• 21 May 2013 at 11:06 AM

Senate Discovers There’s A Tax Code

Here’s a math problem: what does this sentence, from John McCain, tell you?

“Apple claims to be the largest U.S. corporate taxpayer, but by sheer size and scale, it is also among America’s largest tax avoiders,” he said in Monday’s pre-hearing comments.

The answer, of course, is that Apple is among the most profitable companies in America.1 If you have a lot of profits, you can not pay taxes on a lot of them, and still pay lots of taxes on a different lot of them. There is much focus on the exceptions, but for the most part I’d guess that “biggest taxpayers” and “biggest tax avoiders” are both highly correlated to “biggest profits.” Warren Buffett pays more taxes than his secretary, but at a lower rate.

The Senate, not being known for its quickness with math, is holding hearings today on the avoiding part; here you can read (pdf) the committee’s report. Apple does two main things to avoid taxes that the committee doesn’t like:

  • It incorporated two of its main foreign subsidiaries, Apple Operations International (AOI) and Apple Sales International (ASI), in Ireland. Those subsidiaries are, however, managed and controlled in the U.S. by their California-based directors. The U.S. taxes corporate income based on place of incorporation; Ireland taxes corporate income based on place of management and control. So if you’re incorporated in Ireland and managed and controlled in the U.S. you pay taxes nowhere, as AOI does and ASI more or less does. This is … honestly isn’t the surprise that everyone doesn’t do this?2 I’m incorporating myself in Ireland as we speak.
  • It entered a cost sharing agreement that gave ASI the economic rights to Apple intellectual property outside of America, in exchange for ASI funding a share of Apple’s California-based R&D proportional to its share of Apple’s total sales. Apple is in the business of manufacturing cheap electronic components in China, slapping expensive cool on them in California, and selling the package for $500. ASI effectively got the California cool at cost, rather than paying retail, which means that the international share (some 60%) of the profits of that cool are, for tax purposes, “earned” abroad (in a zero-tax subsidiary!) rather than in California.

That’s the main stuff; there’s some stupid stuff too.3 Apple’s response is a lot of blather that boils down to:

  • Yeah, and?
  • If you simplified the tax code perhaps we’d be less convoluted in dodging it.
  • America apple pie freedom jobs!4

All of which are fair though the first is most important. Why shouldn’t Apple not pay taxes it doesn’t have to pay?

I submit to you that you could reasonably feel sympathy for everyone involved here. For Apple, of course, who are really just structuring their stuff in the most tax-efficient way, like every other company in America. Honestly tax optimization is an American tradition and it would be somewhat unpatriotic of them not to join in.

Or for the IRS, which doesn’t crack down on Apple’s not-particularly-substantive foreign subsidiaries for not being substantive enough. Congress sort of wants them to,5 but they’re just being dramatic. Foreign subsidiaries are always controlled by their parent; that’s what being a subsidiary is. (The tax-y name is even “controlled foreign companies.”) A world in which the IRS regularly decided that foreign subs were actually domestically taxable because they were especially controlled by their parents would be … well, very different from the world the IRS is currently signed up for anyway.

Who else? I personally feel a lot of sympathy for Ireland, who are getting shit for being a tax haven. Some of this is unfair – the report makes a big production out of the fact that ASI, one of the Irish subs, paid an effective Irish corporate tax rate of 0.05% in 2011, which sounds low, but remember that ASI is not actually taxable in Ireland under Irish law so 0.05% is a bit stiff compared to the 0.00% you might expect. More broadly, Irish deputy prime minister Eamon Gilmore makes a good point:

“They are not issues that arise from the Irish taxation system. They are issues that arise from the taxation system in the other jurisdictions and that is an issue that has to be addressed in those jurisdictions,” said Mr Gilmore, who is due to attend a meeting in Brussels on Tuesday where tax avoidance is on the agenda.

Well, tautologically, no? If Apple’s subsidiaries pay no taxes under Irish or U.S. law, it’s a bit rough to blame that 100% on Ireland. Really, every country in the world that doesn’t tax AOI is equally responsible for its zero percent tax rate, and all of them should feel some urge to do something about it. Greece, in particular, ought to be looking into it.

You could I guess even feel sorry for Congress, who have set themselves the difficult job of making a tax law that is simultaneously free of loopholes and stuffed with incentives, goodies, and general porky favoritism. Apple makes all the nice noises about supporting a simpler fairer U.S. corporate tax system, which is I guess what everyone says when they’re hauled before Congress to explain the complexities of their tax avoidance, but they probably even mean it.6 If you see a loophole that will save you billions of dollars, you gotta take it, but that doesn’t necessarily mean you like the system. Apple says that it “complies fully with both the laws and spirit of the laws,” and that is surely true. It has plenty of good lawyers to make sure it complies with the actual laws, and as for the spirit … I mean, here is something Apple says:

From a tax policy standpoint, cost sharing agreements play an important role in encouraging companies like Apple to keep R&D efforts – and the high-paying, income tax generating jobs associated with them – in the US.

Here’s how to read that: “Congress stuffs the tax code with loopholes and oddities in order to offer ad hoc bribes and incentives to particular companies at particular times, depending on who’s been bamboozling Congress about what recently, and we’d be schmucks not to take advantage of all of them.” That, surely, is the spirit of the corporate tax code.

Memorandum: Offshore Profit Shifting and the U.S. Tax Code – Part 2 [Senate Permanent Subcommittee on Investigations]
Testimony of Apple Inc. Before the Permanent Subcommittee on Investigations [Apple]
How to make $30 billion and pay no corporate income tax, the Apple way [WonkBlog]
Dublin rejects Apple tax avoidance claims [FT]

1. This seems a simple point but Google is won’t just give me an updated list. Here’s the ranking based on 2011 profits, with Apple third behind XOM and CVX; 2012 profits were $44.9bn for XOM, $41.7bn for AAPL, and $26.2bn for CVX. You can see why Apple claims to be “likely the largest corporate income tax payer in the US”; its only competition for profits comes from oil companies and everyone knows oil companies don’t pay taxes.

2. They do, right? Ireland, notorious tax haven and all that.

3. One is about Subpart F income (pages 33-37 of the report). To simplify and schematicize and, honestly, probably be wrong, the U.S. tax code requires U.S. companies to pay taxes on “passive” income earned by foreign subs (dividends, etc.), but allows them to defer taxes on “active” income. The committee is all mad that Apple used “check-the-box” regulations to “convert taxable, offshore, passive income into nontaxable [active] income.” But this seems wrong, no? Here’s, schematically, what would happen under the committee’s thinking:

With U.S. taxes owed on each level of dividends. And here’s what Apple does:

That surely better reflects the economic reality, no? Like, the money comes from selling stuff to customers, not from “passive” “dividends” or whatever. The mush is more correct than the dividend-from-box-to-box formalism.

4. It is not lost on me that two of those words are arguable puns. Anyway, though, what do you make of this:

Apple’s cost sharing agreement with two of its subsidiaries supports high-paying, tax-revenue generating jobs in the US. Unlike companies that do a substantial share of their research and development in lower cost, foreign jurisdictions, Apple conducts virtually all its R&D in the US. Apple has an agreement with two of its Irish subsidiaries to share the costs and risks of this R&D. The agreement, first established in 1980, is authorized by US law and complies with all US tax regulations. Under the current agreement, the Irish subsidiaries have rights to distribute Apple products in territories outside the Americas in exchange for contributing to jointly-financed R&D efforts in the US. Thus, the agreement supports the funding of the Company’s high-paying R&D jobs in the US, promoting domestic job growth and generating significant tax revenue for federal and state governments.

The idea I suppose is “we can only afford to do R&D in America if we’re taxed as though we did it somewhere else,” and your reaction to it will depend entirely on how you interpret the word “afford.” Like: Apple has the money to both do R&D in the U.S. and pay higher taxes. On the other hand, Apple has some duties to its shareholders to not just throw money away. I don’t think anyone is persuadable either way on this point so I’m gonna let it go.

5. E.g. page 24 of the report:

Since Apple has determined that AOI is not managed or controlled in Ireland, functionally that leaves only the United States as the locus of its management and control. In addition, its management decisions and financial activities appear to be performed almost exclusively by Apple Inc. employees located in the United States for the benefit of Apple Inc. Under those circumstances, an IRS analysis would be appropriate to determine whether AOI functions as an instrumentality of its parent and whether its income should be attributed to that U.S. parent, Apple Inc.

6. Ooh you know who gets zero of my sympathy? These loonies at Grant Thornton who published a comment in Fortune last week about how partnerships, etc., that pay zero corporate-level tax are disadvantaged as compared to corporations that pay 35% corporate-level tax, and that any reduction in corporate tax rates should be accompanied by a reduction in the partnership tax rates from zero to a negative number. I mean! There are real issues about how the corporate form allows businesses to defer taxes on undistributed earnings, as compared to the partnership form, but still: this argument is extremely silly.

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Comments (46)

  1. Posted by quant me maybe... | May 21, 2013 at 11:13 AM

    One question: How do I take advantage of this to insure that I, too, pay no taxes?

  2. Posted by reasonably prudent | May 21, 2013 at 11:40 AM

    Let's see where this is going…

    Senator Levin: Harrumph! These offshore subsidiaries [or last year, offshore hedge funds] are "managed and controlled" by people living in the U.S. We should tax these companies as US corporations based on the presence of the those people.

    The cardboard moving box industry, real estate agents in Singapore, the Caribbean, and Dublin and travel agents: Yay!

    Regular people with back office or middle management jobs for big US companies or financial services firms: [sad face] :-(

  3. Posted by Guest | May 21, 2013 at 11:41 AM

    If they try to bring their profits back onshore, they would pay taxes. So in effect, it's the Eurozone's fault. When the Irish banking system was blowing up, rather than Irish and European taxpayers footing the bill, the EZ should have taken the cash from these corporate bank accounts a la Cyprus style. That would have taught Apple to keep money in Ireland….

  4. Posted by Disgruntled | May 21, 2013 at 11:41 AM

    "I’m incorporating myself in Ireland as we speak"

    Except as an individual you can't, you'd own a private foreign corporation, have to file copious amounts of paperwork, be taxed at your top rate and enjoy none of the benefits that apple could. If you could do the same say with you and your closest 500 or so friends then maybe you could call up the IRS and get the arrangement blessed then you'd be off and running.

    That's the only thing that's really unfair about all this, Apple/Microsoft/Google can because they have billions of dollars and are public companies. You can't because… well… you'd be an evil tax evader.

  5. Posted by Guest | May 21, 2013 at 11:42 AM

    How about them apples?

  6. Posted by Guest | May 21, 2013 at 11:57 AM

    Instead of all this legal/businessy stuff, Apple's defence should be something like "Leprechaun…rainbow…pot of gold…wearing of the green…good craic…Guinness…feck…arse." Usually works on American politicians.

  7. Posted by Guest | May 21, 2013 at 12:00 PM

    Matt, I think you have a terminology issue here. When a corporation keeps profits in offshore tax havens, that rather clearly is "tax dodging". "Tax optimization", strictly speaking, only applies when it is a sitting member of Congress forgetting to report an income-generating asset held offshore.

  8. Posted by Man Is Innocent | May 21, 2013 at 12:03 PM

    For a second I thought this was going to be another one of those Matt post that end with him telling stories about his law practicing days. The stories generally end with Matt bursting into a court room with nothing but a bathrobe and slippers on, holding up a casebook that make's reference to a 1698 witch trial that proves his client is innocent among other things.

  9. Posted by lucas | May 21, 2013 at 12:36 PM

    But as the US owner of a foreign corporation, you'd be able to control when the taxable foreign income is distributed to you (hint: when your domestic day-trading losses peak because you're posting on dealbreaker all day). That's pretty valuable.

  10. Posted by Guest von Taxington | May 21, 2013 at 12:56 PM

    Lemme help out here:

    It's called the Double Irish. Parent X leases the right to collect proceeds from use of its intellectual property outside the U.S. to Irish Sub 1 that is actually HQ'd in Bermuda (or whatever). Irish Sub 1 leases these IP rights to Irish Sub 2 in exchange for a royalty sharing agreement. So:

    1) Irish Sub 2 collects the IP proceeds, but sends the lion's share to Irish Sub 1 (b/c of the agreement).
    2) Irish Sub 2, under Irish law, takes a deduction equal to that amount (so it pays virtually nothing).
    3) Irish Sub 1, now in possession of all the proceeds, also pays virtually nothing in taxes b/c Ireland thinks it's HQ'd in Bermuda, so it won't touch it.
    4) Parent X has parked all its foreign proceeds in an Irish company and paid almost nothing in taxes.

    The IP part is what makes this a favorite toy of Google, Apple, Microsoft, etc. It's also why me and you don't get to play.

  11. Posted by Clear as Mud | May 21, 2013 at 1:00 PM

    'Simplification' would just make it easier to avoid taxes.. Flat 15% on income is quickly followed by – oh, that's not income that's, ummm, capital gain on inventory..

    Let's all just accept that this is a massive arms race in complexity and will continue to be so until it becomes so complex that the cost of hiring people to 'optimize' it equals the savings to be gained (or revenue to be collected)..

    Oh.. That and something that not so bright pundits (or members of congress) can complain about. It's hard to find something new to be angry about each week, and those guys deserve some help.

  12. Posted by GWB | May 21, 2013 at 1:09 PM

    I thought U.S. tax laws were designed to help multinationals avoid paying taxes.. am I missing something?

  13. Posted by VonSloneker | May 21, 2013 at 2:29 PM

    To a hammer, every problem looks like a nail and to some, the answer to every question is a more confiscatory government.

    - Folksy Fiscal Wisdom Guy

  14. Posted by Guest 5 | May 21, 2013 at 2:30 PM

    Does the parent pay taxes on the lease revenues? If so the leases probably aren't at market rates, which makes this a slightly more sophisticated version of transfer pricing and something that you think the government could do something about.

  15. Posted by PermaGuestII | May 21, 2013 at 3:10 PM

    Which government? In the scenario above you have two corporations registered in the Republic of Ireland, one of which is run out of the Crown Colony of Bermuda. Neither the Bermudian nor the Irish governments have a problem with this arrangement.

  16. Posted by PermaGuestII | May 21, 2013 at 3:24 PM

    Yes: your Sociology seminar.

  17. Posted by armchair economist | May 21, 2013 at 3:32 PM

    seem to be 3 big questions here:

    1) do we care if Apple avoided U.S. taxes? (answer is yes we care, but no, they didn't avoid any U.S. tax if you believe Irish 1 legitimately owned the IP)
    2) do we care if Apple avoided non-U.S. taxes by having non-U.S. subs pay big royalties to Ireland? (answer is no – U.S. shouldn't be global cop to collect others' taxes; counterargument is that if U.S. companies can pay no tax outside the U.S., they won't invest here)
    3) if we change the rules and impose a "minimum tax" on offshore earnings (like many, many other countries do), it's just going to be a tax on old companies. if this rule existed, and if I was a forming a new company, no way I form it in the U.S. The only companies that will pay the minimum tax are U.S. companies already in existence…

    -glad I'm not in Congress

  18. Posted by armchair economist | May 21, 2013 at 3:36 PM

    My guess:

    cost of tax planning function at Apple: $15M/yr

    apple's annual tax savings from offshore planning: <$10B/yr

    you've got a way to go until that equilibrium is reached here….

  19. Posted by lucas | May 21, 2013 at 3:40 PM

    Abolish corporate taxes and tax the income at the shareholder level. Easy. Seems to be working fine (and not to be causing any moral outrage) with LLCs, partnerships and S-Corps.

  20. Posted by Guest 5 | May 21, 2013 at 4:01 PM

    "Parent X leases the right to collect proceeds from use of its intellectual property outside the U.S. to Irish Sub 1 that is actually HQ'd in Bermuda (or whatever)."

    I assume Parent X is a U.S. company.

  21. Posted by 2 & 20 | May 21, 2013 at 4:06 PM

    totally agree. partnership tax rules are working just fine.

    -carried interest recipient

  22. Posted by Clear as Mud | May 21, 2013 at 4:22 PM

    It's marginal profit v marginal cost. The question is not whether the first $15M was well spent, it's whether the next $1M will be.

    Otherwise why wouldn't the tax planning function be $16M? Did they just up and decide at some point that they don't like money anymore?

  23. Posted by RogerDodger | May 21, 2013 at 4:46 PM

    VAT…coming to a screen near you.

  24. Posted by Guest | May 21, 2013 at 4:56 PM

    You don't see this kind of "arms race" in sales tax, nor do you see it in property taxes. Both are easy to measure and difficult to conceal.

    The problem is a tax – income or value added – that is based on an accounting abstraction rather than on direct, measurable realities. Shift the tax basis and the incentive and benefit to game it will largely disappear.

    There's an old saying that you get less of what you tax. If you tax honest accounting, what do you think you're going to get less of?

  25. Posted by Guest | May 21, 2013 at 4:58 PM

    The carried interest loophole is probably the clearest example I can think of why the tax code is in serious need of simplification. The problem with these exercise in public outrage over this or that loophole or tax evasion – whoops, tax optimization! – schemes is that they almost always seem to end up creating an even more complex tax code that is even more susceptible to abuse.

  26. Posted by lucas | May 21, 2013 at 4:58 PM

    The argument there is over the tax rate on individual income, not whether that income should be taxed at the partnership level. Of course, you know this but couldn't resist a weak attempt at humor.

  27. Posted by 2 & 20 | May 21, 2013 at 5:02 PM

    ok genius, what's the answer?

    carried interest is a "problem" born from too much simplicity, not too little.

  28. Posted by Guest von Taxington | May 21, 2013 at 5:03 PM

    Very little, if at all.

    SLIGHTLY more sophisticated? This stuff is financial rocket science.

  29. Posted by Guest von Taxington | May 21, 2013 at 5:09 PM

    @ PermaGuestII – the only government pissed off is the U.S.; everybody else is either indifferent (the only reason they're involved is b/c an American company decided to exploit a specific characteristic of their tax code) or happy to have what little tax revenue they get from the deal (while having to do basically nothing).

    @ Armchair – Irish 1 is a wholly owned Apple sub formed and operated specifically as a conduit for this deal. Ireland wouldn't get any taxes without the deal b/c the money has nothing to do with them (it's just a place for Apple to dump the cash until it figures out how to repatriate). I don't know about that minimum tax idea, but considering IRS just decided it has worldwide JDXN over every government (whatup FATCA) who knows?

  30. Posted by Guest 5 | May 21, 2013 at 5:19 PM

    In that case financial rocket science pales compared to actual rocket science, material science, or molecular biology, thermodynamics. I guess compared to the lack of sophistication of the IRS and lawmakers it looks impressive…

  31. Posted by VonSloneker | May 21, 2013 at 5:21 PM

    No whitey, that's my mama.

    - The Ghost of Malcolm X

  32. Posted by Clear as Mud | May 21, 2013 at 5:27 PM

    So are you saying you want fewer sales and properties?

    Also, I don't know if you have ever gone through the joy of a property assessment. Easy to measure and difficult to conceal, not the words I would use to characterize them…

  33. Posted by Another Guest | May 21, 2013 at 5:28 PM

    "The IP part is what makes this a favorite toy of Google, Apple, Microsoft, etc. It's also why me and you don't get to play."

    What if I'm a quant? Can my algos be considered IP, and investment returns the proceeds of that IP?

    - Guy who wants to play

  34. Posted by 2 & 20 | May 21, 2013 at 5:31 PM

    ok. I'll be serious. the partnership tax rules are a complete mess, and huge amounts of planning are done off the back of those rules (ask anyone in the real estate business)

    layer a publicly traded company on top of those rules and you have some massive issues:
    1) who pays the tax on the corporation's flow-through income? The HFT who held the shares for 2 seconds once? If you choose a single date where the shareholders of record as of that date pay the tax, you need to continually price in that hit. And do you let people with huge flowthrough losses buy profitable companies for a day, take the tax hit, and then sell the stock for a gain?
    2) do you make every single foreign shareholder of a U.S. corporation file a U.S. tax return to pay tax on their share of the gain? What about pensions?

    This could get messy quickly….

  35. Posted by Guest | May 21, 2013 at 5:44 PM

    Actually, yes. You would sell all your algos to an offshore subsidiary and licence them from that entity. Your income would be shifted to the offshore sub that has low/no taxes and the US entity could deduct the license fees.

    -Guy who works in SEC reporting but drinks with a lot of tax guys/attorneys

  36. Posted by Butterworth Bank | May 21, 2013 at 5:58 PM

    It's Bermudan, no I.

  37. Posted by guest | May 21, 2013 at 6:19 PM

    You've cut right to core of me!

  38. Posted by guest | May 21, 2013 at 6:50 PM

    Oh man how much is tim cook wishing right now that he'd clicked on that banner ad and attended the san diego transfer pricing conference?

    I think we've all learned a little lesson here today.

  39. Posted by Anthony Weiner | May 21, 2013 at 6:52 PM

    Feeling sorry for Congress is the NKI

  40. Posted by guestest | May 21, 2013 at 7:37 PM

    corporations may be people, but people aren't corporations

    - supreme court legalese dep't

  41. Posted by buboe | May 21, 2013 at 10:17 PM

    and the government of every other country apple and google and Amazon sell in.
    It's not just US sales that get pumped through Ireland. And we don't have the benefit of any of these high payin' tech juuuuurbs!

  42. Posted by buboe | May 21, 2013 at 10:21 PM

    Abolish payroll tax.
    Tax transactions, capital gains and property ownership at flat rates.
    Impose death duties
    Relax.

  43. Posted by 10xLevered | May 21, 2013 at 10:38 PM

    I think this is my favorite Matt Levine article. Well done.

  44. Posted by Kayne | May 22, 2013 at 3:16 AM

    Puns?

    Is it because… America has something to do with… freedom that likes… pie?

  45. Posted by Expat | May 22, 2013 at 7:07 AM

    By renouncing your citizenship and moving to no-tax country e.g.
    http://en.wikipedia.org/wiki/Eduardo_Saverin

  46. Posted by 2 cubes over | May 22, 2013 at 12:37 PM

    There was no spreadsheet… nor any charts… ok, like two diagrams… but still!