The Lawletter Vol 41 No 4
The most straightforward tactic taken by large American corporations since the 1980s to avoid the full brunt of U.S. federal corporate income tax is known as "tax inversion" (or "corporate inversion"). This strategy has drawn considerable attention lately, with President Obama last summer calling on Congress to pass tax legislation to end the practice. In November 2015, the U.S. drug giant Pfizer announced its merger with Irish-headquartered Allergan, which, in the largest tax inversion to date, would give the merged company a situs in Ireland.
Inversion transactions usually involve the transfer of stock of a corporation by one or more shareholders to a wholly owned or controlled foreign subsidiary of that corporation in exchange for newly issued shares of the subsidiary's stock. Internal Revenue Code § 7874 (rules relating to expatriated entities and their foreign parents) contains the tax rules related to inversions.
Apple Inc., based in Cupertino, California, has gone well beyond the standard tax inversion maneuver. According to a study by Citizens for Tax Justice and the U.S. Public Interest Research Group Education Fund, Apple holds $181 billion in profit offshore that has escaped U.S. income tax. A May 20, 2013 report issued by the Senate Homeland Security Permanent Subcommittee on Investigations concluded that Apple's tax arrangements have nothing to do with the U.S. location of all the intellectual property that supports Apple's products. Non-U.S. sales account for 60% of Apple's profits, and these profits are routed through Irish subsidiaries that Apple established four years after its founding and are not taxed by any jurisdiction. The following discussion broadly outlines the rules that Apple, through its web of subsidiaries, takes advantage of to minimize its corporate income tax liability, eliminating U.S. corporate tax liability as long as foreign earnings are not repatriated.
One of Apple's Irish subsidiaries is an Irish holding company, which has no operations or employees but controls Apple's foreign operations and serves as a group finance company. Apple Inc., the U.S. parent of the whole group, pays no U.S. tax beyond the liability of the holding company on its investment income. Otherwise, the holding company, claiming no residence at any location, pays no tax in any jurisdiction.
Beneath the holding company is an Irish principal company, through which most of Apple's foreign sales income flows. The holding company, which claims to have no legal residence, holds the contracts with Apple's Chinese contract manufacturers and owns the inventory that they produce. The holding company has paid some taxes to Ireland but at a rate below the statutory rate (if Ireland were simply a tax haven, Apple's Irish affiliates would be paying taxes to Ireland on their income at the rate of 12.5%, but the lower rate is achieved through a special income calculation).
A key part of the scheme is that Ireland allows some companies to claim nonresident status if they are related to a company doing business in Ireland. This is due to a basic rule of Irish tax law that views the proper jurisdiction for the application of the Irish corporate income tax as the place where the company is managed and controlled.
In conjunction with those rules is the check-the-box rule of Treas. Reg. § 301.7701-3 ("Classification of certain business entities") by which a U.S. corporation can elect, by checking a box on the return, to have a foreign subsidiary treated as if it does not exist for purposes of U.S. corporate income tax liability. Apple has checked the box for all of its Irish subsidiaries. If neither the United States nor Ireland regards a particular corporation as a resident, neither jurisdiction imposes a corporate tax. Moreover, the United States-Ireland tax treaty does not address this situation.
Nevertheless, given that Apple's operations are managed in Cupertino, it may be that Apple's foreign income is subject to the U.S. corporate income tax as income effectively connected with a U.S. trade or business. However, Apple may be relying on a rule that exempts income from U.S. tax liability if it results from sales of inventory for foreign consumption if a foreign affiliate with a foreign office materially participated in the sales.
Apple's tax avoidance machinations may be catching up with it if the company's $350 million settlement with the Italian taxing authorities at the end of 2015 is any indication. The Italian investigation showed that Apple had moved approximately $1.1 billion in revenue from its Italian operations through one of its Irish subsidiaries, thereby avoiding Italy's higher tax rates. Also, Apple's arrangement with the Irish taxing authorities is now under investigation by the European Commission, the executive arm of the European Union. Apple's CEO, Tim Cook, has insisted in an interview with 60 Minutes' Charlie Rose and before a Congressional committee in regard to Apple's allegedly improper avoidance of a good deal of its worldwide tax liability that "[t]hat is total political crap. There's no truth behind it. Apple pays every tax dollar we owe." See Brian Solomon, On 60 Minutes, Apple's Tim Cook Calls Out 'Political Crap', Forbes: Tech (Dec. 21, 2015, 2:57 PM).