Unitary taxation with formulary apportionment would establish a much clearer, more effective, and fairer method of allocating the tax base of MNEs.
- Transfer pricing rules attempt to construct prices for transactions among entities that are part of MNEs as if they were independent, which is inconsistent with the economic reality of a modern-day MNE.
- MNEs should be taxed as single firms by combining their global profits.
- The global profits should be apportioned to the countries where the MNE operates using a formula based on factors such as employment, sales, resources used and fixed assets.
Systemic sticking points
While there have been multiple global agreements to avoid double taxation of MNEs’ profits, the transfer pricing rules used by these agreements have been unsuccessful in avoiding the erosion of the tax base and ensuring profits are taxed where the substantive economic activities of the MNEs actually take place.
The existing system of international taxation has been exploited by MNEs to shift large portions of their overall profits to low tax jurisdictions. This system has further exacerbated tax competition, by pressuring countries into lowering tax rates. While there have been multiple global agreements to avoid double taxation of MNEs’ profits, the transfer pricing rules used by these agreements have been unsuccessful in avoiding the erosion of the tax base and ensuring profits are taxed where the substantive economic activities of the MNEs actually take place. These agreements have also failed to find a common ground to avoid a race to the bottom.
While the Base Erosion and Profit Shifting (BEPS) international reform led by the G20 and the OECD is a step in the right direction and progress that would have been thought of as impossible just 5 years ago, we believe that one of the biggest deficiencies of the BEPS process has been its inability to address the core problem of our global tax system — the fiction that an MNE consists of separate independent entities transacting with each other at arm’s-length.
The transfer pricing rules attempt to construct prices for the transactions among entities that are part of MNEs as if they were independent, which is inconsistent with the economic reality of a modern-day MNE — a unified firm organized to reap the benefits of integration across jurisdictions. Large MNEs are oligopolies, and in practice there are no truly comparable independent local firms that can serve as benchmarks.
The OECD reform proposals, while helpful at the margins, do not help resolve the basic challenge of ensuring that MNEs pay taxes where they have real economic activities take place and create value. They still provide too much opportunity for profit shifting, especially through the exploitation of intangible assets (intellectual property, trademarks, etc.). This is an issue for both developing and advanced countries, but so far tax rules have prioritized the perspective of advanced countries where MNEs tend to be headquartered. This is a major reason why they have failed to ensure profits are taxed where activities take place (at the ‘source’), in favor of where the companies that receive income are based (in the country of ‘residence’), which can easily be manipulated.
ICRICT’s latest report presents concrete solutions to address this issue so that all countries are able to collect a fair share of tax revenue from MNEs and avert a race to the bottom.
One way to improve the situation would be to tax MNEs as single firms by combining their global profits and then allowing each country where the corporation operates or sells goods to tax only the portion of profits attributable to the corporation’s economic activity there. Unfortunately, the BEPS project has not taken this route to reform.
A unitary approach should apportion the MNEs’ global income to the different jurisdictions based on objectively verifiable factors rather than resort to the fiction of arm’s-length transactions or that one could possibly calculate what arm’s-length prices might look like.
These factors, such as employment, sales, resources used, fixed assets, etc., should be chosen to reflect the MNEs’ real economic activity in each jurisdiction. Just as important, these factors cannot be easily moved around the group to avoid taxation. Relocating employees to a low-tax jurisdiction involves much more than transferring intangible assets to a letterbox company in such a jurisdiction, and a firm has even less power over the location of its customers.
Furthermore, these objective factors reflect in different ways actual economic activity, while the separate entity principle and transfer pricing rules enable profit shifting to MNEs’ entities lacking economic activities.
Global formulary apportionment
Global formulary apportionment is the only method that allocates profits in a balanced way using factors reflecting both supply (e.g. assets, employees, resources used) and demand (sales). Neither can create value without the other.
Two major criticisms are frequently made of formulary apportionment: firstly, that states could not agree on a formula, and secondly, that the enterprise could still play jurisdictions against one another by focusing on the factors in the formula.
However, both these arguments overlook the point that, in choosing a suitable formula and the corporate tax rate, states would need to take into account interacting factors: not only the tax revenue it would produce but also the effects on inward investment. This creates a basis for compromise and convergence between states.
While the sales factor in the formula cannot be manipulated, apportioning profits according to other measures of economic activity, such as employees and assets, may affect inward investment. This may pressure countries to veer toward single factor (sales) formulary apportionment. However, sales-based apportionment may limit the tax base of developing countries, where much income is generated by asset- and labor intensive activities. A suitable formula will, therefore, need to reflect the different needs of, and be negotiated by, both advanced and developing countries.
Unitary taxation with formulary apportionment would establish a much clearer, more effective, and fairer method of allocating the tax base of MNEs. While formulary apportionment will effectively eliminate profit shifting, countries will still be able to compete against each other by lowering the corporate tax rate to incentivize investment or the relocation of activities — pressures which are, of course, also present in the current system. It is therefore important to avoid a position where a move to formulary apportionment further exacerbates the race to the bottom in corporate tax rates.
To forestall this competition and the resultant distortionary effects, global formulary apportionment should be accompanied by an agreed minimum rate for taxing all apportioned profits. Such a system of multifactor global formulary apportionment, together with a minimum corporate tax rate, offers the best method of ensuring that source countries where the activities generating MNEs’ profits take place receive their fair share of tax revenues from these profits.
Download the full "What to Tax?' publication here.
Ifueko Okauru is a Commissioner of a nonpartisan body, the Independent Commission for the Reform of International Corporate Taxation (ICRICT). She is also currently engaged as an associate with the Harvard University Faculty of Arts and Science (FAS) undertaking research in Leadership, Social Enterprise, Culture and the Nigerian Nation.