Cyprus: The McDonald's Investigation And Double Non-Taxation Based On The Interpretation Of DTTs

Last Updated: 11 January 2019
Article by Andreas Kapsalis

The McDonalds Group is a US Multinational Enterprise with its parent company McDonald's Corporation, a US company. The operations in Europe and Russia were carried out by subsidiaries in Luxembourg, one holding and one franchising company. The franchising subsidiary controlled also two branches, one in Switzerland and one in the USA.

Based on the structure set up by McDonalds, the Swiss branch was in charge of licensing the franchise rights in Europe and Russia. The Swiss branch collected the payments from the royalties and after deduction of costs allocated them to the US branch that subsequently transferred these payments to the parent company. Given the tax structure of McDonald's in Europe, there was no taxation of profits in Europe.

Following allegations from the press that Luxembourg was granting an advantageous tax treatment to McDonalds, the European Commission requested information on the tax rulings issued for McDonalds.

On the 3rd of December 2015 it was announced by the European Commission that they had opened a formal investigation into Luxembourg's tax treatment of McDonald's. The Commission's preliminary view was that McDonald's might have been granted an advantageous tax treatment deriving from two Luxembourg tax rulings. According to the Commission, this advantage could be in breach of the Union's State Aid rules for the internal market. This case was the Commission's first attempt to tackle a country for failing to check that a US Multinational was properly taxed in the US. It is also quite unique to see the Commission interpret Double Taxation Treaties. Nevertheless, since the Treaty is part of the national law of the Member States, the Commission has the power to do so.

Luxembourg's authorities gave two rulings regarding the structure of McDonald's. The first ruling was given in March of 2009 and confirmed that McDonald's Europe Franchising would not pay corporate income tax in Luxembourg based on the fact that the profits generated from the franchising activity were subject to tax in the US, as long as McDonald's provided proof that the profits were subject to tax in the US. The ruling was justified according to LUX's tax authorities because of the Double Taxation Treaty between LUX and the US.

The second tax ruling was given in September of 2009 and accepted the position of McDonald's that it was no longer required to prove that the profits were subject to tax in the US and thus confirming that the profits were not subject to tax in LUX even if they were not subject to tax in the US either. McDonald's managed to receive this treatment by suggesting to LUX's tax authorities that the US branch was in fact a permanent establishment with sufficient business or trade in the US making it subject to tax in the US, whereas to the US tax authorities McDonald's supported that the US branch was not a permanent establishment due to lack of sufficient business or trade and was not subject to tax in the US.

During the Preliminary Investigation, the Commission discovered that the profits resulting from royalty payments were not taxed anywhere and since 2009, the year that the tax rulings were issued, McDonald's did not pay any corporate tax in Luxembourg. According to the Commission's view, this could potentially be a selective derogation from national tax law provisions of LUX and the LUX – US Double Taxation Treaty and as a result an advantage granted only to McDonald's and no other companies that were comparable in a factual and legal situation.

As mentioned before, the Commission started a formal investigation in early December 2015 to see if its concerns for the second tax ruling are justified and to assess whether LUX authorities selectively derogated from the provisions of their national tax law and the LUX – US Double Tax Treaty resulting to an advantage for McDonald's and not available to other companies in a comparable factual and legal situation. If indeed the result of the investigation was that those concerns were justified then it meant there was in fact a favorable tax treatment in breach of EU State Aid rules. The announcement stated clearly that the purpose of Double Taxation Treaties is to avoid double taxation and not to justify double non-taxation.

During the investigation the Commission examined the measure within the scope of Art 107(1) of TFEU. To determine whether this measure was indeed within the scope of the above-mentioned article, it followed the three-step approach.

Regarding the framework, the Commission in paragraph 69 determined that it had examined the LUX corporate tax system as a whole and defined it as the relevant reference system in order to identify the selectivity of the advantage granted by the ruling. There is also a reference to Paint Graphos as a source of determining the system's objective.

Subsequently and for the determination of the existence of derogation from the framework, the Commission examined both rulings in light of the referenced framework. According to the Commission, there should be an examination of the provisions laid down by the Double Tax Treaty between LUX – US and whether these provisions were applied incorrectly or not. In case the result was positive then it would be deemed that there was indeed a selective advantage in place. During this examination of the DTT the Commission examined Articles 3, 5 and 7 but focused primarily on Art 25 (Art 23A of the current OECD Model Tax Convention).

It is clear from the preliminary investigation that the Commission interpreted the above article in a different manner than both McDonald's and the LUX tax authorities. Its position on this matter was that McDonalds is not effectively taxed in the US and that leads to double non-taxation. LUX and McDonalds on the other hand interpreted the phrase "may be taxed" of the article as subject to tax and not effectively taxed. The Commission stated that their view is in line with the OECD Commentary and specifically paragraph 32.6 of Art 23A.

Furthermore, the Commission stated that "accordingly, to avoid conferring a selective advantage on McD Europe the Luxembourg tax administration should have only agreed to exempt income from corporate taxation to the extent that that income may be taxed in the United States pursuant to Article 7 of the Luxembourg–US DTT. That was also the conclusion reached by the tax administration in the initial tax ruling by which it required McD Europe to demonstrate that "those profits have been declared and are subject to tax in [...] the United States" if it wished to benefit from the tax exemption resulting from Article 25(2) of the Luxembourg–US DTT. The fact that the Luxembourg tax administration was fully aware when it issued the revised tax ruling that the US Franchise Branch does not constitute a PE for US tax purposes, because that was explained in detail by McDonald's tax advisor in the request for a revised ruling, means that it was also fully aware that its business income may not be taxed in the United States as required by Article 7 of the Luxembourg–US DTT. Consequently, the Luxembourg tax administration confirmation that that income could be exempted from Luxembourg corporate income tax by virtue of Article 25 of the Luxembourg–US DTT rests on a misapplication of that provision. In conclusion, the Commission considers, at this stage, that the Luxembourg tax Administration, by confirming in the revised tax ruling an erroneous interpretation of the Luxembourg–US DTT and the Luxembourg domestic law that transposes it, in full knowledge of the fact that the US Franchise Branch is not subject to taxation in the United States, confers a selective advantage to McD Europe for the purposes of Article 107(1) TFEU as compared to Luxembourg tax resident companies in a similar legal and factual situation that are taxed on all their accounting profits, since that erroneous interpretation results in the non-taxation of a sizeable portion of McD Europe's accounting profits."

Additionally, the Commission's investigation stated that no justification was presented by LUX and since it is not its obligation to check if one exists, concluded the analysis.

After the announcement of the decision for a formal investigation, many scholars believed that the Commission's interpretation on A23(2) of OECD MTC was false. One scholar who shared this view was Werner Haslehner in his article "The McDonald's State Aid Case – The EU Commission Interprets a Tax Treaty"1. In the mentioned article it is laid down that:

  1. the LUX-US DTT explicitly only refers to the avoidance of double taxation and prevention of tax evasion, but not to the avoidance of double non-taxation,
  2. the LUX-US DTT has been concluded in 1996, years before a change of the OECD Commentary that lead to the first inclusion of the cited paragraph (par. 32.6 on Art 23A OECD MTC Commentary),
  3. according to case law of the Supreme Administrative Court of Luxembourg, substantive changes to OECD Commentary cannot affect the interpretation of pre-existing tax treaties, and
  4. the Commission's result, appears to be based on a misunderstanding of the OECD Commentary: The rule cited by the Commission, par. 32.61, addresses conflicts of interpretation, it allows the residence state to tax income if the source state "considers that the provisions of the Convention preclude it from taxing an item of income or capital which it would otherwise have had the right to tax", but it seems that the US did not consider itself precluded from taxing the income of the US Franchise Branch by the LUX-US DTT; it simply chose not to exercise its taxing right.

It was also stated in the same article that the Commission examined whether there is a permanent establishment for US tax purposes in the US only regarding the domestic law. However, when the same subject is examined under the DTT the outcome is different since the US considers that there is a permanent establishment for the purposes of the DTT.

Regarding the interpretation of the DTT there was also the supporting argument for LUX that if it can be demonstrated that LUX had consistently interpreted the provisions of the Lux - US DTT in the same way with respect to all taxpayers in a 'comparable legal and factual situation', it seemed questionable that the selectivity criterion would be met.

It is clear from the literature that the Commission should act within its powers and eliminate any State Aid which is not in compliance with the internal market. However, certain benefits tend to arise outside of its jurisdiction like this case. LUX interprets its DTT in a manner which is in compliance with the OECD Commentary. The term "may be taxed" does not require any tax to be levied. The benefit arises merely because the US decides not to tax. In such a situation it is unlikely to be any State Aid involved.

Finally, on the 19th of September 2018 the Commission announced the closure of the formal investigation stating that the non-taxation of certain McDonald's profits in Luxembourg did not lead to illegal State aid, as it is in line with national tax laws and the LUX-US DTT. Furthermore, it stated that the role of EU State aid control is to ensure that Member States do not give selected companies a better treatment than others, through tax rulings or otherwise. In that context, the Commission's in-depth investigation assessed whether the LUX authorities selectively derogated from the provisions of their national tax law and the LUX – US DTT and gave McDonald's an advantage not available to other companies subject to the same tax rules. The conclusion was that this was not the case.

In particular and as stated in the announcement "it could not be established that the interpretation given by the second tax ruling to the LUX – US DTT was incorrect, although it resulted in the double non-taxation of the royalties attributed to the US branch. Therefore, the Commission found that the LUX authorities did not misapply the LUX – US DTT and that the tax advantage conferred to McDonald's Europe Franchising cannot be considered State aid". This is despite the fact that the Commission considers that McDonald's Europe Franchising US branch did not fulfill the relevant provisions under the US tax code to be considered a permanent establishment.

At the same time, the Commission found that the LUX authorities could exempt the US branch of McDonald's Europe Franchising from corporate taxation without violating the DTT because the US branch could be considered a permanent establishment according to LUX tax law. Under the relevant provision in the LUX tax code, the business carried on by the US branch of McDonald's Europe Franchising fulfilled all the conditions of a permanent establishment under LUX tax law. Therefore, the Commission concluded that the LUX authorities did not misapply the LUX – US DTT by exempting the income of the US branch from LUX corporate taxation.

The conclusion of this investigation provides further guidance to Member States on how to interpret their Double Taxation Treaties with Third States. It also clearly shows that when the conditions set by the DTT and national tax legislation are fulfilled in the view of the Member State but the Third State decides not to tax then the Member State is not obliged to interpret the DTT in a way that it grants to the Member State taxing rights.

With regards to Cyprus, this is an important clarification on how to interpret DTTs, which are currently in effect, in similar situations because of our extensive DTT network and our national tax laws that attract companies from all around the world. Based on this investigation, it was made clear that when double non-taxation occurs but this is a result of the decision of the Third State, which is part of the DTT, then Cyprus cannot interpret its DTT in order to be able to tax the company.


[1] Werner Hassleher, "The McDonald's State Aid Case – The EU Commission Interprets a Tax Treaty", Kluwer International Tax Blog, June 22, 2016.

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