By Mark Hibben From Seeking Alpha

Since the late ’80s, Apple and other US multinationals have used Irish tax law to shield overseas profits from taxation by the EU or the US.

The European Union has declared the Irish tax arrangements illegal and asserts that Apple now owes $14.5 billion in “back taxes”.

The US Treasury Department believes that the EU claim is an unjustified attempt to grab tax revenue it would receive from repatriation of Apple’s overseas cash.

The executive arm of the European Union (EU), the European Commission ((NYSE:EC)), has decided that Apple (NASDAQ:AAPL) received illegal tax breaks from Ireland. The EC is now embarked on a crusade to force Ireland to recover back taxes of $14.5 billion it claims Apple should have paid, despite a warning from the US Department of the Treasury not to go there. Almost certainly, the EC will fail in its attempt at retroactive taxation.

Empty Headed

In my article discussing possible impacts on Apple from the Brexit vote, I touched briefly on the tax avoidance scheme that Apple had going for its international subsidiaries in Ireland. In the “double Irish” scheme, two business entities are involved, which are typically wholly owned subsidiaries of the parent corporation. The first entity is an Irish corporation that is not considered tax-resident since it is operated and managed from outside of Ireland, usually in a tax haven such as Bermuda. The second entity is also an Irish corporation, that may be a wholly owned subsidiary of the first, but which is considered tax-resident in Ireland.

The structural relationship between the two entities is illustrated from a 2007 article entitled “Practical US/International Tax Strategies” which speaks glowingly of the benefits of the double Irish scheme.

The second entity conducts business in Ireland (and internationally), and its profits are taxed under Irish law at the Irish corporate tax rate of 12.5%. However, the second entity licenses intellectual property and product distribution rights from the first entity, and the royalty payments under the licensing agreements tend to drain all taxable profit out of the tax-resident Irish concern. Thus its tax liability is next to nothing, while the profits that went to the first entity are beyond the reach of Irish tax law.

In the EC’s announcement of its decision to compel Ireland to collect $14.5 billion in taxes from Apple, its description of the Irish tax scheme is less glowing than the Tax Strategies article. The more complex structural relationships in Apple’s version of double Irish are shown in the graph the EC provided with its announcement.

According to the EC, the first entity in the double Irish scheme was simply a “head office”:

This “head office” was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. Only a fraction of the profits of Apple Sales International were allocated to its Irish branch and subject to tax in Ireland. The remaining vast majority of profits were allocated to the “head office”, where they remained untaxed.

The double Irish scheme was not merely about reducing tax liability, it was about abolishing it altogether. Once again, according to the EC:

Apple Sales International paid less than €10 million of corporate tax in Ireland in 2011 – an effective tax rate of about 0.05% on its overall annual profits. In subsequent years, Apple Sales International’s recorded profits continued to increase but the profits considered taxable in Ireland under the terms of the tax ruling did not. Thus this effective tax rate decreased further to only 0.005% in 2014.

Apple used the same double Irish structure for two separate European subsidiaries, Apple Sales International and Apple Operations Europe.

EU vs. US

The EC goes to some lengths to paint Apple as a greedy tax dodger, and frankly, the EC doesn’t have to work very hard. Apple’s attitude regarding its tax responsibilities both here in the US and abroad is one of the more deplorable holdovers of the Jobs era. But in this regard, the EC is playing to its European public, since the tax arrangement that Apple had with Ireland is not in itself the basis of its decision.

The basis of the EC complaint is not that the tax avoidance scheme was illegal in itself. The EC’s complaint is that it amounted to preferential treatment for Apple and a number of other large multinational corporations, most of them based in the US. This constitutes illegal “state aid”, according to the EC. Members of the EU are forbidden to support preferentially particular businesses. Any government aid or support must be available to all companies that seek to do business in member countries.

The outlawing of preferential state aid represents economic common sense for the Union. If member states were allowed to provide preferential aid to businesses, states would tend to prefer domestic businesses and industries. This would defeat the fundamental goal of the EU to create a unified European economic zone that provides a level playing field for all businesses within the community.

Whether the double Irish tax scheme amounted to preferential treatment for Apple and the other companies that reputedly took advantage of it is open to interpretation. Certainly, that’s not the opinion of the Treasury Department, which released a white paper on the topic last week. Not only does Treasury not agree with the EC interpretation of state aid, it’s really unhappy about the decision to go after the $14.5 billion.

In a very revealing paragraph, Treasury discloses what’s at stake:

There is the 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. 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. To the extent that such foreign taxes are imposed on income that should not have been attributable to the relevant Member State, that outcome is deeply troubling, as it would effectively constitute a transfer of revenue to the EU from the U.S. government and its taxpayers (emphasis mine).

So what Treasury is worried about is that the EU is going to grab tax money right out of its hands. You can’t blame them. But in fact, there’s very little likelihood that the EC will succeed.

In the white paper, Treasury makes a very good case that what the EC has done in the Apple case (and in other cases it is pursuing against Starbucks (NASDAQ:SBUX), Fiat (NYSE:FCAU), and Amazon (NASDAQ:AMZN)) is to interpret the concept of state aid much more broadly.

Apple was not the only multinational to exploit double Irish. According to Wikipedia, 15 other US multinational corporations also indulged, including Abbott Laboratories (NYSE:ABT), Adobe (NASDAQ:ADBE), Facebook (NASDAQ:FB), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), IBM (NYSE:IBM), Microsoft (NASDAQ:MSFT), Oracle (NASDAQ:ORCL), and Yahoo (NASDAQ:YHOO). How then can the EC claim that Apple received preferential treatment in violation of EU regulations regarding state aid? Because the tax scheme was only available to multinationals. Domestic Irish companies need not apply.

This interpretation may not be unreasonable, but Treasury takes issue with it. Treasury points out that it’s a departure from previous interpretations and legal decisions by the European Court of Justice (ECJ). Treasury is probably right about this.

And this is the reason why it’s going to be so difficult for the EC to make good on its $14.5 billion claim. As a new legal interpretation, even if held to be valid, the EC can’t retroactively apply it to a member country such as Ireland. This would violate a more fundamental legal principle within the EU of “legal certainty”.

Members have the right to expect that their legal obligations and rights under the Treaty on the Functioning of the European Union (TFEU) will not change arbitrarily. At most, the EC has the right only to change the rules going forward, after communicating the changes to members so that they can take appropriate steps to be in compliance.

Fundamentally, the EU isn’t really a government, although it has adopted many of the trappings of government, including a bureaucracy and a parliament. It has no power to tax, either member states, or corporations, or individuals who are not EU employees. The EU is more of a club and is dependent on the membership dues that each country pays.

What can the EU do to compel Ireland to collect $14.5 billion in taxes from Apple? The most it can do is threaten to kick Ireland out of the club. But it probably won’t come to that. Ireland will appeal the EC decision to the Court of Justice. The Court will probably agree that the EC’s interpretation of state aid is novel and therefore cannot be applied retroactively. That’s assuming it even agrees with the new interpretation.

And then there’s all that political and economic pressure that the US is clearly intent on bringing to bear. Given the long list of US companies that also had double Irish schemes, the stakes go well beyond Apple. I doubt the Court will be completely oblivious to the pressure.

Investor Takeaway

The EC’s tax crusade seems especially pointless given that Ireland abolished double Irish schemes in 2015, although it gave those using them until 2020 to become compliant with the new regulations. That the EC wants to take action now appears to confirm Treasury’s opinion that this amounts to a grab of tax revenue that the EU has no right to.

However, the US certainly has a right to tax whatever money Apple repatriates, and Apple should start to repatriate some of its overseas cash hoard ($200+ billion). Apple has domestic capital needs that could be met using some of that overseas cash, rather than borrowing.

The tax scheme that Apple cooked up in Ireland represents one of the more unappealing elements of its corporate culture. One can debate at length what the corporate tax rate should be in the US. Certainly Apple’s position that lowering it would stimulate growth and innovation is something I fundamentally agree with. But in the end, most of us pay our taxes whether we like it or not. And most of us feel overtaxed, don’t we?

But we pay up because there’s a fundamental social contract that applies here. For the privilege of living and working in this great country, we incur certain obligations, one of the most important of which is paying taxes. Apple, like any other US company, is under the same fundamental obligation. Apple needs to take a more positive attitude towards this obligation.

The obvious resentment and defensiveness that Apple executives display when the subject of taxation comes up really needs to change. Hopefully, a successful resolution of the EC matter will lead to greater rapport between Apple and government regulators. If this leads to reform of corporate tax rates and the beginning of repatriation of Apple’s cash, it’s a win-win for everyone. Except perhaps the EU. I remain long Apple and recommend it as a buy for investors with a 3-5 year investment horizon.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

IMAGE: Source: Alchetron

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