Harvesting Tax Benefits in Global Supply Chain Management: How Apple Computer Does It
Posted May 31, 2013 by Bierce & Kenerson, P.C. · 
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Supply chain management normally addresses such risks as pricing of commodity components, disruptions in transportation, labor strikes, business continuity planning, disaster recovery, regulatory risks and, with Hon Hai / Foxconn, the risks of occasional suicidal workers. Apple Computer, Inc. (“Apple Computer”) outsources production to contract manufacturers in China and elsewhere, but it insources its operations and centralizes its financial accounts through the use of Irish subsidiaries.
This article addresses some of the key issues for American technology companies, particularly those in pharmaceuticals, software, hardware, game developers and consumer electronics, who can learn from the clever use of complex U.S. tax rules governing controlled foreign corporations (“CFC’s”), transfer pricing and intercompany profit allocation to foreign subsidiaries through cost-sharing agreements, tax-transparency of entities consolidated in one jurisdiction, and, most astounding of all, a holding company that has no tax residency and thus pays no tax.
The road map to massive tax savings was revealed in the pending legislative initiatives that would tighten the U.S. income rules. But there are still lessons for effective international tax planning after such loophole closing. This article is based on published accounts of Apple Computer’s finances and operations, including a lengthy memorandum submitted in May 2013 to a U.S. Senate committee on offshore profit shifting by U.S. companies.
Apple Computer’s Basic Plan. Apple Computer, like Microsoft and Hewlett-Packard, has used offshore entities to conduct foreign business. It established Irish limited liability companies to act as funnels for all sales of products and services outside the United States. Here are the essential details.
Top Irish Holding Company. Apple’s primary holding company has no employees, only three directors, two of whom reside in the U.S. and one of whom resides in Ireland. This company (“AOI”) has no U.S. offices. Under U.S. law, it is not a U.S.-taxable company because it is incorporated in Ireland. Under Irish law, it is not an Irish company because its place of management and control is not in Ireland. So it appears to be obligated nowhere to pay income tax.
Sub Irish Holding Company. A second holding company (“ASI”), likewise incorporated in Ireland, receives resale profits from buying Apple Computer® products made by a contract manufacturer in China and reselling to individual wholesale distributors (100% owned) outside the United States. ASI effectively takes a manufacturer’s profit and the individual wholesale distributors only make a wholesaler’s profit.
Cost-Sharing Agreements for IP R&D. Royalties for intellectual property rights can be avoided by a cost-sharing agreement (“CSA”) relating to R&D expenses. Under a cost sharing agreement, two or more entities agree to share the cost of developing intangible assets (such as software, hardware designs, patents or copyrights) and each acquires a proportionate ownership share of such assets after development. If ASI were unrelated to the owner of the intellectual property, it would normally pay a royalty fee for the right to make (or have made) Apple Computer® products. However, through a cost-sharing arrangement, no royalties are owed since ownership of the intangible assets is proportionately split between an Irish company and the U.S. parent company. Under such cost sharing, which is permitted by IRS regulations under Section 482 of the Internal Revenue Code, two companies can split the economic ownership benefits from new intellectual property developed under a commercially reasonable allocation of costs.
In Apple Computer’s case, the Irish and U.S. companies split R&D costs based on an allocation of gross sales between the U.S. and the “rest of the world.” The Irish company thus does not need to pay any royalties for its use of the resulting technological innovations.
Furthermore, Apple takes advantage of loopholes in the U.S. tax structure which enables it to convert taxable offshore passive income into deferred income and to “disregard” income payments between its lower-tier subsidiaries by electing to treat them as part of a single upper-tier subsidiary. This effectively treats this type of income as internal payments or transfers as opposed to taxable income.
Best Practices for Optimizing Tax Benefits in Global Supply Chain Management. The brouhaha over Apple Computer’s tax strategies highlights the differences between “best practices” and aggressive optimization. By not having any tax residency for two entities, Apple Computer is exposed to the tax collector’s claim (both in the U.S. and in Ireland) that it has abused the corporate formalities, unfairly reducing. income taxes through transfer pricing to artificial “shell” companies that have no business purpose other than tax avoidance.
Transfer Pricing Mechanisms. Transfer pricing regulations under Section 482 have been changing for forty years. The IRS vacillates between bright lines and vague “facts and circumstances” tests. In a global economy, both businesses and tax collectors will have to navigate murky waters, and “reasonable” and “defensible” allocations of profits will continue to survive. Of course, as anyone doing business in India will attest, a “reasonable” allocation in one country is not necessarily “reasonable” to the tax authorities of another. So there are risks of “whipsaw” (double taxation due to differences in “reasonableness” metrics) in any international tax structure.
International Treaties: Limits on Extraterritorial Taxing Jurisdiction. There may be international limits to anti-abuse tax rules. Anti-abuse has been a hot topic for 30 or 40 years under the OECD Model Income Tax Convention formats. The Senate subcommittee report fails to consider U.S. obligations under the WTO Uruguay Round trade agreements on intellectual property (“TRIP’s”), on trade-related investment measures (“TRIM’s”) and trade in services. These agreements generally preclude discrimination in market access and regulation of foreign-owned companies. Any new legislation will need to thread such “treaty needles.”
Bona Fide Business Purpose. Adoption of “stateless” holding companies having no employees and no tax residency appears to fail the test of “business purpose” and may thus be ignored by tax collectors. If you have a valid business non-tax purpose, the tax authorities should respect your choice of business structure. Legitimate business purposes include establishment of legal protections that are based on a foreign country’s rights under international treaties, such as free trade agreements, investment protection treaties and tax treaties, as well as the protection of local law. It also helps to employ local employees.
Controlled Foreign Corporations: Subpart F is still Friendly to U.S. Multinationals. Current U.S. law on “controlled foreign corporations” and “foreign personal holding companies” still do not require repatriation and immediate taxation of foreign profits earned by legitimate foreign operations. Of course, the interposition of a foreign company for no purpose other than to park profits will still fall into the definitions of CFC or FPHC. However, there is no abuse where foreign profits are not actually repatriated and are used for foreign business investment and operations. So, unless the law changes, the tax planning for offshore operations should not cause immediate U.S. taxation.
Tax Benefit Planning in Contract Manufacturing. The use of contract manufacturing and “drop shipment” instructions are likely to continue without further challenge by tax authorities. Under “drop shipment” procedures, a company like ASI might buy from China FOB China and resell to its wholesale buyer CIF at the foreign warehouse of the wholesale buyer, and ASI never takes physical delivery. Such procedures are customary and commercially reasonable between unrelated buyers and sellers, so it bears no bad of any tax avoidance.
Tax Benefit Planning in BPO. As American shared-service organizations and Indian BPO service providers have both learned, transfer pricing between affiliates for “back office” services can be complex and fraught with risks. The U.S. IRS has an advance pricing agreement (“APA”) procedure allowing companies to “negotiate” (explain) a “fair” transfer pricing between affiliates, but this procedure is costly, time-consuming and inefficient in cases where any “material facts” change after the APA is agreed.
Impact of U.S. Tax Reform on Offshoring. Legislation to impose taxes on foreign business operations may be counterproductive. If a company without employees is seen as a sham, then it will hire foreign local employees to conduct real business. If a company cannot arbitrage between the U.S. and the Irish methods of determining a company’s tax residency, then it will still look for the lowest tax rates and conduct business there, assuming the “quality” and quantity of employees is adequate. In short, by taxing “shams” or “insubstantial” foreign operations, the U.S. might well promote foreign employment through legitimate entities with a large foreign employee pool.
This invites further discussion on integration of different teams in different countries in a company’s global workforce. Strategic planning will thus focus on both opportunities for global teamwork as well as tax efficiency.