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EU tax bomb ignited by Apple ruling: What treasury needs to know

10 October 2016   (0 Comments)
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After years of investigations, Apple has been hit with a record-breaking EU tax bill of up to €13bn, having been found to have benefited from illegal state aid from Ireland. When the EU Commission issued its preliminary adverse finding in 2014 that the Irish government had given Apple illegal state aid, JP Morgan analysts estimated that Ireland may have to collect as much €19 billion in taxes dating backing to the 1990s.

Until today’s ruling, expectations were that any final demand would be much lower – between €500 million and €1 billion, so the scale of the announcement is a shock. But the significance of the ruling is much more than the huge size of the amount owed.

Treasurers and their companies have been able to get away with not paying too much heed to politics, especially in developed markets. No more. It started with the OECD BEPs initiative which, despite the profound changes it implies for treasury and tax management, seems to have had little impact on real-world corporate behaviour, partly because of an assumption that countries like the US would fight the proposals (as they did in Apple’s case) causing their indefinite postponement.

This attitude is a mistake. Governments are cash-strapped and looking for revenues. More important, they face populist revolts against perceived elites, notably tax avoiding corporates and their ever more highly-paid executives. The idea that corporations automatically create jobs and wealth that trickle down to benefit all is less and less accepted. Aggressive tax structuring will become much less acceptable too.

Despite the technical basis for the demand, which is that Ireland’s unique treatment of the company amounted to illegal state aid, the Apple case is really about attacking the fictions upon which much of multi-national tax structuring is built.

Apple said the European Commission was trying “to rewrite Apple’s history in Europe, ignore Ireland’s tax laws and upend the international tax system in the process.” But it is hard to argue with what the Commission is really saying, which is that the company’s structure in Ireland “did not correspond to economic reality”.

Two Apple subsidiaries managed all its non-US sales and were internally attributed to a “head office” which the commission found existed “only on paper” and could not have generated the huge profits allocated to it, enabling it to avoid tax in any country. This kind of aggressive tax avoidance – the kind that looks bad even if it is legal – is under sustained attack and the pressure on companies from governments and customers will increase.

Look back in anger

Even if the amount eventually repaid is much lower, the ruling itself will be enormously significant. First, if companies can be forced to repay tax under deals made with national governments dating back years, it creates enormous risk for MNCs all of whom employ complex multi-jurisdictional structures to minimise tax many of which do not reflect underlying business reality.

As in the cases of Uber, Amazon and Stabucks, tax authorities and politicians are becoming increasingly unhappy with the blatant shifting of revenues to low-tax environments and the lowering of profits in high-tax home markets with the use of licensing agreements struck with overseas subsidiaries. As Eurofinance andTreasury Perspectives have said before, as companies get more aggressive, shifting allegedly stand-alone intellectual property around their empires, governments will get angrier at the blatant mismatch between underlying business reality and tax arrangements.

Second, such a ruling opens the way for a more general attack by tax authorities on aggressive tax planning. As a US Treasury department White Paper (published on August 24) on the affair says, the “Commission’s pursuit of retroactive recoveries is not only in tension with the G20’s efforts to emphasise tax certainty, but also sets an undesirable precedent that could lead to other tax authorities … [seeking] large and punitive retroactive recoveries from both US and EU companies”.

The notion that such investigations will demand retrospective repayment should strike fear into the heart of treasurers and their tax departments.

US versus EU

Finally, for corporations with business in the US and EU, the ruling is a threat to the established order. The US Treasury has reacted to the announcement by saying that the “Commission’s actions could threaten to undermine foreign investment, the business climate in Europe, and the important spirit of economic partnership between the US and the EU”.

But even before the ruling the Treasury White Paper argued that the EU Commission was exceeding its powers in its tax investigations: “This shift in approach appears to expand the role of the [competition directorate] beyond enforcement of competition and state aid law … into that of a supranational tax authority that reviews member state” decisions on corporate tax.” It points out that the Commission is a “non-tax agency” and that the dedicated tax authorities in the US and EU member states are better qualified to judge transfer pricing issues.

The paper also says that the investigation runs counter to the OECD BEPs initiative:

“In contrast to the OECD [guidelines], no country will have played a role in developing the commission’s guidance, which also would not be incorporated into bilateral tax treaties between the United States and [EU] member states.”

But it is the suggestion that the investigation is an unfair singling out of US companies which opens the way for retaliation.  And the paper does include the statement that “the US Treasury department continues to consider potential responses should the commission continue its present course”.

Politicians have backed the idea. Earlier this year the Senate finance committee wrote a letter to Treasury Secretary Lew to impose a double tax rate on European companies if the Commission ordered Apple to pay back-taxes in Ireland.

“We are writing to you to express our strong concerns regarding the State aid investigations currently being conducted by the European Commission ("EU Commission") of several of its member States regarding tax rulings and advanced pricing arrangements provided to multinational businesses, most of them U.S. firms … We urge Treasury to intensify its efforts to caution the EU Commission not to reach retroactive results that are inconsistent with internationally accepted standards and that the United States views such results as a direct threat to its interests. We also ask that you consider, pursuant to the President's powers under Internal Revenue Code section 891 (which would impose a double rate of tax on citizens and corporations of foreign countries engaging in discriminatory taxation), whether "corporations of the United States are being subjected to discriminatory or extraterritorial taxes."

One reason why the Committee sees the judgement in this way is that there is potential risk to the federal budget. U.S. companies owe U.S. taxes on the profits they earn around the world and get tax credits for payments to foreign governments. If they pay more in Europe, they pay less to the U.S.

US wants back taxes too

But if you think all that means the US is arguing for a lenient approach to clever-clever tax structures, think again. In July it was announced that the US Internal Revenue Service (IRS) is suing Facebook to force it to comply with summonses related to a 2010 asset transfer. Facebook was summonsed to appear at the agency’s offices in San Jose, Calif., and to produce papers and others records. According to IRS agent Nina Stone, Facebook failed to show up at the appointed date of June 17, nor did it provide the documents.

The IRS is investigating Facebook’s transfer of intangibles (including databases and parts of its online platform) to its Irish subsidiary in 2010. A valuation of these by E&Y “were understated by billions of dollars”, according to a declaration filed in federal court by a local IRS agent. The company has already faced criticism in the US Senate for paying a two per cent corporate tax rate in Ireland versus the headline 12.5 per cent rate.

Treasury and tax need to take a long and hard look

Time for treasury and tax departments to look long and hard at their current structures.

So far, it is mostly the giants of the digital economy that have been affected. But their tax strategies reflect the wider issues of digital business in general, digital IP and services and the fact that tax strategy for the past several decades has been a relentless push to lower corporate tax rates in part by arbitraging real economic activity and its location versus the lowest tax environments.

This will become increasingly untenable. So the real question is simple: what would your business look like if it paid tax on the business it actually does in the countries in which it really does it? What if your transfer pricing mechanisms reflected both real underlying business activity and the real value of the transferred assets? It may be a good time to come up with a contingency plan to run that business rather than the one you have now.