Are Apple's Earnings Taxed Enough?

The Senate's Permanent Subcommittee on Investigations has questioned Apple's (NASDAQ: AAPL  ) tax-avoiding schemes, claiming the company achieved "about $10 billion in tax avoidance per year." Apple has defended itself, saying it is "likely the largest corporate tax payer in the US, having paid $6 billion in taxes" last year. Despite the differing opinions, both sides at least agreed in their written documents with one thing: "Apple is an American success story."

Is this "American success story" paying its fair share? Or just doing the best it can for its shareholders? Let's look at the intricate corporate structure to find out.

The Senate's take
In the Subcommittee's examination, a helpful chart outlines Apple's global subsidiaries:

The memo notes that Apple Sales International has earned $38 billion from 2009 to 2011, yet only paid a total of $21 million in taxes, which means its tax rate was 0.06%. How can Apple achieve this?

The investigation focuses on Apple Operations International, AOI, an Irish corporation that has no tax residency, no physical presence, no employees, and three directors, two of which are in the U.S. The report states that "AOI's net income made up 30% of Apple's total worldwide net profits from 2009-2011, yet Apple also disclosed to the Subcommittee that AOI did not pay any corporate income tax to any national government during that period." The magical, tax-free niche Apple found was in taking advantage of residency rules between the U.S. and Ireland. From the report:

Ireland uses a management and control test to determine tax residency, while the United States determines tax residency based upon the entity's place of formation. Apple explained that, although AOI is incorporated in Ireland, it is not tax resident in Ireland, because AOI is neither managed nor controlled in Ireland. Apple also maintained that, because AOI was not incorporated in the United States, AOI is not a U.S. tax resident under U.S. tax law either.

There are many other schemes the report highlights, the most glaring being an enormous difference between what Apple accounts as its tax provision versus what it paid. For example, Apple's effective tax rate based on its 2011 annual report listed a $8.2 billion tax provision for an effective tax rate of 24%. But, this included state and foreign taxes, and after taking those out, the federal tax provision amounted to $6.9 billion, for a tax rate of 20%. Apple, however, only paid $2.5 billion in taxes, according to IRS returns. This amounts to a tax rate of about 7%. The difference in reported and paid taxes comes about from claiming future tax liabilities if Apple repatriated its foreign earnings, and tax benefits from stock-based compensation.

Apple's take
Of course, Apple contends that its AOI subsidy doesn't reduce its tax liability. In Apple's testimony, it writes, "If AOI did not exist, the funds it receives from other foreign subsidiaries through dividends would simply remain in the custody of those subsidiaries and would not be subject to U.S. corporate income tax." It also defends itself and writes that it reports taxes according to accounting standards.

Apple concludes its testimony with a call for corporate tax reform that is revenue-neutral, eliminates corporate tax expenditures, lowers corporate income tax rates, and implements a reasonable tax on foreign earnings.

Future debates
Apple, no doubt, is an American success story. And, finding out a fair and effective way for it to pay taxes will allow the company to keep the U.S. the home of such innovative companies. If Apple didn't go through such legal means to shield itself from taxes, shareholders might not believe the company is maximizing value. Others believe Apple isn't contributing its fair share to society. What do you think? Leave a comment in the box below.

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