European Commissioner Margrethe Vestager  during a news conference on Ireland’s tax dealings with Apple Inc. at the European Commission in Brussels on Aug. 30. (Eric Vidal/Reuters)

The European Commission — the European Union’s main regulatory body — has hit Apple with a whopping estimated $14.5 billion bill for unpaid taxes. While the commission had been expected to rule against Apple, both Apple and the U.S. government had hoped for a much smaller amount. Here is how it happened — and why U.S. taxpayers may end up having to pay most of the bill.

Apple has taken advantage of creative tax arrangements

Apple, like many other big U.S. tech multinationals, has built its European headquarters in Ireland. There are many reasons Ireland is attractive to U.S. tech companies, including a well-educated, English-speaking workforce and friendly regulators. Still, perhaps the most crucial attraction is Ireland’s extraordinarily corporation-friendly tax system. Until very recently, it was possible for Apple to take advantage of tax arrangements that lowered its tax rate on foreign earnings very substantially. Apple located its intellectual property — the intangible assets that are at the core of its profit model — in Irish subsidiaries. These subsidiaries earned about 90 percent of Apple’s foreign profit, protecting it from tax authorities in the U.S. and elsewhere. For example, in 2011, Apple only paid somewhere between $2.1 million and $21 million in taxes in Ireland despite the fact that one Irish subsidiary accounted for 64 percent of Apple’s $34 billion in pretax income.

Now, European authorities are hitting back

Ireland’s tax policies have angered other countries in the European Union, who believe that Ireland is stealing business and siphoning off their own tax revenue. However, the European Union has only extremely limited authority over taxes, making it very difficult for these countries, or European authorities, to do anything about it. Now, however, the European Commission has come up with a clever legal strategy — interpreting Irish tax policy for multinationals as a kind of state aid to business, which the European Commission does have competences to police. The European Commission has decided that Ireland’s tax arrangements are an illegal state subsidy, which would force Ireland to reverse the subsidy by demanding back taxes from Apple.

This decision has consequences for other companies than Apple. It also has enormous consequences for the power of the European Union over tax policy. If the commission’s decision stands, it will be far harder and more politically risky for countries such as Ireland, Luxembourg or Holland to offer sweetheart deals to foreign and domestic corporations.

One way or another, U.S. taxpayers may end up footing much of the bill

The decision has consequences for U.S. politics, too. Big U.S. corporations have systematically set out to minimize their tax bills through exotic international arrangements. Many of them have accumulated huge stockpiles of money outside the U.S., which they do not want to repatriate under current tax conditions. This has caused a lot of controversy within the U.S. However, the U.S. does not want the E.U. to levy a big tax bill against Apple and other large U.S. firms. They would prefer that U.S. tax authorities get any revenue at some undefined time in the future, when Apple and other big companies repatriate their earnings.

Furthermore, depending on the niceties of the ruling, Apple may be eligible for a U.S. tax credit for any foreign taxes it has to pay. This would mean that Apple would retrospectively be able to claw back a lot of money from the U.S. government and  taxpayers.

U.S. authorities are furious, and U.S. senators are threatening retaliation against European countries. However, European authorities see this as an internal European decision about how Ireland (and perhaps, in future actions, other European countries) have been illegally providing state aid to businesses by offering them special tax deals. Roland Paris (PDF) and other political scientists have written about how difficult it is for states to agree on how to tax e-commerce (since one state’s gain may be another state’s loss), predicting that states will move to international arrangements to stem abuse. The European Commission’s new regime may create just such an arrangement for European states, at the possible expense of the U.S. and other outside countries.

The game isn’t over but Apple and the U.S. will be fighting uphill

The European Commission’s powers on competition law work differently than its closest U.S. analog, the Federal Trade Commission. When the Federal Trade Commission perceives market distortion, it has to win its case first in the law courts. The European Commission, in contrast, acts first, setting out a ruling which aggrieved parties can then appeal to the European Court of Justice in the hope that they can overturn the decision.

This has some important consequences. It creates a precedent, which the court may be less likely to overturn than if it was acting purely on its own judgment. It also makes it harder to bring international pressure to bear. The U.S. tried to push the European Commission to back down and failed. It is usually easier to convince the commission than the European Court of Justice — which is inward-focused and cares more about European law than about international politics. The court is unlikely to pay much attention to threats of retaliation from the U.S. or elsewhere. Instead, its judgment will be guided by internal questions of whether the commission has acted within its competences or exceeded them. The commission is favored by the fact that some previous forms of tax policy have been interpreted as state aid, and by the perception that some E.U. member states are taking advantage of the system. However, the court will want to consider carefully the consequences of giving the commission this new expanded authority, given that politically sensitive aspects of taxation policy are not usually considered to be under the commission’s authority.