At the risk of seeming immodest, I view myself as pretty knowledgeable on how businesses make money. After all, I earn a living explaining the mechanics of that process to readers, and pride myself in looking under the hood to understand how the gears and pistons connect to drive the engine. But with corporate tax reform looming as potentially the biggest boon to business in decades, I realized that I had a lot to learn about the way big corporations treat taxes.
Naturally, I knew that companies don’t actually pay anywhere near the official U.S. rate of 35%. And that multinationals get a big break by keeping offshore earnings abroad instead of sending the money stateside. But what do companies actually send the Treasury in cash? What do they expense now but reserve the right to pay later, in fact, any time they want? What foreign income can they exempt from all taxes? I kept hearing terms like “taxes paid,” “effective tax rate,” and “deferred tax liability” without understanding how they shaped reported earnings and cash flow, and swelled the $2.6 trillion-and-growing horde sitting in foreign subsidiaries.
I figured that if this reporter found corporate taxes baffling, so did lots of sophisticated Fortune readers. So I dug into the financials of Apple to grasp how the world’s most valuable publicly traded company accounts for taxes. Albert Meyer, a forensic accountant and former academic who runs investment firm Bastiat Capital, helped explain how and why Apple books or defers taxes on different categories of income, and which rates it applies to each category. With his help, I assembled a primer on taxation of multinationals, using Apple as a case study.
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Surprisingly, the plethora of confusing terms makes the taxation of multinationals look more complicated than it really is. Mastering the details is a wonkish exercise to be sure. But no exercise is more essential to understanding how multinationals react to a U.S. tax code that imposes rates far higher than those in competing nations, and creates an irresistible incentive to stash profits abroad, when that cash could earn bigger returns stateside. Indeed, examining Apple shows why sweeping tax reform is so important, not just because it would lower rates, but chiefly because it would free our tech, pharma, and auto titans to invest their worldwide capital wherever it earns the biggest returns.
So based on Apple’s financials for FY 2016 (ended in September), here’s a six-part guide to taxation for multinationals. It’s important to emphasize that Apple actually pays a lot of tax compared to other U.S.-based corporations with immense foreign earnings, and takes a highly conservative approach to tax accounting.
1. What was Apple’s tax “expense,” and what did it pay in cash?
For FY 2016, Apple booked total pre-tax earnings of $61.4 billion. On its income statement, Apple showed a “provision for taxes” of $15.685 billion. That number is an expense that’s deducted straight from pre-tax income of $61.4 billion to yield net income of $45.7 billion. Hence, its reported “effective tax rate” was 25.6% ($15.685 billion divided by $61.4 billion), well below the official 35%, but on the high side for multinationals, many of which are in the teens.
Apple, however, paid a lower number in cash. Apple’s 10K discloses that “cash paid for income taxes” was $10.444 billion for the year.
2. What explains the difference between Apple’s “effective” tax and what it paid in cash?
The $10.444 billion that Apple expended in cash consists mainly of payments to the Treasury on its $20.3 billion in U.S. pre-tax profits (one-third of the total). It also included a federal tax payment in the $1.2 billion range on the interest income generated by its accumulated cash that was earned and remains offshore, and another over $2 billion paid to foreign governments, numbers we’ll return to shortly. After R&D and production credits, as well as a deduction for state taxes, the iPhone maker paid, and paid in cash, a lot of tax on its U.S. profits. By Fortune‘s estimates, it sent the Treasury in the vicinity of $6.5 billion on its $20.3 billion in domestic earnings, equating to just a few points below the statutory rate of 35%. (It also paid $990 million to state governments, or $553 million after the credit for federal taxes.)
What about the extra $5.241 billion that’s part of its tax expense, and raises its effective rate to 25.6%? In extensive footnotes to its 10K, Apple shows that it “deferred” a total of $5.241 billion in taxes in FY ’16, and that 96% of that amount ($5.043 billion) applied to federal levies. The additional $5.241 billion is an accrual. That means that Apple owes the the Treasury the money––that’s why it’s an expense for accounting purposes––but that the accounting rules allow it to make the actual payment at the time the money is repatriated.
3. The U.S. rate is 35%. Why is Apple’s effective rate so much lower?
As Apple states on page 56 of its 10K, if the official 35% rate applied to all of its income, it would have paid $21.480 billion to the Treasury for fiscal ’16. But obviously, that wasn’t anything like Apple’s bill, let alone what it paid in cash.
Two big questions arise. First, why is Apple able to defer $5.241 billion instead of paying that amount now? Second, why is its total tax expense of 25.6% (including the deferred amount), well below the “statutory” U.S. rate of 35%?
The answers to both questions lie in the rules that that allow foreign income to be deferred or excluded from U.S. tax. The U.S. is one of the few nations that deploys a “worldwide” tax regime. As a matter of policy, the Treasury imposes our domestic rate of 35% on profits earned abroad as well as earnings generated at home. The U.S. grants a credit for taxes paid to foreign governments; hence, multinationals owe the difference between the local tax and the U.S. levy of 35%, which is extremely high by global standards. (By contrast, multinationals based in most industrialized countries pay tax only in the nation where they generate the earnings, with no additional tax due in their home country.)
But the U.S. code provides ample room for sheltering and avoiding taxes on foreign income, a major reason it needs an overhaul. The rules essentially divide foreign profits into three categories. One bucket of profits is more or less taxed at the full rate of 35%. On a second bucket, the multinational can defer paying the U.S. tax due. And a third category is excluded from all U.S. taxation, amounting to corporate America’s biggest loophole.
4. Apple’s treatment is a primer in the three categories of foreign income
Apple generates more foreign income that any other U.S. company. In FY’16, it booked $41.1 billion pre-tax profits outside the U.S., or 67% of the $61.4 billion total.
On those offshore profits, Apple paid $2.138 billion to foreign governments. For example, in FY’14, the government of Ireland, where Apple has extensive operations, collected $400 million from Apple. The additional amounts that it owed or paid to the U.S. depend on the three category of income. The first category consists of interest on cash earned and residing in foreign subsidiaries. This is what’s called “passive” rather than “active” income generated from making and selling products. The U.S. imposes the full 35% rate on this passive foreign income, regardless of whether a multinational keeps that income abroad or sends it to the U.S. By Fortune‘s estimate, Apple booked around $4 billion in that category in FY’16, and paid the full U.S. levy, minus the local tax, of around $1.2 billion on that amount in cash––no deferral, no exclusion.
The second category consists of earnings that Apple generated from making and selling iPhones and other products, but doesn’t plan to reinvest in expanding its operations. It expects to leave those funds in cash and securities for now, but may eventually “repatriate” those profits–in other words, send them home to the U.S. For this category of “active” but not-to-be-reinvested earnings, multinationals must record the difference between the local tax and the 35% rate in the U.S. as an expense, in the form of an accrual. But they can defer paying the Treasury until the profits are repatriated.
Under current law, multinationals can leave “eventually be be repatriated” earnings abroad for as long as they choose. That makes the deferral option extremely valuable, because the longer they wait, the lower the present value of the U.S. payment. Hence, multi-year deferrals effectively reduce the U.S. tax burden.
In FY’16, Apple had $37 billion in foreign profits after subtracting the $4 billion in interest subject to the full U.S. tax in the current year. Of that remaining $37 billion, it placed a little less than half, in the someday-to-be-repatriated bucket. Remember, it also paid local tax on those profits in cash, accounting for around half of its total payments abroad of $2.1 billion. So it accrued the difference between that payment and the 35% it owes the Treasury. That’s almost all of the $5.241 billion that when added to the $10.444 billion it paid in cash, explains its entire effective tax of $15.685 billion.
It’s the third category that amounts to a big tax break, and explains why Apple’s effective rate is well below the statutory 35%. To be frank, I didn’t know it existed until conducting this analysis with Meyer’s help. Roughly speaking, the other half of that $37 billion in foreign earnings (after subtracting the $4 billion in interest) was also active income, generated from making and selling things. The U.S. GAAP financial accounting rules stipulate that if a multinational either reinvests earnings from operations to grow its business, or intends to do so in the future, it’s required to neither pay U.S. tax on those profits in cash, nor to accrue a tax expense for the future that lowers net income. However, if its plans change, and multinational decides that it will eventually bring those profits back, it has accrue U.S. tax on that income.
It’s important to note that Apple is extremely responsible in the use of this exemption for reinvested earnings. Many multinationals report that they intend to plough all of their foreign profits into operations, and hence, don’t make any accruals for U.S. taxes on their offshore earnings. Apple is the rare tech titan that books large annual accruals that lower net income.
Still, the exception for reinvested earnings is a big deal for Apple. To be sure, Apple pays taxes to foreign jurisdictions on those earnings––that accounts for the remainder of the $2.1 billion in local levies. As disclosed on page 56 of its 10K, excluding around $17 billion from U.S. tax yielded a savings of $5.582 billion. If Apple had been obliged to accrue that amount, its tax expense would have risen by over one-third.
By the way, profits earned from operations in one country do not need to be reinvested in that country to remain free from U.S. tax. A pharma giant can channel earnings generated from a cancer drug in Ireland into a plant for a heart therapy in Germany, without triggering U.S. tax.
5. Let’s sum it all up
Now we have the numbers that answer the basic question: What accounts for the difference between what Apple pays and the official 35% rate? Page 56 of its 10K shows the numbers. Once again, if Apple had faced the full 35% rate, it would have paid $21.46 billion in federal taxes (as well as another $990 million to the states). Instead, it paid $10.444 billion in cash, and accrued $5.241 billion in U.S. tax owed on foreign profits, but deferred to be paid later. That’s the total of $15.685 billion that it booked in tax expense on its income statement. The difference between that number and the approximately $21.5 billion it would have paid at the 35% rate is the almost $5.6 billion attributed “indefinitely invested foreign earnings under the GAAP rules.”
6. The GOP would transform the system, in Apple and America’s favor
In part because of the tax advantages, Apple has accumulated well over $200 billion in profits that remain situated in foreign subsidiaries. Like many multinationals, it’s paying a stiff price for the ability to defer super-high U.S. taxes. Multinationals could often put foreign cash to more profitable use in the U.S. by making acquisitions, building plants, paying special dividends or repurchasing stock. But America’s worldwide system and super-high rates penalize them for bringing the cash stateside.
The “framework” for tax reform proposed by the White House and Congressional Republican leadership would remove the incentive to keep foreign profits growing into offshore mountains of cash. First, it would lower the U.S. levy to a far more competitive 20%. Second, it advocates a “deemed” repatriation of all accumulated foreign earnings, to be taxed at less than the official 20%. All foreign earnings would be taxed each year in the nation in which they’re earned, mirroring the “territorial” systems deployed by most industrial nations. The U.S. would apply a lower, but unspecified, minimum tax on all foreign earnings to protect the tax base, and discourage companies from moving operations to tax shelter nations. Multinationals would no longer be able to defer or avoid U.S. taxes by leaving profits overseas.
Surprisingly, companies such as Apple with an extremely large proportion of foreign sales, could actually pay more U.S. taxes in cash each year under the current proposals. That’s because elimination of deferrals and the option to leave reinvested earnings abroad tax-free would sent more money to the Treasury even at the far lower minimum rate.
After a credit for local taxes paid, the rate on the accumulated earnings, repatriated en masse, could be in the mid-to-high single digits. It’s important to note that all foreign earnings that haven’t been repatriated, encompassing both the “eventually to be repatriated” and “permanently invested” categories, would be taxed. Apple could could pay its levy to the Treasury, and still unlock a windfall of over $200 billion, much of it available for investment and job creation in the U.S. (Apple might need to use some of that cash to pay down debt that it’s used for stock repurchases and dividends.) In its public statements, Apple has strongly supported a deemed repatriation, as well as a simpler system that allows for the free flow of capital. Indeed, that “let freedom ring” solution would be a great thing for America.