The European Commission on Wednesday stepped up its campaign to force big American technology companies to pay more taxes on Wednesday. It ruled that Luxembourg had violated EU rules by allowing the bulk of Amazon's European profits to go untaxed, and it announced it was taking Ireland to court for failing to collect higher taxes from Apple, after Ireland ignored a similar ruling from the EC last year. If the EC wins the battle, Apple could owe €13 billion ($15 billion), while Amazon could owe an extra €250 million ($290 million).

The EU's competition commissioner, Margrethe Vestager, says that she's just trying to create a level playing field by preventing big multinational companies from getting sweetheart deals not available to most companies. But critics say Vestager is meddling in the internal tax policy decisions of democratic nations—and some have also insinuated that she has been singling out American multinationals for extra scrutiny.

Small European countries have found they can attract business from big companies by creating business-friendly tax regimes. Technology companies have taken full advantage. Both Apple and Amazon set up convoluted corporate structures that attribute the bulk of their European profits to shell companies carefully designed to minimize tax payments. Vestager wants to stop some of the most egregious tax dodges in this area, but her campaign is generating a lot of controversy.

Amazon’s sweet deal

The basic question here is about which countries get to collect taxes on the activities of multinational corporations. For example, suppose Amazon designs a Kindle in Seattle, manufactures it in China, and then sells it in Germany. Should its profit on the sale be paid in America, Germany, or China?

Actually, the answer is Luxembourg. Amazon has a subsidiary in Luxembourg that oversees Amazon's European operations. Amazon says it has 1,500 total employees in Luxembourg. When a German customer buys a product from Amazon, he's technically making the purchase from Amazon's Luxembourg subsidiary. So tax liability for the transaction is governed by Luxembourg law.

Luxembourg has a relatively business-friendly tax regime. That includes a low 27 percent corporate tax rate—compared to 30 percent in Germany and almost 39 percent in the United States. It also includes provisions that allow multinational companies to avoid paying even this modest rate on the bulk of their profits.

To accomplish this, Amazon set up a second Luxembourg subsidiary called Amazon Europe Holding Technologies, which has (in the words of the European Commission) "no employees, no offices and no business activities." This subsidiary officially owns some of Amazon's key intellectual property rights, and it charges licensing fees to Amazon's other Luxembourg subsidiary to use these rights. The holding company charges licensing fees high enough to absorb most of the profits that would have otherwise been absorbed by Amazon's other Luxembourg subsidiary—the one that's actually shipping products to customers.

This shell company is structured as a limited partnership. The European Commission says that under EU law, "profits recorded by the holding company are only taxed at the level of the partners and not at the level of the holding company itself. The holding company's partners were located in the US and have so far deferred their tax liability."

The practical result is that Amazon has been able to defer payment of corporate income taxes indefinitely on most of its European profits. The EC says that this tactic allowed Amazon to reduce its tax bill by around 75 percent.

But European officials say the arrangement violates EU rules on state aid. These rules are intended to stop European countries from distorting the market by giving sweetheart deals to some companies but not others. The EC argue that by approving Amazon's elaborate tax-avoidance scheme, Luxembourg authorities were essentially giving Amazon a tax break that's not available to a conventional company. In a Wednesday ruling, the EC ordered Luxembourg to collect an additional €250 million in taxes from Amazon—the amount the EC estimates Amazon would have owed if Amazon hadn't taken advantage of this loophole.

Amazon wasn't happy about the ruling. "“We believe that Amazon did not receive any special treatment from Luxembourg and that we paid tax in full accordance with both Luxembourg and international tax law," the company told Ars in an emailed statement. "We will study the Commission's ruling and consider our legal options, including an appeal. Our 50,000 employees across Europe remain heads-down focused on serving our customers and the hundreds of thousands of small businesses who work with us.”

Why Ireland and the US object to the EC ruling

The situation with Ireland and Apple was a little more complicated, but the fundamental issue was the same. And the numbers are a lot bigger: the EC says Apple's underpayment of taxes is in the neighborhood of €13 billion.

Apple's European business is operated out of Ireland, another country known for its business-friendly tax laws. And Apple has carefully structured its European operations so most of its profits are attributed to an Irish subsidiary that only exists on paper and isn't required to pay corporate income taxes in Ireland—or anywhere else.

The Irish government has been resisting the EC's order last year to collect additional taxes. On Wednesday, the EC announced it would be taking the Irish government to European court over the issue.

You might expect a government to welcome having an extra €13 billion in the bank. But Ireland is fighting the ruling because it knows that its business-friendly tax regime is a key competitive advantage. Taxing companies more will increase revenues in the short run, but it would make companies less enthusiastic about relocating to Ireland in the long run. Ireland also has an incentive to put up a fight for the integrity of its past rulings to ensure that companies will take its future tax rulings seriously.

The US government has expressed displeasure about the EC's work in this area. Last year, the US Treasury Department put out a white paper arguing that the EC was misapplying the relevant European precedents in its Apple ruling. The paper argues the relevant question is whether Amazon and Apple receive the same tax treatment as other multinationals that use the same loophole—not whether the loophole is available to smaller and less sophisticated companies that aren't able to adopt such an elaborate corporate structure.

The issue matters for the US government because any money Apple and Amazon pay to European tax authorities is money they won't pay to the US treasury. Eventually, Apple and Amazon will want to bring their overseas profits back to the United States so they can pay them out to shareholders. Those profits will be subject to US taxes—unless companies have already paid taxes on the profits in Ireland or Luxembourg. So a higher tax bill in Europe will eventually mean a lower tax bill in the US.