Tuesday, May 6, 2014

Corporation Tax Residence: Is Ireland Exceptional?

This is the question posed by a recent discussion paper by Prof. Jim Stewart.  The conclusion is in the affirmative:

This paper argues that the tax regime in Ireland which allows companies incorporated in Ireland to be non-resident for tax purposes, is exceptional.

Some issues around the Irish rules of tax residence for companies were discussed in a previous post.  The post contains a list of ten countries which solely apply the test of management and control as the basis for determining the tax residency of corporations.  In total there are around 20 countries which adopt such a system, though these countries are in the minority with most countries also applying the test of incorporation.

Although not explicitly defined a central feature of the Stewart article is the concept of “bi-location”.  This appears to arise when a company is incorporated in one country but tax resident in another.  There are more than 20 countries who have residency rules that make that possible.  On that basis Ireland does not appear to be exceptional, though is in the minority.

If a company is managed and controlled in Ireland it will be tax resident in Ireland unless the provisions of a double tax agreement with a treaty country deem it to be otherwise – the ‘treaty’ exception.  If a company is incorporated in Ireland it will be tax resident in Ireland unless it is a ‘relevant’ company – the ‘trading’ exception.  See this note from the Revenue Commissioners.

Under Irish law it is possible for a company to be “bi-located” in the sense it is used in the Stewart article.  Of course, under the rules of permanent establishment (PE) it is possible for a company (through branches) to be located in many countries. 

A company can have a PE in any country in which it operates, subject to the rules for determining PE.  If a company has a PE in any country it will be subject to corporate income tax in that country on the profits earned through the permanent establishment. 

Permanent establishment is not analogous to residence though the Stewart article appears to conflate the two.  When discussing some of Apple’s subsidiaries the article says

Thus both subsidiaries would appear to meet the test of ‘permanent establishment’ in Ireland for corporate tax purposes. The fact that they are not so regarded gives these and other ‘bi-located’ firms a very valuable tax advantage.

It is true that some of Apple’s subsidiaries have operations in Ireland that meet the test of permanent establishment in Ireland.  And they are treated as permanent establishments for corporate tax purposes in Ireland.  There can be no advantage for these companies to not being regarded as permanent establishments in Ireland because they are. 

As stated above PEs in any country pay corporate income tax on the profits earned in that country.  If the Apple subsidiaries have operations in Ireland (they do) they will pay Corporation Tax on the profits earned by those operations in Ireland (they do).

The issue is clouded if one wishes to include the global profits earned by these Apple companies.  Almost everything to do with these companies happens in the United States which is not surprising given that Apple is a US company.

The Stewart article makes specific reference to Apple Sales International (ASI).  Here is US Senator, Carl Levin (D) on ASI:

Prior to 2012, ASI, like AOI,  had no employees and carried out its operations through the action of a U.S.-based board of directors, most of whom were Apple Inc. employees in California. Of ASI’s 33 board meetings from May 2006 to March 2012, all 33 took place in California.

In short, these companies’ decision-makers, board meetings, assets, asset managers, and key accounting records are all in the United States. Their activities are entirely controlled by Apple Inc. in the United States.

Here is an extract from the questioning of Apple executives at the Senate hearing last May:

Senator LEVIN. Mr. Bullock, does Apple Inc. own directly or indirectly AOI, AOE, and ASI?
Mr. BULLOCK. Yes, Apple Inc. owns directly or indirectly AOI, AOE, and ASI.
Senator LEVIN. All right. So all those companies in Ireland are owned by Apple effectively. Is that correct?
Mr. BULLOCK. They are all legally owned by Apple Inc., yes.

Senator LEVIN. All right. Now, relative to ASI, Mr. Bullock, is ASI functionally managed and controlled in the United States?
Mr. BULLOCK. As a practical matter, applying the Irish legal standard of central management and control, I believe that it is centrally managed and controlled from the United States.
Senator LEVIN. And does Apple agree that it is functionally managed and controlled in the United States?
Mr. BULLOCK. Under Irish law——
Senator LEVIN. No. Under our law, do you believe that?
Mr. BULLOCK. I do not believe that central management and control is a legal term under U.S. tax law.
Senator LEVIN. All right. Do you believe it is functionally managed and controlled in the United States?
Senator LEVIN. Mr. Cook, do you agree?
Mr. COOK. We have significant employees in Ireland. We have about 4,000. And so there is a significant amount of decisions and leadership and negotiations that go on in Ireland. But some of the most strategic ones do take place in the United States.
Senator LEVIN. Would you agree on balance that ASI is functionally managed and controlled in the United States?
Mr. COOK. From a practical matter. I do not know the legal definition of the word.
Senator LEVIN. As a practical matter, you would agree that it is functionally managed and controlled in the United States?
Mr. COOK. Yes, Senator.

ASI is not resident in Ireland for Corporation Tax.  All the top-level functions of the company happen in the United States.  ASI’s board of directors are based in Cupertino, California.  ASI’s assets are managed in Reno, Nevada.  ASI’s cash is kept in banks in New York, New York.

ASI does have some operations through a branch in Ireland.  These operations are judged to be a permanent establishment in Ireland and Apple pays corporate income tax on the profits generated in Ireland.

Apple does not pay Corporation Tax on the profits earned by ASI outside of Ireland.  In the main ASI earns profits by charging royalty fees for the use of Apple’s intellectual property outside of the US.  ASI in California has entered a cost-sharing agreement with its parent for the use of Apple’s IP outside the US.

Sen. Carl Levin called it an “absurdity” that a company operating from Cupertino, California could defer its US tax liabilities because it was deemed to be “offshore”

Apple is exploiting an absurdity, one that we have not seen other companies use. The absurdity need not continue. Although the United States generally looks to where an entity is incorporated to determine its tax residency, it is possible to penetrate an entity’s corporate structure for tax purposes, and collect U.S. taxes on its income, if the entity is controlled by its U.S. parent to such a degree that the shell entity is nothing more than an “instrumentality” of its parent, a sham that should be treated as the parent itself rather than as a separate legal entity. AOI, AOE and ASI all sure seem to fit that description.

The “absurdity” he is talking about is not in Irish tax law; it is in US tax law.  The “absurdity” allows a company that carries out all its operations in the US not be taxed there solely because it is incorporated somewhere else. Sen. Levin subsequently calls it a “sham”:

Our legal system has a preference to respect the corporate form. But the facts here present this issue:  Are these offshore corporations so totally controlled by Apple Inc. that their identity as separate companies is a sham and a mere instrumentality of the parent, and if so, whether Apple’s claim that AOI and ASI owe no U.S. taxes is a sham as well.

The “sham” is not that Apple pays a relatively small amount of Corporation Tax in Ireland.  Apple is a company that designs consumer products in the US, manufactures them mainly in China and sells them to customers around the world.  Apple’s assets, risks and functions in Ireland contribute very little of Apple’s overall profits.

The source of Apple’s global profits is not its operations in Ireland.

It is true that the source of Apple’s global profits (the IP) is owned by a company that is incorporated in Ireland.  Ireland cannot make Apple move the IP to Ireland but we can change the tax residency rules for corporations.

The issue is one of Irish-registered non-resident (IRNR) companies.  Such companies were a central issue when Ireland introduced the test of incorporation to the residency regime for Irish Corporation Tax in the 1999 Finance Act.  See this 1998 note from the Tax Strategy Group in the Department of Finance.

Concerns about IRNR companies are not new.  In the late nineties it was possible links to outright tax evasion that prompted changes.  After 1999 IRNR companies could not be owned by Irish residents and although IRNR companies could be owned by foreign residents they had to be related to a company carrying out a trade in the State.  This was specifically to avoid “brass plate” IRNR companies who had no presence of substance in the State.  This has usually been judged in terms of employment.

[ASIDE: There are growing concerns about “brass plate” company headquarters moving to Ireland.  A headquarters in Ireland is obviously resident here because of the test of management and control but in some cases very little substance is actually in Ireland.  These companies will have permanents establishments in the countries around the world in which they operate and will pay corporate income tax and the profits earned in those countries.  By the time the profit is attributed to the “Irish” headquarters very little, if any, additional tax will be due – as the tax paid elsewhere will likely exceed the 12.5 per cent rate levied in Ireland.  The movement of company headquarters via “brass plate” offers few tangible benefits to Ireland but is a different strand of the corporate income tax issue to the IRNR issue.]

So back to the IRNRs.  Are the Irish residency rules to blame for ASI’s apparent effective tax rate of 0.1%? No.  Apple is an US company and the risks, assets and functions that generate Apple’s profits are in the US.

There are two key features to Apple’s tax structure:

The first is a cost-sharing agreement between the parent and subsidiary for the use outside the US of Apple’s IP.  The agreement allows the subsidiary to use Apple’s IP at a relatively low cost.  The subsidiary gets to use Apple’s IP but the transfer to the parent is based on the cost of producing the IP not the value of it.

The subsidiary gets the very valuable IP at relatively low cost and can then generate massive profits by licensing the IP to Apple’s manufacturing/retailing functions around the world.  Under the worldwide corporate income tax system operated by the US Apple has to pay US corporate income tax (up to the federal rate of 35 per cent plus any state-level corporate income taxes that apply). 

And this brings us to the second key feature of Apple’s tax structure which is the deferral provisions in the US tax code. Apple can put in place a structure that means the US corporate income tax due on the profits earned on its IP outside the US is not actually paid until the profit is repatriated to the US, if ever.

Apple is a US company that owes US taxes.  It may be right that ASI has an effective tax rate of 0.1 per cent but that ignores the fact that Apple owes US corporate income tax (up to the 35 per cent federal rate) on its worldwide profits.  There is no way for Apple to avoid this but using US tax provisions it can delay, sometimes indefinitely, the actual payment.

According to its latest 10K filing, Apple has a deferred tax liability of around $35 billion.  Apple is clearly saying that it owes the tax to someone, the US, but that it has yet to pay it.  In fact, Apple says there is some of it that might never be paid.  Apple has recognised $16.5 billion of deferred tax liabilities on its income statements over the past few years and this liability appears on the overall balance sheet.  Apple is basically saying that it might repatriate some of its profits and has made provision for the tax that will become due if that were to happen.

On the other hand Apple also say that they have an unrecognised deferred tax liability of $18 billion.  This is the tax due on profits that it does not intend to repatriate.  This is tax that is due to the US because the risks, assets and functions that generate the profits are in the US but Apple is able to engineer a deferral of that tax using the provisions of the US tax code.

They are the key elements of Apples tax structure:

  1. The cost-sharing agreement that moves the rights to use Apple’s IP ‘offshore’ (i.e. outside the US); and
  2. The deferral provisions that enable Apple to delay the actual payment of the corporate income tax due to the US.

The Irish residency rules play a limited role.  #1 has nothing to do with Ireland and there are a huge number of ways in which #2 can be triggered.  The Senate Report on Apple is clear that these are key:

The key roles played by ASI and AOE stem from the fact they are parties to a research and development cost-sharing agreement with Apple Inc., which also gives them joint ownership of the economic rights to Apple’s intellectual property offshore. [page 25]

The cost-sharing agreement that Apple has signed with ASI and AOE is a key component of Apple’s ability to lower its U.S. taxes. [page 28]

And how important are the deferral provisions?

These figures indicate that, in two years alone, from 2011 to 2012, Apple Inc. used the check-the-box loophole to avoid paying $12.5 billion in U.S. taxes or about $17 million per day. [page 34]

“Check-the-box” is a feature of the US tax regime.  The $12.5 billion figure of tax that deferred using the provision is a figure provided by Apple itself.  If Apple has a low effective tax rate it is clear that this is a key reason for it.

There is no disputing that Apple, and other major US companies, are using Irish-incorporated companies in their global tax structures.  But the only tax affected by these is the deferral of US corporate income tax by facilitating use of provisions such as “check-the-box” listed above.  There is nothing that happens in Ireland that affects to right to tax Apple in Australia, the UK, China or any other country.  The US could abolish these deferral provisions almost immediately and much of this debate would  become moot.  But the US is unlikely to do so.

Tax residency has very little to do with Apple’s tax structure.  As the US operates a worldwide system of corporate income tax it doesn’t matter where the subsidiaries are resident.  The Apple parent company is subject to the US 35 per cent federal corporate income tax on its worldwide profits. 

As a result of the deferral provisions Apple, and many other US companies, put in a staging post before repatriating the profits to the US.  In many cases this is Bermuda or the Cayman Islands which have a corporate income tax of zero per cent and no corporate income tax, or nowhere which also obviously has no corporate income tax.  From 2015 IRNR companies will no longer be able to be ‘stateless’ so will have to be resident somewhere.

As long as the current system of international corporation tax uses the source principle and transfer pricing rules based on risks, functions and assets to assign taxing rights in double tax treaties then Apple’s profits will be subject to US corporate income tax.   One aspect of the Stewart article is an absence of any reference to the source principle.  As was previously said here:

Apple doesn’t earn profit by selling to customers in Australia; it earns profit by designing a product in the US that Australians want to buy.  The current rules attribute the profit to the activity in the US.  If Australia wants to collect more tax from the sale of Apple products there it can do so via an increase in sales taxes.

And the suggestion that the profits from products designed in the US, manufactured in China and sold in Australia should be subject to Corporation Tax in Ireland has nothing going for it. 

Ireland might be exceptional when it comes to attracting foreign direct investment, particular from the US, but there is nothing exceptional about Ireland’s tax residence rules for companies.  In fact, if we look at the OECD’s current model tax treaty we can see in Article 4 that the tie-breaker for determining the residence of a person other than an individual, i.e. a company is:

Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated.

In last year’s budget a move against Irish-registered non-resident companies being stateless was made so that if not tax resident in Ireland they have to be tax resident somewhere or else they will be deemed tax resident in Ireland.  Will there be a subsequent move to make all Irish-registered companies tax resident in Ireland? 

Possibly, but that would be a big decision.  Not because of any tax implications for MNCs it might have.  There are a myriad of ways for US MNCs to achieve their current tax outcomes.  The keys for them are #1 and #2 above and Irish residency rules are not going to affect those.

The issue with such a move is that it would erode the reputation for stability that the Irish regime has built up.  If a media storm, no matter how misdirected, can result in a change in Irish Corporation Tax companies will have less confidence in the overall investment environment and may choose somewhere that is less attractive but offers greater stability, perceived or otherwise. 

Making all Irish-incorporated companies tax resident in Ireland would cut out all of this nonsense commentary but at what cost?

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