Apple’s Tax Avoidance: ‘Total Political Crap’

December 22, 2015 1 Comment

Everyone already knows that Apple is probably the most influential companies ever created in the history of this planet (Sorry, Nintendo). With a valuation close to nearly a Trillion dollars and a war chest that would rival small countries, earning its spot within the Dow Jones Industrial average, among 30 of the largest and most influential companies in the world.

That’s not to say it didn’t get to where it is today without making a few enemies along the way. From patent wars with its long-time electronics manufacturing rival Samsung, to royalty payment issues with Taylor Swift and tax advocacy groups insisting the government to go after businesses and corporations who attempt to escape their share of the U.S. tax bill.

Apple also managed to create political enemies both on the left and the right. As usual in politics, it’s always easier to engage in political populism by claiming something is unfair and should be changed. It’s much harder actually to look at the inner-workings (or the economics, in this case) of why things happen the way they do, and what can be done to make an effective change.

For everything else, Tim Cook has the response: Total Political Crap

For the most part, it is true. Apple does pay every tax dollar it owes. According to Apple’s 10-K statements, Apple as a whole pays $19.1 billion in corporate taxes: $16.18 billion in domestic taxes and $2.9 billion in foreign taxes. From a gross profit of $72.5 billion, this makes Apple’s effective tax rate of 26.7%. That is a pretty large sum, regardless of where it originates from.

It makes total sense, from a business perspective, and Apple didn’t become a $700 billion dollar corporation by engaging in inferior business practices.

For example, Apple is able to defer some of its R&D cost with it’s Irish subsidiaries with something called a Cost-Sharing Agreement. This is an arrangement between two parties (usually a parent and subsidiary company) to share the cost of intellectual property, such as patents. In essence, the very purpose of a cost-sharing agreement is to reduce or avoid paying taxes.

For example, let’s say that the parent company is located in the United States, which has a statutory corporate tax rate of 35%; the sub company is located in a country with a 10% rate. In 2010, the parent and sub company constructed a cost-sharing agreement, which stipulates that any future intangibles created by the parent company can be used by both the parent and sub and shared based on future relative earnings. Assume that later in 2010, the parent spends $100 million to develop a new product that increases earnings by $40 million and the sub earnings by $30 million.

Under this agreement, the sub company would have to pay the parent company 30%, as the benefits gained from the sub company was $30 million on the $100 million R&D investment. Without this arrangement, the sub company would have to pay the parent a much larger sum of money, which would be represented in the company’s future earnings (licensing alternative).

From a tax perspective, this adds up to a large amount of savings. The sub company’s payment of $30 million will result in the parent company paying an additional $10.5 million in earnings ($30m x 0.35% = $10.5 million), and resulting in the sub yielding $3 million ( $30m x 0.10%), which can then be used to offset the worldwide tax obligation ($10.5m – $3m = $7.5m).

The idea of Cost-Sharing Arrangements are not new and dates back to at least the early 1960s. Apple currently uses this method to reduce its tax obligation. Considering that two-thirds of Apple’s profit originates from foreign sales, it only makes sense to have your business mode of production structured in such a manner. The profits parent companies would have made the licensing alternative are then attributed to the subsidiary. Cutting foreign subsidiary expenses effectively shift profits overseas. As you can see, there is plenty of cash Apple has sitting overseas.

As you can see, Apple has no intention of sending that money back home. Strangely enough, you will also see that Apple, as of Q3 2013, has taken on some debt. Odd for any company to do that, especially when it has plenty of capital on hand. The reason for this is because Apple would have to pay a 40% tax to repatriate those taxes. Apple also has a responsibility to its shareholders, and the only way to effectively pay out dividends (or buy back stock) is to borrow money to do it. Considering the low-interest rate environment, it cost significantly less to borrow funds than it does to repatriate money to pay shareholders. This does demonstrate how pathetic our tax structure truly is, considering a business would rather go into debt than send up billions of dollars in profit. Without this tactic, Apple would be paying more than $50 billion dollars in taxes each year.

And people who are okay with this continue to point out how many programs can be funded with that money, such as education and health care; almost as if Tim Cook was giving the false dichotomy between making money and educating our students. The solutions, as always, will be to close the loopholes and punish companies that move their business operations overseas. All of this ignores the reason why businesses choose to move overseas. As Tim Cook puts it, “We have a tax code for the industrial age, not the digital age.”

Topics on how to pay for our underfunded government programs is meaningless without figuring out more effective ways of collective tax revenue. As it currently stands, business taxes are a less reliable source of revenue for a couple of reasons:

  1. Most corporations are very small, and therefore, do not earn enough money to pay the largest 33% tax bracket.
  2. Most businesses file their companies under the 1120S category, which are S-Corporations. Unlike C-Corporations, S- Corps are not subject to federal corporate taxes.

These loopholes, as they are currently, are not going to change anytime soon. There are plenty of incentives, from Silicon Valley onward, not to change these laws, so until another budget crisis begins to loom on Capitol Hill, any talk to reign in these tax avoiders will simply be seen as more pontificating from the political elite.

Considering that the U.S. doesn’t have a burdensome federal budget, it can get away with having an inefficient tax system. Anywhere else, and the U.S. would have to be much smarter about its tax code and how it collects revenue (more on this, in the future). Until we bring about those changes, Apple, and companies just like it, will continue to use the legal tactics to lower its own tax burden.

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