Frustrated with the ease with which multinational enterprises can use transfer pricing to shift profits across borders, many tax scholars have called for a shift from the separate entity—arm’s length system of allocating profits to a kind of the formulary apportionment system used in the United States and Canada for subnational income taxes, and more recently proposed for use in the European Union.
Such a move would have consequences on tax revenues. While there has been a wave of research by empirical scholars seeking to estimate the financial impact, in a forthcoming article we conclude that producing an accurate estimate is impossible. Our findings would have implications for governments that are considering switching to a formulary apportionment system.
The development of international taxation
A century ago, shortly before, during, and in the years immediately following World War I, almost all Western countries adopted income taxes, imposing tax on locally sourced profits derived by non-residents and world-wide income derived by residents. As a result, the world’s industrialised nations faced two new fiscal issues needing urgent resolution to facilitate post-war economy rebuilding.
The first issue raised by the new tax system was how to resolve the problem of double taxation, with residents of a capital exporting nation facing home-country taxation on world-wide profits and source-country taxation on the profits they earned from abroad. Countries quickly developed unilateral solutions to the problem with residence countries conceding first taxing rights to source countries, mostly either by way of exemptions for foreign-source income taxed abroad or credits for source country taxation. A few outliers, most notably the UK, initially treated foreign taxes levied by source countries as business expenses, only allowing residents a deduction for the foreign taxes, but most pivoted to a foreign tax credit or exemption solution after a short period.
The second issue was how to allocate the profits of multinational enterprises that effectively operated as a single economic entity across multiple jurisdictions, albeit notionally divided into separate subsidiaries or branches in each jurisdiction. The problem was studied by a ‘group of experts’ comprising leading academics from the United States, Italy, the Netherlands and the United Kingdom, who were appointed by the League of Nations.
The group of experts concluded that the most logical way to allocate multinational enterprises’ profits was by reference to a formula that looked at each country’s contribution to the creation of the profits. Three factors were considered – the relative inputs of labour and capital used to produce the goods and services, and sales revenue, the final source of profits measured as the excess of proceeds over the input costs of capital and labour.
The relative simplicity of the system, which became known by the term ‘formulary apportionment’, was demonstrated following its adoption in federal states such as the US, Canada, and for a time Australia, before its states lost their income tax powers, to allocate the profits of enterprises operating across or selling to multiple states or provinces for state and provincial income tax purposes.
Notwithstanding its acceptance as the preferred profit allocation method for subnational income taxes, at the international level multinational enterprises and some governments resisted the recommendations of the League of Nations.
This led to a second report by US tax advisor Mitchell B. Carroll. Caroll recommended that each part of a multinational enterprise be treated as a separate entity unrelated to the rest and any intra-group transactions be priced at a notional arm’s length price. Hiss proposals were accepted by the developed economies, establishing the separate entity—arm’s length system that has been used by all countries for the past nine decades to allocate the profits of multinational enterprises for tax purposes.
The assumption underlying the system – that arm’s length prices could be found for intra-group transactions within a multinational enterprise – has long ago been proven to be a myth. As there is no true arm’s length price for many intra-group transactions, this provides a significant leeway for enterprises to nominate prices that allow them to shift substantial profits from higher tax to low or no-tax jurisdictions.
Six challenges in estimating the impact on tax revenues
Before governments consider proposals for a formulary apportionment regime, political leaders need to know its financial consequences. This interest has prompted research to estimate the impact a change of this sort would have on tax revenues. The results, however, have been at best inconsistent and in the view of some of limited value.
Scholars attempting the task have encountered six distinct data and geopolitical constraints. The first is the unavailability under current separate entity accounting systems of any measure of the true global profits of a multinational enterprise, the total amount that under formulary apportionment would be allocated to the taxing jurisdictions based on a formula. Surrogate measures need to be used and these are inevitably reliant on assumptions and guesses almost certain to not reflect actual amounts.
The second challenge, following in part from the first, is the use of a dataset relevant only to a particular geographic area. For example, studies that use European Union data, are based on regional profits, and consequently ignore profits shifted outside the region. Often, this means that profits shifted to low or no-tax jurisdictions are simply ignored.
The third challenge arises from the sensitivity of global income allocation calculations to the allocation factors used in any formula along with their respective weightings. A standard three factor equally weighted formula of labour and tangible assets representing inputs and sales at destination representing outputs is often used in studies. However, this does not take into account geo-political considerations and compromises that are likely to affect any formula ultimately used by jurisdictions.
For example, to placate lower wage countries, the European Union has suggested the need for any formulary apportionment system used by member states to use both the conventional labour costs factor and a factor looking at the number of employees without regard to their cost.
The fourth major challenge faced by scholars seeking to estimate formulary apportionment outcomes is the absence of data on sales destination, one of the three factors used in the conventional allocation formula. This data simply is not available and therefore proxies must be used, often being the turnover at the place of origin of sales as a substitution for the destination for sales. The resulting calculation substantially over-allocates profit to wealthier exporting jurisdictions and understates the profit allocation to poorer importing jurisdictions.
A fifth challenge is difficulty in determining whether a one-size-fits-all formula is appropriate for all multinational enterprises or whether the formula should be modified for specific industries. For example, a question often arises as to whether natural resources should be included in the measurement of the capital input factor or whether the finance sector should be subject to its own formula as is done in some subnational regimes.
Finally, a sixth challenge faced by researchers estimating the effects of a move to formulary apportionment is resolving the question of whether redistribution goals should be included in the design of a regime. Some policy advocates suggest that governments should agree to an allocation formula with specific redistribution aims to further global equity goals.
Can we produce an accurate estimate?
While frustrations with the current transfer pricing, arm’s length regime are likely to continue, it is difficult for national governments to fully appreciate the implications of a move to what is a theoretically superior model of formulary apportionment. The revenue effects simply cannot be accurately estimated.
Ironically, there is one group with full access to all the data needed for an accurate estimate of the impact of a move to formulary apportionment, the multinationals whose profits would be reallocated under the system. The fact that none have volunteered the information to researchers or governments suggests the additional tax burden they would face if profits currently shifted to tax havens were reallocated to jurisdictions hosting tangible capital, labour and sales is not insignificant.
Smarter to just forget income tax and go for territorial land and resource revenues. The Arabs understand that resource revenues mean you can be an attractive tax haven. Look at the Gulf States. It is an indictment of Australian fiscal policy that Australia is not a tax haven for labour and capital when we have so much more resource value per capita than they do. Optimal tax theory is simple. There are only three sources of income – the returns to land, labour and capital. Only one of them does not stop breeding or working, wear out, rust out or die off. As the Americans say, go figure. Treasury was smarter in the 60s when it did not like tax treaties save for allies who might fight with us.
Thanks for the article! Was great learning about the challenges in economics due to a switch in apportionment regime.