Monday, March 21, 2016

Apple Sales International–By the numbers

The Apple subsidiary Apple Sales International (ASI) formed a central bank of the 2013 US Senate Investigation into Apple’s tax affairs and subsequently became one of the two Apple subsidiaries which are under the spotlight in the European Commission’s state aid investigation into the treatment by Ireland of Apple.  Here we look at the publicly available information to set out where ASI fits into Apple’s structure, what it does both within Ireland and without and what it’s current tax position in Ireland is.

The following chart summarises the ASI position at the core of Apple’s international structure (click to enlarge).

Apple Sales International Structure

We will focus on the four financial flows (marked in green):

  1. The research and development cost-sharing payment which ASI makes to Apple Inc. through which ASI gets a license to sell Apple’s products outside the Americas.
  2. The manufacturing fee which ASI pays to third-party manufacturers in China to produce Apple’s products.
  3. The sales revenue that ASI receives from the sale of Apple’s products to distribution and retail subsidiaries within Apple and also some customers (including internet customers).
  4. The fee that ASI pays its branch in Ireland for organising the logistics behind the manufacturing  and (up to 2011) the administration involved in the delivery and sales.

The most crucial aspect of the above structure is payment #1.  If this is close to the profit earned by ASI the structure achieves little and the income accrues to Apple Inc.  These payments were a central part of the US Senate investigation which revealed that the cost-sharing payments were actually very small relative to the profits earned by ASI – as shown in the following table taken from the Senate report.

ASI Cost Sharing Payments

By making payments of $5 billion to contribute to the R&D that Apple undertakes (of which 95 per cent is done in the U.S.), ASI was granted the economic rights to exploit Apple’s intellectual property outside of the Americas.  The legal rights owner remains Apple Inc.

The table also shows that the economic rights are hugely valuable.  By 2012, ASI was generating profits of $36 billion a year.  After the relatively small cost-sharing payment this is generated by two factors.  The first is volume and the second is the difference between payments #2 and #3 above.

ASI pays a manufacturing fee to a third-party manufacturer to make the products that arise from the company’s R&D.  ASI then sold that product on to various related parties (Apple distribution and retail subsidiaries) and unrelated parties (such as large customers in the education sector and internet customers).  Under the arm’s length principle ASI must charge similar prices for all of these transactions. 

It is not inconceivable that ASI charges, say, $650 for some Apple product to a customer and pays a fee of $250 to the third-party manufacturer.  Do that on the scale of Apple and it is pretty easy to see how tens of billions of profits will build up.  However, it must be remembered that the iPhone was introduced in 2007 and the iPad in 2010 so these profits are a fairly recent phenomenon.  ASI’s profits were compiled here by Neil Chenoweth and focusing on the likely period for any recovery of taxes arising from the investigation by the European Commission (2004 to 2013) we see the following (in $US thousands)

ASI Company Outcomes

There is no figure available for 2013 but given the overall performance of the company a figure similar to that achieved in 2012 is likely.  The huge run-up in profits is evident.  The cumulative profits for the five years to 2008 of $7.1 billion are only one-fifth of the $35.9 billion of profits earned in 2012 alone.  If the 2013 figure was similar to that achieved in 2012 then the total profit for the ten years is around $113 billion.

ASI has a branch in Ireland which carries out the underlying administrative tasks behind the manufacture and delivery of these products.  According to the European Commission “the main activities of the branch relate to:

  • procurement of Apple finished goods from third-party manufacturers (including a third-party manufacturer in China), […],
  • onward sale of those products to Apple-affiliated companies and other customers, and
  • logistics operations involved in supplying Apple products from the third-party manufacturers to Apple-affiliated companies and other customers.”

The branch is paid for these duties and the pricing agreement with the Revenue Commissioners is one of the contested rulings in the EC investigation.  The pricing agreement is relatively straightforward with the EC letter telling us that:

  • In 1991, a basis for determining Apple Computer Accessories Ltd.’s (subsequently ASI) Irish branch net profit was proposed by Apple and agreed by Irish Revenue. According to that ruling, the net profit attributable to the ASI branch would be calculated as 12.5% of all branch operating costs, excluding material for resale.
  • A modified basis for determining net profit was agreed for the ASI branch in 2007 with a [8-18]% margin on branch operating costs, excluding costs not attributable to the Irish branch, such as […] and material costs.

The Commission go to lengths to mention that the eligible costs in the calculation exclude material for resale and we’ll come back to that.  So what is the result of this calculation?  We can see this by combining figures from the Commission and US Senate.

ASI Branch Outcomes

The turnover figure is taken as the midpoint of the range reported by the European Commission while the taxable income and tax paid figures are taken from the US Senate report.  The effective tax rate is derived from these figures.  The effective tax rate is above the standard 12.5 per cent rate because, as well as the income derived from support activities, the taxable income of the branch includes interest earned which is subject to Ireland’s 25 per cent of Corporation Tax.  This is confirmed by the European Commission who state that:

The taxable income in the table above was taxed at 12.5%, except for limited components taxed at 25% mainly represented by interest payments received.

One would think the key question here is whether the 12.5 per cent cost-plus agreement is appropriate for the Irish branch.  Transfer pricing is an art rather than a science.  Is a cost-plus agreement appropriate for the the type of activities undertaken by ASI’s Irish branch? Probably.  Even then, the margin to be used can be queried but doubling the margin is not going to result in a “material” finding given the figures reported above.

Perhaps the branch should be remunerated on a return on sales basis, i.e. profit should be related to the amount of sales the branch handles.  These are excluded from the cost-plus arrangement outlined above and the Irish authorities have (unsurprisingly) told the Commission that they are “satisfied” with this transfer pricing agreement:

  • As regards the agreements in the rulings in favour of ASI, the Irish authorities express the view in their letter of 25 March 2014 that ASI’s branch was considered to carry out routine, albeit important, functions in the procurement and onward sale and supply of goods for Apple. It would therefore have had no special valuable assets. Although the Irish branch arranged the procurement and onward sale and supply of goods (which did not pass though the Irish branch), the goods concerned derived their value largely from intangibles created in the US. There were also no indications that the Irish branch bore significant risks in relation to the activities of ASI.
  • Furthermore, according to Irish authorities’ letter of 25 March 2014, Irish Revenue was satisfied that the agreed margin on operating costs delivered a net profit commensurate with the value added by the Irish branch. On the basis of a branch-focused analysis of the operations undertaken in Ireland, it would have been clear that the main profit-generating functions and assets were not located in Ireland. All significant risks and all intellectual property would have been borne and economically owned elsewhere in the ASI enterprise or the Apple group and the profit attribution to the Irish branch would have represented full remuneration of its role in that process.

The Commission wasn’t willing to accept this and, in particular, felt there was a disconnect between the revenues and profits of ASI as a company and the revenues and profits of ASI’s Irish branch.

  • Second, the profit allocation to the ASI Irish branch, agreed in the 2007 ruling, does not factor in the evolution of sales. In fact, [.] the sales income of ASI increased by 415% over the three years 2009-2012 to USD 63.9 billion. For the same period, the operating costs as reflected by the taxable income (which represents around [8-18]% of operating costs of the branch according to the ruling of 2007) increased by [10-20]% [.]. As a large part of the operating capacity of ASI as a whole seems to be located in Ireland, the discrepancy between the sales growth and the growth of the Irish operating capacity, cannot be explained.
  • That discrepancy could point to an inconsistency in the allocation of turnover between ASI and its Irish branch. The income of ASI of USD 63.9 billion for 2012 and the respective amounts for previous years [.] represent sales income, which is an active income and generates operating expenses. If the 415% increase in sales is only due to an increase in price and not an increase in volumes, it would not be inconsistent that the operating expense of the ASI branch only increase by [10-20]% over the same period.  However if the sales volumes increased, the operating costs of either the Irish branch of ASI or the operating costs that ASI incurs outside of Ireland should have increased significantly as well. At this stage, the increase in sales cannot be related to a comparable increase in operating costs, which could point to an inconsistency in the profit allocation to the Irish activities.

There seems to be a bit of a contradiction in the Commission’s position.  The Commission are concerned that ASI’s profits have grown substantially but that this is not reflected in a commensurate growth in the operating capacity of the Irish branch (reflected by its costs).  The Commission then argue that the increase in sales suggests an “inconsistency” in the profit allocated to the Irish branch.  But if the sales could increase without an increase in the operating capacity its suggests that the two are not related.  And when ASI’s volumes increase the expense that increases is its cost of sales, i.e. the fee paid to the third-party manufacturer in China.

The are a few answers to the “inconsistency”.  One is that the Irish branch of ASI is actually not central to the overall profitability of the company.  The second is that Apple’s structure changed in 2012 and the responsibilities of ASI’s Irish branch were reduced which is something the EC appear to have overlooked.  The US Senate report tells us that:

Prior to 2012, ASI sold to Apple retail subsidiaries and directly to internet customers.  Since the company re-organised, ASI now sells to ADI and Apple Singapore, and those entities sell to Apple retail subsidiaries, or internet customers.

The impact of this can be seen in the reduction the turnover of ASI’s Irish branch in 2012 in the table above.  ADI is Apple Distribution International, another Irish-registered subsidiary of Apple Inc.  ADI is not subject to investigation by the European Commission but after the 2012 restructure figures from the US Senate show that ADI reported €186 million of taxable income to Ireland and paid €23.8 million of Corporation Tax (effective rate 12.8 per cent).  In fact as a result of the restructure ASI no longer has a sales function and arranges only for the manufacturing of Apple goods and sells them to ADI or Apple Singapore who then manage the subsequent sales.  ADI won’t accumulate huge profits as the price is pays ASI will be close to the resale price. 

But maybe there is an argument that, up to 2011 at least, ASI’s Irish branch should have been remunerated on a return of sales basis.  It is far from clear that it should apply because it is not clear what activities of the Irish branch could have influenced the level of sales.  As we have already seen ASI’s revenues increased rapidly up to 2011 without a comparable increase in the operating capacity of the Irish branch. However, if it is was appropriate to use a return on sales approach and given the level of the sales even a small margin would generate significant profits. 

What might an appropriate margin be?  I can’t say but if we consider the Irish branch to be a fairly ordinary reseller than a margin of around three per cent may be appropriate.  To be honest I have no idea and am really only looking for a number to use as an example.  If we apply a three per cent return on sales margin to the revenues shown above then that would give a profit of around $5.5 billion for the years from 2004 to 20112.  Applying our 12.5 per cent Corporation Tax to that gives a figure of $700 million – in total.

Would Apple Inc. let me handle the logistics of dealing with the third-party manufacturers in China and handle the billing and delivery to customers that Apple virtually hand-deliver to me for a three percent margin on sales? I doubt it.  Maybe one per cent is a better margin and that gives a ten-year tax bill of around $200 million.

The Commission indicate that any margin above 0.2 per cent would result in additional tax being due to Ireland:

For example in 2011, the taxable profit of ASI represented only around [less than 0.2]% of the sales of ASI. Therefore if a margin on sales indicator would have been retained as a net profit indicator, the resulting taxable profit would have been much higher, for any benchmark sales margin above [0.2]%. In detail, the turnover of the ASI subsidiary is taken as reference as no branch turnover seems to be reported (other than the turnover provided by the Irish tax authorities in 2014 and which are according to the submission calculated on the basis of the taxable basis and not according to accounting figures). [T]he sales of ASI for 2011 amounted to USD 47.5 billion, which at the EUR/USD exchange rate 2011 average exchange rate of 1.3920, represents around EUR 34.1 billion. Comparing the 2011 taxable profit in Ireland of ASI of EUR [50,000,000 – 60,000,000] to this sales figure results in a margin on sales of around [less than 0.2]%.

ASI is hugely profitable but it is not because of anything that happens in Hollyhill in Cork.  As outlined above there are three factors driving the profitability of ASI:

  1. The cost-sharing agreement with Apple Inc.
  2. The agreement with the third-party manufacturer in China
  3. The price ASI charges when selling the products on

And we have ample evidence to show that none of these are or ever were part of the responsibilities of the Irish branch.  First the cost-sharing agreement which the US Senate succinctly describes in the following paragraph:

Cost Sharing Agreement. The cost-sharing agreement is structured as follows. In the agreement, Apple Inc. and ASI agree to share in the development of Apple’s products and to divide the resulting intellectual property economic rights. To calculate their respective costs, Apple Inc. first pools the costs of Apple’s worldwide research and development efforts. Apple Inc. and ASI then each pay a portion of the pooled costs based upon the portion of product sales that occur in their respective regions. For instance, in 2011, roughly 40 percent of Apple’s worldwide sales occurred in the Americas, with the remaining 60 percent occurring offshore. That same year, Apple’s worldwide research and development costs totaled $2.4 billion. Apple Inc. and ASI contributed to these shared expenses based on each entity’s percentage of worldwide sales. Apple Inc. paid 40 percent or $1.0 billion, while ASI paid the remaining 60 percent or $1.4 billion.

And later the Senate report tells us that the cost-sharing agreement was signed by US-based employees of Apple Inc.  No competence for the cost-sharing agreement rested with the Irish branch.

Apple’s offshore affiliates operate as one worldwide enterprise, following a coordinated global business plan directed by Apple Inc. In fact, the last two versions of Apple’s cost-sharing agreement were signed by Apple Inc. U.S.-based employees, each of whom worked for multiple Apple entities, including Apple Inc., ASI, and AOE.

The European Commission appear to agree with this when they note that:

All strategic decisions taken by ASI, including in relation to IP, are taken outside of Ireland. As with AOE, ASI is a party to the R&D cost sharing agreement with other Apple Inc. subsidiaries under which the total costs of the group’s worldwide R&D are pooled. ASI’s Irish branch has no authority to make decisions relating to Apple IP or the cost sharing agreement. No rights in relation to the Apple IP concerned are attributed to the Irish branch.

Next is the agreement with the third-party manufacturer which the US Senate told us was negotiated and signed in the US:

Foxconn is a trade name for Hon Hai Precision Industry Co., Ltd ("Hon Hai").  The individuals with primary responsibility for negotiating agreements with Hon Hai for products containing the A5 chip were U.S.-based Apple Inc. employees working in Operations [.] Individuals signing the relevant agreements for Apple Inc. were US-based Apple Inc. employees with the title VP, Procurement.  The individual who signed the relevant agreements for Apple Sales International was a U.S.-based Apple Inc. employee who signed the agreement in his capacity as Director of Apple Sales International.

That just leaves the price that ASI uses when the products are sold on but that actually isn’t subject to negotiation or agreement.  Up to 2011 ASI sold to distributors, retailers and customers and although, there would be slight differences, in rough terms the prices should be comparable.  The arm’s length principle is that the price to a related party should be similar to that charged to a third-party.  And prior to 2012, ASI had plenty of third-party sales. As reported by Apple to the US Senate:

Of the $108.25 billion of Net Sales reported on Apple Inc.'s Form 10-K for period ending September 24, 2011, approximately $26.06 billion of worldwide Net Sales were recorded by Apple Sales International. Apple Sales International was the only Irish entity with third party sales.

We can se sure that ASI made plenty of profit on these sales to third parties (the difference between the fee paid to manufacturer and the sale price).  And because of this ASI makes plenty of profit of sales to related parties.  And it does.  As the first table shows, even after the restructure in 2011, ASI’s profit continued to rise and hit $36 billion in 2012.

Of course, the question the European Commission seems to have concerned itself with is not whether the appropriate tax is collected from Apple’s operations in Ireland but who is collecting the tax on this $36 billion?  The answer ultimately, of course, is the US but the US doesn’t collect it from ASI.  In fact, as Neil Chenoweth shows the tax rates on ASI are incredibly low.

ASI Tax Outcomes

From 2004 when it was just 0.80 per cent the tax rate on ASI fell throughout the period and by 2012 it was just 0.02 per cent (this is the €5.4 million of Corporation Tax paid by the Irish branch as a percentage of the companies $35.9 billion of profits).  The is because ASI’s tax provision is based on the costs it incurs in Cork rather than the sales it has around the world.

Has Apple found the elixir of tax minimisation?  Not really.  While ASI may not owe tax on those profits Apple Inc. does.  It is not our central thesis here and is a well worn track.  Apple Inc. owes US corporate income tax on the profits earned by ASI but can defer it until transferring the profits to a US-incorporated entity within Apple’s structure.  We will not see the tax paid on these profits in the accounts of ASI.  The tax paid will show up in the consolidated accounts of Apple Inc.

Apple accounts show that it makes a tax provision in its Profit and Loss statement of around 26 per cent of its pre-tax earnings.  However, if we look at the effective tax rates on its “foreign” and “domestic” (i.e. US)  earnings we see a wide divergence with the foreign tax rate being less than 10 per cent and the domestic rate seemingly more than 60 per cent.

Apple Tax Rates

The reason for the very large US tax rate is that the provision for US tax includes some of the US tax due on foreign earnings.  That is Apple owes very little foreign tax on the earnings of ASI – as they are generated by risks, functions and assets that are in the US – and makes a provision for some of the the US tax that is due on these earnings.  There are some who believe that this foreign/domestic split is real and that Apple is avoiding huge amounts of foreign tax but making sales abroad is not the same as making profits abroad.  The reality is that the foreign/domestic revenue split in Apple’s accounts does not reflect the position of its risks, functions and assets, so is not useful in helping to determine its tax liabilities. See section on ‘Shifting Profits Offshore’ on page 28 of the US Senate Report.  The tax should be due in the US but Apple have, somewhat artificially, been able to describe much of the income as “foreign” for US tax purposes.

Of course, providing for 26% tax and paying the tax are very different things.  In the case of ASI the payment only becomes due when Apple transfers the profit to a US-registered entity in its structure and it seems pretty clear that Apple is unlikely to do that anytime soon.  Should companies like Apple be able to defer, oftentimes permanently, the tax that is due on their profits?  No, but that is something for the US to remedy.  The point is that while the profits appear untaxed in ASI they are ultimately subject to tax in Apple Inc. 

But what if the profits of ASI were to be deemed taxable in Ireland?  All the noises are that this is a determination that the European Commission could make.  There seems little basis in fact to support it but I guess there are arguments that could be made.  These may be that:

  • ASI should be deemed tax resident in Ireland
  • ASI is an Irish-registered company
  • ASI has employees in only one country – Ireland
  • ASI only has substance through its Irish branch which is enough to deem the parent, which has no substance, taxable in Ireland
  • Such is the nature of the activities of the Irish branch that ASI’s sales should be considered to be fully completed by it

What happens if all of ASI’s profits are deemed taxable in Ireland? Without the exact calculations it is difficult to tell but if it does happen we will be really at the races and the talk will be of billions not millions. 

Assuming ASI performance in 2013 and 2014 tracked that of the overall company then the cumulative profit earned by ASI of the period from 2004 to 2014 is somewhere around €110 billion.  If we just do a crude approximation and apply a 12.5 per cent tax to that you get something approaching €14 billion.

ASI Notional Tax Due

And you can’t just rock up to the Revenue Commissioners in 2016 and say you want to pay tax due for 2004.  At the very least interest will be applied and the interest rate used by the Revenue Commissioners since 2009 has been the equivalent of eight per cent per annum.   If we apply eight per cent interest to this notional €14 billion of tax due over the ten years then the total liability approaches €20 billion.  If the interest rate set out in the EU’s state aid regulations is applied the total would be around €16 billion (as the interest rate is linked to market rates which have been significantly lower than eight per cent for much of the period.)

Is this something that could happen? It seems so though I still consider it unlikely.  Is this something that should happen? No.  There is almost no basis for any argument that 60 per cent of the profits of Apple Inc. over the period in question were generated by risks, functions or assets in Cork.  Even thinking that someone might suggest it seems foolish.  And if Ireland does take a big chunk of tax out of Apple’s profits then we can be sure there will be another hearing of the US Senate on this matter.  And this time they won’t be calling us a tax haven; they’ll be calling us a tax thief!

4 comments:

  1. Does ASI have any other branches, other than Ireland?

    Just to clarify/confirm that it is the case that all ASI profits will be taxed somewhere, at some stage? So it's then not true that some profits are stateless, forever untaxed?

    ReplyDelete
    Replies
    1. No, ASI only has a branch in Ireland and a US Board of Directors. It does not have a presence in any other country.

      The US has a worldwide system so all of ASI's profit are subject to US taxation. They are not untaxed. What is critical is that the US allows a deferral of the actual payment of this tax until the profits are "repatriated". See quote from Pam Olson at the end of this:

      http://economic-incentives.blogspot.ie/2015/06/the-dissolving-global-consensus-on-beps.html

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