The EU’s Taxing Behavior

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In a strange twist, it seems the world's largest multinational free-trade zone-the EU, consisting of 28 nations-has some qualms over both expanding free trade and multinational corporate business practices. Tuesday's headlines blared about Brussels-based bureaucrats' plan to take a $14.5 billion bite out of a company based in Cupertino, CA. Politicians are also raising doubts about big trade deals between the union and North America. For investors, these developments are reminders that the current global environment isn't very conducive to deal-making, and protectionism remains a factor to watch in this bull market. However, there is little proof a trade war this way cometh, and much more evidence we may simply lack the long-term positive of increasingly freer trade.

First, the big story: The EU hit Apple with a $14.5 billion (€13 billion) bill in unpaid taxes from 2003 - 2014. Brussels cited a violation of EU state-aid rules, stemming from Ireland's friendly corporate tax policy. Specifically, companies could book global sales and hold profits in a "head office" at an Irish address where no taxes applied. Most importantly, this was legal-Apple didn't break any tax laws here. Rather, the EU argued the arrangement was a sweetheart deal and amounted to an illegal government subsidy. The EU's tax grab has sparked angry reactions from Apple and the US Treasury, and after having a discussion, Ireland confirmed Friday they were outraged too.

Now, while that $14.5 billion bill sounds like a huge figure,^[i] this won't cripple Apple. For one, they've appealed the decision, and this will likely play out in the courts for a while-the company didn't lose almost $15 billion over night. Also, for scale, $14.5 billion comprises about 6.3% of Apple's cash on hand ($231 billion) and less than 7% of the company's revenue over the past year.^[ii] Thus, the market reaction-Apple stock dropped -0.8% the day the news hit-was rather subdued. At the risk of sounding myopic, Apple stock had 37 worse trading days thus far in 2016,^[iii] yet we can't recall the media spilling as many pixels for those days compared to this tax kerfuffle.

That said, while the direct impact on Apple is limited, this episode exhibits the EU's recent protectionist tendencies, which aren't positive. As some have pointed out, the EU's behavior against businesses seems inconsistent. The bureaucrats in Brussels have hammered multinational companies while European companies receive a slap on the wrist in comparison. It isn't our place to deem who is right and wrong here, but we are wary of haphazard regulatory actions, which can sink confidence and dissuade companies from future business activities. Retroactive tax grabs in particular discourage risk-taking and investment. How can you plan when the rules are never certain? Plus, the EU's behavior risks drawing the ire of other countries. We aren't saying retaliation is forthcoming or a trade war looms, but any developments hampering capital movement wouldn't be good.

Besides the tax forays, some in the EU have started to cool toward the US and Canada on the trade front. Earlier this week, German Vice Chancellor Sigmar Gabriel-Chancellor Angela Merkel's second-in-command and potentially the Social Democratic Party's candidate for chancellor in next year's federal elections-said the Transatlantic Trade and Investment Partnership (TTIP) with the US has "de facto failed." After some negotiators claimed otherwise, France added to the fire after President FranÇois Hollande withdrew his support for a deal through the rest of the year. Similarly, the EU's deal with Canada-the Comprehensive Economic and Trade Agreement (CETA)-has hit some minor snags as it goes to 30 national and regional parliaments for ratification, an extraordinary process launched by EU Trade Commissioner Cecilia Malmström as a concession to rising anti-trade sentiment around the bloc. Though discouraging, these hiccups don't necessarily imperil TTIP or CETA or signal a rising protectionist tide. Big trade agreements notoriously take a long time to complete (if they're completed at all). CETA has been in the works for seven years, TTIP for three. The logic behind free trade agreements is pretty straightforward: By reducing or removing tariffs and administrative barriers to trade in services, competition and opportunities improve, and consumers win. However, tariffs and other barriers benefit certain players, and understandably, those beneficiaries want to keep their advantages. Thus, trade talks drag on-even issues like cheese labeling can take a while to resolve-as negotiators argue and compromise on an acceptable agreement. The task is even harder when more parties, with their own specific interests, get involved, as evidenced by the Trans-Pacific Partnership (TPP) talks' long slog.

If CETA and/or the TTIP do become reality, this would certainly benefit the global economy in the long term. 2015 trade between Canada and the EU was worth approximately C$99 billion. If the US and EU come to terms, trade would be freer for about half of the global economy. However, failure to reach a deal won't release a big negative upon the world. Rather, it would be the absence of a positive and the status quo. Not freeing trade is light years away from raising new barriers, which is what markets would dislike.

The EU's recent actions are telling about the broader global environment, which is becoming increasingly unfriendly to greater integration and cooperation. Populist movements across the developed world have dampened enthusiasm for free trade deals in general. In the US, both presidential candidates speak aggressively about trade, promising to revamp existing deals (NAFTA) or put the kibosh on potential ones (TPP). Free trade has long been a tough sell with voters, increasing reluctance to push for a deal. In Europe, both France and Germany hold federal elections next year, and as Gabriel's and Hollande's latest rhetoric shows, potential candidates are already trying to curry favor with voters. There has also been an increase in regulators' appetite to clamp down on certain "advantageous" tax situations, and it's not just the EU-the US Treasury has made moves here too. Plus, general political gridlock across developed economies decreases the likelihood of big, sweeping change and makes it harder to reach broader agreements.

Now, we aren't saying this is an immediate threat for the bull market, especially since plenty of positive drivers persist. The global economy and Corporate America continue chugging along, however underappreciated. Investors remain a dour bunch, worried about ghosts around every corner, keeping expectations low and positive surprise potential high. While there is always the risk that something like retaliatory action leads to broader trouble, that isn't very probable at the moment-and successful investing is about acting on probabilities, not possibilities.