Tim Cook’s improbable victory in Washington

By Felix Salmon
May 21, 2013

When Apple CEO Tim Cook appeared in front of Carl Levin today, I was hoping for an epic showdown, as presaged by Levin’s highly-aggressive press release yesterday. I was sorely disappointed — although I did end up with a newfound admiration for Tim Cook’s ability to acquit himself with dignity and intelligence and integrity in the toughest of situations.

The Apple executives at the hearing spent most of their time politely listening to various senators pontificate about taxes. But every so often, in response to a rare direct question, they would try to explain why they didn’t think they were evading billions of dollars in taxes.

The Levin report is very long and dry, so let me oversimplify a little. Apple revenues basically end up in one of two places: California, for sales in the Americas; and Ireland, for sales everywhere else. Apple pays US taxes on the money which ends up in California, but only pays US taxes on the interest on the money which ends up in Ireland. Which isn’t very large.

A lot of the hearing was taken up, unhelpfully, with senators asking whether Apple pays taxes on the income from sales made in the US, and Apple saying yes. (Although, as Tim Fernholz points out, “between 2009 and 2011, the company told investors it was setting aside $13.7 billion to pay federal taxes—but it has actually paid only $5.3 billion”. The amount the government receives is significantly lower than we had all been given to believe from Apple’s SEC filings.)

The more interesting questions concern Ireland, the money flowing in there, and the degree to which those enormous sums of money constitute tax avoidance on a massive scale.

There are two parts to this question. The first is the sheer amount of money flowing into Apple Operations International (AOI), a company without tax jurisdiction and which hasn’t filed a tax return in five years. The Apple executives were unflustered about that fact: all of Apple’s various subsidiaries in Europe and Asia pay local tax on their profits. They could then just hold on to those profits themselves, if they wanted. But because it’s nice for Apple to be able to look after all of its money in a single place, the various subsidiaries send it all to Ireland to be invested. It has already been taxed at that point, and shouldn’t be taxed again.

This is more than a little disingenuous, because it seems that Apple is extremely good at ensuring that the “local subsidiary” in question, accounting for the overwhelming majority of the profits being fed into AOI, is ASI — another Irish company without tax jurisdiction. When Apple ships product from its factories in China to its stores in Singapore, the stores in Singapore don’t make much if any profit. That’s because somewhere in the South China Sea, ASI takes ownership of that product at a very low cost, before selling it on to Apple Singapore at much higher cost. The hardware never goes anywhere near Ireland, but title to the hardware changes hands, and substantially all of the profit associated with that hardware thereby ends up being taxed at friendly Irish rates, somewhere south of 2%, rather than at whatever the government of Singapore might charge. Here’s the Levin report:

Transferring title in this manner allowed Apple to retain most of its profits in Ireland, where it has negotiated a favorable tax rate and maintains entities claiming to have no tax residence in any country, and limit the income it reported in the non-tax haven countries where the company did most of its business. For example, in 2011, Apple reported $34 billion in income before taxes; however, just $150 million of those profits, a fraction of one percent, were recorded for Apple’s Japanese subsidiaries, even though Japan is one of Apple’s strongest foreign markets. ASI, meanwhile, reported $22 billion in 2011 net income. Those figures indicate that Apple’s Japanese profits were being shifted away from the United States to Ireland, where Apple had negotiated a minimal tax rate and maintained two non-tax resident corporations.

So we shouldn’t take Apple’s executives at face value when they say that all of the money in AOI has been taxed once already. That might technically be true, but only at extremely low rates.

What’s more, Apple actually does, under the spirit of the law, owe substantial US taxes on that income. The law in question is something called the foreign base company sales income rule — a regulation specifically designed to prevent companies from jurisdiction-shopping when it comes to taxes. Under US law, Apple has to pay US tax on the income that ASI receives on things like the profits from all those Singaporean gadgets. But Apple uses something called the “check-the-box loophole” to make ASI “disregarded” by the IRS. Instead, the IRS looks only at the parent company, AOI, which, being merely a holding company, does not have any foreign base company sales. According to the Levin report, this clever two-step — first putting the income in to ASI, and then disregarding that income using the check-the-box loophole — “allowed Apple to avoid paying taxes on nearly $44 billion in income from 2009-2012″.

The second part of the question is even more important, and surrounds something called a Cost Sharing Agreement which Apple has signed along with its Irish subsidiary, ASI. Under that agreement, ASI pays 60% of Apple’s R&D costs, and in return gets to keep 60% of the income from Apple’s intellectual property. This agreement, Apple executives repeatedly said, was signed “at arm’s length”, with the 60/40 ratio representing the respective proportions of Apple’s sales split: Europe and Asia account for 60% of Apple’s sales, with the Americas accounting for 40%.

But the fact is, as Levin hammered home at the end of the hearing, that Apple’s intellectual property is its crown jewel; that the amount it spends on R&D is in no way reliant on the fact that it’s getting some of that money from Ireland; and that in no conceivable universe would Apple ever sell off 60% of the rights to its intellectual property in return for a promise to pay 60% of present and future R&D costs. Not in a genuine transaction with a non-Apple counterparty, anyway. As Levin said, “95% of the creativity that goes into that product is in California. But two thirds of the profits are in Ireland.”

Apple receives enormous benefits from being based in California — Cook was entirely genuine when he said that it simply never occurred to him that the company might ever be headquartered anywhere else. And yet Apple has decided, in its wisdom, that 60% of the fruits of its Silicon Valley creativity should end up in a corporate shell in Ireland, never to be taxed by the US Treasury. This system has been in place for many years — since long before the Macintosh was invented — but that doesn’t make it any less of an obvious tax dodge. Apple Inc gets to claim the entirety of its global income for its shareholders, but less than half of it is ever taxed in the US. If an American company makes billions of dollars from its creativity and its enviable geographical location, it’s reasonable that the US authorities should be able to tax those profits, rather than helplessly watching them accumulate offshore.

Here’s the Levin report, again:

Despite the fact that ASI conducts only de minimis research and development activity, the cost sharing agreement gives ASI the rights to the “entrepreneurial investment” profits that result from owning the intellectual property. According to Apple, over the four year period, 2009 to 2012, ASI made cost-sharing payments to Apple Inc. of approximately $5 billion. ASI’s resulting income over those same 3 years was $74 billion, a ratio of more than 15 to one, when comparing its income to its costs… the cost-sharing arrangement for Apple Inc. makes little economic sense without the tax effects of directing $74 billion in worldwide sales revenue away from the United States to Ireland, where it undergoes minimal – or perhaps – no taxation due to ASI’s alleged non-tax resident status.

That’s no arm’s-length agreement, that’s a tax dodge — and a pretty blatant one at that. That’s why I’m astonished that Cook emerged from this hearing so unscathed: the facts were against him, but somehow none of the senators — not even Carl Levin — really managed to put him on the spot. It’s almost as though he had some kind of reality distortion field around him.

21 comments

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Honestly the plutocrats need to tread carefully here because it is things like this that sow the seeds of revolution and confiscation, and that almost never goes well.

Hiding from billions of dollars of tax liabilities is all fun and games until suddenly a state confiscates some of your stores/inventory, or some radical leftist bombs something.

I wish people didn’t always need to push every 8 degrees beyond the pale.

Posted by QCIC | Report as abusive

News flash for Congress: you guys make the tax laws. If you don’t like how much some companies are paying, then change the laws and stop whining.

Another thing: I don’t recall reading about hearings on the amount of taxes GE or ExxonMobil, or other very profitable companies (that spend more on campaign contributions), pay, though.

Posted by KenG_CA | Report as abusive

ALL multi-nationals do this stuff, that’s part of the problem. The other part is it’s the politicians’ fault because they make the laws. However, up until now the politicians have either been too stupid or too greedy or too lobbied to do anything about it; with the aftermath of the financial crisis causing great hardship for voters, finally the politicians might have to change some laws – but it will need international cooperation along the lines of the OECD cleaning up offshore tax havens.

Posted by FifthDecade | Report as abusive

The bigger problem is that multinationals have outgrown the ability of governments to regulate them, and not just in the realm of taxation.

Multinationals have better lawyers than the government, better accountants, and an army of lobbyists to boot.

Until ordinary citizens get so pissed off that they both start boycotting companies which behave like this AND start punishing legislators at the ballot box for supporting corporate interests over those of ordinary citizens, nothing is going to change.

Posted by mfw13 | Report as abusive

How much did your car pay in taxes last year? How about your house? What if you own a few pieces of construction equipment? Did your dumptruck pay taxes? Did your bulldozer pay more or less than your steamroller?

People pay taxes. The people who own AAPL pay taxes when they receive their dividends.

The easiest tax to collect is a tax on real estate. The taxing authority get’s to decide what it’s worth, what % of that to collect and if they can’t find the owner they can seize the property and let the owner come screaming to them cash in hand. It is the only tax it is simply impossible to dodge.

The next easiest tax to collect is sales. Here people can do cash deals but most sales tax get’s collected at the point of sale. It’s also the only tax asside from the sin taxes which discourage something we have too much of… consumption. Think about it, taxes on wages discourage work… we want more work not less. Taxes on interest, dividends, and capital gains discourage savings and investment… we want more of those things not less.

Taxing the income of a corporation or a person is pretty tough… as evidenced by the fact that in our nation 150 million people manage to avoid personal income taxes last year as we gripe about AAPL remitting just 6,000,000,000 to our treasury.

Posted by y2kurtus | Report as abusive

Of course this is mostly “a storm in a tea-cup”. At the end of the day all this money gets paid to (mainly) US shareholders who then pay income tax.

In fact, the IRS should be grateful to Apple for minimizing the corporate tax-takes of foreign countries along the way

Posted by FRANKMACC | Report as abusive

Really Apple and a few others have racked up some pretty enormous profits offshore and this is just their way of negotiating with the Supreme Council of Crooks (US Senate) the occasional trip through the tax-free lane at the border. In other words, they take a little polite reaming and look all doe-eyed and the Senate gives them a “one-time” repatriation free ride for the good of the economy. Implausible believabilty ..

Posted by Woltmann | Report as abusive

““between 2009 and 2011, the company told investors it was setting aside $13.7 billion to pay federal taxes—but it has actually paid only $5.3 billion””

Apple is required to account for taxes paid and unpaid, ie pending repatriation. Companies must declare the amount of foreign income they expect to repatriate and to book the US corporate tax on that amount. The bill comes due when the cash comes back. As the Senate’s Professors testified, Apple is unusual in that it actually books a high percentage of foreign income as taxable. Must US multinationals book far less. For example, Apple’s net effective tax rate, which includes the deferred taxes is 25%, while the US corporate avg net effective tax rate is only 13.4%. Obviously there’s alot going into that 13.4%, but one big piece is that US multis are not accounting for much repatriation. If Apple weren’t so conservative, it could book less pending tax and boost their EPS, but they don’t. For comparison, if Apple were to say none of the $100+B were ever to be repatriated, then its net effective tax rate would likely be about 11.3%.

“taxed at friendly Irish rates, somewhere south of 2%, rather than at whatever the government of Singapore might charge”

Interestingly, the less Apple pays internationally, the more it is liable for in the US. Since, Apple must pay the US corporate tax rate on all its earnings, not just domestic, if they lower their international rate to say 2%, then when they repatriate those foreign earnings, they must pay the US Treasury the balance, of 35%, which is 33%.

“Apple Inc gets to claim the entirety of its global income for its shareholders, but less than half of it is ever taxed in the US.”

Actually, the reason why Cook is astonished, is because as I’ve pointed out, Apple is booking US corporate taxes on about 2/3rds of its foreign earnings, the amount it plans to repatriated. That’s why Apple’s net effective tax rate is 25%, and not 11.3%. The taxes may not have been paid yet, but they’ve been accounted for. The accounted numbers are all that’s reported, so there’s been no benefit to the company stock. If Apple didn’t account for those pending US taxes, instead of $9.5B in profit last quarter, Apple might have reported $13B or so.

Posted by ChKen | Report as abusive

“Apple Inc gets to claim the entirety of its global income for its shareholders, but less than half of it is ever taxed in the US.”

I wanted to take another crack at this, because it’s so important to be absolutely clear. Apple does NOT “claim the entirety of its global income for its shareholders”. Shareholders see the EPS based upon the net effective tax rate of 25%. If shareholders were to see the “entirety of its global income”, then the EPS would be calculated based upon the net effective tax rate of 11.3%.

EPS would have been 18.5% higher if Apple had done as you suggest.

Now, we can estimate how much of Apple’s global income is being taxed at US corporate rates, and see if your “less than half” is correct or not. Apple’s net effective US rate is 30.5% according to Tim Cook in yesterday’s testimony. Apple’s net effective international rate is roughly 2%. From reading Apple’s financials, 10K or 10Q, it appears that roughly 1/3rd of Apple’s sales are US, and 2/3rds is international. Do the math, and you get 1/3rd times 30.5%, is 10.2% and 2/3rds times 2% is 1.3%. Totaled they equal 11.5%. But we know Apple books 25%. So, what are they doing?

Apple has declared that about 2/3rds of its foreign income will be repatriated, and thus, they will book the US taxes on it. Will doing the math get us to 25%? 2/3rds of 2/3rds is 4/9ths, at 30.5% is 13.6%. 2/9ths, the foreign income not to be repatriated is still taxed only at 2%, gives us, 0.4%. Then we add those two amounts, 13.6% and the 0.4% to the 10.2% we calculated earlier, and get Apple’s total, which is 24.2%. That’s in the ballpark.

So, now we know that Apple pays US taxes on about 1/3rd of their global income, due to 1/3rd being US sales. And, we know that Apple books US taxes on 2/3rds of its foreign income which is 2/3rds of its global income. or about 4/9ths. Taken together, Apple is accounting for US taxes on 7/9ths of its global income.

That is 78%, so the claim that Apple “gets to claim the entirety of its global income for its shareholders, but less than half of it is ever taxed in the US”, is false. As far as US shareholders can see, Apple has booked US taxes on 78% of its global income, and foreign taxes on 22% of its global income.

Posted by ChKen | Report as abusive

Apple only makes money by selling devices and services (and just a bit by software).
The argument about IP is specious. Great ideas can be built into great devices, but the ideas are very soon copied. There is no way to protect the kind of IP that Apple creates, especially with our legal system that still operates at an 18th century pace. And guess where the most of the revenue from those copied ideas go—Korea. I think Apple should sue the US government for failure to protect IP rights.

Posted by drwam | Report as abusive

Why the surprise Mr. Salmon ? Haven’t you heard of the amounts of overtime Mr. Cook’s lobbyists have charged prior to the hearing ?

Posted by InHellsKitchen | Report as abusive

The point that was made by many (both witnesses and committee members) at yesterday’s witch hunt… er, I mean hearing, was that by making tax laws less complex and more competitive with other countries, American corporations (like Apple) would be more inclined to repatriate foreign funds, and invest that money in the USA rather than in foreign countries.

In other words, forcing companies to pay higher taxes at home is chasing business investments and employment to other countries.

A company’s financial responsibilities are to its share holders… Not to the government.

By making tax laws less complex, and by lowering corporate taxes so that they are inline with taxes in other jurisdictions, those large corporations would end up moving more investments home, resulting in them paying more taxes in the USA and also employing more people there.

It’s a very simple to understand concept, that apparently went over Senator Levin’s head.

Posted by February22 | Report as abusive

I wondered why Tim Cook didn’t take credit for writing the laws. The committee was probably happy he didn’t thank each of them personally making it all possible.

Posted by MyLord | Report as abusive

February22, let Apple leave. They can’t. They owe their life and success to the US, and they can’t function without being headquartered here. And no, they don’t make decisions about where to operate based on taxes. They can start paying taxes in good faith.

If you read the goddamn post, they are hiding US income via their shelters, based on their ridiculous IP pricing scheme.

Nothing went over Senator Levin’s head. The sad part is your licking the balls of a $300B multinational, because, well, I dunno, you tell us why.

Posted by Dollared | Report as abusive

>in our nation 150 million people manage to avoid personal income taxes<

Indeed. If this isn’t a call to repeal the onerous laws that harm employers seeking to give the 54 million people between 0-12 years of age jobs (rugs, fireworks, etc), I don’t know what is!

But going back to the post – Tim Cook is right. In his testimony, corporate taxes in America must go down to single digits.

The only way we will be competitive is if we bring the tax down to a single digit like -9%.

That’s right… we should start rebating money back to our corporations from people – because corporations are people.

This is a tried and tested way to boost economies – just look at how well our states perform when they compete with each other to give out millions of dollars in hand outs. Oh wait what? Those companies usually move back to their original location afterward? Or don’t deliver the jobs promised? Or build highly automated facilities that requires just 50 people to operate? Well, this time it’s different.

Posted by dtc | Report as abusive

I would like to see a move toward requiring formulary apportionment of worldwide consolidated income. Basic concept is apportionment of worldwide consolidated income based on a formula – typically a combination of sales, payroll, and property. (IP transfers could be a sticking point, but maybe just ignore it. Most internally developed IP isn’t capitalized for tax purposes anyway.)

http://en.wikipedia.org/wiki/Formulary_a pportionment

It would require rewriting tax treaties, but I think any significant overhaul of the tax treatment of international transactions will require rewrites. It’s a concept that is used by many U.S. states for state corporate income tax, so the concept is well-developed and has previously been proposed for international taxation also. I see 2 key selling points.

First, it taxes consolidated income, so we do away with the impact of transfer pricing. Transfer pricing is the central issue in huge amounts of tax minimization/avoidance strategies – be that the example of Apple in this case, Starbucks/Google/Amazon in the UK, etc.

For tech, pharma, or branded firms, there’s the question of where patents and trademarks (IP) are located and at what value they are transferred. Those values by definition are highly subjective. Apple’s transfer technique is arguably more objective than many – fund x% of R&D for an x% stake in its benefits – but is still used to game the system. For an example of how tough it is to assign value except retroactively, how would one have valued Apple’s iPhone-related IP in 2007? How about the value of Blackberry’s IP in 2007? Subsequent events give us an answer that was far from obvious at the time.

Even on a physical good, there’s still plenty of scope to manipulate transfer pricing. It sounds like Apple does so with its retail arm. Starbucks does so with its roasted coffee beans. Any multinational manufacturer that produces its own intermediate goods in different countries – think Toyota, Caterpillar, or GE – has plenty of scope to argue for a transfer price anywhere between production cost and sucking all the profit out of the final assembled product.

Worldwide apportionment also provides the capital flow benefits of a territorial system – all income is by definition assigned somewhere, so there’s no argument to taxing cash when it’s moved between countries. It starts with a sound theory of taxation – a corporation should be taxed on income where its activities occur – and applies a reasonable methodology to apportion that activity.

Posted by realist50 | Report as abusive

apple aparently did not break any laws, or they would be facing charges. Congress writes the laws and if they don’t get enough revenue they should re write them. Since congress has written the laws allowing many of us to pay no income taxes at all and those folks get to vote just like I do then, it is my duty as a husband and father to follow the law and take any and all deductions etc that I lawfully can,paying what I owe and not a penny more. congress should enact a flat tax so that we would all have skin in the game.

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