Please ensure Javascript is enabled for purposes of website accessibility

The Biggest Takeaways From Apple's Tax Grilling

By Evan Niu, CFA – May 21, 2013 at 3:52PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Lawmakers give Apple the third degree over its legal tax minimization strategies. Even if the Mac maker ends up paying more from a comprehensive overhaul of the U.S. corporate tax system, the company is all for it.

Earlier today, Apple (AAPL 1.98%) management testified in front of a Senate subcommittee, getting grilled about its tax strategy. The Mac maker's tax strategy has been under fire ever since The New York Times ran an expose about a year ago, "How Apple Sidesteps Billions in Taxes." 

That brought attention from lawmakers, even though the issue at hand is really how broken the U.S. corporate tax system is. Apple just happens to be perhaps the highest-profile example of tax minimization. Here are the biggest takeaways from the hearing and Apple's testimonies, which were delivered by CEO Tim Cook, CFO Peter Oppenheimer, and head of tax operations Philip Bullock.

Everyone's doing it
Strangely, there's a double standard when it comes to corporate income tax and individual income tax. It's entirely acceptable for individuals to seek tax minimization. Every tax preparing service promises to get you the "largest refund ever," which indubitably translates into paying the least amount legally possible.

However, when corporations do this for the benefit of their shareholders, they get vilified. It's also worth noting that the majority of Apple's shareholders are American individuals, whether they own shares individually or through a mutual fund or pension fund, so Apple's broad domestic investor base benefits from tax minimization.

Cook pointed out that Apple is the largest corporate income tax payer in the U.S., expecting to pay $7 billion this fiscal year. The flip side of this is that Apple may also be the largest corporate tax avoider.

It's all legal
Cook reiterated that Apple pays "every single dollar" that it legally owes in taxes, and that Apple's fiscal 2012 total U.S. federal cash effective tax rate was roughly 30.5%. That figure is based on U.S. pre-tax earnings, and doesn't include overseas earnings.

Even as lawmakers gave Apple a hard time, none disputed that the company's practices were fully compliant with current tax laws. There's much debate about whether Apple is violating the spirit of the law, if not the letter of the law.

Kiss me, I'm an Apple Irish subsidiary
At the heart of the scrutiny are three of Apple's Irish subsidiaries: Apple Online International, Apple Sales International, and Apple Operations Europe, or AOI, ASI, and AOE, respectively. AOI is a holding company set up to manage Apple's foreign cash balance, which is now over $100 billion. Subsidiaries further down the food chain distribute income earned around the world to AOI. These subsidiaries pay applicable local taxes in the regions where they operate before sending money to AOI.

None of these subsidiaries have any country of tax residency, in part due to the way that Irish laws are structured. Apple does pay U.S. taxes domestically on the interest income earned from this foreign cash, but that's a relatively small amount relative to the amount of foreign earnings that are taxed at extremely low rates.

These subsidiaries were set up in 1980, and at the time Ireland had offered some generous tax incentives to encourage tech companies like Apple to set up shop. This was before any of Apple's biggest breakthrough products, mind you, including the first Mac. The negotiated maximum tax rate that Apple pays in Ireland is around 2%.

There is a cost-sharing agreement that Apple has with two of its Irish subsidiaries, ASI and AOE, where the entities combine resources and share risk to invest in research and development, of which 95% takes place in the U.S. All parties are then able to reap the rewards from this innovation. This has been mischaracterized as a way for Apple to "shift" income to Ireland. Apple makes it clear that it doesn't move its IP into offshore tax havens and then use the IP to sell products back into the U.S. All products sold in the U.S. are subject to domestic corporate income taxes.

It's the overseas product sales that primarily get favorable tax treatment, although this is now the bulk of Apple's business; 66% of revenue last quarter was international.

Out of sight, out of mind
The real problem is the U.S. corporate tax system, which is in desperate need of reform in order to get with the times. At times, lawmakers lost sight of this and instead focused on chastising Apple about its legal tax practices, many of which are employed by other American multinational corporations.

Apple acknowledged that the current 35% tax that it would need to pay in order to repatriate cash provides a significant disincentive to do so, particularly when the cost of debt is so low. On average, Apple is paying less than 2% (which is tax deductible) for the $17 billion it just borrowed, far less than the 35% that comes off the top for bringing dollars home.

One senator pointed out that Apple's overall effective tax rate, after including its minimization strategies, is very similar to Samsung's. The South Korean conglomerate is easily Apple's biggest competitor right now, and the American company has to jump through all sorts of loops just to pay a similar rate to foreign competitors. However, there's still one big difference: Samsung is free to bring money home to South Korea if it wants to use those funds to invest in infrastructure, pay employees, or distribute dividends, among other uses. Apple is afforded no such luxury under current U.S. tax law.

Taking one for the team
A repatriation holiday isn't a viable long-term solution, either. Cook maintains that such rare holidays aren't predictable, something businesses prefer. It also perpetuates the idea of hoarding cash overseas in anticipation of the next holiday, since the precedent has been set. A rate in the "single-digits" would encourage free movement of capital, in Cook's view.

Even though comprehensive corporate tax reform would very well likely result in Apple paying more taxes, the Mac maker is all for it if the system becomes modernized and simpler.

Fool contributor Evan Niu, CFA, owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.