Formulary apportionment

Last updated November 04, 2023

Formulary apportionment, also known as unitary taxation, is a method of splitting the total pre-tax profit earned (or loss incurred) by a multinational between the tax jurisdictions where it does business. It is an alternative to separate entity accounting, under which a branch or subsidiary within the jurisdiction is accounted for as a separate entity, requiring prices for transactions with other parts of the corporation or group to be assigned according to the arm's length standard commonly used in transfer pricing. In contrast, formulary apportionment attributes a portion of a multinational's total worldwide profit (or loss) to each jurisdiction, based on factors such as the proportion of sales, assets or payroll in that jurisdiction.^[1]

When applied to a corporate group, formulary apportionment requires combined reporting of the group's results. The parent and all of its subsidiaries are viewed as though they were a single entity (unitary combination), and the method is then also known as worldwide unitary taxation. In the US, most states have adopted water's edge combined reporting which restricts the taxable group to just US domestic corporations and excludes "overseas business organization", i.e., unitary foreign affiliates and foreign parents.

In North America taxation

Formulary methods are used in both the United States and Canada to apportion income of corporations between the states or provinces in which they operate.^[2] However, trade between the United States and Canada is not covered, thus requiring transfer prices, leading to increased compliance costs for the corporation. Tax in each US state and Canadian province is thus assessed based on the unitary combination of all related entities.^[3] The related entities included in the unitary combination may be worldwide entities or only entities within the United States, depending on the state. The latter is known as water's edge combined reporting.

Worldwide unitary combined reporting was first approved by the US Supreme Court in 1983 in Container Corp. v. Franchise Tax Board (CA) by a vote of 5-3 (Justice Stevens did not participate). The court re-visited worldwide combined reporting in 1994 in Barclays Bank v. Franchise Tax Board (CA) and Colgate-Palmolive v. Franchise Tax Board (CA) and again approved its use by California but this time by larger majorities. The votes were 7-2 and 9-0, respectively. However, as a result of foreign retaliatory legislation and pressure from the federal government, all states have now abandoned mandatory worldwide combined reporting.

The use of formulary apportionment in the United States dates back to the late 19th century. At that time, there was no state or federal corporate income tax, but the states did assess property and capital stock taxes. With the growth of the transcontinental railroads, state taxation authorities faced companies which had not just immovable property (tracks) but also non-trivial movable property (rolling stock) operating across state lines. The property value of a US company assessable to state tax was thus assessed by examining the proportion of railway lines within the state, and then taking that proportion of the company's total value (including the movable property) as the portion of value located within a certain state. When Wisconsin adopted a state income tax in 1911, it also used formulary apportionment (based on property, cost of manufacture, and sales), pointing to the impracticality of otherwise calculating separate accounts for a US company operating in multiple states.^[4]

By the mid-20th century, the "Massachusetts Formula" had become a commonly used standard of formulary apportionment. The formula placed an equal weight on three factors: group sales, payroll, and property within each jurisdiction.^[1] Out of the forty-four states (plus one more jurisdiction, the District of Columbia) which imposed a corporate income tax in 1978, all but Iowa used the Massachusetts Formula.^[5] Iowa's formula ignored payroll and property, looking solely at sales; the constitutionality of this formula was challenged in the Moorman case in Iowa, and it was held invalid by a trial court under the Due Process Clause of the Fourteenth Amendment as well as the Commerce Clause of Article One; however, the Iowa Supreme Court reversed the trial court in 1978. This marked the beginning of a trend towards increasing weight on sales at the expense of the other two factors; by 2004, there were only twelve states still using an equally weighted formula.^[5]

In international taxation

Formulary apportionment is not used as a method of attributing profit between (rather than within) national tax jurisdictions.^[6] The adoption of formulary apportionment has been advocated at various times since the 1970s. The matter has been hotly debated by OECD member states beginning in the 1970s.^[7] In 2000, there was a proposal to use formulary apportionment within the European Union.^[8] In 2001, the EU issued a communication advocating the use of formulary apportionment.^[9] In 2007, it was suggested that the US Internal Revenue Service use formulary apportionment (actually a hybrid approach: routine return plus residual profit split) in the assessment of federal corporate income tax, believing it would lead to increased tax revenue in the face of a trend for multinational corporations to use transfer pricing to shift profits out of the US into low-tax countries.^[10] None of these suggestions has been adopted.

Several US states allow, but do not mandate, a multinational to include foreign entities in its formulary apportionment. California, for example, began to accept worldwide formulary apportionment in the 1940s. However, its attempt to require such apportionment led to strong protests from US trading partners.^[3] The UK-US double taxation treaty signed in 1975 included a provision to prohibit US states from "tak[ing] into account the income, deductions, receipts, or out-goings of a related enterprise" in the United Kingdom or any other country for the purpose of determining tax liability.^[11] However, the US Senate, whose consent was required to ratify the treaty, rejected this provision,^[3] and the treaty was amended by a protocol in 1979.^[12] The Supreme Court explicitly held worldwide formulary apportionment as constitutional in separate cases in 1983 and 1994 (Barclays Bank PLC v. Franchise Tax Board).^[13] In 1985 the United Kingdom passed retaliatory legislation which would have overridden the UK-US tax treaty and denied significant UK tax benefits to corporations headquartered in US states which applied worldwide formulary apportionment.^[14] This and further pressure from foreign governments,^[15] the executive branch and multinational corporations led US states to adopt a "water's edge" limitation on formulary apportionment, allowing taxpayers to decide for themselves whether or not to include foreign entities in their combined reporting.^[3]

Benefits

Reduced compliance costs to the multinational;
Reduced policing costs for governments;
Profits are apportioned more closely to where value is created;^[10]
Multinationals will locate activities in the most efficient locations, not based on tax rates;^[16]
Multinationals will improve their ethical credentials;^[17]
Tax experts can be redeployed on value-adding tasks; and
Potential efficiency gains from harmonisation with the formulary approach used for apportioning national profits in US, Canada, China and Germany

Criticism

Critics argue:

Formulary apportionment leads to double taxation of the same profits unless there is agreement among all the jurisdictions on the formula to be used and the composition of the combined group.
Tax could be avoided by manipulation of the components of the formula like the location of mobile assets.
Compliance costs would be increased by the need to calculate each component of the formula in each jurisdiction.
Compliance costs would be much higher unless all jurisdictions adopted a common method of calculating taxable profits. Otherwise a separate calculation of worldwide group profits would be required under each jurisdiction's tax accounting rules. The issue is significantly reduced within the United States and Canada because variations among each jurisdiction's tax accounting methods are relatively minor.^[18]
If members of the group account in different currencies, currency exchange rate movements could distort the results of the apportionment.
Formulary apportionment does not reflect the economic profit or loss of each entity. For example, a profitable group that incurs a loss in a particular territory has taxable profit apportioned to that territory, and conversely a loss-making group which makes profits in a particular territory has no taxable profits in that territory.^[19] However, the loss-making entity could be paying artificially high transfer prices for the products it is selling in that particular market.

Notes

1 2 Clausing & Avi-Yonah 2007 , p. 12
↑ Weiner 2005 , p. 9
1 2 3 4 McLure & Weiner 2000 , pp. 254–255
↑ Weiner 2005 , p. 11
1 2 Mayer 2009 , p. 72; see also Moorman Mfg. Co. v. Bair (437 US 267)
↑ OECD 2010 , para 1.16
↑ Weiner 2005 , p. 10
↑ McLure & Weiner 2000 , p. 247
↑ http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2001:0582:FIN:EN:PDF ^{[ bare URL PDF ]}
1 2 Clausing & Avi-Yonah 2007 , p. 14
↑ US-UK Income Tax Convention (1975) Article 9(4)
↑ US-UK Income Tax Convention (1975) Protocol 3
↑ 114 S.Ct. 2268
↑ Income and Corporation Taxes Act 1988 Section 812
↑ "Debate in UK Parliament, December 18, 1989". Archived from the original on March 5, 2012. Retrieved December 17, 2010.
↑ OECD 2010 , p. 8
↑ Simmons, Richard (2019). "Curtailing Manipulative Transfer Pricing in China: The Roles of Enhanced Tax Administration, Corporate Governance and Changing Ethical Perceptions". CSJ: The Journal of the Hong Kong Institute of Chartered Secretaries. 2019 edition (June): 16–21.
↑ http://www.taxjournal.com/tj/articles/debate-should-we-move-system-unitary-taxation-18122012 ^{[ dead link ]}
↑ OECD 2010 , pp. 8–10

Related Research Articles

An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them. Income tax generally is computed as the product of a tax rate times the taxable income. Taxation rates may vary by type or characteristics of the taxpayer and the type of income.

Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because of the potential for cross-border controlled transactions to distort taxable income, tax authorities in many countries can adjust intragroup transfer prices that differ from what would have been charged by unrelated enterprises dealing at arm’s length. The OECD and World Bank recommend intragroup pricing rules based on the arm’s-length principle, and 19 of the 20 members of the G20 have adopted similar measures through bilateral treaties and domestic legislation, regulations, or administrative practice. Countries with transfer pricing legislation generally follow the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in most respects, although their rules can differ on some important details.

<span class="mw-page-title-main">Limited liability company</span> US form of a private limited company

A limited liability company is the United States-specific form of a private limited company. It is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation under state law; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. LLCs are well known for the flexibility that they provide to business owners; depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not-for-profit. In certain U.S. states, businesses that provide professional services requiring a state professional license, such as legal or medical services, may not be allowed to form an LLC but may be required to form a similar entity called a professional limited liability company (PLLC).

Tax avoidance is the legal usage of the tax regime in a single territory to one's own advantage to reduce the amount of tax that is payable by means that are within the law. A tax shelter is one type of tax avoidance, and tax havens are jurisdictions that facilitate reduced taxes. Tax avoidance should not be confused with tax evasion, which is illegal. Both tax evasion and tax avoidance can be viewed as forms of tax noncompliance, as they describe a range of activities that intend to subvert a state's tax system.

A corporate tax, also called corporation tax or company tax, is a type of direct tax levied on the income or capital of corporations and other similar legal entities. The tax is usually imposed at the national level, but it may also be imposed at state or local levels in some countries. Corporate taxes may be referred to as income tax or capital tax, depending on the nature of the tax.

Double taxation is the levying of tax by two or more jurisdictions on the same income, asset, or financial transaction.

Although the actual definitions vary between jurisdictions, in general, a direct tax or income tax is a tax imposed upon a person or property as distinct from a tax imposed upon a transaction, which is described as an indirect tax. There is a distinction between direct and indirect tax depending on whether the tax payer is the actual taxpayer or if the amount of tax is supported by a third party, usually a client. The term may be used in economic and political analyses, but does not itself have any legal implications. However, in the United States, the term has special constitutional significance because of a provision in the U.S. Constitution that any direct taxes imposed by the national government be apportioned among the states on the basis of population. In the European Union direct taxation remains the sole responsibility of member states.

Ireland's Corporate Tax System is a central component of Ireland's economy. In 2016–17, foreign firms paid 80% of Irish corporate tax, employed 25% of the Irish labour force, and created 57% of Irish OECD non-farm value-add. As of 2017, 25 of the top 50 Irish firms were U.S.–controlled businesses, representing 70% of the revenue of the top 50 Irish firms. By 2018, Ireland had received the most U.S. § Corporate tax inversions in history, and Apple was over one–fifth of Irish GDP. Academics rank Ireland as the largest tax haven; larger than the Caribbean tax haven system.

International taxation is the study or determination of tax on a person or business subject to the tax laws of different countries, or the international aspects of an individual country's tax laws as the case may be. Governments usually limit the scope of their income taxation in some manner territorially or provide for offsets to taxation relating to extraterritorial income. The manner of limitation generally takes the form of a territorial, residence-based, or exclusionary system. Some governments have attempted to mitigate the differing limitations of each of these three broad systems by enacting a hybrid system with characteristics of two or more.

Tax consolidation, or combined reporting, is a regime adopted in the tax or revenue legislation of a number of countries which treats a group of wholly owned or majority-owned companies and other entities as a single entity for tax purposes. This generally means that the head entity of the group is responsible for all or most of the group's tax obligations. Consolidation is usually an all-or-nothing event: once the decision to consolidate has been made, companies are irrevocably bound. Only by having less than a 100% interest in a subsidiary can that subsidiary be left out of the consolidation.

Corporate tax is imposed in the United States at the federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Since January 1, 2018, the nominal federal corporate tax rate in the United States of America is a flat 21% following the passage of the Tax Cuts and Jobs Act of 2017. State and local taxes and rules vary by jurisdiction, though many are based on federal concepts and definitions. Taxable income may differ from book income both as to timing of income and tax deductions and as to what is taxable. The corporate Alternative Minimum Tax was also eliminated by the 2017 reform, but some states have alternative taxes. Like individuals, corporations must file tax returns every year. They must make quarterly estimated tax payments. Groups of corporations controlled by the same owners may file a consolidated return.

A tax inversion or corporate tax inversion is a form of tax avoidance where a corporation restructures so that the current parent is replaced by a foreign parent, and the original parent company becomes a subsidiary of the foreign parent, thus moving its tax residence to the foreign country. Executives and operational headquarters can stay in the original country. The US definition requires that the original shareholders remain a majority control of the post-inverted company. In US federal legislation a company which has been restructured in this manner is referred to as an "inverted domestic corporation", and the term "corporate expatriate" is also used.

The Double Irish arrangement was a base erosion and profit shifting (BEPS) corporate tax avoidance tool used mostly by United States multinationals since the late 1980s to avoid corporate taxation on non-U.S. profits. It was the largest tax avoidance tool in history and by 2010 was shielding US$100 billion annually in US multinational foreign profits from taxation, and was the main tool by which US multinationals built up untaxed offshore reserves of US$1 trillion from 2004 to 2018. Traditionally, it was also used with the Dutch Sandwich BEPS tool; however, 2010 changes to tax laws in Ireland dispensed with this requirement.

The Common Consolidated Corporate Tax Base (CCCTB) is a proposal for a common tax scheme for the European Union developed by the European Commission and first proposed in March 2011 that provides a single set of rules for how EU corporations calculate EU taxes, and provide the ability to consolidate EU taxes. Corporate tax rates in the EU would not be changed by the CCCTB, as EU countries would continue to have their own corporate tax rates.

Base erosion and profit shifting (BEPS) refers to corporate tax planning strategies used by multinationals to "shift" profits from higher-tax jurisdictions to lower-tax jurisdictions or no-tax locations where there is little or no economic activity, thus "eroding" the "tax-base" of the higher-tax jurisdictions using deductible payments such as interest or royalties. For the government, the tax base is a company's income or profit. Tax is levied as a percentage on this income/profit. When that income / profit is transferred to another country or tax haven, the tax base is eroded and the company does not pay taxes to the country that is generating the income. As a result, tax revenues are reduced and the government is detained. The Organisation for Economic Co-operation and Development (OECD) define BEPS strategies as "exploiting gaps and mismatches in tax rules". While some of the tactics are illegal, the majority are not. Because businesses that operate across borders can utilize BEPS to obtain a competitive edge over domestic businesses, it affects the righteousness and integrity of tax systems. Furthermore, it lessens deliberate compliance, when taxpayers notice multinationals legally avoiding corporate income taxes. Because developing nations rely more heavily on corporate income tax, they are disproportionately affected by BEPS.

The Tax Attractiveness Index (T.A.X.) indicates the attractiveness of a country's tax environment and the possibilities of tax planning for companies. The T.A.X. is constructed for 100 countries worldwide starting from 2005 on. The index covers 20 equally weighted components of real-world tax systems which are relevant for corporate location decisions. The index ranges between zero and one. The more the index values approaches one, the more attractive is the tax environment of a certain country from a corporate perspective. The 100 countries include 41 European countries, 19 American countries, 6 Caribbean countries, 18 countries that are located in Africa & Middle East, and 16 countries that fall into the Asia-Pacific region.

Ireland has been labelled as a tax haven or corporate tax haven in multiple financial reports, an allegation which the state has rejected in response. Ireland is on all academic "tax haven lists", including the § Leaders in tax haven research, and tax NGOs. Ireland does not meet the 1998 OECD definition of a tax haven, but no OECD member, including Switzerland, ever met this definition; only Trinidad & Tobago met it in 2017. Similarly, no EU–28 country is amongst the 64 listed in the 2017 EU tax haven blacklist and greylist. In September 2016, Brazil became the first G20 country to "blacklist" Ireland as a tax haven.

Kimberly Clausing is an American economist. She is the Eric M. Zolt Chair in Tax Law and Policy at UCLA School of Law, and a nonresident senior fellow at the Peterson Institute for International Economics. From 2021 to 2022, she was the deputy assistant secretary for tax analysis at the United States Department of the Treasury. Clausing is known for her work on international trade and tax policy, particularly the taxation of multinational corporations.

The global minimum corporate tax rate, or simply the global minimum tax, is a minimum rate of tax on corporate income internationally agreed upon and accepted by individual jurisdictions. Each country would be eligible to a share of revenue generated by the tax. The aim is to reduce tax competition between countries and discourage multinational corporations (MNC) from profit shifting to achieve tax avoidance.

Reuven Avi-Yonah is a tax attorney, academic, and author. He is the Irwin I. Cohn Professor of Law, and the director of the International Tax LLM Program at the University of Michigan. He is most known for his research on corporate and international taxation, and is the author of several books including Advanced Introduction to International Tax, Global Perspectives on Income Taxation Law, and International Tax as International Law.

References

Clausing, Kimberley A.; Avi-Yonah, Reuben S. (June 2007), Reforming Corporate Taxation in a Global Economy: A Proposal to Adopt Formulary Apportionment (PDF), The Hamilton Project, Brookings Institution, archived from the original (PDF) on 2012-01-27
Mayer, Stefan (2009), Formulary apportionment for the internal market, Doctoral Series No. 17, International Bureau of Fiscal Documentation, ISBN 978-90-8722-048-8
McLure, Charles E. Jr.; Weiner, Joann M. (2000), "Deciding whether the European Union should adopt Formulary Apportionment of Company income", in Cnossen, Sijbren (ed.), Taxing capital income in the European Union: issues and options for reform, Oxford University Press, pp. 243–292
Weiner, Joann Martens (March 2005), Formulary Apportionment and Group Taxation in the European Union: Insights from the United States and Canada (PDF), Working Papers No. 8, Taxation and Customs Union, European Commission, ISSN 1725-7557
Review of Comparability and of Profit Methods: Revision of Chapters I-III of the Transfer Pricing Guidelines (PDF), Centre for Tax Policy and Administration, Organisation for Economic Co-operation and Development, July 2010