Tax Different

The tax case that Apple CEO Tim Cook might (but probably won’t) make before Congress tomorrow

May 20, 2013
Obsession
Borders
May 20, 2013

Though US companies have seen record-breaking profits in recent years, their tax payments are at record lows. Which is why Tim Cook, CEO of Apple, one of the most valuable companies in the country, is testifying tomorrow (May 21) to the US Senate about allegations that Apple avoids billions in taxes. Congressional investigators say (pdf) Apple routed US profits through Irish subsidiaries that, due to legal quirks, pay no tax in either Ireland or the United States. One subsidiary hasn’t bothered to file a tax return in five years. Cook says he will protest those allegations and offer up concrete ideas to fix the US corporate tax system.

The problem with corporate taxation

Apple’s complaints begin with the idea that the US’s 35% corporate tax rate is so high that companies in other countries have a competitive advantage. However, the effective tax rate paid by US companies is actually comparable (pdf) to other wealthy, advanced economies, because of loopholes in the US tax code. Among the largest is that, while  US companies pay taxes on their foreign as well as domestic income, they can defer these payments virtually indefinitely.

For an example of how companies create Rube Goldberg financial statements to avoid tax enforcement, look at Apple’s recent decision on dividends. Though the company has accumulated $100 billion in overseas cash, leading shareholders to clamor for a pay-out, it won’t bring the money back home, because of the taxes. Instead, the company will borrow billions of dollars to pay its investors—a text-book case of the tax code distorting business choices.

The fixes are as divisive as the problem

In recent years, Apple and the rest of the tech sector have demanded a tax holiday to bring back foreign cash. But many economists are skeptical that such a holiday is a good solution. When it was tried as an experiment in 2004, most companies used the repatriated funds to buy back shares of their stock rather than invest in new infrastructure or jobs.

Republicans and many companies argue that a straightforward territorial system—i.e., taxing only US revenues—is the simplest way to eliminate the whole problem. But that might lead companies to shift even more money and jobs to countries with far lower rates than the US, so Democrats, and the White House, say no dice.

But the status quo isn’t helping the economy, either. Not only are companies deferring taxes on overseas revenue; they are actively shifting domestic profits overseas, particularly in the tech sector, by selling intellectual property to overseas subsidiaries in low tax-countries like Ireland, paying above-market rents for it, and then deducting those from their US tax bill. It’s practices like these that have lawmakers up in arms. Democrats in particular have plans to close a passel of loopholes that multinationals use to shield their income from taxation, guaranteed to face bruising opposition from the business lobby.

Disrupting international tax law

So what’s Apple’s solution to this problem—the elegant, minimalist, brushed-aluminum version of the US tax code? Cook hasn’t given many hints about his proposal except for—in true Apple style—”dramatic simplification.”

Perhaps the best compromise of that sort has been served up (pdf) by University of California economist Alan Auerbach, who argues that policymakers need to get outside the worldwide versus territorial debate. His proposal relies on what he calls “the destination principle”: taxing companies where their products are used. Under this scheme, foreign sales wouldn’t be taxed by the US government, but more than that, all cross-border transactions—including foreign expenses—would no longer affect tax payments.

That means that companies get something they want—their legitimate foreign sales earnings would only be taxed by the foreign country. But they’d also lose the ability to move US profits overseas through the kinds of artificial transactions Apple is accused of. Combined with domestic changes to reduce the tax preference given to debt financing and simplified expensing, Auerbach says these reforms would not only make for a clearer system, but also one that makes it more lucrative for companies to invest in the US.

Cook may not have such a balanced case to make. And if he truly intends to argue that Apple’s Irish subsidiaries make sense for non-tax purposes, he may not even concede that the off-shoring of profits is a problem. But the legislators he’ll address may not have the patience for such a case, and with the billions piling up at his overseas subsidiaries, Cook may no longer be able to afford to pretend that a $30 billion, apparently stateless subsidiary is business as usual.

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