iTaxApples International Tax Structure and the Double Non-Taxation

Issue

Ravi Arora

53 LLB 13

Antony Ting here tries to discern the pattern of Multi-National Enterprises(MNEs) in their
constant endeavour to avoid taxation in the source as well as the resident countries. For this
purpose he relies on the taxation structure of Apple to lay down a clear picture of how the
foregoing is done and who all state and non-state actors are involved in this exercise of tax-
avoidance and accordingly suggests reforms for the same.

Antony coins the word iTax referring to the innovative tax avoidance structure of Apple Inc.
denoted by its favourite vowel i which it uses as a prefix before its every product.

How did Apple do it?

Apple created two subsidiary entities in Ireland: Apple Sales International (ASI) and Apple
Operations Europe(AOE) that effectively own most of the company's intellectual property.
Those companies license that IP to other global Apple subsidiaries, and earn income from those
licensing arrangements.

So when an Apple iPhone is sold in China, for example, Apple's Chinese subsidiary must pay
the Irish company to reflect the use of the Irish companies' intellectual property. Only Apple
knows what percentage of that iPhone sale is subject to those intellectual property licensing
fees. But the result is that profit earned on the sale in China is shifted to the Irish subsidiary.

Ordinarily, those profits would be taxed in Ireland at the relatively low rate of 12.5 percent but
thanks to the complementary taxation policies between US and Ireland that worked in the
favour of Apple.

First Apple sets up subsidiary in Ireland with the specific condition that the central
management and control shall lie with Apple Inc. in US. A company in US is taxed on a single
factor: place of incorporation. So a company incorporated in Ireland with the central
management and control in US shall be a non-resident of both the countries. Ireland follows
the source principle, where the income derived within the country shall be taxable, so the
foreign source income is tax free in the country.1 iTax takes the advantage of the
complementary definition of corporate tax residence in the 2 countries as well as the source
principle.

A diagram illustrating the ingenious tax structure by Apple is depicted below:

Antony also lists out the ways in his article as to how US unethically helps out its MNEs evade
taxes in source countries here he misses an important point that how these source countries
help foreign MNEs evade taxes on certain conditions. European Commission has accused

1
The European Commission used this example to illustrate how this worked in practice: In 2011, Apple Sales
International recorded profits of 16 billion, but under the terms of the tax ruling only around 50 million were
considered taxable in Ireland, leaving 15.95 billion of profits untaxed. Apple Sales International paid less than
10 million of corporate tax in Ireland in 2011 an effective tax rate of about 0.05% on its overall annual profits.
In subsequent years, Apple Sales International's profits continued to climb but, under the agreement, its taxable
profits in Ireland did not the effective tax rate decreased to 0.005% in 2014.
2
James Cook, This map explains Apple's tax structure in Europe that means it has to pay 13 billion in taxes,
BUSINESS INSIDER, Aug. 30, 2016, available at, https://www.businessinsider.in/This-map-explains-Apples-tax-
structure-in-Europe-that-means-it-has-to-pay-13-billion-in-taxes/articleshow/53928640.cms
Ireland of favouring Apple on certain conditions as to the number of Irish citizens it has to
employ and the quantum of investment it has to make in the country.

How US favours its MNEs? Why did the CFC regime fail?

Antony starts with the criticism of the CFC regime of US. He states that the CFC regime proved
to be ineffective on two fronts: first the presence of a no. of exceptions deny the application of
CFC regime to iTax and secondly, the check-the-box regime cripples the CFC regime.

The idea behind the CFC3 regime is to capture the profits shifted to a subsidiary incorporated
in a low-tax country through intra-group sales and is premised on the separate entity doctrine
under which each group company is treated as a separate taxpayer.

One of the many exemptions that favours MNEs, Antony picks out the manufacturing
exception to exempt the income of a CFC from taxation if the latter is a manufacturer that
added substantial value to the goods. This requirement was further relaxed through amendment
even a CFC that makes a substantial contribution to the goods shall be eligible for the
exemption. So ASI could get under the exemption due to its contract manufacturing activities.

Another major crippling effect on the CFC regime has been the check-the-box regime. It was
originally implemented with the intention that it will save both the taxpayers and IRS the
resources to determine the proper classification of entities. Antony criticises the US govt. that
with the introduction check-the-box regime, the latter practically gave up the fight with MNEs
on the battle of entity classification.

The check the box loophole which costs the United States about $10 billion per year,
according to the White House also has been a reflection of US Senates revolving door
culture of policy-making and lobbying. Some of the bureaucrats who helped to write the rule
went on to work for corporations that used it to lower their tax bills. By 2004, thanks in part to
the check the box rule, U.S.-based multinational corporations paid an effective tax rate of
about 2.3 percent on $700 billion in foreign earnings.

Antony in the latter part of his article states that the check-the-box regime together with the
statutory look through rule in the CFC regime, is a structural flaw in the US tax system. It
effectively disables to a large extent the CFC regime and facilitates tax avoidance structures

3
Controlled foreign corporation (CFC) rules are features of an income tax system designed to limit artificial
deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of an
entity that is not currently taxed to the owners of the entity. Generally, certain classes of taxpayers must include
in their income currently certain amounts earned by foreign entities they or related persons control
using hybrid entities. He even points that the US Senate Committee which conducted the Apple
hearing recommended reforming the regime so that it does not undermine the intent of the
CFC regime.

United States has intentionally turned a blind eye towards these tax avoidance activities of
MNEs but at the same time they have underestimated their greed and their desire to minimise
their tax bills. Blessed with the loopholes provided by the US tax law they have implemented
tax structures, like Apple, to not only avoid foreign income tax but also US income tac.

What can be done to prevent this from happening in the future?

To counter these nefarious practices by MNEs, Antony suggests using the Enterprise Doctrine
and Increasing Transparency by designing country-by-country reporting regime.

Enterprise Doctrine is a direct counter to the separate entity doctrine which states that a
corporate group under the common control of a parent company is treated as one single entity
is more likely to produce effective measures to tackle MNEs base erosion and profit shifting
(BEPS) transactions. It is a legal doctrine under which individual entities can be held jointly
liable for some action on the basis of being part of a shared enterprise. He even suggests this
doctrine would be more effective as the underlying principle of anti-BEPS measures.

Antony puts forth a radical reform to deal with BEPS: worldwide tax consolidation of MNEs.
The proposal asks US to tax MNEs on its worldwide net income and allow for foreign tax
credits. Considering the political clout of corporate lobbying groups, it is hard to fathom
whether something like that can ever be introduced in the US, hence the author leaves this idea
as a food-for-thought and doesnt elaborate further.

Reforming the CFC regime so that it doesnt undermine the CFC regime. Strengthening the
CFC regime by removing the exemptions given there under such as manufacturing
exemption. Reforming that transfer pricing rules4 with regard to the sale of intangibles through
cost sharing agreements. To stop the abuse of transfer pricing regulations by ensuring that
taxable profits cant be artificially shifted through the transfer of patents, copyright or other

4
Transfer prices are the prices various parts of a company pay each other for goods or services. They are used to
calculate how profits should be allocated among the different parts of the company in different countries, and
are used to decide how much tax the MNE pays and to which tax administration. There is no simple method for
calculating a transfer price and the lack of good comparables (similar operations carried out at market prices
by unrelated entities) often results in profits being artificially shifted to no- or low-tax jurisdictions.
intangibles away from countries where the value is created, and it will oblige taxpayers to
report their aggressive tax planning arrangements.

Country-by-Country reporting: Here Antony suggests that information to be disclosed by

the corporates to each country and this information be relayed to other countries where these
corporates have base of operations or subsidiaries. Through this pool of information the
countries can figure out if the corporate group is being collectively subjected to low rates of
taxation.

An unconventional way he suggests is by using the reputational route. He notes that

reputation concern has proved to be effective in dampening the appetite of MENs for BEPS
schemes. Corporate groups (such as Starbucks) which depend on daily interactions with
customers give a substantial weightage to their reputation as a law-abiding company. So
naming-and-shaming such corporates can prove to be a successful strategy. This particular
strategy has been adopted by the Govt. of India against the directors linked to shell companies.5

Is Antony right?

International tax rules are generally efficient in ensuring that companies are not subject to
double taxation, but BEPS takes advantage of gaps in the rules to avoid paying tax completely,
so-called double non taxation or to pay a sum across two or more countries that is less than
what they would pay in a single country. Opportunities for MNEs to pay less tax harm
everybody. Governments lose revenue and may have to cut public services and increase taxes
on everybody else. But businesses suffer too. Small businesses, businesses working mainly in
one national market and new firms cant compete with MNEs who shift profits across borders
to avoid or reduce tax. And an MNE that doesnt shift profits is at a disadvantage compared to
its BEPSing rivals. In light of this the afore-said reforms become a must.

OECD launched a 15 point Action Plan that gives governments the domestic and international
arms they need to combat BEPS. The Plan recognises that greater transparency and improved
data are needed to evaluate and stop the growing disconnect between where money and
investments are made and where MNEs report profits for tax purposes.

5
Govt. names and shames disqualified directors of shell companies, available at,
http://www.thehindu.com/news/national/shell-shock-govt-names-and-shames-directors/article19710912.ece