Apple's Tax Strategy Is Tax Avoidance And It Is Necessary

| About: Apple Inc. (AAPL)

Summary

Apple's size and success raises its tax profile, but its strategies are the norm.

Tax strategy increases profits and reduces cost of capital.

Apple's tax planning strategy is necessary to maintain its competitive advantage.

Lost among the rancor and recriminations of the recent EU tax ruling for Apple (NASDAQ:AAPL) to pay EUR 13B in back taxes is he fact that tax liability, like any line of a company's profit and loss statement, should be and must be managed (and whenever possible, reduced) to maximize profitability.

Reducing Taxes is a Necessity

For shareholders, profits are paramount, because healthy and successful companies must invest long-term to maintain and improve their competitiveness. Most of these long-term investments are called capital expenditures ("CapEx"), and we want our management teams to invest whenever they can and as much as they can if and when the CapEx is expected to generate a high return on investment. How profitable a company is will directly drive their cost of capital, and that cost of capital affects their subsequent ability to invest in CapEx.

Click to enlarge

Reducing a company's tax liability has the following results:

  • Increases profitability.
  • Decreases cost of capital. Higher profitability means companies can issue fewer shares or borrow less to fund future investments. And even when they do, higher profitability equates with higher stock prices (reduces shares issued) or higher credit rating (reduces interest rate and interest paid).
  • Increases investment in capital expenditures (e.g., spending more on research, hiring better-qualified employees, deploying more resources).
  • Increases a company's chance to succeed.

The truth is in today's globally competitive marketplace, any corporate officer who fails to utilize a tax planning strategy to minimize taxes is negligent, because it places the company at an extreme disadvantage.

Let's take a simple example: In a competitive industry with a 30% net margin, if your tax rate is 30% and your competitor's is 25%, your profits every year are thereby 7% less.

Tax Rate

30%

25%

Revenue

$100.00

$100.00

COGS

$30.00

$30.00

Gross Profit

$70.00

$70.00

G&A

$10.00

$10.00

PSM

$20.00

$20.00

R&D

$10.00

$10.00

Operating Profit

$30.00

$30.00

Tax

$9.00

$7.50

Net Income

$21.00

$22.50

Difference in Profit

7%

Click to enlarge

This 7% isn't just for one year, it's every year. Over a decade, our competitors will have the ability to reinvest twice the amount of profits as our company, just from this difference. Since our competitors will likely reinvest this difference in high-return projects, this 7% will then compound itself, and over a few years, failing to minimize taxes will degrade our company's competitiveness, an erosion that will continue to compound quickly over time.

Taking the Risk = Taking the Profit

This is the illustration the E.U. used to show the incredibly low tax rate paid by Apple Sales International.

(click to enlarge) Click to enlargeSource: European Union.

What's not mentioned in this illustration is that today's low tax rate (0.005%) and tax savings have been borne by years of lost deductions. As the owner of the intellectual property ("IP"), Apple Sales International (and its chain of subsidiaries) has historically funded the R&D expenses to develop the IP. Losing out on the tax deductions these R&D expenses would have been afforded in the E.U. no doubt increased Apple's overall cash tax rate for years, and likely continues to do so. As Apple continues to fund future IP development offshore, it continues to experience this effective increase in taxes via lost deductions.

It is only because of the incredible success of Apple's products that allows Apple's offshore entities to earn the profits today. But something, some entity, had to pay to develop that IP, and like a developer, this entity now receives the income commensurate with the amount it spent and the risks it took. Of course no mention is made of the failed R&D, failed projects, and failed investments made by the Apple offshore entity that took the risk. If Apple's offshore entity had utterly failed in its projects, would the EU have ruled today to allow a deduction for the failed expenditures? We doubt it.

Apple isn't Alone

Apple is not alone in using a sophisticated tax planning strategy to reduce its taxes. Many U.S.-based multinational corporations employ takes structures somewhat akin to Apple's, and at best, using such a structure only places US companies closer to parity when compared to their non-U.S.-based multinational competitors.

For U.S. companies, there are three types of taxes to worry about: U.S. taxation, foreign taxation, and taxation on the movement of money. Here, we'll address only the first two, as they are most relevant to this discussion.

U.S. Taxation

Apple's tax structure is first a byproduct of the way the US tax system works. As the US taxes on a worldwide basis, US companies are subject to taxation on their worldwide income. The US, however, allows companies to defer their non-US earnings so long as certain "active" business activities (e.g., manufacturing) are conducted overseas. If, however, companies are engaged in generating "passive" income, anti-deferral rules (referred to as "Subpart F") immediately deem the deferred offshore income a dividend back to the US, and the US taxes that income in the current year.

Apple's Irish structure helps it achieve deferral. This deferral isn't a loophole or a luxury; it's allowed under the tax rules, and it's a necessity when US companies are competing against foreign-based multinationals that are only taxed on the income earned in their home countries. If a US company earns 50% of its income outside the US and is taxed on 100% of its worldwide income, that places the company at a severe disadvantage against foreign competitors that are taxed only on 50% of their income. Once again, paying higher taxes than your competitors results in long-term competitive disadvantages.

In addition, deferral (as its name implies) is temporary. Eventually something or someone will need the cash that's now trapped overseas. Whether it's the new offices you're building in the US, or your shareholders asking for a larger dividend, at some point there's pressure to repatriate the earnings, and at that point, the repatriation (in the form of a dividend) is fully taxed by the US.

In Apple's case, it has opted to take on debt to fund such investments rather that repatriate the funds This activity is simply a by-product of how the current tax system distorts the flow of money.

Lastly, even if you successfully defer the income from US taxation, there are the non-US taxes to contend with.

Foreign Taxation

Once you've deferred the income from US taxation, as a corporation you need to also protect the income from local taxation. For example, if the income is now held in an Irish company, how do you prevent Ireland from also taxing it? Enter non-resident Irish companies, Bermuda IP holding companies, etc. This is where tax planning goes one step further to take advantage of the asymmetric tax rules and regulations inherent in global taxation. Many of these rules were put in place by jurisdictions that prioritize jobs (i.e., Ireland) or legal/government fees (e.g., Cayman Island) over the actual tax receipts from corporate income.

As such, they effectively created a set of rules that invite corporations to establish (or not) residency in their countries in exchange for something other than corporate income tax proceeds. Apple and many other multinationals then use a bevy of economic-based transfer pricing and legal concepts to push and pull activities, risks, and, in turn, profits, to various subsidiaries worldwide to fit under these rules. Again: Illegal? No. Necessary? Yes.

At the end of the day, for Apple, Google (GOOG, GOOGL), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), and many others, none of these strategies constitutes tax evasion. Tax evasion is illegal. Tax avoidance, however, is not. It's legal, and it's necessary, given the complicated and problematic worldwide tax system we're dealing with today. No doubt tax reform should be a priority for the US and for the OECD. But until then, tax planning is smart business planning.

Business is pure competition, and if a US multinational company doesn't try to structure a level playing field from a taxation perspective, it's not simply squandering an opportunity, it's handicapping and endangering its own long-term health as a viable enterprise.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.