conduct for Business Taxation, point J. 203 ECJ, 15 July 1964, C-6/64, Flaminio Costa v E.N.E.L. 204 P. Lampreave, supra n. 121, p. 197. 205 E. Traversa, Fighting Harmful Tax Competition through EU State Aid Law: Will the Hardening of Soft Law Suffice, European State Aid Law Quarterly 323, Lexxion, 2015. 206 ECJ, 15 November 2011, European Commission v. Government of Gibraltar and others, Joined cases, C-106/09 P and C-107/09 P.

41 taxes applicable to all entities present in Gibraltar. A payroll tax, a business property occupation tax (BOPT) and a registration fee. The first two were limited to a 15% of the realized profits. The question raised was to establish whether the new tax regime was against the State aid rules of article 107 TFEU. It was a question of material selectivity that needed to be answered in the present case.

As seen in Chapter 3 above, selectivity in State aid is one of the four cumulative conditions that proves to be the most difficult to assess. It entails a three-step test that applies specifically in tax matters. In its decision, the EC upheld that Gibraltar was giving selective treatment to offshore companies which did not have any physical presence in Gibraltar. The “letterbox companies” indeed lacked any employees or offices to which the payroll taxes or the BOPT could apply.

The Court of Justice upheld in its conclusion that even if the measures of the new reform were general in nature and de jure represented the general benchmark against which any derogation had to be compared, de facto they favoured entities which represented the majority of the companies established in Gibraltar and which did not generate any profits.207

Here, the court operated an analysis of the de facto selectivity. This analysis had to be made in the light of the objective pursued by the reform, which was to create a new tax system for all companies established there. In practice, the reform excluded from taxation more companies than it actually taxed. Therefore, in the light of the system the measure was considered selective since it excluded from taxation offshore companies by giving them special treatment.208

The reform was in fact a tax incentive practice which was supposed to lure companies to establish themselves in Gibraltar. It is important to notice that in this case, the incentive was not openly marketed as such (as it usually happens with tax incentives), but it was rather presented as the general tax system. This case is proof that incentives can be detected also in less obvious circumstances and that states can discretely offer them to companies without calling them what they actually are – tax incentives.

This outcome of the Court has raised some criticism as it seemed to stretch the boundaries of the State aid selectivity criterion, while covering situations where the general tax system of a MSs would be designed in a way as to give selective advantages to particular companies. It is certainly interesting to see what the following cases on such matters are going to entail, as the Court raises an important question

207 ECJ, 15 November 2011, European Commission v. Government of Gibraltar and others, Joined cases, C-106/09 P and C-107/09 P., para. 101. 208 C. Micheau, supra n. 69, p. 282.

42 regarding the potential selectivity of general measures which are in fact benefitting only specific types of companies.209

5.4.2. Belgium’s excess profit rulings

The following example is the one of the latest judgments of the CJEU regarding tax rulings - the Belgian excess profit system.210 As seen above, tax rulings can also be a form of incentive practices that states may adopt in order to indirectly engage in tax competition. In 2015, the EC decided to open an in-depth investigation into the Belgian tax scheme, followed by a decision in 2016 concluding that Belgium had to recover around €700 million from 35 MNEs.211

The said scheme was benefitting exclusively MNEs, as Belgium was exempting from tax the “excess” profit that these MNEs made, by effectively taxing only the profit that they would have hypothetically made if they were standalone companies. The “excess” profit was considered to be the profit made by a company due to the fact that it is part of a big MNE, like various group synergies, access to new markets, economies of scale, client networks, reputation and other advantages group companies may have.212 This resulted in a reduction of companies’ tax base between 50% and 90%.

The “excess profit” scheme was presented on the website of the Belgian Ministry of Finance under the logo “Only in Belgium”, therefore being presented as an incentive for foreign MNEs who wanted to benefit from favourable taxation in Belgium. Although the scheme was available to any type of MNEs without distinction, due to its nature it was actually not accessible for standalone companies.

Commissioner Vestager in charge of competition policy stated the following regarding the scheme:

“There are many legal ways for EU countries to subsidise investment and many good reasons to invest in the EU. However, if a country gives certain multinationals illegal tax benefits that allow them to avoid paying taxes on the majority of their actual profits, it seriously harms fair competition in the EU, ultimately at the expense of EU citizens."213

209 A. Bal, supra n. 2, 67. 210 ECJ, 14 February 2019, Judgment in Joined Cases T-131/16 Belgium v Commission and T-263/16 Magnetrol International v Commission. 211 EC Press Release, State aid: Commission concludes Belgian "Excess Profit" tax scheme illegal; around €700 million to be recovered from 35 multinational companies, 11 January 2016. 212 EC Press Release, State aid: Commission concludes Belgian "Excess Profit" tax scheme illegal; around €700 million to be recovered from 35 multinational companies, 11 January 2016. 213 Ibid., Commissioner Vestager on Belgium giving incompatible State aid to 35 MNEs.

43 This is the position that the EC held in numerous cases involving tax rulings around Europe. Companies like Apple, Starbucks, Fiat, Amazon were all subject to the in-depth investigations of the EC. Their tax ruling practices were equally assessed as incompatible State aid by the EC in its efforts to curb harmful tax competition at the level of the EU. Despite the strong criticism of this approach, the EC managed to send a clear message to the EU MSs trying to incentivise companies to come to their jurisdictions in exchange for preferential treatment.

However, in the case of Belgium’s excess profit scheme, the General Court of the CJEU recently decided that Belgium did not grant any State aid through its system and that the deviations from the ordinary tax rules happened in accordance with article 107 TFEU.214 Therefore, according to the CJEU, the incentive practice put in place by Belgium benefitting only MNEs is not selective in nature and does not represent incompatible State aid. It is therefore interesting to see what the position of the CJEU is going to be when it will decide on the matters on appeal.

214 ECJ, 14 February 2019, Judgment in Joined Cases T-131/16 Belgium v Commission and T-263/16 Magnetrol International v Commission, para. 136.

44 6. CONCLUSION

In the light of the issues discussed above, it appears to be complicated to draw strict conclusions in favour or against adopting tax incentives. Nevertheless, it can be affirmed that there are incentive practices which are very carefully tailored to the exact needs of a country’s investment policy, whereas other incentive frameworks seem to be adopted as a result of pressure and ill-advised policymaking, ultimately leading to a race to the bottom.

As a consequence, the countries’ tax bases are suffering, therefore leading to undesirable outcomes. For developed countries, this means that the tax burden is put on labour which is less mobile and shifted away from the mobile income. At a certain point, the increased tax burden on labour becomes unbearable or politically unacceptable, therefore states resort to solutions that damage the welfare state, like cutting through the social safety net. For developing countries, a deficient tax base means not being able to create a welfare state in the first place.

When designing incentives, it is important for policymakers to start from the point that long-lasting investments will happen regardless of whether a tax incentive is offered. Tax incentives are not able to repair economic issues which are deeply entrenched in the system, nor can they attract durable investment if the general investment climate of the country is deficient.

However, if a country desires to offer tax incentives to investors, it should pay special attention to its design. A successful design of the tax incentive is a guarantee for its efficiency. There are many considerations that countries have to take into account when designing tax incentives. Primarily, they have to be designed in a way that is not open to interpretation, therefore they have to be specifically drafted for the purpose they are intended. Furthermore, incentives have to be measurable, so that their effectiveness can be assessed later on in time. In order to influence behaviour, maintain compliance and confidence in the tax system, incentives and their objectives have to be accepted by everyone. Also, they have to be realistically achievable and time-bound. Most importantly, their evolution and effects on the budget have to be monitored on an annual basis and the revenue loss attributable to the incentives needs to be recorded and analysed as well.

Besides the actual design of the incentive, international co-operation through exchange of information and conclusion of tax treaties is crucial for the incentive to be effective. However, differences in the methods of elimination of double taxation and precisely the credit method can nullify the benefits of an incentive. As a solution, tax sparing credit clauses can be introduced in the tax treaties in order to allow

45 the incentive to be effective and abuse related to it (treaty shopping, creation of conduit companies, routing transactions) can be curbed with LOB provisions and PPT rules.

The above-mentioned anti-abuse rules are effective for eliminating other types of abuse relating to tax incentives, precisely those related to capital investment incentives. Companies can try to take advantage of low tax rates available through IP-box regimes by separating the IP from the R&D activities. These schemes are no longer possible also because of Action 5 of the OECD BEPS Project which introduced the modified nexus approach, but also because of the OECD TP Guidelines that require actual substance behind the IP ownership, favouring a substance over form approach.

The EU Member States have the power to take decisions regarding their direct taxation matters and offer the tax incentives they want as long as they do so in conformity with EU law. The offered incentives have to be respectful of the State aid regime of the EU which prohibits MSs to offer selective advantages to economic operators which cannot be justified under article 107 and 108 of the TFEU. Tax incentives are at high risk of being considered incompatible State aid if their drafting is not general enough as to apply to all interested actors on the market (unless justified by the conditions of article 107 TFEU).

However, once can imagine that offering tax incentives without delimiting the activities the incentive applies to can prove to be counterintuitive, as it would potentially open the door to a great number of requests asking for the same type of incentive, therefore putting an immense pressure on the state’s budget. It is nevertheless a condition that Member States have to comply with in order to avoid being in the situation of recovering the aid with interest and putting the taxpayer in a situation of legal uncertainty.

Regarding legal certainty and advantageous outcomes reserved only for certain companies, tax rulings have also been the focus of State aid investigations, especially during the past years. The author acknowledges the different legal mechanisms behind granting tax rulings and tax incentives, the former being part of procedural law and the latter being part of substantive law. However, the granting itself of generous tax rulings behind closed doors can sometimes be perceived as an incentivising practice adopted by certain countries in order to attract multinationals to their jurisdictions.

Considering the points discussed above, it is interesting to follow what are going to be the developments at EU level in respect of tax incentives, State aid and tax rulings, considering Member States’ sovereignty in fiscal matters. Whether this freedom is going to decrease or whether it is going to be reaffirmed is hopefully going to be clarified in the years to come.

46 7. Bibliography

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49

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50

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51

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52

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54 8. Annexes

Figure 1 Basic IP Holding Structure Figure 2. Basic IP holding structure

Figure 2 E-commerce structure using a two-tiered structure and transfer of intangibles under a CCA215

215 OECD, Addressing BEPS, 2013, International Organizations’ Documentation IBFD, p. 74.

55 Figure 3 Past Google structure 216

216 Figure found on http://thetaxtimes.blogspot.com/2017/08/ireland-disagrees-with-eus-decission.html (accessed 19 May 19, 2019). It is to be noted that Google changed their structure after it has become known to the public.

56