One Bad Apple Decision: EU Tax Ruling Entrenches Distortions

Economic

Summary:

Ireland’s massive tax windfall highlights once again the pressing need for reform of profit allocation rules.

At first sight, the 10 September 2024 European Union Court of Justice (CJEU) ruling on Apple’s Irish tax bill seems just about fair. The ruling, confirming that that Ireland granted unlawful aid to Apple and should recover €13 billion in unpaid taxes, tackles an extremely aggressive scheme. European Commission executive vice-president and competition commissioner Margrethe Vestager hailed it a “big win for European citizens and for tax justice” .

But the decision also raises challenging tax policy questions. Apple certainly engaged in very aggressive tax planning, facilitated by Irish law, but the CJEU granted the taxing rights over the shifted profits to Ireland exclusively, despite most the profits accruing elsewhere. This decision could have unintended negative consequences for the EU single market in the long term.

In particular, the ruling validates a situation in which rules on the allocation of profits to jurisdictions for taxing purposes remain flawed and generate distortions among EU members. An effort is underway to reform international rules on taxing some of the profits of the world’s largest companies but this is nowhere near completion; its finalisation is even more unlikely with President Trump back in office in the United States . In this context, there is a serious risk that imbalances in profit allocation within the EU will increase, with small open economies (Ireland, Luxembourg, Malta, Cyprus) being the winners, to the detriment of other member states.

The fruits of an aggressive strategy

Like many other US tech companies, Apple developed very aggressive tax strategies as early as the 1990s, using hybrid tax instruments and taking advantage of loopholes in international tax rules. Their profit-shifting strategy resulted in ‘stateless income’, ie income located outside any tax jurisdiction. This strategy was facilitated by a combination of accommodating tax rules in the United States and continental European countries, and Irish residence and profit-allocation rules. Two tax rulings issued by Ireland in 1991 and 2007 approved the strategy .

As a result, Apple shifted intellectual-property-related income outside of the EU almost tax-free. Profits made from sales of phones, laptops and iPads were largely untaxed in the countries where the sales were made, because they were booked in stateless companies, not taxed on their worldwide income by any country, including Ireland, which was their state of incorporation.

It was the 1991 and 2007 Irish tax rulings that the European Commission disputed. According to the Commission, in 2011 alone, Irish subsidiaries of Apple recorded a €16 billion profit, of which only €50 million was taxable, with tax of €10 million paid – an effective tax rate of 0.005 percent.

Instead, the Commission argued, profit allocation should have been decided on the basis of normal application of rules developed within the Organisation for Economic Co-operation and Development on transfer pricing and profit attribution rules. Though at the time, these rules were not yet incorporated into Irish legislation, they should have, according to the Commission’s view, led to the taxation of IP-related profits in Ireland.

In the Commission’s view, the profits should not have been allocated to the stateless companies because those companies lacked the functions necessary to handle and manage the intellectual property. Apple’s Irish branches performed more functions and the Commission claimed that profits should have been allocated to them in line with, first, the OECD transfer-pricing guidelines (TPG), and second the authorised OECD approach (AOA) on profit attribution to permanent establishments (even though the AOA was adopted by the OECD years after the Irish tax rulings were granted).

The trouble with transfer pricing

Transfer-pricing rules were first adopted by the League of Nations in the 1920s to allocate the profits of multinational companies to the ‘right’ jurisdiction and to avoid the same transactions being taxed in two countries. Under the ‘arm’s length principle’ employed in transfer pricing, transactions between legal entities in the same economic group should be priced at market price, similarly to transactions between independent parties.

Since the 1990s, the OECD has developed sophisticated methods to implement the arm’s length principle, leading in theory to profit being allocated to where it is earned (OECD, 2022). In short, the profit follows company functions, assets and risks. Economically, it should be allocated where value is created.

But the implementation of transfer pricing rules has resulted increasingly in profits being funnelled to low-tax jurisdictions where companies locate certain functions, assets and risks – just enough to attract the profits. In a knowledge-based and digitalised economy, excess returns are generated by capital and intangible assets (mostly intellectual property), which are much easier to shift around than physical assets, which were dominant in the bricks-and-mortar economy when the arm’s length principle was conceived. What was initially an anti-abuse rule has thus become a tool for tax planning.

To redress this situation and update the rules somewhat, a two-part global tax deal was agreed in October 2021 . Endorsed by more than 140 countries, this introduced a 15 percent minimum tax (Pillar Two) and a new profit allocation rule for the largest companies, including Apple. Under the rule (Pillar One), a share of profits would be allocated for taxing purposes to the countries where sales happen .

Pillar One aims precisely to adjust, through a formulaic approach, the deficiencies of the arm’s length principle. It marks an implicit agreement by countries that current rules do not ensure a fair allocation of taxing rights.

Two ironies

The first irony of the CJEU ruling on Apple is that it elevates an anti-abuse rule – transfer pricing – into a general and underlying legal principle at exactly the time when the international community has recognised that it results in flawed profit allocation.

It is probably hard to determine where value is created, but it seems obvious that Apple’s profits from the EU single market (and other jurisdictions) belong more to the countries where the products are sold, or where products are engineered and designed (United States), than to Ireland. At minimum, they should have been shared between these different countries and not allocated fully to Ireland .

The second irony is that the winner – in this case Ireland – takes all… but the winner does not want the money. Ireland aligned with Apple to fight the Commission in court and is now procrastinating in recovering and using the funds. Irish finance minister Jack Chambers said after the September ruling that it would be months before the €13 billion would be drawn down and used . Ireland expects a €25 billion fiscal surplus in 2024, partly from the Apple money, backed up by the 15 percent Pillar Two minimum tax .

Other low-tax countries, such as Luxembourg and Singapore, will also be collecting the minimum tax on the profits allocated by companies to their jurisdictions. They will benefit from windfall revenues. In short, small open economies, where excess returns were recorded benefit from additional revenue and do not have to share it more fairly. The half-repaired international tax system (or still half-broken) benefits them massively.

Meanwhile, Pillar One of the global tax agreement is nowhere near completion. It requires a multilateral convention which is not yet signed, and will need ratification by two thirds of US senators, which is unlikely. In this context, there is a serious risk of that imbalances in profit allocation within the EU will increase, with small open economies (Ireland, Luxembourg, Malta, Cyprus) being the winners to the detriment of other member states.

The EU’s tax struggle

The European Commission is pushing for changes to reduce distortions but EU countries are resistant to EU intervention in their tax affairs.

The Commission has proposed a transfer pricing directive (European Commission, 2023a) but EU countries instead have engaged in discussions to revive a Transfer Pricing Forum that was dissolved in 2019. Such a forum would likely result in a weak form of coordination, allowing for discussions between EU countries but hindering real harmonisation of transfer pricing practices. Furthermore, such a forum can only be established if the Commission withdraws its proposal for a directive, as EU Treaties forbid the Council of the EU from adopting acts that clash with active legislative proposals.

The directive as proposed would have the merit of clarifying the legal situation, with a harmonised application of the arm’s length principle. However, the plan is perceived by EU countries as not providing enough flexibility to reflect the dynamic of international tax rules. There is also a perception of a risk that competence will be transferred to the EU. Nevertheless, adoption of the directive, if it is made more flexible to better align with the OECD rules, could be a short-term win to provide more tax certainty, even though it would not address the issue of unfair profit allocation.

More importantly, in the absence of Pillar One implementation, the EU should revisit its own profit-allocation rules. Small open economies cannot continue to be the winners of the corporate income tax game without generating tensions.

As far back as the early 1990s, the need for EU corporate income tax harmonisation was identified (Ruding, 1992). The Commission proposed a common consolidated corporate income tax base directive in 2013, which would have allocated consolidated profits based on keys including revenue, people and assets. The resistance of member states to Commission meddling in their sovereign tax affairs killed the proposal.

In 2023, the Commission proposed a more modest plan with the BEFIT (Business in Europe: Framework for Income Taxation; European Commission, 2023b) proposal, which provides for common rules to compute profits at the group level but avoids the question of profit allocation between countries. The CJEU ruling might bring the profit-allocation debate back to the table. It may still be that EU countries prefer a less-efficient outcome, without EU competence, over an improved resolution that would transfer tax competence to the EU. Still, it is urgent to take action.

The new Commission for 2024-2029 could organise an open debate on the next steps, from both the tax angle and the fiscal perspective. It is unlikely that EU countries will agree harmonisation, whether of the tax base or transfer pricing. The lack of progress on international negotiations Pillar One will not result in the EU taking the lead. Realistically, to fix the existing imbalances, another Commission proposal, from 2021, on a new statistical resource for the EU budget based on a proxy of corporate profits, could be a quicker win (Saint-Amans, 2024). It would mitigate the absurd outcome of the implementation of the current rules, reinforced by the CJEU’s bad Apple decision.

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