The EU is taking on Apple and their tax avoidance measures. It is a case that will define the future of taxation and how much can be collected from the profits businesses make in a globalised world.

The case marks a defining moment and is a necessary step in freeing trillions of dollars of trapped cash and is necessary to fix the global economy.

Trapped in a tax haven

Apple paid next-to no tax on profits of $74 billion made outside the US between 2009 and 2013 because they use what is known as a 'Double Irish with a Dutch Sandwich' tax avoidance scheme.

The scheme is beautifully creative, but has one fundamental flaw. The accountants worked out a way to get their profits as far as Bermuda or Grand Cayman without incurring any tax, but they cannot move the money any further.

The cash is trapped there: if it is paid to its rightful owner, Apple Inc, the US Treasury will take 35%, less any tax already paid to foreign governments. Because so little tax has been paid abroad, almost 35% is still due on any profits brought back to Apple Inc.

Apple has been quite happy to sit on this tax timebomb because they were in no rush to bring back the profits. They could wait until the US Treasury was desperate enough to offer another repatriation tax holiday.

Unfortunately for them, the EU investigation changes everything.

Photo: a bad Photoshop job by me

A defining moment

The EU has decided to investigate whether Apple and many others received State Aid from Ireland by virtue of that country's tax laws. The EU is fighting Ireland's tax laws as much as they are fighting Apple, but the net result is that Apple and others could be forced to pay back the taxes they thought they had avoided.

If Apple & Ireland win, we will have a race to the bottom with countries falling over themselves to offer the lowest corporate tax rates. Governments will be forced to increase sales, estate, income and other forms of personal taxation to compensate. You may pay more sales tax on your iPhone, because Apple pays less tax on the profits they make when you buy that iPhone.

If the EU wins, then there is likely to be a harmonisation of tax rates and rules across the developed and developing world. The reason we are here is because some countries like Ireland and the Netherlands offer businesses lower rates and bigger carve outs than countries they compete with.

Why the EU's case is a step forward

The European Union does not get a lot of good PR. The Competition Commission in particular seems to relish forcing rebellious companies into compliance and relentlessly pursuing those who get too big for their boots.

The Commission may be undemocratic, but it is this distance from democratic influences - the protectionism, the lobbying and the horse-trading - that gives the Commission the power to prevent national governments acting selfishly. It has the independence of a court and the governmental authority to define laws.

A ruling - any ruling - could finally clear up the standoff between global companies and their governments that has left trillions of dollars in limbo, unusable by anyone until these arguments are resolved. It is an argument that must be played out.

It is important to note that Apple are just one of many companies using these loopholes. They all believe these measures these be legal, but the sheer scale of Apple's profits mean that they have the most to lose financially and so will be at the heart of the EU's investigation. This cartoon does make a good point though.

Apple are the tip of the iceberg

Apple's arrangements have been cloned by many other tech companies who are easily able to relocate their Intellectual Property to a low tax country like Ireland, the Netherlands or Luxembourg.

Even physical goods distributors like Amazon are able to take advantage of the single European market to sell to 500 million consumers from their tax haven in Luxembourg. Most of the profits from each transaction stays there, where Amazon has located their IP, so the company pays little taxes even on tangible goods.

Consider the companies that are paying their dues. Another company using a Double Irish with a Dutch Sandwich, Starbucks, competes with Costa Coffee, a UK business owned by Whitbread that does not offshore profits and therefore pays 22.9% tax on profits. Why should Starbucks have a competitive advantage over Costa? Eventually, Costa and all the others that haven't avoided tax will have to do so or their customers will face higher prices.

It is very easily done. Companies can simply relocate their HQ and transfer their IP wherever the benefit is highest. The threat of relocating one's HQ is a serious and very real one with major impacts on local and regional jobs if global businesses move out. WPP, the advertising giant, already forced the UK government's hand once on tax - they moved to Dublin in 2008 from London due to Ireland's lower tax rate, returning in 2013 when the UK rate was lowered.

While national governments can huff and puff about avoidance, there is relatively little that any one country can do to address the problem. The global nature of business pits countries against each other. Hosting multinational organisations brings employment and supply contracts, even if they don't pay corporate taxes any more.

No one wants to take a unilateral stand and risk losing jobs but the stark fact is this:

In the US ... corporate tax generated 32.1% of all federal taxes in 1952. Today that proportion has fallen to a puny 8.9%.

A dangerous precedent was set in 2004

Companies are hoping that the US government will blink again and allow them to repatriate funds at a discount. In 2004, the Treasury allowed the repatriation of $362 billion of US corporate profits from overseas in at a 5.25% tax rate. This policy was designed to spur investment and to create jobs, but the analysis says that the objectives were not achieved. The policy was a failure.

Nevertheless, the 2004 holiday set a precedent and ever since then, businesses have been piling up the cash offshore, waiting for the next big tax break. Apple and others believe that if they wait long enough, another such deal will be offered, so they are prepared to wait indefinitely until the right deal is on the table.

This money sitting in tax havens is just taken out of the global economy. Don't be fooled into thinking that it is zero sum: companies aren't giving this cash back to shareholders or reinvesting it in growth, they can't without repatriating it and paying US corporate taxes in the process. Instead, the money is sitting in offshore subsidiaries and doing nothing while governments increase hidden taxes and borrow more to make up their revenue shortfall.

The longer the problem is left, the bigger it becomes, which is why the EU's intervention is essential. Some estimate that over $100 billion tax is lost by US and European governments every year. Others say the US alone loses $90 billion a year. Some say that there is about $1.7 trillion of US corporate profits held in this state of limbo. Others make this figure $2,100,000,000,000 ($2.1 trillion).

The companies are waiting for governments to blink and offer a repatriation amnesty. At the US' current 35% corporate tax rate, that is $600 to $735 billion in taxes that would be due if that money comes ashore. But it won't come ashore. At least not willingly and certainly not while there is an expectation that the US Treasury will eventually decide to cut its losses and reduce their rates. They did so once before so it is rational to wait and see if they do it again - there's $500 to $600 billion at stake.

If the companies need the cash in the meantime, they can borrow it from their offshore subsidiary. By doing this and paying the offshore entity interest on the loan, they can move profits made in the USA into the tax haven. Details of how one UK company runs a similar scheme resulting in a $474m profit paying just $14m (3%) in tax is found here.

Politics meets big business

The US Senate interrogated Apple executives in 2013 and gave the company a platform to lobby for tax reform. Governments know they cannot not win a stare-down, and the US has no jurisdiction to prevent the money getting to the tax haven via the Double Irish with a Dutch Sandwich.

Photo: Jason Reed/Reuters

So now, the EU is seeking to outlaw the schemes used to move the funds offshore in the first place, perhaps collecting back taxes in the process. Whereas before, Apple could sit and wait until the US government gave in, now the pressure from the EU may push the company to accept a compromise before the rug is pulled from under them in Ireland. The stakes just got raised and Apple is no longer quite as comfortable as it was.

Fighting too hard and allowing the fight to divert attention away from their real business could cost Apple something much more valuable than a few billion dollars: it could cost them their time, their credibility and their market position. Before they fight, they should consider what happened to Microsoft when they fought the EU ten years ago.

Learning from Microsoft - the EU is deadly serious

Ten years ago, the EU Commission challenged Microsoft's dominance. The competition case cost Microsoft billions of Euros in fines and costs but for the Microsoft of 2004, that was chump change. It took them many years to even take the EU seriously but eventually it became clear that the battle was real.

Distracted, the company lost their way: Windows lost it's 'je ne sais quoi', and Microsoft lost the smartphone war. The full cost was hidden for a while but became apparent in 2007 when Microsoft woke up to find that Apple had re-emerged and Google was starting to park its self-driving cars on Microsoft's lawn.

The risk to Apple is that they do a Microsoft. Of course, they will fight to retain their profits, but organisations rarely beat the EU and the investigations are never quick and simple. Most companies grind to a halt while fighting the battle and if that happens to Apple, they may never find another Next Big Thing.

Tax is an emotive issue

Brand Apple is already looking tired after seven years on top of the world. They could be near a tipping point where appearing greedy and socially irresponsible at a time of great financial hardship for people and governments worldwide, might flip the public's view of who and what is cool.

Tax has the potential to cause that flip because if Apple pays less, I pay more. Consider this internet campaign.

Could the EU tax investigation be Apple's Microsoft moment?

An end to the standoff

Apple has a choice. They can fight and cause the case to drag on for many years and risk losing everything in court and in the minds of their customers. The longer it goes on, the bigger the distraction, the worse the impact will be on innovation and customer loyalty.

Maybe a new competitor will emerge while Apple is busy fighting off the commission.

Or they could continue to lay out the conditions for a deal that will work across the board, pushing hard while compromising and leading Corporate America's solution to the issue. The solution has to include a harmonisation of corporate tax rates across the EU and US, perhaps pushing all to a rate between 15% and 20%. To prevent abuse, the new rules need to prohibit the transfer of IP and IP-based revenues outside this harmonised zone.

The worst case scenario is that nothing changes and these corporate profits continue to accumulate where they are no good to anyone. Even though the cash is trapped, has become irrational for businesses to pay tax while they are able to avoid it so easily.

A positive outcome and an end to recession?

Can you imagine the benefit of having $2.1 trillion flowing back into the global economy? The tax receipts could reduce borrowing and/or fund many new infrastructure projects. At the moment, the cash is no use to anyone.

That much money also opens a lot of new reinvestment opportunities and could pay big dividends to shareholders. It might be that Apple's shareholders and those of many other businesses would be better served by paying some tax to free the trapped cash.

One thing is for sure: we cannot continue the way things are going with all that money getting stuck doing nothing. Maybe the EU just forced the issue.