The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
Aug. 29 — When the Irish Revenue Commissioners issued Apple Inc. one of the world's first advance intercompany pricing agreements, the Soviet Union was breaking up, lawyers faxed agreements to one another and the iPhone hadn't yet been invented. It was a different time and place in the international tax world.
Ireland didn't have detailed transfer pricing rules when the 1991 tax deal was struck, and Irish tax officials didn't find it necessary to ask Apple for an economic analysis to substantiate the intercompany transaction profit margins accepted in the pact. It's this absence of economic underpinning of Irish tax rulings in 1991 and 2007, and Apple's resulting tax savings, that has landed the world's biggest company in its current predicament.
Apple is awaiting a decision that could come as early as Aug. 30 on how much back tax the European Commission believes it should have paid to Ireland over 25 years (see related story in this issue). Predictions of that amount have ranged from the low hundreds of millions to the tens of billions following the EU Commission's 2014 preliminary finding that the two rulings lowered Apple's taxes to such a degree that they skewed competition within the EU.
JP Morgan Chase & Co. analyst Rod Hall has put the likely bill at $19 billion if the Irish government is forced to recoup tax from the company. Matt Larson of Bloomberg Intelligence puts the figure at more than $8 billion (25 Transfer Pricing Report 290, 6/30/16).
In determining how much Ireland must claw back from Apple, at issue is the commission's ability to interpret complex rules that weave together accounting, economic and legal concepts to determine where profits should be allocated within a multinational group on related-party transactions that span the globe.
Complicating the matter is the nature of transfer pricing. It's as much an art as a science, with several right answers possible in determining what a transaction's profit markup—the amount added to the cost of goods or services to cover overhead and profit—would be if the transaction had been completed at an arm's-length price between two unrelated parties instead of within the same company.
The difficulty of finding the correct arm's-length price for vertically integrated multinational companies with unique and valuable intangibles led to an initiative by governments in the early 1990s. Governments decided then to invite companies to discuss in advance the parameters of their intercompany pricing—what prescribed method they would use to calculate the prices, what comparable or third-party transactions would be appropriate to use to measure “arm's-length prices,” and what critical assumptions would be used for future events for a particular period of time. In return, companies got some certainty about their future tax bills.
Apple, the largest taxpayer in County Cork with 1,000 direct employees and 500 sub-contractors, contacted Ireland to discuss such an agreement in 1990. According to the commission's preliminary report, Apple representatives told Ireland's tax authority that the company was reviewing its worldwide operations for expansion and wished to establish an agreement on the profit margins to enable it to have some tax certainty on its Ireland operations. The Apple tax officials said the company in 1989 showed a net profit of $270 million on a turnover of $751 million, and said no company on the Irish stock exchange came close to achieving a similar result.
Apple proposed, and Irish Revenue officials accepted, that the net profit attributable to its contract manufacturing branch should be calculated as 65 percent of operating expenses, capped at $70 million, and 20 percent of operating expenses in excess of that. The commission noted the decision to accept the 20 percent on costs in excess of $70 million was agreed to “in order not to prohibit the expansion of the Irish operations.”
In 2007, the Irish tax authority agreed to a revised approach based on a profit margin of between 10 percent and 20 percent of branch operating costs, and a return of between 1 percent and 9 percent on manufacturing process technology.
The main activity of Apple's Irish manufacturing branch was to make a specialized line of personal computers by purchasing material from related companies and selling manufactured products to related companies, according to the commission preliminary report. The branch also provided shared services to Apple companies in Europe, the Middle East and throughout Africa, including payroll services, centralized purchasing and a customer call center, it said.
For Apple's international sales arm, Ireland in 1991 agreed the net profit attributable to the Irish branch would be 12.5 percent of its operating costs, excluding materials for resale. In 2007, the profit margin was changed to a range of 8 percent to 18 percent. The sales arm, a subsidiary of the manufacturing branch, procured Apple finished goods from third-party manufacturers, sold those products to Apple-affiliated companies and other customers, and provided logistics in those transactions, the commission said.
The European Commission found the profit markups Ireland accepted in both Apple tax agreements were arbitrary based on the lack of economic analysis. Because they resulted “from a negotiation rather than a pricing methodology,” the commission said, they found “that a prudent independent market operator would not have accepted the remuneration allocated to the branches” of Apple Sales International and Apple Operations Europe in the same situation.
The commission challenged the switch in the 1991 APA from the 65 percent profit margin to the lower margins as Apple's sales increased, especially because it said Apple’s representative in 1991 had conceded that the lower 10 percent to 20 percent margin was “meaningless in relation to the computer industry.”
It also faulted the length of the rulings. Governments usually limit the terms of an APA to three to five years because economic circumstances change and can't be projected that far out, yet both rulings seem to have been open-ended, with the 1991 APA lasting as long as 15 years.
Ireland defended both rulings, saying even the lower margins in the 2007 agreement were based on low-risk manufacturing functions. Together with the 1 percent to 9 percent of turnover return on manufacturing know-how developed by the Irish branch, the APA delivered “an aggregate attribution of profit to the Irish branch that would have been commensurate with the activities undertaken in Ireland.”
Apple's international sales arm, Ireland told the EU Commission, bore little risk and carried out routine functions to procure and sell goods and had no special valuable assets that would have increased profit margins. Ireland Revenue officials said the goods derived their value largely from intangibles created in the U.S.
Apple's Irish APAs eventually covered a great amount of its worldwide business. By 2013, Apple's workforce in Ireland grew to 4,000, and in fiscal 2012, approximately 61 percent of its revenue was earned internationally, according to the company's 2013 testimony before the U.S. Senate Permanent Subcommittee on Investigations.
The subcommittee called Apple to testify in 2013 about the Irish APAs, after the subcommittee released a report that said Apple used them to shelter billions of its worldwide income from taxes—specifically from U.S. taxes—by shifting profits through a cost sharing agreement with the Irish subsidiaries.
While the commission says Apple's tax payments in Ireland were too low, the Senate report said the Irish APA margins enabled Apple to use the Irish sales and manufacturing branches to lower its corporate tax rate on many operations outside the Americas to as little as 2 percent in many years. By contrast, Ireland has a regular 12.5 percent corporate rate, already the lowest among EU nations, and the U.S. federal rate is much higher at 35 percent.
Apple and Ireland are adamant that they have done nothing wrong, and steadfastly maintain that Apple owes no additional taxes to Ireland. Apple declined to comment on the case for this article, but Apple Chief Executive Officer Tim Cook recently maintained in an interview with the Washington Post that Apple didn't get a special deal from Ireland.
“The structure we have was applicable to everybody—it wasn't something that was done unique to Apple,” he said, noting that “there's a tug of war going on between the countries of how you allocate profits.”
In his 2013 testimony before the Senate, Cook noted that Apple's cost-sharing agreement is regularly audited by the Internal Revenue Service and complies with Treasury Department regulations. The EU Commission is believed to be studying that cost sharing agreement before rending a decision. The cost-sharing agreement allows Apple to co-develop and share the cost of developing new products with its foreign subsidiaries. Under the cost-sharing agreement's terms, the two Irish subsidiaries partially fund research and development costs incurred by Apple based on the relative share of the revenue they earn outside the Americas.
In addition to studying Apple's cost-sharing agreement “in all its variations since 1989 until the last modification” and the intellectual property covered, the commission is thought to be studying Apple's Irish branches' profit and loss account information for 2004-12, and the number of their full-time equivalent employees.
A finding of state aid in the billions likely would result in Ireland battling the commission before the European Union General Court, and then the European Court of Justice, with a final decision years away.
The commission argues, however, that under established European Court of Justice precedent, the commission is the final arbitrator of whether the APAs deviated from the arm's-length principle under transfer pricing guidelines of the Organization for Economic Cooperation and Development, and constituted government aid to Apple.
In a 68-page memorandum issued May 19, the commission set forth its legal basis for pursuing a state aid case against not only Apple, but also against Amazon.com Inc., Fiat Chrysler Automobiles NV, McDonald's Corp. and Starbucks Corp.—with more to come (25 Transfer Pricing Report 96, 5/26/16).
When examining whether a transfer pricing ruling complies with the arm's-length principle, the commission “may have regard to” the OECD transfer pricing guidelines, the EU memorandum said. Complying with the OECD guidelines, including the choice of the most appropriate method, “leads to a reliable approximation of a market-based outcome.”
The commission also asserts in the document that the European Court of Justice has previously held that a selective advantage occurs when a tax ruling enables a company to employ transfer prices in intra-group transactions that don't resemble prices that “would be charged in conditions of free competition between independent undertakings, negotiating under comparable circumstances, at arm's-length.”
Presumably, Ireland would file its own brief arguing that the commission has radically misinterpreted ECJ precedent, and therefore the commission wouldn't have the authority to determine whether the 1991 ruling complies with the arm's-length standard.
The ECJ would have to rule on this legal issue and others before even getting to an economic analysis. For example, assuming the court were to rule that the 1991 ruling had to comply with the arm's-length standard, the court would then have to rule on which edition of the OECD transfer pricing guidelines apply to the facts of the case.
Meanwhile, the United States continues its effort to convince the commission to refrain from hitting Apple and other U.S. companies with more taxes. The commission in January ordered Belgium to recover about 700 million euros in illegal tax breaks from at least 35 companies, including Anheuser-Busch InBev NV and BP Plc. In 2015, Starbucks Corp. was ordered to pay 30 million euros in back taxes to the Dutch government.
In an Aug. 24 white paper, Treasury accused the European Commission of expanding the role of the commission’s Directorate-General for Competition beyond enforcement of competition and state aid law “into that of a supra-national tax authority that reviews member state transfer price determinations.”
According to the U.S. Treasury paper, the commission can find that a member state granted a company a selective advantage if the commission disagrees with the member state’s application of the arm’s-length principle “to particular, and often highly complicated, facts and circumstances.” This, it said, reduces “a state aid inquiry to whether the Commission believes that a transfer pricing ruling satisfies its view of the arm’s length principle.”
There is a possibility that any repayments ordered by the commission will be considered foreign income taxes that are creditable against U.S. taxes owed by the companies in the United States,” the Treasury paper said. “If so, the companies’ U.S. tax liability would be reduced dollar for dollar by these recoveries when their offshore earnings are repatriated or treated as repatriated as part of possible U.S. tax reform.” This means that “U.S. taxpayers could wind up eventually footing the bill for these State aid recoveries,” Deputy Assistant Treasury Secretary for International Tax Affairs Robert Stack said in a blog post Aug. 24.
The Treasury’s white paper called that potential outcome “deeply troubling, as it would effectively constitute a transfer of revenue to the EU from the U.S. government and its taxpayers.
To contact the editor responsible for this story: Molly Moses at firstname.lastname@example.org
The European Commission's 2014 finding, “Ireland Alleged Aid to Apple,” is at http://ec.europa.eu/competition/state_aid/cases/253200/253200_1582634_87_2.pdf.
The 2013 U.S. Senate Permanent Subcommittee on Investigations report, “Offshore Profit Shifting and the U.S. Tax Code—Part 2 (Apple Inc.)” is at http://src.bna.com/h6r.
The Apple Inc. 2013 testimony before the U.S. Senate Permanent Subcommittee on Investigations is at http://www.apple.com/pr/pdf/Apple_Testimony_to_PSI.pdf.
The U.S. Treasury white paper, “The European Commission's Recent State Aid Investigations of Transfer Pricing Rulings,” is at https://www.treasury.gov/resource-center/tax-policy/treaties/Documents/White-Paper-State-Aid.pdf.
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