The European Commission’s defeat on Irish tax rulings: the Apple case

Through the sentence of the last 15th July, the General Court of European Union rejected the European Commission’s decision against a specific national taxation regime applied to the activities carried out by the two Apple’s Irish subsidiaries, ASI and AOE. Indeed, the Commission stated that, through the so-called ‘tax rulings’, the Irish taxation authorities (Irish Revenue Commissioners) made use of preferential treatment to the two branches, applying a lower taxation on their profits than it is provided by the normal framework. In so doing, Ireland granted an economic advantage to Apple’s enterprise for over a decade, violating the State aid rules established by Article 107 TFEU.

In June 2014, the Commission launched several investigations over a possible violation of the European State aid framework, allegedly put in place by Ireland. The European Commission found that the internal allocation of chargeable profits to the two Irish subsidiaries, on which the tax rulings relied on, and the erroneous taxation method used by the Irish authorities could constitute a source of discriminatory treatment in favour of Apple Group in respect to the normal taxation rules used for the other companies resident in Ireland, representing a distortion of competition within the internal market. On this basis, on 30th August 2016 the Commission addressed its decision about the Ireland’s conduct and imposed the cessation of the preferential treatment towards Apple.

Its observations were based on the internal organization of Apple’s business and on its relationship with the Irish national authorities. The multinational Apple Inc, seated in California, carries out its activities in Ireland through two Irish subsidiaries, Apple Operations Europe (AOE) and Apple Sales International (ASI), which are specialised in two different types of activities. ASI is responsible for procurement, sales and distribution activities to customers outside the Americas, reserving, however, negotiation and signature of the contracts with manufactures of products to Apple Inc, or to the directors of ASI, outside Ireland. AOE, instead, is responsible for manufacture and assembly of specialised ranges of computers such as iMac desktops and MacBook laptops. The two branches are not involved in the critical decision-making at all, having mainly subsidiary functions, such as a monitoring role.

Apple Inc., on one hand, and the two branches, on the other, are bound by a cost-sharing agreement, signed firstly in 1980 and updated then in 1999, that regulates the sharing of costs and risks relating to activities of R&D and the treatment of services and products of Apple Inc. In particular, the agreement states that Apple Inc. remains the official legal owner of cost-shared intangibles, including the Apple Group’s intellectual property (‘IP’) rights. On the other side, the holding company granted a royalty free licence for Apple’s IP rights, enabling the two subsidiaries to manufacture and sell Apple products throughout the world, except North and South America; and for Apple to provide marketing services to ASI for a fee based on Apple’s costs plus a mark-up.

The two subsidiaries are set in Ireland, but they are managed and controlled for the 100% by Apple Inc., set in the United States. Thus, despite their settlement in Ireland, they are not considered as tax resident in the Irish State, while at the same time they could not be considered US resident. This is the reason why the Irish subsidiaries have been subjected to specific ‘tax rulings’, issued in 1991 and then in 2007. These advance tax decisions were in the form of letters through which the Irish taxation authorities confirmed the terms and the chargeable profits applicable to these entities. As to their legal value, these letters are considered as regulatory tools. However, the debate between the European institution and Ireland was focused on the direct taxation method, which, from EU perspective, is likely to raise concerns in relation to the State aid framework and the common principles of international taxation.

In this respect, the Commission’s complaint followed several steps. In its primary line of reasoning, it stated that these rulings unreasonably accepted the assumption that a huge part of profits connected to functions, risks and intangible assets held by ASI and AOE had been incorrectly allocated outside Ireland jurisdiction. In particular, the Commission found that those activities had been apparently corresponded to “head offices” of the two subsidiaries, which, however, did not have physical presence of employees and did not have any base in any country. As a result, the profits coming from activities concerning these intangibles, such as those concerning Apple’s Group’s IP licences, were allocated partially to the Irish branches, while the rest was mostly attributed to their board of directors: thus these profits, since being subjected to any fiscal jurisdiction, remained untaxed. Further, in its second line of reasoning, it stressed that the profit allocation system itself presented several methodological errors. According to the Commission, it reflects the transactional net margin method (‘TNMM’): this one-side profit allocation method defined by OECD Transfer Prices Guidelines identifies the net revenue obtained by the taxpayer, namely the ‘tested party’, calculated through a proper profit level indicator. In this case, the Commission deems the identification of ASI and AOE as tested party as incorrect, since it led to erroneous determination of taxable income. All these reasons convinced the Commission of an unduly internal distribution of profits among integrated companies.

The Commission considered this internal distribution of profits unduly and wrong since it did not respect the corporate taxation benchmark at the international level, the so-called arm’s length principle. Enshrined in Article 9 of OECD Model Tax Convention, this principle ensures fairness and clearness in the companies’ market activity: as mentioned in the decision, it establishes that the transfer pricing used in intra-group transactions must be remunerated “as if it was agreed between independent enterprise under comparable circumstances at arm’s length”. According to the European Antitrust authority, the allocation did not correspond to the economic reality and hurdled the correct taxation of the subsidiaries for their activities on the Irish ground. For example, among the ASI’s €16 billion profits recorded in 2011, only €50 million were considered taxable according to the tax rulings terms, and following the Commission statements, the percentage of taxable profits decreased in the following years, from the 1% paid in 2003 to 0,005% in 2014.

Besides the profit allocation, in its line of reasoning regarding the subsidiaries, the Commission contested specifically the taxation method applied to them by the rulings. In order to this, the Commission looked at the national reference framework on corporate taxation, represented by the Tax Consolidation Act of 1997. The common system specifies that non-resident entities are normally not subjected to corporation tax on their worldwide turnover, differently from the resident ones, except those non-resident companies which carry out trade in Ireland through a branch or an agency. According to the provisions of Section 25 TCA, the latter are taxed over any trading income arising directly or indirectly, any chargeable gain or any asset disposed by the branch. This mechanism aims to tax profits coming from activities carried out in Ireland, regardless of whether they are integrated or autonomous companies.

The tax rulings, instead, allowed the Irish authorities to not require any payment over the trading income of those branches: the taxation over the chargeable profits was made on the basis of the operating costs, rather than sales, taken as the profit level indicator. The Commission specified that operating costs are “generally” chosen in order to analyse profits of low-risk distributors, which does not reflect the activities and the risks assumed by ASI and AOE. It thus stated that those methods were based on inappropriate methodological choices, which contributed to a reduction in the amount of tax that ASI and AOE were required to pay as compared with non-integrated companies.

Overall, the European Antitrust argued that both the lines followed in the investigation on the two tax rulings showed a breach of the arm’s length principle, thus violating the State aid framework given by Article 107 TFEU. Specifically, this unfair reduction granted by Ireland to Apple’s taxable income by Ireland conferred a selective advantage to ASI and AOE, thus affecting free competition. According to the provision’s rules, the Commission required Ireland to recover €13 billion (plus 1,3 billion of interest) in back taxes from Apple. However, the attack unleashed to the giant Apple Inc. eventually failed: after the appeals brought by Ireland on November and by ASI an AOE in December 2016, the European Court’s ruling crushed the Commission lines of reasoning.

The General Court upheld the action brought by Apple and annulled the decision, arguing that the Commission has not satisfied the burden of proof with regard to the alleged advantage granted to the company, for the purposes of Article 107 TFEU.

Contrarily to Ireland and Apple’s arguments regarding an excess of Commission’s competence in the Member States fiscal sovereignty, the Court accepted the latter’s defence that, anyway, any tax measure adopted by a Member State must comply with the EU rules on State aid. Thus the Court recalls , from the case Commission v. Spain (2012), that “while direct taxation, as EU law currently stands, falls within the competence of the Member States, they must nonetheless exercise that competence consistently with EU law”. The Court also rejected Ireland and ASI and AOE’s complaints regarding the legislative instruments used by the Commission in order to assess the existence of a selective advantage. Indeed, the Commission, in line with Article 107 TFEU, should refer to the normal corporate taxation regime in order to determine an economic discount in the treatment of these branches in respect to the normal market condition. Thus, the reference to the ordinary corporate tax law and the Authorised OECD Approach over the profit allocation method has been correctly applied by the Commission, since it is also underlined by the Court that the Irish law is not in itself specific in determine methods through which profits should be attributable to the two branches.

By the way, the General Court recognized that the Commission, in its primary line of reasoning, was wrong in demonstrating that the Irish authorities granted the two branches a selective advantage. Referring to Section 25 TCA, the Court suggested that its enforcement must cover the actual activities of those branches and the market value of the activities actually carried out by the branches themselves. Conversely, when stating that the Apple Group’s IP licences and the linked trading income should have been allocated to those subsidiaries, the Commission did not concretely attempt to prove that this allocation followed from the activities currently carried out by those Irish branches. Indeed, the Commission conducted an abstract analysis over the functions of the whole company, relying on an “exclusion approach”: specifically, considering the entirety of non-resident company’s profits, the fact that they cannot be allocated to other parts of that company induced the Commission to presume that the subsidiaries profits associated to those assets had to be allocated to the two entities, without in-depth analysing the concrete management functions conducted by them. Moreover, Ireland and the ASI and AOE recalled that the activities and functions performed by the latter included neither management nor strategic decision-making concerning the development or marketing of the IP.

As also said in Dataproducts case (1988, I.R. 10 note 4507), profits deriving from property belonging to a company and controlled by its executives, both not resident in Ireland, cannot be allocated to that company’s branch, even if that property is made available to that branch. As the Court repeated, “the ‘centre of gravity’ of the Apple Group’s activities was in Cupertino and not in Ireland”. Thus, the analysis carried out by the Commission has been considered fallacious and unprecise.

Then, the subsidiary line of reasoning referring to the taxation method is incorrect too. The Court pointed out that, “even where there are inconsistencies which show defects in the methodology used to calculate the chargeable profits in the contested tax rulings”, to merely state that there has been a methodological error is not sufficient, in itself, to demonstrate that the tax measures at issue have conferred an advantage to the recipients of those measures. Indeed, although the Commission relied on the international instruments, “those guidelines do not recommend the use of any particular profit level indicators and do not preclude the use of operating costs as a profit level indicator”. For this reason, the defects identified by the Commission are not themselves sufficient to prove the existence of an advantage for the purposes of Article 107 TFEU.

Eventually, this last defeat of the European Commission could be considered as the direct consequence of the lack of a legislative harmonisation, at the European level, in the field of direct taxation, thus this hurdles the Commission’s possibilities to interfere in the national frameworks regarding corporate taxable profits. However, this defeat should not anyway represent a discouragement to the Commission’s watchdog role over the respect of State aid prohibition rules provided by the Treaties: indeed, the Court recognised that the fiscal sector, which still remains a typical national competence, is not totally excluded from the scope of the rules on State aid control. It means that the Commission can still continue to use this legal framework in order to fight against discriminations or other forms of distortion within the internal market. By the way, the General Court made it clear to the Commission the need to change its investigative methods in the assessment of unfair tax rulings and to provide more specific and meticulous analyses of the factual background, in order to better fulfill the required burden of proof.