Why Merrill Lynch Sees Apple’s EU and Irish Tax Woes Blowing Over

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Apple Inc. (NASDAQ: AAPL) saw its shares retreat about 1% early Tuesday after the European Union ruled that Apple would need to pay €13 billion, or about $14.5 billion, in back taxes under its tax scheme in Ireland. Not many companies would only see a 1% drop on news of a $14.5 billion penalty.

It turns out that this ruling comes with a huge headline shocker that may be far greater than the actual damage and cost might end up being. According to Merrill Lynch’s Wamsi Mohan, this situation may be largely overblown. Apple and Ireland are expected to appeal the ruling, that could take years to be resolved, and no immediate financial impact is expected. On top of that, Apple is even said to have more options to maintain a favorable tax structure.

Mohan did note that this tax ruling also was expected, as far as the $14.5 billion. Mohan maintained his Buy rating on Apple. He thinks that Apple will meet or beat near-term estimates, will have long-term market share gains and sees the upcoming launch of new products and optionality afforded by such a large cash balance. His note said:

As was expected, the European Union’s regulator issued a ruling that finds that Apple’s tax arrangement with Ireland violated European Union tax rules. The commission’s ruling requires Apple to pay back taxes, which amount to about 13 billion euro ($14.5 billion) in additional tax to the Irish government for Fiscal Years 2003 to 2014 (potentially higher including interest). We expect Apple and the Irish government to appeal this ruling. Tax matters usually take years to resolve and, given the international scope of this matter and repercussions on future tax cases, we expect no immediate financial impact to Apple.

One issue to consider here is that the implications could be broad and go far beyond Apple. Taxes paid by U.S. companies overseas detract from eventual taxes that might be paid in the United States, and Mohan noted that Treasury Secretary Jack Lew recently expressed concern about the anticipated EU ruling.

Merrill Lynch’s report showed that Apple has various strategies to deploy for the longer term. Ireland is shown to still provide a significant tax benefit for companies that can show a certain amount of research and development in Ireland. The so-called IP box would reduce the tax rate applied to eligible income to about 6.25%, and the potential impact to long-term earnings could be roughly 5%.

Merrill Lynch said that its estimates are unchanged, and the firm’s $120 price objective also is unchanged. In a worst-case scenario, if approximately $14.5 billion, represented as $2.65 per share, is paid in taxes it amounts to about 6.3% of Apple’s gross cash balance. It represents about 10% of Apple’s net cash balance. Mohan said:

In our opinion, many investors apply a higher normalized tax to offshore cash (under current repatriation rules) and, hence, this ruling should not materially affect valuation.

Merrill Lynch also has four more points that drive its Buy rating and $120 price objective for potential upside:

1) Continued long-term opportunity in China;
2) Potential share gains from the release of a lower-end iPhones;
3) strength in the upcoming iPhone 7 cycle;
4) optionality in cash balance.

Apple shares closed at $106.82 on Monday and its shares were last seen trading down about 1.0% at $105.83 on Tuesday. Its consensus analyst price target is $124.11, and the 52-week range is $89.47 to $123.82.