Apple's Tax Bill Is About To Get Much, Much Bigger

Jun.23.14 | About: Apple Inc. (AAPL)

Summary

The European Commission has announced that it will launch a formal investigation into Apple's tax arrangements in Ireland.

The Commission's investigation is part of a global crackdown on multinational corporations launched by the OECD and endorsed by the G20 known as the Base Erosion and Profit Shifting Action.

The adoption of tax harmonization rules by the majority of European states would effectively eliminate the most profitable opportunities for cross-border tax arbitrage regardless of US adoption.

Depending on Apple's capital allocation strategy, BEPS has the potential to be either a windfall or a significant hit for Apple investors in the mid term.

On June 10th, the European Commission announced that it would launch a formal investigation of Apple's (NASDAQ:AAPL) tax arrangements in Ireland. The Commission's decision re-enforces my own conclusions in an article I penned seven months ago, namely that -

The austerity regime imposed by Germany on its southern allies appears to entering a new phase in which the Cyprus template of "bail-ins" via mass expropriation is being applied to U.S.-based businesses operating in Europe. I believe that Apple's Italian woes are a prelude to what I expect will be a litigious year for Silicon Valley as a whole in Europe.

The European Commission and ECN together comprise the enforcement end of Europe's competition law regime, which functions in a similar fashion to the U.S. antitrust laws in preventing the formation of market leaders, cartels and monopolies, as well as regulating market leaders and state aid. That puts Apple's Double Irish with a Dutch Sandwich tax avoidance strategy squarely within the Commission's purview.

The Commission's decision to crack down on Ireland's tax laws isn't happening in a vacuum. Rather, it's part of a global crackdown on multinational corporations launched by the OECD and endorsed by the G20 known as the Base Erosion and Profit Shifting Action Plan, or BEPS, scheduled to launch late next year.

What Is BEPS?

Per the OECD's website, BEPS -

refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits 'disappear' for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid.

The BEPS agenda is specifically aimed at neutralization of treaty shopping, profit shifting, cross-border repos, transfer pricing and other tactics employed by (mostly U.S.) multinationals for the purpose of off-shoring profits. This includes the transfer pricing of intangibles and royalty payments, both major sources of low-tax revenue for Silicon Valley.

Why BEPS?

The OECD's imprimatur on tax harmonization provides G20 member states with an escape hatch from legislative capture. While the US government is all but guaranteed to be a no-show, European governments rely more closely on policy guidelines established by international decision making bodies and are widely expected to act on the recommendations, particularly Action Item 6 [pdf], "Preventing The Granting Of Treaty Benefits In Appropriate Circumstances", which addresses treaty abuse.

In fact, according to a recent survey by tax risk and controversy survey by EY Tax Insights -

61% of large companies believe that some countries will adopt some OECD recommendations. Thirty percent believe that the result will be relatively limited coordinated action and more aggressive unilateral action by individual countries. Four percent believe that all of the OECD's recommendations would be adopted. No one in the Americas thought this would happen.

In addition, 89% of the companies surveyed reported being somewhat or significantly concerned about reputational damage from media coverage of companies paying ultra-low effective tax rates; 74% felt that tax administrators were now challenging existing structures due to changes in the law or their enforcement approach; 69% felt that tax audits had become more aggressive and frequent in the past two years; while 75% cited insufficient funds to cover tax function activities as their leading operational risk.

Decoding the Double Irish

On the chopping block is the widely imitated treaty arbitrage strategy known as the "Double Irish with a Dutch sandwich." In case you're unfamiliar with the mechanics of Apple's seminal tax innovation, The Double Irish works something like this:

Company A sets up two shell companies, which we'll refer to as subsidiaries B and C. B is an ostensibly Irish shell company set up in a tax haven like Bermuda. C is located in Ireland. C is set up as a fully-owned subsidiary of B. Company A makes an entry classification election for C to be disregarded as a separate entity from B. Company A then initiates a cost-sharing agreement between C and B and transfers the rights to its non-US royalties to B.

Non-US royalty payments are then channeled to the Irish resident company (NYSE:C), where they would normally be taxed at Ireland's 12.5% rate. The royalties paid by the Irish-resident shell to the Irish-Bermuda shell are now deductible expenses. C's tax bill is further reduced by booking the revenue on the sale of products shipped by C with a shell company in the Netherlands (Subsidiary D in Fig. 1 below) and the remainder of the profits are then transferred to Bermuda and treated by Ireland's tax authorities as an inter-EU transfer which is non-taxable, as Company B's management and control does not reside in Ireland.

Fig. 1: The Double Irish with a Dutch Sandwich

Click to enlarge

(Source: IPFinance)

The results are too clever by half. Though Apple derives 60% of its revenue from foreign sources, it paid just 0.05% ($10 million) in 2011 on $22 billion in dividend income routed through its subsidiary through Apple Sales International, one of Apple's three Irish subsidiaries. Another Irish subsidiary, Apple Operations International, paid no income tax to any foreign national government on dividend income of $30 billion in the four-year period 2009-2012.

While U.S. multinationals are furiously lobbying against BEPS in Washington, it's unclear what the US Congress can actually do to stop its implementation. Taxation is fundamentally sovereign prerogative, and BEPS is a non-binding policy prescription. The adoption of tax harmonization rules by the majority of European states would effectively eliminate most of the available opportunities for treaty arbitrage regardless of US adoption.

Conclusion

The fact that Apple's tax maneuvers have been copied by virtually every major player in Silicon Valley means that any fallout from harmonization won't be limited to Cupertino. Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), and Facebook (NASDAQ:FB) are on the chopping block, too. The mitigation of cross-border arbitrage may also remove the rationale for stashing mountains of cash overseas and lead to a reset of Apple's capital allocation policies, though it's difficult to imagine a more shareholder friendly board than the one Arthur Levinson currently chairs.

If there's one thing the markets hate more than higher taxes, it's uncertainty about higher taxes. I expect the market to throw a temper tantrum once it sinks in that Europe and other OECD member states might actually be coming to collect. Investors should keep one eye on the progress of OECD BEPS and the other on tech valuations over the next 12 months and ask themselves if the former is accurately priced into the latter. If not, the correction will be both swift and painful.

Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.