There Must Be a Better Way. Right?

Some readers have asked me the following question: isn’t there a better way to figure out where a given multinational’s income should be taxed than by applying the arm’s length standard to intra-group transactions and performing complicated and subjective transfer pricing analyses? Couldn’t we in fact do away with transfer pricing altogether by simply taking the total income earned by a multinational and dividing it in a reasonable fashion across the various countries in which it does business? Wouldn’t life be simpler for both taxpayers and tax authorities if they didn’t have to worry about finding arm’s length prices to apply to all of the transactions that take place within a multinational group?

9921998_sThis proposed method of figuring out a multinational’s taxable income in any particular jurisdiction is known as formulary apportionment, and it’s a tempting alternative to transfer pricing for a variety of reasons. Identifying arm’s length transfer prices is a complex exercise, typically with no single objectively correct answer, and as a result there’s the fear that transfer prices may be manipulated by multinationals to yield favorable tax outcomes. Apportionment, by contrast, would apply a simple formula to a multinational’s worldwide profits to calculate the tax owed in each specific jurisdiction. Advocates argue that this would reduce the scope for multinationals to use financial trickery to reduce their taxes.

Unfortunately, an attempt to move toward formulary apportionment would probably create at least as many problems as it would solve. A good corporate tax system should avoid introducing distortions into the economic decision-making process, so that projects or transactions occur when they have economic merit and don’t occur when they don’t. But unless there is an international consensus on the use of apportionment – as well as on the details of the specific formula to be used – apportionment would be tremendously distortionary.

Imagine a situation where one country uses apportionment while its trading partner doesn’t. In that case companies doing business in both countries would inevitably encounter numerous situations where certain activities would result in non-taxation of profit, while other activities would result in double-taxation. Certain economically worthwhile activities would never happen, while other activities would take place purely for the tax benefit they provide. Even if the company’s overall tax bill is unchanged, society would lose out as a result of this misallocation of resources.

Could this problem be avoided if there was an international consensus on the use of formulary apportionment? Probably not. Even if every major country agreed to switch to apportionment, it is hard to imagine that all of them would agree on the specific formula to use to divide up multinationals’ income. Each country would, naturally, prefer to calculate its share of a multinational’s income using elements (e.g. overall sales, workforce, or assets) that work to their advantage. And then even if a common formula could be agreed on, that formula would encourage companies to manipulate the elements of the allocation formula, again distorting economic activity by incentivizing behaviors that have no real economic rationale.

To add to the list of problems, apportionment would be an accounting nightmare for multinationals, which would have to gather and present data on the group’s worldwide activities to each individual country in a manner consistent with that jurisdiction’s specific book and tax accounting rules. Furthermore, under apportionment exchange rate movements would alter how much tax a multinational owed in each country by affecting any elements of the allocation formula that are measured in units of currency, such as sales or assets. For example, if China’s currency were to continue to strengthen against the dollar over time, China would be able to claim a larger and larger share of the income of multinationals doing business there, even if those multinationals had no change in their sales or transactions. That would be a rather odd tax system indeed.

To be clear, I am not arguing that the current international system of corporate taxation never distorts economic activity. Specific tax incentives for certain industries or activities, as well as varying rules on deductibility from country to country, can and do have these effects. But to justify the enormously complex and expensive undertaking of trying to switch the world economy to formulary apportionment the new system would have to be an unambiguous improvement. It is not.

One comment

  1. Harold McClure says:

    I agree that formulary apportionment is not a panacea. But even if it were, it will never happen. Bradford’s proposal of a progressive consumption tax gets a lot of applause from both progressive and conservative economists but this isn’t going to be implemented by any government any time soon.

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