How Apple managed to pay a 0.005 percent tax rate in 2014

EU faces criticism over the Apple tax decision
EU faces criticism over the Apple tax decision
Apple's record tax bill: What happens next?
Apple's record tax bill: What happens next?
Apple hit by EU news
Apple hit by EU news

How did Apple wind up paying such a low tax rate in Ireland for so long?

The answer is a tax structure that the world's most valuable company made with the country on the edge of Europe.

Apple created two subsidiary entities in Ireland — Apple Sales International and Apple Operations Europe — 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, said Robert Willens, a tax consultant and Columbia Business School professor of taxation.

But the result is that profit earned on the sale in China is shifted to the Irish subsidiary, said Willens.

This is when Apple's agreement with the Irish government — which the European Commission is taking issue with — kicks in.

Ordinarily, those profits would be taxed in Ireland at the relatively low rate of 12.5 percent but — thanks to an agreement between Apple and Ireland — the vast majority of profits in Ireland were attributed to a "head office" not located in any country and therefore not subject to taxes in Ireland or anywhere.

"Apple and Ireland will say that the head office legitimately earned these profits — it's not just an accounting maneuver — that the head office is really doing things that justify attributing most of the profits to it," said Willens.

The European Commission takes a different view, arguing that the head office exists only on paper and was created for the sole purpose of allowing Apple to pay very low taxes in Ireland in exchange for Apple's agreement to invest in the country and to employ a certain number of people there. The EC argues that the the tax arrangement did not reflect "economic reality."

"This "head office" was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings," the European Commission said in a press release on Tuesday. The Commission wants Apple to pay €13 billion for the "undue tax benefits" the Irish government afforded the company.

The European Commission used this example — based on figures from U.S. Senate public hearings — 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.

Only the Irish branch of Apple Sales International had the capacity to generate income from Apple products, so sales profits of the subsidiary should have been recorded in Ireland, not the home office, the Commission argues.

Apple makes an assumption, for accounting purposes, that it will repatriate all the taxes recorded in Ireland to the U.S. The company reports a very high tax rate of around 26 percent, but in reality pays around just 2 or 3 percent. This is something the company says it is required to do according to the accounting laws, and has been doing for years.

"They have one of the largest gaps — if not the largest gap — of any company between what they record and what they actually pay," said Willens. "That's something they have been criticized for — recording high taxes they have no intention actually paying."

Tax agreements between governments and companies are certainly not unique to Ireland and Apple. The EU seems to be taking a very broad view of "illegal state aid" with this tax assessment, which at 13 billion Euros is by far the largest tax assessment in the history of taxation, and leaving no room for negotiation, said Willens. The implications could be extremely wide-ranging, he said.

"If the concept of illegal state aid is broadly interpreted to encompass any sort of tax incentive program that any company would have, then almost any multinational would be affected and almost any of them would have reason to be concerned," said Willens.