Monday, March 27, 2017

Guest post: Nokia’s aggressive patent suits and recent share buybacks; are they related?

The following post was written by Peter W. Rudder, a graduate student at the University of Sydney Business School, who contacted me with some observations and potential conclusions regarding Nokia's share repurchase program and its earth-spanning patent litigation against Apple. I found Peter's analysis insightful, and the fact that Nokia put unusual pressure on Apple through litigation in numerous countries right at the start of a dispute (as opposed to escalating over time, which is the more common approach and also what Nokia did against HTC) could be attributed to some of what Peter has noticed.

Generally speaking, a share repurchase in a situation in which a certain percentage of a company's profitability is being renegotiated either means positive leverage (Nokia's stock would later be worth more that way) if the outcome is good or it can also make things worse (if the stock price goes and stays below where it was at the time of a buyback).

Now the actual guest post:

Nokia's aggressive patent suits and recent share buybacks; are they related?

Back in December Nokia launched several patent suits against long-time adversary, Apple. This was an event that drew much media attention to Nokia, with many calling it a return to their patent trolling days. What didn’t draw nearly as much attention however, was the commencement of a massive share repurchase program that began just over a month before the announcement of the litigation

The announcement came during Nokia's June, 2016 Annual General Meeting in which the board was authorised to repurchase a maximum of 575 million shares, with the authorisation set to expire in December, 2017. Large corporations repurchase shares all the time, most commonly to return capital to existing shareholders or to alter capital structure and almost always when it believes its shares are undervalued. Nokia has made no allusion that it believes its shares are undervalued, stating that the repurchases are only part of its ongoing capital structure optimisation program, which it has invested a total of €7 billion in since October 2015, mainly for de-leveraging purposes as a consequence of the Alcatel-Lucent acquisition.

While it is fair to assume Nokia did not believe its shares were undervalued at the time, the evidence tends to suggest otherwise. The actual repurchase of shares did not commence until November 16, 2016 when Nokia shares were at a 3-year low. This low can mainly be attributed to Nokia's poor Q3’16 earnings results announced in October 2016, compounded with a later announcement from CEO Rajeev Suri on November 15, offering an additional 2% decrease in Networks sales to the existing 2017 guidance figures. The market reaction was harsh, with Nokia's share price falling 18% after the Q3’16 announcements, and many writing off Nokia, saying poor global network sales would stifle any "catalyst for rebound". Despite the prophesised doom and gloom, from November 16, 2016 to March 17, 2017 (the date of the last recorded repurchase) Nokia purchased 93.1 million (€416.6 million in value) of its own shares and saw a 32% increase in its share price.

Even with poor Networks sales and a gloomy outlook from the market, Nokia went ahead with its ambition repurchase program, seemingly unfazed; why? Analysts had already priced in these revenue figures into their models, and concluded that Nokia's share price wouldn’t recover until there was tangible evidence that Networks sales could improve. From this, one could conclude that either Nokia believed it could quickly deliver these results to the market, or that it had an ace up its sleeve that could deliver value to shareholders another way. Sure enough, just over a month later, Nokia announced a slew of patent suits against Apple.

With the launch of these suits, analysts have estimated that Nokia has lost around €150 million in royalty revenues per year from Apple. On the surface, it seems like Nokia is taking an extraordinarily large risk to renegotiate a seemingly small amount of revenue, after all, €150 million is less than a percent of the almost €24 billion Nokia generated in net sales in FY2016. So why go to so much trouble over such little revenue?

Since the disputed patents are mostly to do with smartphone and other consumer electronics devices, all the lost revenue has impacted on Nokia’s Technologies segment. The Technologies segment, once the core of Nokia’s business, now plays a relatively small part, making up only 4.6% of revenues in Q4’16. When it comes to profitability however, the Technologies segment becomes a much more important part of the business, making up 14.3% of positive EBITDA and an EBITDA margin of 52.4% in Q4’16 (report). When compared to the backbone of Nokia’s business, the Networks segment, which has a much lower EBITDA margin of 16%, we can see why Nokia has taken this risk, as each Euro of revenue earned in the Technologies segment contributes to earnings over three times more than it would in the Networks segment. The reason for this is mainly that much of the revenues generated in the Technologies segment come from royalties which are very low risk, high margin cash flows. With an operating profit of €2.2 billion in FY2016, the €150 million represents approximately a 7% loss to Nokia's bottom line, which is a significant hit to its profitability.

The timing of the share repurchases and the announcement of litigation against Apple soon after, seems to suggest that Nokia is confident in its ability to quickly resolve the patent disputes and renegotiate its contracts on more favourable terms. This could possibly entail larger yearly royalty payments and a large sum paid as compensation for the alleged infringement, similar to the resolution of the Ericsson v Apple case in 2015 (Financial Times article; paywall).

The market tends to agree, although a little more conservatively. Analysts from JP Morgan stated that the €150 million in lost revenues should be returned by no later than the end of FY 2017, and are not factoring in the potential for greater royalty payments or a lump sum paid as compensation either. Surely, you’d think, by taking this risk, Nokia is aiming for a much better result than just the return of €150 million. The fact that the potential upside is not priced in to many analyst’s models tends to suggest that they believe future licensing revenues will not be significantly different from the past, and could mean they’re undervaluing Nokia somewhat. The continuing share repurchase and the ongoing litigation, which they are reportedly willing to spend €100 million per year to resolve, seems to support that Nokia believes the potential upside will far exceed the downside, and are expecting a successful result which will have a significant positive impact on their earnings.

Considering the recent share repurchases, the fact that Nokia is willing to spend €100 million per year on this litigation, the success it has had in settling patent suits in the past, and the broadening of Nokia's patents thanks to the recent Alcatel-Lucent acquisition, strongly suggests that Nokia is very confident that it will triumph over Apple. But are they being too confident? As Florian has written previously, Nokia may possibly not receive the outcome it evidently wishes to seek. Given Apple's vast resources, incredibly powerful market position and subsequent leverage over Nokia (see: Apple pulling Withings products from Apple stores), Apple has the potential to draw out this case for years. The longer the case goes on, the longer Nokia are without a significant portion of their earnings, and combined with a shaky outlook for its Networks segment, it could see a significant loss to its share price if shareholders are not delivered relatively quick results. Time is of the essence, so could Nokia's confidence be a risk to its investors? That remains to be seen, but what we do know is that there are certainly interesting times ahead for Nokia.

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Thursday, March 16, 2017

Samsung files petition for Supreme Court review of 2nd Apple case weeks ahead of deadline

Stalling is something else: even though the Chief Justice of the United States had granted Samsung an extension until March 29 for a petition for writ of certiorari (request for Supreme Court review) relating to the second California Apple v. Samsung case , it made its filing on March 10, almost three weeks ahead of the deadline:

17-03-10 Samsung Cert Petition 2nd Apple Case by Florian Mueller on Scribd

Timing is often an interesting indication of a party's priorities. Over these past seven years of Apple v. Android lawsuits (it all started with HTC in March 2010), Android companies--HTC more than anyone else--have often shown the behavior of stallers, at least when they were (as Samsung is here) on the defending end of a litigation (obviously not when they were asserting standard-essential patents themselves). Even parties that don't intend to stall in the slightest (such as Oracle when enforcing its copyrights against Google) typically wait until the end of a filing deadline. It provides them with an opportunity to wait for further relevant developments (case law, public statements by key persons and entities, etc.). So I really am surprised here. Further remedies-related proceedings in that case are ongoing in district court, and a case management conference has just been postponed to next month. With a view to that conference, the Supreme Court is unlikely to make any decision either way in the meantime.

Maybe Samsung believes Apple is going to bring a motion for contempt in connection with an injunction and believes that a more advanced state of its Supreme Court petition will be helpful when seeking stays. It could also be the opposite: with the most important one of the patents-in-suit ('647, often called "quick links") having expired, Samsung might not fear anything and, instead, be pursuing this Supreme Court appeal mostly because of the fundamental principles at stake: overarching issues that affect Samsung in other cases, and not just Samsung, but even Apple would benefit from some of Samsung's proposed statutory interpretations here whenever and wherever its shoe is on the other foot.

The petition as a whole does look very principled. I've never seen a litigant of this nature and stature--no matter which party--who would have managed to be 100% consistent and principled, but of all the motions, petitions and other procedural steps taken by Android companies defending against Apple's (or, in other cases, Microsoft's or Oracle's) patent infringement assertions, I really can't remember a more principled initiative. Obviously, a petitioner's intentions aren't considered by the Supreme Court when deciding on certworthiness, but while the Supreme Court will just focus on the questions presented and their implications, I've been following the entire Apple v. Samsung dispute for almost six years, so I am trying to understand what the parties are trying to achieve. Their last filing with Judge Koh in San Jose said there was no progress regarding a settlement. But neither party has brought a new case against the other in years; instead, various pending lawsuits were withdrawn, with only two U.S. district court cases still awaiting final resolution.

What's ambitious about Samsung's petition is that it raises three questions for review, covering the big three patent litigation questions:

  • validity (here, obviousness),

  • remedies (here, injunctive relief, which is always a more important issue than damages unless damages would really be devastating), and

  • infringement (here, whether all elements of the relevant "quick links" claim were infringed).

If the Supreme Court granted all three, it would be the most comprehensive patent case ever before the top U.S. court, and the implications of a decision could, collectively, go beyond Alice. How did Samsung's petitions fare in the past? The one regarding design patents was a slam dunk. I believed in it 100% from the start, at least in the "article of manufacture" theory, with respect to which cert was granted while a different theory wasn't evaluated. Last year, Samsung brought a little-noticed (I, too, had failed to notice before it was "game over") injunction-related petition that went nowhere, maybe because it wasn't deemed ripe for review. But when evaluating Samsung's track record with cert petitions involving Apple, "1 out of 3" would be the wrong conclusion since one has to weight the importance of the issues and the fact that Samsung only needed to prevail on one of its design patent damages theories, which it did except that there still is some uncertainty as to what the ultimate outcome would be.

The three questions raised have unique strengths-weaknesses profiles from a certworthiness point of view (just talking about certworthiness, not merits):

  • The injunction part is where the petition says something that may get the Supreme Court, especially justices who either were involved with the famous eBay v. MercExchange appeal or care about the related principles anyway, very interested. Samsung argues that the Federal Circuit would basically (and this is my choice of words) gut eBay. I bet Apple will argue (as it did in the past) that a "causal nexus" between infringement and irreparable harm is none of the four eBay factors, while Samsung argues that it is needed. Justice Kennedy's eBay concurrence is nowadays, by far and away, the most influential concurrence in a patent case, and what he wrote in 2006 is probably the closest authority to its own position that Samsung could point to. But the strongest "argument" for getting the Supreme Court interested (which has nothing to do with the merits) is cited at the bottom of page 2 and the top of page 3 of Samsung's petition:

    "As to the injunction decision, its author stated at oral argument, 'I think eBay was wrongly decided .... I think patentees should get injunctions.'"

    The decision's author is Circuit Judge Moore. That statement might persuade the Supreme Court that this case is indeed about eBay reloaded, 11 years after. Samsung also quotes from Chief Judge Prost's dissent, which is quite persuasive, too. What makes Judge Moore's statement so powerful is that even a Supreme Court Justice who doesn't necessarily believe a reasonably strict "causal nexus" requirement is dictated by eBay (or even someone who disagrees with eBay altogether) might find that attitude so dismissive of the highest U.S. court's decision that the Supreme Court would want to take a look. Samsung's cert question quote the two words of the Federal Circuit's majority opinion that sound most eBay-incompatible: "some connection" (between an infringing feature and asserted irreparable harm)

  • As far as the merits are concerned, Samsung's petition exudes maximum confidence with respect to the infringement-of-all-claim-elements part: they say that even if the Supreme Court didn't want to hear this case, the "quick links" infringement judgement "should be summarily reversed or vacated."

    This is the part that would be economically most impactful (about 80% of the $120 million verdict at issue), yet Samsung raised it only as the last of three cert questions. Samsung portrays its position here as what one might call a "no-brainer" that won't be difficult or time-consuming to decide.

    As a software developer, the problem I see with the way the Federal Circuit interpreted the patent here against a previous claim construction is that there's a huge number of client-server software patents out there and if (maybe not all, but still a number of) client-server patents could also be asserted successfully against single pieces of software (here, the client side alone), it would expose to developers to far greater risks. If I were in Apple's shoes, I would probably place particular emphasis on my resistance to this part of the petition because, even if Samsung succeeded on anything else, the net effect would be that roughly 80'% of the original verdict would be affirmed that way (with the rest potentially still going well for Apple), so Apple's PR message could be "most (if not all) of what we won got upheld." But Apple, just like Samsung with its petition, may set priorities based on key principles, and considering how hard Apple fought over the years, the injunction question is probably going to be even more meaningful to it, even if the most important one of the three patents-in-suit in this particular case has already expired.

  • The strongest part of Samsung's argument for cert regarding (non-)obviousness is that it's the most litigated issue in connection with patents but the three judges of the Federal Circuit's panel, who got overruled by an en banc majority, all wrote dissenting opinions that warn against the consequences of the majority decision.

    The patents at issue in this context cover particular aspects of autocomplete and slide-to-unlock functionalities. So Samsung's first cert question relates to the two patents that are substantially less important from a damages point of view than the "quick links" patent.

There is an unofficial fourth issue that Samsung raises and it relates to the proceedings in the Federal Circuit. Samsung points to Professor Chisum's ("Chisum on Patents") and other legal experts' criticism of how things were handled procedurally, with an en banc decision overruling a panel without a hearing and even without further briefing. That part is relevant in connection with the merits questions (validity and infringement), but not to the injunction case, which was a separate appeal. Maybe Samsung felt that a formal cert question about Federal Circuit interna wouldn't be likely to get the Supreme Court's attention, so the procedural part is raised only as a means of undermining the crediblity of the en banc majority decision.

In the design patent damages case, the cert question that the amicus briefs submitted in support of Samsung focused on was also the one that succeeded (it simply was the most interesting question). It will be interesting to see what any amici supporting Samsung will focus on. If past amicus brief activity in different patent cases is any indication, the standard for injunctive relief may very well be the #1 issue for amici. However, if different amici focus on different ones of Samsung's cert questions, then we may see even more amicus brief activity in total here than we did in the design patents case.

The most interesting de facto amicus briefs may already have been filed: the dissents by Chief Judge Prost in the injunction case and by all three panel members, including Chief Judge Prost, in the merits case. Outside of the Samsung group, no one may be more interested in this cert petition succeeding (at least in part) than Chief Judge Prost, whose dissents were very passionate and persuasive in both cases. Samsung quotes her a lot, including among other things her position that the second Apple v. Samsung case "is not a close case" for an injunction.

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Monday, March 6, 2017

The EU Commission's Plan B in the Apple-Ireland "state aid" case: make Apple pay $1.2 billion

Several readers asked for a more specific number after I wrote last month that the European Commission's secondary line of reasoning in the Apple-Ireland "state aid" decision of last August (PDF) would come down to approximately one billion euros (not 13 billion).

The secondary line of reasoning is outlined in paragraph 355 of the EC decision. The gist of it is that the Commission looked at the profitability of other distribution companies and concluded that 3% on sales is an industry-standard profit margin. The numbers themselves are stated in paragraph 97 of the EC decision, with Table 1 (the one relating to ASI, meaning Apple Sales International) being economically relevant and the numbers for AOE (Apple Operations Europe) being pretty much negligible. So, let's apply the standard Irish corporate tax rate of 12.5% (a) to ASI's pre-tax profit as under the Commission's primary line of reasoning ("Plan A profit" column in my table below) and (b) to a hypothetical distributor profit of 3% of ASI's sales ("Plan B profit" column in my table below).

As in paragraph 97 of the EC decision, the numbers below are stated in millions of dollars. Wherever the Commission stated a range, I based my calculation on the middle of the range. Please note that the sum at the end may deviate slightly from the sum of the numbers above it simply due to rounding. Any such differences are negligible.

YearASI SalesPlan A profitPlan B profit
20031 68216550
20042 22326867
20054 068725122
20065 6261 180169
20076 9511 844209
200810 3783 127311
200915 4045 662462
201028 68012 140860
201147 28122 1341 418
201263 25035 2501 898
201362 75026 7501 883
201467 77524 7502 033
total316 068133 9959 482
12.5%:16 7491 185

The Plan A total of $16.7 billion is more than the €13 billion (i.e., approximately $14 billion) that the Commission said would be the starting point for additional taxes to be paid by Apple. But there are explanations for that. Some numbers must be deducted even under the Commission's Plan A, and currency fluctuations explain the rest. ASI's numbers are stated in US dollars but Ireland is a eurozone country. So, basically the EU Commission wants to apply Ireland's 12.5% standard corporate tax rate to ASI's (and AOE's) pretax profits in the relevant period, and that's why an amount of approximately $14 billion has been mentioned over and over.

Under Plan B, however, that recovery amount goes down to approximately $1.2 billion, or less than a tenth of the number that has been making headline news since late August.

Why does the Commission even outline that Plan B in its decision? In paragraph 356, the Commission "contests" that anything other than its Plan A is correct, yet uses it as a fallback line of reasoning in order to argue that Ireland didn't tax ASI on the basis of "a reliable approximation of a market-based outcome in line with the arm's length principle." It may not be the only way in which that EU Commission decision is unusual, but it is the most conspicuous one.

It would not have been unusual at all for the Commission to present two or three legal theories that arrive at materially the same result. If the EC had presented one theory based on Irish statutory law, one based on Irish case law and one based on EU law ("acquis communautaire"), and if all had pointed in the same direction, then that would have made the case stronger, not weaker. I've seen parties make multiple arguments that support a claim, and I've seen judges present more than one theory just to bulletproof their rulings before an appeal. But in all those cases, two or more theories support the same conclusion. Not so here. The Commission's Plan A (tax ASI's pretax profits at a rate of 12.5% even though Irish tax law and even the Commission itself recognize that companies essentially run outside of Ireland need not be taxed there at all) and its Plan B (apply the 12.5% rate to a hypothetical profit amounting to 3% of ASI's sales) share at least one fatal deficiency: the "arm's length principle" as discussed in great detail by the EC in its decision is neither part of Irish statutory law nor Irish case law on the taxation of such entities and the treatment of inter-company charges within a global group. I already talked about that fact last month.

So the fact that there are two theories--with a huge discrepancy (more than a factor of 10) between the results-doesn't make the case as a whole more solid. What must the Commission's approach then be attributed to?

No matter how one looks at it, the fact that there is a Plan A amounting to $14 billion and also a Plan B amounting to less than 10% of that (and even a Plan C, but there is such a lack of specificity at least in the redacted version of the decision and presumably even in the unredacted one that it's impossible to analyze) shows that the Commission is very unsure of what it's doing here.

Let's think of a fictitious parallel. There's one person, Mr. A, demanding money from another person, Mr. B. A tells B that the amount owed is 10 grand, but even if one applied a different theory, it would still be 1 grand, so in A's opinion there can be no opinion that A is right in some way.

The answer most likely lies in politics. The Commission isn't going to collect any of that money itself; it can only (and this is obviously subject to judicial review) order Ireland to collect something from Apple. The Commission wants the amount to be huge, but the Commission would still claim victory as long as any noteworthy amount (and a billion dollars is a lot as long as one doesn't know or consider that the Commission said $14 billion was roughly the right figure) ended up being paid. They would basically say: "Maybe we missed the correct number by a factor of more than 10, but there can be no doubt that we really had to do something in order to right a wrong!" In other words, they'd deny that they wasted taxpayers' money on an investigation of a non-issue.

It may not be necessary for me to reiterate this because I've taken a consistent position on this matter in several posts by now, but I don't even see a reasonably convincing basis on which Ireland would have to collect $1.2 billion. The correct outcome would be for the CJEU to tell the EC that this is all bogus. I just wanted to provide some quantitative analysis in order to complement my previous post on this subject.

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Friday, February 24, 2017

Samsung is now taking the second Apple v. Samsung patent case to the Supreme Court

The first Apple v. Samsung case went all the way up to the Supreme Court and has meanwhile gone all the way back to the Northern District of California to take a new look at the question of design patent damages. But the steps to the Supreme Court are like a revolving door for this huge commercial dispute: a new petition for writ of certiorari (request for Supreme Court review) is already in the making! This time around it's about the second California Apple v. Samsung case (the one that went to trial in 2014, resulting in a $119 million verdict).

Donald Chisum, the author of "Chisum on Patents," described the Federal Circuit majority's decision to overrule (in Apple's favor) a unanimous panel decision (which had been favorable to Samsung's interests) as what may turn out to be the appeals court's "most controversial decision ever." The patent law community at large was very, very surprised (to say the least). Here's another example (on Law360).

After months of not hearing or reading anything about the case except for an Apple motion in California that essentially said "let's get it over with," I looked up the Supreme Court docket in light of a deadline approaching these days and, indeed, under no. 16A823, the top U.S. court has received and granted an application for an extension of time. Samsung now has until March 29, 2017 to file its petition.

Right after the Federal Circuit decision had come down, I already outlined my thoughts on the prospects for another Apple v. Samsung Supreme Court appeal and discussed what kinds of issues might be raised in that event. In a little more than a month, we'll know what issue(s) Samsung's attorneys have decided to bring up.

I'm pretty sure that Professor Chisum's quote will appear in the petition. It's a silver bullet in this situation, where the name of the game for Samsung is to persuade the justices that a second Supreme Court review is warranted in connection with the same dispute (though it's technically a different case involving different patents and different issues). Merits are going to be less than secondary at this stage. Certworthiness in terms of one or more key legal issues and public interest (that's where amici curiae, "friends of the court," can be very helpful) is all that matters now.

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Monday, February 20, 2017

The case against the EU "state aid" case against Apple: 13 billion euros out of thin air

When Apple is party to a litigation, the numbers involved tend to be huge. Sometimes the numbers are just the nature of the beast and there is underlying merit. But not always. Apple itself and, far more frequently, its legal rivals sometimes blow things out of proportion and/or make assertions one doesn't really have to agree with. Case in point: it's been almost three years since I described an Apple damages claim over five software patents as "an objective insanity," and when that case went to trial, a damages claim of well over $2 billion got contracted to an award of roughly 5% that number which (along with a temporary decision by an appeals court to dismiss the entire case) suggests that my criticism wasn't baseless.

The EU "state aid" case against Apple (technically against Ireland, but for all practical intents and purposes against Cupertino) is also an objective insanity. I've read the 130-page decision by the European Commission more than once, and the closer I looked at it and the more I thought about it, the less sense it made to me. I don't think a court that respects itself and its laws can possibly conclude that Ireland granted "state aid" amounting to roughly 13 billion euros to Apple.

Shortly before Christmas, and right before the Commission published its decision, the Irish government provided a summary of its legal arguments against the ruling. Since last summer, senior Apple executives have occasionally voiced their disagreement with Brussels in interviews that were unusual and possibly even unprecedented for a company whose official communications are normally consistent with its approach to product design: minimalistic elegance. For example, Apple's CFO told a German newspaper that the Commission should be ashamed of what it's doing here (which he described as a disgrace for all European citizens).

Ireland's pleas in law and main arguments against the Commission decision were published two weeks ago in the Official Journal of the European Union. Since my post last week on how hypocritical it is of Commissioner Vestager to back the 5% tax rate that applies to the Madeira scheme while alleging that Ireland granted "state aid" to Apple, I've been waiting for Apple's own arguments to be published, and here they are: 14 partly-overlapping pleas.

I'll probably talk about some of those points on other occasions. In this post here I'll just outline why I think this is not a "state aid" case and, actually, not even a "case" by any stretch of the imagination. It's what happens when unelected officials who are not accountable to the people develop an "idée fixe."

Allocation among subsidiaries in different countries has nothing to do with tax avoidance

In its late-August press release, the Commission claimed that Apple's "effective tax rate decreased further to only 0.005% in 2014." That claim portrays Apple as a tax evader that doesn't contribute back to society and fails to pass even the most basic plausibility test because no one, not even a hypothetical merger of a dozen Apple-like companies, could be Ireland's biggest taxpayer that way. The European Commission is all too often a fake news organization--or "very fake news" as President Trump likes to say--and even proud of it (its current president said that you just have to lie when things get serious).

Apple's "effective tax rate" is not what its international subsidiaries pay in one jurisdiction or another. It's what Apple ultimately pays on a global basis, which obviously includes U.S. repatriation taxes. Sooner or later (and it might be sooner rather than later since President Trump hopes to reach an agreement with major U.S. companies on repatriation of overseas funds), Apple would have to bring money back to the U.S. because it can't make dividend payments directly from its Ireland-based operations to its shareholders. At that point, U.S. tax laws would apply, and it goes without saying the tax rate is then not going to be 0.005% or anything like that. Right now it would be more like 35%.

Neither Apple nor Ireland are responsible for a certain asynchronicity of U.S. and European rules governing the taxation of globally-operating corporate groups: while European tax systems (and also the tax systems in many other parts of the world based on what I read) tend to just consolidate a corporation's worldwide income and tax profits in the year in which they were made (no matter where they were made), the U.S. "global deferred" approach focused on when any money gets repatriated.

Until Apple repatriates the money owned by any of its Irish organizations, particularly of Apple Sales International (ASI), it can obviously invest that money. For example, it could make acquisitions. When large U.S. companies with lots of money in the bank in Europe buy European companies (such as Microsoft's deals with Skype and Nokia), they can just use the money they already have in Europe rather than send money over from the U.S. to the selling European shareholders or corporate entities. Then the acquisition targets become subsidiaries of European subsidiaries, and if those deals generate profits, those profits, too, must stay in Europe or will be subjected--as they will be sooner or later--to the U.S. repatriation tax.

In its decision, the Commission does recognize that under Irish tax law a company can be registered in Ireland without being subject to Irish taxes. The Commission describes those companies as "stateless," which again sounds like "never paying taxes anywhere, anytime" and is not the way it is: if a company is registered in Ireland but practically operates outside of Ireland and is managed in the U.S., its profits will be subject to U.S. taxes, just that the point in time when this occurs depends on repatriation.

The EU Commission doesn't say that such companies cannot legally exist. It's all about allocation: it's about how much is taxed in Ireland (and, in that case, taxed immediately) versus how much can be kept in Ireland for a while but will ultimately be subject to U.S. repatriation tax. And that leads us to the second point, which is an incredible legal deficiency of the Commission decision.

There is no basis whatsoever for the "arm's length principle" in EU or Irish statutory or case law

Apple's first plea and Ireland's second and third pleas mention the "arm's length principle" and other pleas involve it indirectly.

When I founded my first limited-liability company in Germany 25 years ago, my tax adviser explained this concept to me. In Germany, it's called "dealings as between third-party strangers," meaning that the business terms of a transaction between myself and a company I own, or between a company and its subsidiaries, have to be reasonable in the sense that one would also, potentially, give that kind of deal to a stranger. If my company bought a laptop for 2,000 euros and sold it to me three days later for 1,000 euros, it would obviously not be the deal it would give anyone else because it just wouldn't make economic sense. However, if my company sold me a laptop today that it bought a year ago, then the commercial value of such a used laptop--and considering that technology has advanced in the interim--may even be less than 1,000 euros.

It's a principle that works very well--though it obviously does keep tax authorities and courts busy--in many jurisdictions. But on 130 pages the European Commission failed to provide a single citation to Irish statutory law or case law that makes it applicable to Apple's inter-company charges in Ireland. The Irish government says it doesn't accept it. Apparently some expert report was provided, too.

Now, theoretically EU rules could require Ireland to apply the principle since EU law can trump national law. But EU law trumps national laws only if a field of law is subject to the acquis communautaire, which is the notion of EU law absorbing more and more parts of national law. However, this ever-expanding nature of EU law (part of the now-failed vision of an "ever closer union") is subject to rules. There must be a democratic process by EU standards. The EU is so undemocratic that one of its past commissioners quipped the EU would have to deny the EU membership in the EU because of its democratic deficit, but even the compromised kind of democracy that the EU has in place is at least partially democratic, with a weak parliament where too many MEPs are directly on the payrolls of corporations and lobby groups and which doesn't have the right of initiative as Nigel Farage recently explained again. So, even the semi-democracy that is called the EU at least has a process in place for what makes something subject to EU law, and that process does involve the European Parliament. The Commission cannot singlehandedly expand the scope of EU law.

There is no EU statute that makes the arm's length principle an EU-wide rule. It's up to the member states to have it or not. The only statute the Commission cites to is the general "state aid" clause, which is not about taxes. There is no EU case law that says the arm's length principle must be applied in all 28 member states. The closest thing that the Commission cites to is a case relating to Belgian tax law, and Belgium, like Germany, simply has the arm's length principle in place in its domestic tax law.

At the fundamentally-flawed heart of the Commission's 130-page decision there is a non-binding recommendation by the non-EU Organization for Economic Co-operation and Development (OECD) concerning the arm's length principle. The OECD is not a legislative body. It's well-respected in some places and contexts, but so are the International Committee of the Red Cross and the World Economic Forum.

Dozens of pages in the Commission decision talk about how to apply some OECD recommendations to the taxes Apple should have paid in Ireland in the opinion of the EU Commission. Dozens of pages to cite to something that is, in legal terminology, persuasive authority at best. It's the kind of thing one would additionally point to in order to show that there is some sort of political support for a law, but it's not a law all by itself.

What adds insult to injury is that the relevant OECD recommendations were issued in 2010, while the Irish tax authority's decisions at issue in the Apple case are from 1992 and 2007. Even if the OECD guidelines predated the relevant decisions, they wouldn't be or make law, but even less so retroactively...

I can't imagine that the Luxembourg-based EU court will content itself with persuasive authority and, on that basis, tell Ireland what its tax laws have to be, when tax sovereignty at the national level is (for better or worse) a cornerstone of EU rules.

Intellectual property

Apple's third plea in law accuses the Eurpoean Commission of "failing to recognize that [the relevant Apple subsidiaries'] profit-driving activities, in particular the development and commercialization of intellectual property ('Apple IP'), were controlled and managed in the United States."

I've been in this industry for decades and I've been on the distribution side as well as on the product development side (that's where my focus is at this point again), and I've been a mediator between both sides, advising IP owners, IP licensees, scouting for products and negotiating agreements. I'm speaking from three decades of experience when telling you that distribution and marketing are generally (there can be exceptions under rare circumstances that merely prove the rule) much less profitable, especially in the long run, than innovation itself.

If Apple commercialized some of its IP in part through entities registered in Ireland but not subject to Irish tax because value creation entirely or essentially occurred in the United States, it's obvious that Europe can't collect taxes on U.S. innovation anymore than it would be acceptable the other way round. As a product scout and dealmaker 99% of my business was about U.S. innovations being commercialized in Europe; now I'm soon going to launch an iPhone app that is very U.S.-focused in its first release (we'll provide content for international markets a little bit later) and I believe I should be taxed in Europe, the place of product development in that case.

The 13-billion euro amount is just a starting point and even the EU Commission recognizes the number could actually be a lot lower

The Commission decision contains three alternative lines of reasoning and it took me a while to figure out how those theories relate to the recovery claims in the decision.

Paragraph 447 of the Commission ruling says that "all profits from the business activities of [Apple Sales International] and [Apple Operations Europe] should, as a starting point, be allocated to their respective Irish branches for the period 12 June 2003 to 27 September 2014 for the purposes of calculating ASI's and AOE's corporation tax liability under the ordinary rules of taxation of corporate profit in Ireland." This approach is like a parody of Occam's razor. They basically look at the profits of those entities--of which ASI is the one that matters for the most part--and apply Ireland's 12.5% standard corporate tax for domestic companies. That's how they arrive at roughly €13 billion, based on the numbers summarized in paragraph 97 (one table for ASI and one for AOE; taxes would then apply to the "profit before tax" column).

But that's just a starting point since paragraph 448 admits that some deductions might still apply. All of us have received communications from tax authorities and they always tell you, down to the cent, how much you are supposed to pay. Here, the Commission doesn't even go through that exercise, yet elevates itself to the Supreme European Tax Authority without lawmakers ever having formally decided that it should play that role.

Then there is a secondary line of reasoning in paragraph 355. Looking at other distribution companies (different companies, different products, but anyway), the Commission determined that 3% is an industry-standard kind of return for distributors. Now, if you compare the "Profit before tax" and "ASI turnover" columns in Table 1 (paragraph 97), ASI's profitability on sales was between about 10% in 2003 and almost 50% in 2011, with only ranges being provided in the redacted version for 2012-2014, which still show a profitability on sales of more than 50% in 2012 and roughly 40% in the following years. So, if the Irish 12.5% tax rates was to be applied to 3% of ASI's turnover, the Commission's recovery amount would go down to a fraction of 12.5% of what the "Profit before tax" column says. With respect to the years when most of the relevant profits were generated (i.e., recent years), the recovery amount would then be less than a tenth (!) of the Commission's primary line of reasoning. Yeah, the €13 billion figure would be more like one billion on that basis. I'll probably take a closer look at it again.

There is also a third line of reasoning in the Commission decision and it just compares the decisions the Irish tax authority took with respect to Apple's business in 1992 and 2007 to decisions made with respect to other companies. Apparently, Apple's lawyers didn't even get any information on those other decisions, making it impossible for them to defend their client. There's nothing in the decision that even specifies what alternative recovery amount the Commission would deem appropriate on the basis of its third line of reasoning. Basically, the Commission just says "we've looked at other decisions and concluded that Apple got some kind of preferential treatment and you all have to take our word for it."

Brussels bogus. I tend to put "state aid" in quotes when writing about this case. It would look too awkward, though it would be justifiable, to also put the word "case" in quotes.

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Tuesday, February 14, 2017

Hypocritical EU competition chief Vestager going after Apple while backing Madeira tax avoidance scheme

This morning I heard an interesting radio report on the European Commission's long-standing, practically unconditional support of one of Europe's worst tax avoidance schemes. In light of the Ireland-Apple "state aid" case, it would be bad enough if this merely involved the European Commission as an institution. Large organizations rarely manage to be consistent. But this is a lot worse: the very same commissioner who wants Apple to pay approximately 13 billion euros in additional taxes, Danish socialist-populist Margrethe Vestager, has given her blessings to the extension of the infamous Madeira tax avoidance scheme until 2027. The aforementioned radio report quotes her spokesman, Ricardo Cardoso, as saying that "the free trade zone is a job engine for the Madeira region and the Commission is presently not aware of any indication that the related structure is not compliant with [EU state aid] rules." That statement is absolutely ridiculous and I'll debunk it further below.

While my primary focus is and remains on patent policy issues, particularly reasonable patent remedies (mostly, but not exclusively, in connection with standard-essential patents), I do take an interest in other issues of concern to my industry, especially competition policy. There was a time when working on EU affairs was an exciting opportunity for me, but I've always viewed the EU's attempts to promote innovation as pathetic, sometimes self-contradictory (with respect to open source, for example), and in some cases downright laughable. What has me concerned now is that the EU has gone from merely failing to have a positive impact on European innovation to causing serious damage, such as by creating legal uncertainty that threatens to dissuade more and more companies from investing here.

There is no way that what Mrs. Vestager is doing against Apple and other U.S. companies (I also disagree with parts of the positions taken by the Commission in the Google investigation) is going to make Europe's own economy any more innovative or competitive. But that may not be the objective. It could be that this is just about anti-American, anti-corporate populism, and it may be driven at least in part by a desire to demonstrate strength while the EU is dealing with enormous centrifugal forces especially in this election year in several key countries.

When the EU Commission handed down its decision against Apple, it stated explicitly that Ireland's 12.5% corporate tax rate is not at issue. Instead, the Commission has made up a "state aid" case when, in reality, the whole issue, for the most part, comes down to Irish tax law not recognizing the arm's-length principle (I support that principle but on 130 pages the Commission's Directorate-General for Competition wasn't able to show that Ireland recognizes it) and the practical effects of different international tax regimes ("global deferred" system in the U.S. versus immediate taxation of global income in Europe).

Instead of blaming Apple for simply playing by the rules, I'm against Ireland's 12.5% rate because it's an abuse of the EU Single Market: it's not the result of fair tax competition but simply arbitrage at the expense of other countries whose taxpayers have to pay for the infrastructure in 99% of the Single Market. If the Commission proposed a change of Single Market rules so as to eliminate this distortion of fair tax competition, I would totally support it. But instead of focusing on the gap between Ireland's abusive 12.5% rate and a more normal corporate tax rate in the 30% range, the Commission is desperately and unconvincingly arguing that Apple unfairly paid less than 12.5%. In other words, instead of tackling two thirds of the problem (the difference betweeen roughly 30% and 12.5%), the Commission is crying foul over whatever may or may not have happened in the bottom third (i.e., whatever the difference may be between 12.5% and what Apple paid).

The EU may very well be the only club in the world that does not have rules in place to get rid of a member if need be. Any sports club, any automotive club, any stamp collectors or pigeon breeders' club can do it. If a member somehow abused the rules, a majority of members could vote to exclude the misbehaving one--and most of the time it will be enough to just threaten with it. But the EU has a bad design that has gotten worse over the years due to grossly incompetent and unbelievably irresponsible "leaders" pursuing the idea of an ever-closer union. Since Brexit, the tide has turned, except that some people in Brussels don't want to face that fact yet.

Ireland's 12.5% corporate tax rate is still high if you compare it to the tax rates that apply to the so-called International Business Centre of Madeira (IBCM) on the namesake, remote Atlantic island belonging to Portugal. According to its own representations, it offers a reduced corporate tax rate of 5% (five percent!), and this official question by a far-left Member of the European Parliament refers to tax rates "vary[ing] between 1[%] and 5%".

The investigative reporters at Bayerischer Rundfunk ("Bavarian Broadcasting") just don't buy the European Commission's claim that the Madeira tax haven is just part of a regional development initiative designed to attract foreign investment on that remote Portuguese island. Instead, it plays a role in tax minimization schemes employeed by such individuals as

  • former FIFA secretary-general Jerome Valcke,

  • someone who was close to Muammar Gaddafi,

  • soccer player Javier Mascherano (who was convicted of tax evasion in Spain),

  • another famous soccer player, Xabi Alonso, who is being investigated by Spanish authorities, and

  • a German rock band, Böhse Onkelz, that assigned all of its trademark rights to a Madeira-based entity.

Furthermore, companies such as Chevron, its Italian competitor eni, Pepsi and Russian aluminum maker Rusal have set up legal entities there.

Approximately 1,600 legal entities benefit from the rockbottom tax rates of this special deal between Madeira and the European Commission. If this were a regional development program, the objective would have to be to create employment. But the EU is lying about the true purpose. All those Madeira-based low-tax entities combined have created only 2,721 jobs according to official statistics (year 2014), which would be a pretty meager number in and of itself but even overstates the actual effect on jobs since a closer look reveals that many individuals formally hold jobs in several such companies at the time, with each job being counted once even if one person holds, as they found in one case, 300 jobs. If this fact is properly taken into account, the whole Madeira scheme has not had any noteworthy effect on employment.

Time and time again, over the course of 30 years and in one or more cases under Ms. Vestager's auspices, the EU Commission has approved the extension of Madeira's tax regime and has declared it as a category "of aid compatible with the internal market"--now even until 2027.

The Commission's decision against Apple is weak; the Commission's inconsistency is also on display in connection with the Monte dei Paschi di Siena bank bailout; but the Commission's handling of the Madeira scheme, as compared to the fabricated "state aid" allegations in the case relating to Apple's Irish taxes, is more than inconsistent. It's hypocritical beyond belief.

Bavarian Broadcasting quotes a German Member of the European Parliament, Markus Ferber, whose regional party is part of Merkel's government coalition, as saying that the EU can only enjoy credibility vis-à-vis Panama, Singapore or the Bahamas (or Switzerland) if it has its own house in order. Therefore, Mr. Ferber finds it incomprehensible that the European Commission has been tolerating the Madeira scheme so far, despite being alerted to the problem that it constitutes. I agree with Mr. Ferber up to this point, but he forgot to mention the Ireland-Apple case and the praise he heaped a few months ago on Ms. Vestager.

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Friday, February 10, 2017

Apple may have paid Qualcomm approx. $40 per iPhone, accounted for third of Qualcomm's revenues

At the end of my previous post on Qualcomm's business model I wrote I would follow up with an analysis of the economic magnitude of the various antitrust investigations and civil complaints concerning Qualcomm's two mutually-reinforcing business areas, baseband processor chipsets and wireless standard-essential patent licensing. While it will probably take a while before a publicly-accessible court filing by either Qualcomm or Apple makes reference to a particular damages claim or royalty rate, some information is already available and I'll take the liberty of connecting some dots. If you consider some of it speculative, that's fine, but someone has to do the job of trying to infer and deduce information even in the early stages of a dispute.

Many media reports on Apple's recent complaint (see PatentlyApple's report, which includes the document) portrayed it as a $1 billion case. However, $1 billion is just the only somewhat precise number that the complaint states but relates to merely a subset of the issue. Paragraph 4 is clear about that:

"Apple, which has been overcharged billions of dollars on Qualcomm's illegal scheme, brings this action to recover its damages, enjoin Qualcomm from further violations of the law, and request declaratory relief. Among Apple's damages are nearly $1 billion that Qualcomm owes to Apple under an agreement between the two companies." (emphases added)

So without much effort or speculation, we know it's about "billions of dollars." But how many billions? Apple's prayers for relief don't say. After the court has determined a fair, reasonable and non-discriminator (FRAND) royalty rate for certain Qualcomm patents, Apple may be more specific.

"Billions of dollars" can mean anything from $2 billion to ten times that amount or more. If we were talking about substantially more than $20 billion, the complaint would almost certainly say "tens of billions." But in the aggregate of damages recovered for the allegedly excessive charges of the past and lower payments being made in the future, that dispute may indeed be about tens of billions of dollars.

The $1 billion part of the overall claim is just about one year's "rebate" (a term that, according to the complaint, Apple uses though Qualcomm rejects it) paid by Qualcomm to Apple. Paragraph 100 provides the following clarification:

"The rebates reduced, but by no means eliminated, Apple's overpayment of royalties to Qualcomm. Taken together, these rebates reduced the effective royalty burden on Apple to around [REDACTED] per iPhone and iPad through 2016. This represents an amount that is still significantly larger than the royalty Apple pays for [REDACTED]—licenses that collectively represent a far greater percentage of the patents declared as essential to the cellular standard."

The second sentence is consistent with other factual representations made by Apple in its complaint, such as the second sentence of paragraph 79:

"In 2016, this was an order of magnitude greater than the royalties that Apple pays to any other patent holder, and indeed is more than Apple pays to all other cellular patent holders combined."

Paragraph 80 focuses on four other licensors (presumably including such companies as Nokia and Ericsson):

"By way of illustration, in 2016, Apple's four largest direct licenses for cellular-related SEPs, excluding Qualcomm, were with [REDACTED], each of which has made claims similar to Qualcomm about the strength and value of their respective portfolios of 3G and 4G cellular SEPs. Together, these four licensors represent [REDACTED] of all 4G cellular SEP declarations, significantly above the 23.5% self-declared by Qualcomm [...]"

The second sentence of paragraph 81 suggests the problem is exacerbating:

"Moreover, Qualcomm currently is demanding Apple pay [REDACTED] that amount starting January 1, 2017."

If we knew how much Apple pays licensors like Nokia and Ericsson, we'd now be able to estimate what Qualcomm has received. I would guess that the four largest cellular patent holders except Qualcomm collectively get something on the order of $10 per iPhone, but this guess could also be very wrong (in whatever direction).

What the complaint makes clear is that Apple has to pay Qualcomm for the baseband processor chipset (except that it's now using Intel chips in part) and for a patent license. Paragraph 83 is a very important one: its first sentence states that "a baseband processor chipset sells for around $10 to $20." It's a reasonable assumption that Qualcomm as the market leader is at the higher end of the range, while anyone still trying to somehow compete with Qualcomm will have to sell products at a much lower price.

The last sentence of paragraph 83 compares Qualcomm's patent royalty demands to the price at which it sells its baseband processors. In the image below, I've added some possibilities for what is hidden under the blackout rectangle (click on the image to enlarge; this post continues below the image):

Note that the numbers are not meant literally: they are just meant to show the width of different kinds of numbers (or the word "half") in the same font. For example, 100% has the same width as 199%, but not the same as 200% ("2" is wider than "1").

A triple-digit percentage with a "1" (all other numbers are wider) in the beginning looks like the most probable scenario. Let's now assume 100% because it's the lowest (i.e., most conservative) percentage that would match the width of the redacted area. The other examples in the above image just aren't wide enough, and it's really very hard to imagine anything else there than a percentage.

So, if Qualcomm sold its baseband processors at approx. $20 per unit and collected or demanded royalties from Apple amounting to more or less the same amount, that would correspond to $40 per iPhone (or cellular iPad). Since 2015, annual iPhone sales have been north of 200 million units. If one multiplied that number with the $40 hypothesis, that would be a total (even before adding cellular iPads) of $8 billion a year, or roughly a third of Qualcomm's revenues.

This is now the right moment for a first plausibility check. Is it possible that Apple alone accounts for approximately a third of Qualcomm's revenues? I believe it is. Qualcomm reports revenues for its two divisions, the chipset division and the patent licensing division. Chipset sales are more than twice as big as patent licensing revenues (see the table on page 10 of Qualcomm's last annual report), but presumably the chipset price doesn't vary nearly as much from customer to customer as patent royalties, given that Qualcomm seeks a percentage of the sales price of a device. The average sales price of the iPhone was $695 last quarter and not much lower in the previous quarters. That's a whole lot more than for other companies in the industry (and part of the reason why Apple is by far and away the most profitable device maker). Apple is also selling the highest number of units (it has surpassed Samsung again, and Samsung's average sales price is substantially lower).

Another plausibility check is based on what is publicly known about Qualcomm's commitments and representations to China's National Development and Reform Commission (NDRC). In this press release (PDF), Qualcomm refers to "royalties of 5% for 3G devices (including multimode 3G/4G devices) and 3.5% for 4G devices (including 3-mode LTE-TDD devices) that do not implement CDMA or WCDMA, in each case using a royalty base of 65% of the net selling price of the device." Multiplying 5% with 65% of the average iPhone sales price is also roughly a $20 per-unit amount.

By the way, while Qualcomm's press release portrays those percentages as having been approved and/or mandated by the NDRC, footnote 10 of this third-party document says:

"The [NDRC] Decision does not define what would constitute a lawful royalty base or royalty rate. It thus stops short of imposing on Qualcomm a 'compulsory license' with any specific rates or terms."

I don't know what exactly the purpose of those percentages is then, but here we just need them for a plausibility check.

What I have no doubt about is that Apple v. Qualcomm is way bigger than Apple v. Samsung, and if Apple succeeds in getting its terms improved, or if further headway is made on the antitrust front, I wouldn't be surprised to see Samsung and others seek refunds and price reductions... actually, in that scenario I'd be surprised if it didn't happen.

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