Wednesday, 5 November 2014

Alternative approaches: unitary taxation with profit apportionment

While multinationals tend to favour the arm’s length principle as the basis for determining transfer pricing – it gives them tremendous leeway to minimise tax – academics, some public sector and private sector practitioners and, increasingly, non-governmental organisations, favour an alternative approach: combined reporting, with formulary apportionment and Unitary Taxation. This would prioritise the economic substance of a multinational and its transactions, instead of prioritising the legal form in which a multinational organises itself and its transactions.
These terms may seem complex and baffling, but the basic principles are quite straightforward, and the system is far simpler than the ineffective “arm’s length” method.
While the arm’s length principle gives multinational companies leeway to decide for themselves where to shift their profits, the unitary taxation approach involves taxing the various parts of a multinational company based on what it is doing in the real world.

Unitary taxation originated in the United States over a century ago, as a response to the difficulties that U.S. states were having in taxing railroads. How would these multi-jurisdictional corporate entities be taxed by each state? Gross receipts within the state? Assets? How should they tax the railroad’s rolling stock? In the state of incorporation, or in the states in which it was used?
The U.S. Supreme Court ruled that taxing rights between states should be apportioned “fairly.” Now over 20 states inside the United States, notably California, have set up a system where they treat a corporate group as a unit, then the corporate group’s income is “apportioned” out to the different states according to an agreed formula. Then each state can apply its own state income tax rate to whatever portion of the overall unit’s income was apportioned to it. Such a formula allocates profits to a jurisdiction based upon real factors such as total third-party sales; total employment (either calculated by headcount or by salaries) and the value of physical assets actually located in each territory where the multinational operates. States can still set whatever local tax rates they want. In what may be a sign of the system’s usefulness, more states have been adopting it of late: Michigan and Massachusetts (2008), New York and West Virginia (2007), Texas (2006) and Vermont (2004.)
Imagine a company with a one-man booking office in the Cayman Islands, with no local sales. Under current “arm’s length” rules, it can shift billions of dollars of profits into this office, and use this to cut its tax bill sharply. Under Unitary Taxation (formulary apportionment) however, the formula based on sales and payroll would allocate only a miniscule portion of the income under the formula to Cayman, so only a miniscule portion would be subected to Cayman’s zero tax rate.
The countries where real economic activity is happening – Africa and the United States, in the above  example, would then be able to tax the income that is rightfully theirs to tax.
There are technical and political complexities involved in designing such an “apportionment” formula, but with political will they are quite surmountable. Limited forms of unitary taxation have been shown to work well in practice, as the experience of U.S. states shows.
The aim of unitary taxation, then, is to tax portions of a multinational company’s income without reference to how that enterprise is organised internally. In addition, multinational enterprises with the same total income generally are treated the same under this method.
Multinational companies would have far less need to set themselves up as highly complex, tax-driven multi-jurisdictional structures, and would simplify their corporate structures, creating major efficiencies. Billions could be saved on tax enforcement. The big losers, apart from multinationals, would be accountancy and legal firms, and economic consultants,  who derive substantial income from setting up and servicing complex tax-driven corporate structures.
Developing countries should have a particular interest in this approach.
There are three main obstacles to unitary taxation:
1.    Path dependency. The “arm’s length” approach is how the international tax system has emerged, and there will be great institutional resistance to change established practices. Still, the alternative of unitary taxation is not an all-or-nothing approach requiring everyone to adopt it at once. It could be adopted by some states and not others, or hybrid versions between Unitary Taxation and the Arm’s Length approach could be adopted as interim steps.
2.    Vested interests. Because multinational corporations like having the leeway to manipulate transfer pricing, they have a strong interest in maintaining the status quo.
3.    Technical issues. There are potentially important technical complexities in designing an appropriate formula, and more work needs to be done in this area.

Unitary taxation is compatible in theory with country-by-country reporting, a concept developed by TJN’s senior adviser Richard Murphy. More precisely, Country by Country reporting could serve as the accounting basis for formulary apportionment and unitary taxation.
Current accounting standards require corporations to publish certain financial and other data, but they allow them to sweep up all the results from a range of different jurisdictions and put them into a single, aggregate figure, perhaps under a heading “International” or some such. It is not possible to unpick multinational corporations’ financial statements, to determine what is happening in each country of operation.
Country-by-country reporting would require each multinational corporation to provide the following information:
(1)    The name of each country in which it operates.
(2)    The names of all its subsidiaries and affiliates in each country in which it operates.
(3)    The performance of each subsidiary and affiliate  in every country in which it operates, without exception.
(4)    The tax charge included in its accounts of each subsidiary and affiliate in  each country in which it operates.
(5)    Details of the cost and net book value of its fixed assets located in each country in which it operates.
(6)    Details of its gross and net assets for each country in which it operates.
Country- by country reporting would also disclose if there was deliberate material mispricing of goods or services across international borders. Criteria could be adapted to fit a formula under unitary taxation.
Even without unitary taxation, Country by country reporting would be extremely valuable in order to try to determine whether arm’s length principles are being complied with.

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