Base Erosion and Profit Shifting: The State Aid Controversy

The Organization for Economic Cooperation and Development (OECD) is a forum where governments discuss social and economic policy, including guidelines for the coordination of various tax laws across the organization’s member jurisdictions. The United States has the highest corporate tax rate among the 35 members of the OECD. The United States is also the only OECD country with a worldwide tax system. Accordingly, American companies have an incentive to reinvest foreign earnings abroad because foreign subsidiary earnings are subject to additional tax when repatriated to countries with worldwide tax systems. As a result, American companies avoid United States tax by trapping their foreign earnings abroad.

The foreign subsidiaries of American companies then engage in jurisdiction shopping, with an eye towards transfer pricing rulings, to impose the lowest possible tax rates on their foreign earnings. Transfer pricing is a method used to determine the price of a transaction between related companies by estimating the price of the same transaction if it were to take place between companies operating at arm’s length. In order to ascertain whether a company meets these conditions, companies often request advance pricing arrangements with the country at issue to determine the price of a transaction, and thus tax liability, in advance of the transaction.

In 2013, the OECD created an action plan on Base Erosion and Profit Shifting (BEPS) to prevent abusive tax avoidance under these circumstances. The main concern is that multinational companies’ tax liabilities may be unduly low or evaded entirely by artificially segregating taxable income from the activities that generate it. This segregation results in profit shifting, which occurs when a multinational company’s income is reduced by making its profits disappear from a certain taxing jurisdiction, and base erosion is the abusive effect of the absence of these profits in the taxing jurisdiction.

While the OECD issues guidelines to curb abusive tax avoidance, profit shifting is not illegal on its own, but rather the result of domestic laws that have not yet been coordinated across international borders in accordance with OECD recommendations. Accordingly, the European Commission has been cracking down on its member states’ tax law discrepancies by invoking its supranational authority in an area that has traditionally been sovereign to each individual state. In particular, the Commission argues that preferential advance pricing arrangements violate state aid rules under EU competition law.

State aid rules are meant to prevent member states from creating business subsidies that distort free market competition in the European Union. Advance pricing arrangements, such as those received by Amazon, Apple, Chrysler, and Starbucks, are being used to retroactively attack tax avoidance by re-characterizing their tax benefits as the equivalent of receiving illegal business subsidies. The Commission’s position states that artificially lowering transfer prices through these preferential arrangements is unlawful because the government is providing a “selective advantage” over EU companies operating at arm’s length. Regardless of its intentions, the Commission may be doing more harm than good because EU nations and American businesses can no longer negotiate new arrangements nor rely upon past arrangements with any confidence due to the threat of the Commission’s retroactive application of state aid rules.

If the Commission decides an arrangement is preferential because it provides a selective advantage, in violation of state aid rules, the company is required to repay the illegal business subsidy it received from the government in the form of lost tax revenue, plus interest. Several appeals are now pending within the EU court system challenging the Commission’s retroactive application of state aid rules to advance pricing arrangements, including the decision ordering Ireland to recover 13 billion euros from Apple, the highest repayment amount sought to date.

In August 2016, the U.S. Treasury Department released a white paper criticizing the Commission’s sovereignty violations and retroactive recoveries in EU nations. Instead of improving tax certainty on a global level by adhering to OECD guidelines, the Department argues a new EU transfer pricing standard is being applied through state aid doctrine that undermines the organization’s goal of achieving international tax coordination. This deviation risks offending OECD members that meaningfully participated in the BEPS project to obtain international standards relating to transfer pricing disputes.

In response to increasing globalization, there has also been a notable backlash this year in the Western world that will undoubtedly wreak havoc on cross-border tax rules and their corresponding enforcement mechanisms. For example, “Brexit” means Britain is no longer subject to EU competition law and a different approach to addressing BEPS between the United States and Europe may naturally prove more versatile than state aid rules. Moreover, President-elect Donald Trump may make anti-avoidance a moot point if the tax rate for repatriation of American companies’ foreign earnings is lowered enough to rival overseas tax havens. In the meantime, the uncertainty faced by EU nations and American businesses with advance pricing arrangements persists while we wait for the Commission’s decisions on appeal.

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Allison Kroeker
akroeker@rroyselaw.com

Allison Kroeker joined the firm after receiving her LL.M. in Taxation. Her areas of focus within the tax practice include business structure planning, corporate transactions, deferred compensation, and income tax compliance. She also writes many of Royse Law Firm’s articles on tax procedure and policy. Read My Full Bio

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