Tuesday, August 11, 2020

Further insights into Apple’s use of capital allowances

Apple Operations International is the Irish-registered Apple subsidiary that sits at the top of the companies that form Apple’s structure outside the Americas.  Previously as an unlimited company it did not have to file financial statements with the Companies Registration Office.

Recent legislative changes mean this is no longer the case and unlimited companies must now publish accounts.  This time last year consolidated 2018 accounts for Apple Operations International and all the companies beneath it were published.  See our discussion here with link to original post on Apple’s post-2015 revised structure. 

The 2019 accounts have now been published (which show that AOI has re-registered as a limited company).  There is lots of detail in the accounts but we will focus on the provision for income taxes in the statement of operations, payments for income taxes in the statement of cash flows and deferred tax assets on the balance sheet.

First the AOI Group’s consolidated income statement where the first thing we notice is that it looks like the company has bought a better scanner:

AOI Income Statement 2019

Of the $141 billion of net sales in 2019, $120 billion came from the sale of products with the remainder due to services.  The AOI group is hugely profitable.  In its 2018 financial year it had an income before income taxes of $46.7 billion.  It was down a bit in 2019 but was still $41.7 billion. 

As outlined previously the primary reason for this is the cost-sharing agreement (CSA) the AOI group has entered with Apple Inc. which provides the AOI group with a license to sell Apple products and use Apple Inc.’s intellectual property outside the Americas. 

To get the license the AOI group makes a cost-share payment to Apple Inc.  The cost to be shared is the R&D expense incurred with the share set relative to the size of the market the participant to the CSA sells into.  Sales outside the Americas make up slightly more than 50 per cent of Apple’s overall sales so the AOI group makes a payment to cover roughly 50 per cent of the overall R&D expense incurred by Apple.

As can be seen above the AOI group had an R&D expense of $7.2 billion in 2018 and $7.6 billion in 2019, and these are close to half of the total R&D expense incurred by Apple.  However, as the table above shows the right to sell Apple’s products and use Apple’s IP is worth much more than this. 

The value comes from the product innovation, R&D, brand development etc., which is carried out by Apple Inc. in the US but through the cost-sharing agreement Apple Inc. transfers this value to the AOI group. 

A profit-share agreement based on royalties would seem like a much more likely type of agreement for someone who is doing all the innovation and research to enter into but such cost-share agreements are allowed under the approach to transfer pricing set out in the US tax code.

Indeed, the IRS has challenged the terms of a number of these transfers used by other US companies, including Amazon and Facebook, but has yet to record a significant win in the US tax courts. 

In principle, the AOI group should be paying much more for the right to sell Apple products outside the Americas. And the US tax code even encourages such profit shifting.  Up to the end of 2017 this was through the deferral provisions there were then in the US tax code. 

Since the Tax Cuts and Jobs Act of December 2017 it is through different rates.  The headline rate of the federal corporate income tax is 21 per cent but lower rates are available via the FDII and GILTI provisions now in the US tax code.  FDII is Foreign-Derived Intangible Income and GILTI is Global Intangible Low-Taxed Income and is the one relevant here.

Anyway, let’s get back to our focus: the taxation of the AOI group.  We can see from the income statement that the AOI group made a provision for income taxes of  $6.7 billion in 2018 and $6.2 billion in 2019.  These correspond to effective accounting tax rates of 14.2 per cent and 14.9 per cent.

Although the AOI group is made up of around 70 subsidiaries with activities right around the world (and 47,000 employees) it does appear that most of the profit of the group is subject to tax in Ireland.  Here is a table that reconciles the above effective tax rates with Ireland’s headline 12.5 per cent rate.

AOI Provision for Income Taxes Notes 2019

In both years, the largest item explaining why the provision is greater than what the 12.5 per cent rate would imply is “Other” which is not very insightful at all.  We can see that both years have a positive figure for “differences in effective tax rates on overseas earnings”. 

In this instance overseas means outside Ireland.  Most jurisdictions have higher rates of corporate taxes than Ireland but the impact on the tax provision for the AOI group seems relatively modest: $150 million in 2018 and $352 million in 2019.  These are net figures so could be reduced by overseas earnings taxes at less than 12.5 per cent but the assumption that most of the income is subject to tax in Ireland is probably fairly safe.

However, a company making a provision for income taxes in its accounts is not the same as a company actually making a tax payment to a government.  Indeed, the cash flow statement in the accounts provides figures for “cash paid for income taxes, net”.  This was $1,418 million in 2018 and $2,229 million in 2019. 

So while the company does pay tax, these figures of $1.4 billion and $2.2 billion are obviously much less than the provisions for income taxes which were north of $6 billion in both years.  While timing can be an issue for temporary differences between the these figures the accounts point us to the reason for the large difference we see in this case.

AOI Provision for Income Taxes Notes 2019 2

Here we get a decomposition of the provision for income taxes into “current income tax” and “deferred income tax”.  Current tax is the tax charge for the period that will be paid.  Now, there may be a slight delay due to when tax returns are filed and the transfers actually made. 

For example, an Irish company with an end-September year-end would make interim Corporation Tax payments in March and August and would have until the following June to file its tax return and pay the final amount.  Anyway, it’s safe enough to take “current income tax” as tax that was been paid during the period in question or will be paid shortly after the year end.

On the other hand we have deferred tax.  This could lead to a deferred tax liability which would have a payment triggered in the future.  Alternatively, a company could previously have had a tax benefit on its income tax statement and the deferred income tax could be the reversal of that.  No payment will be made in the future.  This is the utilisation of a previously-generated deferred tax asset.

This could due to prior losses which can be carried forward for tax purposes.  But we have to go back to the 1990s for the last time Apple was loss making.  As we have shown previously Apple generated significant tax benefits using Section 291A of the Taxes Consolidated Act.

The participating companies are all likely to be part of the AOI group but one company in the group bought the license to sell Apple’s products outside the Americas from another company in the group.  The acquiring company became Irish resident and the expenditure it incurred in acquiring the license (likely to be something around €200 billion) is deductible for Corporation Tax purposes.

This is done through capital allowances -  a certain amount of the expenses incurred related to the asset (acquisition, financing and maintenance) can be used each year as a deduction when determining taxable income.  The AOI group would have recorded a large tax benefit when the transaction was undertaken in 2015.   This tax benefit would probably have been in the region of €25 billion (€200 billion x 0.125).

The amount for deferred income tax in the above table is the utilisation of that tax benefit.  Accounting standards may require it to be called a “deferred” tax expense but in the context here it will never be paid.  It is simply the accounting treatment of the taxation of acquired intangible assets as set out in S291A.

And, to no surprise, the balance sheet of the AOI group shows a deferred tax asset. 

AOI Balance Sheet Assets 2019

The liability side does not show an item for deferred tax liabilities.  The accounts have a table that show how the deferred tax assets have evolved over the past few years.

AOI Deferred Tax Assets 2019

We are primarily interested in those related to “intra-group transactions”.  We can see that these were $18.2 billion in September 2017, were reduced by $4.4 billion in the year to September 2018 to $13.8 billion and were reduced by a further $3.2 billion to reach $10.6 billion in September 2019.  

It seems likely that deferred tax assets from intra-group transactions will have been reduced by around $3-4 billion in the 12 months since and at current rate of utilisation will be exhausted in another two years unless additional expenditure is incurred.

This means that taxable income in Ireland will be reduced by around €25 billion using the capital allowances, while available.  The following extract from AOI’s accounts is worth nothing:

The corporate income taxes in the consolidated statements of operations, balance sheets and statement of cash flows do not include significant US-level corporate taxes borne by Apple Inc., the ultimate parent of the group.
US-level taxes are paid by Apple Inc. on investment income of the Group at the rate of 24.5% (35.0% in 2017) net of applicable foreign tax credits. In addition, under changes in US tax legislation that took effect in December 2017, Apple Inc. is subject to tax on previously deferred foreign income (at a rate of 15.5% on cash and certain other net assets and 8.0% on the remaining income), net of applicable foreign tax credits.  The new legislation also subjects certain current foreign earnings of the Group to a new minimum tax.

The final sentence is a reference to the new GILTI provisions in the US tax code.  Any reduction in Irish Corporation Tax within the AOI group using capital allowances will be made up via a higher tax payment to the US by Apple Inc.  And any payment of non-US tax on the intangible income will result in the company getting a credit equal to 80 per cent of the non-US tax paid to offset against its US GILTI liability.

Of course, as noted above, we are getting closer to the point where the capital allowances from Apple’s massive transaction at the start of 2015 will be exhausted.  What will happen then?  If this income continues to be recorded in Ireland then there will be no deferred tax asset to offset the current tax liability. 

If nothing changes this could see Apple pay an additional €3 billion or so of Irish Corporation tax while seeing its US tax bill fall by a near commensurate amount.  If nothing changes.

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