The Apple Show Trial

Wednesday, May 29, 2013

The recent hearings convened by Senator Carl Levin of Michigan turned the spotlight on the complex tax transactions of Apple, Inc. Apple, Levin insists, “is exploiting an absurdity, one that we have not seen other corporations use. And the absurdity need not continue." John McCain joined Levin in denouncing Apple, making the attack bipartisan. The most explicit charge, which Apple disputes, is that “it avoided U.S. taxes on $44 billion in offshore, taxable income between 2009 and 2012.” It should be noted that Apple paid about $6 billion in U.S. corporate tax on its overall income.

In orchestrating these hearings, Senator Levin used a scathing report of the Senate’s Permanent Subcommittee on Investigations, which was carefully embargoed until the day before the Senate’s May 21, 2013 hearing about Apple. The report charges that “Apple has used a variety of offshore structures, arrangements, and transactions to shift billions of dollars in profits away from the United States and into Ireland, where Apple has negotiated a special corporate tax rate of less than two percent.” The primary allegation is that “U.S. citizens and multinational corporations have exploited and, at times, abused or violated U.S. tax statutes, regulations and accounting rules to shift profits and valuable assets offshore to avoid U.S. taxes.”

  Illustration by Barbara Kelley

The conscious decision to make Apple the focal point of this special investigation offers a bittersweet commentary on the fragile state of American political economy. There is little question that Apple has suffered mightily since the untimely death of Steve Jobs, a genuine American icon, in October 2011 at 56 years old. Jobs was of great value to Apple not only for his extraordinary entrepreneurial skills, but also for his towering reputation, which shielded Apple from political attack.

Since Jobs’ passing, Apple shares have plunged by about 34 percent from their high of over $700 per share in 2012, despite overall market growth of nearly 20 percent during 2013. Part of this loss is attributable no doubt to the general sense that Apple’s current CEO, Tim Cook, however well-regarded, is human, and thus no Steve Jobs. Cook lacks Jobs’ obsessive and supernatural power first to design and then to aggressively market new killer products.

Cook’s political vulnerability explains why Levin thought Cook and Apple’s tax practices were fair targets toward which to direct Washington’s concentrated outrage. Apple has made aggressive use of foreign subsidiaries, especially in Ireland, to shield Apple income from American corporate taxes. As a result, on domestic income, Apple faces a high combined federal and state corporate rate of over 39 percent. By keeping its income overseas, Apple, like many other major corporations, avoids the highest tax rates in the world—the capstone of what has evolved, in recent years, to the most progressive tax system in the world.

Yet, why hold these hearings now? It has nothing to do with Apple, whose tax plan is over 30 years old. It surely cannot be derided as some new-found gimmick that just came to the attention of an outraged federal government. Nor does Levin make any allegation that the steps taken by Apple are anything other than perfectly legal.

These hearings are a distraction from the main event, which are the ongoing hearings and revelations of the IRS scandal on exemptions offered to “civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare.” Here, the contrast could not be more stark. It was the IRS’s Lois Lerner who first announced her innocence in response to a planted question at a meeting of the American Bar Association, only to then plead the Fifth and—for the moment—to block further questioning just as she was put on administrative leave, with both full pay and benefits. Cook’s position was of course quite the opposite; he had no need to plead the Fifth, resign, or obfuscate. His overall message was simplicity itself: “We pay all the taxes we owe.”

Apple has not sat idly by in the face of external pressure, including that from Greenlight Capital’s David Einhorn. The company has authorized a 15 percent income dividend, and share repurchase plan, both financed by issuing $17 billion of long-term debt. No cash from Apple’s overseas subsidiaries was used to finance the dividend and buyout plan, lest the repatriation of foreign revenues trigger basic tax liability. All of these moves were of course driven by the heavy burden that current law places on tax repatriation.

The media’s attacks on Apple, while conceding that Apple has not violated any law, nevertheless follow the lead of the New York Times’ Floyd Norris, who takes Apple to task for the “corrosive” effect of encouraging other organizations and people to “cheat” on their taxes. At this point, however, it is critical to keep in mind the firm distinction between tax avoidance, on the one hand, and tax evasion, on the other.

The most famous articulation of this distinction comes from the late Learned Hand, an illustrious Court of Appeals judge for the Second Circuit, sitting in New York, who had this to say about the problem in his famous 1934 opinion in Helvering v. Gregory:

Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.

It is easy to think that Judge Hand was directing rich and poor alike to the royal road of tax evasion. But the key point to note about this decision is that he wrote this passage in a case that upheld a challenge by Guy Helvering, Franklin Roosevelt’s Commissioner of Internal Revenue, against a tax scheme concocted by one Evelyn Gregory. It is useful, even for non-lawyers, to see exactly what exercised Judge Hand in this case, and prompted a unanimous Supreme Court to affirm his decision one year later.

The current system of taxation imposes two taxes on corporations: a tax on corporate gains and then one on any dividends distributed. Mrs. Gregory personally owned all shares of the United Mortgage Company, the assets of which were, in part, 1000 shares of the Monitor Securities Corporation. An offer arose that allowed Gregory to achieve substantial gains on the sale of those Monitor shares.

If she just sold those shares, the corporation would have been taxed on the difference between the amount she received on the shares and the adjusted basis of the shares, usually equal to their cost. If she then wanted to distribute the cash from the corporation, she would have had to declare a dividend that would be taxed at ordinary gains rates. To see what is at stake, assume that the shares had a zero basis and that the capital gains rate was 20 percent. At that point, the sale of the Monitor shares for $100,000 would generate $20,000 in taxable income for the corporation. Any dividend distribution of the shares for a high-income taxpayer would attract at current rates a second tax of around 40 percent on the $80,000, for another $32,000 in tax. That would leave Gregory with $48,000 net.

To avoid that burden, Gregory’s tax lawyer concocted a scheme to turn this transaction into what is called a tax-free reorganization. Then as now, the Internal Revenue Code had complex provisions that allowed individuals to swap corporate shares for corporate shares without paying any tax, so long as there was some continuity of interest between investments in the old and new companies. One such device allowed individuals to transfer the assets of one company into a subsidiary, which is then “spun off” into a tax-free transaction.

Gregory complied with the literal terms of this provision by transferring her Monitor shares into the Averill Corporation, a wholly owned subsidiary, which it then spun off in what it claimed was a tax free transaction. Three days later, it liquidated the shares in a capital gains transaction. It then sold those shares to the third party. The use of the spin-off plus liquidation avoided the dividend tax on the transaction.

Both Judge Hand and the Supreme Court noted that the transaction met the literal test of a reorganization, but recharacterized the deal as a dividend because there was no business purpose of any sort for the creation of that independent entity, which never did conduct any business. This business purpose requirement has largely been codified into law today, which prevents taxpayers from using spin offs as a “device” to avoid dividend taxation on corporate earnings and profits.

Gregory offers a useful benchmark against which to measure the claims of abuse lodged against Apple. Far from creating a corporate entity that lasts for three days and disappears into a cloud of smoke, Apple organized its permanent business to transfer wealth overseas. It negotiated a great deal with Ireland, bringing its business into that country in exchange for a lower tax rate. It would be strange indeed if the United States could impose some countervailing tax on that same income. It would also be foolish beyond belief for the federal government to try to tax an American corporate transaction that takes place overseas. The last thing that anyone wants is for Apple to spin off into an independent foreign corporation.

And so we are left with a series of distracting hearings meant only to excoriate a profitable American company for making entirely legal, and totally rational, decisions. Those hearings may have been useful if they had addressed serious structural reform. For instance, one possibility for reform is to lower American tax rates, which would induce more businesses to keep operations in this country in the first place. A second, more radical, possibility is to consider shifting to a consumption tax, which would eliminate all the distortions of the current system by gutting the present two-tier corporate tax and allowing the tax-free return of capital from abroad for everyone.  But at this moment, the insatiable demands of the welfare state leave too many misguided champions of tax reform clamoring for more money to fill the federal coffers.