The voices of Tax Policy Center's researchers and staff
The remarkable thing about the Senate Permanent Investigations Subcommittee’s report on Apple Inc.’s corporate tax avoidance is how unremarkable it is.
Because Apple is so profitable, the dollars involved will certainly attract attention (this is a Senate committee after all, so that is the point). The report alleges Apple reduced its U.S. corporate income tax by an average of $10 billion-a-year for the past four years. Since the corporate levy generated only about $240 billion in 2012, $10 billion foregone from one company is a very big number indeed.
But while it added a few interesting twists, Apple cut its taxes with the same tools multinationals have been using for years to minimize their worldwide tax liability. And if there is a scandal, I suppose it is the very ordinariness of these transactions. Apple’s tax avoidance shop, it seems, is a lot less innovative than its phone designers.
The tactics are complicated but the strategy is simple: A company designs its business to locate as much income as possible in those countries where taxes are low. At the same time, it allocates as many costs as possible to those high-tax jurisdictions (like the U.S.) where deductions are especially valuable. A deduction is worth 35 cents on the dollar in the U.S. but only one-third as much in Ireland, where the corporate rate is only 12.5 percent.
To achieve these twin goals, Apple mostly relied on the three golden goodies of international tax avoidance: deferral, transfer pricing, and check-the-box.
What on earth am I talking about?
Deferral allows U.S. firms to avoid paying U.S. tax on foreign income until earnings are brought back home. In practice, companies can keep these earnings offshore indefinitely and never pay U.S. tax. Transfer pricing and check-the-box make the system even more beneficial.
Transfer pricing is the way firms use internal bookkeeping to allocate expenses among various affiliates. For a company like Apple, nearly all the value of its products is in its patents and other intellectual property. By charging a relative pittance to a foreign subsidiary for use of that IP, it can maximize that affiliate’s profit and minimize its IP income in the U.S.
Firms are supposed to price these assets at market value. But what does that mean when it comes to, say, proprietary computer code?
Check-the-box has been around for 15 years. Originally aimed at simplifying filing, these Treasury rules allow firms to classify themselves as one of several different entities—corporations, partnerships and the like. One category, however, is a “disregarded entity”—an affiliate not subject to U.S. income tax.
Normally, firms might be subject to rules (called Subpart F) meant to prevent abuse of deferral. But multinationals avoid these strictures by designating foreign corporations they control as disregarded for tax purposes. All they have to do is, you got it, check a box.
There is some cost to deferral. Apple, for example, recently chose to borrow $17 billion to finance U.S. investments even though it has $100 billion stashed overseas. But if the benefits didn’t outweigh the cost, companies wouldn’t keep holding all that money offshore.
How did Apple do it? It set up two entities in Ireland through which it was able to funnel two-thirds of its pre-tax worldwide income. Of its $34 billion in total 2011 pre-tax income, $22 billion was allocated to these two firms. True, the Irish love to talk. But it is unlikely they bought enough phones to generate $22 billion in pre-tax income.
Remarkably, while these firms were physically located in Ireland, they were not Irish companies for Irish tax purposes. Thus, they produced what Harvard University tax professor Steve Shay describes as “ocean income.” That is, revenue that simply disappears into the deep blue.
As my Tax Policy Center colleague Chris Sanchirico notes, the committee staff found that while the income from those Irish subs was not repatriated to Apple (which would have triggered U.S. tax) it did apparently did make its way back to the U.S., where it is sitting in bank accounts of those Irish subs.
What’s the problem with all this? There is the revenue loss to the U.S., of course. But perhaps worse is the incredible inefficiency driven by the tax code. The price of high corporate rates is the raft of deductions and credits that encourage corporations to lower their taxes rather than produce great new products.
Just imagine if Apple could replace all those tax lawyers with creative new software geeks or industrial designers. It might win back some of the market share it has been losing to Android in recent years.
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