How the World Tax Codes and Governments are Not Prepared for the Digital and Tech New World

Apple CEO Tim Cook testified in late May in front of the Congressional Permanent Subcommittee on Investigations on the company’s corporate tax practices.  Sen. Carl Levin, the chairman of the committee, said “Apple successfully sought the holy grail of tax avoidance.  It has create offshore entities holding tens of billions of dollars while claiming to be tax resident nowhere”.

 Edward Kleinbard, a law professor at the University of Southern California in Los Angeles and the former staff director at the Congressional Joint Committe on Taxation stated that “there is a technical term economists like to use for behaviour like this — Unbelievable chutzpah”.

Investigators haven’t acussed Apple of breaking any laws, and Apple is definitely not the first multinational American organisation accused of facing scrutiny in the structure of their corporations and the accusations of attempted tax evasion.

Cook said that the company paid “all the taxes we owe — every single dollar”, but early on in the testimony, J. Richard Harvey said that the company managed to avoid about $7.7 billion in taxes.

Mihir A. Desai, a professor and Dean at Harvard Business School, sheds some light on the situation in his interview with Gretchen Gavett, writer for the Harvard Business Review.

Desai believes that a consensus emerged during the hearings that Apple had not done anything illegal.  He states that claiming a company avoided paying taxes is tricky to prove or blame, just like when someone takes their mortgage interest deduction to avoid paying taxes.  But claims of tax evasion become much more significant when foreign borders are crossed.

Congressional investigators disclosed:

“Apple avoided billions in taxes in the United States and around the world through a web of subsidiaries so complex it spanned continents and went beyond anything most experts had ever seen”.

The Congressional panel filed a report that showed Apple having subsidaries in Ireland where a tax rate of 2% was negotiated.  These units are:

Apple Operations International:  100% owned by Apple Inc., it is a holding company that receives dividends from offshore affiliates, but has never had any physical prsence or employees.

Apple Operations Europe:  With about 400 employees, it manufactured a spcialty line of computers for sale only in Europe.  It is a subsidary of Apple Operations International.

Apple Sales International:  Contracted with third-party manufactures in China in the productions of Apple products, which were then sold to Apple Distribution International.  Little, if any tax was paid from 2009 to 2012 on the $74 billion in profit.

In April, business lobby groups (the Business and Industry Advisory Committee and Britain’s CBI) questioned the use of the techniques used by Apple, Amazon and Google, but were unsure of how significant the issue was.  The Reuters exam found that 37 of the top 50 U.S. tech companies do not have tax residence in their biggest European markets for their main businesses, according to The Times of India.

 The exam also found that only a quarter of the top firms reported income in the countries where the majority of it was earned.  The remaining 75% declare permanent establishment in smaller markets that offer lower tax rates, such as Ireland, Switzerland and the Netherlands.  This ensures that the German, French and British tax authorities can’t assess or tax their income.

Desai states that the majority of taxes paid by the company are to the U.S. government on income earned in the U.S. that add up to a significant tax rate.  Simultaneously, Apple is beginning to become more profitable overseas and pay a very low tax rate on foreign income.  So the critical question is what is the appropriate policy stance to Apple paying a very low rate on foreign profits?  

Desai gives three separate views on the subject.

First, should the U.S. tax the worldwide income of its corporations wherever that income is earned or should they restrict tax authority to income only earned within the borders?  The first situation is a worldwide system, whereas the following is a territorial system.  This is a design issue.

Right now, the U.S. is alone in having a worldwide system that is run very poorly, considering we only ask corporations to pay taxes when they repatriate profits.  In response, American corporations have kept more than a trillion dollars overseas to avoid the repatriation tax.  This only negatively affects are burdensome system on American corporations who distort their allocation of capital and raises a miniscule amount of revenue.  If we were to switch to a territorial system, it would ensure that corporations from around the world are competing based on their performance attributes rather than their tax attributes.

Additionally, there is a significant scope for corporations to change their national identity through expatriations and corporate mergers, so if the U.S. is the only one using a worldwide system, our corporations have a reason to leave.  According to Desai, the logic for why we tax foreign income through a worldwide system is appropriate — investment abroad means lost investment at home, which doesn’t appear to have much empirical traction.  If we understand the virtues of a territorial system, we don’t need to care what tax rate companies face in foreign jurisdictions, and since we allow the referral of paying taxes until repatriation in our worldwide system, we don’t care about the low rate paid on foreign profits.

The second view looks at how profits are being reported as foreign when they may represent profits that should have been reported as U.S.  Desai says its very obvious — If corporations are taking profits out of the U.S. to get lower tax rates on them, we should monitor and ensure that the profits are not being reallocated away from the U.S. in illegal ways.  This type of behaviour undercuts the credibility of the tax system and violates the norms that have been set in place.

The third discusses the mechanisms by which foreign tax rates have been lowered and if the U.S. should care that foreign governments are being deprived of their tax revenues.  Desai believes that It is really a matter of opinion — if firms are truly avoiding paying taxes to foreign jurisdictions by stripping profits from country to country, should we care?  Some say we should, others believe those countries can watch out for themselves.

Desai also discussed the commonality of overseas tax maneuvering and how big a problem it is for U.S. businesses and the lives of ordinary Americans.

“I think the perverse incentives of the current system, and the behaviors they give rise to, are a significant problem for Americans.  These incentives reflect two features.

First, the worldwide system with a repatriation tax alters the capital allocation process for our firms and locks capital out of the U.S. which hurts all of us.  Second, the fact that the U.S. rate is now the highest rate amongst OECD countries means that investment in the U.S. is less attractive and that the incentives to engage in aggressive tax planning are high.  Indeed, those tax planning incentives can then make it more attractive real activity abroad.”

He believes it is a significant problem, not only because some tax revenue is lost, but also because the entire, largely complex system gives rise to relevant distortions on investment away from the U.S.

In 2004, congress enacted the repatriation holiday, which allows corporations to bring back up to $300 billion from overseas at a tax rate of only 5.25%, compared to the normal 35% corporate rate.  Critics believe that these “repatriation holidays” do nothing to stimulate the U.S. economy since profits are brought back at miniscule tax levels and essentially only provide growth for the corporations, shareholders and executives.   A study by the National Bureau of Economic Research found the 92% of the repatriated cash was used for dividends, share buybacks or executive bonuses.

Cook believes that “If Apple had used its overseas cash to fund this return of capital, the funds would have been diminished by the very high corporate U.S. tax rate of 35 percent — and the current system, which applies industrial era concepts to a digital economy, actually undermines U.S. competitiveness”.  It’s unsure whether to say Apple is walking on the edge of immorality, or just doing a really good job maximizing their overseas profits.