Senate Discovers There's A Tax Code

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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.3Apple'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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