TAX treaties have a long history. The essential purpose of a tax treaty is to ensure that same income is not taxed twice or multiple times for the simple reason that such multiple taxation is bad for the growth of cross border trade and investment. To achieve this end ,countries enter into bilateral tax treaties. The process of relieving double taxation under these treaties often involves giving away taxing rights by one or both of the States but mostly by the source State. Such treaties obviously benefit those having operations across states. Multinationals by definition operate cross border. Therefore, the treaties will mostly benefit MNCs. However, till recently no one really bothered whether the multinational is actually paying tax anywhere.

A tax treaty normally lays down how a resident of one contracting state will be taxed in the other State. For this purpose, Article 4 of any model treaty lays down who is a resident of a Contracting state and how the problem can be resolved if both the States claim the taxpayer to be resident in their respective States. A treaty almost always states in its Article 1- "This Convention (treaty) shall apply to persons who are residents of one or both of the Contracting States." In other words, to avail the benefit of a tax treaty network, the taxpayer must be a resident of one of the States party to the Convention, whatever may be the definition of the term 'resident'.

But then, a combination of a tax treaty along with the domestic tax regime in different countries can produce strange results; a company may be resident nowhere and therefore pays no tax anywhere. The structure adopted by the tech giant Apple involving Ireland and the USA did just that and gave currency to the concept of stateless income. The US senate in its report on the conduct of tax affairs of many of its multinationals has brought out these anomalies. In this connection, the following conversation between Senator Carl Levin and an Apple executive is illuminating:

Senator Levin: Does Apple Inc. own directly or indirectly AOI, AOE, ASI? (subsidiaries of Apple in Ireland)

Phillip Bullock (Head of tax operations, Apple) - Yes, Apple Inc. owns directly or indirectly AOI, AOE and ASI.

Senator Levin- AOI is incorporated in Ireland, is that correct?

Phillip Bullock: Yes, Mr. Chairman, it is incorporated in Ireland.

Senator Levin: Where is AOI a tax resident?

Phillip Bullock: It does not have a tax residency.

The Senate sub committee was examining the tax affairs of its multinationals that are accused of keeping profits offshore since such profits are taxed in USA only on repatriation. In the meantime, the UK PAC was also examining the tax affairs of other US giants like Google, Starbucks and Amazon. It is in the course of these investigations that the modus operandi of the MNCs became public although the structures were being put in place for a long time and then BEPS happened.

The European Union also started its investigations in the tax affairs of some of these companies including Apple. The preliminary investigations in Apple's affairs confirmed that Apple apparently had cut a deal with the Irish government through a ruling.

Finally, two weeks back, the European Commission gave its verdict that is creating waves across the world of international taxation. The Commission stated that the APA rulings offered by Ireland to Apple amounted to State aid that the government of Ireland should recover the same from Apple. The amount involved is a whopping 13 billion Euros. Apple is obviously unhappy and its Chief Executive, Tim Cook has used cuss words to describe the EU ruling. Apple will be appealing the decision. The American government is distinctly unhappy and views this as a means of extracting money from their multinationals. Funnily enough, the Irish government is also unhappy and says it does not want the money. The Irish government is also likely to appeal the order.

The EC investigations have been continuing since 2013 and culminated in the ruling delivered on 30th August, 2016. Although the full ruling is still not out in the public domain, there was a press release that gives a gist along with a statement by its Competition Commissionaire Margreth Vestigar.

The Commission had picked up certain rulings (mostly Advance Pricing Agreements) given by its member states to certain multinationals, Apple being one of them. It may be recalled that APAs decide in advance the mechanism of transfer pricing between the related parties and has been widely held to be one of the efficient methods of dispute resolution. India too has embraced APAs and is in fact actively pursuing this route. The problem with APAs however is that the proceeding are not public and apart from the taxpayer concerned, others do not know what exactly the terms of the transactions and the agreement were. In the case of Apple, the Permanent subcommittee on taxation of the US Senate brought out certain facts and this was used by the European Commission in its investigations.

In fact, the EU Commission had come up with an interim report in 2014 that established that prima-facie the ruling given by Ireland amounted to State aid. At this stage, it may be worthwhile to note what the State aid issue is all about.

According to Article 107(1) of The Treaty on the Functioning of the European Union (TEFU), any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the provision of certain goods shall be incompatible with the common market, in so far as it affects trade between Member States.

For a measure to be considered as aid within the meaning of Article 107(1) the following cumulative conditions are to be met: (i) the measure must be imputable to the State and financed through State resources; (ii) it must confer an advantage on its recipient; (iii) that advantage must be selective; and (iv) the measure must distort or threaten to distort competition and have the potential to affect trade between Member States.

The main question before the EU Commission was therefore whether the rulings given by the Irish tax authorities conferred a selective advantage upon Apple in so far as it results in a lowering of its tax liability in Ireland.

At this stage, it will be worthwhile to consider the structure put in place by Apple. Apple Inc, the ultimate parent based in the USA owns Apple Operations International (AOI), which in turn owns Apple Operations Europe (AOE), which owns Apple Sales International (ASI). All these three companies are incorporated in Ireland. Nevertheless, it was claimed that their central management and control are not located in Ireland. Till recently, under Irish domestic law,a company was considered not resident in Ireland if its central management and control was not in Ireland. Thus these companies, although incorporated in Ireland were non-resident companies as far as Ireland is concerned. It may also be noted that the USA considers a company resident in USA only if it is incorporated in the USA.Thus these companies were not resident in the USA. That explains the answer of the Apple executive before the Permanent sub committee as set out before. The EU Commission investigations were not concerned about the structure chosen by the Apple group. The Commission's order makes it clear. The commission was more concerned with the aspect of profit attribution.

AOE and ASI carried out trade operations in Ireland through a branch. The EU ruling concerns these two companies and not with AOI.

Coming to ASI first, it was not tax resident in any country. It admittedly had a branch in Ireland. It did not have any employees, premises or operations outside Ireland. It had 2 directors resident in USA and 1 resident in Ireland and most of the director's meetings were held in the USA. Thus the control and management will not be in Ireland.

As for actual operations, ASI was 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. According to the Commission, Apple set up their sales operations in Europe (and probably in other countries as well) in such a way that customers were contractually buying products from ASI in Ireland rather than from the shops that physically sold the products to customers. In this way Apple recorded all sales, and the profits arising from these sales, directly in Ireland.

ASI was also a party to a cost sharing agreement for R&D where its contribution was in cash only. Nevertheless, in terms of the arrangement it was the owner of Apple's valuable intellectual property and could exploit the same. The Commission investigated the affairs of the company for ten years and found that it had significant pretax profits over the review period. The commission made it clear that it was not discussing the structure but the division of the profit between the ASI's branch in Ireland and the rest of the enterprise.

ASI itself had no assets or operations but it was the branch that had assets and employees. So, the question was where the profit arising to ASI that had no other operation anywhere should be allocated. It is here that the ruling given by the Irish Revenue comes into picture. From the details given in the Commission's order, it is seen that Apple had entered into an advance pricing arrangement with the Irish tax authorities in 1991, 25 years back. The terms were nominally revised in 2007.

Advance Pricing Arrangement is supposed to be part of the transfer pricing process and the terms agreed upon should be based on some arm's length principle. However, the Commission noted that the basis in the 1991 ruling was negotiated rather than substantiated by reference to comparable transactions. In terms of this APA, in 1991, it was decided that the branch's taxable profit will be 12.5% of all the branch's operating cost (excluding goods purchased for resale). It may be noted that Irish corporate tax rate was reduced to 12.5% from 2003. So, the company would be paying tax in Ireland @12.5% of 12.5% of the profits as determined in terms of the APA. This profit allocation was slightly modified in the 2007 ruling.

In so far as AOE is concerned, again the company was incorporated in Ireland but was not considered resident of Ireland because of identical reasons. The company did not have any employees, operations, premises outside Ireland. The actual activity of assembling a specialized line of personal computers was carried out by a branch established in Ireland. It purchases raw materials from related companies, manufactures the finished goods and sells the finished goods to related companies. It was also party to R&D cost sharing arrangement giving it economic ownership of various intangibles.The company also provided shared services to Apple companies in Europe and other places outside of the USA.

This company also obtained an APA ruling from the Irish tax authorities. According to the 1991 ruling the allocation to the branch will be 65% of branch operating expenses upto 60-70 m USD and 20% of all branch operating expenses in excess of USD 60-70m. Operating expenses include depreciation but exclude raw material costs and cost share payments. Here also in 2007, a revised ruling was given- the profit allocated to the branch will be a mark up of 10-20% on branch operating expenses (excluding raw material costs) and a return of 1-9% on branch turnover.

It is the split of profits between the company (Head Quarters) that existed only in name and the branch admittedly established in Ireland that was the subject of EU investigations. Overall, the Commission pointed out several anomalies in the allocation of profits to the branch and its broad conclusion was that the methods used to determine profit allocation to ASI and AOE resulted from a negotiation rather than a pricing methodology. Therefore the outcome of the agreed method was not arm's length since a prudent independent market operator would not have accepted the remuneration allocated to the branch. The Commission observed that where a ruling concerns transfer pricing arrangements between related companies within a corporate group, that arrangement should not depart from the arrangement or remuneration that a prudent independent operator acting under normal market conditions would have accepted. The commission in its interim report pointed out that in fact, no transfer pricing report was included in the documents provided by the Irish authorities to support the calculation of taxable profits as confirmed in that ruling, which is a common manner by which a transfer pricing proposal is made to tax authorities.

Although the Commission's report has angered the USA that claims that the profits rightfully belonged to the USA and would be taxed there in the event of repatriation, Senator Levin, in a way had endorsed the Commission's interim finding.

"The facts are abundantly clear: Apple developed its crown jewels -- lucrative intellectual property -- in the United States, used a tax loophole to shift the profits generated by that valuable property offshore to avoid paying US taxes, then boosted its profits through a sweetheart deal with the Irish government,". According to Irish Times, Mr. Levin said that Apple's Irish tax rate has "no rational basis", and it was determined by "what Apple was 'prepared to accept' - with the threat that it would cut jobs in Ireland if it didn't get its way".

"That low tax rate came on top of Apple's ploy of saying its three main Irish subsidiaries are not tax resident anywhere. Hopefully this finding will help persuade Congress that we should close the loopholes in our tax code that allow Apple-type gimmicks whose sole purpose is to avoid paying US taxes." [[Source: http://www.irishtimes.com/business/economy/levin-says-apple-struck-a-sweetheart-deal-with-ireland-1.1946910]

The unfairness of the allocation of profits to the Irish branch has been vividly described by Ms. Margreth Vestiger in the context of the activities of ASI:

"..Let me illustrate this for one tax year: In 2011, Apple Sales International made profits of 16 billion euros. Less than 50 million euros were allocated to the Irish branch. All the rest was allocated to the "head office", where they remained untaxed. This means that Apple's effective tax rate in 2011 was 0.05%. To put that in perspective, it means that for every million euros in profit, it paid just 500 euros in tax.

This effective tax rate dropped further to as little as 0.005% in 2014, which means less than 50 euros in tax for every million euro in profit.

"Our decision concludes that splitting the profits did not have any factual or economic justification. As mentioned, the "head office" had no employees, no premises and no real activities. Only the Irish branch of Apple Sales International had any resources and facilities to sell Apple products.

But under the tax rulings it was the "head office" that was attributed almost all of the company's profits – in fact, due to Apple's set-up, it was attributed almost all of the profits Apple made from selling products throughout Europe, the Middle East, Africa and India."

The Commission held that Irish Revenue, being part of the Irish State would come within the purview of the provisions governing state aid. It had pointed out that the notion of aid encompasses not only positive benefits, but also measures, which mitigate the charges, which are normally included in the budget of an undertaking.

Accordingly, rulings should not have the effect of granting the undertakings concerned lower taxation than other undertakings in a similar legal and factual situation. According to the Commission, the Irish tax authorities, by accepting that multinational companies depart from market conditions in setting the commercial conditions of intra-group transactions through a discretionary practice of tax rulings, may renounce taxable revenues in their jurisdiction and thereby forego State resources, in particular when accepting commercial conditions that depart from conditions prevailing between prudent independent operators.

According to the press release, the Commission therefore concluded that the tax rulings issued by Ireland endorsed an artificial allocation of Apple Sales International and Apple Operations Europe's sales profits to their "head offices", where they were not taxed. As a result, the tax rulings enabled Apple to pay substantially less tax than other companies, which is illegal under EU state aid rules and has to be recovered.

As for the recovery of the amount from Apple along with interest, the Commission has put some interesting caveats. According to the press release: "The amount of unpaid taxes to be recovered by the Irish authorities would be reduced if other countries were to require Apple to pay more taxes on the profits recorded by Apple Sales International and Apple Operations Europe for this period. This could be the case if they consider, in view of the information revealed through the Commission's investigation, that Apple's commercial risks, sales and other activities should have been recorded in their jurisdictions. This is because the taxable profits of Apple Sales International in Ireland would be reduced if profits were recorded and taxed in other countries instead of being recorded in Ireland."

Our Tribunals have been merrily accepting all convoluted arguments so as not to permit source country taxation in India in similar circumstances. It will be good if they carefully go through the proceedings and findings of the Commission's order that contains a wealth of information about transfer pricing and profit allocation.