By Chaahat Khattar
This article is the first part of a series of two articles by Chaahat Khattar. Find the second part here.
Apple Just ate a Bite of Double Irish With a Dutch Sandwich
On 7 September 2016, Tim Cook, CEO of Apple Inc.  unveiled the next generation of the iPhone. At the keynote at Bill Graham Civic Auditorium, just as we expected, there was an indication to the European Union that Apple is not only the world’s largest, but also the most powerful technology company as well. On 31 August 2016, the European Commission (the executive body of the European Union responsible for proposing legislation, implementing decisions, upholding the EU treaties and managing the day-to-day business of the EU) ordered Apple to pay Ireland up to 13 billion euros in unpaid taxes stating that Apple had received illegal aid from Ireland. Last year, a mail from Dropbox stated that from June 2015, my cloud storage would be managed from Ireland.
Ireland is a growing tax haven, especially for billion dollar corporations based out of the US and questions the transfer pricing norms for tech giants. The ruling in the case of Apple is not unique. Starbucks Corporation has been ordered to pay up to 30 million euros to the Netherlands, while Amazon.com Inc and McDonald’s Corp are also under investigation by the European Commission. Apparently, a lot of US companies including (not limited to) Microsoft, Google, Facebook, IBM, Oracle, Adobe have their subsidiaries in the EU which to many is another means to evade taxes. No matter how hard the US government tries to negotiate with Ireland for stricter laws, the pace of companies shifting their profit basis to Ireland does not seem to slow down. Let us understand what makes jurisdictions like Ireland and Netherlands so attractive for the giants of developed nations.
Double Irish With a Dutch Sandwich – Problem for the US
“Double Irish With a Dutch Sandwich” is a common term used in the taxation grapevine to refer to tax evasion/avoidance (subjective judgment) technique employed by large corporations, involving the use of a combination of Irish and Dutch subsidiary companies to shift profits to low or no tax jurisdictions. It involves sending profits first through one Irish company, then to a Dutch company and finally to a second Irish company headquartered in a tax haven.
It has been common among tech companies because these firms can easily shift large portions of profits to other countries by assigning intellectual property rights to subsidiaries abroad.
Ireland has a 12.5% corporate tax rate whereas it is 35% in the US. If a US corporation builds a factory in Ireland that generates USD 10 million in profit, it pays USD 1.25 million in Irish tax instead of the USD 3.5 million that it would pay if it built the factory in US. Lax US transfer pricing rules allow the Irish factory to book inordinate profits that should have been taxed in the US. Suppose in the example, the Irish factory books USD 30 million of profit in Ireland. It pays USD 3.75 million in Irish tax, but at the same time, because it shifts USD 20 million of profit from the United States to Ireland, it reduces its US tax by USD 7 million. So the choice between locating a factory in US or Ireland is the choice between paying USD 3.5 million of US tax or net tax of negative USD 3.25 million (that is, USD 3.75 million of Irish tax minus USD 7 million of lower U.S. tax.) In effect, the U.S. Treasury is subsidising investment in Ireland.
The US regulations governing transfer pricing include discussions on the transfers of intellectual property. However, through cost sharing agreements, the US corporations transfer the economic rights of their intellectual property rights to their offshore affiliates in Ireland. One such affiliate (Apple Sales International in the case of Apple Inc.) buys Apple’s finished products from a manufacturer in China, re-sells them at a substantial mark-up to other Apple affiliates, and retains the resulting profits. This arrangement leads to shifting billions of dollars in worldwide profits away from the United States to an offshore entity with allegedly no tax residency and which may have paid little or no income tax to any national government.
What Worries the European Commission – Ruling in Case of Apple Inc.
Now, what is wrong for Ireland here and why does the European Commission have a problem with it? 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 the profits stemming from these sales, directly in Ireland.
The taxable profits of Apple Sales International and Apple Operations Europe in Ireland are determined by a tax ruling granted by Ireland in 1991, which in 2007 was replaced by a second similar tax ruling. This tax ruling was terminated when Apple Sales International and Apple Operations Europe changed their structures in 2015. These 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 its 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.
Therefore, only a small percentage of Apple Sales International’s profits were taxed in Ireland, and the rest were taxed nowhere.
In 2011, (according to figures released at US Senate public hearings), Apple Sales International recorded profits of USD 22 billion but under the terms of tax ruling, only around 50 million euros were considered taxable in Ireland, leaving 15.95 billion euros of profits untaxed. As a result, Apple Sales International paid less than 10 million euros 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 recorded profits continued to increase but the profits considered taxable in Ireland under the terms of the tax ruling did not. Thus this effective tax rate decreased further to only 0.005% in 2014 . Similarly, Apple Operations Europe benefitted from a similar tax arrangement over the same period of time. The company was responsible for manufacturing certain lines of computers for the Apple group. The majority of the profits of this company were also allocated internally to its “head office” and not taxed anywhere.
Advantages Beyond Ireland
Multinationals are not satisfied with Ireland’s 12.5% corporate tax rate as well. They turbocharge their tax benefits by shifting profits out of Ireland to zero-tax jurisdictions like Bermuda. For this, the first step is to transfer the patent from which the value of the service is derived to a firm say in Bermuda, where the tax rate is zero. This transfer of intellectual property is made at an early stage in development, when its value is very low (so that no taxable gain arises in the United States). To overcome the problem of US considering transactions with Bermuda under the tax ambit, another company such as Apple Operations Europe (in case of Apple Inc.) is created in Ireland which is managed by an entity based out of Bermuda.
The simplest structure in a case like this involves a disregarded entity in a tax haven (in Bermuda) making a loan to a subsidiary in a foreign jurisdiction (Ireland). The US recognizes neither the loan nor the interest payments. The foreign country, however, will view the tax haven entity as a corporation and allow the interest to be deducted as a business expense, thereby reducing both tax paid in the foreign jurisdiction and the income taxable in the US. If this turns out to be a properly managed arrangement, the US will treat both Irish entities as a single Irish company, not subject to Controlled Foreign Corporation (CFC or deemed related party) rules, while Ireland will treat Apple Operations Europe as a resident in Bermuda, so that it will pay no corporation tax.
Now the question would be how to get money transferred from Apple Sales International to Bermuda while avoiding paying cross-border withholding taxes?
There is a solution to that and the reason why such a complex arrangement is referred to as Double Irish With a Dutch Sandwich. A conduit company say “S” is set up in the Netherlands. Payments from Ireland entity (Apple Sales International) to the conduit Netherlands company and from Netherlands entity to the second Irish firm (Apple Operations Europe) benefit from the absence of withholding on non-portfolio payments between European Union companies, and those from Apple Operations Europe to Bermuda firm benefit from the absence of withholding tax under domestic Dutch law. Such transfer pricing based tactics (which are nothing more than paper transactions) of the American operations have continuously allowed allocating incomes to tax havens while attributing expenses to higher-tax countries. As much as USD 60 billion is lost in annual revenue by it .
Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller.
The article is only for information and learning purposes. The information and business models depicted in this article are sourced from secondary reliable sources. The analysis and comments presented above are solely of the author of this article and it does not have any relation or bearing with any other party.
 Kimberly A. Clausing, Professor at Reed College in Portland, Oregon