Major tech companies exploit differences between taxation policies in different nations in order to pay as few taxes as possible.
Apple isn't the only one. In fact their competitor Microsoft has a massive system by which to avoid taxation, detailed in another Senate report from last September.
American companies keep sixty percent of their cash overseas and untaxed, some $1.7 trillion, according to a U.S. Senate HSGAC Permanent Subcommittee on Investigations released in September 2012.
That report used Microsoft as a case study for the leaps and bounds that U.S. corporations go through to minimize their tax exposure, and illustrate the current flaws with the international corporate tax regime.
The Senate investigation found that Microsoft reduced its 2011 federal tax bill by a whopping $2.43 billion — or 44 percent — by using a wide, international network of controlled foreign corporations and the exploitation of various loopholes in the U.S. corporate tax code.
According to Microsoft, the company paid $3.11 billion in federal taxes in 2011.
According to the full Senate report , Microsoft Corp does 85 percent of its research and development in the United States. Of its 94,000 employees, 36,000 are in product R&D. The company had reported income of $23.2 billion, but with a federal tax liability of $3.11 billion only paid an effective federal tax rate of 13.4 percent. That's much lower than the top statutory rate of 35 percent for corporations.
The way the group accomplished this is through a wide variety of foreign groups in tax havens like Ireland, Puerto Rico and Singapore, and by exploiting a recently updated tax loophole.
In fairness to Microsoft, they're doing what nearly every other major technology company does. A Microsoft representative commented on the fiduciary responsibility to shareholders to maximize value.
The company accomplished this by selling the intellectual property rights for its retail businesses to different controlled companies in tax havens.
The report found that Microsoft has three main revenue sources resulting from its intellectual property. The first is retail software which is comprised of the sale of products to consumers, retailers, and enterprise licenses to governments and businesses. The second is web products like Microsoft Bing and Xbox Live. The third is licensing to computer manufacturers who pre-install Microsoft on the products they sell.
In the 1990s, Microsoft established three regional retail operating centers in Ireland, Puerto Rico and Singapore. These offices regionally oversee the first revenue stream, retail sales. The Ireland office oversees all retail operations in Europe, the Middle East, and Africa. Singapore oversees all operations in Asia, and Puerto Rico oversees all operations in North America.
These three retail operation centers — plus Microsoft U.S. — all buy in to R&D cost sharing pool, which in turn gives them the right to sell Microsoft products in their respective zones. Each sector pays a percentage of the $9.1 billion Research & Development budget equivalent to their percentage of retail sales.
The Ireland office pays approximately 30 percent, Puerto Rico pays 25 percent, Singapore pays 10 percent and Microsoft U.S. — which oversees the third revenue stream, bulk sales to computer manufacturers like Dell and HP — pays 35 percent.
In exchange, Microsoft Ireland, Singapore and Puerto Rico get the right to sell the retail products in their corner of the world and Microsoft U.S. gets the right to sell licenses to manufacturers.
The foreign offices are actually comprised of multiple different, interconnected companies. The exploitation of the tax code is made possible by a complex arrangement between these companies.
These are the major controlled foreign corporations involved in the scheme:Puerto Rico
Microsoft Operations Puerto Rico (MOPR) is the company that pays for the right to sell Microsoft products in the Americas. MOPR makes digital and physical copies of Microsoft software and sells it throughout the United States and the rest of the Americas through different regional distributors.
When an American buys a copy of Microsoft Office in a Best Buy in Manhattan, that was produced in and shipped from Puerto Rico.
MOPR is owned by a Bermuda-based entity, MACS Holdings, which in turn is owned by Round Island One, a fully owned Microsoft subsidiary that is based in Bermuda but operates in Ireland.
To review: An American buys a copy of Microsoft Office at Best Buy in Manhattan. Best Buy bought that copy of Office from a Microsoft distributor. The regional distributor bought that copy of Office from Microsoft Operations Puerto Rico. Microsoft Operations Puerto Rico is owned by MACS Holdings, which itself is owned by Round Island One, which itself is owned by Microsoft Corp.
The reason for that convoluted supply chain — the reason why that copy of Office wasn't just shipped from Microsoft Corp in Redmond, Washington to Manhattan — is that 47 percent of the profits from that sale go to Puerto Rico, untaxed by the U.S. federal government.
Those profits were taxed by Puerto Rico at an effective rate of 1.02 percent in 2011, a massive savings from the U.S. corporate tax rate of 35 percent. Over three years, Microsoft saved $4.5 billion in taxes on goods sold in the U.S. alone. The company saved $4 million per day by routing domestic operations through Puerto Rico.Ireland
Microsoft Ireland Research (MIR) is the entity that buys into the R&D cost sharing agreement in exchange for the right to sell Microsoft in Europe, the Middle East and Africa.
MIR doesn't actually create or sell any products to any customers. Instead, MIR immediately licenses the Microsoft intellectual property rights to Microsoft Ireland Operations Limited (MIOL) — a wholly owned subsidiary — for $9 billion.
MIR and MIOL are fully owned by Round Island One — the Bermuda company that operates in Ireland and also owns MACS Holdings.
MIOL manufactures copies of Microsoft products and sells them to 120 distributors in Europe, the Middle East and Africa. MIOL has 650 employees and MIR has 350 employees in Ireland, where they have an effective tax rate of 7.3 percent and 7.2 percent, respectively. MIR reported profits of $4.3 billion in 2011 and MIOL reported profits of $2.2 billion. Microsoft did not pay any U.S. tax on any revenues made by the Irish groups.
No U.S. tax was paid on the $9 billion license payment from MIOL to MIR.Singapore
In Singapore, Microsoft Asia Island Limited (MAIL) is the group that pays into the cost sharing agreement. MAIL is actually located in Bermuda and has no employees.
MAIL paid $1.2 billion to Microsoft Corporation for retail sales in Asia. MAIL licenses its rights directly to Microsoft Operations Pte. Ltd (MOPL) for $3 billion. Again, no taxes are paid on this amount. MOPL duplicates the Microsoft software and sells them to distribution entities around Asia.
MAIL and MOPL are both wholly owned subsidiaries of Microsoft Singapore Holdings Pte. Ltd, which is itself a wholly owned controlled foreign subsidiary of Microsoft U.S.
MAIL had no employees but $1.8 billion in earnings. MAIL paid an effective tax rate of 0.3 percent. MOPL had $4.8 billion in revenues from the sale of Microsoft products, with a profit of $592 million and an effective tax rate of 10.6%. MOPL has 687 employees.The Law
Both the Ireland and Singapore arrangements are designed to subvert U.S. taxes entirely. Despite the fact that Microsoft can report these profits to investors — since every single company is technically a subsidiary of Microsoft — they don't need to report these revenues to the IRS because of the way that Ireland describes its relationships to these companies.
Typically, any passive income — such as the licensing arrangements for intellectual property —paid from one separate legal entity to another separate legal entity was immediately taxable, even if both entities are within the same legal structure.
Because of a loophole in the tax law, Microsoft and other companies are able to have the lowest-tiered controlled foreign corporation disregarded and ignored for federal income tax purposes. Essentially, even though MOIL is a separate entity from MIR and all transactions between the two should be taxed, because of the "check the box" loophole MOIL and MIR are not considered separate entities in the eyes of the IRS so there is no tax.
A representative from Microsoft explained that the complex structure was a response to the complex tax code. " Microsoft has a complex business and we must comply with the complicated tax code of the United States, resulting in an exceedingly complex tax structure."
Microsoft has to compete globally. For the company, it makes sense to make the best use of that international presence to mitigate their tax liability. "One of the business imperatives faced by Microsoft and many US-based businesses today is that we must operate in foreign markets in order to compete and succeed as a company," the company said. "Foreign revenue growth helps support the growth of our U.S. operations, creating additional U.S. jobs and supporting an economic ripple effect that leads to greater growth in local communities.
The company is one of many firms urging corporate tax reform. "We’ve advocated for reforms to simplify the US tax code and make it more competitive with the rest of the world," the representative said. Microsoft abides by the law every step of the way, and when it comes to expenses Microsoft has a fiduciary responsibility to shareholders to minimize spending.
Microsoft also holds the federal government responsible for establishing conditions where companies are forced to move operations to far-fetched islands in order to stay internationally competitive.
"US international tax rules are outdated and not competitive with the tax systems of our major trading partners," Microsoft said. "We believe the US should reform its tax rules to support the ability of worldwide American businesses to compete in global markets and invest in the US."
The details of those reforms, though, are crucial before moving forward. The Center on Budget and Policy Priorities report found that a shift to a territorial taxation system — which would not tax any annual income made in foreign countries, but would tax any and all repatriated income at a 35 percent rate — would only exacerbate current problems.
It would create even greater incentives for U.S. multinationals to book profits overseas, potentially reduce wages domestically, could drain revenues from corporate income tax and would risk higher taxes on American small businesses.
So despite the fact that both Microsoft and policymakers want to pursue a better system than the current tax regime, it's increasingly difficult to navigate a solution when literally billions of dollars hang in the balance.
Most importantly, Microsoft is far from the only company that has developed a complicated corporate structure to reduce their tax liability. Almost every major U.S. corporation does this , and there's no reason for the companies to stop.
It makes perfect business sense to maneuver the corporate structure to minimize taxes, and there is a compelling argument that current conditions are set up so that companies would be financially irresponsible not to do it. Until a better taxation solution emerges, it's the only way to do business.Read the full Senate report here Read more about the corporate income tax loopholes
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