Apple Inc.'s success at avoiding billions of dollars in U.S. taxes through some (apparently) legal maneuvers has tax pundits pointing their guns at the corporate tax system. The case has revived numerous hoary cures for the supposed evil of corporate taxes.
The cures include abolishing the corporate tax altogether, turning it into a pure "territorial" system that taxes multinational firms only in proportion to the income generated within the United States, declaring a tax "holiday" allowing businesses to repatriate cash parked overseas (where it is taxed at vanishingly small rates, like Apple's) at a one-time-only discount.
Those are all fantasies. The countervailing realities are these: There are numerous good reasons to have a corporate tax, a territorial system would only encourage more Apple-style shenanigans, and a tax holiday would be an unjustified and ineffective giveaway to undeserving firms.
Let's start with the Apple case. As outlined by the Senate Subcommittee on Investigations, Apple avoided U.S. taxes substantially by such devices as vesting a healthy portion of its intellectual property rights in an Ireland-based affiliate, Apple Operations Inc., which claimed to account for 30% of the company's total net profits.
AO managed to avoid paying tax to any country on those profits by exploiting the cracks between Ireland and U.S. tax rules: Ireland bases tax residency on whether a firm's management and control resides in Ireland, and the U.S. bases residency on where a company is formed. AO was formed in Ireland, so Apple claims it isn't subject to U.S. tax; but its management and control are in the U.S., so Apple claims it isn't subject to Ireland tax. Get the joke? According to testimony before the committee, this maneuver and others saved Apple $7.7 billion in U.S. taxes in 2011 alone.
Apple has parked $102 billion of assets and profits offshore to take advantage of tax loopholes, the committee says; this wealth isn't subject to U.S. tax until it's repatriated to these shores, which could technically be never. A misconception about this stunt needs to be disposed of upfront, however. Although some corporate tax critics say this shows how U.S. tax law prevents a company from repatriating its earnings for the good of the U.S. economy, the money is not truly offshore. It rests in accounts at U.S. banks and investment entities, including Apple's Nevada-based investment fund, Braeburn Holdings, so it actually is deployed widely in the U.S. economy. It's just withheld from the tax authorities.
Moreover, as is pointed out by USC tax expert Edward Kleinbard, a former chief of staff of Congress's Joint Committee on Taxation, Apple effectively is repatriating $16 billion of this hoard tax-free. It is doing so by borrowing that sum to pay for a stock buyback and taking a write-off from U.S. taxes for the interest on the borrowing. In other words, the company will balance the interest income on its overseas billions with an interest write-off in the U.S., and will distribute it to shareholders via the buyback.
Apple is not alone in its chicanery. Estimates of what Kleinbard terms "stateless income" earned by U.S. multinational corporations but untaxed run as high as $1.7 trillion. This has allowed U.S. companies to reduce their effective federal tax rate from the statutory 35% to an average of about 29%, although some big companies have gotten down to single digits or even zero. Apple's effective tax rate in 2011, the Senate committee says, may have been as low as 7%.
Unsurprisingly, about 40% of the profits of U.S. multinationals are reported in such countries as Bermuda, Ireland, Luxembourg and Switzerland, where taxes are minuscule or nonexistent for foreign firms, according to the Congressional Research Service. The phenomenon supposedly bolsters a common rationale you'll hear for abolishing the corporate income tax, which is that it distorts corporate decision-making. Firms spend billions cooking up tax-avoidance strategies, and spend billions more by making otherwise inefficient investments largely for tax reasons. Shed corporate managements of this burden, the argument goes, and they'll be free to deploy their capital sensibly, investing in America and creating jobs in the same atmosphere of cheery amity you'll find (so I'm told) in the world of My Little Pony.
This argument is popular among economists. What it leaves out is that government in the real world requires revenue. Since all taxation imposes economic distortion in one way or another, the question boils down to how to do that in a fair, sensible and efficient way. Having a corporate income tax probably meets those requirements better than not having one.
To begin with, the corporate tax equalizes the tax treatment of all business income. Roughly half of all business income is now earned by non-corporate entities — mostly S-corporations and partnerships — that pass tax liability through to their owners, who pay it on their personal 1040s. Exempting the earnings of big public corporations from taxation would give their shareholders an unfair benefit.
Some argue that the answer is to shift the corporate tax onto the owners of big companies, meaning the shareholders, by raising tax rates on capital gains and dividends, which is how corporate profits typically are distributed. There are a few problems with that. For one thing, replacing the roughly $280 billion in revenue brought in by the corporate income tax (the figure is from 2012) would require tripling or even quadrupling the tax rate on dividends and capital gains. As anybody possessing even a passing familiarity with U.S. politics knows, on the gonna-happen scale that's an ain't.
Adding to the difficulty, Kleinbard notes, the capital gains tax is the only voluntary tax we have — it can be avoided for a lifetime through the expedient of not selling shares; while you live you can borrow against the capital, and when you die the liability is extinguished for your heirs. The revenue return from a sharply hiked tax on capital gains would plummet.
So what should we do about loophole jockeys like Apple? The easiest remedy is to abolish the overseas income loophole: impose a single rate on all income earned by U.S. multinationals, with a credit for taxes paid to foreign countries. That would allow Congress to bring the statutory U.S. corporate tax rate down from the current 35% to about 25% to 28%, close to the effective corporate tax rate in other big industrial countries.
Some tax experts say that closing the foreign asset loophole would simply provoke U.S. companies to reincorporate overseas. That's a lot harder than it sounds, however. Congress effectively closed that loophole in 2004 after a surge in foreign reincorporations by companies such as Seagate and Tyco. The new rules made the transactions so expensive for public companies and their shareholders that there hasn't been an attempt by a major company since then. If closing the foreign-asset loophole were to inspire more to try, you can bet that the inversion rules would be tightened further.
No one doubts that the corporate tax system can be improved by making it fairer and more standardized. But in economic terms there's nothing uniquely burdensome about it. On the contrary, it may be the most efficient way of ensuring that business profits do their part in funding the government that protects their owners' interests. Don't buy into the argument that corporations should be exempt; what they don't pay, you will.
Michael Hiltzik's column appears Sundays and Wednesdays. Reach him at email@example.com, read past columns at latimes.com/hiltzik, check out facebook.com/hiltzik and follow @latimeshiltzik on Twitter.