Setting up shell companies in overseas tax havens sounds like a criminal enterprise, but the big scandal is that it's perfectly legal.
Who said the U.S. Congress was good for nothing? You and I, probably, but neither of us was giving Carl Levin, John McCain, and the other members of the Senate’s Permanent Subcommittee on Investigations their due. In drawing attention to corporate tax avoidance, most recently by hauling before it Apple CEO Tim Cook, the committee is performing an important public service. Nearly everybody agrees the system of corporate taxation is broken. But it is only if the public gets engaged (and enraged) that anything will be done.
Setting up shell companies in overseas tax havens, parking vast sums in offshore bank accounts, pretending that you do a lot of business in places like Puerto Rico and Ireland when actually you run everything from Cupertino, Calif., or Seattle: It sounds like a criminal enterprise, but the big scandal is that it’s legal — to some extent, almost all multinational companies do it. In the words of a defiant Cook: “We pay all the taxes we owe — every single penny.”
But just because something is legal doesn’t mean it’s right or socially efficient. When corporations pay less in taxes, the rest of us have to pay more. In the 1950s, corporate taxes accounted for about a third of federal tax revenues; today they contribute less than a tenth. And that doesn’t consider all the money companies spend on accountants, lawyers, and other tax-avoidance enablers. If you deduct all those costs, the entire phenomenon arguably generates negative value.
Apple has perfected using shell companies and accounting tricks to shift much of the revenues and profits it generates overseas to low-tax countries, particularly Ireland, where it has negotiated a 2% tax rate. (How do you negotiate your own tax rate? Ask the Irish.) Such shenanigans rob foreign governments of tax revenues and allow Apple to shelter money it owes Uncle Sam, who in theory taxes companies on their global earnings.
Yet another form of tax avoidance is perhaps more pernicious: shifting profits generated in the U.S. offshore where the IRS can’t get at them. In knowledge-intensive industries such as technology, that is often done by transferring the ownership (or part ownership) of intellectual-property rights to subsidiaries in tax havens, which then charge the parent company hefty licensing fees — a practice known as “transfer pricing.” Apple doesn’t appear to do that, but Microsoft, Google, and others do. In a report issued last year Levin’s committee detailed how Microsoft, which carries out the vast bulk of its research and development in the U.S., transferred to units in Puerto Rico, Singapore, and, yes, Ireland, the economic rights to some of its intellectual properties. According to the report, the Puerto Rico dodge alone saved the company $4.5 billion in U.S. taxes over three years.
Virtually everybody in the upper echelons of big companies knows this stuff goes on, and so does the IRS. In 2010 the agency appointed a new director to deal with transfer pricing, but not much has happened. The agency can enforce only the tax laws that are on the books, and, thanks partly to legislation that Congress passed during the Clinton and Bush administrations, these laws allow companies to get away with all sorts of things. So what can be done?
A radical solution would be to scrap the corporate levy, treat corporations as “pass-through” entities, and shift the tax burden onto shareholders. To recoup the lost revenue, we’d need to raise the tax rate on dividends and capital gains, tax dividends at source, and elicit some contributions from investing institutions that are now tax-exempt, such as pension funds. Since none of that is likely to happen, the only practical option is to toughen the existing tax code, put pressure on countries like Ireland to play by a new set of rules, and shame multinationals into paying their fair share.
In the U.K. and other countries the shaming part is already happening — as Starbucks and Google can attest. The U.S. public and its political system are a bit behind. Eventually they will catch up.
John Cassidy is a Fortune contributor and a New Yorker staff writer.
This story is from the July 1, 2013 issue of Fortune.