Apple and the Perverse Disincentives of the Tax Code

6/24/2019 - Monocle Journal

The fact that Apple – the most valuable company on the planet with a market capitalisation of USD 740 billion at the time of writing, and a gross profit margin of 40 percent for the last three years – pays one of the lowest effective tax rates of any Fortune 500 company, is surely abhorrent.

It is further perplexing, even to tax experts in the US and Europe, that the actual tax rate that Apple pays is a question of great complexity. One European regulator, at least, pins it as low as 0.005 percent, a number that has been derided by Tim Cook, Apple’s CEO, as “total political crap”. He is right about this: Apple does pay more tax than this microscopic rate would suggest, but there is no doubt that Apple has significantly avoided paying the tax it should pay by offshoring its intellectual property, by headquartering in Ireland – whose corporate tax rate is 12.5 percent for trading income – and by engaging in the process of what is known as inversion.

The downside of inversion, from Tim Cook’s perspective, is that should the profits made offshore by Apple ever be repatriated to the US, the US corporate tax rate of 39 percent will apply. No problem: simply never repatriate the cash, and issue debt instruments in the US to pay shareholder dividends. This way Apple can maintain its argument that it is operating within the boundaries of international tax law whilst maximising shareholder return.

What Tim Cook is forgetting is that the underlying technologies that make his company so powerful – the internet, the microprocessor, the LED screen, basically the very idea of the computer itself – were invented and largely funded by US government grants and research, either directly, or indirectly through the provision of world-class education and research facilities. He is also forgetting that the environment in which Apple was founded is one that is unique in the world: a country in which entrepreneurship and risk-taking and innovation is encouraged more so than anywhere else. To a significant extent, the current battle that is underway between European authorities and Ireland – in which Ireland, under a recent ruling, is forced to charge Apple USD 14.5 billion in back taxes – perhaps misses the main point.

If Tim Cook is to be believed, Apple never engaged in any illegal activity or set up any illegal structure to avoid paying taxes. They merely optimised the existing legislation. Tim Cook is also correct in calling the problem a political one, rather than a legal one. He is of course referring to the apparent coincidence between the European Parliament’s tax claim on Apple and the US Department of Justice decision to fine Deutsche Bank in both cases for an amount that is approximately USD 14 billion.

What is telling, however, is that despite the furore over Apple back taxes, the debt that Apple issued in the US to pay shareholders a dividend since they did not have cash to pay the dividend as it was trapped offshore – was a tax-deductible expense.

Think about it: interest payments on debt are treated by accounting standards worldwide as above-the-line expenses, and are therefore tax deductible. The more debt therefore that a corporate entity holds on its balance sheet, the greater its tax shield, and the lower its aggregate tax rate. On the other hand, if a company in the US has no debt, it will pay a tax rate of 39 percent on its profits before tax. The tax incentives then appear to be strongly weighted against profits, and thereby against equity holders, and appear conversely to be strongly weighted in favour of debt issuance and debt issuers, i.e. the banks.

Thinking in terms of a risk and return framework, in which one would like to see risk-taking rewarded with higher returns, it would seem that the manner in which the world calculates tax in general is perversely anti-capitalist.

Recall that it is the equity holders who are taking all the risk here – they face complete loss should an Enron or WorldCom-like event occur. Whereas the debt holders are protected not only under bankruptcy laws they are armed also with the power to seize collateral and physical assets and even intellectual property. In extreme cases, they are able to sequestrate individuals. And, to be perfectly clear, should things really get rough, as they did in 2008, the debt holders may also be protected by the government, which will bail them out, as governments around the world bailed out their global and systemically important banks in the blink of an eye.

From a tax perspective, the incentives then – within a capitalist framework – seem perverse. The greater the debt, the lower the tax – the greater the profits, the higher the tax. The more innovative a firm is, and the less dependent they are on debt, the higher their tax rate will be, and the lower the return to shareholders will be. No wonder then that there was an enormous growth in US corporate leverage, as well as in household leverage, in the run-up to the 2008 financial crisis.

Increasing capital adequacy requirements on bank balance sheets is small shrift compared to the effect that a radical change to the US tax code would have on the problem of leverage and its deleterious effects on the world economy. It has been undeniably demonstrated by a raft of economists that there is a direct correlation between aggregate debt levels and the advent of economic crises. So then, imagine a different world in which one could alter the tax code. And to be clear: this really would be a thought experiment, since the unravelling of over 75 000 pages of US tax code would be more challenging to pass through Congress than any radical Trump idea that has thus far been floated.

In this radical change to the US tax regime – hopefully leading to a knock-on effect worldwide as other countries adopt similar policies  to remain competitive – one invokes the following. Firstly, interest payments by corporations would only be tax deductible up to a certain ideal leverage level. Any interest expenses above this ideal leverage level would no longer provide a tax shield. Further, one could imagine in fact a tax liability being raised against excessive leverage – and excessive interest expense – in order to promote counter cyclical corporate behaviour. Secondly, all research work, all work related to patent submissions, and all work related to the creation of intellectual property, would be tax deductible. The shortfall in tax receipts from this second directive would be amply funded by tax receipts from the first.

Thirdly, the US would invoke a see-through principle, such that a single US corporate tax rate is applied to profits, irrespective of where in the world they are earned, and irrespective of corporate structure and financial engineering. Of course, this is already the case barring the continued manipulation of differences in international tax codes that are employed in sophisticated ways by Fortune 500 firms. Basically, an end to the process of inversion.

Fourth, the US corporate tax rate would be pulled back from its current eye-watering level of 39 percent to a far more reasonable rate, again amply funded by putting an end to inversion and the advantages of the Irish corporate tax rate, as an example.

Fifth, all tax havens would be shut down finally and thoroughly. The notion that thousands of companies can be domiciled in the Cayman Islands and that that is where the intellectual property and goodwill sits that generates billions of dollars in profit is simply absurd and a scourge upon the notion that we behave as civilised people. In fact, it is these tax havens, frequently employed by both large corporate entities and wealthy individuals, that necessitate such high corporate tax rates in the first place, since the sheer value of what these islands rob from the mainland is staggering.

Finally, US tax authorities would do away with all dividend withholding tax and all capital gains tax. It is counterintuitive that an investor who has taken the risk of total loss is taxed on profit; then – after retaining earnings for the sake of sustainability – is taxed on dividends. And finally, after having taken all these risks and now wishing to exit the position, is then taxed on capital gains. Whilst Apple’s global corporate structure would appear to be cynical and designed entirely around US tax code, one is compelled to agree with Tim Cook were he ever to make the real point: that the tax code disincentivises investment. Of course, he can never make this point because it would jar with his position – that Apple is simply maximising returns under current conditions.

There is a wonderful Raymond Carver story called What We Talk About When We Talk About Love. For any student of American literature, it is a seminal piece. The story somehow gets to the very heart of relationships and how they are damaged and how people arrange their lives to manage their relationships without ever really speaking to each other, not properly.

When one follows the European case against Ireland and makes witness to the legal mud-slinging and technical complexity of calculating effective tax rates on firms like Apple and Pfizer, I sometimes think that what is needed is a complete reboot: something along the lines of What We Talk About When We Talk About Capitalism. Because what we are talking about right now are fines, wrist-slapping, loopholes and legal fees.

If there is any desire that remains for leaders to preserve the principal edict of capitalism: to reward innovation and to drag the middle and bottom of the bell curve of earners to better lives through broad-based economic growth, then we would have to address the main issue: tax.


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