The recent European Commission order to Ireland to collect $14.5 billion in back taxes from Apple Inc. has led to outcries from Apple, Ireland, and the United States government. Apple, of course, defends its aggressive tax avoidance schemes. Ireland defends its tax-haven status. And the U.S. government claims the money may actually be owed to the U.S. rather than EU. The truth is that the United States left the $14.5 billion on the sidewalk, inviting Europe to swoop in and pick it up. It’s time to end the U.S. corruption and incompetence that transfers U.S. taxpayer dollars to the rest of the world.
The underlying economic issue is this: Apple and other tech companies earn their living by selling intellectual property (IP). The input costs of an iPhone are around $240, around one third of the retail list price of the phone. The rest of the retail value reflects the profits earned on Apple’s IP.
The IP has been produced overwhelmingly in the United States, and much of it with U.S. government R&D financing. Given its role in the R&D, the U.S. government—in the name of U.S. taxpayers—not only has a direct claim on the returns to Apple’s IP, but also an indirect claim through the taxation of corporate income.
When Apple sells an iPhone outside of the U.S., whether from a local Apple store in Europe or through a shipment from the U.S. or elsewhere, almost all of the profits on that sale reflect the earnings on Apple’s intellectual property. Even if the sale is from a European Apple store, the earnings on the iPhone sale reflect the export of IP services from the U.S., rather than the earnings of the Apple store itself. As with any U.S.-based income, the earnings should therefore be subject to U.S. corporate income taxation.
Alas, the IRS—under the directives of a political system beholden to U.S. corporate interests—has allowed sheer economic gimmickry to intrude on these basic economic facts. Through a variety of tax-avoidance schemes approved in broad daylight by the IRS and the U.S. Congress, America’s tech giants book their foreign sales as foreign profits rather than as earnings on U.S.-based IP.
In the case of Apple, the U.S. headquarters, Apple Inc., transfers the development rights to its products to a wholly owned Apple subsidiary in Ireland (Apple Sales International, or ASI) according to a "cost-sharing" agreement. Under the tax code, the cost-sharing agreement between affiliates of the same company should follow the principle of "arms-length" pricing. In the corporate books, ASI should be charged a commercial royalty fee for the right to market Apple Inc.’s IP. The royalty fee should reflect the fair market value of the IP, as if ASI was a nonaffiliated company. The bulk of ASI’s earnings would and should thereby be transferred back to the United States as royalty earnings of Apple Inc.
In fact, in a shocking tax gift to Apple, the IRS does not enforce the arms-length rule. Apple Inc. charges only a token royalty fee to ASI under the so-called cost-sharing agreement. As a result, the profits on European sales stay with the European subsidiary. If the IRS required a consolidated income statement of Apple and ASI, the lack of arms-length pricing of the royalties wouldn’t matter. ASI’s inflated profits would still show up on the consolidated account. Yet under another IRS accounting fiction, Apple is allowed to avoid consolidating ASI’s profits with those of the parent company, Apple Inc.
In the next step of the tax-avoidance scheme, ASI was given a sweetheart tax deal by Ireland to encourage Apple to have some small-scale operations in Ireland in the form of ASI. In simple terms, the Irish tax authority agreed not to tax the (wildly inflated) earnings of ASI. Therefore, ASI pays taxes neither in the U.S. nor Ireland nor anywhere else, except for a de minimis amount. If and when those earnings are repatriated to the U.S., Apple would owe U.S. taxes on them, but until that date, the ASI earnings are untaxed.
Other companies use a slightly different stratagem than Apple Inc. to arrive at the same result: zero taxes on the international earnings of U.S.-based IP. The other IP giants permanently shift the IP to a tax haven through an internal "sale" of the IP from the parent company to an offshore subsidiary at a nominal price. For example, Google’s intellectual property is domiciled in Bermuda, a tax haven. This was accomplished through a phony prior transfer of Google’s IP by the parent company to its Bermuda-based subsidiary at some (undisclosed) nominal price.
Of course Google’s R&D is U.S. based, and Google’s pioneering IP was funded by the U.S. National Science Foundation. Yet when Google now makes an international sale, the royalties go to zero-tax Bermuda rather than to the U.S.
The winner for tax chutzpah is Gilead Sciences, the owner of the IP to a life-saving hepatitis C drug named Sovaldi. Gilead owns the exclusive patent to this miracle drug, and uses the patent to charge outrageous prices, selling the drug for around $1,000 per pill compared with the manufacturing cost of $1. Its mega-profits on Sovaldi have repaid the original R&D countless times over.
And guess what? Gilead’s IP was magically transferred to an Irish subsidiary! As a result, Gilead’s profits are also booked in Ireland, even for sales within the U.S. that are funded by the U.S. government (i.e., the U.S. taxpayer) for use by U.S. patients. This transfer of the profits to Ireland occurs in broad daylight with the concurrence of the IRS, which is a measure of either gross incompetence or gross corruption or a combination of the two.
So yes, the European Commission is indeed picking the pocket of U.S. taxpayers. It has directed Ireland to collect taxes on ASI’s profits, but economically speaking, those profits are the earnings on U.S. intellectual property, and should be taxed in the U.S. The U.S. Congress and each succeeding administration have been so eager to shield powerful U.S. companies like Apple Inc. from taxation that they’ve virtually invited Europe to pick up $14.5 billion of U.S. taxes from the sidewalk.
Jeffrey Sachs is the director of the Earth Institute at Columbia University.
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