Minimizing taxes is every person and company’s goal. Individuals have various ways to avoid tax legally by using structured tax shelters or changing their place of residence. Multinational corporations, meanwhile, have found increasingly ingenious ways to exploit loopholes in international tax rules in order to reduce their taxes. Apple Inc., for example, whose corporate headquarters are located in Cupertino, CA, is at the center of a highly publicized debate over the manipulation of tax laws it has used to reduce its corporate income tax. Basically, the Apple story is as follows: Apple licenses its technology to a contract manufacturer in China that produces iPads sold here in the U.S. Apple engages in marketing activities in America but its patents and other intellectual property (IP) are owned by an Apple subsidiary in Ireland, which receives a significant share of Apple’s worldwide profits. Apple pays only a 12.5 percent corporate tax rate in Ireland and avoids even some of this tax by shifting its reported profits to Bermuda, which has no income tax. Apple enjoys billions of profits while parking its earnings in low-tax countries. Now, this is not to pick on Apple. According to securities filings, the largest U.S. based companies added $206 billion to their stockpiles of offshore profits last year. Multinational companies have accumulated $1.95 trillion outside the U.S., up 11.8 percent from the previous year. Loopholes in the tax code incentivize companies to “profit shift” as Apple has. It’s all perfectly legal.
So how exactly does it work? Under current rules for taxing multinational companies, the country where the income is generated (the source country) gets the taxes on that income. The United States (along with a few other countries) taxes the worldwide income of resident corporations, but allows firms to both take a credit for foreign income taxes they pay and defer tax on the active profits of their controlled foreign subsidiaries until the profits are repatriated back to the U.S. parent. Thus, a multinational corporation like Apple can avoid paying U.S. corporate income tax on its active foreign-source profits as long as these profits remain overseas.
Not surprisingly, there is a lot of pushback to these practices. In the late 1990s, the Organization for Economic Cooperation and Development (OECD) declared war on such “harmful tax competition”. Today, tax havens are under particularly intense pressure to exchange more information on clients with their home countries. Reform of the international rules for companies will be tricky, but that’s the direction we are heading. At the urging of the G20, the OECD is working on a plan to tackle the numerous ways multinational corporations massage down their tax bills. The same pressure exists domestically. President Obama this month proposed his biggest tax increases yet on multinational corporations' overseas earnings—$276 billion that companies would have to pay over the next decade largely through changes designed to prevent companies from stashing profits offshore. The changes, part of Obama's fiscal 2015 budget, would be paired with a separate reduction in corporate tax rates that would be included in a broad tax overhaul that he hopes to move through Congress. Republicans are on board with reform, too. When Rep. Dave Camp rolled out his long-awaited tax overhaul plan, it laid out a revamped system of international taxation designed to offset domestic programs (mainly transportation). This one thing -- preventing the use of complex tax maneuvers to stash income in offshore tax havens -- seems to be the one issue both parties in Washington agree upon.
While there are tremendous loopholes in the current system for multinational corporations to shift profits, don’t expect them all to last much longer. Apple, and all U.S.-based multinationals, are going to have their corporate tax policies in the spotlight over the coming months. The ones that survive this period of corporate tax scrutiny will be those that have complete transparency and can report with certainty how (and why) they pay the tax rates they do. Smartly navigating the highly politicized tax debate will be just as important as sound accounting strategy.
