I have had a glorious 24 hours since the EU Commission tax ruling #nerdalert. Mostly, I’ve enjoyed the complete insanity of an unelected EU Commissioner telling a sovereign country:

“Hey Ireland. We’ve decided that you’re owed a lot of money by Apple, because you were so very naughty in giving them a favourable tax ruling that we’ve now decided was actually too much of a helping hand. And, er, competition. So to punish you, and set an example for all these other companies and countries, we’re insisting that you bill them the largest tax bill in history, and earn yourselves a cool €13 billion. And let that be a lesson to you, nasty child.”

At which point, Ireland’s Finance Minister responded with:

And then the US Treasury got involved by saying a number of things:

• “Oi – that’s our uncollected tax revenue that you’re talking about!”
• “OMG – hang on – Apple could claim that €13 billion as a foreign tax credit here in the US (!!) – it really IS our tax revenue that you’re talking about!!!!”
• “The EU is turning itself into a supranational tax authority, and we are having none of it.”
• “#COOLINGTRADERELATIONSTHOUGH”
• “The EU is systematically targeting US companies, and also, ditto, how very dare you.”

Apple’s basic response:

*Yawn*

And then Tim Cook wrote this really great letter to shareholders and customers (although I skim-read through the first part about creating employment, etc – because that’s not so spicy). Some extracts:

As our business has grown over the years, we have become the largest taxpayer in Ireland, the largest taxpayer in the United States, and the largest taxpayer in the world.

Over the years, we received guidance from Irish tax authorities on how to comply correctly with Irish tax law — the same kind of guidance available to any company doing business there. In Ireland and in every country where we operate, Apple follows the law and we pay all the taxes we owe.

The European Commission has launched an effort to rewrite Apple’s history in Europe, ignore Ireland’s tax laws and upend the international tax system in the process. The opinion issued on August 30th alleges that Ireland gave Apple a special deal on our taxes. This claim has no basis in fact or in law. We never asked for, nor did we receive, any special deals. We now find ourselves in the unusual position of being ordered to retroactively pay additional taxes to a government that says we don’t owe them any more than we’ve already paid.

The Commission’s move is unprecedented and it has serious, wide-reaching implications. It is effectively proposing to replace Irish tax laws with a view of what the Commission thinks the law should have been. This would strike a devastating blow to the sovereignty of EU member states over their own tax matters, and to the principle of certainty of law in Europe. Ireland has said they plan to appeal the Commission’s ruling and Apple will do the same. We are confident that the Commission’s order will be reversed.

And also, this:

Using the Commission’s theory, every company in Ireland and across Europe is suddenly at risk of being subjected to taxes under laws that never existed.

So what is actually going on?

Well, of all the content that I’ve now consumed on the Apple-Ireland-EU tax drama, by far the one I like most was this white paper from the US treasury, entitled “The European Commission’s Recent State Aid Investigations Of Transfer Pricing Rules”.

Isn’t that a funny term: ‘state aid’?

And that’s where this all gets so tricky, because the EU Commission is apparently trying to destroy Ireland’s status as a tax-haven through the backdoor by applying anti-competition rules to their taxation policies. It’s very weird.

Firstly, some background for tax law when it comes to multinational companies:

• The problem with multinational companies is that they operate in so many countries.
• All of those countries have their own tax codes.
• And if left unchecked, multinationals could freely shift their profits to whichever country has the best tax code.
• You do it like this:
  • Let’s say that Country A has a tax rate of 50% and Country B has a 5% tax rate.
  • Take Apple – it wants to sell 100 iPhones in each country for $1,000 each.
  • Each iPhone costs $300 to make, and they get imported from China.
  • If it could, Apple would get Country B to import 2,000 iPhones from China at $300 each.
  • Country B would then sell 1,000 iPhones locally for $1,000 each, and then sell the other 1,000 iPhones to a sister company in Country A, ALSO for $1,000 each.
  • That is, the cost of the iPhone for the company in Country A would be $1,000, and it would sell it for $1,000 – and hey presto – there’s no profit in Country A to be taxed at 50%.
  • Now all the profit is sitting in Country B, to be taxed at 5%.
  • This is basically the definition of Transfer Pricing, where multinationals are incentivised to artificially control the pricing between their subsidiaries in order to push profits into friendlier tax jurisdictions.
• In order to stop that happening and/or minimise it, most countries have put in place ‘Transfer Pricing Rules’.
• This is delicate international-negotiation stuff, because Country B doesn’t want to lose half its tax revenue, while Country A wants its tax revenue that it should have earned.
• So in order to keep it fair, over time, standards of Transfer Pricing have been developed and agreed. These basically lay out an ‘arm’s length’ treatment of these transactions. That is, how to measure these types of transactions as though they were taking place between independent companies transacting at arm’s length.
• In particular, the OECD countries have established a kind of best practice for transfer pricing – which have basically become the international standard for dealing with multinationals.
• Ireland and most of the EU countries abide by those OECD guidelines, and have incorporated them into their domestic laws, and have issued tax rulings to companies like Apple based on them.

The short version is: most countries in the world now follow the OECD guidelines for transfer pricing, and the EU countries are no different.

However.

The EU Commission has now come along, and said:

“So, we’re ignoring those OECD guidelines. We know we’re not a tax authority, but we’re going to apply our own interpretation of what we believe transfer pricing is. And what’s more, once we’ve given you our interpretation, we’re going to insist that you should have known our interpretation all along, and we’re also going to insist that you go back and re-do the tax returns as if you’d known our interpretation all along.”

Specifically, here’s the wording that they’ve used:

That decision to abandon the OECD guidelines has allowed the EU Commission to make all kinds of weird rulings, like deciding that the Starbucks brand has no value: and therefore, that no royalty fee could be charged by Starbucks to coffee shops that operate under the Starbucks banner.

A Metaphor for the Non-Tax People

To get an idea of how outrageous that sounds, here’s a similar scenario:

Your parents raised you, and kept you clothed and fed and dressed, and paid for your education, up and until you went off at the age of 25 and became a high-flyer in the family business.

At this point, a tax agent appears on your doorstep, and says:

“Hey. We’ve decided that we’re going to address your privilege, and we can’t believe what an easy life you’ve had. If you were another kind of person, then you might not have had all the advantages of free board and lodging up and until you were 25. So now, we want you to pay for it. We’ve calculated that you owe your parents R30 million in back-compensation for all the benefits that they’ve given you. We’ve spoken to your parents, and we understand that they don’t want the money, and that they just thought that they were being good parents, and that they were allowed to do it. But frankly, we don’t believe that’s how the world should work – and we think you should have known that. So pay up.”

…

“PS: we hear that your dad has cancer, and that he only has 3 months to live. Oh, you didn’t know? Awks. But just so you know, we’re including that R30 million in his estate, and we’ll be assessing full estate taxes on it. You may have to sell the company. We’ll, ah, chat soon. K, bye.”

Fun.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.