On Monday (6th June, 2016), the European Commission published the non-confidential version of its decision to open a State-Aid investigation into the Luxembourg tax arrangements of McDonald’s (see link below):
When a PE is not a PE
The case makes for a very interesting read and should send a chill down the back of all advisors and clients who have take advantage of double tax treaties to claim a PE tax relief in one jurisdiction despite knowing that the income would never be taxed (i.e. no PE in fact) in the foreign tax jurisdiction.
1) The investigation concerns two tax rulings issued by the Luxembourg tax administration in 2009 in favour of McD Europe.
2) McD Europe has two branches: i) US (hereinafter: the “US Franchise Branch”) and ii) Switzerland (hereinafter: the “Swiss Service Branch”).
3) McD Europe acquired beneficial ownership of a number of franchise rights intangibles and subsequently, McD allocated the franchise rights/obligations to its US Franchise Branch.
4) Swiss Service Branch received royalty income from various European Master Franchisors. This royalty income was then paid to the US Franchise Branch (costs associated with the services provided = reduction of the royalties paid by the Swiss Service Branch. N.B. Swiss service income was taxed in Switzerland).
5) Since the Swiss Service Branch and the US Franchise Branch are part of the same legal entity, McD Europe’s consolidated accounts/financial statements included both of those branches.
6) According to McDonald’s tax advisor, McD Europe should be considered as tax resident in Luxembourg pursuant to Article 159(1) of the L.I.R.
7) McD Europe is thus fully liable for corporate income tax in Luxembourg. However, as a Luxembourg tax resident, McD Europe also benefits from all of the provisions of any double tax treaty concluded by Luxembourg.
8) Furthermore, according to the tax advisor, by virtue of Article 5 of the Luxembourg–US DTT, the activities of US Franchise Branch will be considered to be performed in the United States. Consequently, the profits generated by the US Franchise Branch will only be subject to possible taxation in the United States and exempt from corporate income tax in Luxembourg by virtue of Articles 7 and 25 of the Luxembourg–US DTT.
9) Similarly, according to the tax advisor the activities performed by the Swiss Service Branch, i.e. the sub-licensing of the franchise rights to the Master Franchisors, are considered to be performed in Switzerland by virtue of Article 5 of the Luxembourg- Switzerland DTT.21 As a consequence, the profits generated by the Swiss Service Branch will only be taxable in Switzerland and exempt from corporate income tax in Luxembourg by virtue of Articles 7 and 25 of the Luxembourg–Switzerland DTT.
10) In Ruling No. 1, the Luxembourg tax administration accepts that the profits of McD Europe that are imputable to those two branches are subject to tax in their respective countries and tax exempt in Luxembourg. The initial tax ruling subsequently concludes that “in order to benefit from these exemptions in Luxembourg, the company [McD Europe] must submit proof on a yearly basis that those profits have been declared and are subject to tax in Switzerland and the United States respectively”.
11) Tax Advisor and Client are not happy, since US Franchise Branch does not constitute a PE for US tax purposes and, therefore, ask for Ruling No. 2.
12) Tax Advisor points out that Luxembourg–US DTT exempts from Luxembourg corporate income tax income that “may be taxed in the United States”, there is “no reference that effective taxation should occur.”
13) Tax Advisor outlines case under which the PE is a PE for Luxembourg tax purposes but not a PE for US purposes.
14) Luxembourg Tax Authorities Agree! Yes, they sign-off on this interpretation, knowing that that the said profits will not be taxed in Luxembourg or US.
15) The European Commission sees this as a sort of "burger without a bun".
16) The European Commission effectively jumps all over this. In short they trump the "game of semantics" advanced by the tax advisor and tackle the "may be taxed" point head-on.
17) In the case of McD Europe, the profits attributed to the US Franchise Branch cannot be taxed in the United States. Since the US Franchise Branch does not constitute a permanent establishment for US tax purposes, the United States cannot tax any income attributed to that branch. In other words, there is no possibility that those profits "may be taxed" by the United States within the meaning of Article 25(2) of the DTT.
18) In short, the Tax advisor's interpretation of the Luxembourg–US DTT seems neither faithful to the wording of its provisions nor their objective.
19) Hence, under the granting of Ruling No. 2, the European Commission sees a clear case of State Aid by Luxembourg.