US MNCs and nearly $100 billion of deferred taxes

The tax strategies of MNCs, and US MNCs in particular, continues to attract a lot of attention.  This week Apple, Google and Microsoft appeared before the Economics References Committee of the Australian Senate.  The exchanges followed the well-worn path of the companies explaining (some of) what they do with the politicians aghast that they don’t do something else – even though what the politicians suggest the companies do would actually be illegal.

Apple, Google and Microsoft are hugely successful companies (at the moment at any rate) but they are US companies.  The risks, functions and assets that actually generate most of their profits are in the US.  These companies only owe corporate income taxes to other countries on the basis of the risks, functions and assets they have there not because their customers are located there.

And even still these companies are subject to the 35 per cent US federal corporate income tax on their worldwide profits – so even if they do make profits in other countries they will be liable for US tax (though they will be granted a credit for any foreign corporate income tax paid).  The key aspect of the tax strategies used by MNCs is not to avoid corporate income tax in the countries of their customers, it is to trigger a deferral of the 35 per cent US corporate income tax that they are liable for.

The critical aspects of their tax strategies are:

1. A licensing agreement with a subsidiary for the rights to sell the US MNCs products or services outside the US, and
2. A structure to engineer a deferral of the 35 per cent US corporate income tax payment that is due on the profits made from these sales.

The licensing agreement will be with a subsidiary that is based in a low or no corporate tax jurisdiction such as Bermuda and a structure will be set up so that the US corporate income tax is not paid until the profits are transferred to a US-incorporated entity within the company’s structure, if ever.

The licensing agreement is key and this is entirely under the domain of the US tax authorities.  This establishes the payment the offshore subsidiary(i.e. non-US incorporated) must make back to the US parent for the right to sell the company’s products in markets around the world.  It could be that the price would be close to the profit the subsidiary would make from these sales so most of the profit would be transferred back to the US parent and the US corporate income tax that is due would be paid at that point. 

However, if the price is substantially below the profit the offshore subsidiary makes the profit accumulates in the subsidiary and, in certain circumstances, the US corporate income tax is not paid until a decision is made to transfer the profits as a dividend back to the US parent.  The main purpose of tax strategies used by US MNCs is to ensure :

1. A low price is set in the licensing agreement, and
2. that the circumstances to trigger a deferral are in place.

The criteria by which these can be set are set out in US tax law.  It is US tax law that determines whether the licensing agreement is appropriate and it is provisions of US tax law such as “check the box”, the “same-country” exemption and the “look-through” rule that allow a deferral of the tax.

Using these provisions in the US tax code Apple, Google and Microsoft are successfully able to defer the payments of huge amounts of US corporate income tax.  Under existing rules unless the locations of these companies’ risks, functions and assets change this tax would not be due to anyone else.  These are US-based companies and they owe US taxes.  Of course, to be able to defer huge amounts of taxes you need huge amounts of profits and these companies are hugely successful. 

And they do not hide their success in deferring US taxes.  They show how successful these strategies are in their financial statements.  The deferred tax liabilities come in two forms. The first is what the company have actually provided for in their income statements which is recognised on their balance sheets as being owed; the second is unrecognised because they do not intend to transfer the money to a US-incorporated entity within their structure.  Here are extracts from the most recent 10k filings made by Apple, Google and Microsoft to the SEC.

APPLE: $43.6 billion of deferred taxes.

As of September 27, 2014, the Company had non-current deferred tax liabilities of $20.3 billion.

As of September 27, 2014, U.S. income taxes have not been provided on a cumulative total of $69.7 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be approximately $23.3 billion.

GOOGLE: up to $18.5 billion of deferred taxes.

Deferred income taxes, net, non-current $1.9 billion

We have not provided U.S. income taxes and foreign withholding taxes on the undistributed earnings of foreign subsidiaries as of December 31, 2014 because we intend to permanently reinvest such earnings outside the U.S. If these foreign earnings were to be repatriated in the future, the related U.S. tax liability may be reduced by any foreign income taxes previously paid on these earnings. As of December 31, 2014, the cumulative amount of earnings upon which U.S. income taxes have not been provided is approximately $47.4 billion. Determination of the amount of unrecognized deferred tax liability related to these earnings is not practicable.

MICROSOFT: $32.3 billion of deferred taxes.

Deferred income taxes $2.7 billion

As of June 30, 2014, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $92.9 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences was approximately $29.6 billion at June 30, 2014.

This is a total of $94.4 billion of deferred income taxes for just three companies.  There is nothing hidden or untoward about this.  It is all there in the companies’ accounts.  This was achieved with licensing agreements sanctioned by the US and the deferral provisions of Subpart F of the US tax code.

There is a general deferral of the US corporate income tax due for non-US active income of US companies but most of the income in question here will be passive income (or at least has been converted to passive income) through the use of patent royalties, license fees and dividend payments.  There is a general non-deferral of the US corporate income tax due on the non-US passive income of US companies.  However, the companies can avail of the exceptions to this in Subpart F which were introduced for one reason or another.

All those shouting for a “clampdown” on tax avoidance by US MNCs should be aware that it is corporate income tax payments to the US that will be most affected – unless they can get these US MNCs to move the risks, functions and assets that generate these profits to their countries and the US is unlikely to stand for that.  It is one thing for the US to allow their companies to defer the payment of US tax; it is another thing to let another country to collect it.