2.4.4.3 The unitary business approach

Introduction

If applied on a worldwide basis, the unitary business approach for application of unitary taxation is a far-reaching variant of a group approach.1 Unitary taxation treats an international enterprise that operates via various permanent establishments or via various group companies as a unitary business. Unitary taxation basically means that the worldwide income of a multinational enterprise is combined in a single unit for tax purposes. No attention is paid to the legal form of an entity. Therefore, unitary taxation leads to more legal form neutrality. The idea behind the unitary business principle is that many companies operate as an economically integrated unit. The economic reality that an entity usually is part of a bigger enterprise with a shared profit motive is recognized via unitary taxation. Moreover, the problem of the assumed economic independence of the various entities within the multinational enterprise can be avoided through unitary taxation. The principle requires a corporation to evaluate the interactions among its divisions and its related entities to define the elements of the taxable group. This entity is viewed as the unitary business and prepares a combined report to calculate the total income of the group: the parent company and its unitary affiliates.2 Unitary taxation reflects the economic reality that a multilateral company is a unitary business with a shared profit motive.3

In the 19^th century, the unitary business principle – which is the American approach to unitary taxation – became the judicially accepted mode of tax assessment on state property tax and the transcontinental railroad and express companies.4 To determine the tax base, the property or gross receipts of a taxpayer were valued as a whole. Property that crossed over state lines was apportioned to each state by a formula by applying the unit rule. This method was adapted for application for corporate income tax purposes in the early 20^th century.5 The reason this system is used, is to protect against profit shifting between states. In this way it is not necessary to administer the federal practice of transfer pricing, which is perceived as not being very successful.6

The unitary business concept requires a definition in economic terms. There is no ‘unitary’ unitary business concept.7 The states that apply unitary taxation do not use exactly the same definition of the term unitary business. The term is governed by case law and model legislation. Additionally, in literature attempts have been made to extract a common definition. The various definitions used are discussed in this section.

The unitary business concept has been often addressed in case law. The Supreme Court of California articulated the three unities concept: unity of ownership, unity of operation and unity of use can lead to the conclusion that a unitary business exists.8 There is unity of ownership if a single taxpayer owns, directly or indirectly, the majority of the voting stock of two or more corporations.9 That unity of operation exists can be evidenced by central purchasing, advertising, accounting and management divisions.10 The unity of use follows from the executive force and general system of operation.11 This can be found by, inter alia, a flow of goods, shared management and information, common knowledge and expertise.12

In a later judgment the Supreme Court of California explicitly confirmed that the unitary business concept applies – next to activities conducted by branches of the entity – to activities conducted by a multi-corporate group.13 In other words, for determining whether a unitary business exists, it is not relevant whether activities are conducted via a separate legal entity or via a branch.14 Additionally, in that judgment the Supreme Court of California stated that whether one part of the business depends upon or contributes to the operation of the other determines whether parts of a business are unitary.15 This judgment thus entails a contribution and dependency test.

The Supreme Court of the United States stated that characteristics of a unitary business include ‘functional integration, centralization of management and economies of scale’.16 Additionally, the in-state and out-of-state activities were found to be part of a single unitary business.17

In another case the Supreme Court of the United States explained that, as profitability arises from the operation of the business as a whole, it would be misleading to characterize the income of the business as having one single identifiable ‘source’.18 It also came to the conclusion that a flow of goods between the corporate bodies involved is not a prerequisite to be able to conclude that a unitary business exists. Rather, it is important that a flow of value exists.19 A flow of goods is thus not the only way to conclude that the required interdependence exists.20

There is model legislation in the United States that defines the unitary business: the Multistate Tax Compact. The purpose of this model legislation is to promote uniformity of tax laws.21 The term unitary business is defined in the Multistate Tax Compact as ‘a single economic enterprise that is made up either of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.’22 In this definition various of the aforementioned aspects derived from case law are combined.

In literature multiple definitions of the concept unitary business have been developed over the years. Altman and Keesling argue that, to define a unitary business, the test is in essence whether the business activities within a state are dependent upon or contributory to the operation of the business outside the state.23 This definition corresponds with the previously discussed interpretation of the Supreme Court of California.

According to Keesling and Warren, operational unity and economic unity are key elements to determine whether a unitary business exists. Operational unity exists when property or services of individuals directly contribute to earning income, which forms the product of these combined elements. Economic unity means that two or more series of activities, which are not interrelated from an operational point of view, form a single business due to economic interrelationship.24

McLure suggested to define the unitary group in line with its economic interdependencies.25 Due to those interdependencies it is ‘conceptually impossible’ to determine the amount of income that is allocable to the individual members. The author designed the following three stage test to determine whether a unitary business exists:26

First of all, it should be determined whether there is common control. Second, the question is whether shared expenses, economies of scale or scope, intra-group transactions, vertical integration, or other economic interdependencies exist. The third test ensures that the economic interdependencies are substantial and therefore it is not possible to divide profits properly among group members. This condition is necessary to make sure that commonly controlled affiliates that have only insignificant economic relations with the group are not included in the scope of the unitary business.

According to Weiner, the unitary business concept goes beyond legal ownership or control to determine whether there is operational or economic integration or dependency among related entities.27 The following elements are general guidelines to determine whether a unitary business exists: is there an ‘exchange of value’? Is there functional integration, centralized management, and economies of scale? Is there unity of ownership, unity of operation and unity of use? Is there operational or economic interdependence?28

As follows from the above, the definition of unitary business does not include ‘mechanical’ legal rules such as a requirement for the size of the shareholding. The unitary business concept is therefore an open norm, leading to less tax avoidance opportunities. A subjective analysis of the interconnected economic relationships among the various parts of a corporation is required. A less than majority ownership in an entity does not necessarily mean that the entity is not part of the unitary business.29 Therefore, implementing the principle can be rather complex.30 Relying on economic principles is therefore – next to the main strength of the system – a weakness of the system.31 Using economic criteria to define the unitary business can lead to uncertainty and inconsistency in applying the concept.32

Through the unitary business principle, the firm is recognized as a single unit for corporate tax purposes, irrespective of its legal organization. Therefore, it should be applied to all legal entities (companies, partnerships, trusts, etc.).33 It focuses on corporate substance, rather than corporate form.34 There is no possibility to ‘opt out’. The integrated nature, both horizontally and vertically, of a multiple-entity company is reflected.35 The corporations that together form the unitary business should have economic relationships, i.e., the business activities should be integrated with, dependent on and/or should contribute to each other.36

A newly acquired business will generally not be part of an existing unitary business right away.37 Only after a certain amount of time the operations gradually become sufficiently integrated to come to the conclusion a unitary business exists.

All in all, characteristics of a unitary business include a functional integration, the centralization of management and economies of scale. The different definitions of the unitary business in essence require the two steps to determine whether one entity exists from an economic perspective: there should be control and integration.