Tomorrow Tim Cook and the gang head to Washington to have a chat with a Senate committee investigating the possibility of tax avoidance (or evasion, depending on how you look at it) by Apple. Here's what's at stake.

Ahead of the testimony it will be giving before the U.S. Senate tomorrow, Apple (via The Loop) offered up a nicely detailed 17-page PDF document with all sorts of good information inside. The most interesting number is this: Apple pays $1 out of every $40 of corporate income tax collected by the US Treasury. Isn’t it incredible to think that one company is responsible for 2.5% of all US corporate income tax collection?

Despite Apple being the single largest US taxpayer, Senators Carl Levin and John McCain are accusing Apple of establishing “the Holy Grail of tax avoidance”. You can read the entire argument made by the Senate subcommittee on the Financial Times website.

While this stuff is pretty dry reading for most tech people, I find it interesting because I spent over a decade as a stock analyst and I was always fascinated by how some companies managed to achieve very low tax rates ... using perfectly legal structures.

The U.S. Government’s issue with Apple stems from two arguments relating to Apple’s arrangements in Ireland, a well known low cost country. Let’s see if I can break this whole thing down into something easy to understand.

Here’s the first major item as described by Senate:

Apple’s cost sharing agreement (CSA) with its offshore affiliates in Ireland is primarily a conduit for shifting billions of dollars in income from the United States to a low tax jurisdiction. From 2009 to 2012, the CSA facilitated the shift of $74 billion in worldwide sales income away from the United States to Ireland where Apple has negotiated a tax rate of less than 2%.

Plain English? The government doesn’t like the idea that Apple’s Irish subsidiary is treated as a cost center to the US operations, resulting in less US profit and more Irish profit. Apple’s comments regarding this structure are pretty compelling. They’ve had a cost sharing arrangement in place with the Irish subsidiary since 1980. It sounds like the Irish operations are responsible for paying for part of Apple’s US-based R&D efforts, and in return it claims ownership of a certain percentage of the intellectual property that comes out of that R&D. Apple says, “These agreements were sanctioned by the US Congress in 1986 and are expressly authorized by US Treasury regulations.”

Furthermore, Apple points out that these cost sharing arrangements benefit the US because it keeps high-cost R&D jobs in the domestic market. In Apple’s own words, “Some commentators have urged eliminating these types of cost sharing agreements, but doing so would harm American workers and the broader US economy. If cost sharing agreements were no longer available, many US multinational companies would likely move high-paying American R&D jobs overseas.”

I don’t know how other readers will interpret these documents, but I think Apple presented a much stronger argument.

The second major item the Senate is focused on:

Offshore Entities With No Declared Tax Jurisdiction. Apple has established and directed tens of billions of dollars to at least two Irish affiliates, while claiming neither is a tax resident of any jurisdiction, including its primary offshore holding company, Apple Operations International (AOI), and its primary intellectual property rights recipient, Apple Sales International (ASI). AOI, which has no employees, has no physical presence, is managed and controlled in the United States, and received $30 billion of income between 2009 and 2012, has paid no corporate income tax to any national government for the past five years.

What’s this mean? The US government is saying that Apple funnels profits to Irish subsidiaries and then doesn’t pay any tax because the Irish subsidiary isn’t a US resident, based on US tax law, but isn’t an Irish resident either, based on Irish tax law. The suggestion the government is making here is one of, “Well, if you’re not a resident of any particular tax jurisdiction, you must be skipping out on taxes!”

Again, Apple puts forth a very straight-forward argument in explaining its setup. Apple Operations International (AOI) is a holding company incorporated in Ireland. Being incorporated in Ireland, that corporation is not a US taxpayer. End of story. It also just so happens that because of Irish law (which probably requires a certain number of employees or physical presence) it is not an Irish taxpayer either. So AOI doesn’t pay tax. But that’s missing the point. AOI is a holding company. All it does is collect payments from other Apple subsidiaries (payments that have already been taxed) and manage the money from a central location. The money AOI collects in the form of inter-company dividends has already been taxed.

Putting this in simpler terms, let’s say you had 3 separate companies in Ireland. Each company makes a profit and pays required taxes. Wouldn’t it be simpler to dump all of that money into one holding company so you can manage the investment of this money in an efficient manner? Of course. That’s what Apple is doing. Oh, and that money is managed by US people, held in US banks.

The bottom line is the US Senate Subcommittee is bitching about Apple supposedly not paying enough taxes, despite the fact that Apple pays $1 out of every $40 of corporate income tax collected by the US treasury, and despite the fact that the US is responsible for establishing all of the laws that Apple is now abiding by. Furthermore, the Subcommittee is putting its hands where they don’t belong. The Irish subsidiary AOI is clearly not a US resident for tax purposes, since it is incorporated in Ireland. That is where the argument should end. It is irrelevant to the US whether or not the Irish government allows Apple to consider this entity a non-resident of Ireland. Maybe Ireland encourages this practise, making it an ideal place to incorporate holding companies. But regardless, it’s none of the US Treasury’s business so long as it is not a US resident corporation. Newsflash, Senate ... you don’t get to control Irish law. You control your own law and the law is pretty clear. If AOI is incorporated in Ireland, it’s not a US taxpayer. End of story. Whatever the Iaw says about taxation in Ireland are none of your damn business.

Back in 1999 my father encouraged me to read a book called “The Soverign Individual”. As per the Amazon description, “In The Sovereign Individual, Davidson and Rees-Mogg explore the greatest economic and political transition in centuries -- the shift from an industrial to an information-based society. This transition, which they have termed "the fourth stage of human society," will liberate individuals as never before, irrevocably altering the power of government.”

Today the U.S. government is under pressure to collect more tax revenue. They’re fighting information-based global companies like Apple who have organized themselves, legally, in the best interests of shareholders.

This is a battle the U.S. government will lose, and they better start looking at alternative ways to solve their tax revenue problems. Picking a fight with their biggest taxpayer seems utterly stupid.