Via Glenn Reynolds I was pointed to a TUAW article that referenced a SeekingAlpha article about Apple, its mythical mountain of cash, and the Law of Unintended Consequences. (That, by the way, is a demonstration of the fabulosity of the interwebs. Hyperlinks and attributions back to the source. The internet is just one person talking to another.)
Back to tax policy and unintended consequences. This stuff is right up my alley because this type of tax planning is What We Do here at the Hodgen Law Group Tax Ranch & Rocket Factory.
Put this blog post under the heading of “Unintended Consequences of International Tax Policy.”
Apple Inc. has a reported $82 billion of cash. That sounds like Apple could buy anything, do anything. It could even spend that money in the United States and (God forbid) create jobs for people.
The author of the Seeking Alpha blog post has read Apple’s financial statements and points out the obvious. A large chunk of that cash — $54 billion, to be precise — is sitting outside the United States and will not return to the United States.
Here’s why. Blame Congress for this.
How Multinational Corporations Pay Income Tax
The default tax treatment for U.S. taxpayers — corporations included — is “All of your income, earned worldwide, is taxed in the year you earn it.” Whether Apple sells an iPhone in China or in Chicago, the profit it earns will be subjected to U.S. income tax in the year that iPhone was sold.
For U.S. corporations doing business outside the United States, however, we can alter the default tax treatment. If the U.S. corporation configures its business operations correctly, a dollar of profit earned outside the United States will only be taxed by the United States when that dollar of profit is brought back to the United States. Earn a dollar of profit abroad and don’t bring it home? No U.S. income tax. Earn a dollar of profit abroad and bring it home? U.S. income tax.
Call this a “deferral strategy.” The U.S. corporation is not exempt from U.S. income tax on its foreign profits. It is just postponing the day that it has to pay tax on those foreign profits to the Internal Revenue Service.
A corporation that follows the deferral strategy ends up with two buckets of income — the U.S. domestic income, which is fully subject to tax, and the foreign income, on which U.S. income tax is deferred until the corporation chooses to bring the income back to the mothership in the United States.
That’s the picture that Seeking Alpha points out for Apple Inc. It has two buckets of cash:
- $28 billion of cash it generated from selling stuff in the United States, on which U.S. income tax has presumably been paid; and
- $54 billion of cash it generated from selling stuff outside the United States, on which foreign income tax has (probably) been paid but U.S. income tax has not (yet) been paid.
Why Tax Deferral is Good
Why would U.S. corporations do such a thing? The short answer is to blurt out the words “present value” and your nimble brain can connect the dots.
The better way to explain this is with an example.
Pretend that Apple has a subsidiary corporation in China. They sell iPhones in China and generate $1,000,000 of profit.
- Scenario Number 1. If they bring the $1,000,000 back to the United States, that $1,000,000 of income on Apple’s income tax return will be taxed (let’s pretend) at 35%, leaving Apple with $650,000 in after-tax cash. Apple now has $650,000 in the bank. It is going to use that money to build more iPhones to sell. Pretend that each iPhone costs $130 to build–that is Apple’s cost to manufacture an iPhone. (I’m making up numbers here, folks. They’re all fakey-fake for the purpose of this example.) That means Apple can build 5,000 iPhones to sell using the profits it generated from the first batch of iPhones it sold.
- Scenario Number 2. If Apple Inc. leaves the money outside the United States, the IRS does not take 35%. That means Apple has $1,000,000 in the bank to use to build more iPhones to sell. At $130/unit for cost of manufacture, Apple can build (Phil runs to his calculator . . . let’s see . . . $1,000,000 divided by $130 = . . . ) 7,692 iPhones.
If you can build more iPhones, you can sell more iPhones. If you can sell more iPhones, you can make more profit. So we like Scenario Number 2.
Tax Deferral Drives Business Expansion
If you’re going to pick Scenario Number 2 and the deferral strategy, you can’t bring your foreign profits back to the United States. If the foreign profits are transferred to back to the Mothership in Cupertino, they get taxed.
What happens is that a multinational corporation starts to accumulate cash. Self-evidently you can accumulate more cash quicker if you’re not paying tax than if you are. So cash in the bank grows faster outside the United States than inside the United States.
The multinational corporation uses that cash as working capital. Since it has more working capital outside the United States, it has more fuel to generate sales growth which can only occur outside the United States. The multinational corporation has an incentive to focus on foreign markets because its return on investment is higher. Over time, this leads to faster growth outside the United States and the U.S. market becomes a smaller and smaller slice of the multinational corporation’s overall sales.
That’s tax policy at work. U.S. tax policy makes it expensive for a U.S. corporation to repatriate its earnings. That means that it has less working capital in the United States. That, in turn, means it can’t spend as much money in the United States to generate more sales, grow its business, hire people, etc.
There’s another self-evident point. There are more people outside the United States than there are inside the United States.
So from Apple’s perspective, they have a LOT of working capital outside the United States and a LOT of potential customers outside the United States. Hmmm. I wonder what is going through Tim Cook’s mind.
Now do you start to see why there are so many articles about China quickly becoming Apple’s biggest market? It’s not just that there are so many people there who want iPhones. It is because Apple has a big bucket of cash that they must reinvest to fuel further expansion outside the United States. Apple must plow its foreign profits back into making more products to sell outside the United States.
Tax Repatriation Holidays and Some History
Periodically Congress wakes up and sees the problem. Laws are proposed to provide a temporary tax loophole for U.S. corporations to bring their foreign profits back to the United States. Here’s recent example.
That’s dumb.
The better solution would be a wholesale re-architecture of the Internal Revenue Code. That’s a topic for another blog post sometime.
I would just point out, however, that the current Internal Revenue Code we have has its intellectual underpinnings in brains that hearken back to the Civil War. Our current version of the Internal Revenue Code is the 1986 Code. It is largely a creature of the Internal Revenue Code of 1954. The Chairman of the House Ways & Means Committee from 1933 until 1953 (except for a two year stretch) was Robert L. Doughton. He was born in 1863 and his father was a Captain in the Confederate Army.
Imagine what international commerce looked like to someone born in 1863. When Robert Doughton was working on tax laws in the 1930s, 1940s, and 1950s, all of which culminated in the 1954 Code, what did his world look like? His childhood knew of steam ships. The telegraph. Horses as transportation. From brains like these grew our current international tax rules.
Another major slice of the U.S. international tax law came into place in 1960. What was the world like then? People in Congress in 1960 would have been born in the early (20th) Century. What biases and understanding did they bring to the table about America’s place in international commerce?
Life moves fast. You Don’t Live in the World You Were Born Into. But to a surprisingly large extent, Apple Inc.’s current business strategies are driven by tax policies from the brain of a man born in 1863 to a Confederate Army veteran. Funny, that.
Credit where credit is due. Brian Dooley is the one who first introduced me into the history lesson I have described here. He does it far more eloquently than I do.
Reader comments (9)
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I went to China last month. The people I met were all using iphone 4S. Some bought the phone in US market as it is cheaper than in China. Chinese love to buy things in US. A bit ease on immigration visa — that might do good for US as our price in US is much lower.
There is a rumor that US is about to grant Chinese for a visa with mutiple entry valid for 5 years if China is doing the same for US.
China is a huge market, and Chinese love new things. My sister gave me her iphone 3g because she got her iphone 4S in HK.
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Good post, and good lesson on how Corporate offshore earnings are taxed, and of course, it is much different than individual ‘US Persons’ are taxed for earning money overseas. In the individual’s case, they have to deal with double taxation even with the exclusions, credits and complicated form filings that arise for certain types of income, even if they never ever bring it home.
All these distortions arise out of the Citizenship model of taxation, and then the exceptions (loopholes) that come into play when lobby money is at work, and new regulations, rules and statutes issue forth out of Congress (ie the FBAR and FATCA mess) when they decide they have to crack down on homeland cheats beating the system with their off shore accounts.
A simple solution to much of these issues would be a simplified territorial based taxation model that our trading competitors employee and just allow citizens and Corporations alike to be taxed where they do their business or make their earnings and not based upon when of if they expatriate them.
That would go a long way toward leveling the playing field for Expats off shore and would be fairer all the way around for US Corporations.
And then, yes, lower the rates after all the stupid and distorting exceptions credits, deductions and loopholes are removed.
Then you might get some job creation in America! Think how exports could soar if the US were to send an army of Expats to live overseas, unshackled by double US taxation, working for US corporations, selling its products overseas,and armed with purchase orders in brief cases instead of guns in turrets on tanks.
Perish the thought.
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Just Me:
You hit the nail right on the head. Exports don’t sell themselves. That takes feed on the ground working with potential clients on a daily basis. It takes excellent customer service and product support. The double taxation practiced by the US is not a revenue generating tax, it is a Sin tax for the purpose of punishing US citzens who live and work in a country with a tax system that is different from that of the US with rates equal or higher than the US rates.In a country with a system that mirrors the US system the foreign income taxes paid can be credited againts the US tax due and the net amount paid to the IRS is zero. Filly compliant with no tax revenue contribute to the IRS.
But if the foreign country’s tax system is different, with a low or not income tax at all, even though the US may pay much higher consumption and other taxes in that country than in the US, he in essence must pay the difference between the foreign income tax and the US tax. It is a pealty tax for living in a country with a tax system different from that of the US. This is the situation in all but a handful of foreign countries. In those countries the US citizen must be compensated much higher than citizens of any othr country just to survive. It makes Americans non-competitive for deployment in most countries of the world.
And without your own people beating on doors to sell your products, they don’t get sold. That is why the $720 billion US trade deficit is equal to 60% of the total trade deficits of the 130 countries with trade deficits.
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Speaking to the perversion of sound tax policy, and how lobbying essentially creates individual corporate tax rates, plus frankly speaking, is a good return on investment, here is this podcast to consider.
I was just outside mowing the lawn and catching up on some podcasts. I happened to hear this one by Planet Money, related to lobby efforts directed toward repatriation of offshore profits. The guys doing the podcast, are remaining agnostic on the foreign tax issues being lobbied for in the podcast. They are trying to highlight the value of lobbying to those spending the money. It does graphically show you what you are up against, when trying to replace bad tax policy with a simpler territorial tax system. Too many have vested interests in the way things are, including the Politicians, Dem or Rep who need the campaign financing that lobbyist bring. With the lobby dollars they have spent towards this exemption or that benefit, it is hard to imagine how you would undo this citizenship model of taxation…
Have a listen. I think you might learn something new here, or not..
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Again the US is living in 1950. I have just moved the last of my assets to Europe – my standard of living has not dropped leaving the US and in fact it’s better.
Message to US Government 2012 – the world has moved on…the US is no longer the only place to earn a decent living and be happy – wake up!!!
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Fascinating article. Both Mr. Conklin and Just Me make a very good point about how Americans overseas are not getting nearly as good a deal as corporations (are we not people too?). And when it comes to U.S. and foreign tax systems we’re comparing apples and oranges which makes it very difficult for Americans abroad to apply those infamous foreign tax credits. If I can give you a concrete example? There is a tax in France (which is hardly a tax haven) called the CSG (Contribution sociale généralisée) which is not creditable according to the American IRS. I’m not going to argue the merits or demerits of their decision – it’s just a small example of how complex this can get and how difficult it is for an average person to be compliant without costly professional help (and even then beware). It would be easy for an American abroad doing his/her own taxes to make this error and try to get credit for the CSG. And there are many other examples. It’s quite a mess and a serious headache for those of us who are desperately trying to do right or for those who hire Americans abroad and have to help them stay compliant. Why would any foreign company want to hire people with this much bureaucratic baggage?
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I’m in the Czech Republic at the moment where there is a flat income tax of 15%. Yes….wages are lower than Germany for example. However if a US person starts to earn a lot of money here does the US government really think a dual-citizen is going to tell the IRS?
My straw poll of US persons here so far is basically the US government can go to hell. These people have been resident in the Czech Rep for many years and rarely visit the US.
They don’t use any of the resources of the US, but equally the US won’t provide Medicare, Unemployment Ins or other government programmes abroad for the trouble of the b*lls**t of filing taxes.
Carl Levin and Co can stick it.
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Apple has been cited in a Congressional study on offshore earnings. The earnings aren’t actually trapped offshore and prevented from being repatriated to the United States because of high tax rates.
Companies like Apple engage in earnings stripping where foreign subsidiaries are established in tax havens to divert profits to evade US taxes.
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One comment I’ll make from a Canadian perspective is Canada started making the switch to a territorial based system of corporate tax all the back in 1974 when Pierre Trudeau was Prime Minister. So the idea is not exactly new.