What Happens When Hacking Concerns Conflict With A State Electronic Payment Mandate?

Let’s travel to the Bay State for a taxpayer requesting reasonable cause against the imposition of penalties.  

The amount in dispute is $100.

Yes, you read that correctly.

Our protagonist is Jonathan Haar, and he lives in Massachusetts. On April 15, 2011 he had the audacity to file a paper extension and include a $19,517 check for his tax year 2010 state return. The paper extension and payment

“… did not comply with the requirements set forth in Technical Information Release (“TIR”) 04-30 (“TIR 04-30”), which states that if a payment accompanying an extension application equals $5,000 or more, such extension application and payment must be submitted electronically.”

Got it. The state says that it is less expensive to process electronic than paper tax filings and payments. Seems reasonable. How do we get people to follow along, however? One way is to make whatever the state wants mandatory.

Our protagonist unfortunately had travelled this path before, and he had been warned for tax year 2005 and penalized for year 2006.  Massachusetts had a tax recidivist! They assessed the above-mentioned $100 penalty on our ne-er-do-well.

If you were my client, I would have told you to pay the $100 and move on. Mr. Haar is not my client, and he refused to pay. He instead filed an appeal, which appeal went to the Massachusetts Appellate Tax Board.

His argument?

“Mr. Haar maintained that the Commissioner’s electronic payment mandate is a ‘serious invasion of both [his] privacy and [his] personal business practices,’ as it exposes his finances to risk of cyber attack.”

 “I intentionally do no electronic banking nor direct bill paying, I have none of my credit cards linked to my bank accounts directly and I think anyone who does any of the above is exposing themselves to multiple risks of cybercrime and identity theft.”

Mr. Haar further expressed doubts as to the security of the computer systems used by the Department of Revenue (“DOR”), noting that "if the Pentagon can be hacked," he had little confidence that DOR could protect his – or anyone’s – personal data from theft.

Massachusetts argued that it had the authority to mandate electronic filing and payment, as well as assess penalties if a taxpayer failed to comply with their filing and payment mandates. Massachusetts does recognize exceptions for reasonable cause, but its own Administrative Procedure 633 (“AP 633”) provides that

… the fact that a taxpayer does not own a computer or is uncomfortable with electronic data or funds transfer will not support a claim for reasonable cause.”

COMMENT: Call me quaint, but I would say that someone not having a computer is prima facie reasonable cause for not being able to file an electronic return or transfer funds electronically. The issue I see with AP 633 is its absolutism: the language “will not support” leaves no room. Why not say instead “generally will not support,” if only to allow space for unexpected fact patterns? 

In support of its position, the DOR trotted out two officials: the first was Robert Allard, a tax auditor. He pointed out that Mr. Haar filed an electronic return, presumably through a professional preparer. I suppose that Mr. Allard felt that if one could electronically file then one should be able to electronically pay. 

The second was Theresa O’Brien-Horan, a 26-year employee and Deputy Commissioner, who testified that

… the mandate at issue in this appeal – requiring individual taxpayers who apply for an extension with an accompanying payment of $5,000 or more to file and pay electronically – is helpful to DOR because it maximized up-front revenue intake.”

… the $5,000 threshold was chosen because it would ‘impact 17% of the taxpayers, but … get the money banked for 84% of the revenue.”

You can virtually feel the customer service vapor emanating from Ms O’Brien- Horan.

When asked whether reasonable cause was the Massachusetts equivalent of an ”opt out,” Ms. O’Brien-Horan answered “yes.”

OBSERVATION: The IRS, for example, prefers that one file an electronic return. The IRS however did not put the burden on the taxpayer; rather it put the burden on the preparer. If a preparer prepares more than a minimal number of returns annually, the preparer is required to file the returns electronically. This is awkward, as the return belongs to the taxpayer and not to the preparer. The preparer is not allowed to release any return – even to the IRS – without the taxpayer’s approval. What does the preparer do if the taxpayer does not grant approval? The preparer includes yet-another-form with the return indicating that the taxpayer has “opted out.” This prevents the IRS from penalizing the preparer for not filing electronically.

If Mr. Haar’s position was reasonable, then Mr. Haar could “opt out,” irrespective of any self-serving Massachusetts Administrative Procedure.

Ms. O’Brien-Horan just didn’t think that Mr. Haar was being reasonable.

But the Board did.

“Given his reference to the hacking of the Pentagon’s computer system, and in light of the many well-publicized instances of large-scale thefts of financial information following computer breaches at businesses and other institutions, and the appellant’s consistent practice of avoiding electronic payment of all his bills, including his tax obligations, the Board found that the appellant’s failure to utilize the Commissioner’s mandated electronic tax payment to be reasonable.”

Two things strike me immediately.

The first is the cause for concern comprising Mr. Haar’s argument. It had not occurred to me to off-grid all of one’s banking transactions, but he gives one pause. I recently read the following on www.marketwatch.com, for example:

A Russian gang has stolen 1.2 billion user names and their passwords as well as more than 500 million email addresses, the New York Times reports.

The information came from more than 400,000 websites, according to the Times, which says researchers at Milwaukee-based Hold Security discovered the cyber heist.

Mr. Haar is highly cautious. His position is somewhat eccentric but not unfounded. A reasonable tax collection agency would have granted him this one and moved on.  

The second is the inanity of Massachusetts DOR. Rather than abate a $100 penalty, it preferred to pursue the matter, at who knows what cost to state and citizens. We know that cost would include Mr. Allard and Ms O’Brien-Horan’s payroll, not to mention that of their superiors, legal counsel and who-knows-what else. I can understand not wanting to set a precedent, but … really? My take is that the DOR is too well-funded if they have the time and money to pursue nonsense like this. Perhaps DOR budgets cutbacks are in order for Massachusetts.

A Slice of Apple And A Double Irish, Please

Apple has been dragged before Congress for interrogation over its tax planning and practices. Let’s talk about some of them.

Apple’s headquarters are in Cupertino, California. It also has an office in Reno, Nevada, 200 miles away. California’s corporate tax rate is 8.8%. Nevada’s corporate tax rate is zero. Here is a pop quiz: what would you do if you were Apple’s state tax advisor?

You would try to move income otherwise reportable to California to Nevada, that’s what you would do. How would you do this? Would you move employees, lease an office, manufacture iPhones there? Nah. Think along other lines. Apple has cash. Boats and barges of it. It has to manage and invest that cash. Where are you going to advise them to manage it?

You got it: it’s going to happen in Nevada. Let’s set up a subsidiary called Braeburn Capital (get it?). Apple has earned approximately $2.5 billion in interest and dividends since opening Braeburn. What has Apple accomplished? It has saved 8.8% California state tax on that $2.5 billion, that is what it accomplished.

California has of course whined and sputtered and complained. What about their roads and schools and hospitals? Well, Nevada also has roads and schools and hospitals. There is a price point to everything. I may like an iPhone, but I am not going to pay thousands of dollars for it. Sounds to me like California priced itself out of the market.

Steve Jobs several years ago approached the city of Cupertino about a new headquarters for Apple. The city council, seeing an opportunity to get more than its fair share, inquired about Apple providing free wireless internet service. Maybe pony rides too. Steve Jobs responded that Apple paid taxes, and that the city should provide free internet service – and the pony rides. He continued:

“That’s why we pay taxes. Now, if we can get out of paying taxes, I’ll be glad to put up Wi-Fi.”

Jobs pressed on, noting that – if Cupertino did not want them – Apple could just move. Cupertino backed down. One council member complained, wondering what it would take to make Apple feel “more connected.”

COMMENT: I do not need to feel “more connected” to the government. Good grief. Has a flying saucer landed and disembarked these people?

Let’s talk next about Apple and international taxes. This has been the topic of recent Congressional hearings before the Senate Permanent Subcommittee on Investigations. Senator Levin, head of the committee, blasted Apple for using “offshore entities holding tens of billions of dollars, while claiming to be tax resident nowhere.”

One quick moment to explain – again – that the United States imposes a worldwide tax system. A U.S. person, including a domestic corporation, is supposed to pay U.S. tax, no matter where the sale occurred, whether the money was earned inside or outside the U.S. or whether the money returned – or will ever be returned – to the U.S. There are tax deferral provisions, fortunately; otherwise, no U.S. company would be able to compete internationally. Apple has aggressively used those deferral provisions, thereby provoking the senator’s wrath.

One of Apple’s subsidiaries - iTunes S.à r.l.’s – is located in Luxembourg. What does it do? It collects roughly a quarter of iTunes worldwide sales. If someone in Europe or the Middle East or Africa downloads from iTunes, the sale is recorded here. Remember: these are downloads, not an automobile or a wide-screen TV. Downloads can be located anywhere. Apple could download from a satellite circling the earth, if it wanted to. Luxembourg presents a low tax – and friendly - environment. With that, downloads are moved away from Germany, Britain - or the United States.

Senator Levin sees tax avoidance. Me? I see common sense.

BTW, note the market that iTunes S.à r.l.’s serves. We will come back to this.

Apple was one of the first to utilize a tax stratagem that has become known as the “double Irish.”  More specifically, they used a “double Irish” with a “Dutch sandwich.” This is esoteric stuff. Let’s review in general what the tax advisors did, other than think about ordering lunch.  

It takes two Irish companies to make this work (hence, the “double” Irish). The first company (Irish #1) enters into an intellectual property (“IP”) arrangement with Cupertino. Apple transferred its IP rights for Asia, African and the Middle East to Irish #1 back in 1980. At that time, Apple approached the IRS to have it review its advance pricing agreement with Irish #1, which established how the IRS would treat transactions between the two for tax purposes. The deal was favorable for Irish #1, which is to say that Irish #1 paid considerably less to Cupertino than it made selling the IP to other affiliates. 

NOTE: More income, lower expense to Irish #1. The purpose is to keep the income outside Cupertino – which is to say, outside the U.S. 

Someone has to sell the actual product: the iPods or iPhones. Enter Irish #2, which is owned by Irish #1. In fact, it is 100% owned, which allows Irish #1 to make a critical tax election with the IRS: a “check the box” election. While in place, this election means that the IRS will treat Irish #1 and Irish #2 as though they were one company. This is key, as the illusion will stop the IRS from claiming “foreign base company income.” It takes at least two companies to generate foreign base company income, and you do not want foreign base company income. It means that the U.S. will immediately tax you without waiting for you to send the money back to the U.S.  Ireland does not have an equivalent to the U.S. "check the box."

Irish #2 manufactures and/or sells the product. The product is high-tech, so Irish #2 has to pay for the IP. Who does it pay? It pays Irish #1, of course. Cupertino can “control” the amount of income left in Irish #2 by adjusting the amount it pays Irish #1. What profit remains in Irish #2 is taxable to Ireland at 12.5%.

Except it isn’t. Apple received a tax holiday for its first ten years in Ireland (this got them to 1990), and since then it appears to have negotiated its tax rate with Irish Tax & Customs.  This point is unclear, as the Irish government is prohibited from speaking on such matters. What has Ireland gotten in return? Apple now employs over 4,000 people in Ireland and is one of the country’s biggest employers.

Let’s go back to Irish #1. What does it pay Ireland? It pays nothing. Ireland looks and sees a nonresident company. Is Ireland blind? Well … Ireland will not tax nonresident operations of a nonresident company, and it considers a company to be nonresident if:

(1)            The company “controls” an Irish company that conducts a trade or business in Ireland, and

(2)            The company itself is “controlled” by one or more residents of a country with which Ireland has a double taxation treaty. 

OBSERVATION: Now you understand why this Irish has to be a “double.” One Irish company has to own another to put this plan into play.

To close the circle, let’s put the management and control of Irish #1 in the British Virgin Islands (BVI). The BVI does not levy a corporate income tax.

NOTE: Do you see what happened here? Profit is funneled to Irish #1, which does not pay tax to Ireland. The BVI has no tax. Irish #1 pays tax to nobody. Irish #2 pays tax to Ireland, but on greatly reduced profit.

And there you have a “double Irish!”

Let us step it up a notch. 

Let us introduce a third company. We will base this company in the Netherlands. We will call it “Dutch”. Why in the Netherlands? There are several reasons:

(1)            Both Ireland and the Netherlands are in the EU. EU members can move monies around with relative ease.

(2)            Holland’s corporate tax rate is 25%, not as attractive as Ireland’s 12.5%. Why would we send money there? The Netherlands will allow us to route profits through there if we agree to leave behind a small amount to be taxed.

(3)            The Netherlands will allow us to transfer money to tax havens on more favorable terms than Ireland. We intend to transfer the monies to the BVI.

We will place Dutch between Irish #1 and Irish #2. 

How do we get money into Dutch? Dutch will intercept sales bound for Irish #2. It’s not permanent: Dutch will forward those sales on to Irish #2. We will however leave some of Irish #2’s profit in Dutch for its trouble.

And Dutch will then move the profit – to the BVI.

You have just been served a double Irish with a Dutch sandwich. 

Congress blasted Apple because its subsidiaries reported approximately $30 billion in income from 2009 to 2012 but paid little to no tax. It is a fair point, but the following are also fair points:

(1)            Apple’ recent overseas sales have been approximately 60% of worldwide sales.

(2)            Apple keeps approximately $100 billion of its $150 billion cash war chest overseas. Its cash hoard seems – at first blush – in proportion to where it made sales.

(3)            Even with all this tax planning, Apple’s effective tax rate is roughly 14%. To put this in perspective, that is about the same as Samsung, Apple’s closest competitor. Where is Samsung headquartered? South Korea.

Could Apple have done even more? Yes, it could have. Remember my comment when we discussed iTunes S.à r.l.’s? This is the subsidiary that sells downloads to Europe, the Middle East and Africa. Whom does it not sell to? To the United States, Central and South America, that’s who. If Apple were truly concerned about eliminating its tax altogether, don’t you think it would have thought about this? It thought of near everything else.

It is difficult to consider the Apple hearings and not remember that Senator Levin was one of those who previously wrote the IRS demanding that it look into the tax exempt status of 501(c)(4)s, such as the  Club for Growth,  Americans for Tax Reform and Americans for Prosperity. In the summer of 2012, he demanded “why does the IRS allow 501(c)(4) organizations to self-declare?”

Uh, yeah. Thanks Carl. We know how well that turned out.

Ireland did not take well to Levin declaiming them as a “tax haven,” mentioning “Ireland” 37 times and “Irish” 29 times during Congressional hearings. The Irish Minister of State for European Affairs Lucinda Creighton travelled to Washington. She said:

“There is no doubt that some companies are taking advantage of the global legal and tax arrangements in a variety of jurisdictions.” 

“That is not something that Ireland can solve on its own. It is not something that the US or Ireland can solve together.”

Then she pointed out the obvious: the “extremely high corporate tax rate” in the U.S. is part of the problem. 

My take? 

Apple without a doubt pressed the pedal to the floor on its international tax planning. They are in good company, however, with Google, Yahoo, Dell, Pfizer and too many others to mention. Many tax advisors are concerned about this evolution of “stateless” income. “Stateless” means the income is not reported to or taxed by any country, and it is what Apple accomplished. It is one thing to arbitrage tax rates, as we did between California and Nevada. It is another to distill, filter and bottle the income to the extent it winds up being homeless.

I consider Apple to represent – to a great extent – the logical progression of our incoherent worldwide tax system. Congress thinks that multinationals will pay our highest-corporate-tax-rate -in-the-world just because… Well, why would they? Would you? The idiocy of this whole thing is thinking that Congress has a claim to money that someone – whether you, me or Apple - earned in Europe or Africa or Asia. The hubris and greed of Congress is stultifying.

Do you think that Irish Tax & Customs is wondering why Sen. Levin is thundering that Apple did not pay Ireland enough tax?