The media debate about Apple’s tax strategies continues, and continues to be wrong. The Irish Times today features an editorial under the heading ‘Apple’s lucrative tax loophole’.
The first thing to note is that Apple is a US company and therefore has to pay US taxes on all its profits. If Apple operates in other countries, as it does, in those countries it only has to pay tax on the profit it actually generates within those countries.
Apple takes on limited risk outside the US. It engages in manufacturing, distribution, and retailing. In Apple’s operations none of these are very risky and none of them are very profitable.
The main source of Apple’s profits are the products it designs. If Apple designs a good product, activity along its manufacturing, distribution and retailing arms will increase. If Apple designs a poor product that people don’t want to buy, the activity along Apple’s manufacturing, distribution and retailing arms will decrease.
Apple’s manufacturing, distribution and retailing arms contribute almost no risk to Apple and do not add significant value to Apple’s operation; designing innovative products does that. Apple could, and sometimes does, outsource manufacturing, distribution and retailing. It does not, nor will not, outsource designing. Apple is a designer of products.
Apple is rightly taxed where the intellectual property that results from this innovation is located. That is in the United States and the US rightfully taxes US companies on their global profits.
If Apple makes profits from selling to customers in Australia, the UK, Japan, Ireland or any other country it will have to pay tax at 35% to the US Treasury (less credits for any income tax paid on the profits from any low-margin manufacturing, distribution or retail activities it carries out itself in those countries).
Apple does not owe taxes on the profits earned by its intellectual property to any country but the US. That investment took place in the US; the R&D was organised and carried out in the US; and the resulting patents and copyrights (and of course Apple’s trademark) are held in the US. Apple is a US company that owes US taxes.
But here is where the wrinkles come in. In many instances the US does not immediately collect the tax on the foreign-source (i.e. outside the US) income of US companies. The US levies the tax but does not collect it. Provisions in the US tax code allow the payment of the corporate tax by US companies to be deferred until the profit is repatriated from certain foreign subsidiaries to the US parent.
There is a universal deferral for the active income from manufacturing. However, Apple and related “new economy” companies don’t make their profits from manufacturing; they make them from ideas. Ideas generate what is known as passive income. A patent holder earns money by charging to allow the use of the idea. The patent holder doesn’t have to do anything, they charge someone to allow them to do something.
If a US company earns money from passive income it is immediately subject to the 35% US federal rate of corporation tax. If this was universal it would be end of the story. Apple earns lots of profits from selling to customers and most of this is rightfully attributed to the high-risk R&D it engages in so if the profits earned by Apple’s patents were taxed at 35% this vacuous debate would not be happening.
In fact, it might be that a proper debate of the global system of corporation tax would occur. One that discusses, and understands, the merits and faults of the current system based on the source and residence principles, and the oft-proposed moved to formulary apportionment.
Alas, we are a long way from that. Why is that the case? The reason, and almost the only reason, that gives oxygen to this debate is that the US does not collect its 35% federal corporate income tax on the passive income earned by foreign subsidiaries of US parents. There is a raft of deferral exemptions built into the US tax code that allow these deferrals.
Apple earns huge profits as a result of its US-created intellectual property. Apple enters a cost-sharing agreement with a foreign subsidiary and licenses it to use its intellectual property in markets outside the US. This subsidiary, in turn, charges hefty license fees to Apple’s manufacturing and retailing divisions right around the world.
Given the current success of Apple this subsidiary accumulates massive profits. Under US tax law the earning of this subsidiary are passive income (they come from the licensing of intellectual property) and therefore immediately subject to the 35% corporation tax. The subsidiary is using intellectual property developed in the US so this is what could be expected to happen.
But it doesn’t. Although passive income should immediately trigger the US 35% corporate tax it is very simple for US companies to avail of some of the many deferral provisions that have been appended to Subpart F of the US tax code over the years. These have a variety of names that include the “check the box” provision, the “look-through rule” and the “same- country exemption”.
The detail is unnecessary but the effect of these is to allow US companies to defer US corporation tax on their foreign-source passive income that would otherwise be immediately subject to the 35% US corporation tax (with credits for any income tax paid in other countries). If interested there are some useful details in this Forbes article, opprobrium aside.
The starting point is the cost-sharing agreement the parent company enters with the foreign-subsidiary to allow it to avail of the intellectual property. In Apple’s case this subsidiary is Apple Sales International.
The Irish Times editorial states:
ASI was, under Irish law, regarded as a “stateless” company.
There is, nor ever was, a provision under Irish law that allowed a company to be “stateless”. Ireland has a pretty standard set of rules for determining whether a company is resident here. Using those rules ASI is not resident in Ireland and there is nothing untoward about that. International companies are non-resident in most of the countries they operate. They are a resident in one.
The key is the other country ASI operates in. In fact almost all of ASI’s operations are in this other country but that country did not judge it to be resident there. All of ASI’s activities are carried out in the US, but under US law residency is determined on the basis of place of incorporation. ASI in incorporated in Ireland. Again there is nothing unusual about companies being incorporated in one country and being resident somewhere else.
The key here was that Apple designed a company that was tax resident nowhere. It was gaps between tax codes that allowed this not any loophole in the Irish tax code. Ireland has moved against it but not to make companies like ASI resident here. The change will merely ask companies that fail the test of management and control here to state where they are resident with a failure to do so resulting in them being deemed resident here.
This was a move for reputational reasons only. It will have no impact whatsoever on the tax paid by Apple. Apple is a US company that owes US tax. It is laws passed by the US Congress in Washington that allow Apple to defer the tax due on its passive income.
The US companies are happy with this and despite much loud gnashing of teeth the US politicians are happy with this. The fact that much of the ire is being directed at Ireland suits all the US participants.
If the US immediately taxed the foreign-source passive income of its companies the residency of ASI would almost be an irrelevancy. If that was the case you can be sure that the US would not be happy if ASI was deemed Irish resident. Then Ireland would be collecting tax at 12.5% on profits which are the result of US activity and risk-taking. If so, the amount collected by the US 35% corporate tax rate would be reduced by the 12.5% tax collected in Ireland. Ireland has no entitlement to tax the profits earned by Apple’s intellectual property (but can, and does, tax Apple for the limited activities that take place here).
Apple is not avoiding any Irish tax on the profits earned by its intellectual property. There is no sane reason to argue that Apple owes corporate tax to Ireland for sales to customers in Australia, Germany, the UK and Japan which generate profits based almost entirely on intellectual property developed in the US (some manufacturing and retailing that takes place here aside).
It is a nonsense argument but one that continues. And in any debate if you are explaining you are losing. Ireland is losing.
If the US wants to collect tax on Apple’s foreign-source passive income rather than allow it be deferred it could do it almost overnight. It would be an easy change.
Instead the US continues to allow deferral provisions that exempt foreign-source passive income from immediately paying US corporation tax (the tax is due but only has to be paid when the foreign-source profit is repatriated to a US-resident company, and in the absence of this transfer then payment of the tax can be deferred indefinitely).
Does Ireland allow US companies to avail of the deferral exemptions available in the US tax code? Of course we do. But they are US exemptions not Irish ones. There is no Irish “loophole” that allows US companies to avoid US tax. [And there is no unilateral provisions in Irish law that affects the tax collected in other countries.]
Suggestions that Apple “reduced its Irish tax bill by over €850 million” as claimed by The Irish Times are beyond ludicrous. Apple takes almost no risks in Ireland so to suggest that Apple in Ireland generated €850m/0.125 = €6.8 billion in profit (and that just from selling to Australians) is absurd. Apple owes US taxes on that profit and it is up to the US to collect it. We don’t have to be their policeman.
The risk Ireland faces is that the US reforms its tax code and closes off some of the deferral provisions that the US technology and pharmaceutical companies come here to use. There is lots of noise around US tax reform but no sign of anything substantive emerging.
For now, we should just remember that Apple is a US company that owes US taxes and stop falling into the trap that suits those in the US – blaming Ireland.Tweet