Regional selectivity: A fine day of sun for the European “true” autonomies

It is not every day (on the contrary) that Portugal is on the spotlight of the European Court of Justice (ECJ). In the first day after its summer vacations, the European Court of Justice issued a decision concerning the action brought by the Portuguese Republic seeking the annulment of Commission Decision 2003/442/EC which classified as state aid the reductions on the rate of income tax for natural and legal persons having their tax residence in the Portuguese Autonomous Region of the Azores (case C-88/03).(1)

(1) A region is the layer of government directly below the national level. The term is used, especially, in relation to regions with some sort of historical claim or idiosyncrasy in relation to the remaining territory. Examples may include for instance: (i) Scotland, Wales and Northern Ireland, in the UK; (ii) The island-regions of Sardinia and Sicily in Italy; (iii) the Basque country in Spain; or (iv) the Finnish province of Åland. Many other regions exist, with different degrees of decentralisation.

One interesting point is that the Azores case may be of great assistance to other autonomous jurisdictions within the European Union, such as Gibraltar and the Spanish Basque region, in their efforts to reform their tax systems and deviate from their central government tax system. In that regard, it should be mentioned that there is case currently pending in the European Court of First Instance (CFI) contesting the Commission decision regarding to the Government of Gibraltar’s’ plans for corporate tax reform.

The Azores tax benefits

The facts of the case are quite long and for persons not fully involved in state aid maters, this subject may seam a bit wearisome. But for sake of completeness allow me to very briefly explain what is state aid in plain tax terms and why is it important in the framework of the European Union internal market.

In 2000, the Portuguese authorities notified (as required by EC Law) the European Commission of a scheme adapting the national tax system to the specific characteristics of the Autonomous Region of the Azores (2).

(2) The Azores, an archipelago of nine Portuguese islands in the middle of the Atlantic Ocean (1,500 km from Lisbon and 3,900 km from North America), is one of the two Portuguese autonomous regions (the other being Madeira), which possesses its own political and administrative statute and has its own regional government and legislative parliament (elected by universal suffrage).

The measures, approved by the legislative body of the Azores Region, included, in particular, a reduction in the rate of personal income tax of 20 % (15 % for 1999) and a reduction in the rate of corporation tax of 30 % for taxpayers in the region.

In the context of the EU internal market (one of the main goals of the EU), state aid rules are aimed at reducing distortions of competition. Since restrictions on competition are not a “monopoly” of companies, governments when granting public aid to businesses should be assessed in a similar fashion. As such, the Treaty of Rome (Article 87) considers incompatible with the EU internal market any aid (including forgone tax revenue) granted by a Member State, which distorts or competition and affects trade between Member States. In order for a specific measure to be considered incompatible state aid (in the form of forgone tax revenue) it is generally necessary for such measure to: (i) give rise to a selective advantage (e.g. favouring certain undertakings or the production of certain goods); (ii) involve state resources; (iii) affect intra-community trade or competition; and (iv) not be justified by the nature of the tax system (3).

(3) For more details on the application of those rules in tax matters, please see the 1998 Commission notice on the application of the State aid rules to measures relating to direct business taxation and the 2004 Report on the implementation of the Commission notice on the application of the State aid rules to measures relating to direct business taxation.

Taking into account the state aid rules, the EU Commission responded to the Portuguese notification by initiating an investigation procedure, specifically with regard to that part of the scheme concerning reductions in the rates of income and corporate tax.

This investigation was crystallized the Commission Decision 2003/442/EC, which classified as state aid the tax reductions for residents of the Azores. After examining the scheme, in light of the guidelines on national regional aid, the Commission, however, considered that such aid meet the conditions for being considered as being compatible with the Common Market, under the derogations of Art. 87(3)(a) of the EC Treaty, i.e. "aid to promote the economic development of areas where the standard of living is abnormally low or where there is serious under-employment". National regional aid in Azores was, in this case, justified due to its contribution to regional development and the fact that it was proportional to the additional costs they were intended to offset.

Nevertheless, the Commission decision included a caveat. Accordingly, a distinction was made between the financial and the non-financial sectors. In fact, in respect of financial sector firms, the Commission stated that such corporation tax reductions were "not justified by their contribution to regional development" and, therefore, the tax reductions did not qualify as permitted national regional aid under Art. 87(3)(a) (i.e. regional aid) or any other derogation provided for in the EC Treaty. The reasoning was that the existence of real regional handicaps counts for very little for mobile activities, such as financial services and firms of the ‘intra-group services’ or ‘coordination centre’ type of activities.

Accordingly, Portugal was ordered to recover the aid made available to firms carrying on financial or intra-group service activities. Since the Portuguese law did not establish any intra-group service regime, the impact of the decision was primarily on the financial institutions benefiting from the reduced rates.

The Portuguese Counter-attack

Even though the Commission decision impacted only in financial firms having their activities in Azores, it could be said that that the argument as concerns regional selectivity limited future plans for future divergence between the tax system of mainland Portugal and the tax regime in place in the two autonomies, namely Azores and Madeira.

Portugal therefore reverted to the ECJ and attacked the Commission decision on 3 grounds, being the first ground the important issue for the discussion today. Under the first ground, the Portuguese Government submitted that the reduced rates were not selective but general measures, since the reference framework should have been the region and not the whole Portuguese territory.

The United Kingdom and Spain, which intervened in support of the Portugal, mentioned that due regard should be made to the degree of autonomy of the regional or local authority before classifying regional tax rates (which are lower than the national tax rate) as State aid. The Commission, on the other hand, submitted that the selectivity of a measure was to be determined by reference to the national framework and that the degree of autonomy of the Autonomous Region of the Azores was in fact limited.

At this point, it is important to note that, tax measures which are open to all economic agents operating within a Member State are in principle general measures. In that respect, it is commonly said that only measures whose scope extends to the entire territory of the State escape the specificity criterion. But if that assertion would be the case for all situations, then prima facie all national tax variations limited to a geographic subsection of a Member State qualify as ‘geographically’ selective! So an answer is needed as to which should be the point of comparison (tacking into account different degrees of autonomy found in the various member states) in considering whether a geographically limited national tax rate variation “favours certain undertakings or the production of certain goods”.

It should be noted that the Commission, in the 2004 report on applying the State aid rules to direct business taxation, had adopted a rather limitative position with regard to fiscal autonomy. As such, clarification in this regard was “desperately” needed.

The Principles set out by Advocate General Geelhoed

Advocate General Geelhoed, the same advocate which is actively involved in some of the high profile pending tax cases (such as ACT Group Litigation, FII Group Litigation and Denkavit II), delivered its opinion on 20 October 2005. The AG pointed out that since the ECJ has never answered this specific question, it was for the Court to set out the applicable principles. For this purposes, the AG distinguished three different scenarios, depending on the decentralization model adopted by a particular state:

- In a first situation, if a central government of a EU Member State unilaterally decides that the national tax rate should be reduced within a defined geographic area, the AG considers that such a measure should be clearly viewed as selective;

- Secondly, if a local or regional authority has autonomous powers to set the tax rate for their geographical jurisdiction, whether with or without reference to a "national" tax rate, the AG considers the measure to be non-selective within the meaning of the state aid provisions; and

- In a third situation, where a tax rate lower than the national tax rate is decided on by a local authority and applicable only within the territory of that local authority, the AG considers that the selective nature of the measure depends on whether or not the lower tax rate results from a decision taken by a local authority that is "truly" autonomous (i.e. institutionally, procedurally and economically autonomous) from the central government of the EU Member State.

This begs the question as to whether the distinction between an autonomous infra-State body and a not “truly” autonomous infra-State body is a rather straightforward distinction, i.e. easy to apply in practice.

By “truly” autonomous, the AG referred to three different parameters of a state autonomy, namely the institution, the procedural and the economic autonomy. By institutionally autonomous, the AG was referring to infra-State bodies with its own constitutional, political and administrative status separate from that of the central government. By procedurally autonomous, the AG was referring to the independence of infra-State body in the procedure of setting the tax rate and without any obligation on the part of the local authority to take the interest of the central State into account. Finally, by economically autonomous, the AG was referring to the situation of whether the forgone tax revenue (through a tax reduction) is cross subsidised or financed by the central government, so that the economic consequences of such tax reductions are not ultimately borne by the region itself.

The AG concluded that when a local authority decides to institute a tax rate lower than the national rate and it exercises its (tax) autonomy institutionally, procedurally and economically, such decision cannot be qualified as ‘selective’ for State Aid purposes.

The ECJ decision on regional selectivity

As regards the selectivity criterion, the ECJ started by mentioning that it is possible that an infra-State body enjoys a legal and factual autonomy, to the extent that it will be the area in which such infra-State body exercises its powers, and not the country as a whole, the so-called reference framework for the purposes of assessing whether a particular measure is selective.

For the purposes of examining a measure adopted by an infra-State body in the exercise of powers sufficiently autonomous vis-à-vis the central power, the ECJ referred back to AG Geelhoeds’ three different scenarios, set out in his opinion.

In a more polished way (but without deviating from Geelhoeds’principles), the ECJ considered that the exercise of sufficiently autonomous powers requires constitutional autonomy (i.e. separate political and administrative status), procedural autonomy (i.e. no directly intervention by the central government) and financial autonomy (i.e. the cost of tax reductions is borne by the autonomy and not offset by aid or subsidies).

The difference between the AG opinion and the final decision of the court rests in the issue of procedural autonomy. The ECJ made no reference to an “obligation on the part of the local authority to take the interest of the central State into account in setting the tax rate” and that missing element may play an important role in evaluating autonomies, whereby the power to legislate is limited by national interest parameters.

This forth parameter could in fact jeopardize or make the analysis more intricate, as regards cases where the freedom of the infra-body to legislate is limited constitutionally by principles of solidarity, maximum or minimum tax burdens or similar restrictions.

In applying the set of principles, laid down by the AG, to the present case, the ECJ started by noting that the Azores have been designated an "autonomous region" and that this region has the power, in certain circumstances, to exercise their own fiscal competence and the right to adapt national fiscal provisions to regional specificities.

Nevertheless, the ECJ noted that the reduction in tax revenue, resulting form the lower rates, is offset by a financing mechanism, in the form of compensatory financial transfers from the central State. In this regard, the ECJ considered that the decision of the government of the Autonomous Region of the Azores to exercise its power to reduce the rates was not economically autonomous, in view of the budgetary transfers managed by central government.

In conclusion, the ECJ considered that the relevant legal framework for determining the selectivity of the reduced rates was the whole of Portuguese territory and that such reductions were not justified by the nature or the overall structure of the Portuguese tax system.

The Gibraltar Case

As mentioned above, the decision of the ECJ on the Azores case may have a wider impact and eventually influence the currently pending Gibraltar case (Gibraltar is a UK overseas territory which is part of the European Union). On 30 March 2004 the European Commission “pushed the breaks” on the proposed reforms to Gibraltar’s corporate tax system, which were intended to take effect from 1 July 2004, by concluding that they were incompatible with the EU rules on State aid.

According to the planned reform, which could be said to deviate from other EU benchmark tax systems), companies domiciled in Gibraltar would be subject to a yearly payroll tax (per employee) and to a business property occupation tax. As such, every employer in Gibraltar would be required to pay payroll tax for the total number of its full-time and part-time employees who are employed in Gibraltar plus a business property occupation tax at a rate equivalent to a percentage of their liability to the general rates charged on property in Gibraltar. One interesting (and controversial) point of the reform would be that the liability to payroll tax together with business property occupation tax would be capped at 15 % of profits (that would probably mean that an offshore company without any physical presence in Gibraltar would pay no tax at all). The project included other features, such as a registration fee applicable to all Gibraltar companies and an additional top-up or penalty tax on profits generated by certain designated activities.

In its scrutiny of the reform plans, the Commission considered that a number of features of the reform proposals would be liable to confer an advantage on Gibraltar companies. At the top of the list (i.e. the first ground of dispute) was the regional selectivity, which would mean that the proposed system would grant an advantage to Gibraltar companies compared with UK companies. Basically, the corporate tax rate tax in Gibraltar would be set at 15%, rather than the United Kingdom’s 30% statutory corporate tax rate.

The essence of the Commission's view on the regional selectivity of the Gibraltar tax reform proposals, is that they provide, in general, for a lower level of taxation than that applicable in the United Kingdom and that this difference amounts to a selective advantage for companies active in Gibraltar. According to the Commission, a distinction based solely on the body that decides the measure would remove all effectiveness from Article 87 of the Treaty, which seeks to cover the measures concerned exclusively according to their effects on competition and Community trade.

The Commission, in making its point on regional selectivity, even referred to the controversial position of AG Saggio opinion on the cases involving the Basque region (it should be noted there was no final ruling in these cases, as the proceedings were later suspended). According to Saggio, “the fact that the measures [are] adopted by regional authorities with exclusive competence under national law is (...) merely a matter of form, which is not sufficient to justify the preferential treatment reserved to companies which fall under the provincial laws. If this were not the case, the State could easily avoid the application, in part of its own territory, of provisions of Community law on State aid simply by making changes to the internal allocation of competence on certain matters, thus raising the general nature, for that territory, of the measure in question”.

In addition, the Commission pointed out that the use of a purely institutional criterion to differentiate ‘aid’ from ‘general measures’ would inevitably lead to differences in treatment in the application of the rules on aid to Member States, according to whether they had adopted a centralised or decentralised model of allocating tax competence.

Gibraltar counter-attacked by bringing an action to annul the disputed Commission decision, before the Court of First Instance of the European Communities. On the point of regional selectivity, Gibraltar submited that the Commission's regional selectivity principle cannot apply to Gibraltar, since we are dealing with two tax jurisdictions, which are entirely separate and mutually exclusive so that Gibraltar's tax laws cannot be treated as derogations from tax law in the United Kingdom.

It is expected that the acceptance by the ECJ of new parameters to determine regional selectivity in the Azores case may play a considerable role in the forthcoming discussions of this case. Nevertheless, the negative assessment of Gibraltar corporate tax reform plans by the commission also focused on other issues such as material selectivity.

The case of the Spanish Basque regions

Another region where the parameters set out by the ECJ will deserve future attention is in the Basque Country. The Basque territory is an autonomous community with the status of historical region within Spain and its institutional and economic autonomy, may be said, in many ways, the highest standard of autonomy found in EU member states.

The Spanish constitution outlines a quasi-federal system where three levels of government coexist: central, regional, and local. In general, the autonomous area of the Basque Country benefits from a special tax regime, within the framework of the national laws of Spain. Under such special regime, the parliaments of the different regions comprising the Basque Country (Alava, Guipuzcoa and Bizkaia) are authorized to adopt and modify certain taxes within certain prescribed limits. The recognition by the Spanish Constitution of historic rights of the Basque Country resulted in a need to agree on the details of the functioning of the financial and tax system and the Economic Agreement between the Basque country and Spain (Concierto Económico) served that purpose. The Economic Agreement embodies the Spanish fiscal decentralization model, which entails a maximum level of tax autonomy. Conversely, these regions must contribute to the central government by means of the so-called “cupo” (quota), which is linked to the general expenses that the central government makes on their behalf (4).

(4) In the case of the Basque Country, the authority on taxation matters is exercised by the governing bodies (Diputaciones forales) of the three foral provinces: Álava, Bizkaia and Guipuzcoa. Their treasuries regulate, levy and administer all the (conceded) Basque Country’s taxes.

In summary, under the Economic Agreement the Basque Country is given right to have its own tax systems, which include most of the powers to regulate and administer the main taxes, including personal and corporate taxes (VAT is for example excluded). The agreement includes, notwithstanding, a set of provisions that aim to guarantee an adequate level of harmonization between regional system and the common territory system.

Accordingly, the (regional) tax system shall nevertheless be in accordance with the (i) constitutional principle of solidarity; (ii) the general structure of the Spanish tax system; (iii) the coordination, fiscal harmonisation and cooperation with the Spanish State; and (iv) international agreements signed by the Spanish State (i.e. double tax treaties and European Union).

In addition, when drafting tax legislation the infra-state bodies are required: (i) respect the general tax law in matters of terminology and concepts; (ii) maintain an overall effective fiscal pressure equivalent to that in force in the rest of the State; (iii) respect and guarantee fundamental freedoms throughout the territory of Spain, without giving rise to discrimination or a lessening of the possibilities of commercial competition or to distortion in the allocation of resources; and (iv) use the same system (as the common territory) for classifying (...) industrial, commercial (...) activities.

Taking into account this degree of autonomy it is expected that the Basque region competency to regulate tax would fulfil the three principles set out by AG Geelhoed and accepted by the ECJ in the Azores case.

Final comments

Tacking into account the parameters set out by the ECJ in the Azores case, it appears that the issue of regional selectivity under EU state aid rules is close to become settled. Interpretation issues may still arise as to whether a specific region fulfils the criteria of being institutionally, procedurally and economically autonomous and a clarification/update by the EU commission on this field is also welcomed.

Although it is understandable that the Commission is worried with allowing infra-state bodies to make changes to the general tax system and in that way circumvent EU state aid rules, namely the strict limits set out for regional aid, such worries should not be made at the expense of the process of EU fiscal decentralization, a model adopted by certain EU states to preserve and guarantee the unity of their own territories.

Fiscal autonomy has been and will continue to be (perhaps even more) present in the political and social landscape of some of the most important European regions and state aid rules may have a limited role in tackling such fiscal autonomy. Perhaps the outcome on the regional selectivity may reinforce the necessity to develop additional measures to curb (potential) tax competition by infra-state bodies (under the so-called “shadow” of fiscal autonomy). Nevertheless, the outcome on the Azores case may be said to have been fine day of sun for the European “true” autonomies!