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January 13, 2012 - Phil Hodgen

Apple, $82 Billion of Cash, and Tax Policy

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.