STATE AID AND STARBUCKS CASE: WHAT HAVE WE LEARNED?

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www.dlapiper.com UKG/25716349 18 May 2017 0

18 May 2017

STATE AID AND STARBUCKS CASE: WHAT HAVE WE

LEARNED?

Clive Jie-A-Joen

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Clive Jie-A-Joen focuses on helping clients to design, implement, document and defend their company’s transfer pricing policies. Clive is also an expert on valuation of intangibles and the transfer pricing aspects of business restructuring. He has two decades of

experience and an economics background (PhD, Master of Business Valuation). Clive regularly lectures and writes articles on transfer pricing.

"I enjoy helping clients with transfer pricing and valuation of inter-company transactions so they can have a good night sleep and have more time to complete their tasks in the

daytime."

Speaker

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1

Introduction ³

2

Starbucks state aid case ⁸

3

State Aid Risk Management ²⁴

Agenda

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Introduction

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What is EU State Aid?

Intervention by the State and through

State resources

Economic advantage

on a selective

basis

Competition has been or may be distorted Likely to

affect trade between Member

States

 To establish an EU internal market, State aid law has been created to avoid EU Member States engaging in a subsidy race favoring their national industries or attracting businesses to the detriment of other EU Member States

 State aid is "an advantage in any form whatsoever conferred on a selective basis to undertakings by national public authorities"

 European Commission exclusively competent, subject to marginal review by General Court

 Some State aid measures may nevertheless be declared

compatible with the internal market

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 Speech Algirdas Semeta 11 February 2014:

– "The Commission is gathering information on tax planning strategies under state aid rules"

 Margrethe Vestager 2 October 2014:

– "I am going to continue the work that Almunia started in order to throw light on some of special arrangements"

State aid and Corporate Taxation on the European

political agenda

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EU State Aid Rules Can Apply to Tax Arrangements

Tax Arrangements with EU Member States

Unilateral Advance Pricing Agreement

Tax rulings, including excess profits rulings

Audit settlement agreements

Other agreements with local tax authorities

 More than 1000 tax rulings reviewed by the European Commission: what are selection criteria?

 4 Final Decisions and 3 Open Decisions

 Even if a tax arrangement complies with national law, it may still constitute unlawful State aid

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 Consequence: mandatory recovery of tax benefit (including interest) subject to limitation period of 10 years

 European Commission exclusively competent, subject to marginal review by General Court / Court of Justice

 Cross-border impact: can retroactive payment of taxes be credited against taxes paid in another country?

Consequence of State Aid

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Starbucks state aid case

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Starbucks Timeline

2013 / 2014 2015 2016 2017

 June 2013: EC started investigating tax ruling practices

 11 June 2014:

decision to open formal investigation procedure on

Starbucks and Fiat

 21 October 2015:

Final Decisions on Starbucks and Fiat

 23 December 2015:

Netherlands requests General Court to annul EC decision on

Starbucks

 5 September 2016:

Starbucks requests General Court to annul EC Decision of 21 October 2015

 29 March 2017:

Publication of Commission Decision on Starbucks in Official Journal of the

European Union

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Structure of Starbucks based on TP report

 SMBV processes green coffee (roasting facility in Amsterdam) and operates as an intermediary distribution entity for a variety of non-coffee items

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 Advance Pricing Agreement (APA) concluded by the Dutch tax administration and Starbucks Manufacturing EMEA BV ("SMBV") regarding an arm's length remuneration for functions performed by SMBV (including risks and assets):

 From 1 October 2007 to 31 December 2017

 Activities performed by SMBV (40-60 people):

 low risk manufacturer: manufacture / coffee roaster activities

 Logistics and administrative support

 Under a Roasting Agreement, Alki LP acts as the principal and SMBV as the owner of the roasting facility. Alki LP grants SMBV access to IP rights (roasting know-how and curves) and assumes the entrepreneurial risk

 Transactional net margin method was selected as TP method using a mark-up of 9- 12% applied only on relevant cost base where SMBV adds value

 The level of royalty payment is difference between realised operating profit before royalty expenses and the 9-12% mark-up on operating expenses

Contested Measure

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Contested Measure – Royalty Payments to Alki

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 Three-step analysis in fiscal cases:

1. Identification of the reference system (i.e. the common or normal tax regime applicable in the MS): :

 A consistent set of rules that apply on the basis of objective criteria to all undertakings falling within its scope

2. Determination whether the concerned tax measure constitute a derogation from the reference system in so far as it differentiates between economic operators who are in a comparable factual and legal situation

3. If so, it should be established whether the measure is justified by the nature or general scheme of the reference system

Assessment of Selective Advantage

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Step 1: Determination of Reference System

General Dutch Corporate Tax System

Article 8b(1) of the Dutch CITA (arm's length principle) and transfer pricing decree

European Commission  The general Dutch corporate tax system has as objective the taxation of profits of all companies subject to tax in the Netherlands, irrespective of whether these companies are group companies or standalone companies

 Both types of companies are in a similar factual and legal situation

 Artificial distinction between companies based on company structure

 If the Decree establishes special rules for integrated companies, in itself results in finding of

selectivity.

The Netherlands  Incorrect reference framework

 In the APA effect is simply given to this reference framework

 SMBV should be considered in a similar factual and legal situation only to group companies

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 To establish whether the SMBV APA constitutes a derogation from the general Dutch Corporate Income Tax system, leading to unequal treatment between companies that are factually and legally in a similar situation

 The Commission will find a selective advantage when a tax ruling "endorses a transfer pricing methodology for determining a corporate group entity's taxable profit that does not result in a reliable approximation of a market-based

outcome in line with the arm's length principle"

 The ALP is "the principle that transactions between intra-group companies should be remunerated as if they were agreed to by independent companies negotiating under comparable circumstances at arm's length"

 Does the Commission depart from established EU state aid law and case law by not analyzing advantage and selectivity separately by only investigating whether the tax measure constitute selective advantage?

Step 2: Does SMBV APA constitute a Derogation

from the Reference System?

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Step 2: The Arm's Length Principle

European Commission The Netherlands

• The ALP forms part of the

Commission's assessment under Article 107(1) of the Treaty

• The ALP is not that derived from Article 9 of the OECD MTC, but is a general principle of equal

treatment in taxation falling within the application of Article 107(1) of the Treaty

• The EC incorrectly refers to an EU law arm's length principle, which does not exist

• The EC applies a new, own criteria for profit calculation, which does not correspond to national tax rules and the OECD framework

• This leads to uncertainty for tax administration and for companies

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SMBV APA European Commission

• Determining remuneration for SMBV's function (roasting / manufacturing).

• No identification or analysis of SMBV's controlled and

uncontrolled transactions.

Step 2: Transactional versus Functional Approach

Should the focus of Commission's analysis be on the resulting taxable profit of the contested measure or single elements of the APA?

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• TNMM

• Profit level indicator is based on relevant cost basis of SMBV (operating expenses)

• Cost base adjustment and working capital adjustment performed to adjust for differences between the comparables and SMBV

• Royalty is difference between operating profit before royalty expenses and the 9-12% mark-up on operating expenses

• The Netherlands is of the view that the CUP method cannot be applied

• Royalty payment not arm's length:

• Variable royalty payments does not reflect IP value

• No royalty should be due for the roasting IP based on CUP method:

• Starbucks agreements with 3rd parties

• Arrangements between competitors and 3rd party roasters

• SMBV does not capture the value of roasting IP in its relationship with Alki LP

• Royalty payment does not reflect a remuneration for taking over risks

Step 2: Transfer Pricing Methodology – Royalty paid

to Alki LP

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• TNMM • Prices charged to SMBV by SCTC for green coffee beans not at arm's length:

• Average mark-up on costs of green coffee beans supplied by SCTC for 2005-2010 period is around 3%

• Average mark-up on costs of green coffee beans

supplied by SCTC for 2011-2014 period is around 18%

• Starbucks argues that increase in the mark-up from 2011 onwards is due to:

• Growing importance of SCTC's operations, particularly the increased expertise in coffee procurement

• The ownership and operation of the C.A.F.E.

Practices Program

Step 2: Transfer Pricing Methodology – Prices

charged for Green Coffee Beans

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• SMBV performs the least complex function and thus to be regarded as the "tested party"

• The TP report did not consider whether the residual profit allocated to Alki LP is in proportion to its functions, risks and assets

• Alki LP's operating capacity is extremely limited to non-existent

Step 2: Least Complex Function

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• SMBV is a low risk manufacturer

• Profit level indicator is based on relevant cost basis of SMBV (operating expenses)

• Cost base adjustment and working capital adjustment performed to adjust for differences between the comparables and SMBV

• Misidentifies SMBV's main functions to be compensated:

• SMBV resells production bought from 3rd parties to the shop

• This function is not considered in selecting the comparables and the profit level indicator

• The inappropriateness of the working capital adjustments

Step 2: Application of TNMM

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SMBV's APA: EC Conclusion on the Existence of

State Aid

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 Incorrect application of Article 107(1) TFEU in so far as the Commission finds that the APA is selective in nature

 Incorrect application of Article 107(1) TFEU in so far as the Commission assesses the existence of advantage by reference to an EU law ALP

 Incorrect application of Article 107(1) TFEU in so far as the Commission finds that the APA confers an advantage on SMBV as a result of selecting the

TNMM as methodology

 Incorrect application of Article 107(1) TFEU in so far as the Commission states that the APA confers an advantage on SMBV as a result of the manner of

applying the ‘Transactional Net Margin Method’.

 Alleged breach of the duty to exercise due care in so far as the Commission did not assess and include all the relevant information in the decision and also uses as a basis anonymous information, or at least information that has never been shared with the Netherlands Government.

Netherlands versus Commission

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State Aid Risk

Management

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 Working Paper on state aid and tax rulings:

– Consequently, if a transfer pricing arrangement complies with the guidance provided by the OECD Transfer Pricing Guidelines, including the guidance on the choice of the most appropriate method and leading to a reliable approximation of a market based outcome, a tax ruling endorsing that arrangement is unlikely to give rise to State aid.

– Furthermore, the inquiry suggests that the use of certain transfer pricing methods provides a more reliable means to approximate a market based outcome than others.

In particular, the CUP method sets prices for intragroup transactions by making direct comparisons with the price charged on the market for the same goods or services.

However, in some cases, a ruling is based on the CUP method without any comparables being presented.

– Where the TNMM is used, operating expenses are often retained when the taxable base is determined as a mark-up on a performance indicator. In some cases, it seems that this choice of operating expenses as a performance indicator is made systematically, without necessarily representing the commercial value of the functions of the company.

Commission Guidance on State Aid and Tax Rulings

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Potential Impact of EU State Aid Rules

 Materiality (including damages)

 Position Papers for uncertain tax positions in financial statements (e.g. FIN 48)

 Consideration of EU State aid risk during due diligence

 Review of existing business models

 Restructuring of transactions (planned)

 Economic substance (people, functions, and risks)

 Public perception if investigations are

 on-going or finalised

 Mainstream media coverage

 Negative decision requiring payment of back-taxes and compound taxes, for up to 10 years

 No suspensive effect of an appeal

ACCOUNTING AND

DISCLOSURE

M&A

INVESTMENTS DUE

DILIGENCE

BUSINESS OPERATIONS

REPUTATION AND BRAND

COMMISSION INVESTIGATION

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 A state aid risk may qualify as an income tax risk for tax accounting purposes

 Amazon’s FY2016 Annual Report:

"In addition, in October 2014, the European Commission opened a formal investigation to examine whether decisions by the tax authorities in

Luxembourg with regard to the corporate income tax paid by certain of our subsidiaries comply with European Union rules on state aid. If this matter is adversely resolved, Luxembourg may be required to assess, and we may be required to pay, additional amounts with respect to current and prior periods and our taxes in the future could increase. Although we believe our tax

estimates are reasonable, the final outcome of tax audits, investigations, and any related litigation could be materially different from our historical income tax provisions and accruals.”

Uncertainty on State Aid Risks

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Managing State Aid Risks

 Undertake a structured assessment of the impact of State aid on your business

operations

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 Analyse and disclose income tax risks for financial reporting purposes (e.g. FIN48 or similar)

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 Consider solutions that will help you manage and mitigate State aid risk

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 Plan for uncertainty and increased levels of controversy

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 If the EC has already started to investigate, seek specialized State aid assistance

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 Ruling deviates from local law, case law, the general ruling policy, or an administrative decree

 The tax benefit is not granted to other enterprises that find themselves in a legal and factual similar situation

 The ruling results in a significant difference between the commercial profit and the taxable income (other than "normal" participation exemption income)

 No (recent) transfer pricing report and / or contracts are available

 No or insufficient substantiation of:

– the chosen transfer pricing method

– uncontrolled transactions: can the CUP method be applied?

– the chosen profit level indicator(s) – the chosen comparable(s)

Risk indicators state aid (1)

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 Ruling accepts a taxable profit that seems to be inversely proportionate to the size of the functionality and/or employees

– There are doubts on economic rationality of structure

 Ruling includes a cap on the taxable base

 Ruling has no or too long expiry date and/or does not take into account relevant changes in the factual and/or economic environment

 Ruling provides for a fixed taxable base regardless of the actual performance (i.e. de facto lump-sum payment)

 Different interpretations of the OECD TP Guidelines by the Commission: literal application of Guidelines versus best practice

Risk indicators state aid (2)

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 The Commission does not call into question the granting of tax rulings by tax administrations provided they respect EU State aid rules

 The Commission will find a selective advantage when a tax ruling "endorses a transfer pricing methodology for determining a corporate group entity's taxable profit that does not result in a reliable approximation of a market-based

outcome in line with the arm's length principle"

 High threshold: This approximation must be as precise as it can be under the circumstances

 The Commission interprets the OECD TP Guidelines differently

 In-depth Commission review

 Recent Final Decisions by the EC provide some guidance on state aid and tax arrangements, but the General Court's ruling should be awaited

 In the mean time, assess and manage state aid risk

Takeaways

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Questions?

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