Apple's tax planning appears to be almost as elegant as its product designs. Using the rough set of tools available to them, the company's tax planners have achieved very favorable results.
The New York Times examined Apple's tax planning and concluded that the firm is taking advantage of a code that was written for the industrial age. The basic infrastructure of U.S. international tax policy was established in 1962. But the transfer pricing rules, which allow Apple to earn royalties in low-tax jurisdictions, were reviewed and revised in 1986 -- the same year that Steve Jobs founded Pixar, Microsoft became a public company, the first MS-DOS computer virus was released, and the London Stock Exchange moved to electronic trading. (For the article, see "How Apple Sidesteps Billions in Taxes," The New York Times, Apr. 29, 2012, at A1.)
Even though 54 percent of Apple's long-term assets, 69 percent of its stores, and 39 percent of its sales are in the United States, the company reports only 30 percent of its profits as domestic. Apple also uses income-shifting strategies to achieve a foreign effective tax rate of 4.7 percent. According to Tax Analysts' Martin A. Sullivan, the firm's adjusted effective tax rate is only 12.8 percent. (For prior analysis, see Tax Notes, Feb. 13, 2012, p. 777, Doc 2012-2625, or 2012 TNT 29-2.)
It is past time for the tax code to be reassessed, and once it is reformed, one hopes it will be easier to apply for corporate lawyers. Tax reform is probably on hold for the rest of the year because of the election, but when lawmakers are ready to consider it again, three plans will likely be the basis of their discussion on how to tax the tech sector: the excess returns proposal from President Obama, the bill offered by Senate Finance Committee member Ron Wyden, D-Ore., and Sen. Daniel Coats, R-Ind., and the draft by House Ways and Means Committee Chair Dave Camp, R-Mich.
The proposals to address the taxation of firms with many intangibles essentially reach the same conclusion, even though they approach the issue differently. "All of the plans, whether it is the administration's, the Camp plan, Wyden-Coats, or worldwide tax consolidation -- they all contemplate a higher tax burden on the most successful tech firms," said professor Edward Kleinbard of the University of Southern California Gould School of Law.
"Countries all face this problem of undertaxing tech firms," Kleinbard said. "To a significant extent, they are stymied as to what they can do as a political matter so long as the U.S. sets such a bad example." Kleinbard suggested that if the United States were to move to a strong territorial system or a worldwide system with a moderate corporate tax rate, other major developed countries, such as Germany and France, would follow suit.
In the absence of a clearly observable market failure, there is no reason to favor one sector over another, Kleinbard argued. Higher effective rates for the tech sector would likely correspond to lower rates for other industries, such as retail. "It is not a question of punishing" the tech sector, he said. "This is a question of taxing returns on capital investment consistently across industries and across geographies."
Excess Returns Proposal
A tax on excess returns was included in the corporate tax reform framework Obama released in February 2010. The proposal outlines an approach that would backstop the transfer pricing rules to prevent inappropriate shifting of profits through transfers of intangibles. The basic idea is that in circumstances when it appears there is excessive income shifting as a result of a transfer of an intangible by a U.S. company to a foreign affiliate with a low effective tax rate, some of the profit (the excess return) would be taxed as subpart F income.
Tax practitioners gave the proposal a chilly reception. Commentators said that it threatens to depart from the international consensus on the arm's-length principle and that it likely would impose competitive burdens on U.S. multinationals while having little impact on the U.S. fisc. The government defended the plan as a targeted measure that isn't designed to fundamentally change the transfer pricing system. (For prior coverage, see Tax Notes, Mar. 1, 2010, p. 1028, Doc 2010-4055, or 2010 TNT 37-3 . For commentary, see Tax Notes, Apr. 5, 2010, p. 45, Doc 2010-4430, or 2010 TNT 64-4.)
Although there are few details for the excess returns proposal, it seems clear that tech firms are among the most likely taxpayers to have excessive returns in lightly taxed foreign subsidiaries. Apple's subsidiary in Luxembourg, for example, would generate subpart F income under the proposal.
The Obama corporate tax framework is intended to be revenue neutral. It preserves worldwide taxation as a basic policy on the grounds that territoriality may cause a race to the bottom in international tax rates. It features a top marginal rate of 28 percent. The other international tax provisions of Obama's plan include a minimum tax on the income earned by foreign subsidiaries of U.S. parent companies. The foreign tax credit would be preserved. Mark Mazur, Obama's nominee for Treasury assistant secretary for tax policy, said May 8 that a comprehensive tax reform proposal will not be coming soon. (For prior coverage, see Tax Notes, May 14, 2012, p. 823, Doc 2012-9806, or 2012 TNT 90-1.)
The Bipartisan Tax Fairness and Simplification Act of 2011 (S. 727), proposed by Wyden and Coats, would adopt a 24 percent corporate tax rate and eliminate deferral by reinstating the per-country FTC. The per-country limitation was used from 1932 to 1976, and it was included in President Reagan's tax reform proposals in 1985. A per-country limitation requires a taxpayer to separately compute the creditable foreign taxes paid or deemed paid for each foreign country. The limitation is based on the taxpayer's taxable income in each country. (For prior discussion, see Tax Notes, Sept. 20, 2004, p. 1393, Doc 2004-17796, or 2004 TNT 183-28.)
The Wyden-Coats bill includes a temporary repatriation tax holiday that would impose a 5.25 percent rate on repatriated foreign earnings and tighten the domestic reinvestment plan requirements. (For S. 727, see Doc 2011-7271 or 2011 TNT 66-29.)
A move to a 24 percent rate would increase taxes for companies like Apple, and a per-country limitation would make it impossible, or at least very difficult, to cross-credit. The complexity of a per-country limitation would also affect tech firms with many foreign subsidiaries. Interestingly, the criticism of a per-country limitation in 1985 was that it bore little relationship to commercial reality, because firms make their investment decisions based on where a market exists and organize their foreign operations as a single entity. (For prior coverage, see Tax Notes, Oct. 7, 1985, p. 9.)
In October 2011 Camp issued a discussion draft of a proposal to lower the corporate tax rate to 25 percent and adopt a dividend exemption system. Under the plan, domestic corporations would receive a 95 percent deduction for the foreign-source portion of dividends received from controlled foreign corporations. To be eligible for the deduction, corporations would be subject to a one-year holding period on the stock on which the dividend was paid.
The key to making the Camp plan work is the antiabuse rules that are listed as alternatives in the discussion draft, according to Kleinbard. He said that a combination approach would be optimal if the goal is to create a tax system that does not pick winners or losers. A territorial system that is developed along the lines of the Camp plan and isn't gutted in the political process would produce revenues that are roughly equivalent to those under a genuine worldwide system, said Kleinbard.
As under the Wyden-Coats bill, Apple's effective tax rate would likely rise under the Camp plan. The three options to address intangibles migration in the draft -- excess returns, a variation on the low effective tax rate test used in Japan, and a combination of a 15 percent patent box and current subpart F inclusion of foreign intangible income for CFCs based in low-tax jurisdictions -- would probably further undermine Apple's ability to minimize its taxes.
Falling Far From the Tree
The unifying feature of the three options for international tax reform is that established and successful tech firms will see their tax bills rise. The proposals come from both ends of the political spectrum and suggest a consensus among elected officials that placing a higher tax burden on the tech sector is appropriate, or at least inevitable.
John Buckley, a professor at Georgetown University Law Center and former Ways and Means chief Democratic tax counsel, recently remarked that the difference between the worldwide and territorial proposals from the president and from Camp is in their labels. (For prior coverage, see Tax Notes, May 21, 2012, p. 983.) Certainly for profitable tech firms, that seems to be true. However, higher taxes on tech firms would raise questions about the compliance costs of each reform option. Unless Apple and its peers can persuade Congress not to raise their taxes -- a policy reversal that seems unlikely -- the critical question becomes not how much more they will pay the government, but how much more they will pay their advisers.
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