In a confrontation that made headlines in May, the Senate Permanent Subcommittee on Investigations released a report claiming that Cupertino, California-based tech giant Apple has been using a “complex web of offshore entities” to avoid paying US taxes on $44 billion in “otherwise taxable offshore income over the past four years.” According to the report, Apple set up at least three foreign subsidiaries that are “not tax resident in any nation” in order to avoid paying the taxes.
Among numerous statements in its own defense, Apple said that it was likely the largest corporate income taxpayer in the US; that it has created or supported about 600,000 jobs at home; and that it has substantial foreign cash because it sells most of its products outside the US. Echoing such views, Apple’s supporters have argued that the firm’s corporate tax strategy involves nothing illegal or improper, and that it is only playing by the same rules as other global high-tech giants such as Google and Microsoft.
What are the mechanisms that companies like Apple use in order to minimize their taxes without breaking any US laws? Why does the US maintain such a tax system, and what are its economic consequences? Should the system be fixed — and if so, how?
“The whole debate only exists because the US, in theory, has a ‘residential’ tax system instead of a ‘territorial’ system like many European countries,” says Kent Smetters, Wharton professor of business economics and public policy. “Under a territorial system, a tax is paid to a country for economic activity happening in that country, regardless of citizenship. Under our residential system, the US taxpayer (firm or individual) is supposed to pay the US tax rate, less any taxes already paid to another country that has a territorial system, regardless of where the income is earned. There are valid arguments for both types of tax systems, although the lack of international parity is always a concern.” While US companies are liable for taxes on their overseas income, the system allows them to defer their US taxes on foreign income until those funds are repatriated to the United States.
“Double Irish with a Dutch Sandwich”
In practice, there are “big holes” in this system, notes University of Pennsylvania Law School Professor Chris William Sanchirico. Tax havens — often small island countries — use the system to attract US businesses to their territory, and they tax companies at a low rate that is appealing to multinationals, he says. US companies can set up a subsidiary that sells their products to non-US markets without developing sufficient legal connection to those countries to trigger their tax systems. Thus, Apple’s subsidiaries can sell in Europe and Asia without paying European or Asian taxes on income from such sales.
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