Why Europe’s Apple Decision Is Misguided and What It Means for Ireland, Tech Companies, and the Future of Global Tax Reform

Last week, the European Commission ruled that Ireland hasn’t been taxing Apple enough and declared the company should pay back $14.5 billion more than Ireland thinks it owes. This underscores the degree to which European officials, having created a regulatory and economic environment that deters innovation and rapid growth, increasingly resent the competitive success of tech companies such as Apple, Amazon, Google, and Facebook. The large benefits these companies deliver to European consumers are seen not as welcome relief amidst an otherwise dreary economic picture, but as an indication of undue power that needs to be brought to heel. So an ongoing series of official investigations and regulatory actions has pried into not just tax practices, but also antitrust issues, privacy concerns, and business model restrictions.

Although the final ruling has not been published, European Competition Commissioner Margrethe Vestager’s decision almost certainly exceeds the Commission’s powers and provides clear evidence of this European animus toward U.S. companies. The decision is misguided and is going to have serious impact on Ireland’s economic competiveness, deter other innovative companies from expanding in Europe, and put into question the future of global tax reform.

EU rules forbid member countries from giving assistance to narrow groups of companies. This is to prevent the kind of self-defeating competition that often occurs between U.S. states when they try to attract new manufacturing plants and the like. But countries are allowed to set their own tax rates. Ireland’s low corporate rate has long been resented by other Europeans, largely because it has succeeded in attracting a significant amount of corporate activity to the island that might otherwise have gone to continental Europe. There is good reason why a country might lower corporate tax rates and instead raise revenue through a consumption tax: It would impose a much lower economic burden and encourage investment and innovation.

The Commission complains that Ireland charged Apple almost nothing in corporate taxes. Technically, of course, Ireland was free to eliminate all corporate taxes. But the Commission took exception to the fact that Apple’s tax situation is unique, so other companies were unable to benefit from Irish tax law in quite the same way, even though the same interpretations of the law would have been available to them if they were the same kind of business as Apple. But the truth is most large multinational companies are unique in some aspect. This often requires authorities to generate new interpretations of the law in light of their unique fact patterns. Although it claims Apple got preferential treatment, the Commission does not point to any specific company that has been unfairly harmed by the rulings at issue in the Apple case.

At the heart of the Commission’s case against Apple is how the company handles the standard practice of what is known as “transfer pricing.” Companies are generally free to create their own corporate structures, many of which have little substance other than to hold a specific set of assets. When transferring assets between these sub-units, companies are supposed to use an arms-length standard for valuation that is based on what two independent companies would charge each other. A huge bureaucracy and set of rules governs these transactions, and companies use these rules aggressively to minimize their international tax burdens. That is exactly what Apple has been doing in Ireland—strategically positioning capital assets, such as data centers, and booking revenue from European sales. But the Commission’s decision never mentions any disagreement with how Apple applied the rules to determine the level of profits earned by each of its subsidiaries.

In its supporting documents, the EU repeatedly claims that a large portion of Apple’s profits are not subject to tax anywhere in the world. This is false. All of Apple’s worldwide profits are subject to the U.S. corporate tax rate of 35 percent, the highest among developed countries. However, Apple does not have to pay this tax until it decides to bring its foreign profits home. The U.S. proponents of the Commission’s decision have a big problem with this. They often make the implicit assumption that the money will never be repatriated. As a result, they claim that Apple and other large multinational companies can evade U.S. law and pay low effective tax rates. If this were true, then eliminating the U.S. tax on foreign profits should cost very little in lost tax revenue while removing the incentive to invest profits abroad instead of in the United States. Yet these same experts argue that such a change would indeed dramatically reduce tax revenues and unfairly benefit shareholders. They can’t have it both ways.

The story is not over. Ireland and Apple are sure to appeal. For Ireland, the impact is serious. The decision undercuts the country’s strategy of using low corporate tax rates to attract investment. Moreover, various treaties, including with the United States, require Ireland to abide by international transfer-pricing rules when determining the taxable profits of a company and to promptly negotiate any disputes with other countries. Ireland obviously cannot do this, since it no longer controls the application of its own tax laws. Following on the Euro crisis and Brexit, the Commission’s decision to expand its powers over domestic tax legislation will likely provide further momentum for those who think Brussels has too much power. Finally, Apple can expect more scrutiny from other European countries. The Commission’s statement practically invites other countries to reevaluate whether they deserve a slice of Apple’s $14.5 billion.

Because the profits in question are subject to U.S. tax and because Apple gets to deduct any foreign taxes from what it owes the Treasury, the net result is that much of the $14.5 billion will be paid by the U.S. taxpayer rather than Apple. However, the Obama administration is in a weak position to object, having engaged in similar practices. Over the past few years, U.S. regulators have been very aggressive in imposing large penalties on banks and other companies for real and imagined sins of the past. These are usually civil actions where the burden of proof is much lower. The sum demanded is seldom justified by a clear relationship to the harm generated, and companies have a strong reputational interest in settling the matters quickly. The Treasury also recently promulgated retroactive rules to deter so-called “inversions,” in which companies buy foreign entities and then merge into them for tax purposes. The use of raw executive power to generate novel theories to raise money thus occurs on both sides of the Atlantic.

For the last several years, the Obama administration has been participating in an international effort to address base erosion and profit shifting (known as “BEPS”) among multinationals. Certain aspects of how multinationals are taxed clearly need reform, but there always has been suspicion that many European countries are more interested in rewriting tax practices to grab a larger share of revenues for themselves than to improve the existing system. The European Commission’s decision in the Apple case should cause the United States to reevaluate its participation in BEPS and either pull back or become more assertive about the direction it takes. This is a case where it needs to lead from the front for common sense global tax reform (as well as for corporate tax reform at home).

In the meantime, the Commission’s ruling also sends a clear signal to other innovative companies seeking to expand in Europe and to the European countries that want to attract them with low corporate rates and tax incentives: The Commission thinks companies are under-taxed, countries should not compete against each other for investment, American companies are too powerful, and tax and regulatory policies have little effect on investment and innovation. But the practical result of such thinking is likely to be a reduction in inward foreign direct investment and a reduction in the continent’s ability to compete for the markets of the future.