On Tuesday, Apple CEO Timothy Cook testified before the Senate Permanent Investigations Subcommittee on his company’s aggressive tax avoidance strategy. Predictably, Republicans demanded that the U.S. cut its corporate tax rate and cease taxing the foreign income of multinational corporations. But even many liberals are sympathetic, believing, falsely, that this is an issue of jobs that have been exported abroad.
In fact, this problem has almost nothing to do with the location of production facilities, which is primarily a function of labor costs. The tax structure mainly affects the location of tax base; that is, where taxes are paid (or not paid) on sales and profits earned.
People undoubtedly assume that the profits Apple has amassed in foreign jurisdictions relates to actual production in those jurisdictions. In fact, it does not. What companies like Apple have done is systematically transfer their intellectual property to tax havens, such as Ireland or Luxembourg, which allows them to transfer profits from higher-taxed countries such as the U.S. to places with low or nonexistent taxes.
It’s important to understand that the vast bulk of the value of a high-tech company such as Apple is not in its production facilities, but its technology, which is ultimately ideas embodied in hardware and software, designs for computers and other devices, and the patents that protect them. Trademarks and copyrights are other important forms of intellectual property.
Since such intellectual property is intangible, it is very easy for a company such as Apple to establish a subsidiary in some tax haven and then sell that property, based on designs, research and development done in the U.S., to the subsidiary for a pittance.
Since much of the price one pays for Apple products is for the patent royalties, what happens is that when one buys an Apple product, Apple is actually paying its foreign subsidiary a royalty on each sale. In this way, profits made in the U.S. are realized in Ireland as the home company systematically pays royalties on its sales to its own subsidiary for the right to sell its own products in the U.S.
In theory, IRS regulations prohibit this sort of thing. Patents sold to a foreign subsidiary are supposed to reflect the market price of those patents. If the foreign subsidiary paid the true market price to Apple for its patents, then the home company would realize a huge capital gain in the U.S. that would be taxed.
But of course that is not what happens. Since Apple controls both sides of the transaction, it sets the sale price of its patents far below what they would be worth on the open market. This is a problem for the taxation of all multinational corporations which is called transfer pricing. It allows such companies to realize profits in low-tax jurisdictions and tax-deductible costs in high-tax jurisdictions.
A key cost is the issuance of debt because interest payments are tax deductible. Thus a company like Apple can borrow in the U.S., deduct the interest payments here, and use the funds to invest in Ireland, China or wherever it pleases, realizing the profits generated by that investment overseas.
The problem is that profits realized overseas must theoretically be kept there. U.S. taxes only apply to profits that are repatriated to the U.S. Profits that remain abroad are deferred indefinitely. This prevents them from being paid out to shareholders as dividends, although there are ways around this.
Apple itself has shown how this may be done. It simply borrows money in the U.S. and uses that money to pay dividends to its shareholders. In principle, the profits remain overseas and stay untaxed. The dividends will, of course, be taxable to shareholders. But they are taxed at only a 20 percent rate, but a large percentage of Apple stock is owned by pension funds, college endowments are other institutions that pay no income taxes.
Alternatively, Apple could use the money to buy shares of its own stock. This will raise its stock price and benefit shareholders that way. Since unrealized capital gains are never taxed, this would allow shareholders to decide for themselves whether or when to pay any taxes on their stock.
Many conservatives argue that lowering the U.S. corporate tax rate would fix the Apple problem. They point, correctly, to the fact that the U.S. has one of the highest statutory corporate tax rates in the world. What they never mention is that the effective corporate tax rate – taxes actually paid divided by profits earned – is among the lowest in the world due to tax deductions and credits.
A key credit is the foreign tax credit, which allows companies to subtract from their U.S. tax liability all taxes paid on the same profits in foreign countries. This is to prevent double-taxation.
While lowering the corporate tax rate would undoubtedly lead to some repatriation of foreign earnings, it is no panacea. Even if the tax rate is lowered to 25 percent, a widely supported goal of tax reformers, there is no reason to think companies like Apple will pay it when they can continue to pay zero by doing exactly what they are doing now.
Others say that the U.S. should adopt a “territorial” tax system and levy no taxes whatsoever on corporate profits earned abroad. One problem with this idea is that countries like Great Britain have territorial tax systems, but also suffer from massive tax avoidance by multinational companies.
There has been considerable controversy in Britain for some time about companies that earn profits in that country--such as Google and Starbucks--yet pay little, if any, taxes in Britain.
Taxing multinational corporations in a world in which profits and intellectual property can be transferred instantly from one country to another with the click of a mouse is a problem for all major countries. On Wednesday, the European Union held a big conference on the subject.
If the world’s major countries act in concert, I believe they can destroy the tax haven industry. I believe its days are numbered.