A woman walking past an Apple store in Hefei, east China's Anhui province.

The European Commission has published details from its preliminary investigation into Ireland’s tax arrangements with Apple. It argues Dublin gave sustained state support to Apple that may need to be recouped.

What is the commission’s case?

The commission was critical of the way that the Irish tax authority agreed two “rulings” – letters of comfort about the way the iPhone maker’s profits would be taxed – in 1991 and 2007. It challenged the basis of the agreement, saying the way the profits were calculated in the 1991 ruling used a “mark-up” on costs that appeared to be “reverse engineered” to arrive at a particular tax bill. It also criticised a decision to use a lower mark-up rate if the company became more profitable, saying it appeared to be “motivated by employment considerations”.

What is at stake?

The commission is focusing on two companies that act as a receptacle for billions of dollars of profits generated by Apple’s offshore intellectual property. While the vast majority of these companies’ profits fall outside the reach of any tax system, they face some taxation in Ireland where they have branches that employ 4,000 people.

One branch – that of Apple Operations Europe – is employed in manufacturing speciality computers for sale in Europe. The other branch – Apple Sales International – buys Apple products from third-party manufacturers and sells them on.

Their reported turnover and profitability have been relatively small. In 2011, for instance, the combined turnover of the branches was €620m-€680m, on which they reported taxable profits of €60m-€80m and tax of €2m-€20m. The question for the commission is whether these taxable profits should have been bigger.

Should more profit have been booked in Ireland?

The question is whether Apple’s profits have been correctly allocated between different parts of a group. This would comply with internationally agreed so-called transfer pricing standards, that require intra-company transactions to be priced as though they had been carried on an arms-length basis, reflecting market terms.

Incorrect transfer pricing could potentially be used to shift profits to low tax jurisdictions – or, in Apple’s case away from any tax jurisdiction at all. Its Irish companies are – with the exception of its Irish branches – “stateless” for tax purposes. They are incorporated in Ireland but managed and controlled from the US. Neither country recognises them as tax resident as they have different definitions of tax residency.

The unusual tax status of these hugely profitable companies explains their very low tax rates. In 2011 for example, ASI paid $10m in taxes on $22bn in income – a tax rate of 0.05 per cent.

Apple’s ability to book the profits generated from its intellectual property to a non-resident company has not, so far, emerged as a main plank of the commission’s investigation. The information analysed by the commission concerns how the Irish tax authority decided how much profit was being earned in Ireland by the Irish branches. But it has now requested extra information on the profits generated by the intellectual property, which may suggest a broader focus to its inquiry.

A branch paid just $10m of tax in 2011? Why so little?
Before 2010, Ireland had little explicit legislation stipulating how multinationals’ taxable profits should be allocated. Even so, decisions on how to tax a multinational operating in Ireland were centred on how to measure the profits attributable to their activities.

The Irish activities were not responsible for generating a lot of value, in the view of the Irish authorities. It told the commission that the branch’s procurement activities involved “routine, albeit important” functions, with the main profit-generating functions and assets being located elsewhere. AOE’s Irish branch was essentially a “contract manufacturer”, undertaking work at the command of other parts of the business, without taking on any business risk. The Irish tax authority agreed with Apple that the branches should be taxed on the basis they were paid a certain margin over their costs.

The view that operating subsidiaries add little value in cases where the profit-generating risks and intellectual property are located elsewhere is, in itself, in line with international rules. These guidelines have allowed multinationals to ascribe the bulk of their profits to low-tax subsidiaries leading to growing frustration on the part of many governments, sparking the overhaul of the international tax rules now being planned by the G20 group of big countries.

So why does the commission think there has been selective aid to Apple?

Whatever the value generated by the subsidiaries, the commission argues it should have been based on comparable transactions – to gauge what an independent business would have been paid to do the same work. It says the 1991 ruling was “negotiated” and the decision to base the profits of the manufacturing business on its costs was “not reasoned in any way”.

What do the Irish government and Apple say?

Apple says it is confident the allegations will be proved groundless. It says it did not do anything that was against the law and it expects the investigation will ultimately show there was no selective treatment in its favour. The Irish finance ministry said Ireland was confident there was no breach of state aid rules in this case and has already issued a formal response to the commission “addressing in detail the concerns and some misunderstandings” contained in its document.

Is this likely to result in Apple being forced to pay extra tax?

The tone of the commission’s findings suggests it believes it has a strong case. But the arguments are likely to be drawn-out and highly technical. Whatever the ultimate outcome of the commission’s challenge, analysts suggest that it would not have a “material” impact on the finances of the world’s most valuable company.

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