5.3.5.5 Concurrence of the system in the United States with tax treaties

As the system formerly applied in the United States is based on a far-reaching variant of a group approach as it applied on a worldwide basis, its concurrence with tax treaties may reveal relevant issues for a group approach for treaty application. As explained, the allocated income under this approach could differ from the income as determined under the arm’s length principle. This could lead to conflicts under the application of tax treaties.1 The United Kingdom aimed to solve this problem in a tax treaty with the United States in 1975. Under the rules as included in the tax treaty, the various states were not allowed to apply global formulary apportionment in relation to the United Kingdom.2 However, the treaty was ratified with a reservation regarding this specific article. This led to a dispute with respect to the application of global formulary apportionment. As described in par. 5.3.5.3, it ultimately led to a change in the United States approach: a water’s edge election was introduced providing the possibility to exclude the income of foreign enterprises from the apportionment.3

Irrespective of the aforementioned, it should be kept in mind that a tax treaty is solely applicable to the taxes that are covered by the convention. Generally, the system of formulary apportionment as applied by the individual states in the United States is not covered by tax treaties.4 In the treaty between the United States and the United Kingdom, taxes imposed on income by the various states were explicitly included in the scope of the treaty.5 If there is no such extension of the scope of the treaty, there seems to be no issue with respect the concurrence of the United States formulary apportionment system and tax treaties.

The concurrence of the system in the United States with tax treaties thus does not answer the more general question: how would a worldwide tax system based on consolidation and subsequent formulary apportionment reconcile with tax treaties? As follows from the discussion on cross-border group taxation regimes in par. 5.2.4.5, taking the worldwide profits into account at the level of the ultimate parent company can easily lead to conflicts with tax treaties.6 Applying such a regime would thus require changes to existing tax treaties.7