Beware the Commission’s rotten Apple ruling

Diego Zuluaga // 06.09.2016

 

The Wednesday Briefing is a weekly free-market commentary on topical economic issues by our Head of Research, Diego Zuluaga. You can subscribe to the Wednesday Briefing by e-mailing Adam Bartha at abartha@epicenternetwork.eu.

 

The European Commission has ordered Ireland to recover €13bn worth of allegedly unpaid taxes from Apple. Reception of the decision has been mixed, with some hailing the ruling as an indictment of Ireland’s low-tax policy, whilst others have condemned the move as a badly concealed attempt by the EU to obtain tax powers by stealth.

 

Neither of these interpretations is wide of the mark. The Commission has for some time sought greater competences over tax policy in the Member States, not least over the taxation of corporate profits. The most salient initiative in this regard is the proposal for a Common Consolidated Corporate Tax Base (CCCTB), which fell by the wayside when it was first proposed in 2011, but has been revived in the wake of the Luxleaks allegations of preferential tax rulings.

 

Undermining Ireland’s attractiveness as a friendly environment for multinational investment – encapsulated by its comparably low 12.5 per cent statutory rate – is also in the interest of larger EU members, who have the competitive advantage of scale but underperform Ireland when it comes to corporate tax policy. Indeed, their alliance with the Commission is more one of expediency than principle. Higher-tax Member States want the EU to divert a greater share of corporate profits to their jurisdictions, without surrendering any tax autonomy to the Commission.

 

This is also why EU corporates are not worried about the CCCTB’s becoming law any time soon. As one executive involved in tax policy put it to me, “there is no way that Germany and France are going to share their tax base with Spain and Italy.” That is the essence of a joint framework for corporate taxation, and it is why the Commission will struggle to gain the acquiescence of national governments in its efforts.

 

Thus last week’s announcement on Apple has implications which go far beyond Ireland’s tax policy. Still, it is worth examining the arguments made by EU competition authorities. Margrethe Vestager claims not only that Ireland gave favourable treatment to Apple, but that, in so doing, it enabled Apple to structure its international operations in such a way as to avoid tax on a share of its European profits.

 

The Commission has followed this line of thinking before with regard to the tax rulings issued to Starbucks in the Netherlands and Fiat in Luxembourg. When she announced her directorate’s verdict that the rulings contravened EU state aid rules, in October 2015, Vestager underlined the undue advantages that these multinational firms had obtained to lower their tax burden when compared to “stand-alone companies that are not part of a group.”

 

What might be termed the ‘Vestager doctrine’ can be summarised as follows: if a multinational firm is able reduce its international tax obligations by operating through an EU jurisdiction, then that constitutes illegal state aid and the Member State in question must recover the difference between what was paid and what the Commission thinks should have been paid. Indeed, as last week’s statement made clear, the verdicts open the door to third countries’ claiming their share of recoverable taxes.

 

The Commission’s reasoning is deceptively straightforward. In the first place, it effectively charges jurisdictions with the responsibility to monitor the international implications of their tax policy. This would depart from established practice, whereby jurisdictions care about what happens within their remit, and generally not beyond it – that’s what international tax treaties are for. The costs to tax authorities of this added obligation would be substantial. Not only that, but to the extent that there are mismatches in terminology and residence tests, jurisdictions may find themselves punished for discrepancies which they cannot do much about. As Stuart MacLennan puts it with regard to the Apple ruling,

 

The residuary rule in international taxation is that profits that cannot be explicitly attributed to a permanent establishment are taxable only in the jurisdiction in which the enterprise is resident. Ireland, in common with most common law jurisdictions, uses the De Beers test of corporate residence – which is a company’s “place of effective management”. In other words, as a matter of Irish law, those “head office” profits are being allocated to America – the fact that America employs a different test of corporate residence is America’s problem, and not Ireland’s. Contrary to the Commission’s inferences, it is not Ireland’s concern what happens to the profits that fall beyond its jurisdiction.

 

Perhaps more importantly, the Vestager doctrine assumes that jurisdictions can readily assess what does and does not constitute favourable tax treatment. Yet, there is reason to question that assumption. Determining a firm’s tax obligation is no scientific exercise, but rather involves subjectivity and precedent. In the case of multinationals, the final number hinges crucially on the value attached to assets outside the jurisdiction in question, especially intellectual property. This in turn determines the transfers to be made to the other subsidiaries which own those assets – the greater this number, the lower the taxes payable in the location in question.

 

That is indeed the reason why tax rulings exist – to give large firms with potentially quite large tax obligations an indication of what their tax burden will be if they set up shop in a particular jurisdiction. It is however not testament to corporate greed or aggressive tax avoidance, but rather to the great complexity of the current international tax system, that firms seek such assurance from governments.

 

What the Commission’s decision does, above all, is introduce great uncertainty into EU corporate tax policy. Rulings can go back decades and recoveries reach into the billions of euros. In the case of Apple, the alleged shortfall in tax paid took place as early as 2003 – at the dawn of the iPod age and well before the iPhone was launched! The €13bn is equivalent to 27 per cent of Apple’s 2015 consolidated – i.e. worldwide – net income. One wonders if such variance in one’s potential tax obligation really is that different from operating in a country with weak rule of law. From an operating costs perspective, the implications are the same.

 

More than anything, the controversy over last week’s Commission announcement underscores the urgency of fundamental reform of the way in which income from capital is taxed. Globalisation and the rise of intangible assets as sources of value creation are rendering the old system, whereby corporate profits are taxed at the firm level, increasingly inefficient. There are alternatives, however, as my recent paper for the Institute of Economic Affairs makes clear. (For a shorter read, you can have a look at two summary briefings published by EPICENTER here and here.)

 

The Commission may have scored a tactical – political – win with its decision on Apple last week, although antagonising Ireland immediately after the Brexit vote could well backfire. Moreover, the strategic – economic – implications of the ruling will be long-standing, and almost certainly harmful to Europe’s growth prospects.

 

Diego Zuluaga is Head of Research at EPICENTER. You can read our briefings, “Updating the Common Consolidated Corporate Tax Base,” here; “Corporation tax reform: theory, evidence and avoidance,” here; and “Radical, but not equal: assessing corporate tax reforms,” here. Diego’s IEA paper, “Why corporation tax should be scrapped,” here.

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