Last week, the European Commission (EC) opened a formal investigation into McDonald's Corporation's (NYSE: MCD) tax practices in Europe. The Commission alleges that McDonald's Europe Franchising, which I'll refer to as "MEF," has paid virtually zero taxes in Luxembourg, where the subsidiary is based, since 2009.
The Commission's press release, issued December 3rd, used calendar year 2013 to illustrate the magnitude of the alleged non-taxed income, claiming that MEF, which receives royalties from McDonald's European franchisees, generated 250 million euros of profit in that year. Using a "back of the napkin" calculation to extrapolate meaning from this figure, and employing historical exchange rates, profits since 2009 could easily total over $2 billion.
McDonald's responded by claiming that it has complied with all tax laws, and that its companies have paid 2.1 billion euros worth of corporate tax between 2010 and 2014 within the European Union, at an average tax rate of 27%.
Of course, between its own corporate-owned stores and franchisees, McDonald's has multiple operations on the continent, so while its protestation of compliance signals that it will fight any rulings, it doesn't necessarily put the issue to bed for shareholders, especially given the rather interesting case being presented by the European Commission.
Basis for inquiry
It's important to note that this investigation is as much about Luxembourg's treatment of tax law as it is about McDonald's tax practices. The EC is looking into whether Luxembourg authorities allowed MEF to obtain an unfair advantage over other companies through "derogation," that is, relaxing enforcement of both its own tax law and the Luxembourg-U.S. Double Taxation Treaty.
This treaty is designed to protect companies with significant operations in both Luxembourg and the U.S. from enduring double taxation. Yet within the good intentions of the agreement, if the EC is correct, there's more than a bit of grey area.
The EC alleges that in March 2009, Luxembourg exempted MEF from paying taxes within its jurisdiction on the grounds that European profits, which were being transferred out of Switzerland to the U.S., were subject to tax in the U.S.
The 2009 ruling required McDonald's to submit yearly proof that it was declaring the transferred profits to both Switzerland and the U.S., and that those profits were taxable in both countries. MEF contested this ruling, as it could not prove that it had a taxable presence in the U.S.
This is where it gets strange
In pushing back against the ruling, McDonald's argued that under U.S. tax law, MEF's U.S. branch did not have a "permanent establishment" in the U.S., thus, its profits shouldn't be taxed in the U.S.
However, MEF also argued that under Luxembourg's tax law, its U.S. branch was considered a permanent establishment, meaning its profits should be exempt from tax in Luxembourg.
Now, even those of us who aren't experts in international tax law understand that a company's earnings, unless otherwise exempted, have to be taxable somewhere. McDonald's apparently argued that in its opinion, the U.S. branch of its Europe Franchising business didn't meet a taxable standard on either continent, and therefore the company shouldn't owe taxes in either jurisdiction.
Nonetheless, in a second ruling issued in September 2009, knowing that MEF's profits would not be taxed in the U.S., the Luxembourg authorities rather bizarrely exempted that income from tax in Europe as well.
The EC is mystified as to why the Luxembourg authorities issued the second ruling. As I note above, its investigation will seek to determine if Luxembourg selectively relaxed its tax compliance on McDonald's behalf, in breach of European Union state law.
An investigation of this magnitude and complexity will necessarily take some time, so for shareholders of McDonald's stock, there is little immediate consequence, although it's certainly an issue to track closely during 2016. After all, the financial ramifications for McDonald's could be rather significant.
Using the calculations from the beginning of this article, if McDonald's ends up owing tax at anywhere near a 27% rate on roughly $2 billion in profits, the outlay to satisfy the EC could potentially cross a half-billion dollars. That's before any penalties or interest the EC may choose to assess, should it find that the company is indeed liable to the European Union.
In the nearer term, shareholders may see a higher provisioning for income tax in each of McDonald's quarterly earnings reports, if management decides to start reserving some current profits given the possibility of an unfavorable tax ruling.
This would have a negative effect on earnings per share in each quarter that McDonald's raises its tax provisioning. We'll have our first glimpse then of the company's true posture toward this investigation, when it files fourth-quarter 2015 earnings at the end of January. Personally, at this point, my curiosity is quite piqued.
Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.