The “CFC Look Through” Rule, aka the Apple Loophole

Yesterday the Senate Financial Services Committee passed the “Expiring Provisions Improvement Reform and Efficiency (EXPIRE) Act” with bipartisan support, sending it down the road toward final passage.

While enactment cannot be guaranteed, these loopholes have been consistently reauthorized year after year.

The day before the session, Chairman Wyden (D-OR) posted a version of the bill without the “CFC Look Through” loophole in it. That was progress, explained Dan Smith, U.S. PIRG Tax and Budget Advocate.

Multinationals’ Lobbying Gets Results

“Close scrutiny reveals that the CFC look through rule serves only one purpose: letting a handful of giant multinationals use sham subsidiaries in tax havens to shirk their tax responsibilities,“ Smith said.

As a result, Smith continued, “average taxpayers and small business owners are the ones to foot the bill, coping with cuts to public programs, higher taxes, or a larger deficit.” Eliminating the loophole, Smith said, would save taxpayers over $2 billion.

For some reason, however, Sen. Wyden changed his mind, and by the time the hearing got underway the next day, he had amended his bill to include the Look Through rule. Perhaps the army of 1,359 lobbyists pushing these provisions explains the change.

The Apple (and Caterpillar) Loopholes

The Apple (NASDAQ: AAPL) loophole really has two parts, the CFC Look Through Rule and its “Check the Box” cousin. Which tax planning rule applies depends on whether the foreign subsidiary is a corporation or something else, such as an LLC.

Both provide tremendous tax planning flexibility, enabling Apple (and many other, particularly tech, pharma and other IP-rich companies) to pay little U.S. income tax. To shrink their bills, these multinationals paper their operations to document—for tax purposes—that their income was earned in countries with little or no corporate income tax.

See also: Congress Prepares To Give GE A Big Tax Break

Apple is the traditional poster child for this loophole, because as the New York Times explained a couple years ago, Apple has been a leader in using these rules to shield its income in off-shore tax havens. But as a recent hearing of the Senate Permanent Subcommittee on Investigations revealed, Caterpillar (NYSE: CAT) has using Check the Box to avoid paying U.S. tax for years, $2.4 billion all. (For details on Caterpillar, see the testimony of Reuven S. Avi-Yonah here.)

Where In The World?

Prof. J. Richard Harvey, Jr. of Villanova University’s School of Law and Graduate Tax Program has studied Apple’s tax strategies. He testified at a May 2013 hearing held by the Senate Permanent Subcommittee on Investigations, and he published a related slideshow a few months later. (Download here.)

According to Harvey, in 2011 Apple claimed that only 30 percent of its income came from the U.S., despite having 67 percent of its employees, 79 percent of its payroll, and 39 percent of its customers here. Apple asserted nearly every other country in the world accounted for only six percent of Apple’s income. Collectively those countries are home to 29 percent of Apple’s employees, 18 percent of its payroll, and 60 percent of its customers.

So where did Apple say the remaining 64 percent of its income was earned and should be taxed?

Ireland. Apple earned two-thirds of its income in a country home to only four percent of Apple’s workforce, three percent of its payroll, and one percent of its customers because Ireland’s effective tax rate on Apple’s income was 0.1 percent.

According to the 40-page memo from the Subcommittee’s investigation into Apple, (download here) Apple ducked paying U.S. taxes on about $10 billion per year using these and other strategies.

Not Just Ireland

Caterpillar’s use of check the box made for similarly incongruous results between its tax geography and its business geography. As the Subcommittee explained,

“Caterpillar sent the vast majority of its [parts business] profits to Switzerland even though only about 65 of the 8,300 Caterpillar employees who handle parts work in Switzerland” while nearly 5,000 U.S. employees handle parts. Caterpillar was unsatisfied with Switzerland’s normal eight percent tax rate, and cut a deal to be taxed no more than six percent.

Getting rid of the CFC Look Through and Check the Box would contribute $78 billion to America’s coffers over 10 years, according to this fact sheet about the Stop Tax Haven Abuse Act. (See provision 304 at the link.) The number is so large because so many companies use them this way.

IRS Error And Corporate Lobbying Produced The Apple Loophole

The IRS created the “Check the Box” rule in 1997, apparently without understanding how easily it could be exploited to avoid taxes. Once the IRS caught on, it tried to correct its mistake, proposing new rules in March 1998. However supporters of the new freedom to shift income for tax purposes lobbied the IRS into backing down.

To prevent any risk that the IRS might eliminate Check the Box, multinationals lobbied for Congress to strengthen it. Congress respondend in 2006 by passing the CFC Look Through Rule.

Apparently similar lobbying efforts have been successful globally, because the G-20 is alarmed about multinationals’ tax dodging. The 20 sovereigns asked the Organization for Economic Cooperation and Development (OECD) to do something. So the OECD started the Base Erosion and Profit Shifting (BEPS) project.

Given the global nature of the economy and competitiveness concerns, Prof. Harvey said, “it is my hope that eventually, through the efforts of the BEPS project, there will be a global solution. But that is far from certain."

All that’s really certain is that if the extenders bill—as it passed the Senate Committee today—is signed into law by President Obama, American multinational corporations will be able to continue ducking billions in U.S. taxes.