The Real Story About Apple’s Taxes

By :: May 21st, 2013

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.

29Comments

  1. Should Apple just write a big check to the IRS? « Roth & Company, P.C  ::  11:00 am on May 22nd, 2013:

    […] I’ll give Howard Gleckman of TaxVox the last word: […]

  2. Ralph H  ::  12:35 pm on May 22nd, 2013:

    This is disgraceful. I realize most international firms do it but the result is shifting tax burden to Domestic companies and individuals. Completely unfair. How about ending the corporate tax and replacing it with a small national sales tax or VAT? Just make it broad based and include service providers (like lawyers and accountants!).

  3. David M.  ::  12:47 pm on May 22nd, 2013:

    Maybe you haven’t noticed, but in the US, Apple is has the marketshare in phones and is clobbering Android in tablets.

    And for profits, Apple is destroying Android.

    Of course, only Samsung is making any money. Every other Android vendor is losing their shirts. But hey, as long as there is marketshare, all is well.

  4. Ignobilitor  ::  12:56 pm on May 22nd, 2013:

    Good article; however, I would dispute the premise of your last sentence, which betrays a misunderstanding of Apple’s clearly discernible business goals: Apple has never attempted to increase their share in the less profitable segments of a given market.

  5. Ignobilitor  ::  12:56 pm on May 22nd, 2013:

    You beat me to it!

  6. Chris  ::  1:19 pm on May 22nd, 2013:

    National Sales Tax or VAT wouldn’t help. They are avoiding paying US Corporate Income Tax on anything that was NOT sold in the US by allowing the money to build up in an account owned by a subsidiary that isn’t based in the US. They pay US Corporate Income Tax, State Corporate Income Tax, and Sales Tax on everything that is sold in the US.

    The problem is actually really interesting in that the senate is complaining that Apple isn’t paying corporate income tax on money that wasn’t made in the US.

  7. Dave  ::  1:52 pm on May 22nd, 2013:

    You took words right out of my mouth

  8. Łukasz Markiewicz  ::  3:11 pm on May 22nd, 2013:

    My problem with this type of set up is that these companies effectively pay no tax anywhere on a large portion of their incomes, build up massive reserves of cash, then lobby Congress to repatriate that money with symbolic taxation on it, which they end up giving back to shareholders or buy back the stock.

    I’m looking at this from an European perspective. When Tim Cook and Eric Schmidt say that Apple and Google pay all the taxes required by the local jurisdictions I feel very uncomfortable about this. Whatever profit they potentially make by selling goods and services is always wiped out by IP and licensing payments to subsidiaries in countries with no taxation. Cook made it sound like that money will undergo double taxation, since they paid taxes on it in EU. Which is very far from the truth. The biggest problem is the difficulty with regulating transfer pricing “Firms are supposed to price these assets at market value. But what does that mean when it comes to, say, proprietary computer code?” Set up properly you can create potentially unlimited expenses in tax-paying countries and creating profits in tax heavens.

    Also, whenever I see an American CEO including VAT payments in the amount of tax paid by the company, my blood boils.

  9. The Real Story About Apple’s Taxes | The Small Wave.  ::  3:16 pm on May 22nd, 2013:

    […] Source […]

  10. Ralph H  ::  3:36 pm on May 22nd, 2013:

    My understanding of VAT is that whatever labor went into “creating” the IP in California would be taxed. This is more than we get now. Admittedly, Apple could jack up the price of their phones so there was little Value Added at retail, but a pure sales tax would capture tax presuming at least 50% of sales was in US.

    Currently the states may collect sales tax, but as the article pointed out Apple (and others) play games to shift profits to low tax countries, even where the bulk of sales is to the US. Frankly, I am not terribly interested in taxing Apple on sales ocurring in China or France, but we would be much better off if we could get our share.

    Ethically I hate Apple, but the ultimate blame is on Congress who should be smart enough to design a tax system to fairly collect from all.

  11. Jearold  ::  4:35 pm on May 22nd, 2013:

    Decent reporting until the unnecessary and out-of-context snark at the end.

  12. DDD  ::  6:44 pm on May 22nd, 2013:

    It sounds very weird to me that the fiction of a disregarded entity would be accepted by the american tax collectors. Such simplifications should never be allowed for big corporations. Of course, there is always trouble defining big, but surely any sane idea of that would exclude Apple.
    On the other hand, I can’t quite see why should the US be entitled to tax the income received on other countries.

  13. NYT Columnist Joe Nocera laughably calls Tim Cook a liar | The Enigmatic Nerd  ::  4:01 pm on May 23rd, 2013:

    […] Howard Gleckman highlighted this very fact on the Tax Policy Center Blog: […]

  14. Ebests.com – NYT Columnist Joe Nocera laughably calls Tim Cook a liar – Ebests.com  ::  4:01 pm on May 23rd, 2013:

    […] Howard Gleckman highlighted this very fact on the Tax Policy Center Blog: […]

  15. NYT Columnist Joe Nocera laughably calls Tim Cook a liar » webaligns  ::  4:02 pm on May 23rd, 2013:

    […] Howard Gleckman highlighted this very fact on the Tax Policy Center Blog: […]

  16. NYT Columnist Joe Nocera laughably calls Tim Cook a liar | TUAW – The Unofficial Apple Weblog  ::  4:09 pm on May 23rd, 2013:

    […] Howard Gleckman highlighted this very fact on the Tax Policy Center Blog: […]

  17. Technable | Making you Technically Able  ::  7:00 am on May 24th, 2013:

    […] Howard Gleckman highlighted this very fact on the Tax Policy Center Blog: […]

  18. 2014 HOW MUCH TAXES WILL I OWE IN  ::  2:06 pm on May 25th, 2013:

    […] TaxVox » Blog Archive » The Real Story About Apple's Taxes […]

  19. TAX BRACKETS 2013  ::  11:48 pm on May 25th, 2013:

    […] TaxVox » Blog Archive » The Real Story About Apple's Taxes […]

  20. TAXES IN ILLINOIS 2014  ::  9:17 pm on May 27th, 2013:

    […] TaxVox » Blog Archive » The Real Story About Apple's Taxes […]

  21. 2014 TAXES NEW YORK  ::  12:16 pm on May 28th, 2013:

    […] TaxVox » Blog Archive » The Real Story About Apple's Taxes […]

  22. Michael Bindner  ::  12:46 am on June 26th, 2013:

    This is the third reason to do tax reform, to shift to more value added taxes or other types of consumption taxation, such as a VAT-like Net Business Receipts Tax (a VAT with exemptions and additions to replace those in the individual code) so that the benefits to gaming the system are vastly reduced. Indeed, the Intellectual Property benefit would be lost in value added, which would include both the intellectual property income and the labor costs of those who produce it.

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  24. The OECD's International Tax Plan: The First Step On A Very Long Road – AnuragP  ::  2:54 pm on July 24th, 2013:

    […] any tax at all on much of their income. Harvard University tax professor Steve Shay memorably calls this “ocean income”—revenues that simply disappear into the deep and avoid tax by any […]

  25. Maximus  ::  4:38 am on July 29th, 2013:

    Taxes authorities are getting more hungry….
    The good thing is that now days setup an offshore company is not only for the big corporations. Small companies, consultants, freelancers, traders, etc.. can do it too. Or even for “personal assets management”. It’s true that it’s getting too too hard for US citizens to do offshore banking.. For EU citizens or others, here is the place to go (so far excellent services): http://www.icoservices.com

    Regards,
    Max

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