Angry About Multinational Profit Shifting? We Can Fix It

flickr / niallkennedy

On Sunday, The New York Times ran a massive, 3700-word, story on their investigation into aggressive, but legal, tax avoidance at Apple. Apple uses a wide network of subsidiaries in tax havens to shift profits away from high-tax jurisdictions like the United States. Apple has previously been a noted innovator in the tax strategy department, pioneering techniques to drastically reduce their tax bill. Despite explosive growth in Apple’s profits, their tax bill has barely budged in recent years. The article reports,

Apple, for instance, was among the first tech companies to designate overseas salespeople in high-tax countries in a manner that allowed them to sell on behalf of low-tax subsidiaries on other continents, sidestepping income taxes, according to former executives. Apple was a pioneer of an accounting technique known as the “Double Irish With a Dutch Sandwich,” which reduces taxes by routing profits through Irish subsidiaries and the Netherlands and then to the Caribbean. Today, that tactic is used by hundreds of other corporations — some of which directly imitated Apple’s methods, say accountants at those companies.

Without such tactics, Apple’s federal tax bill in the United States most likely would have been $2.4 billion higher last year, according to a recent study by a former Treasury Department economist, Martin A. Sullivan. As it stands, the company paid cash taxes of $3.3 billion around the world on its reported profits of $34.2 billion last year, a tax rate of 9.8 percent. (Apple does not disclose what portion of those payments was in the United States, or what portion is assigned to previous or future years.)

Apple may be an early adopter, but they are not unique. Profit shifting – using abusive transfer pricing to move revenue to subsidiaries in tax havens – is a common strategic by U.S. multinationals. While the U.S. nominally has a 35% tax rate, its effective rate is much lower due to this profit shifting. If you have a skilled enough tax department and lots of intellectual property, you can dramatically reduce your tax bill.

The key concept necessary to understand what is going on is transfer pricing. Transfer pricing is how you account for transactions between two different branches of the same company tree. When General Motors wants to sell in the United States the cars it manufactured in Mexico, it accounts for those parts as if GM-U.S. bought the cars from GM-Mexico at market value. GM-U.S. registers the cost, while GM-Mexico registers the revenue. If no intentional mispricing occurs, General Motors can account for its profit in the different jurisdictions using these credits and debits. Some of the profit remains in Mexico, and some is accounted for back in the United States, and some is taxed in each. Without mispricing, you get something close to a fair distribution of taxes out of transfer pricing.

The trick is to find some way to legally pretend that you made money in a low tax jurisdiction, and then “sell” it to a high tax one. This is where intellectual property comes in. When you have an asset that is very difficult to determine a market price, like a patent or copyright, you can transfer it overseas, then charge that subsidiary for the privilege of using it. According to the New York Times, this is what Apple is doing in Ireland. It sends royalties from its patents – developed in the United States – to Ireland. It routes them through tax havens like the British Virgin Islands and The Netherlands, to come out virtually tax-free. This is how Apple gets down to a 9.8% tax rate, including just 3.2% outside the United States. Companies that deal with harder-to-misprice goods, like cars or clothing or commodities, have a much harder time shifting profits around. Wal-Mart, for example, pays about 24%.

It’s really easy to be angry with Apple for electing to use all sorts of creative legal techniques to avoid paying billions of dollars in U.S. taxes. Apple is an insanely profitable company, and it shouldn’t be able to magically make its U.S. profits disappear. When Apple’s accountants and lawyers exploit gaping holes in the tax code, they are just doing their job. There is, however, a body perfectly capable of making Apple pay its taxes: the United States Congress. The Stop Tax Haven Abuse Act takes aim at the estimated $100 billion a year that the United States loses from offshore tax dodging – both the legal and illegal kinds. If you want to make a change, direct your anger straight at your local Congressman or Senator.

One provision in the bill is the simplest, easiest way to stop companies like Apple from shifting their profits offshore: make them disaggregate their reporting data. Apple should be required to disclose all “employees, sales, financing, tax obligations, and tax payments” on a country-by-country basis wherever it operates. So, if Apple wants to legally claim its subsidiaries in the British Virgin Islands are somehow making billions of dollars, it must put that information out there for all to see. At that point, not only will the New York Times infographics get even more interesting, but the IRS and other worldwide tax authorities will be much better able to keep up with Apple’s tax department, exposing the magic trick for what it is.