Transfer Pricing is in the spotlight again this week with the news of a win for Apple and the Irish Government in the State Aid case brought by the European Commission. With billions of Euros at stake, it is no surprise that the case drew attention. The court decision highlights the importance of transfer pricing planning for businesses of any size that are operating internationally. A minor change in the approach to transfer pricing can result in significant adjustments in profit attribution.
The judgement relied heavily on the OECD transfer pricing guidelines and emphasised the importance of performing a proper functional analysis of the permanent establishment whilst applying the Authorised OECD Approach for profit attribution. Furthermore, the judgement covered issues relating to the selection of the tested party and the profit level indicator for a transfer pricing analysis.
Background
The rulings concerned the way profits relating to Apple IP licenses for manufacture, sale and distribution of the Apple Group’s products outside North and South America were allocated between the Irish branches of Apple group companies and the Irish incorporated, but not Irish resident, subsidiary companies in the Apple Group. The European Commission had contended that the rulings had resulted in an annual chargeable profit for Apple subsidiaries in Ireland which departed from a reliable approximation of a market – based outcome. It had also argued that the results of the Apple subsidiaries were not in line with the arm’s length principle and the rulings of the Irish Revenue were discretionary in basis.
Summary of the General Court’s Judgement
- The General Court of the European Union passed judgement on 15 July, 2020 in the State Aid case of Apple and Ireland. The European Commission had considered that the tax rulings issued by the Irish Revenue to Apple Group Companies incorporated in Ireland constituted State Aid unlawfully put into effect by Ireland. The tax at stake was estimated at EUR13bn.
- The General Court’s ruling annulled the European Commission’s decision of 2016. The General Court concluded that the European Commission had not succeeded in demonstrating that the Irish tax rulings gave an unlawful tax advantage.
- The General Court did, however, uphold the right of the European Commission to apply the arm’s length principle as it provided a benchmark which ensured that non – resident companies operating through a branch in Ireland were not granted favourable treatment compared with Irish resident stand-alone companies whose taxable profits reflected prices negotiated at arm’s length in the market. Further, the General Court observed that the allocation of profits to the Irish branch of a non-resident company had to take into account the allocation of assets, functions and risks between the branch and the other parts of that company. One of the main reasons given by the General Court to annul the decision of the European Commission was that it had erred in not correctly applying the Authorised OECD Approach for the allocation of profits.
Authorised OECD Approach for Attribution of Profits to Permanent Establishment
- The Authorised OECD approach requires an analysis of the functions actually performed by the permanent establishment i.e. the Irish branches.
- However, the European Commission, according to the General Court, had performed the analysis incorrectly by i) identifying the functions performed by the company as a whole without conducting a more detailed analysis of the functions actually performed by the branches and ii) presuming that the functions had been performed by the permanent establishment when those functions could not be allocated to the head office of the company itself.
Transfer Pricing Analysis – Selection of Tested Party
- An interesting observation was made by the General Court with regard to the selection of the tested party for the purposes of performing the transfer pricing analysis. The European Commission in its decision had concluded that the Irish branches had performed IP – related functions that were crucial in building brand awareness and brand recognition in the EMEIA region. Relying on the OECD transfer pricing guidelines that the ‘’least complex entity be chosen as the tested party’’, the European Commission contended that the Irish branches had been incorrectly chosen as tested parties in the Irish rulings and that error had resulted in decreased profits for the Irish incorporated subsidiaries [which were HQs to the Irish branches].
- However, the General Court in its judgement observed that the OECD guidelines do not necessarily require that the least complex entity be chosen, but that they simply advise choosing the entity for which the greatest amount of reliable data exists. The General Court also concluded that the Commission did not put forward sufficient evidence to prove that the choice of Irish branches as tested parties had led to a reduction in the chargeable profits of those companies.
Transfer Pricing Analysis – Selection of Profit Level Indicator
- On the issue of which profit level indicator ought to be considered, the European Commission had argued that the “sales” figure of Apple’s Irish incorporated sales subsidiary should be used and not the “operating costs’’ of its Irish branch. The European Commission considered that “sales” gave a better reflection of the activities carried on and the risks assumed by the Irish branch and thus of its contribution to the subsidiary’s turnover. The General Court, in its judgement, observed that according to the OECD guidelines, the choice of profit level indicator is not fixed for any type of function, provided that that indicator reflects the value of the function in question.
- Further the General Court observed that the European Commission could not demonstrate why, in Apple’s case, the ‘’operating costs’’ of its Irish branch were not capable of reflecting the value which that branch had contributed to the Apple sales subsidiary’s operations through the functions, risks and assets analysis.
- The General Court noted that the Irish Branch of Apple’s sales subsidiary neither took part in negotiations relating to suppliers’ or customers’ agreements nor had decision making powers concerning supply, demand or the prices. Accordingly, the Irish branch of the Irish incorporated Apple sales subsidiary cannot be allocated the risks inherent in products unsold or a drop in demand. Hence, the European Commission did not succeed in demonstrating that the Irish branch was responsible for the risk connected with turnover.
Transfer Pricing Risk Relating to Product Warranties
- The European Commission in its decision had contended that the Irish incorporated Apple sales subsidiary had no staff and hence could not have assumed the significant liabilities related to product warranties.
- The General Court noted that according to Apple, the functions performed by the Irish branches related to gathering data regarding defective products, managing the network of third-party repairers, distributing components and managing the call centre. Having regard to the ancillary nature of those functions, it may not be concluded, in the absence of other evidence, that the Irish branch bore the economic consequences connected with product warranties.
Concluding Thoughts
This judgement emphasises the importance of performing a robust transfer pricing analysis following the Authorised OECD Approach and OECD guidelines with respect to the profit attribution to a permanent establishment and the allocation of profits to different overseas group entities of a multinational group. Whilst this is a win for Apple and Ireland, the key takeaway for multinational businesses having multiple overseas subsidiaries and branches is that the transfer pricing analysis needs to be conducted as a two-sided approach, considering the impact of functions performed, risks assumed and assets employed by each party to the transaction. Traditional transfer pricing planning approaches utilizing transaction-based benchmarking have limitations in producing such two-sided results. Multinational groups may now need to explore alternative transfer pricing approaches like value chain analyses, to factor in the contribution of all parties to the intragroup transactions.
For more information contact:
Malcolm Joy – Malcolm.Joy@frazierdeeter.com
Jay Menon – Jay.Menon@frazierdeeter.com