Apple's $348 Million Tax Settlement In Italy Bodes Ill For Google, Facebook, Microsoft And Others

We have the very surprising news that Apple has made a tax settlement with Italy. A large one too: to the extent of $348 million (€318 million). Given that almost all of the tech giants, and many other companies as well, use much the same arrangements that Apple does and has done this doesn't bode well for the Googles, Facebooks and Microsofts of this world. For if one European Union government has been able to do this then given the extreme similarity of the basic structure of the tax laws governing inter-EU trade then it's highly likely that the same can be done to all of them and in all the different countries. That would also be rather a blow to Apple itself of course.

The underlying question, and one that it's far too early to be able to give a definitive answer to as both the tax office and Apple are being pretty quiet about this, is what actually brought this settlement about. This will probably qualify as a material event even for a company of Apple's size so we'd expect to see some sort of explanation to the SEC at some point. That underlying point being, well, has this come about as a result of some paperwork or similar mistakes by Apple? Or has Italy managed to undermine the basic idea of the international corporate tax system, territorial integrity? If it's that first then it's an interesting story about how important the jots and tittles of paperwork are. If it's the second then we're in for a thorough reordering of how international business is done, most especially in the tech sector.

The news itself:

Dec 30 U.S. tech giant Apple will pay the Italian tax office 318 million euros ($348 million) to settle a dispute and sign an accord early next year on how to manage its tax liabilities from 2015 onwards, a source close to the matter said on Wednesday.

Italian prosecutors have been investigating allegations that Apple failed to pay corporate taxes to the tune of 879 million euros, sources told Reuters earlier this year.

In a little more detail:

The investigation, which involves three Apple executives, focuses on the allegation that Apple booked into its Irish-based unit income it made from sales in Italy in the 2008-2013 period, thereby avoiding corporate taxes.

And it covers the following period:

Italy's tax authorities say the company failed to pay €880m in tax between 2008 and 2013, according to La Repubblica.

That's important: because of course that is starting from when the iPhone first really hit the market, when Apple was a very much smaller company than it is now. So if the real structure of business has changed then there's more pain to come. When this investigation was first announced I dismissed it, pointing out that everyone knew how Apple organised its taxes and everyone agreed that it was legal. Obviously that's not quite as true as I thought it was so it's worth trying to work out why.

Here in the European Union the basic way that the big American tech companies work is well known. This applies to Google , Facebook , Microsoft (Amazon is slightly different, in that it rarely makes profits) and so on as well as Apple. Everyone has noted the basics of the EU Single Market, this means that one company, based in any one of the 28 EU countries, has an absolute right to sell goods and services in all 28 countries. And corporation tax (what we call corporate income tax) is then payable in the country where that one company is based. By choice this is often Ireland for other reasons that don't really concern us (no, it's not because the tax rate there is 12.5%, it's other arrangements that do it, but they're not relevant to this part of the story).

Now that's an absolute right under the Single Market laws. However, the one thing that then brings a company into the remit of more local tax authorities is if it has a "permanent establishment" in a particular country. This all comes, originally, from League of Nation days before WWII but the idea is simple enough, if you just sell the occasional thing across a border then it's ridiculous that you've got to file 28 corporate tax returns. But if you do significant business in a place perhaps the organisation should be contributing? And the definition of a permanent establishment is what defines that change.

What everyone has been doing is mixing and matching to take best advantage of the confluence of these two sets of rules. Sure, Google wants a research and engineering centre in the UK, Apple wants to have support and stores in Italy and so on. But they'd also like to make those sales to those countries from Ireland for the tax advantages (until today, everyone thinking those advantages were entirely legal, even if people argued about the morality). So, that's what they did. There would be a Google UK, and Apple Italy, that was simply paid a fee by the parent company (covering costs and not much more) to provide those services in those countries. But sales would all be made from Google Eire or Apple.ie. That way the sales were booked in Ireland, thus taxed, as per the EU rules, under Irish law, but also the various companies can have an outpost in each European country without those sales being associated with a permanent establishment in each country.

Now, making sure that this is really all working can be slightly complicated. There've been accusations that Google's London office really makes the advertising sales, Google in Ireland merely issuing the contract. If the sales really are being done in London then that is a permanent establishment. Physical goods are a little different, in that Apple can sell iPhones at absolutely any price it likes to anyone. But there's something called the "transfer pricing rules" which mean that if Apple sells phones to Apple Italy, for sale through stores, then it has to do so at the same price that it sells to, say, Vodafone Italy for sale through those stores. If it's not using the same prices, or if it's really concluding those sales through the Italian office and then just booking them in Ireland, then at least some portion of that profit will be subject to Italian taxation.

And that's what we all thought the situation was up until today. There's long been argument about whether it should be this way but all have been agreed that if those rules about transfer pricing and permanent establishments are being obeyed then it was indeed all legal. I think that it's all entirely moral too for I'm against the very idea of corporate income taxation: but I acknowledge that I'm in rather a small minority on that one.

At which point we've got to ask what has changed? To which there are two possible answers. the first is that Apple simply got some of the paperwork wrong. Perhaps the people in Italy really were doing the sales, creating that permanent establishment. Maybe the transfer pricing was wrong, say they were charging Apple Italy more than Vodafone Italy in order to move more of the profit to Ireland. That's obviously possible, but I'm not sure that I think that is what this is. The amount looks to large to me to be that.

Unfortunately Apple doesn't break out it sales by country. We can go and look at what Apply Italy's turnover was, sure, but that doesn't tell us what sales there were for precisely the reason that sales weren't by and large, booked there. But think back to the size Apple was in 2008, 2009, the iPhone was just becoming the success it is, the iPad wasn't available yet, the iPod was still in mass production. And think of what Apple's margins were back then: and at that point it looks about right that Italy is trying to claim Italian tax on some substantial portion at least of Apple's total profits from selling in Italy. And if that's true then that's a substantial change in the international corporate tax system. It completely over rides the general assumption of territorial integrity. As well as violating the principle that we don't pierce the corporate veil.

That, of course, then over rides the whole OECD BEPs process which is trying to deal with the very same structure. So we've a large problem looming as a result of this, assuming that it wasn't just those mistakes which led to this ruling. Essentially, we've one country unilaterally over turning what we all thought was true about the international tax system.

The problems also don't stop with Apple in Italy. To a reasonable level of accuracy most of the tech companies, certainly Facebook, Google and Microsoft, use pretty much the same corporate structures when they sell in Europe. So, if one can topple, then we would expect the others to follow. More than that the international tax rules are pretty much the same in every European country. They have to be, for at that one level they're determined by the European Union's Single Market regulations and at the other everyones' tax treaties are based on the same templates for the League of Nations days. So, exactly the same thing could happen to Apple UK, Facebook Germany and Google France and so on and on through the companies and the European market.

And if we're honest about it we really wouldn't want that to happen. No, not even governments, nor even the tax campaigners would like that to happen. International law simply has to be agreed between everyone: we just would not like the effect of one country unilaterally changing those rules and laws. Whatever your attitude to how those tech companies manage to get themselves taxed is, it's still true that we'd all like any change to be made by general agreement. And that's the deeper economic worry here. That Italy is acting unilaterally, and undermining the common perspective that international law simply has to have in order to be effective. It would actually be better to hope that someone at Apple just made a, very expensive, mistake.

My assumption is that we'll hear more about this in the new year. I would expect an SEC registration from Apple on it as $348 million is a material event even for a company of Apple's size. I would also expect rather more information from the Italian tax office next week. And most certainly other European governments are going to be looking at this very closely. Which is precisely the problem with unilateral action: they'll all be looking to get their slice of the pie from all of those different tech companies and they'll all be squabbling over what that pie is and who gets what slice. Which is why these things are normally detailed by international agreement in the first place.