5.3.2.3 Formulary apportionment

Highlights formulary apportionment

Formulary apportionment – using combined reporting – in principle ignores the separate status of the various entities within a group to determine the total group profits.1 Determining the correct transfer pricing for intra-group sales is no longer necessary. Under formulary apportionment, the economic interdependence that cannot be reflected in the arm’s length principle is no longer an issue. As a first step the profits of a group of companies are calculated as a whole via consolidation.2 If this is done on a worldwide basis, this is called unitary taxation. For unitary taxation economic criteria are used to determine the taxable entity for group taxation purposes, rather than applying a legal test such as a control or ownership threshold.3 Within the unitary group transactions are ignored. The purchase of products, payments for the use of assets, as well as financial transactions in an intra-group context do not influence the corporate tax base. It becomes irrelevant to distinguish between different income flows. Additionally, it is not logical to impose withholding taxes on intra-group dividends, interest or royalties.4 However, conceptually there would still be withholding taxes on passive income flows from the unitary business to non-included companies and the other way around.5

As a second step, a formula is used to divide the net income of a company, or a group of related companies, doing business in more than one country (or state) among the countries (or states) where it operates.6 Formulary apportionment can be applied on an activity-by-activity basis or on the basis of combined income of a taxpayer from all sources. The factors in the formula reflect (or are deemed to reflect) the income producing activities.7 Formulary apportionment aims to attribute the corporate tax base both to the investment jurisdiction, as well as to the jurisdiction where the goods are marketed.8 Thus, the system recognizes that income generation relates both to demand and supply. The market jurisdiction is solely of relevance if sales/turnover is chosen as one of the apportionment factors. Additionally, it should be kept in mind that, even if that factor is used, no profits will be attributed to a country if there is no physical presence in that country (i.e., no labour/assets) and physical presence remains the requirement to define jurisdiction to tax.9

As indicated, the application of formulary apportionment could be done either on a water’s edge or a worldwide basis. Basically, under a water’s edge approach solely the jurisdiction that applies (or jurisdictions that apply) formulary apportionment is (are) taken into account. The income of a corporate group is in that approach thus limited to the jurisdictions involved. Income of entities belonging to the group that are established outside those borders is not included in that case. Another profit allocation mechanism is necessary for these associated companies.10 Worldwide formulary apportionment takes income of a unitary business from all sources worldwide into account.

One of the main benefits of a formulary apportionment system is the fact that substance prevails over the legal form with regard to the allocation of income.11 The chosen legal form of a corporate group does not impact the amount that can be apportioned to the various countries. Therefore, the current rules to determine corporate residence or the source of corporate income would be no longer necessary. However, this would mean that other rules to determine whether a taxable presence in a jurisdiction exists should be established. A company must have a certain economic connection with a jurisdiction before it becomes subject to taxation in that jurisdiction. Therefore, there needs to be consensus on a rule that gives jurisdiction to tax for application of a formulary apportionment system.12

The separate existence of legal entities for tax purposes is key to determine the income on a country-by-country basis in the current international tax domain.13 Moreover, the permanent establishment functions as the rule that gives jurisdiction to tax: business profits of a foreign enterprise are taxable in a jurisdiction if the enterprise has a permanent establishment in that jurisdiction to which the profits are attributable. The question would be: what would be the parameters to allocate profits to the foreign jurisdictions? The permanent establishment concept has been highly criticized, as it is based on the idea of having physical presence in a country. This does not seem to fit within the ‘digital economy’. If the permanent establishment concept would be taken as a starting point to define jurisdiction to tax, this concept should be updated to take into account the digital economy.

Additionally, formulary apportionment could eliminate double non-taxation of income which results from the application of transfer pricing. Moreover, it could minimize profit shifting opportunities that are currently available for multinational enterprises. It would no longer be possible to ‘play games with transfer pricing rules.’14 However, similar to the application of the arm’s length principle, harmonization is essential. Countries should apply a common definition of income as well as the same formula to apportion income among jurisdictions. If there are different definitions and/or formulas, double non-taxation or double taxation will be the result.15

Global adoption of formulary apportionment would mean that there would be no need for methods to eliminate double taxation of business income. After application of global formulary apportionment there would remain no residual claim for source or residence jurisdictions.16 A global formulary apportionment system with uniform rates would contribute to the neutrality of the tax system: domestic and foreign companies would face the same tax treatment under a harmonized tax base definition and pre-determined formula.17 Additionally, there would be no difference in treatment between subsidiaries and permanent establishments. The fact that a permanent establishment is in principle not seen as a treaty resident can currently lead to double taxation. Furthermore, deemed dividends, deemed interest and deemed royalties ‘paid’ between a head office and permanent establishment do not trigger any withholding taxes.18

However, if there would be no harmonized system, locational decisions would be distorted.19 A partial shift to formulary apportionment, leading to inconsistencies between states, would create complexity, uncertainty and double taxation. Still, for some entities it would lead to a simpler, certain and single tax system. According to Hellerstein, even though the costs would be higher in the short run, formulary apportionment may still be the appropriate policy in the long run. In this regard the political and economic context in which formulary apportionment is implemented is relevant: the more economic integration and political coordination, the better the case for formulary apportionment.20

A system based on formulary apportionment is generally less complex and leads to lower compliance costs than a system based on the arm’s length principle.21 It is a straightforward and transparent allocation method.22 Therefore, an advantage of the formulary apportionment system is the fact that it can provide certainty in the international tax regime. As long as the formula is complied with, the chance is very small that the tax authorities will amend an assessment.23

Problems with formulary apportionment

According to the OECD, global formulary apportionment is a non-arm’s length approach and thus not a realistic alternative for the arm’s length principle.24 The most important concern from an OECD perspective is the implementation of the system in a manner that protects against double taxation while it ensures single taxation. A worldwide formulary apportionment system would require international coordination as well as consensus on the formula to be used and the group concept to be applied.25 If countries would apply different formulas, this would lead to double taxation and double non-taxation. However, according to Durst the amount of unpredictable double taxation would be minimized, even if different countries would apply different formulas. Durst argues that the arm’s length rules lead to unpredictable outcomes, while formulary apportionment gives taxpayers more certainty. The latter thus promotes cross-border investment.26 Therefore, formulary apportionment can be seen as a method that is better suited to address the economic damage from double taxation.27 If only certain countries would apply formulary apportionment, whereas the other countries continue the use of the arm’s length principle, this could easily lead to double taxation or double non-taxation.28

The application of formulary apportionment requires defining the group. It will be very challenging to come to a general group definition. In this regard it should also be kept in mind that formulary apportionment would not mean transfer pricing is redundant in full. If transactions take place between entities that are not part of the consolidated group, but are associated, transfer pricing is still required. Additionally, for these transactions transfer pricing manipulation cannot be excluded.29

To be able to apply formulary apportionment, a formula needs to be designed, including the method of measuring the factors in the formula.30 The factors of formulary apportionment are deemed to be an approximation of the relevant sources of income generation. It will be very difficult to design one formula to apply on a harmonized basis.31 In this regard it is problematic that it is assumed that factor productivity is equal across all jurisdictions involved and across all industries. Applying the same formula to all industries can lead to inequities and distortions.32 For a discussion of the potential factors that could be used, see par. 5.3.4.2.33

Formulary apportionment can distort acquisition decisions. If a previously separate entity is acquired by a group, the formulary apportionment mechanism will influence its tax position.34 This influence may be less present under the arm’s length principle.

A peculiarity of formulary apportionment is the fact that a group member can be required to pay corporate income tax as the group is in a profitable position, while the group member would incur losses if the entity would be seen as an independent taxable person.35 Additionally, the formula is merely an approximation of income producing factors. Therefore, formulary apportionment is perceived to lead to arbitrary outcomes. However, the question is whether this allocation method is more arbitrary than the arm’s length method. It can be said that the latter leads to equally arbitrary outcomes, because of the possibilities of base erosion and profit shifting under the arm’s length method.36

Formulary apportionment may reduce fiscal externalities among jurisdictions and therefore reduce tax competition pressure. Though, formulary apportionment does not eliminate all fiscal externalities among jurisdictions.37 A company would be inclined to locate factors included in the formula38 in low-tax jurisdictions to reduce the average tax. Thus, formulary apportionment regimes provide an incentive to locate apportionment factors in low-taxed jurisdictions. In other words, if tax rates are not harmonized, multinationals will engage in profit shifting via factor shifting.39 This factor shifting seems mainly possible at the supply side (i.e., labour and capital), as the demand side (the market jurisdictions) cannot be influenced easily by the supplier of a product or service.

The additional fiscal externalities with respect to apportionment factors might increase tax competition.40 Moreover, for the application of formulary apportionment the nexus of the group entities needs to be determined, which can also be a potential source of tax avoidance.41 In the aforementioned literature no direct comparison is made between separate accounts and formulary apportionment. If both would be compared, the costs for multinationals to engage in profit shifting via transfer pricing would be of relevance. This would be one of the elements to determine which of the two is more effective with respect to controlling tax competition.42 All in all, depending on the chosen jurisdiction to tax and the chosen factors, formulary apportionment seems not immune to manipulation. It could invite new forms of tax planning.43 However, that would require companies to shift real economic activities. Additionally, as these factors would likely include transactions with third parties, manipulation possibilities seem limited.44 Additionally, the costs of manipulating the factors used in the formula might be higher than the costs associated with transfer pricing strategies under the arm’s length principle.45

While proponents of formulary apportionment claim that it would lead to a simpler system from an administrative point of view, it is also argued that the eventual rules that would govern formulary apportionment are as complex as the arm’s length standard. The rules would have to ‘fend off the inherent imprecision of definitions (of the formula factors), timing issues, and valuation much like the current arm’s length standard rules.’46

In the literature it is stated that formulary apportionment in the absence of a common currency would be problematic.47 Translating results into a common currency for reporting would be required.48 Under the transaction method each individual transaction would be translated into the reporting currency as it occurs. A disadvantage of this method is that all books and records should be maintained in the reporting currency of the group. If those companies would also have to prepare their financial statements in the group currency, this does not seem to lead to an additional administrative burden.49

Formulary apportionment & the OECD MTC

One of the problems of formulary apportionment that should receive specific attention in this research is that it allegedly violates tax treaties.50 This logically concerns the articles that deal with business profits: art. 7 and art. 9 OECD MTC.

Art. 9 OECD MTC addresses the commercial or financial relations between associated entities and thus governs transfer pricing. It requires companies to act with each other as if they were independent third parties. In this regard, it should be determined whether the conditions of a transaction meet the arm’s length criterion. Adjustments to the profits of a resident company exceeding the arm’s length profit are prohibited.51 If formulary apportionment would be used, this could lead to a different outcome than under the arm’s length principle.52 Therefore, application of formulary apportionment does not seem in line with the associated enterprise article.53 However, as consolidation is necessary for formulary apportionment, in situations in which a worldwide unitary business exists, it could be argued that art. 9 OECD MTC would become irrelevant, because the intra-unitary business transactions would not be visible.54

Rather, art. 7 OECD MTC would govern formulary apportionment.55 This article prescribes the arm’s length principle in apportioning income to a permanent establishment of an entity. Under the former art. 7 OECD MTC (i.e., pre-2010), both a direct and an indirect method were allowed to determine permanent establishment profits. In the OECD Commentary a preference was expressed for the direct, transaction-based, method. Under the indirect method a profit-oriented approach is applied. This entails the application of formulary apportionment,56 which entails a group approach.57 Such a profit-oriented approach was solely acceptable if the results could fairly be said to be in accordance with the arm’s length principle. It was indicated that formulary apportionment should be used as an exception only, in cases where this application has been customary in the past as a matter of history and is accepted as being satisfactory by the tax authorities as well as by taxpayers in both countries.58 The criteria that were used to characterize the profitability of a unit (permanent establishment or head office) include: receipts,59 expenses60 and capital structure.61

Since the 2010 update of the OECD MTC solely the direct method is admissible. To determine the profits that are attributable to the permanent establishment, the permanent establishment should fictitiously be regarded as an independent separate enterprise. Subsequently, the arm’s length principle should be applied.62

In the literature it has been stated that a unitary taxation system in which subsidiaries are viewed as permanent establishments and for which formulary apportionment is applied, is not necessarily in conflict with tax treaties.63 This argument is mainly based on the ‘old’ art. 7 OECD MTC, which is included in a lot of existing tax treaties worldwide. Consequently, under the current OECD MTC there does not seem to be room to apply formulary apportionment with regard to the attribution of business profits to a permanent establishment, nor to subsidiaries that are viewed as permanent establishments under the unitary business approach.64

Both the ‘old’ and the ‘new’ art. 7 OECD MTC require that profits should be attributable to a permanent establishment in order to grant taxing jurisdiction to the source state. Thus, formulary apportionment would – under art. 7 OECD MTC – be limited by the existing nexus rules.65 In these existing nexus rules physical presence in a country is generally required. The rules are therefore not able to capture sales in the market countries.66

Additionally, the question arises whether the requirement that profits should be attributable to a permanent establishment leads to problems. That seems to be the case. Formulary allocation of global profits of a multinational enterprise can be in conflict with tax treaties even if the treaty includes the old version of art. 7 OECD MTC.67 If a multinational group would conduct distinct lines of businesses around the world, applying formulary apportionment could violate the allocation of business profits as provided for in tax treaties. Even if the distinct lines of businesses are not conducted in every country, under formulary apportionment part of the group profits could be attributed to each country. An example of such a situation is a multinational group that is active in some countries in the manufacturing business, while in other countries it is engaged in the insurance business. Under a system of combined formulary apportionment,68 countries in which solely the insurance business is conducted, would also get a claim on some of the manufacturing income, and vice versa.69 This does not seem to be in line with the business profits article.

It is clear that art. 7 and art. 9 OECD MTC are governed by the arm’s length principle, even though it does not explicitly follow from the text of the articles. It could be considered to include formulary apportionment as an acceptable transfer pricing method. If treaty partners would accept formulary apportionment as a feasible, and administrable, approximation of the arm’s length result, a change in the articles does not seem strictly necessary.70