On December 19, 2016, the European Commission (hereinafter ‘Commission’) published its final decision in the Apple State aid case. The Commission concluded that two tax rulings granted in 1991 and 2007 on the allocation of profits to the Irish branches of Apple Sales International (‘ASI’) and Apple Operations Europe (‘AOE’) amounted to illegal state aid, and ordered Ireland to immediately recover this aid from Apple. The key issue in the Apple decision is where Apple’s foreign income ($187 billion, as of 2016) should be regarded as being generated. In our opinion, there is almost no basis for any argument that two-thirds of the profits of Apple Inc. were generated by functions performed, assets used and risks assumed in Ireland, where only 4 percent of its global workforce and approximately 1 percent of its customers are located. Indeed, under traditional principles, profits originate and taxes are due where value is created – that is, where the research and development is conducted. Accordingly, since almost all of Apple’s research activity takes place in the US, Apple should remit most of its taxes there.

However, this view, recently upheld by Jacob Lew, Neelie Kroes and Pascal Saint-Amans, does not take into account that 60 percent of Apple’s total net sales occurs overseas and the significance of customer markets in value creation. In addition, it is also inconsistent with the position taken by the Internal Revenue Service (‘IRS’) in the Glaxo case, ie, intangibles derive their value primarily in the country where marketing activities are carried out and not where research and development activity is performed.

Our paper discusses how the arguments presented by the IRS in Glaxo can be used by high-tax EU countries to justify locating extra profits to sales and marketing support operations performed by Apple Europe retail subsidiaries. While ordering Ireland to recover €13 billion in illegal tax benefits, the Commission left the door open for other tax authorities to claim for Apple’s commercial risks, sales and other activities that might have taken place in their countries.

In the Glaxo case, the main question was whether the profits made by GlaxoSmithKline plc (a multinational group involved in the pharmaceutical business headquartered in the UK) in the US were primarily attributable to: (i) the UK research and development activities from which resulted Zantac that became the best selling prescription pharmaceutical product in the world beginning in 1986; or (ii) the marketing and launch expenses incurred by the US subsidiary of the Glaxo group. The transfer pricing policy used by the Glaxo group resulted in the majority of the profits being allocated to the UK parent company, on the grounds that the unique characteristics and high quality of Zantac, one of the products discovered at Glaxo UK’s research facilities, were the main reason why Zantac had the greatest US market share in 1987. The IRS denied and alleged that if Glaxo US was able to sell at a premium price, it was the result of its extraordinary efforts and expenditures that were unique, intensive, aggressive, costly and beyond standard industry practices. The IRS also looked at the contractual terms of the 1987 license agreement and stated that the entrepreneurial risk was shifted to Glaxo US, by guaranteeing Glaxo UK a fixed sum regardless of the products supplied. Finally, the IRS argued that Glaxo US was not entitled to deduct the royalties it paid regarding trademarks and other marketing intangibles because Glaxo US was the owner for tax purposes of the trademarks and marketing intangibles licensed from Glaxo UK. For all the above reasons, the IRS allocated to Glaxo US over 80 percent of Glaxo’s total worldwide profits on Glaxo UK’s sales and distributions in the US. The case was settled by the parties before trial. Glaxo US paid the IRS approximately $3.4 billion. Under the settlement agreement, about 60 percent of the profits were allocated to Glaxo US and the remaining 40 percent to Glaxo UK.

In our paper, we argue that this case has broader implications for the State aid issue for several reasons. Firstly, the IRS took a new approach claiming that the value of marketing efforts prevails over the value of patents and technical know-how. That approach helps the argument that Apple Irish’s profits stem in part from high-tax EU countries, such as France, Germany, Italy etc, and should be subject to tax there. Secondly, the IRS presented very interesting arguments that can be used by other tax authorities against Apple Inc. in determining arm’s length compensation for intangibles developed by Apple foreign distributors. For example, the IRS argued that Glaxo UK under-compensated Glaxo US for selling Zantac in the US. The same policy was followed by Apple Inc. Indeed, as argued by Harvey, Apple’s retail subsidiaries located in various countries around Europe appear to have only received relatively small commissions for the distribution and sale of Apple products into their respective countries. Thus, EU tax authorities might seek to either (i) increase the small commission that Apple Europe’s retail subsidiaries received for the sale of goods to customers, or (ii) reduce the price of the manufactured products, that Apple Europe’s retail subsidiaries were required to purchase from ASI. As stated by the US Senate Report, when it re-sold the finished products, ASI charged the Apple affiliates a higher price than it paid for the goods and, as a result, became the recipient of substantial income. In addition, EU tax authorities might also look at the economic substance of the dealings between ASI and Apple Europe’s retail subsidiaries and assert that a royalty should not be imputed from these foreign affiliates because they bore the costs and risks for development of the Apple trademark. Intercompany payments of (deductible) royalties are, indeed, one example of earnings stripping strategies used by multinationals to move profits from subsidiaries in high-tax countries to other jurisdictions with lower or no taxes.

We believe this is the right way that EU Member States should pursue if their desire is to tax Apple and other US-based multinational corporations on their trillions of profits that: (i) are untaxed by anyone, and (ii) can arguably be said to stem in part from EU countries.

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