Lessons from the European Commission’s investigation of Nike in the Netherlands

3 April 2019

Nike’s activities in Europe have been under scrutiny from European authorities lately, and the news hasn’t been good for the US-based multinational. Last week, the European Commission announced it had fined Nike 12.5 million euros for breaking anti-trust rules. An EC investigation opened in 2017 found that Nike restricted out-of-territory branded-merchandise sales within European Economic Area countries in an effort to keep prices high.

Perhaps of more interest to fellow multinationals operating in Europe is another in-depth examination of Nike, which was opened by the EC in January. The new investigation was launched “to examine whether [two] tax rulings granted by the Netherlands to Nike may have given the company an unfair advantage over its competitors, in breach of EU State aid rules.” State aid rules prohibit a company from receiving government support to gain an advantage over its competitors.

The 2019 inquiry follows two separate, now-concluded EC investigations involving Apple and Starbucks. In the case of Apple, the EC found in 2016 that Ireland had given the company unfair tax benefits of 13 billion euros. In the case of Starbucks, the EC decided in 2015 that Netherlands tax authorities had artificially lowered the tax paid by the company by 20 to 30 million euros. The EC’s ongoing efforts to monitor the taxation of intra-group arrangements and operations of EU organizations — using State aid rules to justify any challenges — have serious implications for multinationals.

The reasons for the investigation

The current EC investigation of Nike concerns the Dutch tax treatment of two Netherlands-incorporated Nike group companies. Nike established the companies to develop, market and return the sales of Nike and Converse products throughout Europe, the Middle East and Africa (EMEA). The two Dutch operating companies obtained intra-group licenses to use Nike and Converse intellectual property (IP) and took a tax deduction in the Netherlands for the associated intra-group royalty payments. Significantly, the royalty income received by the two associated Dutch entities was not subject to taxation in the Netherlands.

The EC’s investigation is concerned with a series of tax rulings issued by Dutch tax authorities relating to how royalties are calculated. The rulings approved Nike’s royalty calculation on the basis of the Nike Dutch operating companies’ sales-based operating margin.

The EC is concerned that “the royalty payments endorsed by the rulings may not reflect economic reality.” Specifically, the Commission is concerned that the pricing of the intra-group royalty does not reflect the economic substance of the arrangement; that is, that the arrangement as agreed with the Dutch tax authority is contrary to the arm’s length principle. (The arm’s length principle dictates that pricing between two companies should be set as if they were independent of each other.)

The EC’s case hinges on the value of Nike’s royalty pricing. This valuation appears to be artificially high based on the facts of the situation, says the EC. These facts include the following, based on the EC’s preliminary analysis:

  • The Nike operating entities have more than 1,000 employees.
  • The Nike operating entities are involved in the development, management and exploitation of the IP and they incur related expenses.

Despite the above facts, the Nike entities that actually receive the royalties have no employees and don’t carry out any economic activity.

These royalty practices — which have been endorsed by Netherlands tax authorities — may have, in the words of the EC, “unduly reduced the taxable base in the Netherlands” of Nike’s two group companies. This in turn would give Nike an advantage over stand-alone companies or companies that comply with the arm’s-length principle of transfer pricing. If that’s the case, then the situation would violate EU State aid rules. In the words of the Margrethe Vestager, the EU’s competition commissioner, “Member states should not allow companies to set up complex structures that unduly reduce their taxable profits and give them an unfair advantage over competitors.”

Under EU State aid rules, the EC is empowered to require the Netherlands to recover the associated aid from Nike, similar to the 13.1 billion euros (plus interest) collected by Ireland from Apple late last year.

In the end, what we have is a multinational group (Nike) benefiting from the corporate legal framework of an EU country (the Netherlands) that allows the use of non-taxable entities to receive royalty income; in addition, the local tax authority approved of transfer pricing practices between group entities that does not appear to reflect market realities.

Implications for multinationals

Unfortunately for multinational groups seeking clarity as regards the taxation of their intra-group arrangements and operations, the Nike challenge demonstrates that we are operating in uncertain times. The current EC challenge is similar to the Starbucks case I mentioned. Here again we have the European Commission challenging the locally approved transfer-pricing practices of a US-based multinational with operating companies in the Netherlands.

The EC’s position in both the Starbucks and Nike investigations is a clear example of the need to ensure that the economic benefit derived within a multinational group is aligned with its legal ownership. Moreover, small and mid-sized multinational groups should not be lulled into thinking they’re exempt from scrutiny because news media have focused on high-profile EC investigations into companies like Nike, Apple and Starbucks. European authorities are targeting the transfer-pricing and other tax-related practices of multinational groups of all sizes, using their wide array of detection and enforcement powers to challenge taxpayer positions.

Multinationals should also be aware that the European Commission is far from the only authority looking into the comprehensive cross-border activities of multinationals. Individual countries inside and outside the EU are increasingly concerned about collecting their perceived fair share of taxes based on where a multinational group creates economic value, whether or not that multinational group has a legal presence inside the country. A UK law that goes into effect this month and taxes income derived from intangible property held by non-UK resident entities located in low-tax jurisdictions is a prime example of this trend.

When structuring cross-border arrangements, then, multinationals must balance the desire to create tax efficiency with the reality of widespread and increasingly strict legislation — from anti-avoidance provisions such as the UK’s recent intangible property tax to changing permanent establishment triggers to new transfer pricing requirements such as those related to country-by-country reporting. Multinational groups must also regularly revisit their tax positions in light of those constantly evolving laws, stepped-up enforcement, and potential fines and reputational damage.