Harvesting Tax Benefits in Global Supply Chain Management: How Apple Computer Does It
May 31, 2013 by Bierce & Kenerson, P.C.
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.
Financial Services Outsourcing: New Roles and Risks under a Consumer Financial Protection Agency
May 18, 2010 by Bierce & Kenerson, P.C.
The financial services industry is facing major regulatory changes following the global sub-prime credit crisis and ensuing recovery plans. These changes will have a major impact on outsourcers that deal with consumer financial information or in back-office support for financial investment transactions that are deemed unfair, deceptive or abusive. The adoption of a new Consumer Financial Protection Agency Act would have a significant negative impact on the risks and costs of outsourcing of IT and business process functions by companies that deal with consumers. It would invite a new view of risk allocation between enterprise customers and independent contractors as outsourcers, increasing the costs of doing business by putting the service provider into a new role of whistleblower. It remains to be seen whether the analysis of public policy in this arena will spill over into other industries and other types of outsourcing.
Draft Consumer Financial Protection Agency Act
As of mid-May 2010, the U.S. Congress was considering possible enactment of financial regulatory reform. Among the proposals is the draft “Consumer Financial Protection Agency Act,” as inserted into another draft law, H.R. 4173, “Wall Street Reform and Consumer Protection Act of 2009,” referred to Senate committee after being enacted by the House. This consumer protection bill was originally H.R. 3126, 111th Cong., 1s Sess.; H. Rept. No. 111-367 (Dec. 9, 2009) (“Draft CFPAA”). As the dissenting Republicans observed in that December 2009 House report:
- Rather than address the failure of banking regulations related to consumer protection and the failure of the States to police activities under their purview (e.g., mortgage brokers and real estate agents), the proposed legislation to create the CFPA seeks to consolidate the consumer protection jurisdiction of all banking regulators into one new agency and regulate many new activities and persons that largely are unrelated to the financial markets or the crisis of 2008. (Dissenting views).
General Scope. If enacted, this proposed reform would transfer enforcement of consumer financial protection laws from various existing agencies (including the SEC). The new commission would regulate:
- (1) brokers and dealers registered under the Securities Exchange Act of 1934;
(2) investment advisers under the Investment Advisers Act of 1940;
(3) investment companies (mutual funds) under the Investment Company Act of 1940;
(4) national securities exchanges under the ‘34 Act;
(5) a transfer agent under the ’34 Act;
(6) clearing corporations under the ’34 Act;
(7) municipal securities dealers and self-regulatory organizations registered with the SEC;
(8) national securities exchanges and the Municipal Securities Rulemaking Board.
Regulation of “Financial Activity.” Under H.R. 4173, Sec. 4002 (19) (A), the term `financial activity’ means any of many activities. (The list is long, so we have put it in a separate document.) 1
Liability of “Covered Persons” and “Related Persons.” Under the proposed law, a “covered person” subject to regulation would include “any person who engages directly or indirectly in a financial activity, in connection with the provision of a consumer financial product or service.” This definition is so broad, and governmental involvement in financial operations so extensive, the draft specifically excludes the Secretary, the Department of the Treasury, any agency or bureau under the jurisdiction of the Secretary (H.R. 4173, Sec. 4002 (9)(A)(B)), or any federal tax collector.
Vicarious Liability on Certain “Consultants” and “Independent Contractors.” The proposed law would treat “related persons” in the same manner, and impose the same punishments, as for “covered persons.” By adopting a sweeping definition of “covered person” and an equally sweeping definition of “related person,” the proposed law puts outsourcers at risk of direct liability and for merely doing the tasks assigned under a Master Services Agreement in the ordinary course of business. There would be a distinction between consultants and service providers. A “related person” would include either:
- a “consultant” that, in the view of the new Consumer Financial Protection Commission determines (whether by regulation or on a case-by-case basis), “materially participates in the conduct of the affairs of such covered person” (H.R. 4173, Sec. 4002 (33)(A)(ii)); or
- “any independent contractor (including any attorney, appraiser, or accountant), with respect to such covered person, who knowingly or recklessly participates in any–(I) violation of any law or regulation; or (II) breach of fiduciary duty.” ( H.R. 4173, Sec. 4002 (33)(A)(iii)).
Liability of Outsourcers for “Unfair, Deceptive or Abusive Acts or Practices.” The proposed Consumer Financial Protection Agency Act would not require “related persons” to register with the commission. However, they would be liable for “unfair, deceptive or abusive act or practice in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service.” (H.R. 4173, Sec. 4301(a)). The proposed law would impose federal criminal liability on anyone (including outsourcers as “related persons”) if they are shown to “knowingly or recklessly provide substantial assistance to another person in violation” of the new statute and regulations on “unfair, deceptive or abusive acts or practices.” “Related persons” would be “deemed to be in violation of that section to the same extent as the person to whom such assistance is provided.” (H.R. 4173, Sec. 4308(3)).
Outsourced Business Functions that Would be Exempt. The draft law would exclude certain functions that are typically outsourced from the scope of “financial activity “ that would be regulated.
- “Financial data processing” would be excluded from the definition of “financial activity.” H.R. 4371, Sec. 4002(19)(A)(xi). However, even assuming that the mechanical conditions of processing were satisfied under this exclusion, there remains a subjective standard that could ensnare the outsourcer in an ITO or BPO context: Does the outsourcer provide “a material service to any covered person in connection with the provision of a consumer financial product or service.” (H.R. 4173, Sec. 4002 (19)(A)(xi)(II)(cc))
- Providing certain “information products or services” that are “incidental and complementary” to any activity that the new commission defines as a “financial activity” would be excluded. (H.R. 4173, Sec. 4002 (19)(A)(xvi)(I)(bb)) Specifically, there would be no regulation of such ITO or BPO services that are for identity authentication, fraud or identify theft detection, prevention, or investigation; document retrieval or delivery services; public records information retrieval; or for anti-money laundering activities. That exposes BPO providers of other business functions, such as mortgage and credit card origination, credit verification, and virtually everything else that is not clearly excluded by the draft law.
Neither of these exclusions addresses the growing use by the financial services industry of third party ITO, BPO and LPO services for labor-intensive or labor-value services. This draft law could bring vicarious liability for providers of such services as due diligence for investment banking and finance usually has some consumer financial impact, either in the design of analytics, the design and structuring of financial products or services, document review in an acquisition, divestiture or financing (where “consumers” might be investors in one of the deal participants).
Outsourcers as Auditors and Whistleblowers: The “Knowing or Reckless” Standard of Care for Outsourcers. The draft law would cover independent contractors providing services in support of “financial activity,” but only if their conduct were “knowing” or “reckless.” This standard could establish vicarious liability when the outsourcer “knew” that its actions would be unfair, deceptive or abusive, or because the outsourcer failed to become informed on the legality of its support for its financial institution customer’s unfair, deceptive or abusive practices. In effect, the consultants and outsourcers (other than data transmitters) are enlisted as surrogate auditors and whistleblowers with a duty to cease rendering their services if they “knowingly” or “reckless” participate in their customer’s unfair, deceptive or abusive practices.
Additional Costs of Outsourcing. This role would be a new one. It would entail additional costs of legal reviews and audits by the service provider’s own independent regulatory experts (more lawyers and accountants) and additional premiums for new “directors and officers” liability insurance (if indeed such insurance would cover such vicarious liability). It would add hidden costs on the outsourcer that would have be added to the service charges in order to segregate service costs from legal compliance costs.
Additional Risks of Termination. Under these circumstances, regulated financial institutions and financial service enterprises would face the risk that a whisteblowing outsourcer could unilaterally terminate an ITO or BPO services agreement. Lawyers would argue about the conditions and consequences of when an outsourcer could do so. Relationship governance would involve a new discussion about illegality.
- Service providers would want the right to terminate if, in their good faith opinion, the enterprise customer was engaged in any violation of this draft law or its regulations.
- Financial services enterprises would want a slower trigger. One can imagine a series of steps that delay termination, with notices, opportunity to cure, maybe an independent legal opinion as a letter of comfort (thus escaping “recklessness” as a risk but not necessarily escaping “knowingly” risk).
Due Diligence Process. If this draft law is enacted, it would force service providers to clients engaged in any “financial activity” to conduct due diligence into the legality of the proposed customer’s business practices for the protection of consumers’ financial rights. Such an investigation would normally include questions about existing and future practices as well as information on the actions or recommendations of incumbent service providers who might have sought termination to avoid vicarious liability.
Adverse Impact on Business Process Transformation, Process Change and Operational Innovation. The draft law would impose direct liability on “consultants” who “materially participate” in a financial business. The concepts of “materiality” and “participation” are so broad that any outsourcer who administers any of the “affairs” of its enterprise customer will be treated as such a “consultant” if the outsourcer proposes changes in the “covered person’s” business. This would stifle any proposals by outsourcers for business process transformation, even simple process changes, since the outsourcer might no longer be treated under the “independent contractor” standard of knowing or reckless violation or breach of fiduciary duty.
Spill Over to Other Industries and Outsourcing Services. For perhaps the first time, the draft CFPAA raises the specter of service providers worrying about the risk of vicarious liability because they support a criminal enterprise. “Aider and abettor” liability exists already in relation to the sale or distribution of “securities.” The question now is whether service providers should change their current practices and contract risk allocation in light of such a specter. Informed executives will get more information as this political process unfolds.