The Apple Debacle

Almost six and a half years ago on May 21^st 2013 during a US senate panel hearing, Apple Inc.’s corporate shenanigans were brought to the public’s attention. Among other things, it highlighted how Apple Inc. had setup certain subsidiaries in The Republic of Ireland to avoid paying taxes in the US, where they faced a rate of 35%; a rate relatively high compared to 12.5% they faced in Ireland, “one of the lowest in the world” (Boland, 2016).

Fast forward three years to August 30^th 2016, where Margrethe Vestager is presenting at a press conference in Brussels. Commissioner Vestager, is the Danish politician currently serving as the European Commissioner for competition. She concluded that The Republic of Ireland had given Apple a special deal regarding its treatment of corporate taxes. According to the European Commission’s finding, the favorable tax treatment resulted in Apple not paying €13 billion in taxes, which they would have paid if they were not given the special deal by the government of Ireland.

In essence, this meant that Ireland was required to collect back the unpaid taxes from Apple. The European Commission press release (2016) stated:

Member States cannot give tax benefits to selected companies – this is illegal under EU state aid rules. The Commission’s investigation concluded that Ireland granted illegal tax benefits to Apple, which enabled it to pay substantially less tax than other businesses over many years. In fact, this selective treatment allowed Apple to pay an effective corporate tax rate of 1 per cent on its European profits in 2003 down to 0.005 per cent in 2014.

Back in Palo Alto, this news (for obvious reasons) was not welcomed. Being handed a tax bill of €13 billion plus interest is not exactly the news you want to hear weeks before you introduce a phone without a headphone jack. However, Apple was not alone in criticizing the European Commission’s position, as both Ireland’s and the US governments made their opposition known. Ireland, feeling attacked had no option but to go on the offensive and stated that the “The Commission has exceeded its powers and interfered with national tax sovereignty” (Fraser, 2016). The US Treasury department issued a rare warning ahead of the press conference “that Brussels was becoming a supranational tax authority that threatened international agreements on tax reform.” (Financial Times, Jopson & Beesley, 2016).

Soon afterwards both Apple and the government of Ireland appealed this ruling. This case would be heard at the European Courts of Justice. This is a lengthy process and as with any case of such stature, it could take multiple years before we know what the courts decide.

The start of the love affair

Apple Inc.’s history in Ireland dates back to October 1980, when Apple established its first ever operation in Europe by opening up a factory in Cork, Ireland with 60 employees. The purpose, according to Apple’s letter to its customers (2016), was to “serve customers in Europe”. However, a lower corporate tax rate and a possible sweetheart deal with the Government of Ireland could also be plausible explanations. Today, Apple hires approximately 6000 employees and “its presence in Cork is perhaps the ultimate symbol of Ireland’s transformation from an agrarian society to one of Europe’s most modern and vibrant economies” (Financial Times, Boland, 2016).

Figure 1: Steve Jobs, Apple co-founder, left, and local MP Gene Fitzgerald at Apple’s Cork plant in 1980.

Ireland’s history and its dependency on FDI

Ireland’s reservation regarding the Commission’s finding will make more sense when you understand how modern Ireland has come to be. Five decades after The Republic of Ireland got its independence, its economy still purely revolved around agriculture. The economy was performing poorly and it was on a constant decline, with issues such as mass unemployment, poverty and emigration.

Ireland pressingly needed a way to grow its economy, and its membership into the European Economic Community (EEC), present day European Union (EU), in 1972 enabled just that. This freed up the Irish economy from the shackles of protectionism, and made available to its businesses access to the European single market.

If it wasn’t for its membership into the EU, and more importantly Foreign direct Investment (FDI) into Ireland, it would not be what it is today. With a corporate tax rate of 12.5%, along with the availability of an English speaking workforce, access to the single market, Ireland was able to attract significant amounts of FDI as major foreign corporations started setting up their operations in Ireland. Among these were companies such as Apple, Microsoft, Intel, Google and Pfizer along with big name financial services firms.

It was a mutually beneficial arrangement, where companies not only obtained preferential tax rates but also benefited from access to the European single market. Ireland on the other hand benefited immensely in the form of huge tax revenues, investment and employment opportunities for locals. The Financial Times finds that “The roughly 700 US companies operating in Ireland employ 140,000 people, often in high-paying jobs in research and development, sales, marketing, finance and design” (Financial Times, Boland, 2016).

However, don’t be fooled by this over dependence on FDI, as it does have significant repercussions. Joe Tynan, Head of the PWC’s Tax practice in Ireland put it perfectly when he said “If you were designing the ideal economy, you wouldn’t make it so dependent on FDI” (Financial Times, Boland, 2016). According to finfacts.com, in 2015 only 10 firms accounted for about 50% of corporate tax receipts (Hennigan, 2016). This is clearly too much dependency on FDI, especially in times of changing international tax laws.

Ireland’s fear stems from a possible precedent, a court ruling in the favour of the European Commission, might establish. If the European Commission can come after Apple, the most valuable company in the world and have them pay up huge sums in taxes, then they can certainly come after other multinationals operating in Ireland. No business, let alone a multinational one would want to operate in such a climate of uncertainty and fear. This looming uncertainty could potentially incentivise them to restructure their organization, leave Ireland and move elsewhere.

This would be devastating for Ireland since it would result in a huge decrease in government revenues, public spending cuts and jobs losses. Already having to face austerity measures, the public would certainly not be happy to hear that. I hope you can now appreciate the concern Ireland’s government has regarding this ruling from the EU commissioner, Margrethe Vestager.

Ireland’s economy needs a stimulus badly, and the €13 billion of unpaid taxes could be what they are looking for. But at what cost? Only time will tell.

Apple’s Offshore Organizational Structure

The purpose of this article is to discuss the accusations levied upon Ireland by the European Commission. There are further issues at play here but for the sake of organization and simplicity, I will restrict my discussion to the European Commissions findings.

In essence, the accusation revolves around Ireland providing selective tax treatment to Apple in Ireland, which is considered illegal under State Aid rules of the EU. This is because it allows Apple a competitive advantage over other businesses that don’t have access to such favorable tax treatments.

Specifically, the European Commissioner focuses on two tax rulings that were provided by Ireland to Apple; one in 1991 and the second one in 2007. The question of legality of these two tax rulings is a question that must eventually be answered by the European Court of Justice.

There are two Irish subsidiaries of Apple in question, namely Apple Sales International (ASI) and Apple Operations Europe (AOE); both of which are eventually owned by the US parent company Apple Inc. Apple Sales International is responsible for buying Apple products from its manufactures in China and selling them to Europe, Middle East, Africa and India. Apple Operations Europe on the other hand, is responsible for manufacturing certain Apple computers in Ireland.

Apple Inc. and these two Irish subsidiaries share the economics right to Apple’s intellectual property as part of a cost sharing agreement. The European Commission press release (2016) finds “They (ASI and AOE) hold the rights to use Apple’s intellectual property to sell and manufacture Apple products outside North and South America under a so-called ‘cost-sharing agreement’ with Apple Inc.”. This agreement “gives the subsidiary (ASI and AOE) the right to 60 percent of profits from its intellectual property” (Tax Justice Blog, Phillips, 2013) and in return these subsidiaries have to make yearly payments to Apple Inc. to fund R&D efforts on their behalf.

Figure 2: Apple’s Offshore Organizational Structure

Apple uses Apple Sales International in a way that ensures that majority of the profits from the sales of its products ends up being recorded in Ireland. This is done by using Apple Sales International as the intermediary between the Chinese manufactures and its distribution company, Apple Distribution International (ADI).

For example, Apple Sales International purchases an iPhone from the Chinese manufacturers for €50, and then sells it forward to Apple Distribution International for €600. Apple Distribution International then sells it to different Apple retailers in Europe, and the end consumer ends up buying the iPhone for €650. This way the majority of the sale income ends up in Apple Sales International and not in the the Jurisdiction where the sales actually took place.

In this particular transaction, Apple Sales International just made a profit of €550 for literally doing nothing, and I actually do mean nothing. ASI just took on the initial title of the iPhone when it purchased the iPhone from the Chinese manufacture but not the physical possession of it. The actual shipment goes directly from China to wherever Apple Distribution International wants to sell the iPhone to, let us say the Apple Retail Belgium.

Both Apple Sales International and Apple Operations Europe were incorporated in Ireland. They are split “into two “bits”- an Irish branch and an offshore head office” (Irish Times, Taylor, 2016). The Irish branch is a tax resident in Ireland, however, the head office was a tax resident nowhere in the world. The economic rights to the profits from Apple intellectual property (as discussed above) were owned by the head office .

The European Commission press release (2016) further went on to state that:

This “head office ” was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. Only a fraction of the profits of Apple Sales International were allocated to its Irish branch and subject to tax in Ireland. The remaining vast majority of profits were allocated to the “head office”,where they remained untaxed.

Before I go any further, its important that you understand that concept of tax residency in determining tax liability. The concept of tax residency applies both to individuals and corporations. It helps determine which tax authority (Canada Revenue Agency, Inland Revenue, Internal Revenue Service etc.) you owe tax to. So, as I mentioned above the Irish branch being a tax resident in Ireland, would be liable to pay taxes to “Revenue – Irish tax and customs” on its taxable income.

How Apple was able to setup a “head office” which had no tax residency anywhere in the world is question worth exploring. The US Senate Finance committee report prepared by the Permanent Subcommittee on Investigation explains this perfectly. Apple essentially exploited the difference between the US and the Irish tax residency rules. Ireland determines tax residency based on where the central management and control is exercised, and the US determines tax residency based on whether the company is incorporated in the US or not.

Apple’s justification is that since these subsidiaries (ASI and AOE) are not controlled and managed in Ireland, they don’t meet the definition of being a tax resident there. Further, since these subsidiaries were incorporated in Ireland and not in the US, they don’t meet the definition of a tax resident in the US either. Therefore, these subsidiaries were not a tax resident anywhere in the world.

In order to ensure US multinationals did not get away with such loopholes, US lawmakers brought about some changes in the US tax code. These changes were enacted under President John F. Kennedy in 1962, and were named Subpart F. Subpart F “was designed in substantial part to address the tax avoidance techniques being utilized today by U.S. multinationals in tax havens” (US Permanent Subcommittee on Investigation, 2013).

However, as time passed by, US multinationals found different loopholes available for them to exploit in order for them to partake in aggressive tax avoidance. For Apple, this came in the form of the “Check the box” regulation that simply told the Internal Revenue Services (US tax authority) to disregard its foreign controlled corporations for tax purposes. Basically, this meant that even though under Subpart F, Apple would have paid taxes on its foreign subsidiary profits but with the blessings of the “Check the box” regulation they did not have to do so anymore.

European Commissions findings

This is where the tax rulings come into play and why according to the European Commissions, they constitute illegal state aid. Particularly the objection of the European Commission is regarding how these tax rulings “endorsed a method to internally allocate profits within Apple Sales International and Apple Operations Europe” (European Commission – Press release, 2016). In essence, it permitted these two Apple subsidiaries to allocate profits internally between its “Head office” which does not have to pay any tax at all on its taxable profits and the Irish branch which has to pay tax at the general rate of 12.5%.

Under this method of allocating profits, the majority of the profits of Apple sales International and Apple Operations Europe were allocated away from its Irish branch and towards its “Head office”. In this way, only a fraction of the profits of Apple Sales International and Apple Operations Europe were subject to Irish tax, while the rest remained untaxed since it was allocated to the “head office”.

European Commission’s press release provided further information on this with the following evidence,

In 2011, for example (according to figures released at US Senate public hearings), Apple Sales International recorded profits of US$ 22 billion (c.a. €16 billion[1]) but under the terms of the tax ruling only around €50 million were considered taxable in Ireland, leaving €15.95 billion of profits untaxed. As a result, Apple Sales International paid less than €10 million of corporate tax in Ireland in 2011 – an effective tax rate of about 0.05% on its overall annual profits. In subsequent years, Apple Sales International’s recorded profits continued to increase but the profits considered taxable in Ireland under the terms of the tax ruling did not. Thus this effective tax rate decreased further to only 0.005% in 2014.

Similarly, Apple Operations Europe benefited from these tax rulings, and hence were legally able to ensure that the vast majority of its profits were allocated to the “Head office” and therefore, away from the hands of the taxman.

Basically if you think about it, “if you buy an iPhone 7 in Hong Kong, it was made in China, designed in the United States, financed in Ireland and taxed…. nowhere?” (Quartz, Fernholz, 2013)

Figure 3: Infographics of how Apple shifted profits from Europe to “head office”

The European Commissions believed that this method of internal allocation of profit doesn’t reflect factual and economic reality; it provides an undue advantage to Apple and therefore established these tax rulings to be illegal under state aid rules. During the Q and A session of the press conference on August 31st 2016, replying to a question Commissioner Margrethe Vestager said “Do this company (head office) has any employees? Do they have any activity? If they have no employees and no activities, then how come they (Head office) make so much money? And if they make so much money, how come they don’t pay any taxes?”. This was an important issue raised by the Commissioner since it points to a key principle which is that this structure enables “Head offices” to generate huge profits that are just not economically justifiable.

The commission report continued to state that the only entities that can generate taxable profit were the Irish branch of both Apple Sales International and Apple Operations Europe, and thus should be the entities reporting the entire profit that was “misallocated” to the head office . If this were to be the case, then both of the Irish subsidiaries of Apple would have been paid an effective tax rate of 12.5% and not what it currently pays which is significantly lower.

This is how the value of €13 billion of unpaid taxes were calculated. The Commission looked at the amount of taxable profit misallocated from the Irish branch to the head offices from 2003 to 2014. After calculating the new taxable profit of both the Irish branches, they applied the 12.5% corporation tax rate.

The Commission ends its report by stating that “Ireland must now recover the unpaid taxes in Ireland from Apple for the years 2003 to 2014 of up to €13 billion, plus interest.”(European Commission – Press release, 2016). One important thing to understand is that the €13 billion plus interest is NOT a fine, but it actually represents the unpaid taxes that Apple would have paid, if it weren’t for the illegal state aid provided by the Government of Ireland. Therefore, this is not a punitive action taken by the European Commission rather a measure to ensure fairness in the market.

Apple would be required to pay the monies to Ireland in the short term regardless whether they eventually win the legal battle or not. In the short term, the money would be deposited in an escrow account pending the outcome of the court decision.

There is one more critical thing to understand here, which might potentially impact the amount Ireland actually receives. Margrethe Vestager noted at the end of her press conference that the entire amount of €13 billion plus interest is not due to Ireland alone. It could potentially be reduced if another tax authority is able to prove in court that Apple should have recorded majority of its sales income in their jurisdiction instead of in the books of Apple Sales International. therefore, Apple was liable to pay tax on its taxable income in that jurisdiction.

So for example, if there were €500 million sales of Apple products in France in the years 2003 and 2014 and France believed “that Apple’s commercial risks, sales and other activities should have been recorded in their jurisdictions” (European Commission – Press release, 2016); And was able to prove this in European Courts of Justice then the amount recoverable by Ireland would reduce. This is because now, €500 million of less sales are being recorded in the Irish subsidiary and therefore not subject to the 12.5% Irish corporation tax but rather the 33.33% French corporation tax.

Although unprecedented, based on the amount of claw back of taxes, this was not the first time the European Commission exercised its muscle against multinationals engaging in tax avoidance while in breach of state aid rules. Just over a year ago, the European Commission concluded that the selective tax advantages provided to Fiat in Luxembourg and Starbucks in Netherlands constituted illegal state aid. Both Starbucks and Fiat were required to pay approximately €20 – €30 million.

Since the initial press conference, Apple’s position has been the same. It states that this is a retroactive application of changes in law. However, if you know anything about tax, it is that the changes are applied prospectively and not retroactively. However, when asked during the Q and A session, Margrethe Vestager said that no new law had been implemented and these are just the basic principle of the state aid rule.

During the press conference, a reporter made a comment regarding about how this ruling has led to the creation of a climate of legal uncertainty amongst multinationals operating in Europe. The Commissioner response, “If you want legal certainty, then you need a commission (European) decision, that creates legal certainty”. What this meant was that if Apple and Ireland had requested the European Commission to look into the legality of their tax rulings they should have done that in 1991 and in 2007. Now its too late.

Now the decision is in the hands of the European Courts of Justice and there is no point of speculating any further this issue, until the proceedings start at the courts.

On a side note, with Donald Trump in office, we are getting closer to a United States that has an effective corporate tax rate of 15%; a significant drop from its current 35% tax rate. This is part of Mr. Trump grand plan to bring jobs back to the US. Additionally, as part of his plan to make America great again, he is willing to provide a tax repatriation holiday by only taxing them 10% of repatriated profits.

Apple would definitely be enticed to repatriate its billions of overseas profit to the US and pay a nominal tax rate of 10% instead of the 35%. According to the Tax Justice Network, this would result in tax savings for Apple to be of $48.1 billion.

Figure 4: 10 companies with biggest tax breaks from Trump’s proposed 10% transition tax

Its certainly not the Trump that is prepared to significantly reduce corporation tax, but a lot of leaders around the world are thinking about this. This phenomenon is being termed “Tax competition”, and its one of the more recent way to attract investment in the country. This will have a wide implication for countries in areas such as their national debt as well as the public sector spending, but I will leave that topic for another article.

I would like to thank you for reading this article. This piece of writing was a fact based and not an opinionated one. I will be writing opinionated ones as well though on this website. As I have mentioned above, I have only focused on the European Commissions findings in this article, however, there are other issues in the Apple story at play that I will be discussing in further detail in future articles. This included a detailed look at the US tax system, specifically, its Controlled Foreign Corporation regime and the check the box regulation.

I would love to hear from you regarding what you think about this issue.

References

Boland , V. (2016, September 2). Apple and state aid: End of the affair. Retrieved February 05, 2017, from https://www.ft.com/content/8dd1b256-70f8-11e6-a0c9-1365ce54b926