Introduction
In the landmark cases on turnover taxes implemented by Hungary and Poland, the Court of Justice censured the European Commission for defining its own hypothetical reference tax system that was different from the relevant tax provisions in those two countries.
The Court again faulted the Commission in its more recent judgments on advance tax rulings. Given the discretion of Member States to design their tax systems, the Commission must interpret national tax provisions in accordance to the national tax case law and administrative practice. On 5 December 2023, in joined cases C-451/21 P and C-454/21 P, Luxembourg & Engie v European Commission, the Court of Justice annulled the corresponding Commission decision primarily on the grounds that the Commission lumped together distinct provisions to make up the reference tax system, even though the Luxembourg authorities applied them individually, not jointly. The significance of the judgment is also indicated by the fact that it was delivered by the grand chamber of the Court.
Luxembourg and Engie appealed against the judgment of the General Court in joined cases T-516/18, Luxembourg v European Commission, and T-525/18, Engie v European Commission, by which the General Court dismissed their actions for annulment of Commission decision 2019/421. In that decision the Commission had found that Luxembourg had granted incompatible State aid to Engie.
Engie is a French group of energy companies that also owns a number of holding and subsidiaries incorporated in Luxembourg. The Luxembourg tax authorities issued a number of tax rulings to Engie concerning transactions between the Luxembourg-based holding companies and subsidiaries.
In most tax jurisdictions the cost of debt – i.e. interest – is deducted from the tax liability of the borrower. So, it is the lender that pays tax on interest it earns. By contrast, in most tax jurisdictions the cost of capital is treated differently. The company that distributes profit in dividends pays tax while the dividends received by the shareholders are free of tax. But they pay tax on capital gains when they sell their shareholdings. The Engie group of companies
devised an ingenuous arrangement by which neither the borrower, nor the lender or investor paid any tax, apart from the small percentage determined in the advance tax rulings.
The typical transaction can be described as follows. A company in the Engie group would sell assets to a subsidiary company. In order to finance that purchase, the subsidiary would issue to an intermediary company, also owned by Engie, a bond for a term of 15 years that would be mandatorily converted into shares at maturity. That bond did not pay interest to the intermediary. The conversion would take into account the performance, either positive or negative, of the subsidiary, during the term of that bond. This type of contract was known as a zéro-intérêts obligation remboursable en actions (zero-interest bond repayable in shares (ZORA)). When the bond would mature, the subsidiary would repay the intermediary, by issuing shares of value equivalent to the nominal amount of the bond plus a premium consisting of all the profit made by the subsidiary during the term of the bond. This was referred to as ZORA accretion. However, the amount of the premium would be reduced by the amount resulting from the application of the percentage corresponding to the taxation agreed with the Luxembourg tax authorities. If the subsidiary would make a loss in a financial year, that loss would be taken into account in the same way, reducing the profit for the purpose of calculating the final amount of the premium. This was referred to as ZORA reduction.
In order to finance the bond that it acquired, the intermediary would use a prepaid forward sale contract entered into with an Engie holding company, which was the sole shareholder of both the subsidiary and the intermediary. The holding company would pay to the intermediary an amount corresponding to the nominal amount of the ZORA. In return, the intermediary transferred to the holding company the rights to the shares that would be issued at the end of the ZORA, including the cumulative value of the ZORA accretions.
In the tax rulings, the Luxembourg authorities defined the tax to be paid by the subsidiary as a percentage or margin on its asset. The ZORA accretions were considered to be tax deductible expenses (like interest on loans) and they were paid gross to the intermediary when the bond was converted to shares. Under the Luxembourg tax law, capital gains were tax exempted between parent and subsidiary companies (in compliance with the EU parent-subsidiary directive). Therefore, when the shares acquired by the intermediary were transferred to the holding company, the holding company did not pay tax either.
The Commission considered that the tax rulings conferred a selective advantage to the Engie group, regarded as a single economic unit, because almost all of the profit made by the Engie subsidiaries in Luxembourg had not actually been taxed. The ZORA accretions had not been taxed at the level of the subsidiaries, at the level of intermediaries or at the level of holding companies, with subsidiaries paying only tax for which the basis of assessment was a limited margin agreed with the Luxembourg tax authorities.
The Commission held that the tax rulings conferred a selective advantage not only because they deviated from the reference tax system but also because Luxembourg failed to apply its own tax anti-avoidance rules. This was the first case where the Commission found that the non-enforcement of tax anti-avoidance rules had conferred a selective advantage.
The General Court upheld the analysis and conclusions of the Commission decision.
The discretion of Member States and the obligations of the Commission
After finding that the appellants had standing, the Court of Justice turned its attention to the substantive arguments of the parties.
First, the Court reiterated that well-established principle that “(104) action by Member States in areas that are not subject to harmonisation by EU law is not excluded from the scope of the provisions of the FEU Treaty on monitoring State aid. The Member States must thus refrain from adopting any tax measure liable to constitute State aid that is incompatible with the internal market”.
The Court also repeated its standard approach to establishing whether a measure is selective. “(106) So far as concerns the condition relating to selective advantage, it requires a determination as to whether, under a particular legal regime, the national measure at issue is such as to favour ‘certain undertakings or the production of certain goods’ over other undertakings which, in the light of the objective pursued by that regime, are in a comparable factual and legal situation and which accordingly suffer different treatment that can, in essence, be classified as discriminatory”.
“(107) In order to classify a national tax measure as ‘selective’, the Commission must begin by identifying the reference system, that is the ‘normal’ tax system applicable in the Member State concerned, and demonstrate, as a second step, that the tax measure at issue is a derogation from that reference system, in so far as it differentiates between operators who, in the light of the objective pursued by that system, are in a comparable factual and legal situation. The concept of ‘State aid’ does not, however, cover measures that differentiate between undertakings which, in the light of the objective pursued by the legal regime concerned, are in a comparable factual and legal situation, and are, therefore, a priori selective, where the Member State concerned is able to demonstrate, as a third step, that that differentiation is justified, in the sense that it flows from the nature or general structure of the system of which those measures form part”.
“(109) Thus, determination of the set of undertakings which are in a comparable factual and legal situation depends on the prior definition of the legal regime in the light of whose objective it is necessary, where applicable, to examine whether the factual and legal situation of the undertakings favoured by the measure in question is comparable with that of those which are not”.
“(110) For the purposes of assessing the selective nature of a tax measure, it is, therefore, necessary that the common tax regime or the reference system applicable in the Member State concerned be correctly identified in the Commission decision and examined by the court hearing a dispute concerning that identification. Since the determination of the reference system constitutes the starting point for the comparative examination to be carried out in the context of the assessment of selectivity, an error made in that determination necessarily vitiates the whole of the analysis of the condition relating to selectivity”.
The Commission may not construct a reference system according to its own preferences. This is because “(111) the determination of the reference framework, […], must follow from an objective examination of the content, the structure and the specific effects of the applicable rules under the national law of that State”.
In this connection, the Commission must respect the preferences of Member States because, “(112) outside the spheres in which EU tax law has been harmonised, it is the Member State concerned which determines, by exercising its own competence in the matter of direct taxation and with due regard for its fiscal autonomy, the characteristics constituting the tax, which define, in principle, the reference system or the ‘normal’ tax regime, from which it is necessary to analyse the condition relating to selectivity. This includes, in particular, the determination of the basis of assessment, the taxable event and any exemptions to which the tax is subject”.
“(113) It follows that only the national law applicable in the Member State concerned must be taken into account in order to identify the reference system for direct taxation, that identification being itself an essential prerequisite for assessing not only the existence of an advantage, but also whether it is selective in nature”.
On the basis of the above principles, the Court of Justice proceeded to examine whether the Commission committed any errors in the determination of the reference framework.
Was the non-taxation at the level of the holding company dependent on taxation at the level of the subsidiary?
The two appellants argued that the Commission and the General Court lumped together two distinct provisions of the Luxembourg tax law: The tax deductibility of debt costs (at the level of the subsidiary) and the tax exemption of capital gains (at the level of the holding company).
The Court, first, recalled that “(115) in order to determine what, under Luxembourg law, normal taxation should have been and, therefore, whether there was a selective advantage in favour of the Engie group, the Commission, […], interpreted Luxembourg law on the basis, inter alia, of the assertion that the general corporate income tax system in Luxembourg, providing for the principle of taxation of corporate income, did not permit, in the case of the Engie group, the exemption of income from participations at the level of the holding companies […] and […] that law precluded the concurrent application of an exemption of that income at the level of those holding companies and a deduction of the corresponding sums at the level of the subsidiaries.”
“(120) It follows that, when determining the reference framework for the purpose of applying Article 107(1) TFEU to tax measures, the Commission is in principle required to accept the interpretation of the relevant provisions of national law given by the Member State concerned […], provided that that interpretation is compatible with the wording of those provisions.”
“(121) The Commission may depart from that interpretation only if it is able to establish, on the basis of reliable and consistent evidence that has been the subject of that exchange of
arguments, that another interpretation prevails in the case-law or the administrative practice of that Member State.”
In other words, the Court seems to be saying here that the Commission’s own interpretation is irrelevant as long as the interpretation of national authorities conforms with the national case law. However, it is unclear whose interpretation prevails if there is no national case law on a particular issue.
Then the Court of Justice noted that “(124) the General Court […] departed from a literal interpretation of [the relevant Luxembourg tax] provisions. Confirming the Commission’s approach, the General Court first considered that the exemption of a holding company’s income from participations could be contemplated under Luxembourg law only if the income distributed by its subsidiary had been taxed beforehand.”
“(125) The General Court referred to the 1965 opinion of the Council of State on the bill incorporating Article 166 into the LIR, in which it stated that that provision made it possible, ‘for reasons of fiscal equity and economic order’, to avoid double or triple taxation of distributed income, but not, in essence, to avoid the complete non-taxation of that income.”
“(126) The General Court then found that it was necessary to abandon the formalistic approach consisting of taking in isolation each of the transactions comprising the financial arrangement drawn up by the companies concerned and to go beyond the legal form in order to understand the economic and fiscal reality of that arrangement, which led it to hold, […], that the ZORA accretions corresponded, in practical terms, ‘in the very specific circumstances of the present case, to profit distributions’.”
“(127) Thus, after recalling, […], the existence of a link, in Luxembourg law, between the exemption of income from participations at the level of a parent company and the deductibility of distributed income at the level of its subsidiary, the General Court concluded, […], that, ‘on account of that link and the consideration of the combined effect of those two transactions at the level of the holding companies concerned, the tax rulings at issue [derogated] from the […] reference framework’ […]. It followed, according to the General Court’s analysis […], first, that the Commission was fully entitled to infer from that combined effect, […], that there was a derogation from that reference framework and, second, that that institution had not erred in law by looking at the combined effect, at the level of the holding companies, of the deductibility of income at the level of a subsidiary and the subsequent exemption of that income at the level of its parent company.”
“(128) However, the elements on which the General Court relied, […], did not permit it validly to find that […] the Commission had been able to establish to the requisite legal standard that, with regard to whether the exemption provided for [in the relevant Luxembourg law] is made dependent on the taxation, at the level of the subsidiary companies, of the income exempted at the level of the holding companies, an interpretation prevailed in Luxembourg law other than that put forward by the Grand Duchy of Luxembourg, that interpretation being compatible with the wording of that provision, which does not formally establish such dependence.”
Therefore, the Court of Justice upheld the plea of the appellants.
The application of the Luxembourg tax anti-avoidance rules
The Commission had concluded in its decision that the tax rulings were selective also because Luxembourg failed to apply its own anti-avoidance rules. The appellants counter-argued that the General Court erred in finding that the Commission could establish the selective nature of the tax rulings without taking into account the national administrative practice.
The Court of Justice, first, recalled that “(152) classifying a tax measure as ‘selective’ presupposes not only familiarity with the content of the provisions of relevant law but also requires examination of their scope on the basis, inter alia, of the administrative and judicial practice of the Member State concerned”.
“(153) In the second place, […], a provision intended to prevent abuse in tax matters horizontally, […], is inherently particularly general in nature, and may be applied in a very wide range of contexts and situations.”
“(154) The choice to lay down such [an anti-abuse] provision in national law and to define the manner in which the tax authorities are to implement it falls within the Member States’ own competence in the matter of direct taxation in areas that have not been harmonised under EU law and, therefore, within their fiscal autonomy.”
“(155) In view of the nature of an anti-abuse provision […], the Commission could not conclude that the non-application of that provision by the tax authorities in order to refuse the tax treatment sought by a taxpayer in a tax ruling request led to the grant of a selective advantage unless that non-application departs from the national case-law or administrative practice relating to that provision. If that were not the case, the Commission would itself be able to define what does or does not constitute a correct application of such a provision, which would exceed the limits of the powers conferred on it by the Treaties in the field of State aid review and would be incompatible with the fiscal autonomy of the Member States”.
“(156) It follows that the General Court erred in law when it held, […], that the Commission was not required to take into account the administrative practice of the Luxembourg tax authorities […], on the ground that that provision did not give rise to any difficulties of interpretation.”
“(158) The Commission confined itself, […], to a general examination of the conditions for the application of [the anti-abuse rules], without establishing that, in the tax rulings at issue, the Luxembourg tax authorities had departed, in particular, from their own practice concerning transactions comparable to those at issue.”
On the basis of the above reasoning, the Court of Justice annulled the judgment of the General Court and proceeded to give itself final judgment in the matter without returning the case to the General Court.
Final judgment
Given its earlier findings, the Court of Justice focused on the second line of reasoning of the Commission concerning the selectivity of the tax rulings. As may be recalled, the first line was based on the premise that the tax exemption at the level of the holding company applied only when the distributed amount had already been taxed. The second line relied on the interpretation of whether what the holding company, as the sole shareholder, received was income or capital. The Commission, after finding that the concept of income from participations was not defined in the relevant Luxembourg law, it concluded that the receipts of the holding company had to be taxed irrespective of whether they could be classified as income from profits or as capital gains.
In addition, the Commission held the view that from an economic perspective, income received from the conversion of the ZORAs was equivalent to a profit distribution. However, since that distribution was not taxed at the level of the distributing companies, the Commission concluded that there was a derogation from a reference framework comprising the rules of Luxembourg law on the exemption of income from participations and the taxation of profit distributions. In other words, in the case at hand, the Commission inferred the existence of a derogation from the fact that the Luxembourg tax authorities, by means of the tax rulings at issue, accepted that the realisation of the ZORA accretions at the level of the holding companies could benefit from the exemption of income from participations, even though those accretions had been deducted from the taxable profit of the subsidiaries.
The Court of Justice again faulted the Commission on the ground that the Commission constructed its own interpretation of the Luxembourg tax law, even though that interpretation had no foundation in Luxembourg’s case law or administrative practice.
It therefore annulled Commission decision 2019/421.
