Monday, September 29, 2014

Getting behind the story that some are ahead of

The Financial Times, or at least one of their headline writers has been getting excited about an announcement today from the European Commission on their ongoing investigation in Apple’s tax affairs in Ireland.  When published online the article was published as:

FT Apple 1

Nothing has been found “illegal” (yet!) and all that will really be revealed today is the parameters of what it is the European Commission will be investigating, i.e. what it is they think might be illegal.  The text of the piece states this but the headline is a bit ahead of the story.

For the print edition they put it on the front page and got more correct (at least in the sub-heading): the Commission will make an accusation in relation to Apple’s tax dealings in Ireland.

Apple FT 2

The story gets significant coverage and one further interesting aspect is the prospect of a fine being levied on Apple to repay any state aid to Ireland that may have been provided.  For example, The Irish Times report that if there is an adverse state aid finding such an outcome “could leave the iPhone maker with a record fine of as much as several billions of euros.”  The outcome would not be a fine; it would be the repayment of any state-aid given to the company.  In this case it is lower tax then would otherwise be payable.  As Ireland is being investigated for granting state-aid to Apple, this retrospective tax would be payable to Ireland.  There will likely be no retrospective tax payment and even if there was payment would be a few million not a couple of billion.

Apple is a massively profitable company with annual profits of around $40 billion a year but it generates little of that profit in Ireland.  Apple is a US company that designs, manufactures and retails electronic devices and related services for consumers.  Apple has a large presence in Cork but the risk, assets and functions that generate Apple’s massive products are its design, innovations, branding and reputation. 

Lots of companies manufacture and retail consumer electronics.  None of them are as profitable as Apple.  Making electronics and selling them is relatively easy and not very profitable.  Designing devices that consumers are willing to pay €400-€600 is extremely difficult and very profitable.  Apple is best in class at this.

Under existing transfer pricing rules the profit Apple generates will be allocated based on risks, assets and functions.   Apple’s profitable risks, assets and functions (designers, innovators, patents and trademarks) are almost all in the US. 

As a US company with its most profitable functions and assets in US, Apple is liable to pay the US 35 per cent corporate income tax.  The US tax code is a mess and Apple can create a deferral of the actual payment of this tax until the money is notionally repatriated to the US.  The Senate Report on Apple highlighted the importance of two provisions in the US tax code - “check-the-box” and the “look-through rule”. 

Using these provisions Apple was able to initiate a deferral of the US tax that it should pay.  It’s a bit of a complex web but the net result is that Apple is able to avoid paying the US tax it owes by keeping the profits in what are described as “offshore” subsidiaries.  Almost everything about these subsidiaries happens in the US.  They are managed and controlled (residence) in the US.  Their assets (the intangibles) are held in the US.  Their cash holdings (the profits) are held in US banks.  It is the US tax code that considers these offshore.  To everyone else they are in the US.

In is financial statements Apple indicate that they would owe around $36 billion of tax to the US if the profits were repatriated from the subsidiaries to the US parent, Apple Inc.  Ireland gets a headline role in the structure because the subsidiaries are Irish-incorporated, but place of incorporation has little significance when determining where a company must pay corporate income tax – the location of risks, functions and assets does.

The EC investigation into Apple will be very different to the Senate investigation into Apple.  The Senate looked at Apple’s overall tax structure.  The EC will only look at how the risks, functions and assets Apple actually has in Ireland are taxed.  The question will be whether Apple has paid the right amount of tax to Ireland based on the activities that actually take place here. 

The question of the $36 billion that Apple could pay to the US is not at issue.  Apple has activities in Cork but in the broader scheme of Apple’s overall profitability they are not massively important.  For example, Apple in Cork could manufacture a product for the company.  Apple could make a lot of profit from that product but the actual manufacturing of it would not contribute a lot to that. 

Under transfer pricing agreements the profit would be allocated between different functions.  Back in 1990, Ireland was starting to phase out the 10 percent export profits tax.  It is possible that Apple entered a transfer pricing agreement to allocated 20 per cent of the profit from some product to the activities in Ireland (say manufacturing) and 80 per cent of the profit to the activities elsewhere (mainly the designing in the US). 

It can be seen that 20 per cent of the profit taxed at ten per cent gives a two per cent tax rate.  This becomes the effective tax rate if the US does not collect the tax that is attributed to the functions in the US.  Using the deferral provisions in what is known as Subpart F of the US tax code, Apple was able to engineer this.  The issue for the EC is whether the 20/80 profit split is appropriate.  [It is a bit simplistic to describe the transfer pricing arrangement as a straightforward 20/80 profit split but for our purposes here it is sufficient.]

The likelihood is that this type of split was/is appropriate but the way it was suggested Apple got a “special two per cent rate in Ireland” at the US Senate means a state-aid investigation is warranted.  Companies in the EU cannot get “special” treatment.  However, the EC will likely find that this was result of taxing 20 per cent of the profit at 10 per cent beginning in 1990 and subsequently at the 12.5 per cent rate when the uniform Corporate Tax rate was introduced in 2003.  Apple never said it got a “special” rate as what the company actually said was:

“Since the early 1990’s, the Government of Ireland has calculated Apple’s taxable income in such a way as to produce an effective rate in the low single digits …. The rate has varied from year to year, but since 2003 has been 2% or less.”

It is the transfer pricing agreement that determines the amount of taxable income in Ireland.

Of course, Apple became hugely successful and massively more profitable following the launch of the iPhone in 2007.  Under current transfer pricing rules the profits tax on the iPhone should be paid mostly in the US.  Apple used the Irish-incorporated companies (some of which were formed in 1980) as part of its tax structure to generate a deferral of US tax due on the global (i.e. non-US) sales of the iPhone and iPad.  The suggestion that Apple could owe billions in tax to Ireland from these profits is daft. 

The activities and assets that led to these profits were in the US and had nothing to do with Ireland – apart, crucially, from Apple housing them in Irish-incorporated companies.  What happens in the US with the taxing is US profits is beyond the remit of the EC investigation.  The companies may be Irish-incorporated but place of incorporation does not determine the location of tax liabilities. Countries can use incorporation to determine tax residence but that is a different concept. 

A company will be resident in only one country (or at least it should be!) but it will be liable for corporate income tax in every country in which it has a tax presence – based on the location of risks, functions and assets.  There has been the perception that everything these Apple subsidiaries do happens in Ireland.  Yes, they are Irish-incorporated but almost everything they do happens in the US.

These companies hold the non-US rights to Apple’s intellectual property – trademarks, patents etc.  Apple does not have to make any declaration of these to the Revenue Commissioners or enter any transfer pricing agreement to split the profit between Ireland and elsewhere.  The intangible assets behind the iPhone are not created or held in Ireland.  The iPhone is not manufactured in Ireland and only a tiny proportion of them are sold in Ireland.

Apple does not have to enter a profit-sharing transfer pricing agreement with its Irish operations for the iPhone profits.  None of the risks, functions and assets that generate the profits are in Ireland.  It could be the case that 98 per cent of the profits these subsidiaries generate come from the assets behind the iPhone and iPad etc and two per cent comes from the activities that these companies actually do in Ireland (lots of shared services – accountancy, HR etc. – some manufacturing and maybe even a bit of product development.) 

Under the TP agreement 20 per cent of the two per cent is taxable in Ireland while the rest of that and the 98 per cent of the profit that comes from the assets behind the iPhone is taxable in the US.  Apple has a deferral for this so does actually pay the tax at all.

Paying a 12.5 per cent tax on 20 per cent of 2 per cent of the profits is 0.05 per cent.  This becomes the effective tax rate when the 35 per cent tax due to the US on the rest of the profits is not collected at all.  Here is a table from the US Senate Report on Apple.

Apple Tax US Senate

The tax rate for ASI (Apple Sales International) in 2011 was 0.05%.  This was achieved using the structure outlined above.  Apple was able to defer the payment of the US taxes using “check-the-box”.  The Senate report says that in 2011 “check-the-box” allowed Apple to defer paying $3.5 billion in US tax (and $9 billion in 2012!).

Apple Tax US Senate 2

We don’t need to go into how it works; the point is simply that the bulk of the taxes Apple should be paying are owed to the US.  In its announcement back in June, the European Commission said the Irish part of the investigation would focus on:

  • the individual rulings issued by the Irish tax authorities on the calculation of the taxable profit allocated to the Irish branches of Apple Sales International and of Apple Operations Europe;

The key words in the middle of that are “Irish branches”.  ASI has massive profits.  However most of this (maybe around 98 per cent) is due to the assets behind the iPhone and other Apple products and services which have nothing to do with the Irish branches.  The Irish branch probably contributes around two per cent of ASI’s profits.  This two per cent is the focus of the EC investigation.  Even in the extreme case that the EC finds that Ireland should have taxed all of this at 12.5 per cent they amount of tax foregone that would contribute to any retrospective payment would still be small.  In reality the likelihood is that an 20/80 profit split is not materially incorrect and no retrospective payment be imposed.

The fact the all the attention is on Ireland which taxes 0.4 per cent of ASI’s profits at 12.5 per cent while the remaining 99.6 per cent goes largely untaxed because of US rules must delight many of the lobbyists and interested parties in the US. 

When Apple went before the US Senate they knew full well who to blame – and it wasn’t the politicians they were sitting in front of who passed the provisions, such as the “look-through rule” in 2005, that allowed Apple to massively reduce the tax on 99.6 per cent of the profits.  No, the light was shone on the 0.4 per cent.  This worked great in the US Senate but it has come back to bite Apple through the EC investigation. 

The attention on the investigation is huge but the outcome is likely to underwhelm many – particularly the headline writers for the FT.  It is also worth noting that the OECD’s BEPS project would do little to Apple’s tax bill in the existing structure.  One of the driving features of BEPS is to try and ensure profit is aligned with substance, i.e. that companies cannot locate profits in places like Bermuda where they have nothing but a brass-plate operation.

Apple are locating their profits where they have substance – the US – and the taxing right to those profits is given to the right country – the US.  It is US rules that allow Apple to defer actually paying that tax.  Ireland deserves some attention for our role in this, which is probably more errors of omission rather than acts of commission, but not all of it.

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