69 Am. U. L. Rev. 479 (2019).

* Edwin S. Cohen Distinguished Professor of Law and Taxation, University of Virginia School of Law. This Article was written in part while the author was professor in residence at the International Bureau of Fiscal Documentation, Amsterdam. The author thanks Reuven Avi-Yonah, John Brooks, Quinn Curtis, John Duffy, Lilian Faulhaber, Josh Fischman, Jens Frankenreiter, Brian Galle, Sriram Govind, Werner Haslehner, Andrew Hayashi, Georg Kofler, Sarah Lawsky, David Lenter, Mitchell Kane, Rebecca Kysar, Michael Livermore, Helena Malikova, Tarcísio Magalhães, Omri Marian, Tom Nachbar, Lee Osofsky, Fadi Shaheen, Dan Shaviro, Paul Stephan, Bret Wells, and workshop participants at Boston College, BYU, Fordham, the IBFD, Luxembourg University, the Max Planck Institute for Tax Law and Public Finance, Northwestern University, Georgetown University, University of Houston, University of Pennsylvania, University of Virginia, and Vienna University of Economics and Business Administration. I owe special thanks to Michael Knoll and Wolfgang Schön for reading multiple drafts. Librarians at the UVA Law Library, especially Xinh Luu, provided excellent research support, as did my research assistants, Justin Aimonetti, Emily Ostertag, and Griffin Peeples. This Article benefitted from discussions with tax practitioners and Commission officials; it represents only my own views. © 2019, Ruth Mason, all rights reserved.

This Article argues that current methods for identifying illegal tax subsidies trigger the well-known conceptual difficulties of tax-expenditure analysis. To avoid these problems—particularly the irresolvable conflict over the correct baseline for measuring tax expenditures and tax subsidies—this Article advocates the “internal consistency test” as a superior method for identifying illegal subsidies. Developed by the U.S. Supreme Court to evaluate the compatibility of state taxes with the dormant Commerce Clause, the internal consistency test easily can be adapted to the subsidy context.


In 2016, the European Commission dropped a bombshell—it ordered the U.S. technology giant Apple to repay Ireland subsidies of $14.5 billion, plus interest. The Commission’s decision enforced the prohibition on state aid found in the Treaty on the Functioning of the European Union (TFEU). The state-aid rules prevent European Union (EU) Member States from distorting market competition by granting subsidies that are protectionist or that operate as import or export subsidies.1Commission Notice on the Notion of State Aid, art. 5, 2016 O.J. (C 262) 1, 27–40 [hereinafter 2016 Notice] (describing state aid); Consolidated Version of the Treaty on the Functioning of the European Union of Dec. 13, 2007, art. 107(1), 2012 O.J. (C 326) 47, 91 [hereinafter TFEU] (prohibiting state aid). The Commission found that Ireland illegally subsidized Apple by allowing it to pay too little Irish tax.2Commission Decision 2017/1283 of Aug. 30, 2016, On State Aid Implemented by Ireland to Apple, 2017 O.J. (L 187) 1, 109 (EU) [hereinafter Apple].

This Article uses controversy over Apple3Id. and other recent EU state-aid cases to explore a defect common to many anti-subsidy regimes that limit states’ ability to use subsidies to interfere with private competition, including World Trade Organization (WTO) rules, soft-law agreements, and even the U.S. Constitution. Each regime applies not only to cash subsidies and regulation but also to taxation.4See, e.g., Dan T. Coenen & Walter Hellerstein, Suspect Linkage: The Interplay of State Taxing and Spending Measures in the Application of Constitutional Antidiscrimination Rules, 95 Mich. L. Rev. 2167, 2169 (1997) (discussing dormant Commerce Clause); Lilian V. Faulhaber, The Trouble with Tax Competition: From Practice to Theory, 71 Tax L. Rev.311, 330 n.99 (2018) (discussing international soft law); Ruth Mason, Common Markets, Common Tax Problems, 8 Fla. Tax Rev. 599, 624–28 (2007) (comparing treatment of discriminatory taxes and subsidies under U.S. and EU law); John O. McGinnis & Mark L. Movsesian, The World Trade Constitution, 114 Harv. L. Rev. 511, 546 n.203 (2000) (discussing WTO). Anti-subsidy regimes typically rely on tax-expenditure analysis to identify subsidies delivered through the tax law or tax administration.5Stanley Surrey introduced the tax-expenditure concept to the United States. Stanley S. Surrey, Pathways to Tax Reform: The Concept of Tax Expenditures (1973); Stanley S. Surrey & Paul R. McDaniel, Tax Expenditures (1985). Under this approach, a state confers a tax subsidy when it deviates from its own generally applicable domestic law or procedure to reduce taxes for particular enterprises, such as exporters or multinationals. Special tax reductions could take the form of reduced tax rates, tax deductions, tax credits, or the like. This tax-expenditure approach to identifying subsidies works well when both the domestic law baseline and the “special” or deviating provisions are readily identifiable.

But this Article argues that the approach becomes intractable when the subsidy reviewer and the accused state disagree over how to define the baseline from which tax expenditures (and therefore illegal subsidies) can be measured. This baseline problem is familiar to the tax-expenditure debate, and despite the enormous importance of the tax-expenditure concept to tax policy analysis, fifty years of study has brought little progress in finding a neutral tax baseline against which tax expenditures can be judged.6See, e.g., Staff of J. Comm. on Taxation, 110th Cong., A Reconsideration of Tax Expenditure Analysis (Comm. Print 2008) [hereinafter 2008 JCT Report] (reviewing “seemingly endless debates about what should and should not be included in the ‘normal’ tax base” and reviewing various academic attempts to resolve the issue).

As just one example, tax-expenditure analysis fails in cases involving “structural” tax rules.7See infra Section II.A. Structural rules are the background rules of the tax system, including the taxable unit, the accounting period, progressive tax rates, and the like. Under a tax-expenditure approach that relies exclusively on domestic law to formulate the baseline, the subsidy adjudicator would incorporate all structural rules into the baseline with the result that no structural rules would be regarded as tax expenditures, and, therefore, no structural rules would be regarded as conferring illegal subsidies. But an approach that regards all structural rules as permissible, no matter their actual effects on cross-border commerce, is underinclusive.8Structural provisions can convey tax benefits. See, e.g., 2008 JCT Report, supra note 6, at 10 (giving deferral of tax on foreign income and the debt-equity distinction as examples of structural rules that “materially affect economic decisions”). For more examples, see infra Section IV. At the same time, however, it is unclear how a subsidy adjudicator ought to handle structural rules under tax-expenditure analysis if such rules will not be automatically incorporated into the reference base.

This Article argues that the Commission’s need to evaluate tax provisions that were not easily cognizable under traditional tax-expenditure analysis—including structural rules—led it to adopt a new approach to identifying illegal subsidies in recent cases. Instead of evaluating Member State tax rules against a baseline consisting of the challenged state’s own generally applicable tax law, the Commission began to evaluate Member State tax rules against external norms.9See, e.g., Apple, supra note 2, ¶ 441. In some cases, the Commission used an internationally accepted norm; in others, the Commission judged Member State taxes against its own view of good tax policy.

Failure to adequately explain its departure from the reference-law approach left the Commission vulnerable to criticism that it exceeded its institutional authority. Member States officials—especially those from the small states targeted for state-aid review—argued that judging national tax rules by reference to external benchmarks threatened tax diversity in the European Union and invaded the reserved tax powers of the Member States.10See, e.g., Advisory Bd., Fed. Ministry of Fin., Tax Benefits and EU State Aid Control: The Problem of and Approaches to Resolving the Conflict of Jurisdiction with Fiscal Autonomy 5, 10 (2017) (Ger.) (report, prepared by academics for the German finance ministry, complaining of incursion by the Commission into reserved state tax powers); Kelyn Bacon, European Union Law of State Aid 5 (2017) (“State aid is being used partly as a tool to incentivise tax harmonisation.”). Under long-standing interpretations of the TFEU, states are free to have tax laws that differ from each other, as long as they avoid tax rules that function equivalently to tariffs and import/export subsidies.11See infra Section I.A. The TFEU, therefore, does not completely eliminate tax competition, nor does it prevent so-called tax mismatches, cross-border tax advantages (and disadvantages) that arise from differences between states’ rules.12See infra Section I.A.

Perceptions that the Commission invaded the reserved powers of the states provoked sharp criticism in recent cases. For example, in the Amazon13Commission Decision 2017/6740 of Oct. 4, 2017 on State Aid Implemented by Luxembourg to Amazon, 2018 O.J. (L 153) 1 [hereinafter Amazon]. state-aid case, Luxembourg accused the Commission of engaging in “covert fiscal harmonisation . . . thereby infringing the exclusive competence of the Member States in . . . taxation.”14See, e.g., Case T-816/17, Luxembourg v. Comm’n, 2018 O.J. (C 72) 38, ¶ 14. Similarly, the Irish government appealedApple to defend against “the encroachment of EU state aid rules into the sovereign Member State competence of taxation.”15Irish Department of Finance, Explanatory Memorandum for the Members of the Oireachtas Dáil Debate of Government Motion on the Apple State Aid Case, 13 (Sept. 7 2016). Officials from the United Kingdom have been particularly sharp in their criticism. Campbell Bannerman, a U.K. member of European Parliament, called Apple an “EU power grab” and a “tax trespass,” while his fellow member Steven Woolfe called it “an attack on the tax sovereignty of EU nation states by the back door.”16J.P. Finet, Apple Ruling Is EU Power Grab, U.K. and Irish Lawmakers Say, 83 Tax Notes Int’l 1019, 1019–20 (2016) (quoting pre-Brexit-vote EU parliamentary debates). Some commentators even connected Brexit directly to the Commission’s Apple decision.17Max Bearak, How the E.U.’s Ruling on Apple Explains Why Brexit Happened, Wash. Post (Aug. 30, 2016), https://www.washingtonpost.com/news/worldviews/wp/2016/08/30/how-the-e-u-s-ruling-on-apple-explains-why-brexit-happened. Because many of the recent cases involved U.S. multinationals, U.S. lawmakers also weighed in to complain about the Commission’s arrogation of power.18The Senate Finance Committee complained that the Commission was “using State aid . . . to achieve a ‘reform agenda.’” Letter from U.S. S. Comm. on Fin. to Jacob Lew, U.S. Sec’y of the Treasury, U.S. Dep’t of the Treasury 1 (May 23, 2016), https://www.finance.senate.gov/imo/media/doc/Hatch,%20Wyden,%20Portman,%20Schumer%20Continue%20Push%20for%20Fairness%20in%20EU%20State%20Aid%20Investigations.pdf [https://perma.cc/E46Z-QRGW]; Alexander Lewis, Apple’s Income Should Be Taxed in U.S., Not Ireland, Lew Says, 83 Tax Notes Int’l 862, 862 (2016) (quoting Department of the Treasury Secretary Jack Lew as asserting that the Commission was “overrid[ing] national tax law authority”); U.S. Dep’t of the Treasury, The European Commission’s Recent State Aid Investigations of Transfer Pricing Rulings, at 1 (2016) (arguing that the Commission applied EU law too broadly in the state-aid cases).

Academic critics argue that the Commission is using state aid to mandate “single taxation,” an aspirational tax policy goal that ensures taxation of one hundred percent of a multinational’s global income.19See Reuven S. Avi-Yonah, Advanced Introduction to International Tax Law 59–65 (2015) (giving history of the single-tax principle); Daniël S. Smit, Recovery of Fiscal State Aid: Always Somewhere?, Kluwer Int’l Tax Blog (Oct. 3, 2016), https://kluwertaxblog.com/2016/10/03/recovery-of-fiscal-state-aid-always-somewhere [https://perma.cc/3GN5-Y9DT] (characterizing the Commission’s Apple decision as holding Ireland “responsible to ensure single taxation”). Typically, critics of the recent cases make both the harmonization and the single-tax claim; these claims are closely related. See supra note 10 and accompanying text. Not all commentators who regard the Commission as enforcing single taxation oppose this interpretation. See, e.g., Pierpaolo Rossi-Maccanico, Fiscal State Aids, Tax Base Erosion and Profit Shifting, 24 EC Tax Rev. 63 (2015). Controversial comments by Commissioner of Competition Vestager on the recent U.S. cases lent credence to fears that the Commission interpreted state aid to mandate single taxation. Margrethe Vestager, Comm’r, European Comm’n, Speech to EU Parliament TAXE 2 Committee 2 (Apr. 4, 2016), https://www.europarl.europa.eu/cmsdata/99649/Vestager_Speaking%20Points%20TAXE%204%20April%20NEW.pdf [https://perma.cc/2DQC-5U9M] [hereinafter Commissioner Vestager Speech to TAXE] (lamenting the “loophole” that opens when a state’s allocation rules result in untaxed profits). Single taxation may seem like a worthy—even uncontroversial—goal, and countries increasingly coordinate their laws to promote single taxation.20See infra Section V.B. But the idea that all of a multinational’s income must be subject to taxation is fundamentally inconsistent with the notion that each state’s definition of income may differ from that of its neighbors. Thus, single taxation and state tax autonomy are incompatible. In the absence of international harmonization, tax mismatches will lead inevitably to tax gaps (and overlaps). In contrast with these criticisms, this Article suggests that, rather than a blatant power grab or an attempt to impose single taxation, the Commission’s use of external benchmarks in recent cases represents a response to the deficiencies of tax-expenditure analysis as a methodology for identifying tax subsidies.

Regardless of how it ended up there, the Commission now finds itself in a double bind. Benchmarking tax subsidies exclusively by reference to domestic law is underinclusive; for example, it regards structural rules as incapable of conveying state aid, regardless of their actual effects on cross-border commerce. But benchmarking by norms replaces policy preferences enacted by elected representatives with the policy preferences of the unelected Commission. Furthermore, because it mistakes mismatches for state aid, benchmarking by norms is overinclusive.

This Article offers an escape from the double bind of tax-expenditure analysis. The European Commission and other subsidy adjudicators could use the U.S. Supreme Court’s internal consistency test to review tax laws. The Supreme Court developed the internal consistency test to analyze dormant Commerce Clause challenges to state tax rules, including structural provisions.21See Ruth Mason, Made in America for European Tax: The Internal Consistency Test, 49 B.C. L. Rev. 1277 (2008) (arguing that the test could be used in fundamental freedoms cases). Under the test, the Supreme Court assumes all states apply the challenged state’s law.22Id. at 1283 (citing Okla. Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 185 (1995)). If cross-border tax disadvantages persist despite hypothetical harmonization, they unconstitutionally discriminate against cross-border commerce.

The internal consistency test easily can be adapted for subsidy analysis by looking for cross-border tax advantages rather than disadvantages. The test offers several benefits compared to tax-expenditure analysis. First, the assumption embedded in the test—that all states apply the challenged state’s rule—has the effect of hypothetically harmonizing Member State tax laws. As a result, if the cross-border tax advantage disappears under the harmony assumption, the Commission can safely conclude that it arose from a tax mismatch, not from discriminatory subsidization by a single state. By preventing the Commission from mistaking tax mismatches for state aid, internal consistency could help the Commission avoid false positives.

Second, economic analysis has shown that the second step of the internal consistency test, which considers the impact on cross-border commerce of the harmonized rule, reveals whether the challenged rule functions equivalently to a tariff or an import or export subsidy.23Internal consistency correctly identifies tax measures with effects equivalent to import and export subsidies and tariffs. Brief of Michael S. Knoll & Ruth Mason as Amici Curiae in Support of Respondents at 9–24, Comptroller of Treasury v. Wynne, 135 S. Ct. 1787 (2015) (No. 13-485) [hereinafter Knoll & Mason Wynne Brief]; Brief of the Tax Economists as Amici Curiae in Support of Respondents at 23–27, Comptroller of Treasury v. Wynne, 135 S. Ct. 1787 (2015) (No. 13-485) [hereinafter Tax Economists’ Wynne Brief]; see Michael S. Knoll & Ruth Mason, How the Massachusetts Supreme Judicial Court Should Apply Wynne, 78 St. Tax Notes 921 (2015) (explaining how to use the internal consistency test to evaluate allocation rules); Michael S. Knoll & Ruth Mason, The Economic Foundation of the Dormant Commerce Clause, 103 Va. L. Rev. 309 (2017); Ryan Lirette & Alan D. Viard, Putting the Commerce Back in the Dormant Commerce Clause: State Taxes, State Subsidies, and Commerce Neutrality, 24 J. Law & Pol’y 467 (2016). Because this is the precise effect the state aid rules aim to prohibit, internal consistency is a reliable test for state aid.

Third, internal consistency applies the same way to every tax rule—structural or non-structural. By dispensing with the need to identify a baseline—be it the state’s own “normally” applicable law or an external norm—internal consistency completely avoids a major area of dispute between the Commission and the Member States.

Part I briefly explores EU law, emphasizing the goals of state-aid enforcement. Part II presents the Commission’s traditional tax-expenditure approach to identifying state aid, which relies on a domestic-law reference benchmark. Using recent examples, Part III presents the double bind of tax-expenditure analysis: benchmarking by reference law causes the Commission to err, but benchmarking by norms invades the reserved powers of the states. Part III also explains the types of cases that the traditional approach fails to address and argues that these failures drove the Commission to adopt external norms in recent cases. Finally, Part III presents arguments against benchmarking by external norms, including that it is unpredictable and illegitimate. Part IV advocates the internal consistency test as an alternative to tax-expenditure analysis, and it details the advantages of internal consistency over tax-expenditure analysis in identifying illegal subsidies. In addition, Part IV discusses the limits of the internal consistency approach, including that it would leave the European Union more vulnerable to tax competition from mismatches than would evaluating Member State rules against external norms. Tax mismatches—including differences in tax rates, definitions of tax residence, definitions of debt and equity, and rules for allocating income from cross-border transactions—present classic tax arbitrage opportunities. Such mismatches may seem undesirable, but the EU Treaties do not forbid them. Part V considers legislative options for ameliorating tax competition in the European Union.

I.   Balancing Regulatory and Market Competition in State Aid

The prohibition of state aid has appeared—nearly unaltered—in every EU treaty since the Treaty of Rome in 1958, and it applies to all areas, not just tax.24See Claire Micheau, State Aid, Subsidy and Tax Incentives under EU and WTO Law 57 (2014) (detailing the stability of the language and noting that alterations to the text merely changed the word “Community” to “Union”). Article 107 of the Treaty on the Functioning of the European Union (TFEU) prohibits state aid in the European Union:

Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.25TFEU, supra note 1.

The TFEU obliges the Commission to monitor state aid and ensure abolition of incompatible aid.26Id. art. 108. This Part briefly describes the prohibition of state aid and its enforcement by the Commission.

A.   State-Aid Goals and Limits

The Member States of the European Union retain significant tax powers under the TFEU. Because the European Union can legislate on taxes only by unanimous agreement of the Member States, taxes largely remain creatures of the Member States, and each state’s system differs from the others.27See id. art. 115 (requiring unanimity); id. art. 4 (“[C]ompetences not conferred upon the Union in the Treaties remain with the Member States.”). Despite the high bar of unanimity, the states have legislatively harmonized value-added taxes across the EU, as well as several aspects of corporate income taxation.28See, e.g., Council Directive 2006/112/EC of Nov. 28, 2006 on the Common System of Value Added Tax, 2006 O.J. (L 347) 1 (providing harmonized VAT rules); Council Directive 2011/96/EU of Nov. 30, 2011 on the Common System of Taxation Applicable in the Case of Parent Companies and Subsidiaries of Different Member States, 2011 O.J. (L 345) 8 (eliminating double taxation of cross-border direct dividends).

State aid and the fundamental freedoms are two doctrines that limit Member States’ retained tax powers. The prohibition of state aid forbids subsidies that treat cross-border and domestic commerce unjustifiably differently from each other; the fundamental freedoms forbid taxes that do so.29See generally Micheau, supra note 24 (state aid); Ruth Mason & Michael S. Knoll, Waiting for Perseus: A Sur-Reply to Graetz and Warren, 67 Tax L. Rev. 375 (2014) (fundamental freedoms and state aid); Ruth Mason & Michael S. Knoll, What is Tax Discrimination?, 121 Yale L.J. 1014 (2012) (fundamental freedoms). Together they guarantee the free movement across state borders of goods, people, business activity, services, and capital.30The fundamental freedoms permit freedom of movement of goods and productive factors across the EU. See TFEU, supra note 1, art. 26 (internal market); id. art. 28 (goods); id. art. 45 (workers); id. art. 49 (establishment); id. art. 56 (services); id. art. 63 (capital).

The state-aid prohibition prevents states from interfering with market competition by selecting winners—such as particular industries, large multinationals, or national champions—and conferring on them unfair advantages in the form of discriminatory subsidies. I direct the arguments in this Article to a particular aspect of the prohibition of state aid, namely, its function of promoting the free flow of commerce across the states. Commentators use different terms to refer to this value, including “competitive neutrality,” “commerce neutrality,” a “level playing field,” “capital ownership neutrality,” and “nondiscrimination.”31The Commission refers to the state-aid rules as “limiting distortions of competition, preserving a level playing field and combating protectionism.” Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions: EU State Aid Modernisation, ¶ 15, COM (2012) 209 final (May 8, 2012) [hereinafter Commission Communication on State Aid Modernisation]. Various formulations of this idea exist in the literature. Mihir A. Desai & James R. Hines Jr., Evaluating International Tax Reform, 56 Nat’l Tax J. 487, 487 (2003) (taxes are “capital ownership neutral[]” when they do not “distort the ownership of capital assets” and such neutrality “promotes global efficiency whenever the productivity of an investment differs based on its ownership”). To emphasize its connection to facilitating private competition and to make clear that it applies outside the capital-investment context, Michael Knoll and I adopted the term “competitive neutrality” to refer to this idea. Mason & Knoll (2012), supra note 29, at 1021 (“A tax law is competitively neutral when it does not distort the matching of owners with investments (or workers with jobs). Viewed in this way, a tax system is competitively neutral if it maintains a level tax playing field between resident and nonresident taxpayers.”). By using “competitive neutrality,” we also sought to avoid ambiguity. See Michael S. Knoll, Reconsidering International Tax Neutrality, 64 Tax L. Rev. 99, 110 n.47 (2011) (noting that economists refer to competitive neutrality as “capital ownership neutrality,” whereas tax policymakers refer to it as “capital import neutrality,” which is itself a term economists reserve for distortions of savings neutrality). Referring to competitive neutrality, Ryan Lirette and Alan Viard adopted the term “commerce neutrality” to emphasize the role of the concept in U.S. dormant Commerce Clause doctrine. See Lirette & Viard, supra note 23, at 482–83 (“commerce neutral” tax systems are “those for which prices can change to preserve relative incentives for interstate transactions”); see alsoKnoll & Mason (2017), supra note 23, at 319, 336 n.126 (continuing to use “competitive neutrality” when discussing the principle in the dormant Commerce Clause context). The Supreme Court refers to both “discrimination” and taxes that “operate[] as tariffs.” See, e.g., Comptroller of Treasury v. Wynne, 135 S. Ct. 1787, 1804 (2015) (“Maryland’s tax scheme is inherently discriminatory and operates as a tariff.”). Regardless of terminology, the underlying idea is simple: states should not use their spending, regulatory, or tax systems to distort competition between economic actors of different states.32See references in supra note 31. Put differently, within the EU, the prohibition of state aid prevents protectionism and retentionism;33“Whereas taxes or regulations are protectionist when they discourage outsiders from engaging in economic activities within a state, taxes or regulations are retentionist when they discourage in-state economic actors from engaging in out-of-state activities.” Knoll & Mason (2017), supra note 23, at 309. it prevents taxes that function equivalently to tariffs or import/export subsidies.34Mason & Knoll (2012), supra note 29, at 1046 n.121, 1061 n.151 (defining competitive neutrality for labor taxes). In this Article, I focus on differences in treatment between cross-border and domestic commerce, and, therefore, I do not take up other types of state aid, including sectoral discrimination. Although the techniques proposed here may be helpful in sectoral discrimination cases, I do not focus on them.

Equally critical to my analysis is the claim that EU law generally preserves state tax autonomy, including autonomy to set tax bases, tax rates, and methods for taxing cross-border income.35See TFEU, supra note 1, art. 4 (“[C]ompetences not conferred upon the Union in the Treaties remain with the Member States.”); see also Alexandre Saydé, One Law, Two Competitions: An Enquiry into the Contradictions of Free Movement Law, in 13 Cambridge Y.B. Eur. Legal Stud. 365 (Catherine Barnard & Okeoghene Odudu eds., 2011) (explaining that the EU values both regulatory and market competition). The tax state-aid doctrine of the European Union’s highest court, the Court of Justice of the European Union (CJEU or “Court of Justice”), is still nascent. But the Court has decided many cases under the fundamental freedoms that help explicate the relative tax competences of the EU and the Member States and the ways that EU law limits Member State tax powers.36See generally Mason & Knoll (2012), supra note 29, at 390–99 (highlighting cases where the CJEU has interpreted the fundamental freedoms as promoting competition).

Although Member States may not discriminate against cross-border commerce or against nationals from other Member States, the TFEU generally does not prohibit nondiscriminatory tax laws, even if those laws distort where EU taxpayers work, invest, and do business.37See generally id. at 425–28 (providing examples of laws that the TFEU has allowed, despite the locational distortions they created). Significant consequences follow from this interpretation. Most importantly, neither the fundamental freedoms nor the state-aid rules require allocational efficiency, or what tax policymakers refer to as “capital export neutrality” or “locational neutrality.”38For a remarkably clear explanation of the various benchmarks, see Rosanne Altshuler, Recent Developments in the Debate on Deferral, 20 Tax Notes Int’l 1579 (2000). For a general discussion of the neutrality benchmarks for international tax versus EU law, see Elizabeth F. Donald, Michael S. Knoll & Ruth Mason, Tax Discrimination (manuscript on file). For implications of the neutrality benchmarks for common markets, see generally Mason & Knoll (2012), supra note 29; Knoll & Mason (2017), supra note 23. For the argument that the fundamental freedoms do not coherently enforce any of the neutrality benchmarks, see Michael J. Graetz & Alvin C. Warren, Jr., Income Tax Discrimination: Still Stuck in the Labyrinth of Impossibility, 121 Yale L.J. 1118 (2012). Although the EU’s tax nondiscrimination rules contribute to efficient allocation of productive factors across the EU, that is not their primary purpose.

This limit on EU law is crucial for maintaining Member State tax autonomy. For example, the Court of Justice consistently regards “tax disparities” as compatible with the TFEU.39See, e.g., Case C-403/03, Schempp v. Finanzamt München V, ECLI:EU:C:2005:446 ¶ 34 (July 12, 2005). Tax disparities are cross-border tax differences that “result from divergences existing between the various Member States, so long as they affect all persons subject to them in accordance with objective criteria and without regard to their nationality.”40Id. Thus, as long as they do not discriminate, Member States may define their tax bases as they wish, even though tax disparities may inefficiently distort location of productive factors across the European Union. To survive EU law challenges, divergent laws must apply the same way to Member State nationals and nationals of other EU Member States. They also must apply the same way to cross-border and purely domestic commerce. In keeping with tax vernacular, I will refer to such disparities as “tax mismatches.”41See, e.g., Organisation for Economic Co-operation and Development (OECD), Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report 11 (2015) (developing unilateral defensive measures for combatting mismatches); Mitchell A. Kane, Strategy and Cooperation in National Responses to International Tax Arbitrage, 53 Emory L.J. 89, 114 (2004) (referring to mismatches as creating “international tax arbitrage” opportunities). For more on mismatches under EU law, see Mason, supra note 21.

Mismatches in tax rates are the classic example. A taxpayer from a high-tax state who invests in a low-tax state may secure a cross-border tax advantage. A taxpayer from a low-tax state who invests in a high-tax state may suffer a cross-border tax disadvantage. Because states retain autonomy over their rates, however, EU law does not prohibit such cross-border tax advantages or disadvantages, as long as each state applies its tax rules evenhandedly to all.42See, e.g., Case C-336/96, Gilly v. Directeur des Services Fiscaux du Bas-Rhin, ECLI:EU:C:1998:221 ¶ 1 (May 12, 1998)(declining to remediate a cross-border tax disadvantage arising from a rate mismatch). Thus high tax rates do not violate the fundamental freedoms as discriminatory taxes, and low tax rates do not constitute illegal state aid. This is true even though differences in tax rates may cause locational distortions and perhaps even a race to the bottom on taxes. According to the CJEU, EU law “offers no guarantee to a citizen of the Union that transferring his activities . . . will be neutral as regards taxation.”43Case C-365/02, In re Lindfors, ECLI:EU:C:2004:449 ¶ 34 (Mar. 4, 2004). EU law does not prevent tax mismatches because, according to the Court of Justice, requiring tax harmonization “would . . . encroach on [Member State] sovereignty in matters of direct taxation.”44See, e.g., Gilly, ECLI:EU:C:1998:221 ¶ 48.

Taxpayers frequently argue that double taxation arising from mismatches violates EU law.45See, e.g., Schempp, ECLI:EU:C:2005:446 ¶¶ 9–10. The Court of Justice has consistently rejected such claims under the fundamental freedoms, reasoning that because the TFEU provides no rules for setting tax rates, tax bases, or methods to divide income among the states, the Court cannot resolve double taxation arising from the application of different, but nondiscriminatory, laws adopted by two or more states.46See id. The CJEU has come to this conclusion notwithstanding that double taxation may chill cross-border economic activity.47See Case C-376/03, D. v. Inspecteur van de Belastingdienst, ECLI:EU:C:2004:663 ¶ 85 (opinion of Advocate General Ruiz-Jarabo Colomer) (“[T]he fact that a taxable event might be taxed twice is the most serious obstacle there can be to people and their capital crossing internal borders.”).

For example, in Block,48Case C-67/08, Block v. Finanzamt Kaufbeuren, 2009 ECLI:EU:C:2009:92 (Feb. 12, 2009). Germany considered debt instruments to be taxable German assets under its inheritance tax if the creditor resided in Germany.49Id. ¶ 7, 9. In contrast, Spain had the opposite rule. It considered bonds to be Spanish if the debtor resided in Spain.50See id. ¶ 9. When a German creditor owned debt in a Spanish company, both Germany and Spain would include the debt for inheritance tax purposes. A taxpayer complained that the resulting double taxation violated the fundamental freedoms, but the Court of Justice disagreed. It observed that “Community law . . . does not lay down any general criteria for the attribution of areas of competence between the Member States in relation to the elimination of double taxation.”51See id. ¶ 30.

To fix the overlap that resulted from differences in the Spanish and German rules, the Court would have had to choose between the German and Spanish rule. But the Court acknowledged that absent EU legislation, the EU Treaties do not require any state to conform its tax laws to that of any other.52Id. ¶¶ 30–31 (“[T]he Member States . . . are not obliged therefore to adapt their own tax systems to the different systems of tax of the other Member States in order, inter alia, to eliminate the double taxation arising from the exercise in parallel by those Member States of their fiscal sovereignty . . . .”). With unanimous agreement of the Member States, the EU central government could set a common rule for the states. But the Court acknowledged that, in the absence of such legislation, states may implement the tax policies that their voters prefer.53Id. (“[N]o uniform or harmonisation measure designed to eliminate double taxation has as yet been adopted at Community law level.” (citation omitted)). This interpretation accommodates tax competition; under it, states may compete with each other to attract business, investment, and residents to their jurisdiction.

If the facts of Block had been reversed so that a Spanish creditor owned bonds in a German company, neither country would include the asset in its inheritance tax. This mismatch would create a tax gap or a double benefit that would only occur in cases of cross-border debt holdings. Just as Block did not violate the fundamental freedoms as tax discrimination, reverse-Block would not violate the state-aid rules as an illegal tax subsidy.

A consequence of this division of tax powers between the EU central government and the Member States is that some forms of tax competition (including tax-rate competition) must be tolerated, even though the impact of those policies spills over, affecting residents of other states.54Tax competition risks a race-to-the-bottom in which states lower tax burdens until they cannot adequately fund public goods and services or must shift taxes to less mobile factors such as labor or land. Empirical studies arrive at mixed conclusions on the impact of tax competition. For a literature review, see Michael Keen & Kai A. Konrad, The Theory of International Tax Competition and Coordination, in 5 Handbook of Public Economics 257 (Alan J. Auerbach et al. eds., 2013). Indeed, the Court of Justice repeatedly has emphasized that regulatory competition is a value protected by the EU Treaties.55See Case C-212/97, Centros, ECLI:EU:C:1999:126 ¶ 27 (Mar. 9, 199) (affirming regulatory competition as an EU value). Similarly, gaps and overlaps arising from mismatches may distort cross-border economic activity and intensify tax competition. For example, the German-Spanish mismatch approved in Block may distort taxpayers’ decisions about where to reside and whether to hold debt or other types of assets. It may impact taxpayers’ preferences for holding cross-border versus domestic debt. Nevertheless, the TFEU does not require conformity in state tax laws; it only prohibits states from discriminating among nationals or enterprises of different states or between cross-border and domestic commerce.56See, e.g., TFEU, supra note 1, art. 107 (also forbidding sectoral discrimination). This approach is not unusual in the common-market context. The Supreme Court has held that nondiscriminatory tax mismatches among U.S. states do not violate the dormant Commerce Clause and that only Congress—not courts—may eliminate them.57See, e.g., Comptroller of Treasury v. Wynne, 135 S. Ct. 1787, 1802 (2015); Moorman Mfg. Co. v. Bair, 437 U.S. 267, 278 (1978). See generally Knoll & Mason (2017), supra note 23 (discussing Wynne).

Appropriately mindful of states’ reserved tax powers, the Commission has not interpreted the prohibition of state aid to forbid mismatches, require tax harmonization, or require minimum taxation.58See 2016 Notice, supra note 1, ¶¶ 132–89. Rather, the Commission has interpreted the state-aid rules to promote competitive neutrality, that is to “preserv[e] a level playing field” among private enterprises and to “combat[] protectionism.”59Commission Communication on State Aid Modernisation, supra note 31, ¶ 15. As Advocate General Jääskinen put it, “[H]armful institutional or tax competition between Member States clearly does not fall within the mechanism for controlling State aid established by the Treaty, even though there are cases where measures are liable to amount both to harmful tax competition and to State aid incompatible with the common market.” Joined Cases C-106/09 P & C-107/09 P, Comm’n v. Gibraltar, ECLI:EU:C:2011:215 ¶ 143 (Apr. 7, 2011) (opinion of Advocate General Jääskinen), https://curia.europa.eu/juris/celex.jsf?celex=62009CC0106 [https://perma.cc/93QB-ZA2Q]. It is worth emphasizing once more that the rest of this Article assumes that, like the fundamental freedoms, the state-aid rules, at least in part60This Article does not cover some aspects of state aid, including its prohibition of sectoral discrimination., are designed to promote competitive neutrality, and they are not properly interpreted to eliminate interstate tax (or other regulatory) competition, except incidentally to promote competitive neutrality. If my assumptions are unjustifiably narrow, or if the state-aid doctrine expands to encompass more general limits on tax competition, then the arguments in this Article would apply only to a subset of cases, namely those implicating differences in tax treatment between cross-border and domestic commerce.61EU law expressly recognizes that the state-aid concept evolves with the common market, so that Member State policies previously judged compliant can become illegal aid due to further EU integration. See, Joined Cases C-182/03 & C-217/03, Belgium & Forum 187 v. Comm’n, ECLI:EU:C:2005:266 (June 22, 2006) (finding to confer state aid a regime that the Commission had previously approved as notified aid); Ryan Finley, Commission’s State Aid Powers Are Too Broad, German Report Says, Tax Notes Int’l (Nov. 27, 2017) (quoting the technical advisory board on state aid of the German Ministry of Finance as observing that the state-aid rules have a reputation for “permanent expansion”).

B.   Subsidy Control: Practice and Procedure

1.      Elements of state aid

The EU Commission bears the burden to prove the core element of tax state aid: the presence of a so-called “selective advantage.”62See, e.g., Joined Cases C-393/04 & C-41/05, Air Liquide Indus. Belg. SA v. Ville de Seraing, ECLI:EU:C:2006:403 ¶ 30 (June 15, 2006); 2016 Notice, supra note 1, ¶ 118. The Commission bears the burden of proof for other issues, including showing that the aid expended state resources and impacted the EU market. Proving the former is trivial in tax cases, and the CJEU permits the Commission to assume the latter. Selective advantage therefore represents the Commission’s main burden in any tax state-aid case. The “advantage” is the financial benefit that accrues to the enterprise on account of the state’s action. In cases involving state aid delivered through the tax system, it is the tax savings.63See, e.g., Commission Notice on the Application of the State Aid Rules to Measures Relating to Direct Business Taxation, 1998 O.J. (C 384) 3, ¶ 22 [hereinafter 1998 Notice]; 2016 Notice, supra note 1, ¶ 127. This can include tax savings delivered through deductions, exemptions, credits, deferral, and the like.64See 2016 Notice, supra note 1, ¶¶ 126–41; 1998 Notice, supra note 63, ¶ 9.

The Commission also must show that the state granted the subsidy “selectively.” Selectivity is state aid’s discrimination requirement; the Commission must show that the state granted the benefit to some firms, but not to similarly situated others.65See, e.g., Air Liquide, ECLI:EU:C:2006:403 ¶¶ 31–32; 2016 Notice, supra note 1, ¶ 118. Selectivity derives from Article 107’s requirement that, to be illegal, aid must favor “certain undertakings or the production of certain goods.”66TFEU, supra note 1, art. 107(1).

Although the CJEU does not refer to “suspect classes” the way the U.S. Supreme Court does, analysis of state-aid cases reveals that state aid’s “selective classes” include nationality, region, and whether an enterprise engages in domestic or cross-border economic activity.672016 Notice, supra note 1, ¶ 121; see also Ruth Mason, An American View of State Aid, 157 Tax Notes 645, 647, 649 (2017) (cataloging selective classifications and linking them to state-aid’s goal to prevent discrimination between cross-border and domestic commerce). State aid includes other selective classes not considered here, including sector. The Commission sometimes claims that categories having nothing to do with sector or cross-border commerce constitute selective classes, which suggests that the application of the state aid prohibition could be very broad. For example, although the CJEU rejected it, the Commission made the argument that companies making losses constitute a selective class. See, e.g., Joined Cases C-106/09 P & C-107/09 P, Gibraltar v. Comm’n, ECLI:EU:C:2011:732 ¶ 77 (Nov. 15, 2011) (annulling the Commission’s decision that a tax limited to fifteen percent of a company’s profits favored companies that made losses). In another recent case, the Commission determined that a Member State conferred state aid when it restricted loss offsets to “insolvent or over-indebted” companies, while denying offsets to other companies. Commission Decision 2011/527 of Jan. 26, 2011 on State Aid Implemented by Germany (Sanierungsklausel), 2011 O.J. (L 235) 33, ¶ 73. This decision suggests that the Commission regards distressed companies as a selective class. Such an expansive interpretation would unmoor state aid from its goal to facilitate market integration. The CJEU reversed the Commission’s decision on other grounds. Case C‑203/16 P, Andres v. Comm’n, ECLI:EU:C:2018:505 ¶ 93 (June 28, 2018) (holding that the Commission used the wrong reference base for determining selective advantage). Additionally, when a state confers an advantage to only a single company, the Commission is entitled to presume that such “individual aid” is selective.68Case C-15/14 P, Comm’n v. MOL, ECLI:EU:C:2015:362 ¶ 60 (June 4, 2015). Most of the cases discussed in this Article involved individual aid.

That these classifications would draw the focus of the Commission and CJEU makes sense because states could use these classifications to enact policies that undermine the European common market. The state-aid rules promote free trade by prohibiting protectionism and policies that function equivalently to import or export subsidies.69See, e.g., Joined Cases C-20/15 P & C-21/15 P, Comm’n v. World Duty Free Grp. SA, ECLI:EU:C:2016:981 (Dec. 21, 2016) (capital export subsidy); Joined Cases C-182/03 & C-217/03, Belgium & Forum 187 v. Comm’n, ECLI:EU:C:2005:266 (June 22, 2006) (subsidy for increasing economic activity within the challenged state). It is not the goal of this Article to summarize the Commission’s state-aid doctrine. Many others have ably done so. Micheau, supra note 24 (emphasizing the similarity to WTO rules). Again, while I acknowledge that the state-aid rules prohibit sectoral subsidies, the principal focus of this Article is the impact of the prohibition of state aid on Member States’ ability to treat cross-border and domestic commerce differently. If the Commission were to expand its conception of state aid, we would expect to add to my list of “selective classes.”

As the last step in state-aid analysis, if the Commission carries its burden to show selective advantage, the accused state has a chance to show that public policy reasons justified the aid.70MOL, ECLI:EU:C:2015:362, ¶ 60.

2.      State-aid procedure

The TFEU assigns the Commission the responsibility to monitor state aid and abolish it where appropriate.71TFEU, supra note 1, art. 108. The prohibition of state aid is subject to many treaty and statutory exceptions. See, e.g., id. art. 107(2)–(3) (exceptions to raise standards of living in less developed regions, address natural monopolies and other market failures, and aid to remedy natural disasters). For more on state-aid procedure, see Ruth Mason, Tax Rulings as State Aid FAQ, 154 Tax Notes 451 (2017). Due to its association with what Europeans call competition policy (what Americans call antitrust), the Commission’s Directorate-General for Competition handles most state-aid enforcement, including tax state aid.

The Commission enjoys wide investigatory discretion and broad compulsory powers—it can obtain information from any state and any firm, including a putatively aided company and its competitors.72Council Regulation 2015/1589 of 13 July 2015, Laying Down Detailed Rules for the Application of Article 108 of the TFEU, 2015 O.J. (L 248) 9 [hereinafter 2015 Regulation] (information gathering powers). The challenged state, other EU states, and other interested parties (including competitors of the putatively favored enterprise) may participate in the investigation.73Id. arts. 1(h), 12(1).

Adverse Commission decisions lead to modification or termination of the aid, as well as monetary recovery of the subsidy from the aided enterprise, going back ten years from the Commission’s action.74The aiding state determines the exact amount of recovery under guidance from the Commission. See, e.g., Apple, supra note 2, ¶¶ 445–51 (describing how Ireland should calculate the recovery from Apple “to restore the position to the status quo ante”). The enterprise repays the aid to the state that originally granted it, a remedy intended to put the enterprise in the position it would be in had it not received aid.752015 Regulation, supra note 72, art. 16. That is why the blockbuster case against Ireland resulted in an order to recover billions in back taxes from Apple. The taxpayer must pay the recovery amount regardless of the Member State’s statute of limitations for taxes.76Id. pmbl. ¶ 25, art. 16. Contrary to other anti-subsidy rules, the offending state keeps the recovery.77Rather than disgorgement, WTO law permits members to impose countervailing duties on goods from WTO states judged to have provided specified kinds of subsidies. General Agreement on Tariffs and Trade, Oct. 30, 1947, 61 Stat. A-11, 55 U.N.T.S. 188, art. VI, ¶ 2.

The aided taxpayer, the aiding Member State, or both may appeal the Commission’s state-aid determination, first to the European Union’s lower court and then to the CJEU. All the cases involving U.S. multinationals discussed in this Article that resulted in a recovery order have been appealed.

II.   Identifying Subsidies Using Tax-Expenditure Analysis

The familiar problem at the heart of tax-expenditure analysis—whether performed for purposes of legislative accountability or identifying illegal subsidies—is that it requires a baseline against which “special” deviations can be measured. Unfortunately, it has never been clear how to construct the baseline.78See generally Boris I. Bittker, Accounting for Federal “Tax Subsidies” in the National Budget, 22 Nat’l Tax J. 244, 247 (1969). Until recently, the Commission exclusively used reference law as the benchmark for identifying tax state aid. Reference-law benchmarking regards facially neutral rules—including structural rules—as conferring no tax advantages (and therefore no state aid), and it regards all facially selective rules as conferring tax advantages that may be state aid. Because facially neutral rules can violate competitive neutrality and facially selective rules can comply with competitive neutrality, however, reference-law benchmarking is both under- and overinclusive. The main alternative approach to reference-law benchmarking favored by the Commission in recent cases—external benchmarking—has problems of its own. For example, selecting an external benchmark for evaluating Member State rules requires the Commission to make tax policy decisions that exceed the powers conferred to it by the TFEU. This leads to tax-expenditure’s double bind: reference-law benchmarking causes the Commission to err; benchmarking by norms causes the Commission to invade the reserved tax powers of the states.

A.   The Ineluctable Baseline Problem

Tax-expenditure analysis did not begin as a tool to identify illegal subsidies under trade law or constitutional law. Instead, it began as a tool for promoting legislative accountability. Many countries, including the United States, calculate tax-expenditure budgets to keep lawmakers and the public informed about how the government spends and regulates through the tax system. For example, the Congressional Budget Act of 1974 defines tax expenditures as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”792 U.S.C. § 622(3) (2006).

The Joint Committee on Taxation and the Treasury Department typically use reference law as the baseline for calculating tax expenditures.80Staff of J. Comm. on Taxation, 115th Cong., Estimates of Federal Tax Expenditures for Fiscal Years 2018-2022 at 2(Comm. Print 2018). This choice means that some provisions are not labeled as tax expenditures, even though they confer tax savings.81For example, the Joint Committee and Treasury regard the exclusion of imputed income and the realization rule to be part of the reference base, so they do not score as tax expenditures.

As an alternative to using reference law as the benchmark, estimators can identify an external benchmark and then deem any provisions that vary from the external benchmark to be tax expenditures. The external benchmark could be a normative benchmark consisting of an idealized view of tax policy, or it could consist of an international standard, dominant state practice, or another norm.822008 JCT Report, supra note 6, at 39–40; see also David Kamin, Basing Budget Baselines, 57 Wm. & Mary L. Rev. 143 (2015) (providing a taxonomy of baselines for federal budgeting purposes). For example, depreciation schedules can be benchmarked against economic depreciation under financial accounting rules.

An obvious drawback of external benchmarking is the need to select an external norm. Whereas a reference-law baseline has political legitimacy, it is not clear where the budget estimator or subsidy adjudicator derives the authority to choose a norm other than the reference law, that is, other than the tax law as determined by democratically elected lawmakers. Boris Bittker famously observed that “every man can create his own set of ‘tax expenditures,’ but it will be no more than his collection of disparities between the income tax law as it is, and as he thinks it ought to be.”83Bittker, supra note 78, at 244.

Setting aside the legitimacy of benchmark choices, both reference-law and external-norm benchmarking leave important questions unanswered due to ambiguity or indeterminacy.84Cf. 2008 JCT Report, supra note 6, at 41 (acknowledging that for some tax provisions, tax-expenditure analysis “arbitrarily select[s] one taxing pattern or another as the general rule”). The appropriateness of a tax rule or administrative practice can be ambiguous under either approach. For example, one could treat corporate debt as a favorable deviation from equity just as easily as one could treat equity as a tax penalty relative to debt. Or both corporate debt and equity could be measured against some normative tax treatment of all corporate capital. Likewise, one could understand a tax exemption for pass-through entities as a favorable deviation from corporate taxation, yet one could just as easily regard corporate taxation as a tax penalty relative to pass-through treatment. The equivalent for individual taxpayers would be to decide whether married couples are penalized relative to singles, or whether singles are advantaged relative to couples. Because there exists neither a clear reference-law baseline nor a clear normative answer to these questions, the proper baseline for tax provisions touching on these questions is ambiguous under either reference-law benchmarking or external-norm benchmarking. Selecting a baseline in such cases is necessarily arbitrary. For other tax provisions, both the proper (in a normative sense) and the reference-law tax treatment may be indeterminate. Suppose we suspect that the annual filing period and the marginal rate system confer tax advantages. Against what baseline would we measure such advantages?

The problem of ambiguity or indeterminacy of the baseline is particularly acute for so-called structural provisions. The distinction between structural and non-structural rules basically tracks the distinction between the background features of the tax system and its particular provisions, but the notion of structural tax provisions is not well-defined and may be illustrated best by examples.85See 2008 JCT Report, supra note 6, at 2 (quoting Surrey as defining structural provisions as those “necessary to implement the income tax” and distinguishing them from tax expenditures); see also Daniel N. Shaviro, Rethinking Tax Expenditures and Fiscal Language, 57 Tax L. Rev. 187, 212 (2004) (defining “structural rules” as those that are “usefully distinguished both from theoretically pure income tax rules and from conventional tax expenditures that seem more politically interchangeable with appropriations”). One category of structural provisions involves tax-mix questions that policymakers do not typically intend to revisit. For example, selection of an income-tax base necessarily implies rejection of a consumption-tax base.

Another type of structural provision results from practical necessity; for simplicity and ease of administration, the tax system may, for example, ignore inflation, exempt imputed income, defer tax on gains until realization, and choose an arbitrary reporting period (such as one year).86Imputed income is the value of services one provides to oneself or the value of using one’s own assets. For example, if a taxpayer lives in a house she owns, she has imputed rental income, which the United States excludes from taxation. Under the realization rule, states defer inclusion of gains and deduction of losses until disposition of the related asset. An alternative would be a mark-to-market regime, which would account for annual appreciation and depreciation of assets. Ari Glogower, Taxing Capital Appreciation, 70 Tax L. Rev. 111, 111, 113 (2016). Other building blocks of the tax system that generally lie outside tax-expenditure analysis involve definitions or classifications (such as entity classification, filing status, or definitions of debt and equity), progressive rates, and, importantly for this Article, methods for dividing income from cross-border transactions among states with jurisdiction to tax it.

That a provision is structural does not mean it conveys no tax advantages. For example, the realization rule favors long-term capital investments over wage income, and differences in the tax treatment of debt and equity distort capitalization of companies.87See Tax Reform and the Tax Treatment of Capital Gains: Joint Hearing Before the H. Comm. on Ways and Means & S. Fin. Comm., 112th Cong. 36 (2012) (statement of Leonard E. Burman, Daniel Patrick Moynihan Professor of Public Affairs, Syracuse University). The main characteristic of structural tax provisions that is relevant to tax-expenditure analysis is uncertainty regarding the baseline against which they could be tested.88See Victor Thuronyi, Tax Expenditures: A Reassessment, 1988 Duke L.J. 1155, 1165–70 (1988) (noting that the Haig-Simons definition of income is “ambiguous or silent regarding some basic structural features of the tax system,” including rates, taxable unit, corporate integration, and the treatment of capital gains). For example, is it helpful to conceive of an income tax as a set of tax expenditures and penalties compared to a consumption-tax base? How confident could we be that resulting tax expenditures represent relevant subsidies?

Importantly for the recent state-aid cases, the normative basis for splitting international income among states is contested.89See id. at 1200; see also 2008 JCT Report, supra note 6, at 10 (concluding that the “general rule for taxing foreign earnings” “can fairly be said to be ambiguous”); Mitchell A. Kane, A Defense of Source Rules in International Taxation, 32 Yale J. on Reg. 311 (2015) (discussing various justifications for source rules). Before we conclude that normative indeterminacy should lead us to a reference-law approach, it is worth noting that for many countries, it may not be possible to identify with confidence a state’s principal income-allocation rule.90See infra note 143.

B.   Easy Cases Under Reference-Law Benchmarking

The Commission traditionally has identified illegal state aid by comparing the tax treatment of a selective class (or particular company) to a “reference system . . . composed of a consistent set of rules that generally apply.”91See 2016 Notice, supra note 1, ¶ 133; see also id. ¶ 128 (describing a “three-step analysis” involving (1) identifying the “system of reference,” (2) “determin[ing] whether a given measure constitutes a derogation from that system,” and (3) determining whether that derogation is selective). The Commission has identified some provisions that it regards as part of the state’s reference baseline, including “the taxable persons, the taxable event and the tax rates.” Id. ¶ 134. “Purely technical” provisions, such as depreciation rules, usually do not constitute state aid, even if they “var[y] from one Member State to another.” Id. ¶¶ 177–80. But see Joined Cases C‑78/08 & C‑80/08, Ministero dell’Economia e delle Finanze v. Paint Graphos, ECLI:EU:C:2011:550 ¶ 50 (Sept. 8, 2011) (agreeing with the Commission that the benchmark for evaluating the taxation of exempt cooperative association was the corporate tax base but holding that the tax exemption for cooperatives could be justified). This is a tax-expenditure approach.921998 Notice, supra note 63, ¶ 9 (explaining that illegal state aid can consist of tax savings delivered through “special deductions,” exemptions, credits, deferral, or cancellation or rescheduling of tax debts); see also 2016 Notice, supra note 1, ¶ 128 (confirming this approach). Crucially, it uses the state’s own domestic law as the baseline for measuring the tax advantage.932016 Notice, supra note 1, ¶ 129. Although this method finds no direct support in the TFEU, the Court of Justice accepts it,94See, e.g., Case C‑203/16 P, Andres v. Comm’n, ECLI:EU:C:2018:505 ¶ 93 (June 28, 2018) (describing the approach in detail). and in the late 1990s, the Commission committed to using it as a best practice.95See 1998 Notice, supra note 63, ¶¶ 9–10. The Commission is far from alone in using reference-law benchmarking to identify illegal subsidies, and the approach works well most of the time. The WTO Dispute Resolution Body and Supreme Court under the dormant Commerce Clause both use the approach to scrutinize subsidies.96See, e.g., Coenen & Hellerstein, supra note 4 (dormant Commerce Clause); Paul R. McDaniel, Trade Agreements and Income Taxation: Interactions, Conflicts, and Resolutions, 57 Tax L. Rev. 275 (2004) (WTO).

The Commission typically has encountered two types of easy cases under tax-expenditure analysis that uses a reference-law benchmark. The first category of easy cases centers on special tax provisions that benefit only members of selective classes. An example might be an overt export subsidy. Tax-expenditure analysis that uses reference law as a baseline properly identifies such provisions as conferring selective advantages. As a result, overtly selective tax expenditures are state aid unless they are justified.97Neither the Commission nor CJEU has been clear on what it takes to justify a selective tax advantage. The CJEU has said that a tax advantage can be justified by the “nature or general scheme of the [tax] system.” Joined Cases C-106/09 P & C-107/09 P, Gibraltar v. Comm’n, ECLI:EU:C:2011:732 ¶ 36 (Nov. 15, 2011). The Commission has declared that “intrinsic basic or guiding principles . . . [and] inherent mechanisms necessary for the functioning and effectiveness of the [tax] system” can justify differences in treatment. 2016 Notice, supra note 1, ¶ 138 (distinguishing “external policy objectives”). While it is unclear what justifies selective tax advantages, selective provisions that are justified for public policy reasons must be narrowly tailored. Id. ¶ 140 (justified selectivity must “not go beyond what is necessary to achieve the legitimate objective being pursued, in that the objective could not be attained by less far-reaching measures”). The second category of easy cases involves derogating provisions that do not benefit selective classes.98See 2016 Notice, supra note 1, ¶¶ 117–18. An example might be a one-year-only expensing rule that is available to all companies. Although such derogating provisions may be regarded as conferring tax advantages as judged by a reference-law benchmark, they are not relevantly discriminatory because they do not treat cross-border commerce differently from domestic commerce. Thus, derogating provisions that benefit no selective class do not constitute state aid. Because they involve tax subsidies delivered via overt derogations, both types of cases are easy to identify, and because the two types of cases—selective and nonselective—are typically easy to distinguish from each other, reference-law benchmarking has, until recently, produced predictable and uncontroversial outcomes.

1.      Unjustified facially selective rules

Countless cases illustrate the Commission’s reference-law benchmarking approach to state-aid analysis. For example, the CJEU affirmed the following as illegal aid: special deductions for foreign branch start-up and promotional costs when those costs were incurred by steel exporters, but not when incurred by other enterprises;99Case C-501/00, Spain v. Comm’n, ECLI:EU:C:2004:438 ¶ 120 (July 15, 2004). special income-calculation rules available to the coordination centers of multinational groups, but not other kinds of companies;100Joined Cases C-182/03 & C-217/03, Belgium & Forum 187 v. Comm’n, ECLI:EU:C:2005:266 (June 22, 2006). exemption from a tax on stopovers available to local, but not foreign, vessel owners;101Case C-169/08, Presidente del Consiglio dei Ministri v. Regione Sardegna, ECLI:EU:C:2009:709 ¶ 66 (Nov. 17, 2009). and favorable goodwill depreciation deductions available for purchases of foreign, but not domestic, stock.102Joined Cases C-20/15 P & C-21/15 P, Comm’n v. World Duty Free Group, ECLI:EU:C:2016:981 ¶ 22 (Dec. 21, 2016).

In each case, the Commission used deviations from the state’s own domestic law to establish the existence of a tax advantage. In each case, the Commission compared the state’s treatment of expressly favored taxpayers (e.g., exporters or purchasers of foreign stock) to that same state’s treatment of taxpayers outside the selective class (i.e., non-exporters or purchasers of domestic stock).103See, e.g., id. ¶¶ 68, 76–77, 98, 106. In these cases, the Commission focused on facially selective (i.e., discriminatory) tax rules.104See, e.g., id.

Each of these cases upheld a traditional value underlying the prohibition of state aid. The Commission held that protectionist tax benefits available only to steel exporters105Case C-501/00, Spain v. Comm’n, ECLI:EU:C:2004:438 ¶¶ 120–25 (July 15, 2004) (holding that a start-up cost deduction for steel exporters operated as an export subsidy even though it was not linked directly to exports). or local vessel owners locals were state aid.106See Regione Sardegna, ECLI:EU:C:2009:709 ¶ 66 (holding that limiting a tax exemption to Sardinian vessels discriminated against foreign vessel owners). It also held that capital export subsidies in the form of faster cost-recovery for foreign than domestic investments constituted state aid.107See World Duty Free Grp. SA, ECLI:EU:C:2016:981 ¶¶ 71–77 (holding that favorable goodwill depreciation available for purchases of foreign, but not domestic, stock constituted state aid). Each of these cases straightforwardly enforced the values undergirding the prohibition of state aid; they also all represent “easy cases” under the reference-law benchmarking approach. In each case, the state clearly derogated from its own generally applicable law to favor one of state aid’s selective classes. Before Part III introduces hard cases, the next Subsection reviews derogating tax provisions that were not state aid because they did not benefit selective classes.

2.      Nonselective advantageous rules

Not all derogations from generally applicable law confer tax advantages that require scrutiny as possible illegal state aid. Tax expenditures are permissible, provided they do not benefit a selective class. Thus, the following cases did not involve state aid: a tax on all companies limited to fifteen percent of their profits;108Joined Cases C-106/09 P & C-107/09 P, Gibraltar v. Comm’n, ECLI:EU:C:2011:732 ¶¶ 77–84 (Nov. 15, 2011). a procedural rule allowing companies with tax disputes that were more than ten years old to settle those disputes by paying five percent of the deficiency;109See Case C-417/10, Ministero dell’Economia e delle Finanze v. 3M Italia SpA, ECLI:EU:C:2011:550 ¶ 26 (Sept. 8, 2011). and an accelerated depreciation rule limited to certain tangible assets custom-built for leasing.110Case C-100/15 P, Neth. Mar. Tech. Ass’n v. Comm’n, ECLI:EU:C:2016:254 ¶¶ 61, 71, 74, 77, 84, 88 (Apr. 14, 2016) (affirming the Commission, which had decided not to pursue a formal state-aid case against Spain because its rule was not selective). Although the states in these cases drew distinctions—including distinctions related to profitability, the age of the tax dispute, or the intended use of assets—the states avoided use of selective classifications.

Not every state would make the same policy choices as the ones reflected in this set of cases, but none of the challenged policies involved covert subsidies to darling enterprises or industries; none involved preferences to national taxpayers; none functioned equivalently to an import or export subsidy. Because the TFEU leaves states free to pursue their own tax policy goals (absent protectionism or other discrimination between domestic and cross-border commerce), the state-aid rules do not prohibit these policies, even if they are foolish or inefficient.

III.   Hard Cases Under Tax-Expenditure Analysis

Most state-aid cases do not raise thorny baseline questions. Instead, they involve overt tax advantages conferred to selective classes of taxpayers in cases in which the state can provide no justification for the selective advantage. When a state overtly favors a selective class, both the deviation and baseline are clear: the deviation is the treatment of the selective class, and the baseline is the treatment of everyone else. Because past cases involved such unjustified facial selectivity, the Commission’s decisions employing tax-expenditure analysis received little political or academic criticism—or even attention. The widespread acceptance of the Commission’s approach to state aid was probably due to observers’ familiarity with tax-expenditure analysis as a technique for identifying tax subsidies and due to the Commission’s use of the state’s own law as its reference benchmark, which seemed either neutral or properly deferential to state tax policy decisions.111The Court of Justice itself observed that the tax-expenditure approach is sufficient to identify state-aid in cases involving facially selective derogations. Case C‑203/16 P, Andres v. Comm’n, ECLI:EU:C:2018:505 ¶ 93 (June 28, 2018) (referring to cases in which “two categories of operators are distinguished and a priori treated differently”).

Thus, until recently, the Commission’s tax-expenditure approach to state-aid review performed well. Using a domestic-law reference base allowed the Commission to avoid accusations that it exceeded its authority. Nor did such deference render the standard toothless. Instead, it branded as illegal any rules that facially derogated in favor of selective classes. But, in my view, recent cases posed two puzzles that tax-expenditure analysis is ill-equipped to handle: Can facially neutral rules convey state aid? and Can facially selective rules confer tax advantages that are not state aid? This Part explains that these questions are arising now because the Commission has stumbled into the tax-expenditure trap. Recent cases expose that not all tax provisions can be neatly categorized as either tax expenditures or normal provisions. For cases in the grey area, tax-expenditure analysis is unreliable.

To confront these emerging challenges, the Commission altered its approach in recent cases. Failure to adequately explain its departure from the reference-law approach left the Commission vulnerable to criticism that it sought to harmonize state taxes outside the European Union’s legislative process or that it sought to impose a single-tax requirement.112See Advisory Bd., Fed. Ministry of Fin., supra note 10, at 12. Either of these goals falls outside the Commission’s institutional authority.

A.   Facially Neutral Rules

State-aid enforcement targets not only overtly selective classifications, such as nationality, but also facially neutral classifications that correlate strongly with a selective classification. For example, under long-standing precedent, discriminating against nonresidents is tantamount to discriminating against non-nationals.113See, e.g., Case C-330/91, Queen v. Inland Revenue Comm’rs ex parte: Commerzbank AG, ECLI:EU:C:1993:303 ¶ 1, 14–18 (July 13, 1993). Tax-expenditure analysis does a good job of analyzing covert discrimination, at least when the Commission is correct in its conclusion that a particular facially neutral classification impermissiblyproxies a selective classification. Yet, as this Section explains, tax-expenditure analysis provides no traction in cases that employ neither facially discriminatory classifications nor proxy classifications. To address the inability of tax-expenditure analysis to handle facially neutral rules, in recent cases the Commission turned to both impact analysis and external benchmarking.

1.      Vodafone

A recent referral114See, e.g., Request for a Preliminary Hearing from the Fővárosi Közigazgatási és Munkaügyi Bíróság (Hungary) Lodged on 6 February 2018—Vodafone Magyarország Mobil Távközlési Zrt. v. Nemzeti Adó-és Vámhivatal Fellebbviteli Igazgatósága, 2018 O.J. (C 221) 2, 3 [hereinafter, Vodafone reference]. concerns the application of Hungary’s turnover-tax regime to Vodafone. The regime imposed graduated tax rates that increased with companies’ turnover, and it included a complete exemption for companies with turnover below a statutory threshold. Because high-turnover companies tend to be foreign, while low-turnover companies tend to be domestic, graduated turnover taxes raise indirect discrimination questions.115Id. (also raising the question of whether the higher tax on higher-turnover companies violates the fundamental freedoms). The Hungarian regime does not employ overtly selective classes. Instead, Vodafone raises the question of whether the state’s use of turnover size indirectly discriminates on the basis of company nationality. The CJEU typically analyzes such cases according to the impact of the proxy classification on the legally relevant class.116See generally Ruth Mason & Leopoldo Parada, Company Size Matters, Brit. Tax Rev. (forthcoming Dec. 2019). For company-size cases, the Court recently held that the relevant question was whether a majority of those subject to higher taxes were foreign.117Case C-385/12, Hervis Sport-és Divatkereskedelmi Kft. v. Nemzeti Adó-és Vámhivatal Közép-dunántúli Regionális Adó Fóigazgatósága, ECLI:EU:C:2014:47 ¶ 46 (Feb. 5, 2014).

Whether turnover-size constitutes an impermissible proxy for nationality remains an open legal question. But, assuming that the Commission can accurately identify proxies for selective classes, the Commission can easily adapt its traditional tax-expenditure approach for use with proxy classifications. Instead of measuring the tax advantage as a favorable deviation from the state’s regular tax base that benefits a selective class, the Commission simply would measure the tax advantage as a favorable deviation from the regular tax that benefits a proxy class.

Thus, if the subsidy adjudicator “correctly”118The question of how the Commission and EU courts ought to identify such proxies remains for another day. Note also that due to its specific procedural history, the CJEU, not the Commission, will conduct the state-aid analysis in Vodafone. concludes that a facially neutral classification proxies a selective class, application of traditional tax-expenditure analysis becomes straightforward. What this means in Vodafone is that if CJEU determines that turnover size proxies nationality, the Hungarian law would derogate in favor of small (national) companies. If Hungary could offer no convincing justification for such favoritism, its graduated turnover tax would constitute illegal state aid. Under these conditions, Vodafone would become an “easy” case under tax-expenditure analysis; the proxy classification (turnover size) would be treated as a facially selective classification.119In contrast, if the subsidy adjudicator were to conclude that size does not proxy nationality, then there would be no derogation from domestic law that favored a proxy or a selective class, and therefore there would be no state aid under current methods of state-aid analysis. Section II.A.2, infra, analyzes scenarios like this.

2.      Gibraltar

Tax regimes can confer benefits to selective classes without using selective classifications or proxy classifications. The 2011 Gibraltar120Joined Cases C-106/09 P & C-107/09 P, Gibraltar v. Comm’n, ECLI:EU:C:2011:732 (Nov. 15, 2011). case involved a proposal for a facially neutral tax regime that, if adopted, would have had disproportionate cross-border impacts.121See id. EU law governs Gibraltar as part of the United Kingdom. See id.; see also TFEU, supra note 1, art. 355(3). Gibraltar submitted a proposed tax regime to the Commission for advance determination of whether the regime would be state aid if implemented.122See Gibraltar, ECLI:EU:C:2011:732 ¶¶ 8–14. The proposal was for a payroll and property tax capped at a percentage of corporate income.123Id. ¶¶ 77–84. The regime also envisioned a corporate registration tax. The Commission originally argued that the profit cap constituted a selective advantage for unprofitable companies. See Aid C 66/2002 (ex N 534/2002)—Gibraltar Government Corporation Tax Reform, 2002/C 300/02, ¶ 38, 2002 O.J. (C 300) 7 (noting the profit caps would “appear self-evidently to grant an advantage to those companies that make no profit”). The CJEU rejected this argument. See Gibraltar, ECLI:EU:C:2011:732 ¶ 77. The descriptions of the proposed Gibraltar regime in the Commission’s decisions and the EU courts’ judgments makes it difficult to determine whether the rule was facially discriminatory (because it only applied to Gibraltar companies that employed people in Gibraltar or occupied business property in Gibraltar) or facially neutral (applied to all companies, regardless of whether they were registered in Gibraltar, that employed people in Gibraltar or occupied business property there). See, e.g., Commission Invitation to Submit Comments Pursuant to Article 88(2) of the EC Treaty on Gibraltar Government Corporation Tax Reform, 2002 O.J. (C 300) 2, ¶ 7 (Dec. 4, 2002) (describing the payroll tax as applicable to “Gibraltar employers,” which are “companies incorporated or registered in Gibraltar”). It is not clear whether companies incorporated outside Gibraltar would have to register there to have employees there. See, e.g., id. ¶ 12 (suggesting that all non-public employees in Gibraltar would generate tax for their employers). It appears that the property tax would have applied to both resident and nonresident companies. See id. ¶ 12 (property tax would apply to “all companies occupying property in Gibraltar for business purposes); see also Commission Decision 2005/261 of Mar. 30, 2004 on Gibraltar Corporation Tax Reform, 2005 O.J. (L 85) ¶ 63 (noting that “the reform abolishes any distinction between resident and nonresident companies”). Although the discussion in the text assumes facial neutrality, infra note 291 considers how the analysis would change if the regime was facially selective such that it applied only to certain companies with payroll and property in Gibraltar, such as companies incorporated there.

The Commission refused to approve the proposal, even though the regime would nominally apply the same way to all taxpayers.124Gibraltar, ECLI:EU:C:2011:732 ¶¶ 85–110. The Commission reasoned that the regime would confer state aid as applied because it would favor “offshore companies,” which tended not to have payroll and property in Gibraltar, over onshore companies that tended to have property and payroll in Gibraltar.125Id. ¶ 106. Although the Commission did not define “offshore companies,” the term seemed to refer to “letterbox” companies, companies formally incorporated in Gibraltar, but that did not have much substantive activity there. Id. ¶ 17 (referring to “letterbox” or “asset management companies”).

It was not just the expected outcome but surely also the intended result that the proposed Gibraltar regime would tax offshore companies lightly while taxing onshore companies more heavily. A tiny British territory with a population of about 30,000, Gibraltar thrives by offering foreign companies a low-tax berth for their profits.126See Daniel Bunn, Fiscal Fact No. 623, Corporate Income Tax Rates Around the World (2018), Tax Found. (Nov. 2018), https://files.taxfoundation.org/20190603100114/ Tax-Foundation-FF623.pdf [https://perma.cc/LUE4-CV5M] (listing Gibraltar’s ten percent tax rate as one of the twenty lowest in the world and noting the worldwide average corporate income tax as twenty-three percent). Prior to the proposed regime, Gibraltar had another offshore-friendly tax regime, but the Commission had invalidated it as state aid.127Gibraltar, ECLI:EU:C:2011:732 ¶¶ 4–6. The old regime was facially selective.128See id. ¶ 4. The proposed new regime was Gibraltar’s clever attempt to duplicate the result of the old regime while avoiding facial selectivity, and thereby, Gibraltar hoped, avoiding an adverse state-aid decision.

The Commission saw through Gibraltar’s gambit; it understood that the goal of the regime was to favor offshore companies, a selective class. But the Commission could not establish that Gibraltar conferred a selective advantage using its traditional tax-expenditure approach because that approach depended on identifying the tax advantage as a selective deviation from generally applicable law. Since the Gibraltar regime was facially neutral and applied to all companies the same way, the Commission could not point to any deviating provision that conferred tax advantages only to offshore companies. Unlike in a typical indirect discrimination case, the Commission also could not point to any classification in the Gibraltar law that clearly proxied a selective class. The Gibraltar regime was ingenious—it was engineered to exempt offshore companies as applied, but not only was it facially neutral, it also employed no overt proxy classifications. It achieved its goal to exempt offshore companies by taxing factors that offshore companies tended not to possess in Gibraltar—namely, payroll and property.

Tax-expenditure analysis provides no traction in a case like Gibraltar because the state used neither a selective class nor a proxy class. Lacking a preexisting doctrinal rule to defeat the proposed Gibraltar regime, the Commission invented a new one. It asserted that the Commission was not required to measure state aid as a deviation from a domestic-law reference-law base. According to the Commission, Gibraltar’s facially neutral rule constituted illegal state aid because it would benefit a selective class (offshore companies) as applied.129See id. ¶¶ 14, 20–22.

The lower EU court vacated the Commission’s decision on appeal because the Commission failed to use the traditional tax-expenditure approach.130The Court of First Instance, now known as the General Court, is the European Union’s lower court; its decisions are appealable to the Court of Justice of the European Union, the European Union’s highest court. The court held that EU law required the Commission to show that Gibraltar deviated from its own domestic law to advantage a selective class.131See Joined Cases T-211/04 & T-215/04, Gibraltar v. Comm’n, ECLI:EU:T:2008:595 ¶ 143 (Dec. 18, 2008). According to the lower court, dispensing with the domestic-law reference base would invade Member State competences; it would “enable the Commission to assume the role of the Member State with regard to determination of that State’s tax system.”132Id. ¶ 145. The court noted that states have the power “to devise systems of corporate taxation which they consider the best suited to the needs of their economies,” and the state-aid rules do not “prejudice . . . the power of the Member States to decide on their economic policy and, therefore, on the tax system . . . they consider the most appropriate and, in particular, to spread the tax burden as they see fit across the different factors of production.”133Id. ¶ 146.

On appeal, however, the Court of Justice sided with the Commission to overrule the lower court. The CJEU agreed with the Commission that, as applied, the proposed Gibraltar regime would favor offshore companies, a selective class for state-aid purposes.134Again, the European Union does not use the term “selective class;” I use it for the convenience of U.S. readers. The Court further accepted that the Commission could show selectivity not only by establishing a deviation from a domestic-law reference base but also by looking to the practical effect of the regime.135Joined Cases C-106/09 P & C-107/09 P, Gibraltar v. Comm’n, ECLI:EU:C:2011:732 ¶¶ 85–110 (Nov. 15, 2011). The high court emphasized that relying exclusively on domestic-law deviations to identify tax advantages could create loopholes in state-aid enforcement because a facially neutral regime could achieve the same result as a facially discriminatory regime “by adjusting and combining the tax rules in such a way that their very application results in a different tax burden for different undertakings.”136Id. ¶ 93. The CJEU seemed to be asserting that facial neutrality could not immunize intentional discrimination.137See Mason & Parada, supra note 116 (considering the role of legislative intent in EU tax discrimination cases).

In addition to evaluating the likely impact of the proposed rule on offshore companies, the Court of Justice asserted that the Commission had, in fact, employed a reference-base approach in Gibraltar. Instead of a domestic-law reference base, however, the Commission devised a new benchmark for establishing selectivity, namely whether as applied the regime deviated from its apparent objective. The CJEU observed that despite being “founded on criteria that are in themselves of a general nature, in practice [the proposed regime] discriminates between companies which are in a comparable situation with regard to the objectiveof the proposed tax reform, namely to introduce a general system of taxation for all companies established in Gibraltar.”138Gibraltar, ECLI:EU:C:2011:732 ¶ 101 (emphasis added).

According to the Court, because the proposed regime would not generate tax for “all companies,” it did not achieve its objective, and it therefore constituted illegal state aid.139Id. ¶¶ 100–01. We can think of this analysis as evaluating the anticipated impact of the proposed Gibraltar regime against an external reference base consisting of “a general system of taxation for all companies.”140Id. ¶ 101. Although neither the Commission nor CJEU was explicit about what that tax base might look like, they presumably had in mind a more typical comprehensive corporate income tax base of the type seen in other Member States.

B.   Facially Selective Rules

In my view, Gibraltar posed the question of whether facially neutral rules that do not employ proxy classifications nevertheless can confer tax advantages that warrant state-aid scrutiny. Other recent cases—including Apple—posed essentially the inverse question: can facially selective rules that confer advantages nevertheless avoid conferring state aid? Under the traditional tax-expenditure approach, derogating tax provisions that benefit a selective class are state aid unless justified. But, as this Subsection explains, there are good reasons for states to write and enforce tax rules that distinguish between members of certain selective classes. The most obvious example is income-allocation rules; rules that determine which part of a multinational’s income will be taxed by a particular state. Such rules regularly distinguish between resident and nonresident taxpayers, but they do so by necessity. Facial selectivity, therefore, does not always signal state aid. Although this observation rings true, traditional tax-expenditure analysis cannot separate out facially selective rules that do not confer state aid from those that do. Because it could not resolve recent income-allocation cases using traditional tax-expenditure analysis, the Commission turned to external benchmarking.

1.      Transfer pricing

The inability of traditional tax-expenditure analysis to separate problematic uses of selective classes from nonproblematic ones can be seen in controversial recent cases, which involved a particular kind of allocation rule, namely, arm’s-length transfer pricing.141See infra note 154 and accompanying text; see also Avi-Yonah, supra note 19, at 105 (describing the rise of arm’s-length transfer pricing).

To understand the recent cases, we need some background on international tax. Rules for taxing cross-border income often employ selective classifications—particularly classifications based on tax residence, geographic location of economic activities, and so on. States need these classifications to accommodate differences in their jurisdiction to tax resident versus nonresident taxpayers. International law permits states to tax resident companies on their worldwide income, but states may tax nonresidents only on income “sourced” in their territory.142See, e.g., Restatement (Fourth) of Foreign Relations Law § 411 (Am. Law Inst. 2018). Whether a company resides in a state depends on whether the company meets the state’s definition of corporate tax residence. As the Apple tax-residence mismatch shows, there is no global definition of tax residence; this lack of consensus can lead to dual-resident companies or companies that reside nowhere. Disputes have arisen over the proper way to source income; it is sufficient for our purposes to observe that although many source rules are widely accepted, others are not, and there is no agreed normative framework for determining source.143See, e.g., 2008 JCT Report, supra note 6, at 10 (concluding that the pre-2017 “general rule for taxing foreign earnings . . . can fairly be said to be ambiguous”); J. Clifton Fleming, Jr. & Robert J. Peroni, Reinvigorating Tax Expenditure Analysis and Its International Dimension, 27 Va. Tax Rev. 437, 528–61 (2008) (scoring U.S. income-allocation rules as tax expenditures (or not) against various benchmarks, including a normative ability-to-pay benchmark of the author’s own devising, a reference-law benchmark consisting of the tax treatment of similar domestic income, and a normative anti-deferral benchmark). Kane, supra note 89, at 314–15, 317–18 (arguing that source rules make practical sense but do not follow clear economic principles); Wolfgang Schön, State Aid in the Area of Taxation, in EU State Aids 321, 323–24, 333 (Leigh Hancher et al. eds., 2016) (discussing the absence of a common international tax system to form a baseline for transfer pricing).

Reflecting limits on tax jurisdiction, income-allocation rules—including “source” rules, apportionment rules, methods of relieving double taxation, and so on—typically distinguish between residents and nonresidents or between domestic and foreign income.144See, e.g., Brian J. Arnold, Future Directions in International Tax Reform, 5 Austl. Tax F. 451, 452 (1988) (describing the interplay between resident and nonresident allocation schemes in the international context). Such distinctions constitute selective classifications for state-aid purposes. Moreover, income-allocation rules often seem to favor selective classes. For example, nonresidents are subject to a narrower tax base than are residents, and some types of income that would be taxed if earned domestically may be exempt when earned abroad.145See I.R.C. § 245A (2017) (exempting certain foreign dividends).

Transfer-pricing rules for determining the income of entities that are part of a multinational group likewise may employ selective classifications. Vertically integrated multinationals have affiliates and business activities in many states, and each state must determine how much of the group’s income it should tax. There exist many theoretical frameworks for taxing the cross-border income of multinationals, but separate accounting paired with arm’s-length transfer pricing dominates the world.146In contrast, some subnational jurisdictions, including the U.S. states and the Canadian provinces, use unitary taxation with formulary apportionment. I will discuss formulary in infra Section IV.A. Under separate accounting with arm’s-length transfer pricing, states separately determine the income of each taxable unit of the business (typically, each domestic corporation and/or each taxable branch).

Related companies can secure advantages under separate accounting by manipulating which entity in the group is deemed for tax purposes to earn the integrated enterprise’s income. For example, a group can shift income from a subsidiary in a high-tax country to a subsidiary in a low-tax country by causing the high-tax subsidiary to buy goods or services from the low-tax subsidiary at an artificially inflated price. The high-tax subsidiary gets a larger expense deduction, and the low-tax subsidiary has a larger income inclusion. The group’s overall profit remains the same, but it saves taxes due to the rate differential between the two countries.

Moreover, companies may do better than lowering their tax rates. By exploiting differences between states’ definitions of tax residence, they may be able to escape tax entirely. For example, under laws applicable at the time the facts of Apple arose, Ireland regarded certain companies to be tax resident in Ireland only if they were managed and controlled in Ireland.147Apple, supra note 2, ¶ 7 n.12 (describing old and new Irish tax-residence rules). Ireland has since changed its law to deem as an Irish resident any company incorporated in Ireland, but not regarded by any other state as resident there by virtue of management and control. See Revenue Commissioners, Company Residency Rules, https://www.revenue.ie/en/companies-and-charities/corporation-tax-for-companies/corporation-tax/company-residency-rules.aspx [https://perma.cc/D3ZD-23GU]. In contrast, the United States long has used a place-of-incorporation rule for tax residence.148I.R.C. § 7701(a)(30). By incorporating subsidiaries in Ireland that Apple managed and controlled in the United States, Apple was able to create companies that resided nowhere for tax purposes.149Offshore Profit Shifting and the U.S. Tax Code—Part 2 (Apple Inc.): Hearing Before the Permanent Subcomm. on Investigations of the S. Comm. On Homeland Sec. & Governmental Affairs, 113th Cong. 1–4, 6–7 (2013) (detailing the U.S., European, and Member State tax rules that Apple exploited to effectuate this profit shift). By shifting profits to these nowhere companies, Apple escaped tax on them.150See id. at 42.

The arm’s-length standard counters abusive profit-shifting by requiring both group members to report a market, or arm’s-length, transfer price on the transaction. The arm’s-length standard has faced significant and warranted criticism, but lack of politically viable alternatives has led to its widespread adoption.151See Avi-Yonah, supra note 19, at 28–29. Although the idea of a market price may seem straightforward, determining transfer prices in related-party transactions and allocating income among related companies is no simple matter. Over decades, states have cooperated through the OECD to develop sophisticated and voluminous guidance on acceptable ways to determine income in related-party settings.152Of the twenty-eight EU members (including the United Kingdom), twenty-three are among the thirty-six OECD Member States. Compare Where: Global Reach, OECD, https://www.oecd.org/about/members-and-partners [https://perma.cc/L6 BY-4TQW] (listing OECD Member countries) with Countries, Eur. Union, https://europa.eu/european-union/about-eu/countries_en [https://perma.cc/K9 8X-F3LV]. Memorialized in the OECD Transfer Pricing Guidelines and other OECD reports,153OECD Comm. On Fiscal Affairs, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2017) [hereinafter 2017 OECD Transfer Pricing Guidelines]. most countries, including non-OECD countries, follow this guidance. Typically, states incorporate into domestic law both the arm’s-length standard and OECD guidance for interpreting the arm’s-length standard, but each state modifies the standard and guidance as it sees fit.154See Commission Decision 2017/502 of Oct. 21, 2015 on State Aid Implemented by the Netherlands to Starbucks, 2017 O.J. (L 83) 38, ¶¶ 409–12 [hereinafter Starbucks] (reporting that the Netherlands incorporated the OECD arm’s-length standard into domestic law); Commission Decision 2016/2326 of Oct. 21, 2015 on State Aid Luxembourg Granted to Fiat, 2016 O.J. (L 351) 1, ¶¶ 219–311 [hereinafter Fiat] (reporting that Luxembourg incorporated the OECD standard into domestic law); Amazon, supra note 13, ¶ 129 (same). In contrast, Ireland did not expressly endorse the arm’s-length standard for allocating income to Irish branches of nonresident companies. See Apple, supra note 2, ¶ 152. The Commission argued that arm’s-length was Ireland’s de facto standard. Id. ¶¶ 369–78.

Application of the arm’s-length standard is notoriously complex, and it involves considerable discretion.155See generally Avi-Yonah, supra note 19 (providing an overview of the rise of the arm’s-length standard). Given this environment of legal uncertainty, it is no surprise that multinationals seek confirmation from governments about how to apply the standard to their particular facts. Many countries, including the United States, supply this confirmation in the form of administrative rulings.156See IRS, Rev. Proc. 2015-41, Procedures for Advance Pricing Agreements (2015). Such rulings are usually prospective and cover several years—they describe the taxpayer’s situation and how the taxpayer intends to report income.157See id. at 2 (noting that advance pricing agreements can apply to past or “rollback” years). Because arm’s-length determinations require taxpayers to disclose sensitive business information, they are confidential, although they may be forwarded to tax administrators in other countries in which the multinational has activity.158See IRS, Announcement and Report Concerning Advance Pricing Agreements (2018), https://www.irs.gov/pub/irs-drop/a-18-08.pdf [https://perma.cc/MKT2-L6S9].

Ruling procedures are generally open to any taxpayer, and the Commission acknowledges that rulings usually constitute a legitimate means of increasing legal certainty.159Commissioner Vestager Speech to TAXE, supra note 19, at 2. Although it is valuable, legal certainty is not a relevant advantage for state-aid purposes. But rulings can do more than confirm the application of laws to the taxpayer’s specific facts. Due to their obscurity, the complexity of the laws they apply, their confidentiality, and their application to only a single taxpayer, tax rulings represent an ideal mechanism for governments to deliver benefits to a favored taxpayer while denying similar treatment to the taxpayer’s competitors. When such rulings are secret and unilateral—and all the recent state-aid cases involved secret unilateral rulings—states can use them to impose different, and more favorable, tax rules than those available under domestic law. Disclosure in 2014 by whistleblowers of a large cache of Luxembourg’s secret unilateral rulings for multinationals, an event known as LuxLeaks, seemed to reveal that Luxembourg deviated from its own laws and guidance in secret rulings.160See Omri Marian, The State Administration of International Tax Avoidance, 7 Harv. Bus. L. Rev. 1, 3 (2017) (“Luxembourg ignored its own administrative guidance, binding intergovernmental legal procedures, and well-established principles of international tax law.”). The leak ultimately prompted the Commission to demand that every Member State submit for Commission inspection all tax rulings issued from 2010 to 2012.161Background to the High Level Forum on State Aid of 3 June 2016 ¶ 6 (DG Competition, Working Paper).

2.      Apple and other transfer-pricing cases

Following inspection of these rulings, the Commission initiated several cases against small EU Member States for rulings they granted to large, mostly U.S., multinationals. The Commission found that tax rulings by Ireland for Apple, by the Netherlands for Starbucks, and by Luxembourg for Amazon and Fiat-Chrysler all conferred state aid.162Apple, supra note 2, ¶ 452; Starbucks, supra note 154, ¶ 450; Amazon, supra note 13, ¶ 616; Fiat, supra note 154, ¶ 371. It also found that Luxembourg aided French energy giant Engie. European Commission Press Release IP/18/4228, Commission Finds Luxembourg Gave Illegal Tax Benefits to Engie; Has to Recover Around €120 Million (Jun. 20, 2018). Cases involving IKEA and Nike are pending. European Commission Press Release IP/17/5343, State Aid: Commission Opens In-Depth Investigation into the Netherlands’ Tax Treatment of Inter IKEA (Dec. 18, 2017). The essential question in all four cases was the same: did the Member State illegally favor the company when determining what portion of its income would be taxable by the state? The Commission’s answer in all four cases was “Yes.”

In one strand of reasoning in these cases, the Commission employed its traditional tax-expenditure approach, under which a state confers aid only if it deviates from domestic law to favor a selective class. For example, the Netherlands had incorporated the OECD arm’s-length standard and Transfer Pricing Guidelines as its own domestic standard for allocating income. The Commission in Starbucks,163Starbucks, supra note 154. however, found that the Netherlands deviated from that standard to relieve Starbucks of taxes.164Id. ¶¶ 409–12. The Commission took exactly the same analytical approach in Amazon and Fiat,165Fiat, supra note 154. the two cases involving Luxembourg.166Amazon, supra note 13, ¶ 599; Fiat, supra note 154, ¶¶ 315–17. To this extent, all three decisions employed a traditional tax-expenditure approach. All three cases involved facial selectivity—the states deviated from their regularly applicable law to favor a particular company, and particular companies are a selective class.

Starbucks, Amazon, and Fiat all involved transfer-pricing rulings that determined the taxable income of a resident corporation. In contrast, Apple involved rulings that determined how much income to allocate to the Irish branch of one of Apple’s Irish-incorporated, but nowhere-resident subsidiaries. Because Ireland had not adopted into its domestic law the OECD arm’s-length standard to allocate income to Irish branches of foreign companies, it was unclear whether it was appropriate for the Commission to evaluate the Apple rulings against that standard. Ireland asserted that the Commission was required to evaluate the rulings against a benchmark consisting only of Irish law, and Ireland furthermore insisted that it had followed its own law, which required allocation of “taxable profits commensurate with the value of the contribution made by the Irish branch in each case to overall company profitability.”167Apple, supra note 2, ¶ 159. Irish domestic law provides that nonresident companies are subject to tax only on Irish-source income, unless they have an Irish branch, in which case, the branch is taxable on “all its chargeable profits wherever arising.” Id. ¶ 73. An Irish branch’s chargeable profits are “any trading income arising directly or indirectly through or from the branch or agency, and any income from property or rights used by, or held by or for, the branch or agency, [not including] distributions received from [resident] companies.” Id. Beyond that, Ireland’s descriptions of its attribution rule were vague. Ireland stated that its attribution rule was fair, consistent, appropriate, and not the result of a bargaining process. Id.¶¶ 157–58. Ireland reasoned that since the Irish branches contributed only a small amount to Apple’s global profitability, it was appropriate and consistent with Irish law to allocate only a small amount of Apple’s global profit to Ireland.168Ireland argued that not only was it not obliged to tax the billions of profits made by Apple’s nowhere-resident subsidiaries, but that it had no authority under Irish law to tax that profit. Ireland’s obligation, in its view, was limited to determining and taxing the profits of the Irish branch of the nowhere companies (and therefore it had no responsibility to determine, much less tax, the companies’ total profits). Id. ¶¶ 276–308.

The Commission advanced three alternative accounts as to how Ireland illegally aided Apple. First, it argued that, notwithstanding Ireland’s protestations to the contrary, arm’s length was—de facto, if not de jure—the standard Ireland used to allocate income to branches.169After examining of all of Ireland’s branch-profit allocation rulings over ten years (amounting to only eleven such rulings), the Commission determined that Ireland consistently accepted income allocations to branches that relied on the OECD arm’s-length standard. Id. ¶¶ 371–72, 372 n.310. Armed with this de facto reference-law benchmark, the Commission could use traditional tax-expenditure analysis to find that Ireland deviated from its own law to favor Apple.170See id. ¶ 377. Under this approach, Ireland—like the Member States in Starbucks, Amazon, and Fiat—violated its own domestic allocation rules to favor an individual company, a selective class for state-aid purposes.171See id. ¶¶ 361–78. On this account, all the recent cases fit easily with the Commission’s prior decisions.

The Commission’s second theory was that Ireland had no pre-determined allocation rules; it just made special deals with taxpayers.172See id. ¶¶ 396–403 (highlighting Ireland’s inconsistent application of allocation rules). Such tax negotiation would be state aid under long-standing doctrine because it would allow Irish officials too much discretion.173Permitting excessive administrative discretion can lead to adverse state-aid decisions under long-standing guidance. 2016 Notice, supra note 1, ¶¶ 123–25.

But what if, as Ireland claimed, Ireland had income-allocation rules other than the arm’s-length standard, and what if, as Ireland also claimed, it applied those rules uniformly to all taxpayers, including Apple? The ruling for Apple was technically selective because tax rulings apply only to a particular company, and particular companies constitute a selective class. And because states’ tax jurisdiction over nonresidents is limited compared to their jurisdiction over residents, nonresidents typically face less tax than residents; this difference technically may qualify as a tax advantage under tax-expenditure analysis. But selectivity in income-allocation rules, even when paired with advantageous tax treatment, does not seem to be enough to make a reliable finding that a state conferred the type of tax advantage that the state-aid rules ought to care about. Thus, unlike in the easy cases discussed in Part II, the presence of a selective tax advantage in the income-allocation cases cannot be dispositive.174See supra Section II.B.1.

But to simply approve of the result of Apple’s tax plan—tens of billions of income in an Irish-incorporated company that would face no current tax anywhere in the world—must have seemed untenable to the Commission. Apple and Ireland argued that the income eventually would be taxed by the United States when distributed as dividends to Apple’s U.S. parent,175The Irish-incorporated Apple subsidiaries would trigger this tax by distributing profits to their U.S. parent. Because the timing of the U.S. tax was, at the time of the case, controlled entirely by Apple, Apple could indefinitely defer it. Since the Commission’s final decision in Apple, U.S. law changed so that rather than indefinite deferral, previously retained foreign profits will be taxed whether distributed or not. See I.R.C. § 965 (2017). but no one knew when that would be, and in the meantime, if Ireland did not tax Apple, no one would.

To resolve the dilemma, the Commission advanced its controversial third theory for how Ireland violated the state-aid rules in Apple. The Commission concluded that the state-aid rules themselves require all states to allocate income according to the arm’s-length standard, regardless of domestic law.176See Apple, supra note 2, ¶ 255. In other words, the Commission used arm’s length as an external benchmark from which to measure the advantage Ireland conferred to Apple.

Earlier, I described benchmarks for tax-expenditure analysis as falling into several categories.177See supra Section II.A. Any of the following could serve as the benchmark for measuring tax expenditures: reference law, idealized tax policy views, or commonly accepted standards, such as financial accounting rules. Supporting the notion that it saw arm’s-length as a normative standard, the Commission asserted that the standard applied in all cases as a matter of EU law.178Starbucks, supra note 154, ¶¶ 264–65; Fiat, supra note 154, ¶ 229; Apple, supra note 2, ¶¶ 255–57. The Commission even left open the possibility that a ruling that complied with OECD guidance nevertheless could violate the EU arm’s-length standard.179See, e.g., 2016 Notice, supra note 1, ¶ 173 (noting that rulings complying with the OECD Transfer Pricing Guidelines are “unlikely to give rise to State aid”).

At the same time, the Commission also used language that suggested it applied the arm’s-length standard because it viewed arm’s length as a dominant state practice.180Apple, supra note 2, ¶ 322 (internal citations and footnotes omitted) (noting that, aside from OECD guidance, “no other alternative detailed and comprehensive analyses on methods of attributing profits are available to tax administrations and multinational enterprises to assist them in establishing arm’s length conditions”); see also 2016 Notice, supra note 1, ¶ 173 (explaining that the OECD “guidelines do not deal with matters of State aid per se, but they capture the international consensus on transfer pricing and provide useful guidance to tax administrations and multinational enterprises on how to ensure that a transfer pricing methodology produces an outcome in line with market conditions”). Additionally, it fleshed out the standard by reference to OECD guidance. In Apple, it used both OECD guidance that was in effect at the time Ireland rendered the Apple rulings and OECD guidance issued thereafter. The Commission thus retroactively applied modern OECD guidance to a country that had adopted into its domestic law neither the OECD guidance itself nor the arm’s-length standard it modified.181Apple, supra note 2, ¶¶ 88–89, 272–73, 323 (relying heavily on the 2010 OECD branch profits attribution report, even though Ireland granted the later of the two contested rulings in 2007); see also Starbucks, supra note 154, ¶¶ 174, 177 (citing both the 1995 OECD Transfer Pricing Guidelines, which the Netherlands had incorporated into domestic law, and the 2010 OECD Transfer Pricing Guidelines, which post-dated the tax rulings at issue in the case).

Using this external benchmark for allocating income, the Commission concluded that all the income that Apple had booked in its nowhere-resident subsidiaries should have been taxed by Ireland as part of the profits of those subsidiaries’ Irish branches. That interpretation led to the counter-intuitive result that half of Apple’s global profit was Irish.182Apple, supra note 2, ¶¶ 305–07. Apple’s aggressive tax planning drove this counter-intuitive result because Apple, believing that the profits of its nowhere subsidiaries would not be taxed, shifted as much of Apple’s global profit to those subsidiaries as possible. That is why the tax bill in Apple was so high. In contrast with the Irish approach, which focused only on the contribution of the Irish branches to Apple’s global profitability, the Commission reasoned that because the head offices of the nowhere subsidiaries (of which the Irish branches formed part) had no substance, whereas the Irish branches had substance, all the profit of the nowhere subsidiaries had to be allocated only to the branches, and none of the profit could be allocated to the head offices. See id.¶¶ 276–307. It is not a goal of this paper to analyze the correctness of the Commission’s application of the arm’s-length standard to Apple. Rather, this Article concerns the Commission’s legal justifications for applying that standard in a state-aid case.

Perhaps to shore up its claims in Apple about the state-aid arm’s-length standard, the Commission claimed in its nearly contemporaneous decisions in Starbucks, Amazon, and Fiat that, in addition to violating their own law, the Netherlands and Luxembourg also violated the EU arm’s-length standard that applied regardless of domestic law.183Fiat, supra note 154, ¶ 228 (“The arm’s length principle therefore necessarily forms part of the Commission’s assessment under Article 107(1) of the TFEU of tax measures granted to group companies independently of whether a Member State has incorporated this principle into its national legal system.”); see Amazon, supra note 13, ¶¶ 402–08 (establishing the arm’s-length principle as a requirement under state-aid law); Starbucks, supra note 154, ¶ 245 (“The arm’s length principle therefore necessarily forms part of the Commission’s assessment under Article 107(1) of the Treaty of tax measures granted to group companies independently of whether a Member State has incorporated this principle into its national legal system”); id. (the state-aid arm’s-length standard “is not that derived from Article 9 of the OECD Model”). The Commission regards only its own arm’s-length standard as producing a state-aid compatible “market-based outcome.” See generally id. In each of these cases, the Commission argued that the state’s application of what the Commission regarded as a deviating arm’s-length standard was selective because it unjustifiably favored a selective class. Either it constituted individual aid to a particular company, which was selective per se,184See Amazon, supra note 13, ¶ 399; Apple, supra note 2, ¶ 244; Starbucks, supra note 154, ¶ 254; Fiat, supra note 154, ¶ 218. or it favored multinational companies engaged in cross-border commerce over domestic companies engaged in domestic commerce.185Amazon, supra note 13, ¶ 599; Starbucks, supra note 154, ¶ 236; Fiat, supra note 154, ¶¶ 198–209.

3.      Belgian Excess Profits

Like the tax rulings cases, Belgian Excess Profits186Commission Decision 2016/1699 of Jan. 11, 2016 on the Excess Profit Exemption State Aid Scheme S.A. 37667 Implemented by Belgium, 2016 O.J. (L 260) 61 [hereinafter Belgian Excess Profits]. involved a facially selective regime. The Belgian regime exempted from tax so-called excess profits earned by multinational corporate groups. Excess profits were those deriving from “synergies, economies of scale or other benefits drawn from . . . participation in a multinational group and which would not exist for a comparable standalone company.”187Id. ¶ 14. The exclusion applied to the Belgian portions of all multinational groups, whether those groups were headquartered in Belgium or not, but it did not apply to domestic groups.188Id. ¶ 13 (describing the benefits as applying to Belgian companies or Belgian permanent establishments that were part of a multinational group). Despite Belgium’s protests that the excess-profits regime should be regarded as part of its domestic-law reference base,189Id. ¶ 123. and that the exclusion ensured that multinationals would be taxed—like domestic companies—only on arm’s-length profits,190According to Belgium, “the rationale for the Excess Profit exemption is to ensure that a Belgian group entity is only taxed on its arm’s length profit.” Id. ¶ 14. the Commission took a normative approach. It claimed that the “objective of the Belgian corporate income tax system is to tax all corporate taxpayers on their actual profits, whether they are a standalone or group company.”191Id. ¶ 126. Having identified “tax[ing] . . . actual profits” as Belgium’s policy objective, the Commission concluded, as it had in prior cases, that the state-aid specific arm’s-length method of allocating income formed a necessary part of the reference system, regardless of whether Belgium adopted it into domestic law.192Id. ¶¶ 126, 150. The Commission concluded that the excess-profits regime conferred tax advantages by deviating from this purposive benchmark.193Id. ¶¶ 132–33. Belgium’s expressed policy preference as to taxability of excess profits was simply irrelevant under the benchmark the Commission chose.

C.   Hard-to-Classify Rules

Some rules may be hard to classify as either facially selective of facially neutral, making it particularly difficult under tax-expenditure analysis to determine whether the state has conferred state aid. This Subsection provides two examples.

1.      McDonald’s

McDonald’s194Commission Decision of Sept. 19, 2018 on Tax Rulings in Case SA.38945 (ex 2015/NN) (ex 2014/CP) Granted by Luxembourg in Favour of McDonald’s Europe, 2018 O.J. (L 195) 20, https://ec.europa.eu/competition/state_aid/cases/261647/ 261647_2033697_264_2.pdf [https://perma.cc/4D8N-YRK9] [hereinafter McDonald’s Final Commission Decision]. was the only recent case against a U.S. multinational in which the Commission found no state aid.195Id. It involved a tax-treaty question. Under the U.S.-Luxembourg tax treaty, Luxembourg undertook an obligation to exempt income that, under the treaty, “may be taxed in the United States.”196Id. ¶ 60. The case involved the U.S. branch of a Luxembourg subsidiary of the U.S. franchise giant McDonald’s.197Id. ¶¶ 20–22. As is typical under tax treaties, the United States could tax the branch of a Luxembourg company only if the company had a nexus and business profits in the United States, as defined in the tax treaty and under U.S. law.198Id. ¶¶ 111–23 (the conflict involved interpreting the tax-treaty terms “permanent establishment” (i.e., nexus), “business” and “business profits”).

The tax treaty directs a state to interpret unclear treaty terms by referring to the law of the state applying the treaty.199Id. ¶ 113 (referring to Article 3(2) of the U.S.-Luxembourg tax treaty). Following this prescription, the United States concluded that the branch did not meet U.S. nexus and business-profits conceptions, and, consequently, the United States could not tax the branch.200Id. ¶¶ 39–41, 46, 66­–67, 73. In contrast, when Luxembourg considered the same question, it came to a different conclusion. Luxembourg interpreted the tax treaty terms by reference to its own law.201Id. ¶¶ 34, 38. Since U.S. law and Luxembourg law differed on the meaning of the terms used in the tax treaty, the United States concluded it could not tax the branch, but Luxembourg, applying its own domestic-law interpretations of these terms, concluded that the United States could have taxed the branch.202Id. ¶ 114.

In reality, the United States did not tax the branch, and Luxembourg knew the United States would not tax it.203Id. ¶ 74. Nevertheless, Luxembourg took the position that because the branch’s income “may be taxed in the United States,” the tax treaty obliged Luxembourg to exempt the branch’s income.204State Aid SA. 38945 (2015/C) (ex 2015/NN) Luxembourg Alleged Aid to McDonald’s ¶ 84 (Dec. 12, 2015) [hereinafter McDonald’s Opening Commission Decision] (explaining that in its ruling for McDonald’s, Luxembourg accepted McDonald’s argument that “since the US Franchise Branch constitutes a PE under Luxembourg tax law, the profits attributed to it should be exempt from Luxembourg corporate income tax, irrespective of whether it also constitutes a PE under US tax law”). The result, which involved a known tax-planning technique, was that the branch—to which McDonald’s had shifted as much income as possible—was taxed by neither Luxembourg nor the United States.205Id. ¶ 85 (Dec. 12, 2015).

Luxembourg interpreted its treaty in a way that resulted in nontaxation. It presumably did so deliberately to attract business to Luxembourg. Other countries might have interpreted the same language not to require exemption.206See Fadi Shaheen, Tax Treaty Aspects of the McDonald’s State Aid Investigation, 86 Tax Notes Int’l 331, 340 (2017) (arguing in part that because the relevant paragraph of the treaty begins “in Luxembourg double taxation shall be eliminated as follows,” Luxembourg was obliged to exempt only in cases where failure to do so could result in double taxation; since the U.S. branch of McDonald’s Luxembourg subsidiary was not taxed by the United States, there would be no double taxation, and therefore the treaty did not require Luxembourg to exempt). Both interpretations are plausible.207For discussion of the controversy, see generally Klaus Vogel on Double Taxation Conventions § (Ekkehart Reimer et al. eds., 4th ed. 2015). Some commentators would argue that Luxembourg’s interpretation was unreasonable. See, e.g., Shaheen, supra note 206, at 340. What matters for the analysis in this Article is not whether Luxembourg’s interpretation was correct, but that the Commission regarded it as part of the reference base.

While Luxembourg may not have used a facially selective classification or a proxy classification, tax-treaty interpretations by their nature apply only to cross-border situations. Thus, if they confer systematic benefits, those benefits will redound only to cross-border taxpayers, a selective class. But if multiple potential treaty interpretations are plausible, and the state chooses the one most favorable to cross-border taxpayers or to a particular taxpayer, does it thereby confer state aid?

Rather than apply either of the two new approaches introduced in the earlier Gibraltar case, in McDonald’s, the Commission hewed to its traditional reference-law approach and concluded that Luxembourg conferred no state aid. The Commission reasoned that Luxembourg’s reference law included both the tax treaty itself and Luxembourg’s reasonable interpretation of that tax treaty.208McDonald’s Final Commission Decision, supra note 194, ¶ 109 (“It is not established that the contested tax rulings constitute a derogation from the rules set by the double taxation treaty. Such a derogation would exist if the contested tax rulings misapplied (i.e. deviated from) a rule of the double taxation treaty . . . .”). In doing so, the Commission emphasized that there were twenty-five rulings for other companies in which the Luxembourg tax authorities took the same position, amounting to “a coherent interpretation.”209See id. ¶ 123. Since Luxembourg’s tax-treaty interpretation for McDonald’s did not derogate from Luxembourg’s reference law, the Commission concluded that Luxembourg conferred no aid, notwithstanding that McDonald’s paid no tax anywhere on the income of its branch.210See id. ¶ 124. The Commission concluded that the double nontaxation arose from the failure of the United States to “make use of its right to tax assigned to it under the double taxation treaty,”211Id. ¶ 117. This conclusion by the Commission calls into question whether it actually understood the legal background in the case. The United States did not regard itself as having authority to tax the income, which it then affirmatively exempted. Rather, the United States concluded that it had no authority to tax the income under the tax treaty. While the possibility that the Commission misunderstood the law is concerning, it does not affect the analysis here because I am using this case for the principle that the Commission announced in it, which was that a state’s tax-treaty interpretation forms part of its reference law. a gap for which Luxembourg could not be held responsible. In reality, of course, the United States was no more at fault than was Luxembourg; under its own interpretation of the tax treaty and U.S. law, the United State