Thursday, September 1, 2016

Why tax campaigners should be aghast at the Apple ruling

The European Commission ruling that Apple should pay €13 billion of Corporation Tax to Ireland has been met with approval in some quarters.  But one problem is that many of those who are approving have a completely different view of how companies should be taxed when compared to the broad logic used by the Commission to reach the €13 billion figure.  It is as if the ruling should be welcomed for the simple reason that it involves more tax (or at least appears to involve more tax).

Would other companies like to replicate the outcome that the ruling reflects?  Absolutely. And particularly for non-US companies as US companies are subject to US tax on their worldwide earnings.  But what about a company in France or Germany?  Would they like to have 60 per cent of their profits taxed at 12.5 per cent in Ireland. You bet they would.

So how can they achieve that?  If we follow the logic of the EC ruling it would be relatively straightforward.

Let’s take a company in France as an example.  The company should aim to have as much of its profits accumulated in a single subsidiary as possible using transfer pricing to maximise the difference between the prices it pays and receives.  There will tax due on the profits on other subsidiaries but the company should be looking for a central ‘hoover’ type subsidiary where as much of the profit as possible is located. 

It could be a company that buys off manufacturing units and then sells on to distribution or retail units or even final customers.  It doesn’t really matter just as long as it captures the maximum amount of profit possible.

This subsidiary can be in France, it can hold intellectual property (which may be how the profit is allocated to it), it can record sales on its accounts, its board of directors can stay in France, its accounts can be maintained in France and its financial assets can be kept in France.  It is crucial though that the company has no employees or physical assets in France.  The company must exist in France “on paper only” (leaving aside the fact that this is  is actually how companies exist).

This subsidiary should then set up a branch in Ireland where the only employees of the subsidiary are located.  The Irish employees implement the decisions of the board of directors.  They can deal with production units within the company and external suppliers.  The can do inventory management on the output to be produced.  They can oversee the logistics of the transport and delivery of the product.  And they can manage the invoicing and payments with customers.

How much profit should be attributed to the Irish branch that undertakes these functions?  Here is the Commission outlining position in the case of the Apple subsidiaries which had their head office in the US and a branches in Ireland with their only employees:

The Commission's investigation has shown that the tax rulings issued by Ireland endorsed an artificial internal allocation of profits within Apple Sales International and Apple Operations Europe, which has no factual or economic justification. As a result of the tax rulings, most sales profits of Apple Sales International were allocated to its "head office" when this "head office" had no operating capacity to handle and manage the distribution business, or any other substantive business for that matter. Only the Irish branch of Apple Sales International had the capacity to generate any income from trading, i.e. from the distribution of Apple products. Therefore, the sales profits of Apple Sales International should have been recorded with the Irish branch and taxed there.

The "head office" did not have any employees or own premises. The only activities that can be associated with the "head offices" are limited decisions taken by its directors (many of which were at the same time working full-time as executives for Apple Inc.) on the distribution of dividends, administrative arrangements and cash management. These activities generated profits in terms of interest that, based on the Commission's assessment, are the only profits which can be attributed to the "head offices".

Per the EC ruling ALL of the profits of this subsidiary should be “recorded with the Irish branch and taxed there”.  The tax to be allocated to France is nil – except for the interest earned on French bank accounts.

If the company can set up this structure they can get a good chunk of their profits taxed at Ireland’s 12.5 per cent and may not have to pay any more corporate income tax on those profits.

How big a chunk depends on the structure of the company and what it does.  Apple is an unusual case in that so much of its profit is derived from IP – design, brand, reputation, innovation etc.  Its central hoover subsidiary had about 60 per cent of the companies profit accumulating in it.  And per the Commission ruling this 60 per cent of Apple’s profits will be subject to Ireland’s 12.5 per cent rate of Corporation Tax. 

This isn’t much of a gain for Apple as US companies are liable for the US 35 per cent federal corporate income tax on their worldwide earnings (though obviously they can defer this).  But France operates a territorial system.  In theory, at least, this means that French companies are only taxed on their profits earned in France.  Profits earned abroad are not subject to French tax.

So our example company could set itself up with a French subsidiary that has a branch in Ireland and have all the profit of that subsidiary taxed in Ireland as long as the only employees of that company are in Ireland.  And it doesn’t matter how many employees. Just a few will do. 

Now we really have Ireland acting as a tax haven.  Think of the possibilities.  Companies all over the world can set up this central subsidiary that hoovers up as much of their profit as possible (within the confines of transfer pricing regulations).  This subsidiary maintains its board of directors in the home country but sets up a branch in Ireland that has the subsidiary’s only employees.  As long as this is the only “operating capacity” of the subsidiary then ALL of the profits will be allocated to the Irish branch and taxed in Ireland.

This would lead to huge profit shifting and significant exploitation of Ireland’s 12.5 per cent Corporation Tax rate.  Countries with territorial system would see large parts of their tax bases shifting to Ireland.  There is no other country in the world where this would be possible but the application of the EC ruling means that this is what Ireland should do. 

Any time the Revenue are faced with a non-resident company with an Irish branch then 100 per cent of profits of that company should be taxable in Ireland if Ireland is the only country that company has employees in.  This is being a tax haven on a grand scale.

How would the authorities in France react if one of its companies tried to pull this stunt?  They would be up in arms.  And rightly so.  There is no way they would accept Ireland taxing 100 per cent of the profits of that subsidiary just because Ireland was the only country it had employees in. 

They would say to Ireland to look at the branch operating there and collect tax based on the risks, functions and assets in the branch and leave the residual profit with the “head office” for the French to tax.  France will only allow Ireland to collect tax based on what happens in the Irish branch.

But this would put Ireland in contradiction to the EC ruling.  The two paragraphs quoted above clearly state that if the subsidiary only has employees in an Irish branch ALL of the profits are taxable in Ireland.  The Revenue Commissioners are between a rock and a hard place.  To avoid falling foul of further state-aid inquires all branches should be treated as the EC ruling requires but France will only allow Ireland to levy tax on the functions that the Irish branch actually undertakes.

This is why there have been many people saying that the EC ruling “flies in the face of international tax practice”.  But not only does it do that it opens the possibility of Ireland becoming a tax haven of grand proportions.  Maybe we should scrap the IDA and set up an agency with the tagline “set up a branch in Ireland, pay all your tax here”.  For companies in countries that have territorial tax systems it would be hugely attractive.  There could be tens of billions in revenue in it for us (if it was possible, which it is not!).

This is all a bit whimsical.  And although what the Commission have done in the case of Apple goes against all principles of taxation what is here is not enough to say they are wrong on the particulars of that case.  We will come back to that.  But it does highlight the inconsistency of some of the reaction to the ruling. 

If other companies set up structures to try and avail of what the ruling offers they would be accused of tax avoidance by many of those welcoming the ruling.  And they would be right. So, rather than welcoming this ruling, if anything, campaigners should be aghast at what this ruling means.  Do they really want the tax system to function as implied by the two paragraphs quoted above?    

Does the arithmetic behind the €13 billion stack up?

In a word: yes.  This is from a post last March which looked at ASI in detail.

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 tracked that of the overall company then the cumulative profit earned by ASI over the ten-year period from 2004 to 2013 is somewhere around $113 billion.  If we just do a crude approximation and apply a 12.5 per cent tax to that you get $14 billion.

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 reaches $19 billion.

The calculation was from 2004 to 2013 and is based on the figures in the table below showing ASI’s profits and taxes.  Convert to €, add in the amounts for 2014 and interest for another 8 months and you get around €13 billion of tax and around €6 billion of interest.  There is nothing wrong with the Commission’s arithmetic.

The table below also shows some of the effective rates used by the Commission in their press release. 

ASI Tax Outcomes

Getting the arithmetic right is one thing; getting the logic right is another.  As shown above we suggested five possibilities through which the Commission might conclude that the entire profits of ASI could be deemed taxable in Ireland.  They went for a variation of the fourth:

  • ASI only has substance through its Irish branch which is enough to deem the parent, which has no substance, taxable in Ireland

Essentially what the Commission have said is that because the parent – which the Commission describe as the “head office” and with the quotation marks! – has no substance (in their view) all the profit allocation within the company should be zero to the “head office” and 100 per cent to the Irish branch (bar some interest income).

So while they have the arithmetic right the key question is do they have the basis for the logic behind the arithmetic right.  We only have the press release to go on so far so it can be hard to tell what the exact justification is.  The government and Apple have the full 130-page ruling so they are in a better position to assess what the Commission have done.  But once the smoked has cleared it is something we will come back to over the next while.