- Apple stirred further controversy over international taxes following the EU investigation.
- After weighing the arguments made by the EU commissioner, I come away with similar observations.
- The findings from the EU investigation allow me to forecast Apple’s weighted average tax rate.
It has become increasingly obvious that Apple Inc.'s (NSDQ:AAPL) foreign tax haven(s) will become less effective over time.
I’m taking a deeper look at Apple’s international tax expense given the lack of predictability, and on-going speculation via various members of the media and analyst community. Notwithstanding the speculation on my part, we find some common threads pertaining to the EU Commission’s assumptions on tax receipts relative to other non-tax haven zones like Japan.
The European Commission’s press release on Ireland’s illegal state aid is implicit of diminished profitability. This is due to heightened tax rates on a go-forward basis, and potential back taxes owed to the tune of 13 billion euros, which, by current exchange rates, is implicit of a tax increase to $14.5 billion, for back owed taxes. There’s also an interest rate component, which is why analysts are anticipating the figure to increase by an additional $2 to $3 billion.
The tax rate will move to the corporate tax rate of Ireland. In this scenario, Apple could still leverage Irish tax rates, which are the lowest in the EU/OECD region at appx. 12.5%, with the exclusion of natural resource trade (commodities) and investment income (capital gains), which is taxed at a 25% corporate rate.
Addressing the European Commission’s assessment
It’s highly probable that Apple will defray the incremental tax through some form of a drawn out legal battle with the EU commissions. The inevitable outcome is higher taxes, but it will not materially alter financial estimates/earnings figures for a while longer (perhaps a couple years).
Apple made foreign transactions in EU jurisdictions outside of Ireland, but recognized the earnings under Irish tax law. However, Irish Tax Code provides a double tax shelter allowing for a net effective tax rate of 0% for the bulk of all foreign earnings with the exception of some countries like the USA or Japan for that matter.
Here were the key points to the European Commission’s tax assessment:
Under the agreed method, most profits were internally allocated away from Ireland to a "head office" within Apple Sales International. This "head office" was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. Only a fraction of the profits of Apple Sales International were allocated to its Irish branch and subject to tax in Ireland.
The degree to which Apple was able to lower its tax rate is so substantial that it’s hard to logically articulate a legal counter-argument aside from pre-existing legal precedence favoring Apple. The effective tax rate is so low that it’s difficult to imagine sustainability for much longer.
Here were some additional comments by the EU Commission:
In 2011, for example (according to figures released at US Senate public hearings), Apple Sales International recorded profits of US$ 22 billion (c.a. €16 billion) but under the terms of the tax ruling only around €50 million were considered taxable in Ireland, leaving €15.95 billion of profits untaxed. As a result, Apple Sales International paid less than €10 million of corporate tax in Ireland in 2011 – an effective tax rate of about 0.05% on its overall annual profits. In subsequent years, Apple Sales International's recorded profits continued to increase but the profits considered taxable in Ireland under the terms of the tax ruling did not. Thus this effective tax rate decreased further to only 0.005% in 2014.
The bulk of Apple’s foreign earnings is un-taxed. A 0% tax rate on 99.68% of EU operating income just doesn’t sound sustainable, but it gives us a basis for projecting future taxes going forward.
So, where is Apple paying its international taxes?
It is my view that Apple will eventually report a full allocation to the income statement when pertaining to pre-existing tax liabilities, or provide some indications of higher corporate taxes at some later point.
In a recent Quartz article, the journalists attempt to articulate Apple’s foreign taxes:
The company earned $23 billion in operating income in Greater China in its latest fiscal year, so by a completely crude measure, even if all of the $2.9 billion it set aside for foreign taxes for that period were paid in China and none elsewhere, it would still be paying less than a 15% tax rate—about 12.6% to be exact.
While the Quartz reporters are accurate on $2.9 billion in foreign taxes, the Greater China region alone generated $23 billion in operating income at an operating margin of 39%. The Quartz comments suggest that Apple is yet again shifting earnings via a software/royalty license agreement to the Irish subsidiary (Apple International).
When I do the math, I come away with the impression that Japan’s tax code is the most robust in the entire OECB region (excluding USA).
Japan’s “Tax Haven Counter Measure Law” prevents Apple from using its Irish subsidiary to recognize earnings in Japan under the Irish tax code.
The math proves this. As Japan’s 33% corporate tax rate on operating income of $7.6 billion corresponds to $2.5 billion in taxes paid to the Japanese government (pg.67 10-K 2015), the remaining regions are getting shafted by the Irish tax code.
When referencing (pg. 23) HLB international’s report on Japan’s tax code, the code is robust enough to prevent Apple from using Apple International as a means of tax avoidance.
When excluding Japan earnings/tax, the international tax rate is .88% on $45 billion in operating income, as it’s implied that Apple paid a microscopic portion of its FY’15 earnings to foreign governments with the exclusion of Japan (similar to the EU).
I believe the $400 million difference in tax was split between China and a couple other regions. It was reported that Apple back-owed China $80 million in taxes in 2015, the difference in tax assessment is minimal and in-line with a Chinese tax figure that’s likely in the realm of a couple hundred million dollars at most.
In other words, my estimate implies an international average .88% tax rate (excluding Japan), which already corresponds to EU commissioners Margrethe Vestager’s claims of an effective .05% tax rate, which she computes using the differences paid on Irish taxes, as opposed to untaxed earnings from other EU member regions. However, my figure is somewhat higher, as I believe Apple pays retail transaction taxes from its foreign Apple stores, and property tax on some of its facilities in China.
My calculation is still comparable to Vestager’s, and I also believe these assumptions to be accurate enough to estimate Apple’s forward corporate tax rate for FY’17 and FY’18.
Likewise, investors can take on a more granular approach by modeling a 0.5% to 1% tax rate on operating income from foreign markets excluding Japan and utilizing the corporate average tax rate of 33% for Japan operating income. Given the drawn-out time frame for legal action to occur, I believe Apple's current tax agreement with Ireland will withstand for a couple more years. As such, I'm using the observations made by the EU commission as a basis for predicting Apple's tax rate over the next couple years.
Based upon an agreed settlement, it's likely that Apple will make a one-time payment for deferred taxes. But, up until that inflection point, I'm not attempting to articulate future owed taxes from such a settlement.
As such, I continue to reiterate my buy recommendation on Apple. I will publish my financial model for FY’17 and assign a new 12-month price target/outlook in a future article.