The Apple Judgment[1]
On July 15, 2020, the European General Court published its long-awaited judgment in the Apple “state aid” case.[2] At issue is whether Ireland “aided” Apple by providing tax rulings limiting Irish tax to an agreed measure of the branch profits attributable only to activities in Ireland of two Apple subsidiaries that were not tax residents of Ireland or resident anywhere else, notably excluding any return associated with Apple intellectual property.[3]
Impermissible state aid exists under subsection 107(1) of Treaty on the Functioning of the European Union (TFEU) if a country’s resources are deployed essentially to subsidize the commercial affairs of private parties or the economic and industrial sectors in which they carry on business, with the effect of providing a selective trade distorting advantage over competitors and in result distorting the economic and fiscal circumstances of other EU countries whose prospects are disabled by the actions of the offender. Selective or preferential taxation, often associated with transfer pricing, has been a prominent and is a recurring focus of the Commission’s inquiries into state aid alleged to have been provided to businesses by a number of countries including notably Ireland, Luxembourg, The Netherlands, and Belgium.
State aid inquiries involving rulings practices, again with a view to detecting selective advantage, have also included Gibraltar. It needs to be emphasized at the outset of these comments that a country’s provision of “aid” via its tax system is not for that reason alone impugnable in relation to the TFEU; what makes it so is “selectivity” and “advantage” with the consequential implications of trade distortion. A tax system feature that provides financial support is not generally thought to be “selective” in the sense contemplated by subsection 107(1) of the TFEU if its benefit is generally applicable, essentially as a feature of a country’s tax system although recent decisions of the European courts may be seen to have blurred this distinction. A related observation is that tax practices that may be thought to constitute “base erosion” in the sense threading through the Organisation for Economic Development’s (OECD) “base erosion and profit shifting” (BEPS) project may not, given the requirements of “selectivity” and “advantage”, constitute “state aid” as contemplated in the TFEU although commonly, and perhaps too commonly, the two are conflated. These are important considerations to bear in mind for the balance of these comments. In particular, the distinction between selective aid and aid that is not considered to be selective may be less easy to establish than would be expected, leading to recent decisions of the European courts that merely the architectural features of a tax system that directly, indirectly, effectively or even covertly provide some kind of assistance to taxpayers could constitute state aid even without the particular taxpayers, industries or economic sectors overtly being the objects of that assistance.
Even so, however, in a broader sense the BEPS inquiry fundamentally does concern some manner of intervention by countries through their tax systems that has, and even may be meant to have, economic effects that change the pattern of trade as it would otherwise occur. As noted again later in these comments, this effect is one of the factors lying at the centre of “modern” parameters and rules associated with “international taxation”, originating with the work of the League of Nations in the early part of the twentieth century as, at the same time, “income” taxation took wider hold. And, because the architectural features of tax systems are not accidental – even though sometimes their effects may be surprising or unintended – and their objects more often than not in the deliberate focus of countries’ fiscal policies, the possible opacity of “selectivity” and “advantage”, as conceived by the EU in the TFEU or more broadly is readily understandable. And, to what seems to be a significant degree, the general implications of a seemingly preferential tax outcome evidently affected the European Commission’s context with Apple even though the General Court effectively decided that there was no preferential taxation, at least in so far as the Commission had tried to make its case. In that regard, though, as a possible brake on the enthusiasm with which the Apple decision may be received, the Court found significant deficiencies in the Commission’s work underlying the case and hints that had that work been more thorough and careful, possibly the outcome would not necessarily have been the same. In other words, bluntly, in the Court’s view the Commission failed to make out is case.
How Tax-Based “Aid” – or “Subsidy” – May Arise
In the transfer pricing realm, the alleged aid commonly arises from tax rulings – we would say, “advance pricing arrangements” – fixing an agreement about applicable methodology and, necessarily its outcome, between the tax authorities and taxpayers about the acceptable degree of source country taxation taking account of the relative significance of local source country business contributions of a taxable enterprise. Otherwise, a more recent dimension of state aid inquiries, reflected in recent decisions of the European Court concerning, for example, the application of Spanish sectoral tax (though not in relation to a tax system as such although an earlier Spanish case did raise the tax system issue), Luxembourg income tax and Hungarian progressive turnover tax – and epitomized by judgments of the General Court in the recent Fiat and Starbucks cases[4] in the Fall of 2019, is on whether merely the systemic characteristics of a tax system, narrowly or broadly construed, that in the ordinary course of its application reduce taxation in applicable circumstances are sufficient to constitute offending aid.
“Aid” and “Subsidy” are in the Eye of the Beholder – Perspective Matters
The Report by the OECD for Action 11 of the ongoing BEPS project that now envelops much of the tax world is a sobering point of reference for the Apple case and, more generally, the common use by countries of their tax systems to enable their fiscal policy choices. These choices include key aspects of countries’ social welfare systems as well as the objects and modalities of economic development with reference to their economic resources and capabilities. Action 11 aims to define and then measure “BEPS”. Yet, shed of its extended narrative, the Report says two things that are of general significance and of which the Apple decision is a sympathetic reflection even though BEPS and trade / competition regulation are not the same and need not yield the same outcomes despite in cases such as Apple being fueled by the implications of avoided tax whether by legislative design or happenstance.
First, we do not really know what BEPS is, because perspective matters in evaluating the allegedly destabilizing effects of a country’s tax policy and legislation and the private law regime to which tax law is accessory. What may be seen as unwarranted base erosion by a country where a taxpayer undertakes income earning activities may be the outcome of deliberate, and normative, fiscal policy of another country, say the taxpayer’s residence country. The effect is to form a kind of financial partnership of sorts between that country and its taxpayers to fund and encourage features of its social and economic life through activities that private taxpayers are well situated to identify and perform and from which the country benefits. No doubt, there is, or may be, avoided tax of that country that inures to the immediate benefit of the affected taxpayers. But presumably, the quid pro quo for what amounts to or may be seen to have the same effect as interest – free government financing is sought after economic development of comparable benefit. Second, even if BEPS was amenable to a universal definition, which seems as if there would need to be consider able harmony among affected countries’ fiscal conditions, we do not know how the effects or features of BEPS would incontrovertibly or even clearly be measured. Critically, all of this occurs in an international environment of countries’ own legal and tax regimes, none of which necessarily is the same as or systematically devised and orchestrated with those of others.
I hasten to say at the outset that a significant issue exists about the extent to which tax law should influence trade and competition law analysis and decisions. As the Court in the Apple case seems to recognize and even insist, “state aid” is not the same thing as “base erosion and profit shifting”, BEPS - and BEPS is not the same thing as or controlled by notions of “aid” or “subsidy”. As noted earlier, it may well be that BEPS outcomes will not be considered impugnable “state aid” if the requisite “selectivity” and “advantage”, which are two distinct and separate requirements, as contemplated by subsection 107(1) are not present, although as also noted and the Apple Judgment reflect, what constitutes “selectivity” and “advantage” is not always easy to establish and to some extent, it seems, may be influenced by perspective, as the OECD’s Action 11 report, too, reflects. However, it is hard to escape that the underlying tendencies of official concerns in both areas arise from how countries use their financial resources. And, as other observations in this commentary reflect, not collecting tax that otherwise is or could be due is tantamount to an affirmative “use” of financial resources, it being left to the particular regulatory discipline, tax or trade and competition, to determine if this is intrinsically bad. “Aid” in the TFEU sense is not defined with reference to or confined by the analytical tenets of BEPS, focusing as it does not only on the effects of tax not collected but a country’s motivation relative to its peers in engineering or accommodating such an outcome. And, BEPS is most commonly associated with outcomes in circumstances, unlike competition law framed by the TFEU or trade law more generally, lacking an universally applicable legal regime but nevertheless tax liabilities are thought to have been manipulated to the detriment of otherwise deserving and entitled fiscs. I want to be clear as is evident in the Apple Judgment that BEPS and “state aid” ought not to be confused or conflated; but by the same token, they do intersect even if they serve different or at least not entirely the same objectives. In both cases, but from separate but seemingly intersecting perspectives, both are concerned with overt or covert discrimination by countries, including through the instrumentality of their tax systems, to alter the course of trade with inevitable and no doubt often intended economic outcomes even if not malicious in relation to the interests of other countries incidentally affected by them. Again, though, in relation to the TFEU, “selectivity” and “advantage” are not easily established categorically and to some extent, like BEPS, may be said to exist in the eye of the beholder
An important aspect of BEPS that receives little if any attention is why countries may quite intentionally be prepared to relinquish tax by legislative design in pursuit of their fiscal objectives and why, therefore, avoided tax – more neutrally tax that legal and tax systems communicate may not be payable assuming satisfaction of certain underlying legal conditions – may not be “tax avoidance” associated with “bad behavior” of countries and their taxpayers. But avoided tax, whatever the motivation, is like money fungible. Avoided tax may be “aid” because of the fiscal motivation giving rise to it in the first place. The tax and competition / trade regulatory regimes are inextricably linked in this way and to this extent, even if their objectives may not be entirely consonant. And underlying both is detecting where income earning activities take place, to test whether and to what extent private law constructions – entities and contracts – should have any influence on whether tax is exigible and whether somehow it has been “forgiven” by misadventure or fiscal design to serve fiscal interests.
A not uncommon reaction to this line of thinking is a concern about what is perceived to be an inevitable “race to the bottom”, as taxing jurisdictions would seek to outpace each other with tax accommodations of private enterprise, cannot be ignored. But that outlook, too, has a context, including in the BEPS environment which is focused on this possibility. What the BEPS inquiry targets is the avoidance of tax that “should” be levied and collected, not the tax that should not. In that regard, the focus of much of the BEPS project’s work, though possibly not expressed in so many words, is to detect jurisdictions with which income and the means by which it is earned cannot reasonably be thought to have any necessary or, in fact, actual or observable connection, leaving the unallocated pool of income to be assigned to those jurisdictions for which a meaningful connection can be established. This does not dispense with possible disagreement about the shared allocation of this income, but it does remove from the sharing equation interventions that are merely organizational or structural but not productive. The watchwords of the BEPS analysis are “meaningful connection” – my words, not the OECD’s.
The Apple outcome, at least in so far as taxation within Europe is concerned, can withstand scrutiny according to this test. It would be said that neither Ireland nor anywhere else aside from the US could establish a meaningful connection to Apple’s and the two subsidiaries IP-related profits, the main point of contention in the case. Even so, as the Court recognized, quite apart from Apple’s organizational structure, the strong and indeed reasonable likelihood is that Apple’s IP is mainly the responsibility of and originated with Apple in the US. It would be further said that the US’s legislative decision not to tax the income of its two subsidiaries is not quixotic but a direct manifestation of US fiscal and tax policy, even though other countries from their own perspectives and with their own interests in mind might take issue with it. In other words, the effect is as if the US would have taxed the two subsidiaries but in some manner or another relinquished that tax, conveying it back to Apple as financial support, for example as an interest free loan or in the rawest form a direct “subsidy” almost like a tax sparing credit. As earlier noted, however, the Court did not exclude the possibility had it been proved by the Commission that “aid” might have been provided by Ireland, although it recognized that most of the “subsidy”, notably the tax-induced subsidy, of Apple’s operations arose from how the US tax system applied (to the point, did not apply) with respect to the two Apple subsidiaries, focusing on Apple’s IP and its closest, in the Court’s view, association with Apple’s head office in California.
In Canada we are accustomed to taxing taxpayers, that is making them liable for tax, without subjecting them to tax. That is essentially how pension plans and other deferred income plans as well not for profit or other tax-exempt entities are “taxed”; to be relieved by exemption of a tax liability, that is to not be subject to tax, it is first necessary to be liable for the tax – in effect it is an affirmative assessment of tax but the tax is levied effectively at a zero rate. This is not out of national generosity, but in the national interest, the expectation being that underlying fiscal and economic objectives will be served if only eventually. The relief from the tax by legislated limitations in the Income Tax Act is, in other words, an act of taxation – an expression by the law, according to a pre-existing tax liability, of how much tax to collect. Limitations are the product of fiscal policy decisions – deliberate intercession in the tax that would otherwise by paid, presumably with important ulterior social welfare and economic goals meant in result to be achieved.[5]
It is this sort of more critical analysis, however, that makes the Apple case so difficult to address and so charged with international tax controversy, particularly in the BEPS environment. The country that, it may be said, did subsidize the Apple subsidiaries – the United States - is not an EU country, is not part of or subject to EU law. For discussion at another time is what the influence of third country aid or subsidies ought to be, that is aid or subsidy from outside the regulatory region and the compass of its law. Yet it almost goes without saying that the financial boost enjoyed by Apple from its non-EU government, the US, is not something its competitors are able to realize and the Commission’s concern that this could be destabilizing within the EU is hard to contest. But as is a recurring theme in these comments, not all countries are alike or similarly motivated in their fiscal situations. The texture and resources of their societies in large part dictate the fiscal choices they make which are only enabled by taxation. Not surprisingly they are not necessarily aligned, let alone systematically co-ordinated on what their respective fiscal policies are or should be or how they should be enlivened by tax policy and legislation. What is lacking is a “common standard”, which together with rethinking dispute resolution forums, are two main considerations in the BEPS debate.
More broadly, the underlying question in the ongoing international debate, including as it is present in trade and competition cases like the Apple case, is how self-effacing, how deferential a country must be in its fiscal policy as it would be enabled by tax policy and tax legislation, in relation to the fiscal policy of other countries the circumstances of which – the choices about what constitutes a “civil” society – are not the same. The related question, also understated, is why a country would be deferential to the circumstances of others – certainly some measure of international comity among nations is warranted and present, but beyond that countries are economic actors in relation to each other and they do make “bargains” in their own interests just as private contracting parties do in much more mundane settings.
Possibly, like many seemingly complex questions, it comes down to a much simpler though no less knotty issue. This is whether within a region such as the EU that functions in many respects as a single jurisdiction or more broadly in a larger international context, tax regimes ought to be judged and possibly moderated in their application by trade and competition effects, necessarily infused by fiscal policy. This is not a new question; a primary catalyst for “international taxation” in the form we take for granted was the recognition in the 1920s and 1930s by the League of Nations that uncoordinated intersecting but otherwise legally sustainable tax claims would distort trade. In effect this question asks whether countries should be limited in their fiscal policy by that of others the circumstances of which are not necessarily or even likely the same, and if so only in the interest of international comity or because of their respective self-interests, and even so whether trade and competition law should be the forum for this debate. An exception, outside the trade context as such, would be tax rules dealing directly with non-discrimination, for example in non-discrimination articles of tax treaties, and limitations on the use by countries of their laws to undermine international treaty commitments, for example Article 27 of the Vienna Convention on the Law of Treaties, may provide.
It does seem that all of this comes down to the even more fundamental question, which lies silently at the centre of the tax world’s preoccupation with base erosion according to ostensibly universal principles. To say it again, that is whether a country is or should be limited in its fiscal policy by other countries that have their own but not unlikely different fiscal policies to suit their notions of national civility, even respecting some degree of multilateralism and related good faith dealing among countries. In other words, one size may not fit all, and the focus is or ought to be on sorting out the intersection of meaningful intersections of countries economic circumstances, legal systems and tax claims, not making them somehow more alike than not.
To orient the Apple case and show the significance of its underlying issues for tax situations generally, and to highlight the conundrum underlying BEPS of which the Apple case is an example, we might think of these questions in the following way. Does Canada subsidize its corporate taxpayers by not taxing the “exempt surplus” of their “foreign affiliates” as long as that surplus remains in corporate solution somewhere, and is that “aid” amplified by allowing those taxpayer to deduct in computing Canadian taxable income financing costs, i.e., interest, associated with money borrowed to capitalize the income earning activities of the foreign affiliates? Ought Canada to do that? When in the late 1990s the OECD initiated its aborted study of “harmful tax competition” – which morphed into a study of tax transparency and reporting in the 2000s – a tax regime with these characteristics and notably our character preservation rule in subparagraph 95(2)(a)(ii) of the Income Tax Act was high on the list of offenders. We take for granted that both features of the Canadian tax system are more or less uncontroversial, sometimes more sometimes less, but that they are normative features of the Canadian system. Again, however, even if we regard these features of the Canadian tax system as delivering “subsidy” nor “aid”, particularly concerning the deduction of financing costs, if seen through the lens or subsection 107(1) of the TFEU, the “selectivity” and “advantage” elements still would need to be established to constitute “state aid” in the TFEU sense. However, more broadly this discussion does focus attention on the fiscal policy origins of components of a country’s tax, illustrating how difficult it may be to criticize or impugn that country’s fiscal policy according to judgments made from the perspective of another country or countries that do not share the same underlying social and economic characteristics or resources, and in any event which have different views about what may be described as the “social contract” among its citizens that ultimately is what tax policy and tax legislation serve. There is a “motherhood and apple pie” adage that may be apt in this more rarefied fiscal and tax context, to the effect that before judging another one should first take a few moments to imagine being in the shoes, the circumstances of that other.
Income Tax and Trade
A broader issue, though, that is noted here but will be left for another time to explore more fully, is whether according to trade regulation to which Canada is subject via various trade agreements and according to its membership in and adherence to the rules of the World Trade Organisation, is whether direct (income) taxation may constitute unwarranted subsidy and discriminatory trade or competition practice? It is commonly, though incorrectly, thought that trade and competition regulation only apply to indirect taxes. This is not in fact the case as, among indications, the Apple judgment reminds us.[6] A recent trade agreement to which Canada is a party for which the kinds of considerations noted here, notably the influence of direct taxes as prohibited trade irritant, are relevant is Canada-European Union Comprehensive Economic and Trade Agreement (CETA); Chapter 7 of that Agreement deals with subsidies as they are conceived in the seminal WTO Agreement on Subsidies and Countervailing Measures (the SCM Agreement).
Interestingly, as notable context, the United States was embroiled in a General Agreement on Tariffs and Trade / WTO case from the 1970s through the 2000s concerning tax reduction it provided in the Internal Revenue Code for income earned by taxpayers from selling and distributing their product internationally, first via “Domestic International Sales Corporations” (DISCs) whose foreign sales profits were not taxed in the normal way and then, in the face of GATT complaints about them “Foreign Sales Corporations” (FSCs), both the object of successful WTO actions against the US. In the case of DISCSs, foreign branch profits were tax-preferred; in the case of FSCs income of what we would call foreign affiliates (in US terms, “controlled foreign corporations”) that, in our terms would have navigated principally paragraphs 95(2)(a.1) and 95(2)(b) enjoyed the tax reduction. In both cases, by not taxing US taxpayers’ foreign business profits or at least deferring taxation indefinitely, those taxpayers enjoyed what effectively amounted to costless financing from the US government, much as our foreign affiliates do according to how foreign incorporated business activities may be financed and profits not taxed. With the added catalyst of transfer pricing, these are essentially the Apple case.
Now … the Apple Judgment
Despite the detailed thoroughness of the European Commission’s initial decision from which the appeal to the General Court was taken in the Apple case and the General Court’s painstaking and rigorous analysis in its Judgment, the case is very simple.
Two indirect Irish incorporated subsidiaries of Apple, Apple Operations Europe and Apple Sales International, that were not Irish residents and therefore were not fully taxable in Ireland (in the sense that we would explain using the kind of analysis found in the Canadian Supreme Court’s Crown Forest decision) carried on “branch” businesses in Ireland to sell and distribute Apple products, and in the case of one of them to manufacture those products, for sale and distribution in regions outside North and South America, nevertheless according to Apple’s overarching business practices, policies and procedures, and governance. Also, the two subsidiaries were parties to a “cost sharing agreement”; in exchange for contributing to the cost of Apple R & D, they were entitled to use pertinent intellectual property in the regions where they conducted business, royalty free. The Irish tax authorities and Apple agreed on the limited amount of income associated with and arising from the Irish business operations – “functions” and “risks assumed” in Ireland and memorialized their determination in a tax ruling. The balance of these subsidiaries’ income was not taxable anywhere including by the US despite evidence that the observable business reality outside Ireland of these subsidiaries was meager and notwithstanding formal adherence to corporate governance practices these subsidiaries effectively were directed and managed at Apple’s US headquarters in California.
In short, the Court decided that: (i) Apple had not received the benefit of a trade distorting selective tax advantage from Ireland, (ii) the European Commission had misconceived the basis on which selective advantage attributable to preferential taxation should be determined under the applicable law, (ii) the European Commission had misconceived and in any event not applied correctly transfer pricing principles in the Organisation for Co-operation and Development’s (OECD) Transfer Pricing Guidelines including as they infuse the OECD’s “Authorized OECD Approach” (AOA) for attributing business profits to a permanent establishment according to the application of Articles 5 and 7 of the OECD Model Tax Convention, and (iii) in any event the Commission had failed to properly investigate and consider the evidence of Apple’s Irish business activities notwithstanding the leanness of the commercial presence and local governance elsewhere of the two Apple subsidiaries whose Irish branch activities were the object of the Commission’s investigation.
The Heart of the Judgment
The heart of the decision, regardless of the fine points of the applicable law, is the Court’s clear determination that the Commission essentially “blinkered” itself by applying what the Court referred to as an “exclusion” approach to measuring the Irish income. This is possibly an important observation even for transfer pricing practice in taxation generally, outside the trade and competition law context and indeed beyond the EU. Effectively, the Commission accepted the legal integrity of the two subsidiaries despite seemingly their more or less merely formal legal existence (which the Court noted Apple respected) but admonished the Commission for reverse engineering the transfer pricing outcome on which the state aid finding depended, by assigning income to the subsidiaries’ Irish branches that could not in the Court’s view reasonably be considered to have been earned in Ireland. The Court noted that neither of subsidiaries had an observable business presence anywhere but Ireland. Even so, however, it found the Commission’s transitive reasoning to be faulty that all their income including that associated with the development and application of valuable Apple intellectual property must be within the compass of the Irish tax base. The Court rejected, for legal and evidentiary reasons this approach which it saw as simplistic and wrong-headed and in any event without evidentiary support about what the subsidiaries actually did at the Irish branches and how little responsibility, that is, assumed risk, they had for the activities they conducted and products they sold and distributed or manufactured, as the case may be. In other words, the Commission had, in the Court’s view, assumed and constructed its case on the basis that the income of the subsidiaries was entirely European, and within that “box” there was only one corner where it could be found – where observable activities took place.
The analysis was blinkered, as the Court effectively decided, because in its European centricity and focus, including its concentration on the material insubstantiality of the subsidiaries, the Commission failed to acknowledge the obvious “real” source of most of the subsidy, namely the US. There is an evident sense in the Judgment that the Court also thought that Ireland might also have provided aid though proportionately small in relation to that it inferred originated in the US, but nevertheless the Commission’s analysis on this point and more generally on transfer pricing and the arm’s length principle was so deficient that it failed to prove this. Apple IP was at the core, so to speak, of the case and there was no hiding the fact that apart from boots on the ground activities at their Irish branches the existence of the subsidiaries was more legal than “substantial” in any material or tangible sense. The Court observed the unlikelihood that the two subsidiaries were responsible for valuable Apple IP, which even according to their participation in the cost sharing agreement their interests such as they were in which did not arise, the Court said, from their branch activities in Ireland.
The case that would be made, should the US have chosen to make it, is that the subsidiaries carried on business, too, where they were directed and managed, namely California in the US. According to US tax law for taxing effectively connected branch business income of non-residents of the US carrying on business there – as determined by applying specific and detailed rules of “effective connection” in the US tax legislation – the argument is that the subsidiaries would be taxable in the US on income considered to be connected to the branch. United States tax law taxes corporations comprehensively by place of US incorporation. In the case of non-residents, at the risk of oversimplifying, the tax charge relies on the effective connection of income to a taxable presence – in our terms, carrying on business in the source country but also with a measure of connection determined by the legislation, not on a basis that we would regard as or associate with the common law residence test of central management and control. On this basis, the otherwise fallow income seemingly and according to how Apple pleaded its case arguably would default if anywhere to a US, not a European tax base. But evidently the US tax authorities and, of course Apple, did and do not see it that way. And, the financial effect of not taxing the balance of the subsidiaries income – presumably because it is not considered to be branch income under the US tax rules for effective connection – is to provide financial benefit to the subsidiaries and more broadly the Apple enterprise worldwide. Yes, there may be subsidy, but it does not arise from the tax law of any EU country – so the Court found.
This was not an obscure point in the case. Even if the US tax authorities would not otherwise have noticed it, it was in plain sight in Apple’s application to the General Court: In its pleading before the General Court, unabashedly and indeed it might be said courageously, Apple said the following[7]:
…The Commission made fundamental errors by failing to recognise that the applicants' profit-driving activities, in particular the development and commercialisation of intellectual property ('Apple IP'), were controlled and managed in the United States. The profits from those activities were attributable to the United States, not Ireland. The Commission wrongly considered only the minutes of the applicants' board meetings and ignored all other evidence of activities. [Emphasis added]
…The Commission failed to recognise that the Irish branches carried out only routine functions and were not involved in the development and commercialisation of Apple IP which drove profits.
…The Commission presumed that all of the applicants' critical profit-making activities were attributable to the Irish branches without properly assessing the evidence, including extensive expert evidence showing that the profits were not attributable to activities in Ireland.
Some Key Findings of the Court and Their Possible Connections to Canadian and Other Countries’ Transfer Pricing
The Court made several findings that apart from their immediate significance in interpreting and applying subsection 107(1) of the TFEU in Apple’s immediate context may have broader significance in transfer pricing even where issues of “selectivity” and “advantage” as contemplated by the TFEU are not relevant and the TFEU does not apply. In the remainder of this post, several them are noted with comments about how they might be pertinent to Canadian transfer pricing law and practice.
The Reference Point for (Selective) Tax Advantage
The Court confirmed that whether selective tax advantage existed was to be determined with reference to the generally applicable tax law of Ireland, that is of the particular country concerned and not any other country or according to some supervening even extra-legal principle, as it would have applied absent the contested tax rulings. This seems as if it should be obvious, but in EU state aid cases and, it may be noted, more broadly in connection with BEPS despite the separation of BEPS as such (though possibly not its tendencies) from competition law evident in the Court’s reasons, an underlying contention in international tax and trade discourse can be detected that income must be taxable, that is actually subject to collected tax, “somewhere”. Closely connected to that is whether there is some normative overarching or supervening standard or degree of taxation that must be borne, absent which steps are justified by any taxing jurisdiction to fill the gap. Inevitably, almost, this approach infuses questions of tax avoidance with judgment informed by standards and circumstances that may not have anything or not much, anyway, to do with the circumstance of any particular taxing jurisdiction or the taxpayer in respect of it. The Court in the Apple case rejected, with the benefit of painstaking analysis, any such notion. That the Court did this and that it did not do it in an offhand way but with care and attention to applicable law and in that regard an evidence based legal rather than philosophical examination of pertinent circumstances is more broadly significant in the BEPS era even apart from the specific limitations on “state aid” in and because of the TFEU when it applies. This also makes clear, indeed reminds us, that though “economics” essentially underlies any evidence associated with business and commercial dealings, we do not and ought not to tax on the basis economic perception but instead on the basis of the inevitable necessary configuration and expression of “economics” as evidence, which is a legal notion and not a matter of economic impression.
In the transfer pricing context, a taxpayer’s situation with reference to the relevant circumstances of the enterprise of which it is a part may be a pertinent point of inquiry, as contemplated by subsection 247(4) of the Income Tax Act. That said, though the fact that income of the group is not as taxable elsewhere as it might otherwise be by Canada or that the income fairly is not “Canadian” is not a basis for more severe Canadian taxation than the law otherwise contemplates. The Court also addresses systemic tax differences or outcomes within a tax system between different categories or circumstances of taxpayers and concludes that these differences are insufficient to establish selective advantage, or more generally outside the state aid context relative tax avoidance. In the Apple case, resident enterprises and the local branches of non-resident enterprises but otherwise similarly situated functionally, were comparable even thought the applicable scope of taxation for the latter was less. As noted earlier, the Court was critical of the exclusion approach – the income (from the IP licenses) has be somewhere and if there is nowhere else it must be Ireland evidence or not - taken by the Commission to attribute income to the Irish branches of the two Apple subsidiaries as a default, there being no other observable business presence within the Commission’s frame of reference with which to associate the income.
Unlegislated Transfer Pricing Guidance
Embedded in determining the applicable legal context was the question of the relevance of transfer pricing guidance: the OECD Transfer Pricing Guidelines, and as a convenient though possibly not necessary descriptive or analytical device the OECD’s AOA guidance which is heavily infused with transfer pricing notions and methodology. Apple had argued that the arm’s length principle and the AOA held no place in determining relevant “normal” taxation in Ireland absent the rulings, in as much as that principle, in its view, lacked a proper legal footing. Much as Canadian courts have said, in the GlaxoSmithKline and Cameco cases, guidance that has not been legislated is just that, only guidance and not law or to treated as equivalent to legislation. It may be analytically useful in getting at what the transfer pricing legislation requires, but it does not supplant or in a legal sense supplement that law. In the case of the AOA, Canada’s position is a little different, at least in its relations with the US; Annex B to the Canada-US tax treaty and a related Memorandum of Understanding of the tax authorities specifically incorporates OECD transfer pricing guidance in the determination of branch profits under that treaty.
Importance of Actual Evidence of Actual Activities and Actual Responsibility for Risk
The Court is clear that there is no room for surmise in the functional analysis that transfer pricing and the attribution of profits to a branch (permanent establishment) entails, and that what matters is what the ostensibly taxable person does on its own. Indeed, to a great extent it seems that the Commission’s case failed in the General Court because the Commission assumed that the dearth of taxation of the subsidiaries anywhere but Ireland spoke for itself about an inevitable legitimacy of residual Irish taxation. The Court was critical of the quality of the Commission’s examination, in tax language its audit, of Apple. It found that the Commission simply lacked sufficient evidence to support its propositions and / or had misconceived and misapplied key analytical reference points. And the Court was critical of the Commission’s insistence that procedural or analytical shortcomings of Apple’s analysis and reporting were sufficient, in themselves, to disregard the possibility nevertheless that the “right” amount of income still was taxable by Ireland.
There are various statements to this effect in the Judgement though perhaps one of the most pithy and in light of transfer pricing’s focus on “intangibles” most penetrating is this, which also at least sympathetically crosses over into the BEPS realm. The Court said:
…[I]n so far as it had been established that the strategic decisions – in particular those concerning the development of the Apple Group’s products underlying the Apple Group’s I – were taken in Cupertino [California, USA] on behalf of the Apple Group as a whole, the Commission erred when it concluded that the Apple Group’s IP was necessarily managed by the Irish branches of ASI and AOE, which held the licenses for that IP. In this connection, the lack of the autonomous “tangible” manifestations of the subsidiaries’ commercial and legal existence did not distract the Court from insisting that the necessary analysis concerns discovery the meaningful connections of income and how it is earned.
This is not the same as a form for form’s sake analysis, as Apple’s and the Court’s clear acknowledgment of the US as the putative taxing jurisdiction for the IP reflects. The gist of the Judgment is that the Apple subsidiaries could not be relieved, via the rulings, of “normal” taxation that otherwise would have applied, since the Commission failed to show the necessary meaningful connections of the disputed IP income with the subsidiaries’ Irish branches. In other words, it is not possible for tax that was not otherwise exigible to be reduced. Consequently, by the degree of their taxation, the subsidiaries could not experience an advantage by way of avoided tax even as that notion would be conceived for subsection 107(1) of the TFEU, respecting phantom tax.
Imperfect Application of Transfer Pricing Methodology and Differences of View About the Best Method and How to Apply It
It is not uncommon in transfer pricing to encounter differences of view among taxpayers and with tax authorities about whether and how features of methodological guidance common to transfer pricing should be applied. Among others, differences in views exist about whether analytical guidance that is unlegislated should be allowed to ground or significantly influence a determination about a taxpayer’s compliance with its reporting obligations raising the spectre of a transfer pricing penalty. In the Apple case issues were present about Apple’s reporting diligence, its choice of transfer pricing method for measuring Irish branch income, and in applying the Transactional Net Margin Method the suitability of its chosen “profit level indicator” measurement standard. As well there was a difference of view about “who” ought to have been the “tested party” and the insistence by the Commission in line with views common among tax authorities that the tested party must be the transaction party performing the relatively simplest functions and with the relatively simplest responsibilities.
The Court essentially found all these considerations to be of marginal significance, focusing instead on getting to the right income measurement outcome without finding fault with the means or even, necessarily, the reporting diligence underlying the outcome. Pointedly, too, by way of example pertinent to transfer pricing analysis anywhere, unlike tax authorities the Court was not concerned with who in principle is or might commonly be thought to be the “tested party” in a transfer pricing analysis regardless of the relative complexity of the contenders in the analysis. And the Court did not think that the selection of analytical reference criteria for transfer pricing methods requiring them are inviolate or dictated by an unconditional overarching expectation, choosing to focus instead on real value added and commensurate income. Indeed, the Court found that these sorts of assumptions about what doctrinaire transfer pricing guidance not only are constraints but in at least one case was sharply said to be irrelevant .
Several observations by the Court are notable and pertinent well beyond the immediate Apple context:
… [I]t should be noted that the mere non-observance of methodological requirements, in particular in connection with the OECD Transfer Pricing Guidelines, is not a sufficient ground for concluding that the calculated profit is not a reliable approximation of a market-based outcome, let alone that the calculated profit is lower than the profit that should have been obtained if the method for determining the transfer pricing had bee n correctly applied. Thus, merely stating that there has been a methodological error is not sufficient, in itself, to demonstrate that the tax measures at issue have conferred an advantage on the recipients of those measures. Indeed, the Commission must also demonstrate that the methodological errors that have been identified have led to a reduction in the chargeable profit and thus in the tax burden born by those recipients, in the light of the tax burden which they would have borne pursuant to the normal rules of taxation under the national tax law had the tax measures in question not been adopted.
… [T]he OECD Transfer Pricing Guidelines do not state which party to the transaction must be chosen [as the tested party], but recommend choosing the undertaking for which reliable data regarding the most closely comparable transactions can be found. It is then specified that this often means choosing the associated undertaking which is the least complex of the undertakings concerned by the transaction and which does not have any valuable intangibles or unique assets. It follows that those guidelines to not necessary [necessarily] require that the least complex entity be chosen, but that they simply advise choosing the entity for which the greatest amount of reliable data exists. …Thus, provided that the functions of the tested party have been correctly identified, and that the return for those functions has been correctly calculated, the fact that one party or another has been chosen as the test party is irrelevant. [Emphasis added]
… [In relation to the disputed choice of profit level indicator in applying the TNMM] … [i]t should be noted at the outset that the Commission did not specifically state the source on which it was relying in order to make such an assertion [that the use of operating costs as the profit level indicator “did not reflect a reliable approximation of a market-based outcome in line with the arm’s length principle”]. In addition, the use of the term ‘generally’ [in the Commission’s comment that “operating costs” … would be ‘generally recommended’ for analysing the profits of low-risk distributors …” which it asserted the affected Irish subsidiary was not] indicates that is was not ruling out the use of operating costs as a profit level indicator in certain situations. …Besides the fact that the argument presented by the Commission is imprecise, it should be noted that such an argument is not in line with the OECD Transfer Pricing Guidelines, on which the Commission relied in connection with its subsidiary line of reasoning, as is correctly argued by Ireland and ASI and AOE. It follows from paragraph 2.87 of those guidelines that the profit level indicator must be focused on the value of the functions of the tested party, taking account of its assets and risks. Therefore, according to those guidelines, the choice of profit level indicator is not fixed for any type of function, provided that that indicator reflects the value of the function in question. [Emphasis added]
Next …
There is a lot to wonder about because of the Apple Judgment, and this post only scratches the surface. The case and the decision do reflect, however, the somewhat uneasy convergence of trade law, tax law and the private law constructions – entities and contracts – underpinning tax law, and public law, and the significance of each in conducting a coherent tax-related analysis according to any of these legal disciplines. It should be said again that Apple is a competition law case, and the forces underlying such a case and the objectives to which they are directed are not the same as for BEPS. That said, however, both in parallel are propelled by the implications of perceived tax avoidance; BEPS abjures such an outcome and searches for some measure of international consensus to ensure a perceived “rightful” degree of taxation somewhere. Trade and competition law effectively seek to determine if avoided tax is an extension of a taxing country’s economic influence relative to other countries and accordingly to grand it as aid or subsidy, still though to replenish an otherwise depleted fisc of the country otherwise prepared to relinquish the tax.
All of this, for which the Apple case is a catalyst for discussion and consideration, shows also that from any perspective what really is the focus is the elusive notion of income’s “source” which despite casual associations with geography and economics, is intrinsically legal taking account of a pertinent and thorough evidence-based analysis of the legal constructions relied on by taxpayers and the fiscal undergrowth of the tax law on which the tax community’s eyes so quickly and unquestioningly focus. It will be interesting to see if there is a next judicial step for this case, an appeal to the European Court of Justice, and otherwise what its influence may be in any of the converging disciplines that make up the international tax kaleidoscope.
[1] I want to acknowledge my gratitude for perceptive and helpful comments and in particular guidance on European law provided by my colleague and friend Professor Adolfo Martín Jiménez who is the Chairman of the European Association of Tax Law Professors and Professor of Tax Law Derecho Público / Public Law in the Facultad de Derecho Universidad de Cádiz, Spain. Of course, I alone am responsible for errors or oversight in this commentary.
[2] The link for the General Court’s Judgment is:
http://curia.europa.eu/juris/document/document.jsf;jsessionid=9C841C91B68382140A7EEA8EB780EC2D?text=&docid=228621&pageIndex=0&doclang=EN&mode=req&dir=&occ=first&part=1&cid=9715286
[3] European Commission, Press Release, August 30, 2016, Brussels, State Aid: Ireland gave illegal tax benefits to Apple worth up to € 13 billion, in which the Commission said: Apple Sales International is responsible for buying Apple products from equipment manufacturers around the world and selling these products in Europe (as well as in the Middle East, Africa and India). Apple set up their sales operations in Europe in such a way that customers were contractually buying products from Apple Sales International in Ireland rather than from the shops that physically sold the products to customers. In this way Apple recorded all sales, and the profits stemming from these sales, directly in Ireland. … The two tax rulings issued by Ireland concerned the internal allocation of these profits within Apple Sales International (rather than the wider set-up of Apple's sales operations in Europe). Specifically, they endorsed a split of the profits for tax purposes in Ireland: Under the agreed method, most profits were internally allocated away from Ireland to a "head office" within Apple Sales International. This "head office" was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. Only a fraction of the profits of Apple Sales International were allocated to its Irish branch and subject to tax in Ireland. The remaining vast majority of profits were allocated to the "head office", where they remained untaxed.
[4] See, for example, Ruth Mason, Implications of the Rulings in Starbucks and Fiat for the Apple State Aid Case, Tax Notes Federal, Volume 16, Number 1, October 7, 2019 – written before the General Court released its Judgment. Professor Mason has written widely on “aid” and “subsidy” associated with taxation, notably from a US perspective.
[5] There are other examples, in Canada and elsewhere, about “partnerships” between taxpayers and countries via their tax regimes, some of which have become notable in the context of BEPS. See for example: Nick Pantaleo, Finn Poschmann and Scott Wilkie, Improving the Tax Treatment of Intellectual Property Income in Canada, Institut C.D. Howe Institute Commentary 379 (2013), which considers tax-supported intellectual property development, sometimes euphemistically referred to or associated with what are described as “patent boxes” or “innovation” boxes, in light of economic “spillover” effects of broad significance to a country’s economic wellbeing.
[6] See Michael Daly, Fiscal Affairs Department, International Monetary Fund, Is the WTO a World Tax Organization? A Primer on WTO Rule for Tax Policy Makers, International Monetary Fund, March 2016.
[7] Action brought on 19 December 2016 — Apple Sales International and Apple Operations Europe v Commission (Case T-892116) (2017/C 053/46), 20.2.2017 EN Official Journal of the European Union C 53/37_