On 3 May 2019, the European Commission published the official decision opening an in-depth investigation into possible illegal State aid granted by Luxembourg to the Finnish food and drink packaging company Huhtamäki. This adds another tax ruling case to the list of pending State aid cases in the area of tax. The Huhtamäki investigation focuses on three tax rulings issued by Luxembourg in 2009, 2012 and 2013. Interestingly, the 2009 tax ruling only became public knowledge because of the "Luxleaks" investigation in 2014. The official investigation decision offers useful insights into the Commission's approach to State aid in tax ruling cases. 

THE COMMISSION'S ANALYSIS OF THE DISPUTED TAX RULINGS

The three tax rulings which the Commission is investigating were issued by the Luxembourg tax administration to Huhtalux Supra S.à r.l. and Huhtalux S.à r.l., two Luxembourg tax resident entities of the Huhtamäki group ("Huhtalux"). Huhtalux received interest-free loans from an Irish group entity, which it subsequently used to finance other group entities through interest-bearing loans. The disputed tax rulings allowed Huhtalux to deduct a deemed interest on the interest-free loans from its taxable base. Luxembourg believes this unilateral adjustment reflects an arm’s length interest that would have been charged by an independent lender under market-based conditions. However, the Commission is concerned that the unilateral downward adjustment in Luxembourg, without a corresponding upward adjustment in Ireland, may give Huhtamäki an anti-competitive advantage.

In essence, the Commission takes the view that the tax rulings allowed the Huhtamäki group entities to deduct deemed interest expenses and pay less tax than standalone companies, which constitutes a selective advantage from a State aid perspective. The objective of the applicable tax provision (concerning hidden capital contributions and hidden dividend distributions) is to ensure that a company's taxable income is aligned with the income it actually generates in Luxembourg. According to the Commission, the scope of the relevant tax provision seems to target only upward adjustments. Even if a downward adjustment was allowed by that provision, or any other provision, it would have to be considered as selective due to its discretionary nature. In the Commission's view, this derogates from corporate Luxembourg income tax law.

In order for a measure to constitute State aid, it must give a selective advantage to the parties it applies to. To assess the selectivity of the tax rulings, the Commission has analysed the Luxembourg tax rulings on the basis of a three-step analysis, following from EU case law (see our Brochure on State aid and Taxation for more information on this).

In the first step, the Commission considers the Luxembourg corporate income tax system as the reference system.

In the second step, the Commission believes that the tax treatment of Huhtalux appears to derogate from the reference system. The Commission emphasises that the objective of the system is taxing the actual profits realised by companies subject to corporate income tax in Luxembourg, taking the commercial profit recorded in their accounts as a starting point.

In the Commission's view, the deduction of the deemed interest does not correspond to an actual expense incurred by Huhtalux. The effect of the deemed interest deduction is that a substantial proportion of Huhtalux's profits remains untaxed. Consequently, the effective tax rate for these entities is significantly lower than the rate applicable to standalone companies which find themselves in a factually and legally comparable situation in the view of the general objective of the tax system.

In the third step, the justification for the deemed interest deductions is assessed with reference to the nature and design of the tax system as put forward by Luxembourg.

The Commission gives the following reasons for its initial conclusion that the derogation of the tax treatment for group companies cannot be justified:

  1. The Commission rejects the arm's length principle as a justification for the deemed interest deduction, as the application of the principle is merely a tool to achieve the objectives of equal treatment and avoiding double taxation;
  2. The derogation is not adequate because it provides a more favourable treatment to group companies and is granted regardless of whether the corresponding profit has actually beentaxed in another jurisdiction;
  3. The derogation is not necessary for avoiding double taxation and ensuring equal treatment with other standalone companies, since it would have been sufficient for Huhtalux to effectively pay the interest to the Irish group entity in order to be taxed at the same level as standalone companies; and
  4. The derogation is not proportionate since the downward transfer pricing adjustment aimed at avoiding double taxation, which could in principle be justified, is not limited to the cases where evidence is provided that there is a risk of double taxation due to a corresponding upward adjustment of the tax base in Ireland.

Conclusion

It is remarkable that the Commission has based its investigation on the information that it obtained from the controversial LuxLeaks. This follows on from the Nike investigation, where the information was retrieved from the Panama Papers. Given that LuxLeaks happened in 2014, questions could be raised about why the Commission took almost five years to start this investigation. Furthermore, given that 343 companies were exposed in the LuxLeaks database, we expect that more rulings will be investigated by the Commission in the near future.

It can be argued that the question of whether the deduction of deemed interest payments is allowed is a matter of domestic tax law, rather than EU State aid rules. Some countries generally allow for the deduction of deemed interest payments, while others do not. Where there is a mismatch between domestic laws, it could be argued that there are other, more suitable, measures to tackle these mismatches in domestic tax rules, especially given the EU ATAD mismatch provisions.

The Commission's final conclusions in the McDonald's case have shown that the fact that an investigation is opened does not prejudge its outcome. However, the published decision here shows that the Commission has based its initial conclusions on a thorough analysis of the Luxembourg tax system. Moreover, the Commission has investigated the justifications for the tax rulings put forward by Luxembourg. Therefore, it is clear that if the in-depth investigation confirms the Commission's initial conclusion on the selective advantage granted to Huhtamäki, other investigations into similar tax treatments by Luxembourg will follow.