Apple's Tax Avoiding Bond Deal: Time To Change The Tax System

(Forbes) A number of people are getting a little het up about Apple AAPL +1.63%‘s recent bond deal. It is true that the whole driver of the deal is the way that the tax code operates. So perhaps it is time that the tax system were changed. Here’s Naked Capitalism fulminating on the subject:

As is par for the course, the financial media is telling a story about a major US company from the perspective of the investing classes, rather than the broader public.

The poster child is the New York Times’ Dealbook, in a story titled “To Satisfy Its Investors, Cash-Rich Apple Borrows Money.” It third paragraph reads:

Apple’s return to the debt markets raises a riddle: Why would a company with so much cash even bother to issue debt?

A full seven paragraphs later, the article gets around to the last, and arguably the most important reason:

By raising cheap debt for the shareholder payout, Apple also avoids a potentially big tax hit. About two-thirds of Apple’s cash — about $102 billion — sits overseas in lower-tax jurisdictions. If it returned some of that cash to the United States to reward its investors, it could have significant tax consequences for the company. In some ways, the bond issue is a response to that tax situation.

All of this is absolutely true. Indeed, I said very much the same myself yesterday on this very blog. I would also agree that such silliness requires that we at least think about changing the way that corporations are taxed. I’m sure I could get Naked Capitalism and other critics to go along with that.

I don’t think I could get them to go along with the changes I would propose though. Essentially, my solution would be to make profits earned outside the US by American companies tax free to those companies.

Here’s the basic backgrounder. A US company that makes a profit is charged the corporate income tax. This is currently 35% of profits. Yes, there are lots of allowances and so on but let us keep it simple. If that US company makes a profit overseas, outside the US, then it will pay tax wherever it has made the profit. It will also pay US tax (ie, the 35% minus whatever foreign profits taxes it has already paid) when it brings those profits back into the US. Again, there are complications, tax havens and all the rest, but let’s keep it simple.

So, what a lot of US companies have been doing is leaving their foreign profits out there in foreign. They don’t bring them back because they don’t want to pay that extra level of US taxation. However, if you want to get that money into the hands of your shareholders, either through dividends or stock buybacks, you must bring it into the US and thus must pay the US corporate income tax.

The end result of this is that there are vast amounts of money piling up on corporate balance sheets. All those foreign profits that they don’t want to pay that tax on. But this is also money which the shareholders cannot get either. It cannot be spent or invested in the US. Even though American companies, or at one remove, American shareholders, own that money it cannot come into the US economy.

The amount of money is large too. No one’s entirely sure, not exactly, how much there is but $1 trillion is not a bad estimate.

Various solutions are offered: why not just tax US companies even if they do leave their profits offshore? My answer to that one is that I’m really not sure at all why Uncle Sam should get a share of that money. I don’t see why the US should get a cut of something made in China being sold in, for example, Germany. But I do agree that this solution would work: the money would no longer pile up offshore.

Another idea being floated is that there should be a tax holiday on repatriation. This has been done before and a large amount of money did come back. Instead of charging the full 35%, why not charge 5% and see that cash flowing back into the US? The usual complaint about this is that the money that did come back wasn’t invested: it was paid out again to shareholders in dividends and buybacks. To which my response is yes, this is what we want to happen (see below).

Which brings me to the two useful alterations to the tax code that I would suggest. The first would be to clear up the basic US method of taxing corporate profits. In most countries dividends are taxed either at the corporate level or at the recipient level. A company makes a profit, pays tax, then the dividends are tax free (or at least, free of basic rate tax) to the recipients. Or, alternatively, the company does not pay corporate taxation on the money that is paid out as dividends: but the recipients pay full income tax just as on any other income. The US is very odd indeed in that it taxes dividends at both stages: the corporate income tax is paid on all profits, before dividends, then income tax is charged again to the recipients.

Move MOVE -0.71% the US system to either of the alternatives, rather than one which does both, and the temptation for a company to keep money offshore will significantly decline.

The other alternative is to move to what is known as a territorial taxation system. US companies working in the US do indeed benefit from a lot of things that US taxes pay for. The roads, the education system, law and order and so on. So, it seems fair enough (I would at other times disagree with this but that’s for another time) that profits made in the US should pay US profit taxation. But profits made outside the US don’t benefit from all those things that US taxes pay for. Because they’re made outside the US, obviously. So why should those profits pay US taxation at all? The territorial part of the system is simply to say that US profits pay US taxes, not US profits do not pay US taxes.

It would almost be like treating US profits as C Corp profits (which is how all are treated currently, in the large companies) but foreign profits are more like S Corp ones.

This would entirely remove the temptation for a company to keep its foreign profits outside the US. As above, some will complain that, as with the earlier tax holiday, these repatriated profits will simply be paid out as dividends (or buybacks). But to my mind, this is exactly what we want to happen. The corporations themselves obviously don’t have anything useful to invest them in. That’s why they’re piling up. So we would actually like the money to flow back to investors. They can only do one of two things with it: either spend it (fiscal stimulus, Hurrah!) or reinvest it (higher investment, Hurrah!). And with the economy in its current state we really would rather like to have an additional $ trillion being pumped into the domestic economy.

Do note that this would actually be larger than Obama’s great stimulus. And it wouldn’t even have to be paid back in the future: for it isn’t borrowing. It’s simply moving money from where it’s dead, doing no good at all to the US economy, to where it is being deployed in the US economy and thus doing good.

Which detailed method is used doesn’t particularly bother me. But there is this simple solution to those offshore profits. Just stop taxing them at all.

Read article here.