A Fine Mess
Page 16
This left Caterpillar’s spare-parts business with an organization chart wildly out of balance. Responding to questions from a congressional committee, the company said it designed no parts in Switzerland. It manufactured no parts in Switzerland. It stored no parts in Switzerland. Caterpillar had ten warehouses in the United States storing some 1.5 billion spare parts but not a single warehouse in Switzerland. The company had forty-nine hundred employees running the parts business in the United States and sixty-six in Switzerland.
And yet Caterpillar reported to the IRS that 85% of all the profits it made on international sales of spare parts were earned by the Swiss subsidiary and thus not taxable in the United States.
Shifting the parts business (on paper) to Switzerland was not simple and was not cheap. The arrangement consumed months of lawyer time. Caterpillar paid the PricewaterhouseCoopers tax planners $55 million in consulting fees to create the Swiss detour for its spare-parts profit and a few million more for the auditors’ determination that there was no conflict in asking PwC to audit a PwC plan. But those millions were small change for Caterpillar, compared with the huge sums the firm was able to keep away from the IRS. The Swiss bypass shifted about $8 billion in profits from the U.S. parts operation in Peoria to CSARL in Geneva in the first fifteen years of the twenty-first century. If its effective corporate income tax rate in the United States was 29%, that meant Caterpillar cut its U.S. tax payments by $2.3 billion.2
Not a bad return on a $55 million investment. And that rate of return explains why so many American companies have followed the route plowed by Caterpillar. However high the consultants’ fees, and however absurd the resulting organizational chart may look, corporate taxpayers are willing to do what it takes to escape the 35% corporate income tax.
The federal tax on corporate earnings is older than the tax on personal income. The federal corporate income tax was first collected in 1909, four years before the first Form 1040 was sent to a small number of wealthy taxpayers. For some eight decades, the corporate tax rate in the United States was roughly the same as that in other major industrialized countries, so moving to a foreign country would make little difference in the tax a corporation had to pay. Beginning in the 1980s, though, major countries began to cut their corporate income tax rates sharply. The new century brought even lower rates. Between 1997 and 2014, thirty-one of the thirty-four members of the OECD—the club of the world’s richest nations—reduced the rate of corporate income tax. The United States did not follow this trend. By 2016, as a result, the base U.S. tax on corporate income was the highest of any major democracy. America’s corporate income tax ranges from 15% to 35%, depending on the company’s size, but in practice almost all major corporations are in the top bracket, 35%. The French, those nonpareil soakers of the rich, have a slightly lower base rate, but they’ve added a pair of “temporary” surtaxes that make their corporate rate higher than America’s. A few poorer countries, including Argentina and Chad, also tax corporate profits at 35%. But other rich countries, including all of our major economic competitors, have lower corporate rates.
Here’s a sample of corporate income tax rates in 2015.3 The chart on the next page lists the top statutory rate in various countries. Some countries, however, will cut specific deals with individual corporations to give them an even lower rate. That’s why Caterpillar’s Swiss subsidiary in the spare-parts trade had to pay only 6% in Swiss taxes and why Apple, as we’ll see shortly, struck an even better deal with the tax authorities in Ireland.
Country
Rate
Australia
30%
Austria
25%
Belgium
33%
Canada
15%
France
33.3%
Germany
15%
Ireland
12.5%
Israel
26.5%
Japan
23.9%
Mexico
30%
Netherlands
25%
Norway
27%
South Korea
22%
Sweden
22%
Switzerland
8.5%
U.K.
20%
United States
35%
Beyond the high rate, the United States stands apart from most other industrialized democracies in that it imposes the corporate tax rate on a worldwide basis; that is, if a company incorporated in the United States makes a product in Ireland and sells it there, the profit from that sale is subject to the U.S. corporate income tax. The firm won’t be taxed at the full 35% rate, because it can subtract the amount it paid in foreign tax from the U.S. tax bill, but some U.S. tax is owed on that foreign-earned income. Other rich countries, for the most part, impose the corporate tax on a “territorial” basis; that means a German company has to pay tax in Germany only on profits earned within Germany’s borders. Just a few other major nations—for example, Chile, Greece, Israel, and Mexico—impose a tax on money their firms earn overseas.
But the money an American company earns overseas is not subject to the U.S. corporate tax until it is “repatriated”—that is, until the company takes the money out of a foreign bank or security and transfers it to the United States to pay salaries or dividends or to invest in buildings or machinery. Because of the worldwide basis of American taxation, the money is subject to the corporate income tax when it comes home. The result—rather predictable, if you think about it—is that American corporations routinely choose to leave large amounts of foreign earnings overseas. They deposit the money in a Swiss or Spanish bank; they invest it in German or Japanese corporate bonds; they buy Irish or Italian companies. This practice is so common today that the standard estimates say U.S. companies have more than $2.3 trillion stashed overseas. This huge accumulation of cash outside our borders is a key reason for the recent surge in a tax-dodging process called inversion.
It’s important to note that the 35% rate on corporate profits is the “nominal” rate—that is, the figure set forth in the tax law. It’s safe to say that no American corporation pays the full 35% in taxes. Any company with a chief financial officer who is not sound asleep all day long can take advantage of the myriad giveaways in the Internal Revenue Code to reduce its tax burden. As a result, the “effective” tax rate paid by U.S. corporations—that is, the percentage of profits that is actually paid in taxes—is well below the nominal 35% level. But estimates differ sharply about just how far below.
The most comprehensive unbiased study of effective tax rates paid by U.S. firms was issued by the Government Accountability Office (GAO)—essentially, the accounting arm of Congress—in 2013.4 Looking at profits, and taxes paid, in the years 2008–10, the GAO said large U.S. companies actually paid 12.6% of their profits in federal tax. Many companies had to pay state and local income taxes, and some paid income tax to foreign countries on their overseas earnings. But even when all those taxes were added up, the effective rate of tax paid by large U.S. corporations was only 16.9%. The GAO said that companies were able to cut their tax bills far below the statutory rate because of “exemptions, deferrals, tax credits, and other forms of incentives” in the law and because
they have successfully transferred much of their profit to foreign countries, as Caterpillar did. Big companies were so successful in the game of tax avoidance that “nearly 55 percent of all large U.S.-controlled corporations reported no federal tax liability in at least one year between 1998 and 2005,” the GAO found.
For the business community, which had been fighting for years to reduce the corporate income tax rate, that report from a respected, nonpartisan observer was a serious political blow. While corporate America was complaining about the world’s highest corporate tax rate, the GAO study said U.S. companies actually paid tax at about one-third of the nominal rate and at lower rates than big companies pay in many other countries. Critics of the tax preferences for corporations piled on. “Some U.S. multinational corporations like to complain about the U.S. 35% statutory tax rate,” said Senator Carl Levin, a Michigan Democrat. “What they don’t like to admit is that hardly any of them pay anything close to it . . . due in large part to the unjustified loopholes and gimmicks that riddle our tax code.”
In response, corporate America unleashed its own studies, designed to show that the GAO was simply wrong. An analyst at PricewaterhouseCoopers issued a report saying that the total tax burden (including taxes paid to foreign countries) on all U.S. corporations “exceeded 35% for the 2004–2010 period.” The Tax Foundation, a respected economic think tank funded by large corporations, disagreed with both the GAO and the PwC studies; its report said U.S. corporations in 2011 paid tax at an effective rate of 29.8%.5
Whatever the actual rate paid, it’s clear that America’s corporate income tax is high enough to motivate corporations to go to enormous lengths to avoid it. “U.S. multinational firms have established themselves as world leaders in global tax avoidance strategies,” notes Professor Edward D. Kleinbard, who teaches tax law at the University of Southern California. Indeed, Apple, with the help of tax-law geniuses, managed to shift its profits (on paper) to a legal concoction where it paid no corporate tax at all.
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APPLE, OF COURSE, IS A famously innovative company, and its lawyers and accountants have been searching for tax reduction stratagems for decades. But the effort picked up significantly in the twenty-first century, as the iPod, the iPad, and, since 2007, the iPhone turned into major generators of profit—profit that would be taxable at the 35% corporate income tax rate. To duck that tax bill, Apple struck deals with the government of Ireland. “Apple, Inc., a U.S. corporation, has used a variety of offshore structures, arrangements, and transactions to shift billions of dollars in profits away from the United States and into Ireland, where Apple has negotiated a special corporate tax rate of less than 2%,” a congressional investigation found.6
But even a 2% rate was more tax than Apple wanted to pay. So the company bookkeepers set up a subsidiary company, Apple Operations International. This legal entity was incorporated in Ireland but managed and controlled from the company headquarters in Cupertino, California. This “company” had no employees and no address; it had a three-member board of directors, which held its meetings in Cupertino. The home office then created a subsidiary of this Irish subsidiary, Apple Operations Europe, and a separate subsidiary of that subsidiary, Apple Sales International. Those two lower-level subsidiaries of Apple Operations International were also incorporated in Ireland but controlled and managed in Cupertino. Then Apple Inc., the American company, designated its network of Irish subsidiaries to be the official seller of Apple products everywhere outside the United States. These products were developed, designed, and programmed in the United States, and manufactured largely in China, but the right to sell them was transferred (on paper) to the Irish subsidiaries. Sales were excellent; in just four years, from 2009 to 2012, Apple Operations International had income of $74 billion.
The tax bill on this income? Zero. Apple Inc., the sole owner of the Irish subsidiaries, paid no U.S. tax on these earnings. The three companies incorporated in Ireland paid no Irish tax on these earnings. This happy outcome (for the stockholders) was the result of a clever organizational dance around the tax laws of both countries. As the company’s tax lawyers had discerned, a company operating in Ireland is subject to Irish tax only if it is “managed and controlled” in Ireland. But under American law, a company is subject to U.S. corporate tax liability only if it is incorporated in the United States. Because those three companies were not managed in Ireland and not incorporated in the United States, they owed no corporate tax to either country. Apple had created $74 billion worth of what the economists call “stateless income.” Of course the company still depended on the police, courts, fire departments, roads, infrastructure, educational system, and other government services provided by both the United States and Ireland; it just decided not to pay for those services, at least not on the tens of billions of dollars earned by its Irish subsidiaries.
When confronted about these tactics by angry U.S. senators from both parties—“It is completely outrageous,” said John McCain, the Arizona Republican, “that Apple has not only dodged full payment of U.S. taxes, but it has managed to evade paying taxes around the world through its convoluted and pernicious strategies”—Apple executives responded with indignation of their own.
“We pay all the taxes we owe, every single dollar,” declared Tim Cook, Apple’s CEO, who noted that Apple paid significant sums in U.S. taxes on its sales in the United States—more than $16 million in corporate income tax every day of the year. “We do not depend on tax gimmicks. . . . We do not stash money on some Caribbean island.” The problem, Cook said, was that 35% corporate tax rate, which would make it “very expensive” to record those international sales in the United States or to bring home the billions of dollars Apple had assigned to its foreign subsidiaries. The best solution would be for the United States to “eliminate all corporate tax expenditures, lower corporate income tax rates, and implement a reasonable tax on foreign earnings that allows the free flow of capital back to the United States.” In short, Tim Cook gave Congress the same message that Gérard Depardieu had given to François Hollande: if you set tax rates high, taxpayers will fall back on “convoluted and pernicious strategies” to avoid them—including taking their money to a different country.
Although Cook did not mention it to the senators, Apple Inc. had actually found a roundabout way to bring home some of the billions it held overseas without paying U.S. tax on the earnings. In 2013, Apple borrowed billions of dollars—that is, it sold corporate bonds—in the United States. It used the interest it earned on the money deposited overseas to pay the interest on the bonds. This maneuver, fully legal, meant that Apple could use the money it held overseas to provide cash at no cost in the United States—without a penny to the tax man.
For all Senator McCain’s ire, Apple’s subsidiary-of-a-subsidiary-of-a-subsidiary structure—the scheme that placed $74 billion beyond the reach of the tax authorities—was actually not as convoluted as another tax-dodging contraption, the intricate mechanism known as a “Double Irish with a Dutch Sandwich.” This one works nicely to shield profits from the tax man for companies that have a good deal of intellectual property, like search engines, software, cancer drugs, or computer operating systems. The “Double Irish” has been used by the likes of Apple and Microsoft, but it’s generally agreed, among aficionados of tax avoidance, that the paradigm case of this particular apparatus is Google’s international tax shifting, which is complicated to the point of being difficult to pin down precisely.
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GOOGLE CREATED A COMPANY called Google Bermuda Unlimited, based in Hamilton, Bermuda. That island nation is famous among tourists for its pink beaches and swaying palms, but it is favored by corporate treasurers for another national asset: a corporate tax rate of 0%. Google’s Bermuda subsidiary is the official corporate owner of a separate subsidiary called Google Ireland Holdings. This one is also based in Bermuda, but the name is appropriate because Google Ireland Holdings is the designated corporate ow
ner of yet another Google subsidiary known as Google Ireland Limited, based in Dublin.
Once this corporate structure was established, Google’s headquarters in the United States assigned the rights to its intellectual property—its search and advertising technology, the golden goose of Google profits—to the “Ireland Holdings” subsidiary in Bermuda. Then it designated the “Ireland Limited” subsidiary in Dublin as the official seller of all Google advertising in Europe, the Middle East, and Africa. This business brought in huge earnings for “Ireland Limited,” the Dublin subsidiary. That would have created large profits for the Dublin subsidiary, which would be taxable in Ireland (at the 12.5% corporate tax rate there). But the Dublin subsidiary paid a “license fee” to the holder of the intellectual property—that is, to the Bermuda subsidiary. The license fees were so large that the Dublin company ended up paying out more than 99% of its earnings to its sister company in zero-tax Bermuda. The result was no taxable income in the United States. Almost no taxable income in Ireland. And lots of corporate income in Bermuda, where there’s no tax on corporate income.
It gets worse. There was a problem with the intricate plan outlined in the previous paragraph. The Irish tax code limits how much profit can be transferred out of Ireland to another country; because Google intended to shift virtually all the profits from Ireland to Bermuda, that limit could have stifled the whole complex transfer scheme. But there was an escape route: Ireland has treaties with certain countries (but not Bermuda) that permit such transfers on a tax-free basis. One of those countries is the Netherlands. So the profit earned on Google’s advertising in much of the world was collected by Google Ireland Limited, in Dublin, and then transferred to Google Netherlands Holdings BV, a shell company (no employees) in the Netherlands (“BV” is the Dutch equivalent of “Inc.”). From there, the money was shifted (on paper) to the Bermuda subsidiary. In essence, the two “Google Ireland” subsidiaries form a sandwich around the Dutch subsidiary. This exercise in three-part harmony means that billions of dollars of earnings built on intellectual property developed in the United States come to Google tax-free. Bloomberg Businessweek estimated that the sandwich cut Google’s U.S. tax bill by $3.1 billion over a four-year period.7