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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