Treaty Application for Companies in a Group (FM nr. 178) 2022/5.3.2.1:5.3.2.1 Introduction

Treaty Application for Companies in a Group (FM nr. 178) 2022/5.3.2.1

5.3.2.1 Introduction

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The current international tax system was designed in the 1920s. At that time, the world looked entirely different from how it looks nowadays, as most international investment flows concerned private and public loans.1 A separate entity approach, in which each separate entity is seen as a taxable person, was chosen. Via this approach dealings between different parts of a multinational enterprise are to be treated for tax purposes as if they took place with a third party. The individual entities are taxed on the basis that their transactions with each other are conducted at arm’s length. The question arises whether this system still fits within the increasingly internationalized and digitalised world we currently live in. In the literature it is claimed that formulary apportionment is a better method to allocate profits than the arm’s length principle.2 A simple example can explain the difficulties the separate entity approach can cause (see figure 5.1):3

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‘Suppose that T, which has a PE in State A and State B, has a customer C in State A who will pay USD 100 for a horse. T finds that it will cost him USD 100 to purchase and deliver a horse to C. Accordingly, if T bought a horse and sold it to C, he would have no income. However, T finds that he can buy two horses for USD 150. If he buys both horses and sells one to C, he will suffer a USD 50 loss. But T now finds customer D in State B who will pay USD 75 for the second horse. T therefore proceeds to buy the two horses for USD 150, sell them to C and D and earn USD 25 on the transaction. Under an arm’s length/separate-geographic-accounting analysis, one would presumably allocate the entire gain to State A, because the horses were purchased for an average cost of USD 75, and the only one that was sold for a profit was the horse that was sold in State A. But it would be just as reasonable to attribute the entire income to State B on the theory that the first horse cost T USD 100 and the second one cost him USD 50, and the only horse that could be sold for more than its costs price was the horse sold in State B.’

Considering the profits of companies within a group on a separate entity basis does not do justice to economic reality. Both sales in the example were required to derive the profit from the transaction. Therefore, it is not logical to allocate the profits to either State A or State B. The activities in each state contributed in an ‘essential but indeterminate’ manner to it. Therefore, the profits should be determined by taking into account the group as such, i.e., the group should be seen as the taxable person. Subsequently, according to proponents of formula apportionment the problem can be solved by using a formula to allocate the income. This formula should take into account the various factors that contribute to earning the income.

Countries aim to divide a single tax base among them, without double taxation or tax avoidance opportunities. In literature it is claimed that the arm’s length principle can better determine the true geographic source of income, than formulary apportionment can.4 But is the goal of the methods to allocate income to find the true geographic source of income? Is there even a true source of income?5 Another point of view could be that the goal is to come to an equitable division of income based on other considerations than geographic source.6 In fact, the major purpose seems to be to allocate the tax base among jurisdictions in some reasonable relation to activities.7 That is precisely what formulary apportionment in theory provides: a split of income in two or more shares in a legitimate manner.8 However, the question is: what is considered an equitable division of income?9 Equal treatment and thus contributing to neutrality is key to achieve the goals of the OECD MTC: economically similar situations should be treated in the same manner for tax purposes. Taxation should not influence business decisions. The legal form of a structure should thus not influence the total taxes payable. This also means there should be no possibilities for tax avoidance. Additionally, it seems most logical that the income is allocated to the state in which the taxpayer benefited from government resources.10

Moreover, it is often stated that a profit allocation system should adhere to the single tax principle: all income should be subject to tax only once, i.e., there should be no double taxation nor non-taxation.11 However, it can be said that it is only unjust when ‘one taxpayer is assessed twice while another in substantially the same class is assessed but once.’12The allocation of international income ideally leads to a situation in which the income allocated to the jurisdiction is in line with the economic activities carried on in that jurisdiction. Additionally, there should be no overtaxation and undertaxation of the income in comparison to the situation where income is earned in a single jurisdiction.13

To determine whether a water’s edge, bloc or worldwide consolidation in combination with formulary apportionment would better fit within the objectives of the OECD MTC, first of all the highlights and problems of the arm’s length system are described.14 Subsequently, the highlights and problems of formulary apportionment are discussed. In this regard, attention is also paid to the concurrence of formulary apportionment with tax treaties.

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