Apple set for showdown on Capitol Hill over corporate taxes

tim cook apple
Tim Cook is set to testify on Capitol Hill Tuesday.

Apple executives are set to defend the company's tax practices and call for corporate tax reform on Capitol Hill Tuesday amid harsh criticism following a Senate investigation.

A report released Monday by Senators John McCain, R-Arizona, and Carl Levin, D-Michigan, charged that Apple "has used a complex web of offshore entities -- including three foreign subsidiaries the company claims are not tax resident in any nation -- to avoid paying billions of dollars in U.S. income taxes."

The report says Apple (AAPL) relies on a number of unusual accounting tactics along with a handful of subsidiaries in Ireland -- where it has negotiated a tax rate of less than 2% -- to reduce its tax bill. The U.S. corporate tax rate stands at 35%.

One Irish subsidiary -- Apple Operations International, or AOI -- has no employees or presence in Ireland, holding its board meetings and keeping its bank accounts in the U.S., the senators said. AOI reported $30 billion in income from 2009 to 2012, but its management structure allowed Apple to exploit a gap between U.S. and Irish law and avoid paying taxes in either country, the report claims.

Another Apple subsidiary in Ireland, Apple Sales International, had an effective 2011 tax rate of just five hundredths of one percent, the report says. Apple also ducked taxes on $44 billion in income by transferring the rights to its intellectual property though cost-sharing agreements with its subsidiaries, the senators alleged.

"A company that found remarkable success by harnessing American ingenuity and the opportunities afforded by the U.S. economy should not be shifting its profits overseas to avoid the payment of U.S. tax, purposefully depriving the American people of revenue," McCain said in a statement Monday. The senators did not weigh in on the legality of Apple's tactics.

Apple CEO Tim Cook will take questions from McCain, Levin and other members of the Senate's Permanent Subcommittee on Investigations at a hearing Tuesday morning alongside Apple CFO Peter Oppenheimer and Head of Tax Operations Phillip Bullock.

In testimony posted online ahead of Tuesday's hearing, Apple brushed off charges that it is gaming the U.S. tax system, saying it "pays an extraordinary amount in U.S. taxes" and "does not use tax gimmicks."

The company disputed the characterization of its subsidiaries as tax shelters, saying its Irish operations employ nearly 4,000 people and "are involved in manufacturing, distribution, technical support, sales support and finance support services."

"For cash management purposes, these subsidiaries distribute foreign, post-tax income as dividends within Apple's corporate structure," Apple said. "Under US tax law, these foreign intercompany payments are not taxable."

The cost-sharing agreement with its subsidiaries, Apple added, "is authorized by US law and complies with all US tax regulations."

"This agreement allows the Company to co-develop and share the risk of developing new products with its foreign subsidiaries," Apple said.

Tuesday's hearing comes amid criticism of American corporations over practices by which they lower their tax bills through legal means, holding cash overseas and funneling profits through subsidiaries in low-tax countries. Apple says this issue could be solved via new legislation, arguing that the U.S. tax system "has not kept pace with the advent of the digital age and the rapidly changing global economy."

The California-based company holds more than $102 billion offshore, allowing it to avoid the 35% tax it would pay upon returning the money to the U.S. The firm recently borrowed $17 billion to buy its own stock from shareholders rather than draw on its overseas cash, avoiding substantial U.S. taxes as a result.

In the testimony prepared for Tuesday's hearing, Apple said its foreign cash holdings are so high because the majority of its sales -- 61% last year -- come overseas. The company added that it's "likely the largest corporate income tax payer in the US," having paid $6 billion to the U.S. government in its previous fiscal year, and says it has "created or supported approximately 600,000 jobs for American workers," an estimate that includes 290,000 tied to its App Store.

Related: Apple -- What it's like to drown in cash

Apple employs nearly 50,000 people directly in the U.S. The firm said its mountain of overseas cash supports its expansion and capital investments.

"Current US corporate income tax law severely discourages the use of these funds in the US," the company said, noting its duty to protect pension funds and other shareholders.

Looking ahead, Apple called for "a dramatic simplification of the corporate tax system that is revenue neutral, eliminates all tax expenditures, lowers tax rates and implements a reasonable tax on foreign earnings that allows free movement of capital back to the US." The company said that while such reform could increase its tax burden, it "is not opposed to such a result if it occurs in the context of an overall improvement in efficiency, flexibility and competitiveness."

In September, the Senate subcommittee heard from Apple competitors Microsoft (MSFT) and Hewlett-Packard (HPQ), whom Levin called "case studies of how U.S. multinational corporations... exploit the weaknesses in tax and accounting rules and lax enforcement."

What's next for Apple?
What's next for Apple?

A subcommittee report at the time alleged that Microsoft had saved nearly $7 billion off its U.S. tax bill since 2009 by using loopholes to shift profits offshore. H-P, the report said, avoided paying taxes through a series of loans that shifted billions of dollars between two offshore subsidiaries.

McCain and Levin have called for corporate tax reform that prevents U.S. corporations from shifting profits offshore through accounting gimmicks.

Fortune's Philip Elmer-DeWitt contributed reporting.

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