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U.S. and EU Police Each Other's Companies

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Apple has always denied there was anything illegal about the corporate structure it set up in Ireland to radically cut the tax it pays on non-U.S. operations. Now it has warned investors that a European investigation may have a material effect on its future earnings. The probe is part of an evolving practice, in which the U.S. and the European Union do each other's law enforcement. 

Apple's tax arrangement was based on a discrepancy between Irish and U.S. tax laws. In Ireland, a company's domicile is where it is run from; in the U.S., it's where it's is incorporated. Thanks to this quirk, Apple's Irish subsidiaries, which receive most of the company's overseas profits, have had essentially no domicile for tax purposes. The Irish authorities didn't mind that: Apple employs thousands of people in the country and pays some taxes on its Irish-related business. For Ireland, something is better than nothing.

For years, Apple filings to the U.S. Securities and Exchange Commission mentioned this arrangement, but never described it in detail or warned it could lead to adverse consequences. Even the company's July, 2014 quarterly report, issued a month after the European Union started a formal investigation into what it thinks could be illegal state aid from Ireland to Apple, said only this to explain its 26.1 percent effective tax rate:

The Company’s effective tax rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S.

Apple could not, however, ignore the EU investigation, which may force Ireland to charge the company back taxes for 10 years. So in its annual report, filed last October, the company carefully mentioned the possibility of paying more taxes in the future and even refunding some money to Ireland[note]. The iPhone maker waited until now to warn investors that this could all be really bad. It said: 

The Company believes the European Commission’s assertions are without merit. If the European Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount could be material, as of March 28, 2015 the Company is unable to estimate the impact.

The definition of materiality is murky in the U.S., but the SEC loosely considers a 5 percent effect on a financial statement to be material. In the current financial year, Apple's net income is projected to reach $51.7 billion, so a material impact on that number would mean at least a $2.5 billion tax charge. That's a mosquito bite to mighty Apple, but an enormous potential fine that would equal Deutsche Bank's recent punishment at the hands of U.S. regulators for fixing the Libor benchmark.

Apart from the Irish state aid case involving Apple, the EU is also investigating the tax rulings obtained by Amazon in Luxembourg and Starbucks in the Netherlands. That investigation has the potential to expand to more European jurisdictions and U.S. companies, especially tech and pharmaceutical ones able to reduce taxable profits by diverting intellectual property royalties to shell companies. 

Essentially, the EU, which has no influence on its members' fiscal policies except by policing state aid, is doing Uncle Sam's job. It's mainly U.S. taxes that these companies are trying to avoid, as they accumulate profits overseas for "indefinite reinvestment." In some cases, the U.S. authorities have moved to close down the stratagems: Financier George Soros, for example, faces a tax bill of $6.7 billion to be paid by 2017, on client fees that were reinvested in his hedge funds through Irish vehicles. When it comes to tech giants, though, the U.S. hasn't done much to stop them from using Dutch, Irish and other EU-basis tax schemes to lower their tax bills. 

The U.S. government is much better at punishing wrongdoing by financial institutions. Last year, it levied close to $60 billion in bank fines, much of it on European lenders. That includes the $8.9 billion paid by France's BNP Paribas for breaking sanctions against Iran, and the first penalties in the Libor-fixing scandal that continues to take its toll this year. Although the EU and its member states fine banks, too, the amounts are much more modest. In December, 2013, EU regulators hit six banks with a total of $2.3 billion in Libor penalties -- a huge bill by European standards.

It's probably fair that, in a globalized world, each regulatory system plays to its strengths; it's just another facet of the international division of labor. It would be idealistic to expect countries to adopt similar enough rules to create a level playing field for multinationals, eliminating both the glaring loopholes and nasty surprises. The current set-up, however, could degenerate into political tit-for-tat exchanges.

Given how hard the U.S. comes down on European banks, for example, the EU may be stricter than necessary when dealing with the likes of Apple, Amazon and Google (now under an antitrust investigation in Europe).  

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Marc Champion at mchampion7@bloomberg.net