Ed Lotterman: Tax law favors big multinationals

May 31, 2013 

Problems in the U.S. system of taxing corporate income were front and center recently when senators grilled Apple CEO Tim Cook about his company's tax minimization measures. Yet no one argued that Apple has violated U.S. tax laws or even that it is particularly aggressive or egregious in its tax avoidance.

It is simply large, well-known and highly global in its operations. And this last feature is the central point.

These international operations allow Apple and other U.S. multinationals to take advantage of "transfer pricing," moving profits from high-tax countries to low-tax ones, especially Ireland and "fiscal paradises" like the Cayman Islands.

Transfer pricing in itself is a legitimate procedure of setting prices on transactions between different entities of the same corporation located in different countries. Consider the case of a U.S. copper company that mined and refined copper in Peru, but manufactured copper wire and tubing in the United States. The Peruvian operations legally were a separate Peruvian corporation, albeit owned entirely by the U.S. parent company. So when copper ingots were shipped from Peru to the tubing and wire mills here, the U.S. operation would have to pay its Peruvian counterpart for them. Set the price high and they increase the profits of the Peruvian subsidiary, but decrease those of the U.S. business. Set the price low and the reverse happens.

Similarly, for many years Ford's factory in Brazil made small four-cylinder engines used in the automaker's compacts assembled here and in Canada. Ford-Brazil had to sell to Ford-North America. Again, a high price raised Ford-Brazil's profits and lowered Ford-North America's. A low price did the opposite.

Now consider a high-tech company making mobile phones. The parent company sells its patent rights to a wholly owned subsidiary that is legally located in Ireland. There are no Irish employees, no American citizens working there, and no office, factory or warehouse there. When the company sells its finished electronic devices in, say, Japan, its Japanese sales subsidiary must pay its manufacturing subsidiary for producing the phones. But it must also pay licensing fees to the Irish subsidiary that owns the patent rights. A low licensing fee will increase the profits of the Japanese sales subsidiary and lower those of the patent-holding entity in Ireland. A high fee will do the reverse.

These are all examples of how having the ability to set the "transfer price" on sales from a corporate subsidiary located in one country to a subsidiary of the same corporation in another country gives the parent corporation the ability to book profits in whichever country is most advantageous.

Governments understood this early on, and there have been tax laws regarding transfer prices for decades. The usual approach is to require that the good or service be booked at the same price that would prevail in an arms-length transaction between two unrelated businesses.

However, determining such a market price is increasingly difficult as one moves from standardized commodities to proprietary physical products to intangible goods like intellectual property royalties.

Copper of any standard level of purity is an openly traded commodity with a clear market price.

But what is the value of a license to manufacture or sell an electronic device that is nearly unique, but which may be obsolete in a couple of years?

The particular tax avoidance structure used by Apple is termed a "double Irish with a Dutch sandwich" in international tax accounting. It involves two separate Irish subsidiaries, one holding all patent rights and the other overseeing all international operations. The "Dutch" refers to the fact that some payments from the operations subsidiary are routed through a third subsidiary in the Netherlands before heading back to the patent-owning entity in Ireland.

Apple CEO Cook asserted that Apple does not use any "gimmicks" to avoid paying taxes. Let's just say that "gimmick" must be a very subjective term that varies in the eyes of the beholder. But Apple's strategy clearly is not illegal, at least under current U.S. and Irish law.

But the upshot is that large multinational corporations such as Apple that deal largely in intangible services, like software or patent rights, end up paying a lower tax rate than other U.S. corporations that do most of their business at home and that deal in physical goods. If you are a large, but primarily domestic, construction company or manufacturing company, your effective tax rate will probably be near 30 percent. If you are a multinational high-tech or financial firm, it may be half that. And this discrimination against manufacturing and against smaller firms comes at a time when both these categories are struggling.

Don't multinational firms have to pay taxes eventually, when they bring the money home? Don't they have to bring the money home to pay dividends to their shareholders? Yes they do, but there are many advantages to holding the money overseas for a long time.

The patent-holding subsidiary in Ireland will accumulate large balances of retained earnings. These can be lent to the company's other subsidiaries in any country. Any domestic firm would have taxes taken away from such retained earnings, and the effective cost of self-generated capital would be higher.

Moreover, while profits retained overseas are not available to be paid as dividends, their existence does, all other things being equal, raise the market price of the corporation's stock. So shareholders do benefit and can take that benefit in the form of capital gains, which face a favorable lower rate in the individual income tax, when they decide to sell.

Write Ed Lotterman at ed@edlotterman.com.

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