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Friday, July 22, 2016

A bet with Tim Worstall on Apple's state aid repayment

Tim Worstall, a contributor at the Forbes Magazine website, wrote a column Thursday wherein he challenges all comers to a bet on the outcome of Apple's state aid case I discussed Sunday. He repeated the challenge to me specifically in the comments section of my post, and I accepted. It's for bragging rights only (I think I'd prefer for the prize to be a beer next time I go to London, oh well).

Worstall's angle is that he believes winning the bet shows he has a better understanding of the issues than I do.That's conceivable, but not necessarily true. In particular, he challenges my emphasis on
Ireland's creation of a corporate entity that is taxable nowhere, and the possibility that the company negotiated a tax rate far below the country's already-low 12.5% corporate income tax rate.
The thing is, we have strong evidence for what the case is about: The Commission decision that started this Article 108(2) detailed investigation. So let's turn to the decision and see what the Commission says it is investigating.

As paragraph (or "recital" in legalese) 6 states, this investigation revolves around transfer pricing (i.e., between different Apple subsidiaries) agreements called "advance pricing arrangements" or APAs. APAs are precisely the result of negotiations. Here is what the New York Times says about Apple Operations International:
Atop Apple’s offshore network is a subsidiary named Apple Operations International, which is incorporated in Ireland — where Apple had negotiated a special corporate tax rate of 2 percent or less in recent years — but keeps its bank accounts and records in the United States and holds board meetings in California.
Worstall is correct that these negotiations do not change the official tax rate of 12.5%; what they change is the effective tax rate. What the APAs do is reduce the amount of earnings of Apple Operations Europe (a wholly-owned subsidiary of Apple Operations International) and Apple Sales International (a wholly-owned subsidiary of Apple Operations Europe) -- I'll get to the details in a moment -- and these artificially derived profit numbers are then taxed at the standard rate of corporate income tax, 12.5%. To get the effective tax rate of under 2%, as cited by the NYT, is to claim that the tax paid (12.5% of the amount of profits as determined under the APAs) is actually less than 1/50th of the true profits these subsidiaries earned.

To take a numerical example, let's say that Apple Operations Europe made $625 million in 2015. However, under its advance pricing arrangement, let's say AOE is only deemed to have $100 million in profits for the year (we'll see how in a minute). AOE then pays 12.5% tax, or $12.5 million, in Irish corporation taxes. But 12.5/625=2%, so its effective tax rate is 2%.

So, when Worstall says this state aid case is not about a negotiated tax rate, he is not replying to what Apple's critics are actually saying.

How does Apple get its profit determined for the two subsidiaries with APAs? There are four separate rulings by the Irish government, two in 1991 (one for each company) and two in 2007 (one for each company). We'll take the 1991 APA for Apple Operations Europe as our example to show the main ideas. According to paragraph 31,
the net profit attributable to the AOE branch would calculated as 65% of operating expenses up to an annual amount of USD [60-70] million and 20% of operating expenses in excess of USD [60-70] million.
 When you think about this for a minute, you realize that this is a very odd formula for calculating "profit." Usually, we'd think about it as sales minus costs. This formula does not mention sales at all! So it's not surprising that it could give a figure far from what we would consider the true profit of Apple Operations Europe. For the record, AOE's 2007 formula does mention sales of intellectual property (paragraph 32), but neither the 1991 or 2007 formula for Apple Sales International uses sales in its calculation (paragraphs 33-34). Ho-kay!

Indeed, in its detailed analysis, the decision says that the formula for AOE was "reverse engineered" to allocate a specific profit number to the subsidiary (paragraph 61).

What about the non-tax resident company structure? Again, Worstall denies it's relevant here. But in fact, both Apple Operations Europe and Apple Sales International (and Apple Operations International, for that matter, though it's not a direct target in the case) are incorporated in Ireland but are not tax-resident there (paragraphs 25 and 27). These are the only Apple subsidiaries in Ireland that are not tax-resident in Ireland (paragraph 19). So this case wouldn't exist without this very unusual corporate structure.

To sum up, I believe that Worstall has misunderstood the reasons for the case given in the decision to open a detailed investigation. As I pointed out two years ago, if the Commission opens an investigation, it almost always finds that state aid was given, and that it is not compatible with the common market. So I am quite confident Apple will lose the case. Unless the Commission unexpectedly changes its mind on the importance of regulating fiscal aid, I am also confident that I will win my bet with Worstall. We'll know soon enough.

Sunday, July 17, 2016

We will soon know if Apple is ordered to pay billions in EU state aid case UPDATED

$19 billion? $8 billion? A few hundred million? Estimates are all over the map regarding the European Commission's imminent decision on whether Apple received illegal, unnotified state aid (subsidies) from Ireland. As I mentioned two years ago, two factors go into the Commission's claim: Ireland's creation of a corporate entity that is taxable nowhere, and the possibility that the company negotiated a tax rate far below the country's already-low 12.5% corporate income tax rate.

As you may remember from earlier posts, if the Commission rules against Apple, the sanction it will impose will be the repayment of the illegal subsidies, with interest. Some estimates of Apple's tax savings are astronomical (the New York Times reported an estimate Apple saved $7.7 billion in 2011 alone), which creates the possibility of an extremely high repayment order. On the other hand, recent cases have seen relatively low repayments, such as the mere 30 million the Commission ordered Starbucks to repay the Netherlands last year. Still, it is perfectly possible that the Commission used smaller cases as a way to establish the legal precedent regarding fiscal aid before dropping the bomb on Apple.

It's worth noting, as reported by Bloomberg, that the largest state aid repayment order ever made was approximately €1.4 billion charged to Électricité de France, followed by two orders in the €1 billion range. When this decision is announced, we may see a new record by a large margin. Or maybe we won't. Either way, the Commission will be giving us a clear sign regarding how seriously it intends to treat fiscal aid abuses.

Update: For a little perspective on fines, Chillin' Competition (via email) points out that the European Commission has just imposed an anti-trust fine on four truck manufacturers of over 2.9 billion , a new record.

Cross-posted at Angry Bear.