apple-wordpressBy Europe Editor Tony Connelly

The European Commission’s salvo against Apple’s tax arrangements in Ireland is the most serious assault yet on the Government’s long-standing defence of the country’s tax system as it affects overseas companies.

The investigation does not deal with the 12.5% corporate tax rate per se, which has always been eyed with suspicion by several large member states.

Furthermore, the Government insists it operated within the law in all its dealings with the US computer giant.

Nonetheless, the level of detail contained in the Commission’s letter to Ireland – sent in June but only made public on Tuesday – about meetings between Revenue officials and Apple’s tax advisors 23 years ago makes uncomfortable and very public reading.

The Government may yet win the case.  It has pledged to take it to the European Court of Justice should the Commission’s competition arm find that Ireland illegally gave Apple preferential tax arrangements that weren’t available to other companies.

But the procedural step of publishing Brussels’ concerns about backroom deals, albeit in a redacted way, has drawn attention to the anatomy of Ireland’s tax regime.

Once the letter appears in the EU’s official journal in a couple of weeks, “interested parties” can make their comments known.

That doesn’t mean just the company at the heart of the investigation, Apple.  It also opens the door for member states who have griped about Ireland’s tax rate for years to make their objections known.

“I would be surprised if they didn’t get involved,” one well-placed Commission official said.

Essentially, Ireland is accused of giving Apple “selective advantage” through two tax deals; one in 1991, the other in 2007.

The deals were done through what is called Transfer Pricing, where profits are shifted between subsidiaries and between jurisdictions artificially so that a lower corporate rate of tax can be applied.

In the 1991 deal, the Commission quotes internal documents and interviews apparently revealing an arrangement on how Apple’s Irish subsidiary, Apple Sales Ireland (ASI), would end up paying less tax.

The details are complex, but what the Commission argues is that the Irish tax authorities agreed to exaggerate the level of operating costs so that the amount of profit liable for tax could be reduced.

Up to a certain amount ($60-$70 million), the taxable profit of the Irish subsidiary Apple Operations Europe (AOE) was calculated as being equal to 65% of the operating costs.

The report found that this amounted to “reverse engineering” so that Apple would arrive at a taxable income of between $28-38 million, ie far lower than the figure above.

In a damning extract, the Apple tax advisor confessed “there was no scientific basis” to this system.

Companies do often record high operational costs (which are tax deductable), but only in countries with traditionally very high corporate tax.

The Commission’s complaint is that this was all done through “negotiation” and not through pricing methodology.

It was not done “in a reasoned way,” the letter suggested.

By contrast, when operating costs should have increased, the record showed that they didn’t.

After 2007, when Apple’s wealth grew spectacularly thanks to the introduction of the iPhone, the level of profits recorded by the other subsidiary, Apple Sales International (ASI), grew by a staggering 415%.

Yet the operating costs remained unchanged at between 10%-12%, a figure that was reflected in an updated agreement between Apple and the Irish authorities in 2007.

The Commission opined: “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.”

According to the letter sent by the EU’s outgoing competition commissioner Joaquin Almunia: “The Commission is of the opinion that through those rulings the Irish authorities confer an advantage on Apple.

“That advantage is obtained every year and ongoing, when the annual tax liability is agreed upon by the tax authorities in view of that ruling.  That advantage is also granted in a selective manner.”

The extracts, based on documentation Dublin has been sending Brussels since June 2013, also suggest an undercurrent of threat in Apple’s dealings with Ireland.

The aforementioned tax advisor “mentioned by way of background information that Apple was now the largest employer in the Cork area with 1,000 direct employees and 500 persons engaged on a sub-contract basis”.

The interview recorded the tax advisor as stating that Apple was “at present reviewing its worldwide operations” and it wished to “establish a profit margin on its Irish operations”.

In the event, according to regulators, Apple negotiated a “mark up on costs” at its Irish branch “in order not to prohibit the expansion of the Irish operations.”

In other words, if you value the jobs, look favourably on our tax suggestions.

Does the Government have strong grounds for defence?

Its strongest argument is that, in 1991, this was all well within the law and reflected in international best practice.

Transfer pricing is not illegal, and the Government will argue vehemently that according to the global standards of the time Ireland was within its right to allow Apple to shift profits between its subsidiaries.

It will argue that all companies were treated in the same way.

The Government too will argue, with some justification, that the OECD’s most recent standards on transfer pricing were drawn up in 2010, so it is unfair to hold Dublin to those standards when the alleged offences happened two decades previously.

Where the Government is on weaker ground is the fact that the letters of comfort, or Advance Payment Agreements (APAs), which governed these tax arrangements were not reviewed every three- five years as they are in most other EU countries, but instead ran uninterrupted from 1991 to 2007.

In the event the Commission’s core argument is that the Transfer Pricing used was not “arms length”, the accepted industry term for fairness:  Brussels contends that other companies didn’t benefit from the same system, the Government will have to show that they did.

What next?

The letter issued by the Commission will be the last public communication until the end of the investigation.

Other interested parties – companies and member states – will have 30 days to comment and that’s where it could get uncomfortable for the government.

Already the world will be looking with some bemusement at the elaborate web of Apple subsidiaries set out in a graphic within the Commission letter, four of which are tax resident in Ireland.

As the Financial Times’s Lex Column quipped: Apple: Designed in California, Taxed in Ireland.

If the Commission finds that the arrangements for Apple amount to illegal state aid, then the company could be forced to repay outstanding tax going back ten years.

In reality, this is all very new territory for the EU’s competition arm, known as DG Competition.

Normally EU regulators have focussed on monopolies and cartels.   But tax has steadily crept within its remit given the outcry during the financial crisis over allegations that some of the world’s wealthiest corporations end up paying very little in tax.

There was a signal of intent one year ago when DG Competition set up a task force on taxation.

Indeed, in his mission letter to the incoming Commissioner Margrethe Westager, Commission president Jean Claude Juncker outlined the priorities that she needed to focus on, and they included “mobilising competition policy tools and market expertise so that they contribute, as appropriate, to… the fight against tax evasion,” among other issues.

Vestager is from a smaller member state, and she has spoken already about the need to avoid what she called anti-Americanism in dealing with competition issues, but it’s hard to see how her approach will be radically different.

State aid is a fundamental issue for the European Union – everyone has to abide by the rules.  So far the countries being looked at under the DG Competition’s new focus on tax are small: Ireland, the Netherlands, Luxembourg and Gibraltar.

But bigger member states are being looked at in another area:  both DG Competition and the OECD are casting a cold eye on the use of so-called Patent Boxes.

These are low-tax vehicles used to encourage companies to innovate and generate new Intellectual Property.

Essentially such products are placed in a “patent box” where their royalties attract a lower tax rate.

The UK has been at the fore in pushing the idea in order to encourage companies to commercialise their R&D in the UK, but critics, including the Irish Government, suspect it’s a covert way of lowering their tax liabilities.

So far nine countries operate a Patent Box:  the UK, which has a rate of 10%, Luxembourg, the Netherlands, France, Malta, Spain, Hungary, Cyprus and Belgium.

Germany has long lobbied against the use of patent boxes, largely because so many German firms have been registering their patents in the UK in order to avail of the 10% rate.

Wolfgang Schauble, Germany’s finance minister, has publicly raised the question of closing the loophole so that such firms would be prohibited from parking their products in a patent box (such a prohibition already exists in Austria).

The official German position is that clamping down on patent boxes is something that should be done at G20 and OECD level.

The question is whether these patent boxes contain genuine products that create things, or whether they are simply shell products there to attract a low tax rate.  Intellectual property can include patents, designs, copyright, models, trademarks and trade names.

The problem is that some products attracting the low patent box tax rates can acquire or license the products from third parties, meaning they don’t actually have to develop it in the country offering the tax rate.

The Government is likely to take a more assertive line, especially after British Prime Minister David Cameron’s public swipe at Ireland’s tax arrangements.

It is also sticking to the line that Ireland is fully engaged in the process at OECD and G20 level to make all of these opaque and potentially unfair tax practices much more transparent and equitable.

Whatever the outcome, the age of innocence for Ireland’s tax arrangements for the global behemoths, which have been so beneficial to the Irish economy, may be over.