Why Apple's 'Stateless Income' Tax Strategy Will Be Largely Unaffected By The EC Ruling

| About: Apple Inc. (AAPL)

Summary

Fundamentally, the U.S. "check the box" rule will still facilitate a similar tax strategy using a tax haven such as Bermuda.

Braeburn Capital, which manages AAPL's $170bn portfolio of Treasuries and short-dated corporate paper, is also instrumental and faces no immediate regulatory threat.

Analyst estimates of a possible $8bn in tax liability are likely to be significantly overstated.

Any unfavourable ruling will likely merely relate to the cost-plus transfer pricing arrangements entered into with the Irish government, and not the worldwide income earned by Apple Sales International.

The Irish general election has taken place, and a new government has finally been formed, so we could expect the EC to deliver a ruling as early as this summer.

Much attention has been given to Apple's (NASDAQ:AAPL) corporate structure in recent times on account of its low effective tax rate on global profits as well as owing to negative publicity arising from U.S. Senate hearings and the pending European Commission investigation under article 107 of the Treaty on the Functioning of the European Union into the joint costing/pricing arrangements entered into by Apple with the Irish government. For example, The Irish Times claims Apple cut its Irish tax bill by more than €850 million between 2004 and 2008, using an unexplained "lower rate". Apple itself has said that it pays less than 2 percent in Ireland over the 10 years to 2013. The mounting pressure has already resulted in €318 million being paid to settle an Italian tax claim in relation to profits declared in Ireland. So, are the Irish tax authorities really to blame for facilitating Apple in diminishing its tax liability?

The decision to take a tougher stance on Ireland's idiosyncratic rules for determining corporate residency is unlikely to pose a significant obstacle to Apple's so-called "stateless income" tax strategy, which is not at all dissimilar to the "double Irish" strategy employed by others such as Google (NASDAQ:GOOG) (NASDAQ:GOOGL). Both structures fundamentally depend on the U.S. "check the box" classification rules to create a hybrid entity mismatch arrangement, as well as the cost-sharing provisions of Treas. reg. section 1.482-7.

According to Joseph P. Brothers, an associate with Caplin & Drysdale in Washington, the EU is attacking the wrong target.

"It is focusing on Irish domestic tax law, when the real culprits, if any exist, are: the U.S. check-the-box rules; the U.S. cost-sharing safe harbor under Treas. reg. section 1.482-7; and the general international tax principle that wholly owned shell entities located in tax havens (regardless of whether the term 'located' means incorporated, managed, or something else) should be respected as economically independent entities rather than mere instrumentalities of their parent companies or overall corporate groups".

Unlike the "double Irish", Apple's tax structuring structure does not involve any Irish incorporated entities being controlled from tax havens such as Bermuda or the Cayman Islands. In Apple's case, Apple Operations International (AOI) is an entity incorporated in Ireland and controlled from Cupertino, California (arguably). AOI files no residency-based corporate income tax returns in any jurisdiction, because from a U.S. perspective, it is resident in Ireland, but from an Irish perspective, it is a tax-resident of California. This is because under Irish tax law, the residence of some companies is evaluated on the basis of where they are managed and controlled. One of the few who is providing a comprehensive analysis of the EC investigation is Seamus Coffey, an economist at University College Cork, the city where Apple is located in Ireland. As Coffey, puts it, "it is like a company that was born here but now lives somewhere else".

While the "double Irish" loophole has been repealed and will be phased out by 2020, more fundamentally, the U.S. "check the box" rule will still facilitate a similar tax strategy using tax havens such as Bermuda or the Cayman Islands. A 1962 compromise between President John Kennedy and Congress imposed U.S. taxes on "passive" income earned abroad in a law known as Subpart F. In 1996, the Treasury sought to simplify Subpart F with a rule that enabled companies to "check the box" to label a subsidiary as a "disregarded entity" for tax purposes. In 2006, Congress bolstered the loophole by giving corporations more latitude to move some types of income from one foreign unit to another without paying a tax with legislation that became known as the "look through" rule.

Due to the "check the box" and "look through" loopholes, only Apple Distribution International (ADI) and Apple Retail Holding Europe are recognized as being tax resident in Ireland while the transactions among other entities such as ASI disregarded as being transfers within Ireland.

Apple Sales International (ASI) has an Irish logistics and administration branch, but like AOI is tax resident nowhere. ASI contracts with the third-party manufacturer in China as well as international offshore distribution subsidiaries. ASI pays dividends to AOE which similarly has an Irish branch but no tax residence. AOE in turn pays a dividend to AOI. These payments represent passive income for R&D, which Karl Levin referred to as "crown jewels".

This has garnered much attention considering it is estimated $120 billion of profits earned by ASI between 2004 and 2013. Joseph Brothers believes that hypothetically if the Irish holding company with tax residence nowhere was transformed into asserting its tax residency in a tax haven such as Bermuda, "most of the crucial details would function more or less identically". The check-the-box election does not require any same country showing, so the activities of the Irish operating subsidiary would still be imputed to Bermudan holding company, thus avoiding FBCSI. By the same token, any royalties paid from the Irish operations to the Bermudan holding company would still be ignored from the U.S. perspective, so that no FPHCI income would result. At the same time, these royalties would still be deductible against the trading income of the Irish operating subsidiary. The cost-sharing arrangement would not be affected. Hence the Irish treatment of "management and control" is not instrumental to the avoidance strategy. The double Irish works mainly because of the hybrid entity mismatch possibilities available because of the check-the-box and the cost-sharing regime under U.S. domestic rules.

Moreover, a point that Seamus Coffey alluded to back in 2015 is that simply because the profits are in an Irish-incorporated company does give the EU the right to tax them. Indeed, assistant U.S. Treasury Secretary Robert Stack reiterated to a Treasury Finance Committee hearing that if Apple was liable to pay more tax in Ireland, it would be the U.S. taxpayer who would effectively be footing the bill, owing to the U.S. tax credit system afforded to the U.S. based multinationals. Some such as Coy and Drucker argue that if the U.S. was to adopt a territorial system akin to what is used by most of the OECD, the U.S. would largely stop trying to go after companies' worldwide income and instead would mostly tax profits earned in the U.S. Supporters of a territorial taxation include the bipartisan National Commission on Fiscal Responsibility and Reform created by Obama.

The crux of the matter, as Coffey succinctly summarized, it appears to be that "the U.S. wants to have its cake and eat it". According to the Fiscal Times, lobbyists argued that eliminating the "check the box" loophole would damage the U.S.-based multinational companies by forcing them to pay more taxes not only in the United States, but also to other high-tax regions such as France.

While much condemnation has been cast upon "tax havens" such as Ireland, it is quite clear that U.S. politics is the instrumental factor in facilitating such tax avoidance schemes. According to a former Treasury Department official who helped write the "check the box" rule, "once a policy mistake is made that is favorable to taxpayers, and particularly to big taxpayers, it is extremely difficult to reverse".

Ironically enough, the U.S. has been passed the mantle of "the biggest tax haven in the world" according to Andrew Penney of Rothschild & Co. in an interview with Bloomberg. This was made in reference to certain states such as Nevada's refusal to comply with newly imposed OECD disclosure standards. These new international standards were inspired by U.S.'s own Foreign Account Tax Compliance Act in 2010 which now they are actively resisting when it comes to aiding other countries in fighting tax evasion. Save perhaps a tax holiday on repatriated profits, any change to the U.S. corporate tax code is highly unlikely. Therefore, Apple's tax avoidance strategy is unlikely to face any threat on the Western side of the pond.

From a narrower perspective, the profits accumulated by ASI are ultimately not actually held in cash of course, but as Treasury bills and short-dated corporate bonds managed by Braeburn Capital, which is effectively "the world's largest hedge fund" as labelled by zerohedge.com. Braeburn Capital is located in Reno, Nevada, which has become the "banking secrecy jurisdiction du jour" according to Peter A. Cotorceanu, a lawyer at Anaford AG, a Zurich law firm. It is not eminently clear why Braeburn is located in Reno, but it is likely because "passive entities" or "entities organized solely to manage intangible investments" are not subject to commerce tax under Nevada state law. Moreover, "intellectual property revenue from the sale or exchange of the right to use trademarks, trade names, patents, copyrights, or other similar property" is not considered gross taxable income, and "dividends and interest from federal and state bonds or securities" is tax deductible, which would be very favorable on any count. Thus, an equity holder in AAPL will incur capital gains through Braeburn accumulating reinvested tax-free coupon payments, which would otherwise be subject to income tax if an individual investor were to hold them rather than the Nevada incorporated holding company. Braeburn may receive far less media attention than Ireland does in Apple's tax strategy, but the weight it lifts in avoiding taxes is far from insignificant. Importantly, Braeburn is not likely to be subject to regulatory threat any time soon either.

The more pressing issue, which of course will have implications for AAPL in the near term, is the pending European Commission ruling, which could be returned as early as this month. While the impact of the investigation on Apple's share price thus far appears to be negligible, in its 10-Q filing for 2015 Q1, Apple was obliged to warn that it could face material financial penalties as a result of the investigation. Analysts are estimating clawbacks of $8bn or even more. In a worst-case scenario, JPM even estimates a $19bn clawback based on a 12.5% rate on $153bn of international income over 10 years. This is highly implausible as it would mean a tectonic shift in the aforementioned tax-residency rules.

What is far more realistic is an unfavourable ruling based on the Irish Department of Finance's validation of transfer pricing arrangements, also known as advance pricing arrangements ("APAs"). APAs are arrangements that determine, in advance of intra-group transactions, an appropriate set of criteria for the determination of the transfer pricing for those transactions over a fixed period of time. The question is whether the cost-plus arrangements adhered to the "arm's length" principle.

In 1991, a basis for determining AOE's net profit was proposed by Apple and agreed by Irish Revenue. According to that ruling, the net profit attributable to the AOE branch would be calculated as 65% of operating expenses up to an annual amount of USD [60-70] million, and crucially, in addition it was agreed to accept a mark-up of 20% on costs in excess of $[60-70] million in order not to prohibit the expansion of the Irish operations.

The Commission made clear that its investigation was focused these TP arrangements. It asserted that the reduction of the margin after a certain level above USD [60-70] million would have been motivated by employment considerations, which is not a reasoning based on the arm's length principle. In particular, the two margins of 20% and 65% are relatively far apart and, should the margin of 65% effectively constitute an arm's length pricing, the margin of 20% would be unlikely to fall within the same range of pricing while applying the same degree of prudence.

However, this relates to how much profit is attributed to the Irish branches and doesn't establish that all of the profit of these companies is taxable in Ireland. The agreements were on a "cost-plus" basis, so essentially were unrelated to the revenues and profits of the overall company which have accelerated dramatically since 2007. It is probable that the EC will rule against Apple on these grounds.

However, this matter is unrelated to the worldwide income attributed to ASI and would not bring the taxability of the $120bn or some of the absurd headline figures that have been floating around into question. Bloomberg Intelligence reckons the recovery of profits from favourable APAs, based on gross margins, could still be large, estimating a sum of $8bn. I believe that this figure is still at the high end. Even if we are to assume the worst-case scenario and take the profit figures from the ASI filings obtained by the Australian Financial Review from 2004 to 2009 and the ASI filings from 2010 to 2012 made public by the U.S. Senate subcommittee, the profit earned by ASI between 2004 and 2012 is around $81bn. If the EC was to rule that this should be subject to Ireland's 12.5% tax rate, then Apple would be liable for around a $10.1bn clawback. This simple figure, albeit excluding ASI profits from 2013 and 2014 which are not yet available, is the worst possible case, which would lead me to believe the $8bn Bloomberg estimate is on the high end of the scale. Moreover, the actual ruling may bode far more favourably for Apple than the market is currently pricing in. In any event, the Irish government has signalled its reluctance to accept such a windfall, and Tim Cook has of course stated his intention to fight an unfavourable ruling, which would make for a long, arduous process.

When will we get a ruling on the matter? The Financial Times is of the belief that the EC's delay in delivering a judgement has been on account of not wanting to influence the result of Ireland's general election last February. A ruling against Apple and the Irish government would likely have provided ammunition to the rising left in Ireland which is deeply critical of Ireland's accommodative policy for attracting multinationals. The FT had predicted a ruling to be made by this summer, but Vestager has warned "don't hold your breath".

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.