Did Apple Cheat On Its Taxes?

After I wrote a recent post about Apple on Forbes, I was surprised that many of the comments focused not on Apple’s business (the subject of my post), but it’s tax optimization activity.  It seems that this has blown up into a major issue.

Another thing I noticed is how bad the reporting on this has been (with some notable exceptions from Forbes contributor Tim Worstall here and here).

It’s almost impossible to find a simple answer to the question, “Did Apple do anything wrong,” without delving into the arcana of the tax code or a long winded political opinion on the subject of taxes in general.

While I’m not a tax expert, I spent 15 years running businesses in countries of the former Eastern Bloc and have more than a passing familiarity with offshore structures.  I've also owned a few companies in sunny, out of the way places related to some of those business. So here’s what I know based on that experience.  I hope it helps clarify the issues.

First of all, it doesn’t seem that Apple did anything remotely wrong, much less illegal.  In fact, their activity doesn’t even seem to be particularly aggressive or complex, given the size and complexity of their business (after all, they operate in dozens of countries).

Now to the more specific issues.

1. Apple’s Offshore Structure Supports Offshore Businesses, Not US Operations

The most salient point is that Apple’s offshore structure (at least as it’s been reported) is entirely related to its international businesses and not at all to the US operations.  So Apple wouldn’t pay any US tax on those profits anyway, unless it brings the money back.

Some have suggested that we allow US corporations to bring back profits overseas for free and that might be a good idea, but I doubt that it would change much with respect to Apple.  They have billions of dollars onshore as well and would presumably need a compelling reason to shift overseas funds to US accounts (I don’t think a dividend suffices).

Besides tax concerns, it would also stand to reason that a company with Apple’s international scope would prefer to keep large amounts of money overseas simply for purposes of diversification.

Finally, while Apple did work out a nice deal with Ireland regarding its taxes, they could just as easily have put it a variety of other places with low (or no) corporate taxes.  After all, they need to run their offshore finance out of somewhere and can’t be expected to set up separate holding companies in each and every country they do business in.

2.  Apple’s Offshore Structure Is Most Likely Unrelated To The US Tax Code

Many have suggested that Apple’s offshore activity is actually the product of complex and nonsensical tax policy and that comprehensive tax reform would encourage Apple and other firms to bring money back home.

While it may be true that US tax policy is overly complex and nonsensical, that doesn’t appear to have much to do with how Apple structures its offshore operations.  As noted above, the structure only supports offshore operations so has little, if anything, to do with the US tax code.

In fact, it appears that large corporations use the complexity of the tax code to their advantage, so reasonable reform would most likely result in US firms paying more taxes, not less (although they would probably save some money on accountants).

3. The US Tax Code (And That Of Many Countries) Favors Debt Over Equity

Another issue that has attracted some scrutiny is Apple’s borrowing to pay a huge dividend to its investors.  While this is clearly a strategy designed to avoid paying US taxes, it is not illegal nor it is immoral.  It is, in fact, very much like going to a duty-free shop.  They are simply doing what the law explicitly allows to lower the taxes they pay.

The simple truth is that the US tax code (and that of most jurisdictions) favors debt over equity.  If you borrow money, you can expense the interest.  There is no such advantage if you take money from investors and pay them back.

This does seem like a serious problem to me and one that would not be overly complex to fix.  If US corporations could expense dividends (which would then be presumably taxed as regular income to shareholders), they would be encouraged to get rid of money they don’t need and those funds could be invested where they could be better used.

4. Here’s What You Should Look Out For

None of this is to say that there isn’t a lot of fishy stuff going on in the world of corporate offshore finance.  There is and Apple CEO Tim Cook even pointed out some of the common practices that firms employ in his statement to Congress.  Here’s a crucial excerpt:

Apple does not use tax gimmicks. Apple does not move its intellectual property into offshore tax havens and use it to sell products back into the US in order to avoid US tax; it does not use revolving loans from foreign subsidiaries to fund its domestic operations; it does not hold money on a Caribbean island; and it does not have a bank account in the Cayman Islands. Apple has substantial foreign cash because it sells the majority of its products outside the US. International operations accounted for 61% of Apple’s revenue last year and two-thirds of its revenue last quarter. These foreign earnings are taxed in the jurisdiction where they are earned (“foreign, post-tax income”).

In a nutshell, that’s what many US businesses do to avoid paying their fair share of taxes (and what former Presidential nominee Mitt Romney is widely suspected of doing): using offshore structures as tax shelters for onshore operations.

Cook pointed to a few of the most common practices.  The simplest is moving money offshore and then loaning it back to yourself, thereby not only moving profits to a tax haven, but also paying yourself interest (remember, debt is favored over equity).

The other common practice he calls out is moving intellectual property (which can be patents, brands, etc.) and then licensing it back to the onshore entity. He could have also mentioned setting up sales operations overseas (often using a proxy corporation) and then paying yourself a hefty. tax free commission.

In other words, once somebody starts setting up companies overseas to do business in the US, something fishy is going on.  The practices, while they may not be illegal, are wrong and we should do as much as we can to eliminate them.  Companies doing businesses in the US should pay their fair share of US taxes.

However, if we assume that Mr. Cook did not perjure himself (and there is no reason we should believe he did), Apple has done nothing even remotely untoward, much less illegal.  If anything, they seem to be a model corporate citizen.

(Disclosure:  I own Apple stock indirectly through a fund.)