FORTUNE — There’s a widely shared idea that if the U.S. Reduced its corporate income tax rate to 25% from the current 35%, big corporations would stop playing tax games. They would then pour all their attention into profit-making rather than allocating a ton of talent to tax avoidance, and we would all be richer and happier as a result.
Apple’s recent plan to supposedly return a big part of its company’s cash hoard to investors shows how naïve that kind of thinking is. And, by the way, it also shows that Apple (AAPL) is actually more into playing tax and accounting games than it is into returning cash.
As you likely know, about two-thirds of the $145 billion of cash on Apple’s books is held in overseas subsidiaries, and Apple would have to pay U.S. Income tax if it used that money in the U.S. So instead of bringing in money from overseas to pay for its stepped-up stock buybacks and higher cash dividend, Apple will borrow money instead.
It’s a perfect tax arbitrage. Let’s say Apple borrows money at an interest cost of 3% a year (which is more than it would likely pay), and uses it to buy back stock at the current price of about $410 a share. Each share that Apple buys back will reduce its annual dividend obligation by $12.20 a share, at the company’s current dividend rate. The interest on the borrowed money would be $12.30 a share — about the same as the dividend. But interest is tax deductible, and dividends aren’t.
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At a 35% tax rate, the borrowed money would cost Apple $8 after taxes for each share it bought back. That’s significantly less than the $12.20 after-tax cost of its $12.20 dividend. At a 25% tax rate, the borrowing would cost $9.23 after taxes — but that’s still less than $12.20. So lowering the tax rate to 25% from 35% doesn’t remove Apple’s incentive to play the deduct-interest-to-retire-stock tax game. It would be less lucrative than it is at 35% — but it’s still lucrative. And, by the way, the borrowing-to-buy back maneuver would not only reduce Apple’s taxes, it would increase its earnings per share.
With tax rates at 35%, it’s considerably cheaper for Apple to borrow money in the U.S. Than it would be for it to repatriate cash held in foreign subsidiaries. But even if the tax rate were only 25%, it would still be cheaper for it to borrow than to repatriate.
Besides, history shows that lowering the corporate tax rate doesn’t reduce companies’ desires to play games. The 1986 tax reform act reduced the corporate rate to 34% from the previous 46%. So what happened? After a brief period, probably measured in nanoseconds, companies began trying to get around the 34% (now 35%) rate the same way they had tried to get around the 46% rate.
There’s a wonderful series that Reuters published last year detailing the efforts made by European subsidiaries of U.S. Multinationals like Starbucks (SBUX) and Amazon (AMZN) and eBay (EBAY) to move taxable income out of places like England, Germany, and France, which have corporate rates in the mid-20s, to places like Luxembourg, where rates are considerably lower.
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These games are familiar to those of us who follow U.S. Tax policy, such as it is. You set up a subsidiary in a low-tax area that owns “intellectual property,” and that collects royalties that subsidiaries in higher-tax areas get to deduct. You have all sorts of intra-corporate loans, with tax-deductible interest paid in higher-tax areas and collected in low-tax and no-tax areas. And on and on and on. Except that instead of moving income from the U.S. To low-tax places, you move income from higher-tax European countries to lower-tax European countries.
The bottom line: Even if Washington gridlock is broken long enough to cut the corporate rate to 25%, there will always be a Luxembourg or a Cayman Islands, or some other low-tax Shangri-la that will offer rates low enough to keep tax lawyers gainfully employed. You can take it to the bank. An offshore bank, of course.
