The EU: Apple and The Republic of Ireland
The state aid case against Apple and the Republic of Ireland took its latest step on 15 June when the lower-tier General Court found that Apple did not receive illegal state aid, thus annulling the European Commission’s (EC) decision of 30 August 2016.
The EC claimed that tax rulings obtained by Apple in respect of two Irish incorporated, but not resident, companies amounted to illegal state aid. Pursuant to the rulings almost all the profits of the Irish companies were allocated to a head office outside Ireland leaving only a small margin on which Irish tax was paid.
The General Court confirmed that the EC does have the right to check the compatibility of tax rulings with EU State aid rules (this was the good news for the EC), but went on to dismiss the EC’s three lines of reasoning (Primary, Subsidiary and Alternative) as follows:
Because the foreign head offices had no employees and little substance it was unable to perform the functions and bear the risks related to the key value-generating assets (i.e. the IP). This being the case, the EC argued that the functions and risks should be allocated to the Irish branches.
- the EC can use the arm’s length principle to check profit allocation reflects market values;
- it is acceptable to use the OECD approach to assess the split of profits allocable to the head office and to a branch under TP rules;
- the EC failed to show that the functions and risks related to the value-generating IP were in Ireland; and
- that the key functions were performed outside of Ireland (i.e. the U.S.)
The allocation of the IP assets and related profits was outside Ireland but the application of the transfer pricing method (transactional net margin method) was defective.
- the EC incorrectly allocated risks to the Irish branches;
- the EC failed to demonstrate that Apple’s TP studies were unreliable; and
- a lack of contemporaneous TP documentation cannot lead to a presumption of State Aid.
Essentially the discretion of the Irish tax authorities was excessively broad which resulted in a selective advantage being granted to the two Irish companies.
- The EC failed to show that the Irish tax authorities had exercised a (too) broad discretion in this case.
Next Steps and Our Thoughts
In our opinion the EC is likely to appeal the judgment to the highest court (the European Court of Justice or ECJ). Whether this will be successful is anyone’s guess, particularly since the General Court dismissed the factual findings of the EC.
This latter point is pretty damning as far as the EC is concerned, but the fact that the General Court confirmed the EC’s right to investigate national tax measures for compliance with state aid rules and the applicability of the arm’s length principle gives the EC the ammunition it needs to attack tax issues using the stick of state aid. That said, the EC will have to undertake much more detailed economic analysis of transfer pricing arrangements if it is to successfully use state aid in tax cases.
So, whilst Apple and Ireland have prevailed in this instance, it’s very much a score draw. Businesses will welcome the ruling, but the door hasn’t been closed on the EC use of state aid. Watch this space.
If you’re interested in the background to the case, please read on!
In 2013, the EC brought a case against the Irish government for providing illegal state aid to Apple. A state aid claim has a window of limitation of 10 years meaning that the EC’s assessment goes back to 2003/4. On 30 August 2016, the EC concluded that the tax benefits afforded to Apple by Ireland amounted to illegal state aid, on the basis that it (the Republic) allowed Apple to pay substantially less tax than other businesses. As a matter of principle, EU state aid rules require that illegal state aid is recovered in order to remove the distortion of competition created by the aid with the EC assessing that Apple owes Ireland c.EUR13bn.
In 1991, Apple obtained rulings from the Irish government in relation to its transfer pricing strategy (i.e. its strategy to allocate revenue and expenses to its Irish operations on an arm’s length basis) that allowed it to allocate a significant proportion of the profits of two Irish companies, Apple Sales International and Apple Operations Europe, to a head office that was not subject to tax in any country. As a result of the rulings Apple paid a far lower effective corporate tax rate on its European profits than other businesses. The EC has estimated the effective tax rates as being 1% in 2003, declining to 0.005% in 2014 on the profits of Apple Sales International.
Most countries operate transfer pricing (TP) rules. These dictate that transactions between connected parties (e.g. entities within a multinational group) must be undertaken on the same terms that would have existed had the transaction been between wholly independent parties (i.e. no common ownership/control). The OECD published TP guidelines in 1979, which have been substantially updated over the past 39 years, that establish the methods to be used to identify such arm’s length terms.
At the time the rulings were issued, Ireland did not have TP rules. Apple nonetheless operated in many countries that did have TP rules and thus had a strategy that was potentially compliant with the TP rules of those countries. The absence of TP rules in Ireland, however, created uncertainty and it was therefore prudent and good business practice to obtain a ruling on the allocation of profits to Ireland, a system that was available to all undertakings, not just Apple.
Most countries that have a TP regime also offer taxpayers the possibility of entering into an Advance Pricing Agreement, arguably not that different to the Irish ruling system. A ruling is merely a method by which a taxpayer can obtain certainty over its tax position.
The basis of the EC’s claim in Apple
The EC asserted that the method used to determine the profit allocation to Ireland is wrong and that instead of using the Transactional Net Margin Method (‘TNMM’), the Comparable Uncontrolled Price Method (‘CUP’) should have been applied. Now, until 2010 Ireland did not have TP rules within its domestic legislation and in the absence of any domestic TP rules, the state in question, Ireland, was presumably at liberty to select the methodology that best suited it and the taxpayer (Apple).
Issues with the application of state aid to tax matters
EC competition law specialists ordinarily deal with matters of state aid. Their remit also extends to state aid matters pertaining to tax, despite the fact that their primary area of expertise is not taxation. Consequently, a unique interpretation of the ‘arm’s length principle’ that is inconsistent with the OECD TP Guidelines (and therefore the TP regimes of a significant number of countries both within and without the EU) has been developed (as discussed below).
When will a measure constitute state aid?
For a measure to constitute aid it must have the following hallmarks as prescribed by case law of the Court of Justice (CJEU) and the General Court:
- it is provided by a member state and financed through state resources (i.e. intervention by the member state that departs from the norm);
- an economic advantage is provided to an undertaking;
- it is selective in favour of a particular undertaking, category of undertakings or category of goods; and
- it distorts or threatens to distort competition and affects trade between member states – this is assumed to be the result where intervention, economic advantage and selection exist).
Application of state aid principles to the Ireland / Apple case
Intervention: Has there been an intervention by the Irish government?
In this case a ruling was granted to give certainty over the taxpayer’s tax position in the absence of specific TP legislation. The EC has asserted (in its state aid case against Luxembourg in respect of Amazon), that any tax assessment that results in a tax benefit by virtue of the EC’s application and interpretation of the arm’s length price will constitute ‘intervention’. This, in our opinion, has to be wrong. Ireland had very limited TP rules at the time it entered into the Apple rulings. It included the concept of the arm’s length principle, but not the methodologies and how to apply them in determining an arm’s length price for the transactions and, as such, there appear very few cases in which the arm’s length principle was applied. Consequently, up until the introduction of its TP regime in 2010, Ireland would have had no real basis to challenge or make an adjustment to Apple’s TP policy, regardless of whether a ruling was granted or not. In which case, we would argue that there can be no tax benefit conferred upon Apple for most of the period to which the state aid case applies (2003-2010).
However, the EC argue that Ireland did not need domestic TP law, because Article 107 of the Treaty on the Functioning of the European Union (‘TFEU’) provides that where a state provides aid that distorts competition, it will be illegal and incompatible with the Single Market. In respect of tax cases it allows the member state to make an adjustment to a taxpayer’s liability to prevent such illegal state aid.
To suggest that Article 107 allows (or forces) a member state to levy tax in the absence of domestic rules, would create incomprehensible uncertainty for taxpayers and undermines established domestic parliamentary and legislative process (i.e. the rule of law). An attempt to redesign Ireland’s corporate tax system exceeds the EC’s power granted by Article 107 (one of Apple’s appeal arguments), a notion echoed by the Irish Department of Finance in its press release of 30 August 2016: “It is not appropriate that EU state aid competition rules are being used in this new and unprecedented way in the area of taxation, which is a member state competence and a fundamental matter of sovereignty.”
Economic advantage: Is there an economic advantage to Apple?
The EC seeks to rely on case law from the Court of Justice of the European Union (‘CJEU’) that establishes an ‘economic advantage’ as an economic benefit that an undertaking would not have obtained under normal market conditions (C-39/94, SFEI).
This disregards the fact that transactions between connected parties do not reflect market conditions. Instead the arm’s length principle is applied as a mechanism to substitute market conditions. To identify market conditions would not be comparative and it is necessary to apply the OECD transfer pricing guidelines as to how to determine an arm’s length price and thus whether an economic advantage has arisen.
In each of the recent fiscal state aid cases referred to above, the Commission’s preliminary finding has been that the respective tax rulings diverged from the ‘arm’s length principle’ and this provided the selective economic advantage.
The EC held, in an Italian non-tax state aid case, that policy measures do not automatically constitute state aid, and that it is necessary to look at the effect(s) of the measure. It appears that, as a result of this decision, the EC gives more weight to the effect of a policy or measure than the established conditions for state aid. For instance, whether there has been an economic benefit to the taxpayer is secondary to whether there is a disadvantage to others. This approach was extended further by the CJEU in World Duty Free Group C-20/15P, where it was broadly held that a measure that is merely discriminatory (i.e. not necessarily causing an advantage to the taxpayer or a disadvantage to other undertakings) against other undertakings will constitute state aid. It seems the ‘economic advantage condition’ required to be present for state aid to arise has been completely rewritten.
In TP cases, it is likely that there will always be a difference in the treatment of a related party transaction as against transactions between independent parties. Whether this difference means that independent parties are discriminated against and whether this is sufficient for illegal state aid remains to be seen. The risk for MNGs is that any ruling or APA approving an MNG’s pricing policy is now potentially subject to a state aid claim.
Selective: Has Apple benefited from a measure that other businesses can’t benefit from?
The ‘measure’ in question is the granting of a ruling by Ireland to Apple agreeing the profits that would be allocated to Apple’s Irish operations (i.e. a transaction between connected parties). However, to answer the question of whether the measure was ‘selective’, one would need to consider all undertakings, including those that have no connected party transactions. In our view, the only way to answer this question would be to consider whether the transactions between Apple’s non-Irish entities and its Irish entity were arm’s length – the price that would have been charged had the entities not been connected.
The EC’s response has been to develop and apply its own version of the arm’s length principle:
“A reduction in the taxable base that results from a tax measure that enables a taxpayer to employ transfer prices in intra-group transactions that do not resemble prices that would be charged in conditions of free competition between independent undertakings negotiating under comparable circumstances at arm’s length considers a selective advantage. This is because that taxpayer’s tax liability determined under ordinary rules of taxation of corporate profit is reduced as compared to independent undertakings whose taxable profit reflects prices determined on the market negotiated at arm’s length”.
In other words, if a tax authority accepts a taxpayer’s use of a method other than the CUP, this results in the state aid ‘selective’ condition always being met since the EC is suggesting that only market prices actually negotiated between independent parties would be acceptable prices to use.
However, use of the CUP method in accordance with OECD standards is only possible where the taxpayer makes sales or provides services to an unrelated third party in the same ways as it does internally (i.e. there is a direct comparative price for the sales or services provided internally) or where there is market data available showing the price between independent parties for such sales or services. It is noted that such data is almost never available.
The EC’s approach again undermines standard domestic parliamentary or legislative process, since no tax authority applying the arm’s length principle can adjust a taxpayer’s pricing of a related party transaction to the market price had the taxpayer been structured differently, organised itself more or less efficiently etc. A tax authority can only make adjustments where it considers a transaction is not arm’s length. To determine this, the tax authority will apply the arm’s length principle (i.e. the substitution mechanism for market value / price) using methods prescribed by domestic law or those set down in the OECD TP Guidelines.
If you have any questions or would like to know more,
please contact Zoe Wyatt on +44 7909 786 144
or Miles Dean on +44 7785 770 431 or firstname.lastname@example.org