Electronic copy available at: http://ssrn.com/abstract=2342319

VILLANOVA Public Law and Legal Theory Working Paper Series

Apples International Tax Planning

By

J. Richard (Dick) Harvey, Jr.

October 2013

Villanova University School of Law Public Law and Legal Theory Working Paper No. 2013-3061

This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at http://ssrn.com/abstract=2342319

Electronic copy available at: http://ssrn.com/abstract=2342319

Apples International Tax Planning J. Richard (Dick) Harvey, Jr.

Distinguished Professor of Practice

Villanova School of Law

Tax and Corporate Law Societies Wednesday, October 26, 2013

Electronic copy available at: http://ssrn.com/abstract=2342319

Agenda

2

Results of Apples 2011 tax planning

International tax planning basics

Tax Policy issues:

Is income shifting a problem?

Alternatives?

Questions?

Results of Apples

2011 Tax Planning

3

Global Effective Tax Rates (ETR)

4

ETR = global tax expense/global pre-tax income

$ billions Global Tax

Expense

Global Pre-

Tax Income

ETR

Reported $8.3 $34.2 24.2%

Adjusted** $4.4 $34.2 12.8%

Key Point: Need to analyze why adjusted ETR is so low

** Adjusted to exclude $3.9 billion of deferred US tax expense on foreign earnings since amount may never be paid.

ETRs by Tax Jurisdiction

5

$ millions

Adjusted Tax

Expense

Applicable Pre-

Tax Income ETR

Federal $2,984 $10,200 29.3%

State & Local 799 10,200 7.8%

Foreign 602 24,000 2.5%

Total $4,385 $34,200 12.8%

Key Point: Foreign ETR is very low!

Further Analysis of Foreign ETR

6

($ millions)

Tax

Expense

Pre-Tax

Income ETR

Ireland $ 13 $22,000 0.1%

Other foreign countries 589 2,000 29.5%

All foreign countries $602 $24,000 2.5%

Key Point: Despite stated 12.5% Irish tax rate, basically paying no tax

to Ireland on $22 billion of income.

Another Point: In addition to analyzing ETRs, must analyze

pre-tax income see next slide.

Pre-Tax Income Allocation

7

Country

2011 Pre-Tax Income Employees @ June

2011 2011

Customer

Location $ Billions % # $

United States $10.2 30% 67% 79% 39%

Ireland 22.0 64 4 3 1

Other countries 2.0 6 29 18 60

Consolidated $34.2 100% 100% 100% 100%

Key Points: (1) Ireland = 64% of pre-tax income but few employees and customers

(2) US = 30% of pre-tax income but most employees and 39% of customers

(3) Other countries = only 6% of income with 60% of customers and 29% of

employees

Profitability of US vs. Foreign Operations

8

Pre-Tax

Income

G&A

Expenses

Sales, Marketing, &

Distribution

Expenses

Pre-Tax

Income/Sales

US 30% 85% 59% 24%

Non-US 70% 15% 41% 36%

Consolidated 100% 100% 100% 32%

Key Points: (1) Expenses disproportionately allocated to the US relative to income

(2) US sales appear to be substantially less profitable

Summary Results of Apples Tax Planning

9

Ireland: Allocated 64% of income with little physical presence

Basically paying no tax despite 12.5% stated Irish tax rate

US: Only 30% of income despite 39% of customers and 79% of payroll

cost

37.1% ETR on US income

Other Foreign Countries: Only 6% of income despite 60% of customers and 29% of employees

(18% of payroll cost)

29.5% ETR

How Did Apple Accomplish This Result?

10

Income shifted out of the US to Ireland by:

Transferring marketing and distribution rights to Ireland, and

Allocating overhead costs disproportionately to the US

Minimized foreign tax in other foreign countries by:

Carefully structured business to avoid Irish entities having a permanent establishment

Therefore, only allocated a small sales commission to foreign countries

Lets now discuss some simple International Tax Planning

11

International Tax Planning Basics

Background - International Tax (1 of 2)

12

Generally respect:

Legal entities and

Contracts between entities

US taxes on a worldwide basis, but:

Active income of foreign subsidiaries not taxed until distributed

back to the US

Passive income (e.g., interest, dividends, and royalties) supposed

to be taxed immediately

Background - International Tax (2 of 2)

13

Foreign countries generally only tax businesses that have

a PE in the country. Usually requires:

Physical presence, or

Agent that has approval authority

Tax Havens:

Little or no tax

Want to attract jobs

Observations

14

US MNCs motivated to shift income from high tax to low tax jurisdictions

Income shifting possible because:

Legal entities are respected, and

Contracts are respected if at arms-length

Primary methods of shifting income include:

Locate debt in high tax country and equity in low-tax countries

Transfer valuable intangibles to tax havens

Incur overhead in high-tax countries

Locate Debt in High Tax Jurisdiction

15

Interest expense generally deductible in legal entity that incurs the debt

If affiliated business operates in multiple tax jurisdictions should:

Locate debt in high-tax jurisdiction

Locate equity in low-tax jurisdiction

Conceptually sounds easy, BUT in practice need to:

Avoid various rules designed to prevent this sort of activity

Move loan proceeds to entities that need funding

Base Case and an Alternative

Base Case borrow in the US and lend money on same terms to foreign operating subsidiary (FOS)

US = interest expense offset by interest income

FOS = interest expense deduction

Bottom Line - No tax benefit

Alternatives #1 and #2 - borrow in the US, equity fund tax haven, and have tax haven loan funds to FOS.

US = interest expense

Tax Haven = Interest income but not taxed

FOS = interest expense deduction

16

Base Case Funding Structure

17

US Parent

Foreign Operating

Subsidiary (FOS)

Loan Annual interest payments

End Results - (1) US Parent has no net interest expense because interest income

from FOS offsets interest expense to 3rd party

(2) FOS has interest deduction

Third

Party

Loan

Interest

Alternative Funding Structure #1

18

US Parent

Tax Haven Corp

Foreign Operating

Subsidiary (FOS)

Contribute equity

Loan Annual interest payments

Partial Result:

(1) US claims interest expense deduction for payment to 3rd party

(2) Interest expense deduction in FOS

Query:

(1) Is interest income earned by Tax Haven considered passive and taxed immediately in the US?

Third

Party

Loan

Interest

Alternative Funding Structure #2

19

US Parent

Tax Haven Corp

Contribute equity

Loan Annual interest payments

Foreign

Operating

Company**

** Foreign operating company treated as corporation for foreign country tax purposes, but treated as disregarded entity for US tax purposes under the check-the-box regs. Interest payments are treated as not existing for US tax purposes and

therefore avoid subpart F inclusion.

End Result - Get double interest deduction (i.e., one in the US and one in FOS)

Third

Party

Loan

Interest

Shifting Valuable Intangibles (1 of 2)

20

Potentially more powerful than favorable financing structures

Both often used

Technology and Pharmaceutical industries have been very

aggressive:

However, other businesses (e.g., Starbucks secret blend) have been

able to benefit.

Reason this strategy has worked Governments respect:

Separate legal entities

Contracts between separate entities if at an arms-length

Shifting Valuable Intangibles (2 of 2)

21

Common methods for shifting intangible assets:

Cost-sharing agreements at early stage of development used

by Apple

Sale

License

Basic Idea:

Transfer intangibles out of a high tax jurisdiction (e.g., US) for

the least amount of compensation possible

Locate intangibles in tax haven so income is not taxed

Avoid subpart F rules on income earned by the tax haven

Shifting Intangibles - Example

22

US Parent

Tax Haven Corp

Transfer Intangible

Right to use intangibles Annual royalty payments

Foreign

Operating

Company**

** Foreign operating company treated as corporation for foreign country tax purposes, but treated as disregarded entity for US tax purposes under the check-the-box regs. Royalty payments are treated as not existing for US tax purposes and

therefore avoid subpart F inclusion.

End Result Income that would have inured to the US Parent is recorded in a tax haven.

Is Income Shifting a Problem?

23

US vs. Foreign MNCs

24

US MNCs believe they are at a competitive disadvantage with foreign MNCs because:

US marginal corporate tax rate is highest in the world, and

US taxes on worldwide income

Thus, US MNCs believe they need to be able to shift income

to be competitive.

Some policy makers believe US MNCs may actually have a slight advantage

over foreign MNCs because:

Subpart F rules have been gutted

US deductions available for expenses related to foreign subsidiaries

Ability to cross-credit high tax income with low-tax income

Can recognize foreign losses in the US (branches or liquidations)

But What About Domestic Businesses?

25

0

1

2

3

4

5

6

7

8

9

DomesticOnly

US MNCs ForeignMNCs

Ability to ShiftIncome to TaxHavens

Tax Policy Alternatives

26

US Unilateral Options

Favorable to US MNCs

Unfavorable to US MNCs

Options Favorable to US MNCs

28

Eliminate corporate income tax or substantially reduce

35% tax rate

Abandon hybrid worldwide system in favor of territorial

system

Adopt patent box regime (i.e., low tax rate on certain

earnings)

Unfavorable Options to US MNCs

29

Adopt anti-base erosion rules, including: Allocate US interest expense to foreign subsidiaries

Reinvigorate subpart F anti-abuse rules by eliminating: check-the-box, CFC look-through rules, and contract manufacturing

Require increased transparency of where income is earned (e.g., country-by-country reporting)

Impose 10 to 15% minimum tax on foreign earnings

Eliminate deferral of active income from foreign subsidiary

Adopt formula apportionment (i.e., abandon separate entity accounting)

Nirvana Obtaining Global Consensus

30

Recent Multilateral Actions:

G-20 communique from Moscow meeting in Sept.

OECD working on Base Erosion Profit Splitting (BEPS) project

Will there be global consensus on how to address tax havens?

Some agreement is possible

Total agreement is very unlikely. Reasons include:

Who should be allocated the tax haven income (i.e., resident country or source country)?

Always will be countries willing to collect no corporate income tax in order to attract jobs

Summary - Key Tax Policy Questions

31

Should we be concerned about the potential competitive advantage US MNCs have over domestic only businesses?

Does US tax law really put US MNCs at a competitive disadvantage vs. foreign MNCs?

Should the US act unilaterally or wait for global action?

If the US cracks down to hard, could US MNCs expatriate?

Should retain the arms-length standard, and if so, what base erosion protections are needed?

32

Questions from Audience

Contact and Other Information

33

Prof. J. Richard (Dick) Harvey, Jr.

Distinguished Professor of Practice

Villanova School of Law and Graduate Tax Program

1-610-519-4474

rharvey@law.villanova.edu

Other information:

Prof. Harvey written testimony - see

http://ssrn.com/abstract=2273653

Tax Notes article see http://ssrn.com/abstract=2273634