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A Study of International Tax Minimization Strategies
In Multinational Companies
With Focus on The Apple Company
Taxation II (ACT 562)
People might not like the idea of paying tax, but without it, nations or countries will struggle to function and will be unable to provide good services to their society. Taxation plays a critical role in the development of the nation. Therefore, all individuals and corporations have to pay taxes to support their nation. However, some individuals and companies have figured out ways to avoid paying extremely huge amounts of taxes.
Several commentators believe that some U.S. citizens and corporation have used loopholes and gimmicks to avoid taxes. They claim that U.S. multinational companies, such as Apple Inc, Google Inc., Microsoft Inc., Starbucks Inc., have exploited tax code written years ago and they used loopholes to save billions U.S. dollar. U.S. multinational companies are trying to get around the taxation of passive income under Subpart F.
During the first senate hearings on September 20, 2012, the subcommittee has learned that for Fiscal Years 2009, 2010, and 2011, Apple has been able to defer taxes on over $35.4 billion in offshore passive income covered by Subpart F. Google has deferred over $24.2 billion in the same period. It also followed by Microsoft for $21 billion.
During the second senate hearings on May 21, 2013, the subcommittee claim that the loss to U.S. Treasury is increasing in an enormous amount. They estimated that U.S. based multinational companies have shifted $1,9 trillion profit in offshore tax havens which are shielded from U.S. taxes. One study has estimated that offshore earnings shifted by S&P 500 to tax havens countries using these techniques have increased 400 percent in the last decade.
This paper will focus on Apple Inc. as a multinational corporation and describe the international tax minimization strategies available to them. The author decided to focus on this company because the potential tax savings from this company are very high and its profits climb to a higher level every year. The author hopes that it will help to give a better view of international tax minimization practices that are being used by multinational companies.
INTERNATIONAL TAX SYSTEM
A multinational company generally has at least one subsidiary in a foreign country. Income from subsidiary can be subjected to taxation in parent and subsidiary country which would lead to double taxation. The foreign source of income is one of the important issues to determine which country has the right to collect the tax. To address this issue related to jurisdiction for the basis of taxation, Doupnik and Perera (2012), countries generally use three combinations for determining jurisdictional authority as follows:
- Source of Income
In general, almost all countries assert the jurisdictional authority to tax income where it is earned regardless of the residence or citizenship of the recipient.
Under the citizenship basis of taxation, citizens are taxed by their country of citizenship regardless of where they reside or the source of the income being taxed. The United States is unusual among countries in that it taxes on the basis of citizenship. Thus, a U.S. citizen who lives and works overseas will be subject to U.S. income tax on his or her worldwide income regardless of where the citizen earns that income or resides.
Under the residence approach, residents of a country are taxed by the country in which they reside, regardless of their citizenship or where the income was earned. For example, assume a citizen of Singapore resides permanently in the United States and earns dividends from an investment in the shares of a company in the United Kingdom. Taxing on the basis of residence, this individual will be subject to taxation in the United States in his or her foreign source income, even though he or she is a citizen of Singapore.
Transfer pricing refers to the determination of the price at which transactions between related parties will be carried out. Transfers can be from a subsidiary to its parent, from the parent to a subsidiary, or from one subsidiary to another of the same parent (Doupnik and Perera : 2012). In general, multinational companies focus on the use of transfer pricing to generate an efficient allocation of resources within companies. Based on a 2003 survey by Ernst & Young, 68% of the respondent main objective for transfer pricing is “optimizing tax arrangements”. However, taxation rules transfer price between related parties must be fair or arm’s length price shall be applied.
Transfer pricing is one of the most important factors for both managerial accounting and tax purposes. It determines the distribution of income across different segment of the companies. According to Hiemann and Reichelstein (2012), there are three alternative transfer pricing scenario:
- Cost-based Transfer Pricing
The transfer price is based on the total cost to produce the product. It can be calculated from fixed costs plus variable costs and added to the profit margin for the seller. This method is generally used when there are no comparable market price for the product. One of the issues arise from this method is that inefficiencies in one division might be transferred to another division.
- Market-based Transfer Pricing
The transfer price to related parties that is acceptable by unrelated parties or customers for similar products or services. Market-based method gives a solution to the problem from cost-based method. However, a new problem will come up when there is no competitive market for the products or services.
- Transfer of Intangible Assets
Intangible assets such as patents, trademarks, or production technology, play an important role for many multinational companies. It is very hard to determine the fair transfer price for intangible assets, since it is unique and mostly there is no comparable assets similar to one and another.
TAX SYSTEMS AND THE U.S. TAX CODES
Tax expenses are one of the most significant costs incurred by business enterprises, because taxes reduce their net profit as well as cash flow. It follows that corporations attempt to minimize their taxes while making sure they are in accordance with applicable tax law. Multinational corporations are subject to different tax rules in numerous jurisdictions which might face taxes on assets, input or output, and income. However, some multinational companies are using the difference to minimize their taxes worldwide.
Many major companies in the U.S. by exploiting the weaknesses of the U.S. tax codes. They shift their profit to new controlled foreign corporations to get benefit from subpart F passive income tax to protect their profit from U.S. taxes. This condition urges members of the U.S. Senate and other foreign organizations to increase scrutiny to minimize these practices.
Senate Hearings on Offshore Profit Shifting and the U.S. Tax Code
The U.S. Senate of the Homeland Security and Governmental Affairs concerned with the issue of offshore profit shifting. On September 20, 2012, the senate held a hearing called “Offshore Profit Shifting and the U.S. Tax Code - Part 1 (Microsoft & Hewlett-Packard)”. The hearing was focused on the review of the U.S. multinational corporation strategies that suspiciously transferring their profit to offshore jurisdictions and avoid paying taxes in the United States. They are trying to get benefit from U.S. security and stability of the economy, productivity, expertise of U.S. worker, and the strength of U.S. infrastructure to generate profits, but they are attempting to avoid their responsibility of paying taxes to U.S. government. They created complicated transactions and legal fictions structures to shift the profit overseas that cannot be reached by the U.S. Tax Laws.
Some multinational companies identified the limitation of the U.S. Tax Laws and financial accounting rules. They have exploited the weaknesses of transfer pricing by moving assets and profits out of U.S. to a low tax jurisdiction and passive income under Subpart F of the Tax Code to defer earns income from an active business activity offshore (Levin, 2012).
The Permanent Subcommittee on Investigations revealed that multinational companies utilized U.S. Tax Laws by licensing valuable assets or selling intellectual property that was developed in the U.S. to its subsidiary in a low tax jurisdictions or tax havens countries for a very low price or lower than market value. Even though, under U.S. Tax Laws mentioned that the transactions between related parties must use “arm’s length” price for the assets, it is very difficult to value the fair price for the assets if there is no comparable price in the market. These strategies will allow multinational companies to move their profit outside the United States to its subsidiaries in tax havens countries or other countries with a low tax jurisdictions and minimize taxable income in the United States.
Furthermore, the multinational companies benefit from passive income under Subpart F. All active income from business activity outside the United States will not subject to the United States Tax until the income is returned to the United States. This deferral allows multinational companies to hold other passive incomes from other subsidiaries. It will result no tax income for the U.S.
On May 21, 2013, the U.S. senate held the second hearings called “Offshore Profit Shifting and the U.S. Tax Code - Part 2 (Apple Inc.)”. In the second hearings, the subcommittee investigates international tax minimization strategies focused on how apple shifts billions of dollars in offshore. The senate claimed that U.S.-based multinational companies have shifted an estimated $1.9 trillion in profit in offshore tax havens, shielded from U.S. taxes and Apple Inc. alone has shifted more than $100 billion in offshore cash in tax havens countries. Also, one study has estimated that offshore earnings stockpiled by S&P 500 companies using these techniques have increased 400 percent in the last decade. (Levin, 2013).
The subcommittee explained that Apple Inc. moved its incomes by selling its intellectual property to its controlled foreign corporations in an offshore tax havens. It will result in directing incomes to the tax havens. To execute this idea, Apple has formed three offshore companies: Apple Operational International (AOI), Apple Sales International (ASI), and Apple Operational Europe (AOE). Those companies are incorporated in Ireland and take advantages of the Irish and U.S. standards on tax residency. Under Irish law, companies will be considered as an Irish resident for tax purposes when they are managed and controlled in Ireland. On the other hand, U.S. tax resident will be applicable when they are incorporated in the United States. We can easily reach a conclusion that those companies are neither tax resident of the United States nor Ireland. In another word, they have no tax home or invisible.
Moreover, Apple Inc. protects those profits from U.S. taxes by utilizing passive income under Subpart F. It will defer tax income until the income returned to the United States.
APPLE’S STRATEGIES FOR GLOBAL TAX MINIMIZATION
Intercompany transactions could occur across national borders, it would lead MNC companies to get more exposure to the differences of the tax regulations between countries. This might lead MNC companies to set up their objective to minimize their taxes through the use of discretionary transfer prices. These issues have attracted the attention of the member of the U.S. senate, foreign governments and international organization such as the OECD, G20 and European Union (EU).
Apple Inc. is one of the companies implementing tax minimization strategies to lower taxes. Apple received a lot of criticism from various parties (media, governments, and international organizations). It is because the estimation of tax savings from the company are very high as its worldwide earnings are so high. Apple set up new companies in tax havens countries and shifts the profit to those companies. This article will give an explanation on how Apple Inc. lower its taxes through international tax minimization strategies.
Apple profits are not generated from physical goods, but from royalties of intellectual property like patent. It is similar to other giant technology companies such as Google, Yahoo, Microsoft, Amazon, and Hewlett-Packard. It allows them to move their profits very easy to their subsidiaries in the low tax jurisdiction, since their products are downloadable and can be sold from anywhere around the world. They don’t need a physical store or manufacture like automakers or grocery store. Therefore, although technology companies are now becoming a part of the largest companies in the U.S., they are among the least companies taxed, according to the government.
In 1980s, Apple was the first company in designing an international tax minimization strategy known as “Double Irish”. This strategy enables companies to reduce worldwide tax by moving profits in other countries with lower tax jurisdictions. Apple executed this strategy by forming two subsidiaries in Ireland named Apple Operations International (AOI) and Apple Sales International (ASI), and building a glass-encased factory. It allowed Apple to reduce its worldwide tax since Ireland wants to create more jobs by providing tax breaks in exchange of jobs (Duhigg and Kocieniewski, 2012).
The tax breaks from Irish government enabled Apple to pay taxes at the Irish tax rate of 12.5 percent, which is lower than U.S. tax rate of 35 percent. By transferring its patent developed in the U.S. to Irish subsidiaries, Apple’s profits were taxed at the Irish tax rate and saved billions from U.S. taxes. Furthermore, the second Irish subsidiary is formed to receive additional income from countries outside the United States. However, the taxes paid to the second subsidiary are low because the royalties paid to the first Irish subsidiary are deductible expenses.
Finally, Apple incorporated another company Apple Operation Europe (AOE) in Netherland to cover the tax planning from outside observers and tax authorities called “a Dutch Sandwich”. By utilizing European tax treaty, Ireland subsidiaries are able to transfer profits without taxes.
Although 95 percent of Research and Development, which is a key to Apple success in generating profit, conducted in the United States. According to Apple’s Form 10-K, the “Double Irish with a Dutch Sandwich” allowed Apple Inc. to move its earnings about 70 percent overseas with lower tax rates (Duhigg and Kocieniewski, 2012). It follows that the effective rate of tax paid worldwide in 2013, 2012, and 2011 were at 26%, 25.2%, and 24.2%. It is lower compared to U.S. tax rate at 35%.
On the Statement of Carl Levin before the U.S. Senate Permanent Subcommitte, Apple argues that it is one of the biggest corporate taxpayer in the United States that paid taxes of $6 billion in 2012 alone; however, the Senate questions the apple’s claim that it shifted $36 billion in worldwide sales income away from U.S. and paid no tax on it.
Apple has exploited the weakness of the difference between Irish and U.S. taxation. As discussed earlier in the senate hearings that AOI and ASI are neither U.S. tax residence nor Irish. Even though, they have a larger amount of profit than Apple in U.S., they do not have a physical or actual address anywhere.
In this article, the author has explained the international tax minimization strategy adopted by some multinational companies. We can learn about how multinational companies design corporation structure that allows them to benefit from the difference of the taxation regulation across countries.
The U.S. government concern about the issues related to tax minimization strategy used by multinational companies. The U.S. Senate is working on finding the best method to eliminate the weaknesses of the tax code and tighten tax provision to prevent multinational companies transfer their intellectual property overseas or shifting their profits overseas.
The U.S. government realized that international tax minimization involved more than one country. This issue not only about how to tax multinational companies, but the government has to take into consideration on how to increase domestic and national revenue. They also should consider giving “Tax Holiday” in order to collect taxes from MNC that has been shifted to foreign countries known as “repatriation”.
To address this problem, the U.S. government needs support from other foreign governments and international organization concerned about tax minimization such as Organization of Economic Cooperation and Development (OECD), Group of Twenty (G20), and European Union (EU).
Profit shifting can be minimized when there is an initiative from every party to provide transparency in information of the financial reporting. Moreover, harmonization of definitions and regulation would result in comparability of financial reporting.
Apple Inc. 2012. Form 10-K, Apple, Inc.
Apple Inc. 2011. Form 10-K, Apple, Inc.
Duhigg, C., and Kocieniewski, D. 2012. How Apple Sidesteps Billion in Taxes. The New York Times. (April 28). Available at : http://www.nytimes.com
Doupnik, Timothy and Perera, Hector. International Accounting. Third Ed. New York : McGraw-Hill. 2012.
Hiemann, Moritz and Reichelstein, Stefan. Fundamentals of International Transfer Pricing in Law and Economics : Transfer Pricing in Multinational Corporations: An Integrated Management- and Tax Perspective. Schön, Wolfgang and Konrad, Kai A. (eds.). New York : Springer. 2012.
Huizinga, Harry and Laeven, Luc. International Profit Shifting within European Multinationals. May 2005.
Levin, C. 2013. Statement of Carl Levin before the U.S. Senate Permanent Subcommitte on Investigations on Offshore Profit Shifting and the U.S. Tax Code – Part 2 (Apple Inc.). (May 21). The Permanent Subcommittee On Investigations, available at : http://www.hsgac.senate.gov
Levin, C. 2012. Statement of Carl Levin before the U.S. Senate Permanent Subcommitte on Investigations on Offshore Profit Shifting and the U.S. Tax Code – Part 1 (Microsoft and Hewlett-Packard). (September 21). The Permanent Subcommittee On Investigations, available at : http://www.hsgac.senate.gov