Paul L. Caron

Friday, October 30, 2020

Weekly SSRN Tax Article Review And Roundup: Kim Reviews The Apple State Aid Case By Daly & Mason

This week, Young Ran (Christine) Kim (Utah) reviews a new work by Ruth Mason (Virginia) and Stephen Daly (King's College London), State Aid: The General Court Decision in Apple, 99 Tax Notes Int’l 1317 (Sept. 7, 2020), also published as 168 Tax Notes Fed. 1791 (Sept. 7, 2020).

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The recent court case Apple (the full text of the judgement is available here) revolves around an EU doctrine known as “state aid.” Under the state aid principle, member states are prohibited from subsidizing favored actors or industries in the form of, e.g., tax treatment or benefits. Unless the reader is an expert in international tax, the reader might find the details of the Apple case to be overwhelming and difficult to understand because Apple is also a hardcore transfer pricing case. However, for those who are interested in Apple and would like to understand the technical aspects as well as a big picture of the case, I would like to recommend State Aid: The General Court Decision in Apple by Ruth Mason (Virginia) and Stephen Daly (King's College London), published in 99 Tax Notes Int’l 1317 (Sept. 7, 2020), also published as 168 Tax Notes Fed. 1791 (Sept. 7, 2020). The first half of the article offers the summary of the recent decision by the General Court of the European Union (GCEU), and the second half offers the authors' commentary.

The summary of the case is as follows: Apple Inc., the U.S. tech giant, assigned its intellectual property rights to manufacture and sell Apple products in markets outside the U.S. to its two Irish subsidiaries— namely Apple Sales International (ASI) and Apple Operations Europe (AOE). However, Apple paid very little tax on the profits generated by this IP because of various profit-shifting techniques. The late Ed Kleinbard referred to these untaxed profits as "stateless income." The U.S. did not tax Apple's profits because they were not repatriated, not Subpart F, and (in Apple’s view anyway) not effectively connected income (ECI). But why has Apple paid little to no tax to Ireland? The reason for this is that the Irish subsidiaries that held the IP rights were managed and controlled elsewhere, and therefore were not tax resident in Ireland. However, each subsidiary had a branch in Ireland which had substance. Thus, the main issue of Apple was whether the profits arising from the IP rights owned by Apple's stateless companies could be attributed to the Irish branches. The European Commission’s (the “Commission”) theory was that, since the stateless head offices had no substance, but the Irish branches had at least some substance, profits could be attributed to the branches, but not the head offices. The Commission thus decided that Ireland unlawfully approved transfer pricing rulings for Apple that allowed the company to pay too little Irish tax, and thus more profit—and indeed the entire profit earned by the stateless companies—should be attributed to the Irish branches. The Commission ordered Ireland to recover €13 billion ($15.1 billion) for illegal state aid to Apple, and in response Apple and Ireland brought this case to the GCEU. In July 2020, the court held that such allocation of income "by exclusion" was wrong under both Irish law and OECD guidance, and annulled the commission’s €13.1 billion recovery order.

To be more specific, the parties have fought over two issues: i) the applicable rules and ii) their application to the facts. The issue on the applicable rules was whether the Commission was entitled to apply the arm's-length standard as a benchmark or a tool to check whether Ireland correctly determined the profits of Apple's Irish branches, even if the investigated member state had not incorporated that standard into its domestic law. This question has a broader implication because the Commission relied on OECD guidance as part of its arm's-length assessment. The GCEU agreed with the Commission that it was entitled to use the arm's-length standard and to use the OECD guidance, because the GCEU found that the authorized OECD approach was similar to the approach under Irish domestic law to attributing profits to a branch. However, when it came to the application of those rules to the facts, the GCEU decided that the Commission failed its burden of proof. In state aid cases, the burden of proof on selective advantage resides with the Commission. Thus, the Commission had to prove that Ireland’s allocation of little profits to Irish branches was wrong by analyzing the actual activities of the branches. However, the Commission had not, in the GCEU’s view, focused enough on what the branches affirmatively did. Instead, the Commission had been more concerned with establishing the fact that the Irish subsidiaries could not have done anything because they were empty, based on which it argued that control and management could only have been performed by the Irish branches. But this allocation-by-exclusion approach was supported by neither Irish law nor OECD guidance.

The authors also provide their comments on the state aid issues of the case and its broader implications on international tax system. This review cannot introduce all their comments, but here are some of the notable points.

First, the GCEU concluded that the Treaty on the Functioning of the European Union (the “TFEU”) does not oblige member states to use the arm’s-length standard. Nonetheless, the court also held that the Commission could use the OECD arm's-length standard as a “benchmark” to judge whatever allocation method the member state did choose, as long as that domestic method could reasonably be regarded as similar to the arm’s length standard. The decision thus has the effect of making OECD guidance a benchmark for state aid cases involving transfer pricing. However, the authors are concerned about the notion that states’ transfer pricing decisions can be measured not only against their own law but also against an external OECD standard they never adopted—here, the authorized OECD approach for attributing profits to a branch. In fact, there is a lack of international consensus on the operation of the principles of article 7 and thus a lack of international consensus on the authorized OECD approach. Only a few countries fully endorse the authorized OECD approach to branch allocations.

Second, the authors indicate the heavy burden of proof on the Commission in state aid cases and how difficult it is to satisfy it in transfer pricing cases. The Commission must demonstrate that any errors committed by the tax administration that issued the ruling caused the reduction in tax. However, that will be difficult because i) transfer pricing cases are always highly factually dependent, and ii) the OECD transfer pricing guidelines result in a range of acceptable results. In Apple, the GCEU acknowledged serious problems pertaining to Ireland’s ruling practices, but it nonetheless dismissed all those defects because the Commission had failed to prove that they caused Apple to pay less tax.

Third, the authors imply their nuanced regrets on the issue of statelessness. When the Commission referred to the Apple's Irish subsidiaries (ASI and AOE) as stateless, the GCEU mildly criticized such argument because Irish law alone does not provide for statelessness. However, the authors point out that the Irish rules resulted in statelessness when combined with the U.S. place of incorporation rule and suggest that the Commission should have pushed the stateless nature of Apple further because the Irish rules were very narrow and carefully calibrated to advantage U.S. multinationals, such as Apple, Inc. 

Finally, the authors explain that Apple could earn huge profits without being subject to tax anywhere because of the systemic problems in the international tax system, and they emphasize the need for comprehensive solutions, such as pillars 1 and 2 of BEPS 2.0 and the common consolidated corporate tax base (CCCTB). In addition, they urge the Commission to put its state aid analysis on a firmer footing. Daly has proposed to pursue improper administration of rules by tax authorities here, and Mason has proposed here to use a coherent means—for example, the Supreme Court's internal consistency test—for identifying structural tax advantages for multinationals embedded in member state rules. The Commission could employ either of these approaches to find that Ireland conferred state aid to Apple, without the Commission having to devise or apply non-Irish transfer pricing rules.

In conclusion, the Commission has decided to appeal this case and this paper offers a great review as well as a preview for those who want to learn the key things to watch for in the appeal. However, even if the Commission had chosen not to appeal, the authors commend the Commission for contributing to the development of international tax in various ways (such as Irish reform of its corporate residency rule, the increased exchange of information between tax authorities, and the 2017 U.S. corporate tax reform introducing Global Intangible Low-Taxed Income (GILTI)) by effecting change through its investigations.

Here’s the rest of this week’s SSRN Tax Roundup:

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