Archive for Europe

The EU Commission’s Problematic Reasoning on Amazon

Today the EU Commission released a document detailing its reasoning behind its decision to consider Luxembourg’s tax treatment of Amazon to be a violation of EU competition rules. The full document can be found here (pdf).

The crux of the EU Commission’s argument is that Luxembourg gave Amazon permission to set up a transfer pricing structure that was inconsistent with the arm’s length standard, and that in so doing it conferred a “selective advantage upon Amazon in so far as it results in a lowering of its tax liability in Luxembourg.” And that’s where the problems start in the EU’s reasoning.

EU v AmazonTo begin with, one might think that in order for Amazon to have received a “selective advantage” it must be the case that Luxembourg would have rejected the same structure for another taxpayer. But there’s no evidence presented that Luxembourg would have interpreted its own tax code differently for any other taxpayer.

But even putting that issue aside, how does the Commission believe that the Amazon structure was inconsistent with the arm’s length standard? Its argument is based on the following points:

  1. Luxembourg did not provide the Commission with Amazon’s transfer pricing analysis supporting its transfer pricing policies.
  2. The method used to calculate Amazon’s transfer prices in Luxembourg (specifically royalty payments to the owner of the Amazon IP in Europe) “does not seem to correspond to any of the methods listed in the OECD Guidelines”.
  3. Amazon’s calculation of the royalty payments “is not related to output, sales, or to profit.”
  4. Luxembourg accepted a margin of 4-6% over cost for the Amazon entity without a comparability analysis, and that margin may be too low.
  5. Luxembourg also accepted a floor on the Amazon entity’s profitability of 0.45% of Amazon’s EU sales revenue, along with a cap equal to all of Amazon’s European profits.

There are problems with each of these points. Taking them in turn:

1. The fact that Luxembourg did not provide the Commission with Amazon’s transfer pricing analysis says nothing about whether or not the arrangement is inconsistent with the arm’s length standard.

2. The method described in the Commission report is easily recognizable as the income method (i.e. the TNMM as specified in the OECD Guidelines) for the calculation of payment for intangibles. The income method is a frequently used approach in determining an appropriate level of royalty payments, and in fact is the method preferred by many tax authorities, such as those in the US.

3. Amazon’s calculation methodology is in fact directly related to sales and/or profit. This is obscured somewhat by the two-step nature of the calculation, in which the royalty payments are calculated such that they leave Amazon’s Luxembourg entity with profits equal to either 4-6% of its cost base or at least 0.45% of total Amazon sales revenue in Europe. But it’s clear that as Amazon’s sales and profitability in Europe go up, the income attributable to Amazon’s Luxembourg entity will also rise. So it’s hard to see where the Commission arrived at this particular conclusion.

4. The 4-6% range of profitability for the Amazon Luxembourg entity is not obviously too low; a 5% margin is considered very typical for a wide range of service providers. Whether or not it’s the right range in this case depends on the specific functions performed by the Luxembourg entity. A full functional analysis and set of comparable companies would be necessary to form a final opinion on this issue, but given the widespread use of 5% margins for intragroup services it seems oddly ill-informed to pick on this figure. Regardless, this point is largely irrelevant due to the second portion of the calculation methodology, in which the profitability reported by the Luxembourg entity actually depends on Amazon’s European revenues, not its cost base, as discussed in the next point below…

5. Yes, Luxembourg accepted Amazon’s rather unusual policy of having its Luxembourg entity’s taxable income depend not just on its cost base, but on total sales revenue in Europe. But there are two important points to be made about this. First, it’s not at all unusual to see arm’s length licensing arrangements where two or more alternative calculations are used to arrive at the amount of the payment, so this is not an obvious flag that the arrangement is inconsistent with the arm’s length standard. Second, given reasonable assumptions it’s entirely possible that the second, sales-based condition could actually increase Amazon’s tax bill in Luxembourg over what it would otherwise pay. Consider that Amazon’s sales in Europe were around €13.6 bn in 2013. Applying the 0.45% floor on the Amazon entity’s taxable income means that it must have declared income of at least €60m in Luxembourg in that year. Amazon’s Luxembourg entity has about 1,000 employees, suggesting that its direct operating expenses are probably in the neighborhood of a few hundred million euro. Even if its operating costs were €600m in 2013, it would have earned a margin of 10% over its costs – arguably significantly more than would be expected in an arm’s length arrangement. The point is that it’s not at all clear that Amazon’s transfer pricing policy yields a lower-tax result than would be expected in an arm’s length arrangement.

More fundamentally, the weaknesses in the EU Commission’s argumentation remind us that the EU competition authority is taking on a vast new area of inquiry with its recent push to address transfer pricing issues. Are the EU’s competition regulators now going to try to seriously assume a new role as a review body for each member country’s interpretation and enforcement of transfer pricing policies? If so, they have a lot of work in front of them.


UPDATE: For a bit more on the issue of “selective advantage”, take a look at this post by Renata Ardous. In it she points out that the General Court of the EU has recently taken issue with the Commission’s attempts to characterize aspects of national tax laws as providing selective advantage, and that similar reasoning may apply to this case.

German Wishes for Irish Taxes

Ireland has long been a favorite country for multinationals to set up shop in, thanks in part to its 12.5% corporate tax rate – one of the lowest in the world. A typical situation would be for a multinational based in the US or Asia to set up an Irish subsidiary as the principal entity from which to run its European business, thereby allowing it to legally record a significant portion of its European income in Ireland.

But this low tax rate has not been so popular among other European countries, as it is seen as making it difficult to compete with Ireland in their ongoing quiet contest for tax revenues from multinationals. So with the visit of German finance minister Wolfgang Schäuble to Dublin this week to deliver some low-interest loans, The Irish Times posed an interesting question: why hasn’t Berlin demanded that Ireland raise its corporate tax rate in exchange for its assistance?

German officials mystified by inaction on Irish corporate tax rate

German finance minister Wolfgang Schäuble is in Dublin tomorrow to help Ireland’s Halloween party with a €150 million loan from Germany’s KfW state development bank. Matched by the European Investment Bank (EIB), this is the starting capital for Ireland’s Strategic Banking Corporation of Ireland…

As on previous occasions where Ireland was looking for something from Berlin – the prom note reconfiguration, or the bailout itself – Berlin demanded something in return, having already given Dublin what it wanted first…

Given the regular German swipes at Ireland’s 12.5 per cent tax rate, it’s interesting that Berlin never followed the Cyprus strategy. Last year, Nicosia was “encouraged” to make a sovereign decision to raise corporate tax rates as a precondition for the required assistance.

It’s a good question, though I’d like to rephrase it slightly: why does Germany treat Ireland so differently from Cyprus when it comes to providing financial assistance? One possible explanation is that the corporate tax rate in Cyprus, which had been set at 10%, was seen by Germany as being more egregious than Ireland’s rate. But it may also be a subtle symptom of the north-south divide in Europe that has emerged so strongly in recent years. The distrust and hostility between northern European nations and southern Europe has been displayed in many ways since the Eurozone crisis began in 2009-10. Perhaps this is another one.

Fighting Over Tax Revenue in Europe

There’s been a burst of news recently about how multinational companies (“MNCs”) use corporate structures (and of course the transfer pricing that goes with it) to reduce their tax bills. Starbucks, Apple, and most recently Amazon have all been getting lots of unwelcome press about their European tax planning strategies.

This is nothing new, of course. But there does seem to be a slightly different flavor to the criticism this time around. In the current round of attention it seems that national tax administrations are coming under as much scrutiny as the companies involved, with certain countries being accused of essentially colluding with MNCs to facilitate their tax minimization. Last week we learned that the EU has commenced an anti-competition investigation against Luxembourg related to the tax treatment that the country applies to MNCs.  And this week it was announced that Ireland will, under pressure, revise its tax regulations to eliminate one type of corporate structure that MNCs can use to reduce their tax liabilities.  The Economist reports:


BONO may front one of the world’s most popular rock bands, but the U2 singer did not earn many new fans when he recently defended Ireland’s controversial tax policies, which are widely seen as helping multinationals to avoid paying their fair share. Even Ireland’s government seems to be having doubts. On October 14th it announced plans to close the country’s biggest loophole, the “Double Irish”.

The Double Irish allows companies to shift their profits from high-tax countries to havens… Users can thereby cut their effective tax rate—perfectly legally—far below Ireland’s already low 12.5% rate, in some cases down to less than 2%…

From January all new companies domiciled in Ireland will also have to be tax-residents there, making the Double Irish impossible. Ireland is acting under pressure from America, the European Commission and the OECD, which are working on multilateral reform of international tax rules to curb avoidance.

On one level focusing attention on the countries involved, rather than MNCs, makes perfect sense.  After all, MNCs are simply doing the best that they can for their owners, given each country’s tax rules as they are written. (The degree of involvement that MNCs have in the writing of those tax rules is an interesting but separate question that we’ll have to leave for another time.) So if you think that MNCs should pay higher taxes, you really should be directing your criticism at the creators and administrators of tax regulations, not the taxpayers.

But why now?  And why does the attention seem to be falling not on those stereotypical sunny, shorts-wearing, palm tree-fringed, tropical island tax havens, but instead on respectable (if rather more gloomy, weather-wise) northern European nations like the Netherlands, Luxembourg, and Ireland?

I think a couple of factors are contributing to this.  First of all, I don’t think it’s a coincidence that the countries in question are EU members. In case you hadn’t noticed, the EU has been going through a bit of an economic rough patch over the past few years. The eurozone financial crisis that began in earnest in 2010 has highlighted and contributed to dramatic differences in economic performance and budget policy between EU member nations. Suspicion and resentment between European countries over economic and financial issues has probably never been greater since before the second world war.

But more specifically, I think that the troubled economic landscape in Europe over the past several years has brought to the forefront something that usually lies unseen in the background, but which transfer pricing practitioners are constantly reminded of: the world’s major countries are engaged in a constant, usually quiet battle with each other for tax revenue from MNCs.  It’s not quite true that MNC tax payments are a zero sum game, but as a first approximation that idea captures how tax administrations view the problem.  Each MNC has a pie of global tax payments. And each tax administration wants to capture as large a slice of that pie as they can.

So as many European countries feel the accumulated burden of years of economic and financial struggle, it’s not surprising that they have become more aggressive with each other in their battles over the share of the tax revenue they can claim from the world’s largest MNCs. I think this phenomenon will help keep the pressure on the participants in the OECD BEPS project to make sure that the new rules that come out of those negotiations are quite strict. And I’m sure we haven’t heard the last of how Europe’s low-tax jurisdictions help the world’s MNCs to reduce their overall tax bills.

A New Arena for Transfer Pricing Disputes

You may have seen last week’s news that the tax treatment of Amazon by the country of Luxembourg is being examined by the European Commission as a possible violation of EU competition rules.This follows the opening of similar investigations by the EU into the tax arrangements of Apple, Starbucks, and Fiat.

This is interesting for a variety of reasons.  First of all, this marks one of the first times that transfer pricing arrangements are being actively and specifically scrutinized not by any national tax authority, but by a multinational body with no direct financial stake in the outcome.  Secondly, the tax authorities of Ireland and Luxembourg — i.e., the tax authorities that stand to gain tax revenue if the EU rules against the companies in each case — are actually in the position of defending those companies, even though if they lose the legal battle with the EU, they stand to gain billions of dollars in tax revenue.

But perhaps the most fascinating aspect of this development is that transfer pricing is now being explicitly and directly addressed as an aspect of competition policy, rather than simply as a tax matter. The Economist put it thus (subscription required):

[T]he European Commission has been exploring those dark recesses to establish whether multinationals’ arrangements with tax-friendly Ireland, Luxembourg and the Netherlands amount to illegal subsidies. For the three companies targeted so far (Apple, Fiat and Starbucks), and for the many others that routinely engage in complex tax-planning, the probes have taken the crackdown on cheeky tax avoidance into uncomfortable new territory…

Citing minutes of meetings between Apple’s tax advisers and officials, the commission suggests they reached a quid pro quo in which the company was allowed to shelter profits from tax in return for maintaining jobs. The suspected mechanism was “transfer pricing” agreements that deviated from international accounting guidelines, which require transactions between group subsidiaries to be priced at market rates. The costs attributable to one Irish subsidiary appear to have been “reverse-engineered” to arrive at a certain level of taxable income with “no economic basis”, says the commission.

These investigations and the resulting legal fallout could have substantial implications well beyond the companies and countries in question. If transfer pricing arrangements become subject to anti-competition investigations in addition to scrutiny from tax authorities, the regulatory landscape suddenly has the potential to look very different from what we’re used to.  Stay tuned.