Third country, second thoughts? The EU’s foreign subsidies regulation

The European Parliament and the Council are currently debating the European Commission’s proposed regulation on foreign subsidies, which covers subsidies granted by third countries that have the potential to distort competition in the EU. In particular, the proposed regulation targets large M&A deals and public procurement procedures involving financial contributions from public authorities outside the EU. Economic tools from the state aid context could help to assess the existence of a foreign subsidy, and its impact on competition.

In May 2021, the Commission adopted a proposal for a regulation to address distortions caused by foreign subsidies.¹ While the granting of support from EU member states is subject to state aid control, no comparable regime is in place for support granted by non-EU countries to companies that operate in the EU. The proposed regulation would provide the Commission with tools to take action when foreign subsidies cause competitive distortions in the EU market.

The proposed regulation focuses in particular on large mergers and acquisitions (M&A) and public tender procedures, where investors benefitting from subsidies from a non-EU country may be able to make advantageous offers, thereby distorting the level playing field in the EU. An overview of the proposed regulation is provided in the box below.

This article outlines the tools that can be used to assess—from an economics perspective—the existence of a foreign subsidy, and whether the negative effects of a foreign subsidy might outweigh their positive effects.

From ‘financial contribution’ to ‘subsidy’—the definition of a foreign subsidy

According to the proposed regulation, a foreign subsidy exists:²

where a third country provides a financial contribution which confers a benefit to a recipient in the EU and which is limited, in law or in fact, to an individual undertaking or industry or to several undertakings or industries.

Under the proposed regulation, the definition of a financial contribution is relatively broad. It captures different types of measure, such as grants, loans, equity injections, loan guarantees and fiscal incentives, as well as the supply or the purchase of goods and services. As most investors acquiring companies in the EU are private undertakings, certain private firms (including financial institutions) may be captured by the proposed regulation, if they have received a financial contribution from a foreign state in the past.³

For a financial contribution to constitute a subsidy, however, it must ‘confer a benefit to a recipient in the EU’. In order to assess this, two aspects need to be considered:

1. whether the financial contribution from the foreign state has conferred an advantage on the investor or acquirer;
2. whether this advantage might be ‘passed on’ to a recipient in the EU.

For example, a foreign subsidy received by an investor or acquirer in the past could strengthen its financial position and lead to an inflated bid for a notifiable M&A transaction, such that the benefit is ‘passed on’ to a recipient in the EU.

How to assess whether a financial contribution confers a benefit

The Commission clarifies that the existence of a benefit should be determined based on an assessment of the practice of private investors.⁴ Under state aid rules, an economic advantage is not conferred (and hence funding does not constitute aid) if the public authority providing the funding does so on market terms. Therefore, it is plausible that the same methods that are available to determine compliance with the so-called market economy operator principle (MEOP) in state aid cases could also be used to assess the existence of a ‘benefit’ in the context of foreign subsidies.⁵

The MEOP, and the economic conceptual framework underpinning it, has become a key tool used by the Commission to assess a broad spectrum of public measures. In the context of foreign subsidies, a MEOP test could be applied to assess whether a financial contribution from a third country confers a benefit on the investor or acquirer (which could potentially be ‘passed on’), and whether a benefit is conferred on a recipient in the EU as a result of the transaction (e.g. a notifiable M&A transaction). Two stylised examples are provided in the box below.

The figure below summarises the process for assessing the existence of a foreign subsidy, and at which points a MEOP assessment could be undertaken to determine whether the transaction would be likely to be captured by the proposed regulation.

Figure 1   Assessing whether the transaction in question would be captured by the regulation

While a MEOP assessment could be undertaken to assess whether a financial contribution from a foreign state confers an advantage on an investor or acquirer, under the Commission’s current proposal, it is unclear if a MEOP test in relation to the transaction in question would be sufficient to rule out that the investor or acquirer is captured by the regulation, in case it has received funding not on market terms from a non-EU state over the last three years. It remains to be seen how the Commission will apply the assessment in practice.⁶

In order to assess whether a public measure is in line with the MEOP, benchmarking and profitability analysis can be undertaken.

• Benchmarking involves analysing whether the terms (especially the price) of a transaction are in line with comparable transactions observed on the market between private entities.
• Profitability analysis can be used to assess whether the expected return from the transaction is in line with, or higher than, the return required by a private operator in a similar transaction.

In addition to financial data provided by the company under assessment, the MEOP assessment can be based on data from financial databases such as Datastream, Orbis or Bloomberg, as well as analyst reports. Examples of the types of economic and financial analysis that could be applied to assess the existence of a foreign subsidy are set out in the box below.

How to undertake the balancing test

When a foreign subsidy has been identified, the Commission will balance the negative effects of the foreign subsidy on competition in the EU with its positive effects on the development of the relevant subsidised activity.⁷ If the negative effects outweigh the positive effects, the Commission can impose remedies, including requirements on the company to reduce its capacity or market presence, restrictions on certain investments, or the divestment of certain assets.⁸ In some cases, the Commission can require the foreign subsidy to be repaid, including with interest.⁹

In its proposed regulation, the Commission outlines a set of indicators to determine the distortive impact of a subsidy on competition, including:¹⁰

• the amount and nature of the subsidy;
• the purpose and conditions attached to the subsidy;
• the situation of the undertaking and the markets concerned, such as the degree of barriers to entry;
• the level of economic activity of the undertaking concerned on the EU market, and its presence on the internal market.

As outlined in Oxera’s study for the Commission that analysed the impact of aid on competition, similar economic techniques to those that are standard in merger control could be undertaken to assess the impact of a foreign subsidy on competition.¹¹ In particular, the following steps could be undertaken:

1. identifying the main characteristics of the foreign subsidy (such as the form of the subsidy, or the amount of subsidy granted) and defining the relevant markets in the EU that might have been affected by the foreign subsidy;
2. defining the hypotheses to be tested to assess the impact of the foreign subsidy on the relevant EU markets relative to what would have been likely to have been the case in the absence of the foreign subsidy (i.e. the counterfactual scenario);
3. assessing and measuring the impact of the foreign subsidy on competition in the EU relative to the counterfactual scenario.¹²

In relation to the positive effects of a subsidy, the proposed regulation does not discuss how the impact of a subsidy on the development of the relevant economic activity in the EU will be assessed. Under state aid rules, the balancing exercise involves assessing the impact of the aid on a common interest objective, such as the impact of the aid on employment and GDP, research spillovers or regional connectivity, depending on the market failure that is addressed. Similar to a state aid assessment, it therefore seems important that, as a foreign investor, a transaction is also considered in the context of the EU’s economic policy objectives in order to meet the balancing test. However, the way in which the balancing exercise will be undertaken by the Commission remains to be seen.

Looking ahead

The proposed regulation is far reaching, and will bring about significant changes for foreign investors who are considering investing or expanding their activities in the EU. For firms looking to make acquisitions that would be captured by the new rules, the proposal introduces the need to undertake detailed due diligence of the bidder and the target. In this article, we have outlined some methods to guide the analysis.

In the state aid context, the concept of the MEOP (and the economic conceptual framework underpinning it) has been developed and refined over the years. It has become a key tool for the Commission to assess the existence of aid for a broad (and increasingly complex) spectrum of public measures. As the Commission is well acquainted with the economic methods used to assess the MEOP, it is plausible that public funding from third countries will not be considered to be a foreign subsidy, and thus will fall outside the scope of regulation, if it meets the requirements of the MEOP.

Even if a financial contribution is considered to constitute a subsidy, economic analysis, as used in state aid compatibility assessments, could be applied to assess the degree of distortion to competition in the EU resulting from a foreign subsidy, as well as the subsidy’s positive effects.

How the Commission will apply the regulation in practice remains to be seen, particularly with regard to the balancing test. But as we have set out in this article, economic and financial analysis, alongside the necessary legal analysis, can help investors to navigate the complex requirements of this regulation.

¹ European Commission (2021), ‘Proposal for a Regulation of the European Parliament and of the Council on foreign subsidies distorting the internal market’, COM(2021) 223 final, 5 May.

² European Commission (2021), op. cit., Article 2. Foreign subsidies below €5m are not subject to the regulation.

³ Ibid.

⁴ Ibid., p. 16, para. (10).

⁵ For further information on the methods available to establish MEOP compliance in state aid cases, see Robins, N. and Puglisi, L. (2020), ‘The market economy operator principle: an economic role model for assessing economic advantage’, in L. Hancher and J.J. Piernas López (eds), Research Handbook on European State Aid Law, Second Edition, Edward Elgar.

⁶ In any event, a MEOP assessment on the transaction in question could provide helpful evidence as to whether competition in the EU is more likely to be distorted (as part of the balancing test), in particular for cases that have to be notified to the Commission.

⁷ European Commission (2021), op. cit., Article 5.

⁸ Ibid., Article 6.

⁹ Ibid., Article 6(3)(h).

¹⁰ Ibid., Article 3. Certain categories of subsidy are deemed ‘most likely to distort the internal market’. These include public support to ailing undertakings (unless a credible restructuring plan exists), unlimited guarantees, and subsidies that are directly aimed at supporting a concentration or a participation to a tender. Ibid., Article 4.

¹¹ See Oxera (2017), ‘Ex post assessment of the impact of state aid on competition’, Final report, prepared for the European Commission Directorate-General for Competition, November.

¹² For further details about the economic tools that can be used to assess the impact of aid on competition, see Oxera (2017), op. cit.