Column: Inside the Apple tax bombshell: Why it’s not good for anyone (especially Apple)

Apple investors have seemed to be taking in stride the $14.5-billion tax bill levied on the company by the European Commission on Aug. 30. Apple shares actually have been up modestly in Nasdaq trading in the days following the EC action.

Perhaps there are good reasons for complacency. The EC’s order that Apple pay 13 billion euros to Ireland as back taxes will be appealed by both the company and Ireland, which could mean years will pass before a single euro is paid on the bill, if ever. Even if the full sum were to come due, Apple has the cash. The bill is about one-fourth of the company’s 2015 profits and 6% of its revenue, and it could be paid easily out of the $180-billion cash Apple is holding overseas — out of reach, for now, of the U.S. tax authorities.

But there also are grounds for Apple investors — and those of other U.S. corporations that have been playing international tax rules like an orchestra for profit — to be worried about the EC investigation and its outcome. First and foremost, the jig is up.

Edward Kleinbard, USC’s peerless corporate tax expert, may have said it best during an appearance Monday on CNBC, a day before the EC issued its widely-anticipated ruling: “The easy days of single-digit tax rates are going to be over.”

International corporations have been so brazen about manipulating the rules that the EC and its member countries were already tightening up; Ireland ended some of the practices that benefited Apple last year. But remaking the system is going to be painful for all concerned. Not only will companies be paying higher taxes, but organizations such as the EC will have to undertake a politically-delicate rebalancing of tax rates. In the U.S., Congress and the White House will face more pressure to align the corporate income tax system with international norms, but that will mean closing loopholes long enjoyed by U.S.-based international tax dodgers.

Here are the main points to consider.

— Apple stands accused of rank financial dishonesty, and with good reason. Apple’s tax scheme has been described before, including by the U.S. Senate Permanent Subcommittee on Investigations in 2013.

As we explained the scheme at that time, Apple avoided a substantial amount of its U.S. taxes by vesting a healthy portion of its intellectual property rights in an Ireland-based affiliate, Apple Operations Inc., which claimed to account for 30% of the company’s total net profits. AO avoided paying tax to any country on those profits by exploiting the cracks between Ireland and U.S. tax rules: Ireland bases tax residency on whether a firm’s management and control resides in Ireland, and the U.S. bases residency on where a company is formed. AO was formed in Ireland, so Apple claimed it wasn’t subject to U.S. tax; but its management and control are in the U.S., so Apple claimed it wasn’t subject to Ireland tax. According to testimony before the Senate panel, this maneuver and others saved Apple $7.7 billion in U.S. taxes in 2011 alone.

The EC found that Ireland gave up a lot, too. Although the republic’s statutory corporate tax rate is 12.5%, Apple’s maneuvers cut its effective rate to 1% in 2003 and as low as five thousandths of a percent in 2014. It did so, the EC said, by treating the profits of Apple Operations and Apple Sales International, two subsidiaries, in a way that “did not correspond to economic reality.” The profits of the two units were “attributed to a ‘head office’ … that existed only on paper.” Therefore the profits were exempt from Ireland tax.

Part of Apple’s scheme, the EC says, was to treat all European sales as though they occurred in Ireland — but profits on those sales were largely attributed to a “head office” that was “not based in any country and did not have any employees or own premises. This deprived other European countries of taxes on those sales and ensured that the taxes Apple did pay were rock-bottom.

“Only a small percentage of Apple Sales International’s profits were taxed in Ireland,” the EC says, “and the rest was taxed nowhere.”

— Apple’s defense of this scheme is transparently bogus. Apple CEO Tim Cook’s written response to the EC order ranges from wildly misleading to flatly untrue. That’s not even counting what he said in an interview with the Irish Independent, in which he called the order “total political crap.”

Cook says Apple’s tax deal is legal under Irish law, which is true. He says the EC is “effectively proposing to replace Irish tax laws with a view of what the Commission thinks the law should have been,” which is questionable. The EC’s position is that Ireland treated Apple differently from other companies in Ireland, which is a violation of European Union rules.

Cook says “we never asked for, nor did we receive, any special deals.” This paints its tax arrangement as something that fell from the sky as sort of a lucky meteor. But records of meetings in the 1990s between Apple and Irish officials published by the EC in 2014 tell a different story. They show the company dickering with Ireland over how much tax it was willing to pay, with the size of its Ireland workforce hanging in the balance. “It was stated that the company is at present reviewing it’s worldwide operations and wishes to establish a profit margin on it’s Irish operations.” (Grammar from the original.)

Cook further asserts that “at its root, the commission’s case is not about how much Apple pays in taxes. It is about which government collects the money.” He also says “investment and job creation in Europe” might be at stake. Taken together, these statements are partially true, and wholly fishy.

The EC says plainly that Apple reaped as much as $14.5 billion in tax savings from 2003 through 2014, which means no government collected the money. As for where Apple chooses to do investment and job creation, it’s true that the company will seek host countries where that spending will be most tax-advantaged.

But that’s very much a zero-sum game. Apple doesn’t invest and hire workers just to create a tax break or to be charitable; it does so to build and service its business. Those jobs will go somewhere, just maybe not in Ireland. The EC’s goal is to end the beggar-thy-neighbor game Apple and Ireland concocted at the expense of other member countries.

— Other companies and EC countries are on notice that their tax schemes won’t work either. The EC ordered the Netherlands last year to recoup $33 million in tax breaks it had given to Starbucks, and issued a similar order to Luxembourg related to Fiat. The spotlight now shifts to Amazon, which has a deal with Luxembourg that may have saved the online retailer as much as $450 million, and McDonald’s, which also has a dubious arrangement with Luxembourg.

— Giving U.S. corporations a tax break for bringing these profits home is a scam. (Are you listening, Mr. Trump?) The global corporate quest for corporate tax breaks, including U.S. companies’ taste for “inversion” mergers that allow them to pretend they’re foreign companies, has triggered more thinking on how to remake the U.S. tax system to discourage such cleverness. As Kleinbard says of Apple: “They put as much energy into tax avoidance policies as they did into industrial design.”

But we should be wary of some ideas being floated by the business lobby. One is an “amnesty” allowing U.S. companies such as Apple to bring their huge stashes of foreign profits home at a one-time preferential rate — a key motivator of inversions. Donald Trump advocates this provision, with a 10% tax. He argues this would inspire U.S. companies to invest in the United States again.

The last time this was tried, it turned into a massive scam. In 2004, a repatriation “holiday” setting a 5.25% tax rate on homeward-bound dollars (compared to a 35% statutory corporate tax rate) brought $312 billion home from overseas. To get the lower rate, companies had to pledge to spend the money on jobs and research and development, and not on stock buybacks or executive pay.

What happened? Big companies found a way around the rules, a Senate committee discovered. The top 15 repatriating companies cut their workforces by 20,000 jobs over the next three years. R&D spending didn’t budge. Share repurchases rose by as much as 38%; shareholders ended up collecting as much as 92 cents of every dollar brought home. Compensation for the top executives at the 15 major repatriating companies increased by more than 50% by 2007.

It’s certainly true that the U.S. corporate tax system needs revision, as do European systems. But beware: the same advisors who cleverly figured out how to exploit the existing rules will be even harder at work figuring out how to make money from the changes looming ahead.

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UPDATES:

10:39 p.m., Sept. 1: This post has been updated with further remarks from Tim Cook.