Apple's Double Irish With a Dutch Sandwich, Will The Next President Take Notice?

Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the First Presidential Debate, we saw President Obama and Mitt Romney in an interesting face-off. There was hardly any issue in question that the two rivals agreed on, except one--corporate taxes. Both opponents agreed that corporate taxes should be cut, no matter who takes the next charge of the oval office. President Obama claimed that should he stay at the presidency for another four years, corporate taxes would be cut down from 35% to 25%. Gov. Romney didn't talk exclusively of corporate tax rates but was very vocal about cutting taxes in general.

To begin with, it's important for us to come to terms with the fact that the listed 35% federal corporate tax rate is not what corporations in the country are actually paying. In fact, what big US corporations pay in annual taxes, compared to their incomes, is sometimes even lesser than the proposed future 25% rate. This is largely because of the countless loopholes present in the US tax code. As Republican Party rep., J.C. Watts, once said:

'The heart of IRS abuse lies in the existing tax code. Most of the folks who work for the IRS are good people just trying to do their job, but they are caught in a bad, overextended tax system. At 3,458 pages, twice the length of the Bible, it's impossible for the average taxpayer to know, understand, and accurately apply its provisions. The length is twice that of the Bible! Even tax experts cannot do so reliably.' 

The result is tax evasion. You, my reader, must be aware that this practice isn't new. We've heard about it on news and read in papers. It was there before the Obama Administration, before the Bush Administration. It has probably been there forever.  

The 'Double Irish With a Dutch Sandwich' Technique

Last year in November, a study on Corporate Tax Dodgers revealed that about 280 US corporations (including Goldman Sachs and ExxonMobil) that made pretax profits of over $1.4 trillion during the period of 2008-2010 paid an average effective tax rate of 17%-18% against the imposed 35%. Some of these corporations paid way less than that. Some didn't even pay a single penny! But the practice couldn't be challenged. It was legal in light of the complicated tax code that most of us don't understand. The big corporations somehow find a way around it every time. One such way is extensively being used by tech big-wigs.

Last year, SEC questioned Google (NASDAQ: GOOG) about its tax filings because the tech giant was making more profits in countries like Ireland, Netherlands and Bermuda where corporate taxes were low or zero and lesser profits at home. By showing dispersed profits in Irish tax havens, Google was able to avoid paying $3.1 billion in US taxes in just three years. The technique Google used is a variant. The actual scheme, called the 'Double Irish with a Dutch Sandwich', is the routing of profits through Ireland, then a Dutch country like Netherlands, then back to Irish tax havens, and is thought to have been invented by Apple (NASDAQ: AAPL). The world's most valuable company today parks most of its profits offshore and side steps billions of taxes. Can anybody dare to question how truly innovative this tech behemoth is? 

And the practice continues.  

This week Bloomberg reports that the leading US pharmaceutical corporation, Pfizer (NYSE: PFE), is the latest tax side-stepper to come under SEC's probe-radar. Pfizer's filings show that the company is also making billions of dollars in profits abroad but lost over $2 billion in the US this year (which is a huge plunge from last year's $27 billion US profits). How does Pfizer respond to this? They say, “We do not believe that disclosure regarding the reasons for the geographical split of pretax earnings would be meaningful or useful to investors”. Well, why don't you make full disclosure and let us decide what we find useful and what we don't?

Implications for shareholders

The geographical split of pretax earnings is definitely meaningful to investors. Firstly, varying macroeconomic environment, political stability and monetary and fiscal policies in different countries all impact the multinational corporations functioning in those areas. For instance, a company that generates a major portion of its revenues in the Eurozone is presently suffering at the hands of the local debt crisis. So, if Pfizer's filings show that it generated most of its earnings abroad, then investors have a right to know 'where', 'why' and 'how' for forming correct future forecasts.

Secondly, the big slump of Pfizer's US earnings from profits in one year to losses in another raises questions of earnings stability. Will investors see earnings rebounding in case US corporate tax rates are cut, as proposed? Such fluctuations appear to give the impression of accounting shenanigans and raise doubts in investors' minds. And if the reason is tax avoidance, investors need to be made aware of it, otherwise it is a likely breach of management's fiduciary duty towards its principals. In most cases, a CEO or CFO's compensation is tied to earnings (or stock) performance and avoiding taxes is one way of meeting Wall Street's earnings forecasts and keeping the stock afloat.

In other words, Pfizer's management is wrong in saying that shareholders don't need to know the reasons behind differing pre-tax earnings in differing geographical locations. They DO need to know if the reason is tax avoidance or a personal agenda of its management. 

As long as corporate tax rates remain high at home, these corporations will find incentives to park their cash in foreign banks or actually take their operations abroad. Either ways, the US economy and its people lose. Take for instance, Ford (NYSE: F), a heavily government-subsidized US automaker that is fast shifting operations to China. This year Ford built its biggest assembly plant in China, which is its largest investment in a foreign country in decades. Not only does Ford get cheaper labor there, but the corporate tax rate is also lower than the US--at 25%.  Unlike small businesses, which are the ones truly disadvantaged by the high tax rates, these big corps. contribute less to the US GDP than they can (and should). Unemployment rates may be down from 8.4% to this month's 7.8%, but the percentage could have been even lower if the potential employment opportunities weren't being taken abroad. Apple's manufacturer Foxconn in China continues to have troubles with iPhone 5's timely production but Apple refuses to bring job opportunities back home. If you think this has to do more with wages and less with taxes, you need to think again. High taxes, that translate into higher costs for businesses, induce them to cut costs elsewhere. 

The economy is gradually heading from a slowdown towards a potential recession. Circumstances call for tax cuts. Both the presidential candidates acknowledge it. But will it do the trick? Maybe, for the time being, but not for the long run. It's actually the tax code that requires Government's prudent scrutiny for long term benefits to the economy and its people. Here's to hoping that the next President will put this issue on his priority list for the year. 

PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Ford, and Google. Motley Fool newsletter services recommend Apple, Ford, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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