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posted on 31 August 2016

There Is A Simple Solution To Problems Like The 14.5 Billion Issue With Ireland And Apple

by Elliott Morss, Morss Global Finance

The Problem

Let's keep it simple - no need to get into the details to understand what this and other international corporate income tax disputes are all about.

Apple's CEO Tim Cook said:

"A company's profits should be taxed in the country where the value is created."

He is right. And that is the rub. Lawyers will argue. But it is not really possible to locate where value is added if a company produces in one location and sells in another. Why? Because you need both production and sales for value/profits to be generated.

This is not a new problem. States in the US have been dealing with it for many years. 44 US states have corporate income taxes. When a good is produced in North Carolina (corporate tax rate - 4%) and sold in Iowa (corporate tax rate - 12%), what should happen? What is the corporate tax base for each state?

Back in the 'sixties, I took a summer job working for the Special Subcommittee of State Taxation of Interstate Commerce of the US House Judiciary Committee. My Ph.D. dissertation ended up being "A Study of How Corporate Income Should Be Apportioned for Taxation by States." Efforts by US states to tax corporate profits face the same problems nations face when trying to tax the profits of global companies. Many corporations do business in all 50 US states, so there is an issue as to how their profits should be divided among states for taxation. The Subcommittee tried to get states to adopt a uniform formula to allocate profits among states. If they had succeeded, all corporate profits would have at least been taxable in one or another state.

The Subcommittee favored a three-factor formula: the average of the shares of a corporation's payrolls, property, and sales within the state. If P = Payrolls, A = Property, and S = Sales with subscripts S and T designating state and total, a state's share of a company's tax base would be (Ps/Pt + As/At + Ss/St)/3. Does it sound simple? It is not. Definitions for payrolls and property located in a state can be worked out. But the sales factor is a very different story. When I did my dissertation in 1961, the sales factor definitions being used by states included:

"origin (manufactured in state)", "destination (shipped into state)", "sales activities", "sales office", "receiving office", "acceptance office", "location of goods", and "shipments from warehouse(s) within the state".

Efforts were made to get states to sign a compact to use this formula. And at least early on, there was some success. I quote from the CCH State Tax Handbook (2013): "At one time, most states utilized the evenly weighted three-factor apportionment formula promulgated under the Uniform Division of Income for Tax Purposes Act (UDITPA), which consists of property, payroll, and sales (or receipts) factors."

But hopes for uniformity are waning: The reality: it is not just companies working to minimize taxes paid. Governments are also manipulating definitions in hopes of getting to tax a larger share of corporate profits. I quote again from the CCH Handbook:

"...the number of states that still weight each factor equally is decreasing. Many states have an apportionment formula with a double-weighted sales factor. In addition, the number of states that have adopted a one-factor sales formula is growing."

The International Setting

In a recent New York Times article, David Leonhardt said:

"In Singapore, Coca-Cola recently opened a plant with the capacity to produce the underlying ingredient for 18 billion cans of soda a year. In Cork, Ireland, PepsiCo has located its 'worldwide concentrate headquarters,' which until 2007 had been in New York. More than half of all PepsiCo soda sold around the world starts, as concentrate, in Ireland."

Why is this so troubling? If Coke and Pepsi choose to produce the high value ingredient of their products in these countries, should these countries not have the right to tax the corporate profits of these companies? Let me ask this differently: if not the share of a company's production in a country, how should corporate profits of a company be allocated among nations for taxation? Headquarters? Location of a company's think tanks? Or what?

So the international setting is no different - without any agreement among countries on where profits are generated, tax lawyers will have a ball!

Country Postures

Like most, the Apple's Irish case is complex. I quote from a Reuters piece: "Apple licenses the rights to technology designed in the United States to Irish subsidiaries. These then hire contract manufacturers to make devices which they sell to Apple retail subsidiaries around Europe and Asia. Since the manufacturing cost is a small portion of device sales prices and retail subsidiaries are allocated a small operating margin, Apple Ireland is very profitable. In 2011, it earned $22 billion after paying $2 billion to its U.S. parent in relation to the rights to Apple intellectual property. However, the Irish tax authority agreed that only €50 million of this was taxable in Ireland. Under the terms of Apple's tax deal, first agreed in 1991 and renewed in 2007, Apple could allocate most of the profits earned by its Irish operating units to a 'head office' that did not have any employees or own any premises.

The European Commission disagreed. It said:

"...this agreement had no basis in tax law and was not available to others, and so represented state aid.

What is US law as applied to Apple? It completely dodges the question of where profits are actually generated. It simply says Apple's Irish profits are taxable if brought back to the United States - something the company would have to do if it wanted to use the money to pay dividends. But taxes paid in Europe reduce the US tax liability.

The reality: international corporate tax laws are a jungle that nations (and their tax lawyers) will continue to make sui generis claims.

A Very Modest Proposal

Trying to decide how corporate income should be allocated among nations as a tax base is just as problematic as in the US case with states. Since there is no allocation method nations can agree on, over and under taxation of corporate income will continue. And we can expect:

  • Nations will take steps to increase their share of the corporate tax base, and

  • Corporations will go on hiring teams of lawyers to minimize their corporate tax liabilities.

Personal income taxes are justified on equity grounds: that is, a person's income reflects ability to pay. The same equity argument does not hold for corporations.

However, if there is a global consensus that corporate income should be taxed, I recommend a single global corporate tax to be collected by some international organization - maybe the International Monetary Fund. The proceeds could then be distributed back to countries in accordance with their GDP shares. The tax could be made "progressive vis-à-vis countries if the allocation formula included a factor that resulted in countries with lower per capita incomes getting larger shares.

How much could be collected? According to the US Bureau of Economic Analysis, US corporate profits in 2011 were $1.9 trillion. The US share of global GDP is 22%. US corporate profits as a share of GDP is probably higher than for the world, so let's assume global corporate profits are 8% of global GDP, or $6 trillion. That would mean a 20% corporate profits tax would generate $1.2 trillion annually. The cost savings to corporations and governments no longer trying to minimize/maximize taxes would be large.

What is the likelihood that an international compact will be agreed to soon?

Don't hold your breath.

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