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When Apple CEO Tim Cook appeared in front of Carl Levin on Tuesday, I was hoping for an epic showdown, as presaged by Levin’s highly aggressive press release from Monday. I was sorely disappointed — although I did end up with a newfound admiration for Tim Cook’s ability to acquit himself with dignity and intelligence and integrity in the toughest of situations.

The Apple (AAPL) executives at the hearing spent most of their time politely listening to various senators pontificate about taxes. But every so often, in response to a rare direct question, they would try to explain why they didn’t think they were evading billions of dollars in taxes.

The Levin report is very long and dry, so let me oversimplify a little. Apple revenues basically end up in one of two places: California, for sales in the Americas; and Ireland, for sales everywhere else. Apple pays US taxes on the money, which ends up in California, but only pays US taxes on the interest on the money, which ends up in Ireland. Which isn’t very large.

A lot of the hearing was taken up, unhelpfully, with senators asking whether Apple pays taxes on the income from sales made in the US, and Apple saying yes. (Although, as Tim Fernholz points out, “between 2009 and 2011, the company told investors it was setting aside $13.7 billion to pay federal taxes—but it has actually paid only $5.3 billion.” The amount the government receives is significantly lower than we had all been given to believe from Apple’s SEC filings.)

The more interesting questions concern Ireland, the money flowing in there, and the degree to which those enormous sums of money constitute tax avoidance on a massive scale.

There are two parts to this question. The first is the sheer amount of money flowing into Apple Operations International (AOI), a company without tax jurisdiction and which hasn’t filed a tax return in five years. The Apple executives were unflustered about that fact: all of Apple’s various subsidiaries in Europe and Asia pay local tax on their profits. They could then just hold on to those profits themselves, if they wanted. But because it’s nice for Apple to be able to look after all of its money in a single place, the various subsidiaries send it all to Ireland to be invested. It has already been taxed at that point, and shouldn’t be taxed again.

This is more than a little disingenuous, because it seems that Apple is extremely good at ensuring that the “local subsidiary” in question, accounting for the overwhelming majority of the profits being fed into AOI, is ASI — another Irish company without tax jurisdiction. When Apple ships product from its factories in China to its stores in Singapore, the stores in Singapore don’t make much if any profit. That’s because somewhere in the South China Sea, ASI takes ownership of that product at a very low cost, before selling it on to Apple Singapore at much higher cost. The hardware never goes anywhere near Ireland, but title to the hardware changes hands, and substantially all of the profit associated with that hardware thereby ends up being taxed at friendly Irish rates, somewhere south of 2%, rather than at whatever the government of Singapore might charge. Here’s the Levin report:

Transferring title in this manner allowed Apple to retain most of its profits in Ireland, where it has negotiated a favorable tax rate and maintains entities claiming to have no tax residence in any country, and limit the income it reported in the non-tax haven countries where the company did most of its business. For example, in 2011, Apple reported $34 billion in income before taxes; however, just $150 million of those profits, a fraction of one percent, were recorded for Apple’s Japanese subsidiaries, even though Japan is one of Apple’s strongest foreign markets. ASI, meanwhile, reported $22 billion in 2011 net income. Those figures indicate that Apple’s Japanese profits were being shifted away from the United States to Ireland, where Apple had negotiated a minimal tax rate and maintained two non-tax resident corporations.

So we shouldn’t take Apple’s executives at face value when they say that all of the money in AOI has been taxed once already. That might technically be true, but only at extremely low rates.

What’s more, Apple actually does, under the spirit of the law, owe substantial US taxes on that income. The law in question is something called the foreign base company sales income rule — a regulation specifically designed to prevent companies from jurisdiction-shopping when it comes to taxes. Under US law, Apple has to pay US tax on the income that ASI receives on things like the profits from all those Singaporean gadgets. But Apple uses something called the “check-the-box loophole” to make ASI “disregarded” by the IRS. Instead, the IRS looks only at the parent company, AOI, which, being merely a holding company, does not have any foreign base company sales. According to the Levin report, this clever two-step — first putting the income into ASI, and then disregarding that income using the check-the-box loophole — “allowed Apple to avoid paying taxes on nearly $44 billion in income from 2009-2012.″

The second part of the question is even more important, and surrounds something called a Cost Sharing Agreement, which Apple has signed along with its Irish subsidiary, ASI. Under that agreement, ASI pays 60% of Apple’s R&D costs, and in return gets to keep 60% of the income from Apple’s intellectual property. This agreement, Apple executives repeatedly said, was signed “at arm’s length,” with the 60/40 ratio representing the respective proportions of Apple’s sales split: Europe and Asia account for 60% of Apple’s sales, with the Americas accounting for 40%.

But the fact is, as Levin hammered home at the end of the hearing, that Apple’s intellectual property is its crown jewel; that the amount it spends on R&D is in no way reliant on the fact that it’s getting some of that money from Ireland; and that in no conceivable universe would Apple ever sell off 60% of the rights to its intellectual property in return for a promise to pay 60% of present and future R&D costs. Not in a genuine transaction with a non-Apple counterparty, anyway. As Levin said, “95% of the creativity that goes into that product is in California. But two thirds of the profits are in Ireland.”

Apple receives enormous benefits from being based in California — Cook was entirely genuine when he said that it simply never occurred to him that the company might ever be headquartered anywhere else. And yet Apple has decided, in its wisdom, that 60% of the fruits of its Silicon Valley creativity should end up in a corporate shell in Ireland, never to be taxed by the US Treasury. This system has been in place for many years — since long before the Macintosh was invented — but that doesn’t make it any less of an obvious tax dodge. Apple Inc. gets to claim the entirety of its global income for its shareholders, but less than half of it is ever taxed in the US. If an American company makes billions of dollars from its creativity and its enviable geographical location, it’s reasonable that the US authorities should be able to tax those profits, rather than helplessly watching them accumulate offshore.

Here’s the Levin report, again:

Despite the fact that ASI conducts only de minimis research and development activity, the cost sharing agreement gives ASI the rights to the “entrepreneurial investment” profits that result from owning the intellectual property. According to Apple, over the four- year period, 2009 to 2012, ASI made cost-sharing payments to Apple Inc. of approximately $5 billion. ASI’s resulting income over those same 3 years was $74 billion, a ratio of more than 15 to one, when comparing its income to its costs… the cost-sharing arrangement for Apple Inc. makes little economic sense without the tax effects of directing $74 billion in worldwide sales revenue away from the United States to Ireland, where it undergoes minimal – or perhaps – no taxation due to ASI’s alleged non-tax resident status.

That’s no arm’s-length agreement, that’s a tax dodge — and a pretty blatant one at that. That’s why I’m astonished that Cook emerged from this hearing so unscathed: the facts were against him, but somehow none of the senators — not even Carl Levin — really managed to put him on the spot. It’s almost as though he had some kind of reality distortion field around him.

Source: Tim Cook's Improbable Victory In Washington