The European Commission's preliminary findings on Ireland's tax arrangement with Apple has refocused attention on Ireland's corporate tax regime, but it also opens up questions about the EU's power over countries' tax affairs.

In essence, Brussels is concerned the Irish authorities underestimated the amount of taxable income that should have been attributed to two Apple subsidiary companies incorporated in Ireland, thereby giving Apple a selective advantage over competitors.

The most damning part of the 21-page letter sent to the Government in June is a section detailing an interchange between an Irish Revenue official and a tax adviser for Apple in 1990 that illustrates how the taxable profits were calculated.

The commission claims Revenue engaged in “reverse- engineering” in calculating costs in order to arrive at an already-agreed figure with Apple. It claims officials “negotiated” the transfer-pricing agreement, rather than substantiated it by comparing it to other comparable transactions. It also says the calculation was “motivated by employment considerations”.

In short, Ireland’s tax deal with Apple was based on a back- of-the-envelope, wink- and-a-nudge process of decision-making, the letter suggests.

Something unsavoury

The vivid description of the crude negotiating policy of Irish authorities in 1990 may point to something unsavoury, but the pertinent question is, is it illegal? The commission evidently thinks so. Its letter essentially sets out the prosecution case against Ireland; the Government – and Apple – are likely to pick apart its legal argument bit-by-bit.

The commission's main legal backing derives from article 107 of the Treaty on the Functioning of the European Union, which deals with state aid.

As was confirmed during the Lisbon and Nice treaty debates, EU member states have sovereignty over their tax affairs, with national governments free to choose and implement different tax regimes. But there are limits. These fall mainly under the area of state aid, one of the most powerful areas of EU law.

Article 107 states “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 production of certain goods shall, in so far as it affects trade between member states, be incompatible with the internal market”. However, the article goes on to outline exceptions: aid is permissible, for example, if it is intended to promote the economic development of certain areas or to facilitate the development of certain economic activities in specific cases.

The central plank of the EU’s prosecution in the Apple case is that Ireland was in violation of article 107.

Arm’s length principle

While much of the letter cites Ireland’s failure to adhere to the “arm’s length principle” outlined by the OECD in calculating its transfer-pricing arrangement with Apple, the OECD rules are not binding, and in any event were not in existence at the time of the Apple negotiations.

The letter also argues that, unlike Luxembourg, Ireland was unable to provide "transfer-pricing reports", showing the rationale behind its decision, though, again, there appears to have been no legal requirement on countries to have such a system in place.

The commission also refers to case law to back up its case. While the commission’s competition arm is one of the most powerful divisions of the EU, it tends to intervene in corporate matters rather than national tax issues. Nonetheless, there are instances of competition rulings on tax.

In 2003, for example, the commission ruled that tax breaks offered in Belgium, the Netherlands and Ireland, which in the Irish case exempted foreign dividends from taxation, constituted state aid.

This summer it launched an investigation into tax-exemptions offered by the Netherlands that may grant an unfair advantage to its state-owned ports.

Nonetheless, the Apple case is the strongest indication yet that the EU’s mighty competition arm is prepared to flex its muscles in terms of national tax systems.

Right to investigate

The EU has strongly dismissed suggestions that the decision to move on Ireland was political, with outgoing competition commissioner Joaquin Almunia defending the commission's right to investigate breaches of state aid rules as it sees fit.

Worryingly, the commission has not ruled out investigating more companies in Ireland, and it is also pressing the Government for more information regarding its knowledge of Apple’s intellectual property arrangements.

As the Government mulls over the wisdom of pre-emptively changing parts of Ireland’s corporate tax regime in the forthcoming budget, it may well consider whether any move on tax is likely to gain Ireland any political capital in Brussels, or whether the Apple investigation is only the tip of the iceberg.