From an Irish perspective the most significant announcement made yesterday by Commissioner Vestager was in relation to Amazon not Apple. The Commission announced that Luxembourg had granted €250 million of illegal sate aid to Amazon. The structure used by Amazon in Luxembourg is close to a replica of that used by US companies in Ireland. It is a double-luxembourgish. Here is the Commission’s description of the Amazon structure:
Amazon’s structure in Europe
The Commission decision concerns Luxembourg’s tax treatment of two companies in the Amazon group – Amazon EU and Amazon Europe Holding Technologies. Both are Luxembourg-incorporated companies that are fully-owned by the Amazon group and ultimately controlled by the US parent, Amazon.com, Inc.
- Amazon EU (the “operating company”) operates Amazon’s retail business throughout Europe. In 2014, it had over 500 employees, who selected the goods for sale on Amazon’s websites in Europe, bought them from manufacturers, and managed the online sale and the delivery of products to the customer.Amazon set up their sales operations in Europe in such a way that customers buying products on any of Amazon’s websites in Europe were contractually buying products from the operating company in Luxembourg. This way, Amazon recorded all European sales, and the profits stemming from these sales, in Luxembourg.
- Amazon Europe Holding Technologies (the “holding company”) is a limited partnership with no employees, no offices and no business activities. The holding company acts as an intermediary between the operating company and Amazon in the US. It holds certain intellectual property rights for Europe under a so-called “cost-sharing agreement” with Amazon in the US. The holding company itself makes no active use of this intellectual property. It merely grants an exclusive license to this intellectual property to the operating company, which uses it to run Amazon’s European retail business.
Under the cost-sharing agreement the holding company makes annual payments to Amazon in the US to contribute to the costs of developing the intellectual property. The appropriate level of these payments has recently been determined by a US tax court.
Under Luxembourg’s general tax laws, the operating company is subject to corporate taxation in Luxembourg, whilst the holding company is not because of its legal form, a limited partnership.Profits recorded by the holding company are only taxed at the level of the partners and not at the level of the holding company itself. The holding company’s partners were located in the US and have so far deferred their tax liability.
We know why US companies set up this structure: it is to defer the US tax that is due on the profits. The US has a general anti-deferral regime for passive income [the so-called Subpart F] but there are some exemptions. One notable one is the “same country exemption” where passive income flows within the same country do not trigger a payment of the US tax due. By registering two subsidiaries in the same country US companies can avail of this exemption for passive income flowing between them.
The companies then ensure that the company receiving the income is not subject to tax in the country of registration. In Ireland, this has been achieved by being non-resident; in Luxembourg it is achieved by being a hybrid entity such as a partnership with non-resident partners. The outcome is the same: an operating company subject to tax where it is based and a holding company not subject to tax or resident in a jurisdiction with no tax.
The Commission’s case rests on the royalty payment made by the operating company to the holding company for the rights to use intellectual property (that is developed by the parent in the US). Although the details in the press release are scant it looks like we can see how the €250 million tax bill arises.
Amazon’s operating company made €4 billion of royalty payments to the holding company. In turn the holding company made around €2.7 billion of cost-sharing payments to Amazon Inc. as its contribution to the R&D undertaken by the parent. That left an excess of around €1.3 billion in the holding company.
The Commission’s case seems to be that the holding company was not entitled to all of this €1.3 billion (as it has no substance) and therefore most of this income should have remained with the operating company and included in its taxable income. If the €1.3 billion was subject to Luxembourg’s corporate income tax of around 20 per cent it would give a tax liability of around €250 million. Municipal business taxes could increase that amount.
The 2003 ruling that set the royalty was done on a cost-plus basis (see recital 37 of the opening decision). Cost-plus arrangements are not unusual and there a number the Commission has sight of from Ireland. See recitals 385 to 395 of the Apple ruling. Concerns were raised about the inconsistencies between these.
In Amazon’s case in Luxembourg the margin used was around 5 per cent of the costs of the operating company with additional limits set to ensure that the profit was always between 0.45 and 0.55 per cent of revenue. Anyway, over the years in question (2006 to 2014) this resulted in the €4 billion of royalty payments to the holding company that held the license to Amazon’s IP for use in Europe.
The Commission have ruled that this basis for computing the taxable income of the operating company was wrong – or at least not in line with the Commission’s view of how the arm’s length principle, and the concept of the market economy operator in the Treaty, should operate to. But it is not clear what this view is.
Numerous times in the press conference Vestager made reference to the cost-sharing payment made by the holding company back to the parent in the US. She indicated that the amount of additional tax to be paid by the operating company in Luxembourg depends on the cost-sharing payments made by the holding company. In her statement she said:
Furthermore, Amazon’s European profits depend on the level of payments due to Amazon in the US for the IP. This will be reflected when calculating the unpaid tax due in Luxembourg.
By that logic if the holding company had made €4 billion of cost-sharing payments rather than €2.7 billion then the additional tax would have been nil. This seems an odd way of looking at the tax due by a company which does not make these payments to the US but absent the full ruling it is what is implied by what Vestager said yesterday.
From the description above we note that the Commission have said “[t]he appropriate level of these payments has recently been determined by a US tax court.” Yesterday, the IRS announced that they would appeal the ruling of the US tax court and Vestager indicated that the final amount of tax due based on her ruling would depend on the outcome of that. In the question and answer session she said:
The court decisions in the US affect the final calculation of the profit to be taxed in Luxembourg but it is not for us to have a say in how they evaluate what should be paid for the use or development of the IP. This is not for us and we have not being looking into this. And this also means that the appeal of the US tax authorities doesn’t change the methodology that we have set up or how we have been looking into the case.
The thing is that almost nobody thinks the cost-sharing payments are “appropriate”. They might be those as required under US law but that in itself doesn’t make them right. Large profits accruing to holding companies with little or no substance was one of the primary issues that the OECD BEPS project was set up to address. The OECD have clearly stated that the profit should accrue to the activities that generate the profit. In the case of Amazon this would seem to be the R&D activities in the US not the inventory and invoice management undertaken in Luxembourg.
Unlike the Apple case Vestager did not make any comments about the structure used by Amazon or whether additional tax could be due in other (market) countries. She said:
On the question whether or not other tax authorities or national tax authorities should be looking into this I don’t think that it is a given. It wasn’t in the Apple case either but that were, sort of, more hooks in the decision to consider that. We don’t find that to be as obvious in this case. This is very much about European sales recorded in Luxembourg and therefore, sort of, the question about the royalty payment and what should then be taxed in Luxembourg from the profits earned.
This time her concern was limited to the profit attributed to the activities in Luxembourg. Per the OECD approach the correct attribution of Amazon’s profit requires an adjustment of the payment made from the holding company to the parent company rather than adjusting the payments from the operating company to the holding company as Vestager has suggested. But this is not straightforward.
Obviously, most of the focus is drawn to the payments that relate to successful R&D activities, i.e. those that result in large profits, but many arrangements will not lead to large profits. A profit-split based on the proportion of the profit generated by the activities undertaken seems like an attractive alternative and a holding company with no substance would only be entitled to a small share of the profits but costs must be covered even if profits aren’t generated.
Many of the most successful cost-sharing arrangements have their operating bases outside the US in Ireland. As a result Ireland is the origin of huge amounts of royalty payments. Since 2010 these have summed to over €300 billion with €72 billion of outbound royalty payments made last year. We are already seeing the end of this through the onshoring of IP with companies aligning their profits with the substance they have in Ireland. The application of the OECD’s 2016 transfer pricing guidelines would likely disallow such payments.
But the state-aid cases are historic in nature and it may be the view of the Commission that such payments should never have been allowed. We don’t know how much of the royalty payments that have originated from Ireland relate to holding company subsidiaries of US MNCs but it is likely to be a large amount. Nor do we know how much is paid on by the holding companies to the parents as the contributions under the cost-sharing arrangements.
One of the unusual things about Amazon is that it spends a huge amount of its gross margin on R&D. Amazon spends around one-third of its gross margin on R&D which is double the rate of Google, Apple and Facebook. For these companies we can expect the cost-sharing payments to be a lower proportion of the profit accruing to the holding companies.
At this stage it is not clear where all this is going. Maybe all we have had so far is a few foreshocks. What we really need is for some of these cases to come before the courts so that the Commission’s approach to transfer pricing can be adjudicated on. If decisions like the Amazon one are upheld then we really could end up anywhere. If the decisions are overturned then maybe this will peter out. New rules are being written but for the time being we can’t be sure what the old ones were.