Following an in-depth investigation formally launched in June 2014, the European Commission has recently concluded that Ireland granted tax benefits of up to €13 billion to Apple in violation of the State aid rules. As a result, Ireland must now recover the illegal aid. That decision has been sharply criticized by Jack Lew, the US Treasury Secretary, who believes that only the Internal Revenue Service (IRS) has the right to tax Apple’s foreign income, since the vast majority of the company’s research activity is performed in the United States. However, that is not the way the big EU countries, where sales are made, see things. Our paper seeks to answer the following question: where should Apple’s foreign income be regarded as being generated?

The first part of the paper is dedicated to the analysis of the international tax structure of Apple and how it achieved the double non-taxation on its foreign source income. Apple Inc was able to remit little or no corporate income tax on its overseas income through the combined effect of various tax planning techniques.

Firstly, the economic rights of Apple’s intellectual property were transferred to Apple Operations Europe (AOE) and Apple Sales International (ASI), under a cost-sharing agreement. Cost-sharing is a regime introduced by the Treasury and the IRS in the early 1990s. Under cost-sharing, the US parent enters into an agreement with a controlled foreign corporation (CFC) to share the costs of developing an intangible. Importantly, none of the actual work is done by the CFC: most of the research and development takes place in the US. The CFC contributes a portion of the costs (eg 60%), which it can do by simply receiving a contribution from its parent and paying it back. If the development is successful, the CFC is then entitled to 60% of the profits from the intangible. Under IRS regulations, this is permitted because, if the research is unsuccessful, the taxpayer risks losing its ability to deduct the costs sent offshore. Thus, the IRS thought this would inhibit the taxpayer from taking too aggressive a position in their cost-sharing agreements.

Secondly, a portion of Apple’s profits derive from countries where its products are sold to final customers. ASI licenses the right to use Apple’s brand and intellectual property to Apple retail subsidiaries located in various countries around Europe. Those affiliates in turn pay substantial royalties. The result is that profit earned in those countries is shifted to Ireland. From the EU perspective, this was made easier by Directive 2003/49/EC which eliminated all withholding taxes at source on interest and royalty payments made between associated companies of different Member States. From the US perspective, before 1997 such a scheme would not have worked because those intercompany deductible payments would have been subject to tax in the US under so-called Subpart F. But, in 1997 the Treasury, under the Clinton administration, adopted a rule called “Check-the-Box” under which US multinationals can choose to treat, solely for US tax purposes, foreign corporations as tax transparent rather than separate taxable entities. The result is that, for US tax purposes, deductible royalties and interests paid from those entities to other CFCs are disregarded and do not give rise to Subpart F income.

Thirdly, Apple exploited a mismatch between Irish and US tax residency rules. Ireland uses a central management and control test, while the US applies the place of incorporation test. Therefore, for US tax purposes, AOI, AOE and ASI were treated as Irish companies because they were incorporated in Ireland. But, for Irish tax purposes, they were treated as American companies because their central management and control was exercised in California. As a result, AOI, AOE and ASI claimed to have no tax residence anywhere.

Finally, Apple has negotiated with the Irish Government a special corporate tax rate of less than two percent on the profits attributable to its Irish branches.

The second part of the paper is dedicated to the analysis of EU Commission’s reaction. By comparing the letter sent to the Irish Government with the recent press release, we argue that the Commission’s finding reflects an attempt to improve source-based taxation of active income by high-tax countries, in response to the void that the Treasury inadvertently or deliberately created in 1996 when it extended the “Check-the-Box” regulations to the international context.

Indeed, the Commission invited other Member States to revisit the question as to whether some of the profits should have been taxed in their jurisdictions. It suggested that, if higher profits should have been taxed elsewhere, the amount to be recovered by Ireland would be reduced.

Whether State aid is the right tool to fight against aggressive tax planning or not, we conclude that this might be the right occasion to reform the current framework of international tax rules, which allows Apple to claim that most of its profits originate from Ireland, where less than 1 percent of its R&D is conducted and where just 1 percent of its total customers are located. The taxing rights over Apple’s foreign income should ideally be shared between the US, where value is created, and foreign countries, where products are largely sold.  

Reuven S. Avi-Yonah Irwin is the I. Cohn Professor of Law and Gianluca Mazzoni is an SJD Candidate and an LL.M graduate (2016), both from the University of Michigan