The Financial Times reported on September 30th that the European Commission has decided to open a formal investigation into whether Apple received illegal subsidies (“state aid,” in EU-speak) from Ireland going as far back as 1991. The FT quotes “people involved in the case” as saying that this can cost Apple billions of euros.

What the decision technically does is establish what is known as an “Article 108(2)” investigation, which means that the Commission has concluded from its preliminary investigation that state aid has been granted in violation of the EU’s competition policy rules. It is therefore opening a more comprehensive investigation. It is worth noting that if the Commission opens an Article 108(2) investigation, it almost always decides that illegal state aid was given. The only recent exception I can think of is state aid from Poland to relocate Dell computer manufacturing from Ireland in 2009, and I actually think the Commission should have ruled against that as well, as I discussed in my book Investment Incentives and the Global Competition for Capital.

As I speculated in June, one issue raised by the Commission is Apple’s “nowhere” subsidiaries created under Irish law. Both Apple Operations Europe (AOE) and its subsidiary, Apple Sales International ASI, are incorporated in Ireland, hence not immediately taxable by the United States until they repatriate their profits to the U.S. However, they are managed from the U.S., which by the provisions of Irish tax law makes them not taxable in Ireland. It is these provisions that are at issue in the case. See, in particular, paragraphs 25-29 of the decision, especially paragraph 29: “According to the information provided by the Irish authorities, the territory of tax residency of AOE and ASI is not identified.” Richard Murphy suggests today that these corporate provisions account for the largest proportion of Apple’s tax risk.

What is especially important for this investigation (and the similar ones of Starbucks and Fiat) is that if the Commission finds that state aid was given, it was never notified in advance to the Commission. The state aid laws require that any proposed subsidy be notified in advance and not implemented until approved. Ever since the 1980s, the penalty for giving non-notified, illegal (“not compatible with the common market”) aid is that the aid must be repaid with interest. Since this alleged aid was not notified, and will probably be found to be incompatible with the common market, Apple will be on the hook for aid repayment.

As I reported in June, this would not be the first time the Commission has used the state aid law to force changes to Ireland’s tax system. In 1998, it ruled that Ireland’s 10% corporate income tax for manufacturing was specific enough to be a state aid. Ireland then reduced the corporate income tax to 12.5% for non-manufacturing firms, while raising it to that level for manufacturing (mainly foreign multinational) companies.

If the Commission rules against Ireland and Apple, this will send a signal that the European Union is going to take tax manipulation very seriously with all the tools at its disposal. It would be especially great to see one of the pioneers of arcane tax avoidance strategies taken down a notch. For Ireland, at least there would be a small silver lining from losing this case: Apple’s aid repayment would go to Ireland and help reduce its budget deficit.

Cross-posted from Middle Class Political Economist.