In a confrontation that made headlines in May, the Senate Permanent Subcommittee on Investigations released a report claiming that Cupertino, Calif.-based tech giant Apple has been using a “complex web of offshore entities” to avoid paying U.S. taxes on $44 billion in “otherwise taxable offshore income over the past four years.” According to the report, Apple set up at least three foreign subsidiaries that are “not tax resident in any nation” in order to avoid paying the taxes.

Among numerous statements in its own defense, Apple said that it was likely the largest corporate income taxpayer in the U.S.; that it has created or supported about 600,000 jobs at home; and that it has substantial foreign cash because it sells most of its products outside the U.S. Echoing such views, Apple’s supporters have argued that the firm’s corporate tax strategy involves nothing illegal or improper, and that it is only playing by the same rules as other global high-tech giants such as Google and Microsoft.

What are the mechanisms that companies like Apple use in order to minimize their taxes without breaking any U.S. laws? Why does the U.S. maintain such a tax system, and what are its economic consequences? Should the system be fixed — and if so, how?  

“The whole debate only exists because the U.S., in theory, has a ‘residential’ tax system instead of a ‘territorial’ system like many European countries,” says Kent Smetters, Wharton professor of business economics and public policy. “Under a territorial system, a tax is paid to a country for economic activity happening in that country, regardless of citizenship. Under our residential system, the U.S. taxpayer (firm or individual) is supposed to pay the U.S. tax rate, less any taxes already paid to another country that has a territorial system, regardless of where the income is earned. There are valid arguments for both types of tax systems, although the lack of international parity is always a concern.” While U.S. companies are liable for taxes on their overseas income, the system allows them to defer their U.S. taxes on foreign income until those funds are repatriated to the United States.

‘Double Irish with a Dutch Sandwich’

In practice, there are “big holes” in this system, notes University of Pennsylvania Law School professor Chris William Sanchirico. Tax havens — often small island countries — use the system to attract U.S. businesses to their territory, and they tax companies at a low rate that is appealing to multinationals, he says. U.S. companies can set up a subsidiary that sells their products to non-U.S. markets without developing sufficient legal connection to those countries to trigger their tax systems. Thus, Apple’s subsidiaries can sell in Europe and Asia without paying European or Asian taxes on income from such sales.

Since the tax rate in such foreign countries is lower than that of the U.S., the American firms want “to shift their income” so it is on the books of the subsidiary. This “transfer price” between a company and its overseas subsidiaries “is not really a market price, but it ends up determining its income” in that foreign country, Sanchirico notes. In this case, “Apple has the intellectual property (IP), including its brand and know-how. Apple sends that [IP] to its foreign subsidiary [in Ireland, for example], which gets to stamp [those devices] as made by Apple. Apple wants the transfer price to be at an artificially low level so that the subsidiary pays very little for the product.”

That’s just part of the process. “Ireland then allows [the U.S. company] to go and shift that income into even lower-tax areas” via more transfer pricing, this time to shell corporations in Bermuda, the Cayman Islands and elsewhere, he adds. In one intricate arrangement, U.S. companies can set up two Irish corporations and have one corporation own the other. This is known as “Double Irish.” Sometimes, Sanchirico says, there is a Dutch corporation interposed between the two Irish corporations in order to tax the Dutch company between them. This is known as “Double Irish with a Dutch Sandwich.” Such arrangements wind up being very complicated because of anti-abuse provisions in the U.S. that are designed to catch American companies that take advantage of shell corporations. According to press reports, other companies that have employed the Double Irish include Adobe Systems, Eli Lilly, Facebook, GE, Microsoft, Oracle, Pfizer and Starbucks.

While in theory, Apple could repatriate its storehouse of overseas cash, Victor Fleischer, a professor at the University of Colorado Law School, notes that the firm would be reluctant to do so. “[Apple] would rather lobby for a ‘tax holiday’ and bring the cash back tax-free. An added benefit of a tax holiday for Apple is that it would provide a quick jump in reported earnings when the accounting entry for the deferred tax liability is reversed.”

Fair Rates?

Given such complexities, what is the best way to estimate how much in taxes that Apple and similar multinationals are actually paying worldwide? Wharton accounting professor Stephanie Sikes says that firms must disclose the amount of cash taxes paid during the year in their annual reports to shareholders. “Although this number could include refunds or additional taxes plus interest and penalties from prior years’ returns, it is the best publicly available estimate of the amount of cash taxes paid for a particular year, because firms’ tax returns are confidential.”

Sikes adds that a common measure of the relative amount of taxes that a company pays is its long-run cash effective tax rate. This rate is calculated “by summing a company’s cash taxes paid across all jurisdictions (federal, international, state and local) over X years and dividing it by the sum of the company’s worldwide pre-tax book income over X years. The reason to calculate a long-term rate, as opposed to an annual rate, is that cash taxes paid in any one year could include refunds or additional taxes owed from prior years. Thus, the long-run measure removes the lumpiness of the annual measure.”

But how can one decide if the effective tax rate paid by a multinational is ‘fair’? “Obviously, this is a very subjective question, and different people will have very different answers,” notes Sikes. “If the question is what is ‘fair’ to shareholders, I suspect many people would agree that Apple and the other companies in the spotlight are paying their fair share because their tax planning is meant to maximize shareholder value. These companies are paying all taxes that they legally owe. They spend large sums of money on accountants and lawyers to devise these structures, and the benefits must outweigh the costs; otherwise they would not do it.”

At times, pressure by customers to be a “good corporate citizen” can result in firms reducing their tax planning or paying more taxes than they actually owe, Sikes adds. For example, in December 2012, Starbucks agreed to pay the British government 10 million pounds in each of the next two years — which it does not legally owe — in order to end a consumer boycott that was hurting sales. “Starbucks obviously felt that paying the additional taxes was in its shareholders’ best interests.”

Critics of Apple and other U.S. companies often overlook the fact that similar tax strategies are being pursued by other multinationals located elsewhere around the world, notes Wharton accounting professor Jennifer Blouin. “I understand the political debate. People say, ‘Gosh, this company makes so much money, and it is not paying [tax] in the U.S.,’ but on the other hand, why would I force Apple to pay 35 cents on every dollar when Samsung — and many other non-U.S. competitors — don’t have to? They could price Apple out of the market…. Apple is not unique. Samsung has to have a similar situation.” Like the politically unpopular — but essential — corporate strategy of supply chain outsourcing, these tax strategies reflect the fact that in the age of globalization, “residence and nationality are becoming less clear,” Blouin says.

Sikes agrees. “These companies are competing in an international market, and the U.S. has the highest statutory corporate tax rate in the world. In addition, the U.S. is one of the few countries that still have a worldwide tax system, meaning that it taxes corporations incorporated in the U.S. on all income earned, even if it is earned outside of the U.S. Most other countries have a territorial tax system, in which a country only taxes income earned within its borders. The combination of the U.S. having the highest statutory tax rate and a worldwide tax system results in U.S. corporations shifting investment abroad to lower-taxed countries and then avoiding at all costs repatriating the foreign earnings back to the U.S.” For example, even though Apple has plenty of cash to pay dividends and repurchase shares, it issues debt and uses the borrowed funds to pay dividends and to repurchase shares, she points out. “This is because its cash is overseas, and it does not want to pay the U.S. taxes that it would owe if it were to repatriate.”

A Threat to Growth?

Critics contend that such practices are damaging to U.S. economic growth. However, “what [Apple and other firms] are moving overseas … is intangible assets,” such as intellectual property, Blouin says. “So it is not as if we are losing jobs out of the United States to Ireland. There are a few [jobs lost] because they have to [do that] legitimately; they will open up an office and put in servers in Ireland, but that’s at the margin. What they are really doing is shifting a lot of profits out of the United States.”

Ironically, Blouin adds, it is the Europeans who “really care about this now. Europe is starting to get nervous” about the Double Irish and the Dutch Sandwich because “those structures facilitate the reduction of the European tax obligations of these firms…. Apple has this quasi-Irish entity that, it turns out, is not filing taxes anywhere for that income that supposedly is in this Irish entity.” That means Europe is losing out.

According to Sikes, while no one can expect U.S. companies to pay more taxes than they are legally bound to pay, “the U.S. corporate tax system is broken and needs to be reformed. [It] is stunting U.S. economic growth. The corporate tax rate should be cut in order to incentivize companies to invest in the U.S.” Many critics also call for the U.S. to move to a territorial system. On the one hand, says Sikes, “a territorial system would remove the disincentive to repatriate foreign earnings. However, it will not attract business to the U.S. The only way to do that is to cut the rate. The government could cut the rate in a revenue neutral manner by broadening the base [i.e., eliminating loopholes]. Cutting the corporate tax rate and broadening the base will stimulate the U.S. economy and cultivate jobs at home.”           

“What we are concerned about is where the dollars get invested,” notes Fleischer. “What matters is whether the cash is getting invested offshore instead of in the United States. We don’t want the tax code to push companies to invest offshore in order to avoid tax on repatriated funds.”

A Range of Reforms

Given its obvious deficiencies, many agree the current U.S. tax system is broken. But there is widespread disagreement about what a reformed system should look like. According to Fleischer, the liberal position on reform involves taxing U.S. companies’ worldwide income at the current 35% rate, and closing the loopholes that plague the current system. At the center of the political spectrum, reformists advocate a worldwide system without tax deferrals, at a lowered rate of about 20%. In such a system, U.S. companies would be taxed on their worldwide income regardless of whether it was repatriated, and they would pay no additional tax if the money were repatriated to the U.S.

“The lower the tax rate, the less incentive there is for companies to engage in sophisticated gamesmanship to get around the rate,” argues Fleischer. “The [current] 35% sticker price is not doing us any good because no one is paying attention to it.” Republican Congressman Dave Camp, chairman of the House Ways and Means Committee, favors lowering the U.S. tax rate and establishing a territorial system — thus taxing only U.S.-source income. U.S. companies would be free to repatriate their foreign earnings at no cost. How much could U.S. taxes be cut? According to the Organisation for Economic Co-operation and Development, the average corporate tax rate among industrialized nations is between 20% and 25%. U.S. companies and business associations argue that U.S. rates must not exceed that level if the U.S. is to be competitive worldwide.

For the time being, notes Blouin, “if we at least reduce our tax rate, companies may be willing to bring the money back to the United States.” Meanwhile, legislators may start imposing a minimum tax on the income from intellectual property that is used by foreign subsidiaries, she adds. “I am cautiously optimistic that we will move forward, either to reduce the U.S. tax rate on corporate income, while maintaining the worldwide system and coming up with some sort of favorable regime to tax this intellectual property” at a reduced rate — much like the U.K.’s “patent box” system, which taxes intellectual property at an especially low rate. “Or we will do a really big shift, and think about moving toward territorial taxes. This much is clear: It makes little sense for the U.S. to establish a nominally high rate, and then create loopholes in the law that allow companies like Apple to avoid those high rates through means of transfer pricing and tax deferrals.”