shortcoming of the international tax framework?
Adv LLM thesis
submitted by
Gert Greve
in fulfilment of the requirements of the
'Advanced Master of Laws in International Tax Law'
degree at the University of Amsterdam
supervised by
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Table of Contents
Table of Contents ... III
List of Abbreviations used ... IV
Executive Summary ... V
Main Findings ... VI
1.
Reference framework ... 1
1.1. Justification ... 1 1.1.1. International consensus ... 1 1.1.2. Current rules ... 2 1.1.3. Proposals ... 21.1.4. What the discussion unveils ... 4
1.2. Scope of the thesis ... 5
2.
Formulary apportionment and the worldwide unitary regime ... 6
2.1. Formulary apportionment ... 6
2.2. Justification of a worldwide unitary regime ... 8
2.2.1. The geographic location of the corporate income ... 8
2.2.2. Theory of the firm ... 9
3.
Formulary apportionment in practice ... 11
3.1. US states. ... 11
3.1.1. A little history ... 11
3.1.2. The US states unitary business ... 11
3.1.3. The US states tax base ... 12
3.1.4. The US states formula ... 13
3.1.5. How the US states take into account the market contribution ... 15
3.2. Canada…. ... 16
3.2.1. A little history ... 16
3.2.2. Canada provincial corporate taxation ... 17
3.2.3. Canadian unity? ... 17
3.2.4. The Canadian formula ... 18
3.2.5. How the Canadian provinces take into account the market contribution ... 18
3.2.6. Fiscal capacity equalisation ... 19
3.3. Interim conclusion ... 20
4.
Testing if the worldwide unitary regimes address the issue appropriately . 20
4.1. Economic efficiency ... 214.2. Effectiveness ... 22
4.3. Fairness... ... 23
4.4. Is it possible to maximise the performance of the regime? ... 25
5.
Summary and conclusions ... 25
List of Abbreviations used
BEPS CCCTB G20 MNE MTC OECD TCA UDITPA UN USBase Erosion and Profit Shifting Project Common Consolidated Corporate Tax Base Group of Twenty
Multinational enterprise Multistate Tax Commission
The Organisation for Economic Co-operation and Development Tax Collection Agreement
Uniform Division of Income for Tax Purposes Act United Nations
Executive Summary
The current international tax framework was adopted a hundred years ago when brick and mortar businesses were the rule. Recognising taxing rights on corporate income to the source country based on the physical presence of production factors seemed fair at that moment.
However, technology now allows businesses to access a market with minimal or no physical presence. The digitalisation of the economy is challenging the roots of the political consensus. It is frustrating the jurisdiction of the market country to obtain what was considered agreed before. In this regard, the claim to 'rebalance' the taxing rights of these countries for some seems fair.
The proposals that emerged to satisfy the appetite of the market countries lack substantive arguments and create additional issues. It can endanger what is needed for a lasting political agreement.
From this standpoint, this work analyses the suitability of the other historical alternative to allocate taxing rights on MNE profits among different tax jurisdictions – the formulary apportionment. In particular, its consolidated and global version – the worldwide unitary taxation.
The aim of this work is to determine (i) if the worldwide unitary regime is able to recognise the demand-side as a factor of income production in the allocation of profits of an MNE and (ii) if it appropriately allocates taxing rights to the market countries according to the principles of economic efficiency, effectiveness and fairness.
Main Findings
The worldwide unitary regime is able to recognise the demand-side of the market's contribution to the production of income. This through the incorporation as a factor in the formula of proxies of the demand-side of the market. In practice, it has been done by the application of the sales factor or the gross revenue factor, both on a destination basis. In this regard, part of the income is allocated to the market countries. However, to perform appropriately in this sense, the regime needs that the nexus requirement does not rely on the physical presence of production factors. It will prevent the market country from exercising its taxing rights. On the contrary, it is more appropriate to rely on a de minimis sales threshold in order to create nexus.
Regarding the suitability of the regime, it can be established that it performs differently depending on how mobile the factors included in the formula are. In this regard, the use of mobile factors reduces the efficiency and the effectiveness of the system. On the contrary, the use of less mobile factors ensures the efficiency and effectiveness of the system.
With respect to the sales factor, it is considered a less mobile factor and therefore its use in the formula increases the performance of the system in efficiency and effectiveness. Moreover, the application of a worldwide unitary regime based only on sales produces the most efficient and effective outcome. However, considering that it represents only the demand-side of the market, it can be regarded that it results unfairly. In this regard, the system presents a trade-off between efficiency-effectiveness and fairness.
This work suggests analysing the possibility of including an external support that can provide a fairer outcome.
1. Reference framework
1.1. Justification1.1.1. International consensus
Since the presentation of the OECD/G20 BEPS Project, the effects of the digitalisation of the economy over the corporate tax system have been under examination of political1 and academic2 circles. A change in the way of doing business does not necessarily mean the compulsory need for changing the international tax regime. Historically, the changes in the way that businesses are developed have been translated into changes 'within' the boundaries of the agreed international tax system.3
Nevertheless, for some, it seems that the digitalisation of the economy is eroding the political consensus that our international tax system reached a hundred years ago.4 According to them, this consensus between residence and source countries is based in the assumption that MNEs required physical presence through a permanent establishment or a subsidiary entity in the source country in order to obtain access to its market.5 In this regard, providing taxing rights to the source country on the profits determined by separate accounting and the arm's length standard with respect to the activities carried out by the MNE seemed fair and legitimate at that moment.6
However, the new methods of interaction between enterprises and customers provided by new technologies, which do not require physical presence, are frustrating the jurisdiction of the source country to obtain what was considered agreed before. From this standpoint, the claim to 'rebalance' the taxing rights of these countries for some seems fair.7 But it would imply a large change to the current
1 OECD, Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015 Final Report (OECD 2015) 1;
OECD, Tax Challenges Arising from Digitalisation – Interim Report 2018: Inclusive Framework on BEPS (OECD
2018); OECD, Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the
Digitalisation of the Economy (2019); OECD, ‘Addressing the Tax Challenges of the Digitalisation of the Economy’ 29; OECD, ‘Public Consultation Document: Secretariat Proposal for a “Unified Approach” under Pillar One (9 October - 12 November 2019)’ 21; OECD, ‘Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy’ 30; European Commission, ‘Communication from the Commission to the European Parliament and the Council. a Fair and Efficient Tax System in the European Union for the Digital Single Market’ 11; G-20, ‘Digital Economy Development and Cooperation Initiative’ (2016) 20; G-24, ‘Proposal for Addressing Tax Challenges Arising from Digitalisation’ (2019) 24.
2 Yariv Brauner and Pasquale Pistone, “Adapting Current International Taxation to New Business Models: Two
Proposals for the European Union,” Bulletin for International Taxation, December 2017, 681–87; Marcel Olbert and Christoph Spengel, “International Taxation in the Digital Economy: Challenge Accepted?,” World Tax
Journal, February 2017, 3–46; Wolfgang Schön, “Ten Questions About Why and How to Tax the Digitalized
Economy,” Bulletin for International Taxation, May 2018, 278–92; Wolfgang Schön, “One Answer to Why and How to Tax the Digitalized Economy,” SSRN Electronic Journal, June 2019, 30; Reuven S Avi-Yonah and Kimberly A Clausing, “Toward a 21st-Century International Tax Regime,” Tax Notes International, August 26, 2019, 839–49.
3 Adolfo J Martın, ‘OECD / International Value Creation: A Guiding Light for the Interpretation of Tax Treaties?’
(2020) 74 Bulletin for International Taxation 18, 6.
4 Mitchell B Carroll, ‘Taxation of Foreigns and National Enterprises: Volume IV: Methods of Allocation of Taxable
Income’ (League of Nations 1933) vol IV.
5 Loyens & Loeff, ‘Comments In’, OECD tax challenges in digitalisation: Comments received on request for input - part II (2017) 136; Yariv Brauner and Andrés Baez, ‘Withholding Taxes in the Service of BEPS Action 1 - Address the Tax Challenges’ (2015) IBFD 33, 5; Brauner and Pistone (n 2) 681; Daniel W Blum, ‘Permanent Establishments and Action 1 on the Digital Economy of the OECD Base Erosion and Profit Shifting Initiative – The Nexus Criterion Redefined?’ (2015) Bulletin for International Taxation 314, 314–315.
6 Brauner and Baez (n 5) 4 and 5.
system.
The technology is making it possible for businesses to penetrate a market with no or minimal physical presence. It is what at the end of the day the so-called market countries are claiming to resolve. It is the perceived shortcoming of the current system.
1.1.2. Current rules
The current rules are not internally equipped with the proper tools to provide a solution inside the system.8 This can be understood from the structure of the transfer pricing rules and the physical presence requirement of the permanent establishment concept.
On the one hand, the transfer pricing rules in the application of the arm's length standard attribute tax base among related enterprises in accordance with the functions performed, assets used and risks assumed in a jurisdiction, where 'significant people functions' are the key elements to take into account.9 The scope of transfer pricing rules considers the supply-side of the income production, paying almost no attention to the demand-side of the market (i.e. consumers).10 To put it simply, this means that without any activity of the supplier in the market country, there is no tax base attributable to these jurisdictions under these rules.
On the other hand, the requirement of physical presence of the permanent establishment concept as a threshold to allow the source jurisdiction to tax, clearly does not satisfy the appetite of the market countries.
Technology allows MNEs to engage consumers of a market with no or minimal physical presence in its jurisdiction. In practice, this means that market countries are prevented from exercising taxing rights in many situations.
Moreover, the concept of permanent establishment serves not only as a threshold for the source country taxation (nexus) but also as a mean for identifying the income attributable to the permanent establishment (quantum).11 In this regard, the current rules allocate income to the source jurisdiction solely on the base of supply-side elements (production factors, i.e. capital and labour) located in that jurisdiction.
This results in not only the prevention of the market country from exercising its taxing rights if there is no physical presence of the MNE when there is not enough economic nexus, but also a reduction to the minimal expression of the income allocated to it. Technological advances are allowing access to a market with everyday less activity in there.
1.1.3. Proposals
Against this background, the following three proposals arise in the context of the work of the OECD/G20
8 Richard Collier and John Vella, ‘Five Core Problems in the Attribution of Profits to Permanent Establishments’
(2019) World Tax Journal 159, 182.
9 OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD
Publishing 2017) 44–45.
10 Loyens & Loeff (n 5) 137. It is important to mention that there are some minor exceptions, for instance, the
position of China and India with respect of the recognition of the value provided by location savings and marketing intangibles recognised in part D of the UN Transfer Pricing Manual. Nevertheless these elements are not considered in the OECD Guidelines.
Inclusive Framework:
1) The 'user participation' proposal, which tries to align the taxation with the contribution of the users in certain highly digitalised businesses (e.g. social media platforms, search engines and online marketplaces). In order to do so, it allocates taxing rights to the jurisdiction where users are located even if there is no physical presence of the enterprise, regarding the improvement that the involvement of the user grants to the expansion of the business.12
2) The 'marketing intangible' proposal, which provides taxing rights to the market countries on the profits related to the "marketing intangibles" used to penetrate its market (e.g. brand name, customer data). In this sense, regarding the nexus of the intangibles with the market, the market jurisdiction would have taxing rights even if the enterprises do not have a physical presence.13 3) The 'significant economic presence' proposal, which amends the nexus concept for digitalised
businesses in order to recognise the fact that enterprises can be heavily involved in a market without physical presence. It suggests allocating profits to the market on a formulary basis.14 These proposals were not fully developed and tackled the described issue from clearly different perspectives while reaching totally different outcomes.
In this context and as an attempt to reach a political consensus solution, the OECD Secretariat presented the unified approach (or Pillar One). Considering its purpose, the unified approach is a blend of the proposals discussed in the Inclusive Framework.
It establishes that the scope is the large consumer-facing businesses with worldwide revenue of more than 750 million euros. It proposes a new nexus not dependent on physical presence but on sales and modifies the profit allocation rules in order to make applicable its new nexus.15
The OECD Secretariat proposal represents an effort to reach a political consensus regarding the different policy drivers of the other proposals. At the end of the day, it tries to satisfy the revenue appetite of some countries through a scheme that ring-fences some large businesses without more arguments. It overlooks the continuum of the digitalisation of the economy and recklessly departs from the arm's length standard and the transfer pricing rules going 'beyond them'16 to provide a political solution. It comes from the understanding that it is necessary to ensure that profits are taxed where economic activities take place and 'value is created' to restore the confidence in the system.17 Something everyone agrees on in principle, but not on its content.
Scholars have shown how this concept does not help to solve the controversy.18 The reason is that it is too broad to mean something useful. Such a vast and ambiguous concept is just assisting every country to justify its own position and reproducing the residence source country debate with new ammunition.19 It seems that it is only helpful on its negative face: to deny taxing rights to intermediate countries without
12 OECD, ‘Addressing the Tax Challenges of the Digitalisation of the Economy’ (n 1) 9–11. 13 Ibid 11–16.
14 Ibid 16–17; G-24 (n 1) 24.
15 OECD, ‘Public Consultation Document: Secretariat Proposal for a “Unified Approach” under Pillar One (9
October - 12 November 2019)’ 21.
16 Ibid 5.
17 OECD, Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015 Final Report (n 1) 3.
18 Itai Grinberg, ‘International Taxation in an Era of Digital Disruption: Analyzing the Current Debate’ (2018) SSRN
Electronic Journal 5–6 <https://www.ssrn.com/abstract=3275737> accessed 28 April 2020; Martın (n 3) 17–18.
19 Martın (n 3) 10; John Vella, ‘Value Creation and the Allocation of Profits under a Formulary Apportionment’, The allocation of multinational business income: reassessing the formulary apportionment option (Kluwer Law
substantial activities (i.e. instrumental low tax jurisdictions).20 In this regard, it seems reckless and pointless to try to rebuild our international tax consensus on this vague concept. It must be said that the value creation concept 'cannot assume a normative role'.21
1.1.4. What the discussion unveils
In different ways and to varying degrees, all the emerged proposals try to enshrine something new for the international understanding of the corporate income tax system, the contribution of the demand-side on the production of income.22
The economic science long ago almost unanimously acknowledged that to produce value the interaction of the supply and demand-sides of the market was needed. The interaction of labour and capital is necessary to produce goods and provide services, but without a consumer, any product or service is a waste of resources.23 Income would not arise in the absence of a market.24 It is clearly explained by the famous scissor metaphor of the economist Alfred Marshall:
'We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.'. 25
From this standpoint, the recognition of taxing rights to the demand-side jurisdiction for corporate income tax purposes seems fair. 26 Nevertheless, the most important issues remain, regarding that it does not provide any clue with respect to how to disentangle the contribution of the supply and the demand-side in order to divide the profit of an MNE for corporate income tax purposes. 27
In this regard, it seems essential to humbly assume that this is a strictly political issue and there is no pure scientific or neutral solution. 28 It helps to understand the position that academia should take to face the disagreement. Academia is called upon to unpretentiously provide inputs to the political resolution, i.e. assess the pros and cons of the analysed proposals to generate a stronger foundation to reach a
20 Martın (n 3) 17. 21 Vella (n 19) 275.
22 It is important to mention that the OECD Model and UN Model have always recognised elements of the market
to allocate taxing rights, such as royalties and interest or the leasing of equipment. In this regard, the current issue is specifically related to those provisions that minimise the recognition of the demand-side. For more information please see Martın (n 3).
23 Loyens & Loeff (n 5) 137. 24 Vella (n 19) 267.
25 In order to refuse the cost of production theories of value, the economist Alfred Marshall presented this metaphor
to express that both demand and supply-sides contribute to the creation of value. Alfred Marshall, Principles of
Economics: An Introductory Volume. (Eighth, 1920) 290.
26 It is important to mention that the demand-side is recognised by consumption taxes (e.g. Value-added tax)
regarding the application of the destination principle. This must be taken into account to develop a thorough analysis of the allocation of taxing rights. There are some scholars that consider that the current pressure of revenue may be related to the enforceability issues related to these taxes with respect to digital businesses. Nevertheless, that is outside the scope of this thesis. Marcel Olbert and Christoph Spengel, ‘Taxation in the Digital Economy – Recent Policy Developments and the Question of Value Creation’ (2019) SSRN Electronic Journal 31.
27 It is particularly clear if the subjective theory of value is endorsed. According to this theory the value of a good
is not determined by any inherent property of the good, nor by the amount of labour necessary to produce the good. Instead it is determined by the importance that each individual places on a good for the achievement of his desired ends. For more information please see Carl Menger and others, Principles of Economics (Ludwig von Mises Institute 2007) 114–148.
lasting consensus.
Against this background, it seems that the mentioned proposals are attempts to satisfy the revenue appetite of market countries, but without considering the fundamentals of international taxation that can provide this consensus. It is particularly relevant with respect to the proposals that hesitantly depart from the arm's length standard and the transfer pricing rules going 'beyond', but not abandoning them. Because in addition to their own weaknesses, they create an additional issue – the compulsory obligation of reconciling these new rules with the existing income allocation rules. 29
On these grounds, reaching an agreement appears to be challenging. And even if it is reached, it seems that it could be easily broken within a short period of time.
From this standpoint, it is crucial to build a new consensus based on fundamental principles that can provide a broader and lasting agreement.
1.2. Scope of the thesis
The perceived shortcoming of the international tax system pushes the boundaries and forces to propose innovative solutions that depart from the arm's length standard. However, the shown proposals lack from the substantive argument and create additional issues that can endanger a lasting consensus. In this regard, the purpose of this thesis is to take a step back from the current international corporate tax system and analyse the other historical option to allocate taxing rights on MNE profits among countries – the formulary apportionment, in particular its consolidated and global version – the worldwide unitary taxation.30
The formulary apportionment is not new in this history, and it currently operates at a subnational level in some countries. It was analysed by the international community a hundred years ago when the current standard was adopted. At that time, the so-called 'Carroll Report' required by the League of Nations dismissed it because of the difficulty to reach a political agreement on (i) tax accounting principles for assessment and (ii) a common allocation formula. In this context, the arm's length standard was much easier to endorse in an environment where less consensus was needed and can be administered just through bilateral treaties.31 A hundred years later, we are facing the same problem pushed by the digitalisation of the economy, but in entirely different circumstances. The current international framework may allow us to think that the political consensus is reachable because it is compulsorily required.32 Against this background, the aim of this work is to analyse the application of this approach in a consolidated and global basis, specifically to examine if it is a suitable method to face the described perceived failure of the current system. This mean scrutinises (i) if the worldwide unitary regime is able to recognise the demand-side as a factor of income production in the allocation of profits of an MNE and (ii) if it appropriately allocates taxing rights to the market countries.
29 Collier and Vella (n 8) 184–186.
30 Maarten Floris de Wilde, ‘Sharing the Pie’; Taxing Multinationals in a Global Market (2016) 375.
31 Sol Picciotto, ‘Is the International Tax System Fit for Purpose, Especially for Developing Countries?’ (2013)
SSRN Electronic Journal 35, 13.
32 Sol Picciotto explains this clearly: ‘This is entirely understandable in view of the political weakness of the League
of Nations: the US did not join that body due to a negative vote in the Senate; Russia and Germany were not admitted; and others such as Japan left. In that context international coordination under its auspices of issues such as tax, with the participation of non-member states and indeed in this case with US leadership, was clearly only possible without the involvement of politicians. Since then the technical experts have constructed a system which is now producing outcomes which are equally clearly politically unacceptable’. Ibid.
In order to evaluate the suitability of the worldwide unitary regime, some fundamentals principles of taxation are going to be used as benchmarks. The principles that are going to be used are economic efficiency, effectiveness and fairness.
The focus of this work is on the ability of the worldwide unitary regime to recognise the demand-side of the market appropriately. Even though there will be references to these topics, issues related to the tax base, the group definition, nexus and harmonisation are outside of the scope of this work. Matters related to withholding taxes, consumption taxes, exchange rates are outside of the scope of this work as well.
This work is structured in three chapters. The first chapter analyses the main features of the formulary apportionment and its worldwide unitary regime version. The second one examines the application of the formulary apportionment in practice at a subnational level in the United States and Canada and determines if they can recognise the contribution of the demand-side of the market. The last one tests the regime against the mentioned principles in order to measure its aptness. The work finishes with some brief conclusions.
2. Formulary apportionment and the worldwide unitary regime
2.1. Formulary apportionmentThe formulary apportionment regime consists of the distribution of profits among different jurisdictions by reference to a predetermined formula. 33 Through this way, there is no need to calculate the profits earned in each jurisdiction separately.34 The factors considered in the formula are easily-perceived elements that are deemed relevant in the production of income.35 The formula traditionally reflects property, payroll and sales as factors, but there is no limitation to take other factors into account.36 The weight of each factor in the formula may vary jurisdiction to jurisdiction.37 The following formula illustrates the method: 38
33 Carroll (n 4) 58; Joann Martens Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in
Implementing Formula Apportionment at the International Level’ (1996) Tax Notes International 45, 5; Lindsay C Célestin, ‘The Formulary Approach to the Taxation of Transnational Corporations: A Realistic Alternative?’ (University of Sidney 2000) 133; Charles E McLure, ‘Replacing Separate Entity Accounting and the Arm’s Length Principle with Formulary Apportionment’ (2002) IBFD 586, 587; Stefan Mayer, ‘Formulary Apportionment for the Internal Market’ (Ludwig Maximilians University 2009) para 2.1.; de Wilde (n 30) 367.
34 Joann Martens Weiner, Formulary Apportionment and Group Taxation in the European Union: Insights from the United States and Canada (Office for Official Publ of the Europ Communities 2005) 9.
35 Célestin (n 33) 133; Reuven S Avi-Yonah and Ilan Benshalom, ‘Formulary Apportionment—Myths and
Prospects’ (2010) Working Paper No. 221 30, pt II; de Wilde (n 30) 361–362.
36 The US states use property, payroll and sales as factors to allocate business income for state corporate income
tax purposes. Shirley Sicilian and Joe Huddleston, ‘The US States’ Experience with Formulary Apportionment’,
The allocation of multinational business income: reassessing the formulary apportionment option (Kluwer Law
International BV 2020) 42. Canada uses a two factors formula base in gross revenue and salaries and wages to allocate income between the provinces. Michael Smart and François Vaillancourt, ‘Formulary Apportionment in Canada and Taxation of Corporate Income in 2019: Current Practice, Origins and Evaluation’, The allocation
of multinational business income: reassessing the formulary apportionment option (Kluwer Law International BV
2020) 80.
37 In the US states the weight of each factor in the formula varies state from state. Sicilian and Huddleston (n 36)
49–51. In Canada each factor is equally weight. Smart and Vaillancourt (n 36) 80.
38 The described formula is the Massachusetts formula. A three-factor formula that considers property, payroll and
sales equally weight. This formula was firstly introduce in Massachusetss in 1919 and then applied commonly used as the standard formula. Richard Krever and Peter Mellor, ‘History and Theory of Formulary Apportionment’, The allocation of multinational business income: reassessing the formulary apportionment
To exemplify the application of this formula, if a business has the 50% of its property, payroll and sales in a jurisdiction that applies the depicted formula, the formula will attribute the 50% of the profits of the business to this jurisdiction.
Formulary apportionment is often mistaken with unitary taxation, but it is not strictly the same.39 Formulary apportionment is only related to the allocation of tax base among different jurisdictions based on a formula. Instead, the unitary taxation concept does not refer to the distribution of profits, but rather to grouping entities whose profits are allocated typically through a formula.40 The unitary taxation traditionally requires a formula to allocate the profits of a whole group.41 The formulary apportionment can be applied to the profits of a stand-alone company.42
The application of the unitary version of the formulary apportionment produces two main effects. On the one hand, it ignores the transaction among the entities that belong to the unit. It allows to avoid determining the fair market value of the transactions among entities of the group in the application of the arm's length standard, reducing the arbitrage of the taxpayers.43 On the other hand, it combines the income of the entities that belong to the unit, which is considered beneficial to the group because it allows offsetting losses 'attributed' to a jurisdiction against profits 'attributed' to another jurisdiction. There is one net result of the whole unit.44
The unitary regime is commonly related to tax base uniformity and territorial taxation.45 Tax base uniformity refers to the agreement between different jurisdictions to apply the same tax base to improve coordination and avoid multiple taxations (or non-taxation).46 Territorial taxation, also called water's edge, makes reference to the application of the regimen just within the boundaries of a particular jurisdiction.47 Outside the boundaries of the country, the separate accounting and the arm's length standards apply. In this regard, under territorial taxation, both regimes may coexist. One may apply to the entities that are located within the boundaries of the country (formulary apportionment) and the other to the entities that are located outside the country (separate accounting and arm's length standard).48
39 Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at
the International Level’ (n 33) 5; de Wilde (n 30) 367.
40 Mayer (n 33) para 2.1.
41 Some scholars distinguish between the concept of consolidation and combination. They consider that
consolidation is based on ownership and does not consider whether the companies are part of an economic unit as a combination. Despite that this distinction is a key issue in the application of the unitary regime, it is not part of the scope of this work. Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at the International Level’ (n 33) 5–6; Célestin (n 33) 133; Mayer (n 33) pt 2.1.
42 Such is the formulary apportionment method used in Canada to allocate business profits among provinces.
Smart and Vaillancourt (n 36) 85.
43 Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at
the International Level’ (n 33) 5.
44 Avi-Yonah and Benshalom (n 35) pt II. 45 de Wilde (n 30) 367.
46 Such is the case of Canada under the Tax Collection Agreements between the provinces and the federal
government. Smart and Vaillancourt (n 36) 77.
47 Mayer (n 33) para 2.1.
48 Weiner, Formulary Apportionment and Group Taxation in the European Union (n 34) 37. Property x Payroll x Sales x
= + + =
Property all Payroll all Sales all
3 Taxpayer's total profits Taxpayer's profits apportioned to jurisdiction x
Against this background, the worldwide unitary regime considers the application of the formulary apportionment method under a combined, uniform and worldwide tax basis. It means that the net result of a unity of entities (total income minus total deductions) is allocated to different jurisdictions on the basis of a formula without geographic limitations. Thus, the opportunities for taxpayers to arbitrage are reduced.49
In order to work correctly and avoid multiple taxations (or non-taxation), the worldwide unitary regime requires broad and specific agreement among the international community on (i) nexus, (ii) the tax base, (iii) the unit and (iv) the formula.50
2.2. Justification of a worldwide unitary regime
2.2.1. The geographic location of the corporate income
Traditionally a country may tax an income because a nexus exists between the country and the person deriving the income (residence jurisdiction) or between that country and the income (source jurisdiction).51 However, there is no clear consensus on the definition of source concept.52 It has been commonly accepted that it is broad enough to represent many ideas. Some consider that it is so broad that it works as the negative face of other concepts such as a 'not residence taxation' or 'pure territorial taxation'. This makes reference to the jurisdictions that have any link to the income that allows them to tax under a nexus that is different from the personal connection of residence taxation.53 Nevertheless, the source concept is more commonly used to describe two different ideas:
1) A class of income to which the 'amount' belongs (e.g. dividends, royalties, interest, business); or
2) A geographical place from which the income is derived, answering to 'arising in', 'having its origin in' or 'having a domestic source'.54
Against this background, the discussion of income allocation among different countries is mainly focused on the search of the 'true' source of income. Understanding it as seeking the holy grail of the 'true' geographic location of the source income.55 However, it has been recognised by many scholars that it is impossible to determine the geographic location of an income.56
The source of the corporate income under the current rules has been commonly related to the location of the production factors (i.e. capital and labour) and measured as what they generate. In this regard, the location of the income has been mistakenly attributed to the geographic location of the production factors. This idea wrongly assumes that the production factors represent the geographic location of the income. Under these assumptions rest the mistaken notion that the arm's length standard and the transfer pricing rules are more precise and effective to determine the 'true' geographic location of the
49 In reference to the application of the formulary apportionment Richard D. Pomp said “A state that does not
require related corporations conducting a unitary business to file a combined report is at the mercy of its corporate taxpayers” Richard D. Pomp, ‘The Future of the State Corporate Income Tax: Reflections (and Confessions) of a Tax Lawyer’, 16 State Tax Notes 939 (22 March 1999), 939-948, at 945. Quoted by de Wilde (n 30) 374.
50 Walter Hellerstein, ‘International Income Allocation in the Twenty-First Century: The Case for Formulary
Apportionment’ 62, 69; Michael Kobetsky, ‘The Case for Unitary Taxation of International Enterprises’ (2008) Bulletin for International Taxation 201, 211–212.
51 Arnold (n 11) 17.
52 John F Avery-Jones and others, ‘Tax Treaty Problems Relating to Source’ (1998) 38 European Taxation 78, 79. 53 Mayer (n 33) para 2.3.1.3.
54 Célestin (n 33) 185.
55 Hellerstein (n 50) 63; Mayer (n 33) para 2.3.1.4.
56 de Wilde (n 30) 301. Klaus Vogel, ‘Worldwide vs. Source Taxation of Income: A Review and Re-Evaluation of
source of income.57 However, it is conceptually wrong.58
In order to produce income, the interaction between the supply-side and the demand-side of the market is strictly necessary. The interaction of labour and capital to supply a good or service is meaningless without a consumer that demands them. In this regard, the production of profits requires this interaction. But the interaction is entirely immaterial and therefore lacks a unique geographic location.
Within this context, it is only possible to consider that the inputs (supply-side) and outputs (demand-side) of an enterprise are proxies of the 'true' source of income. But that says nothing about how the income should break-down and be allocated among the jurisdictions that participate in this interaction. In this regard, some scholars consider that the question about the 'true' geographic location is not the right question.59 Then the problem of income allocation turns into a normative question about 'how' the income 'should' be allocated among states that have a legitimate claim to it. It is a purely political question. As Hellerstein said '[the] resolution of this question may be more a matter of faith than of logic'.60
At first glance, a formulary apportionment regime seems to face this task. Mainly for three reasons. First, the structure of formulary apportionment is flexible enough to be governed by the principles that will provide the normative answer about how the income should be allocated. The factors and its weight in the formula should represent the answer to this question. Second, a formulary apportionment regime may introduce as a factor the proxies of the 'source' of income. In this regard, it would be able to recognise the interaction of the supply and demand in the production of income. Lastly and along the same line, a formulary apportionment regime is able to use some elements of the demand-side as proxy, and therefore recognise its participation in the production of income. However, this does not mean that it addresses this task properly. This will be analysed later in this work.
2.2.2. Theory of the firm
Neoclassical economics theory wrongly considered that the market through the price system was the only way to allocate scarce resources efficiently. About this Hayek said: '[T]he spontaneous interplay of the actions of individuals may produce something which is not the deliberate object of their actions but an organism in which every part performs a necessary function for the continuance of the whole, without any human mind having devised it'.61
A firm was only a 'mysterious' figure that merely produced outputs from some inputs. The resource allocation system as proposed understood that markets' allocation of resources through prices was
57 Hellerstein (n 50) 63.
58 Moreover, even if it is wrongly assumed that the production factors reflect the geographic location of the
corporate income, many times it is impossible to determine the ‘true’ source. Especially with respect to intangibles assets or highly integrated businesses. Sol Picciotto quotes the submission of the German-based chemical firm BASF to illustrate this: ‘Quality management and controls relating to the risks, functions and assets employed are to a wide extent part of corporate procedures which are generally valid group-wide and are fully integrated in the business processes. The research and development process is managed by electronic systems which track the allocation of projects to specific research centres, the adherence to budgets, the sign-off processes and the registration of IP rights. ‘Control’ is therefore to a large extent built in to group-wide guidelines and operating systems, and can therefore be performed anywhere as such systems enable a decentralised, collaborative organisation’. Sol Picciotto, ‘Taxing Multinational Enterprises as Unitary Firms’ (2016) 53 International Center for Tax and Development 37, 19.
59 Michael J McIntyre, ‘The Use of Combined Reporting by Nation-States’, The taxation of business profits under tax treaties (Canadian Tax Foundation 2003) 261.
60 Hellerstein (n 50) 63.
61 Friedrich A Hayek, The Trend of Economic Thinking: Essays on Political Economists and Economic History, vol
absolutely efficient. However, that was against reality.
Observing how markets operate, economic science later understood that the price system was sometimes displaced, taking into account that in the real world this system was replaced by the internal organisation of a firm many times. In this regard, they understood that firms were not only a production structure and its shape, size, and activities actually internalise the interaction of the market.62 They exposed that firms arise to make greater profits by directing the allocation of resources instead of leaving this allocation decision to the market.63 The main reason why this occurs is that there are some transaction costs associated with the use of the price system of the market.64 The firms arise to reduce such transaction cost through the allocation of resources within the organisation.65 Firms arise when they are the most efficient institution to organise the resources.66
This is also applicable to an MNE. Where they are more efficient than markets and organise through contracts economic relationships between productive elements located in different countries.67 Under this regard, this theory revealed how MNE are able to make profits above those available in the market from the internal direction of resources.68 MNEs can produce residual profits that cannot be linked to any particular production factor or activity developed inside the MNE. This problem was even known and avoided by Mitchell Carroll when he was developing the current system.69
In this regard, MNEs are a kind of black box. They can operate as a large structure to exploit the benefits of integration. This process is more extensive every day because of the technological advances that allow more integration.70 Under these circumstances, any reference to 'market prices' or consideration over the possibility of splitting the MNE activities to determine the allocation of profits among different jurisdiction will be inaccurate because it will disregard the very reason why an MNE arise.
Against this background, the worldwide unitary regime seems to be aligned with the economic reality and the features of the MNEs. On the one hand, the unitary regime structure recognises the economic
62 Ronald Coase was the first to introduce this theory known as the theory of the firm. He received the Nobel
memorial prize in economics sciences in 1991 mainly for this work. Ronald H Coase, ‘The Nature of the Firm’ (1937) 4 386-405.
63 Richard J Vann, ‘Taxing International Business Income: Hard-Boiled Wonderland and the End of the World’
(2010) World Tax Journal 291, 293.
64 There are also other reasons such as the incompleteness of contracts; exploitation of assets which because of
their special characteristics cannot be fully exploited in the market; and the role of the entrepreneur. Ibid 293– 294.
65 D.H. Robertson explain this clearly: ‘[we find] islands of conscious power in this ocean of unconscious
co-operation like lumps of butter coagulating in a pail of buttermilk’. Coase (n 62) 388.
66 Jean‐François Hennart, ‘Theories of the Multinational Enterprise’ in Alan M Rugman and Thomas L Brewer
(eds), Oxford Handbook of International Business (Oxford University Press 2001) 132.
67 Hennart explain this through the following example: ’firm A may have established a distribution system and a
manufacturing capacity in its own country, but may be looking for foreign licenses to manufacture and distribute complementary products; while on the other hand a foreign manufacturer may have already developed such a product and can sell its technology to firm A at a very low marginal cost. However, such cooperation, which would be profitable to both parties, will not automatically take place. Both parties must be aware of the potential gain of cooperating, and they must be able to agree on a price for the technology, and they must prevent protracted bargaining from eating all the potential gains from cooperation. Ibid 133.
68 Vann (n 63) 321.
69 Mitchell Carroll explains: [I]n the usual case where an enterprise has its principal establishment in one country
and secondary establishment in others […] the real centre of management is probably at the principal establishment […] The profit or loss results from all the activities of the enterprise taken together, but how can the part attributable to the establishment in each country be most readily measured? If we recognise the fact that the real centre of management, especially if it is situated at the principal productive establishment, is the most vital part of the enterprise, the most practical approach to the problem is to five the residuum of profit or loss after allocating to each outlying secondary establishment compensation for the services it has rendered to the enterprise in accordance with what would be paid to and independent enterprise rendering such services.’Carroll (n 4) para 677.
rationale that an MNE constitutes a unitary business and that profits arise from the operation of the business as a whole. Its structure seems to deal appropriately with the operations of MNEs that are more integrated every day because of the possibilities that the new technologies provide. On the other hand, the application of the formula allows allocating these 'residual' profits according to an agreed upon key that should represent the consensus. In this regard, it does not leave space for arbitrage inside the MNE to shift this residual through internal transactions.
3. Formulary apportionment in practice
3.1. US states3.1.1. A little history
The first time that the United States applied an apportionment method was at the end of the XIX century concerning the property tax. The property tax was the most relevant state tax, and railroads were one of the businesses affected since they operate in more than one state.71
For state income tax purposes the problem arose since the beginning of the XX century. Wisconsin was the first state that introduced a general income tax on both residents and non-residents that derived income sourced in the state. Income sourced in Wisconsin was computed in relation to the proportion of capital assets and business carried in the state. But this was considered too complicated.72 T.S. Adams proposed a formula based on the proportion of a company's property and payroll, as a proxy of production activities as a short-term solution. He assumed that it would provide a rough solution and that a more 'scientific' solution could be reached later.73
Under these circumstances, Massachusetts adopted the famous three-factor formula based on the proportions of a company's tangible property, payroll and sales attributable to a state. Each factor was equally weighted.74 From 1940 onwards the 'Massachusetts formula' spread among all US states and by 1978 most of the states applied this formula.75 From then on, many things have changed.76
3.1.2. The US states unitary business
Currently, forty-five US states and the District of Columbia impose a state corporate income tax on corporations that have enough nexus.77 This nexus consideration can make liable corporate taxpayers that are resident inside or outside the state. State corporate income tax rates range from 2.5% to 12%78
71 Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at
the International Level’ (n 33) 5. . Sicilian and Huddleston (n 36) 62.
72 Krever and Mellor (n 38) 13. 73 Ibid 13–14.
74 Commonwealth of Massachusetts, ‘General Acts’ s 355.6.
<https://archive.org/details/actsresolvespass1919mass/page/442/> accessed 10 June 2020.
75 Every US state, but Iowa which applied a sales only factor. Mayer (n 33) para 3.2.1.3.
76 For more please see Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in Implementing
Formula Apportionment at the International Level’ (n 33); Joann Martens Weiner, ‘Would Introducing Formula Apportionment in the European Union Be a Dream Come True or the EU’s Worst Nightmare?’ 519; Joann Martens Weiner, Company Tax Reform in the European Union: Guidance from the United States and Canada
on Implementing Formulary Apportionment in the EU (Springer 2005); Weiner, Formulary Apportionment and Group Taxation in the European Union (n 34); Krever and Mellor (n 38); Sicilian and Huddleston (n 36). 77 Sicilian and Huddleston (n 36) 42.
78 Nevada, Ohio, Texas and Washington impose gross receipts taxes instead of a state corporate income tax.
South Dakota and Wyoming are the only states that do not impose a state corporate income tax or gross receipt tax. Janelle Cammenga, ‘State Corporate Income Tax Rates and Brackets for 2020’ (2020) 692 Fiscal Fact 5, 1.
US states are allowed to tax the activities carried out in their jurisdictions by in-state taxpayers or out-state taxpayers. The US Constitution forbids a out-state to levy income that arises from an activity outside its borders. Nonetheless, if an in-state taxpayer has activities outside the state, and that activity has some concrete connection with its in-state activity, then the in-state and the out-state activity can be considered part of a unitary business. Then, the state has nexus to tax a share of the total income arising from that unity wherever it is conducted.79
A unitary business may or may not be carried by a single legal enterprise. A unitary business can be carried by a stand-alone legal entity or by several related legal entities. A unitary business can consider domestic and foreign legal entities that operate together.80
The US Constitution does not allow both the income and factors of entities that are not part of the unitary business to be include in the apportionment. However, most states limit themselves more than the constitution requires.81
Many states exclude both income and factors of some entities that are part of a unitary business. The so-called ‘separate reporting' states choose to limit the computation to stand-alone companies (i.e. considering income and factors of one corporate taxpayer). The called ‘combined reporting' states consider in the computation multiple legal entities.82
Moreover, no state requires to determine its share based on the income and factors of the whole unitary business. ‘Combined reporting’ states exclude, or allow taxpayers to elect to exclude, the foreign entities of the unit. This results in the so-called 'water's edge combined reporting', regarding that the formula apportionment is applied finally just inside the boundaries of the US.83 Surprisingly, only the state of Alaska mandates for a worldwide combined reporting, but solely on oil and gas producers and pipelines companies.84
Combined reporting considers the net business income of the unit to establish the corporate taxpayer's pre apportioned tax base. In this regard, there is no need for transfer pricing analysis. However, taking into account that some entities of the tax unity are excluded (separate reporting or water's edge method) the concerns about the fair market value of the intra-unit transactions remain.85
3.1.3. The US states tax base
Every state applies a two-step approach to determine the tax liability of a corporate taxpayer. The first step is to determine the apportionable income of a business. The second step is to establish the portion of income that corresponds to the state according to the formula.
79 In order to analyse if there is a unitary business, the US Supreme Court applies the Mobil three factors’ test
which consist in analyse if the income results from (1) functional integration, (2) economies of scale or (3) centralized management. Sicilian and Huddleston (n 36) 43–44.
80 Ibid. 81 Ibid 46.
82 California was the first state that applied the combined reporting in 1937 because of the issues with the movie
industry with respect to the separation of the production and the distribution in different entities. California applied it without an explicit statutory authority arguing that the combined reporting was part of the unitary business principle. Ibid 63.
83 Walter Hellerstein, ‘Formulary Apportionment and Related Entities: US Lessons’, The allocation of multinational business income: reassessing the formulary apportionment option (Kluwer Law International BV 2020) 149;
Mayer (n 33) para 2.1.
84 State of Alaska, ‘Alaska Statutes - s. 43.20.072.’
<https://law.justia.com/codes/alaska/2011/title43/chapter43-20/sec-43-20-072/> accessed 10 June 2020.
85 Some water’s edged combined reporting states have enacted anti-avoidance provisions in order not to exclude
The apportionable income is the business income, in opposition to the non-business income.86 The business income is the income that arises from the operations of the taxpayer's business. Half of the states use the model Uniform Division of Income for Tax Purposes Act (UDITPA) definition of business income: 87 '[I]ncome arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations'. 88
Most of the states that have implemented this definition understand that it includes two kinds of incomes: transactional and functional income.89 On the one hand, transactional income refers to the 'income arising from transactions and activity in the regular course of the taxpayer's trade of business'. 90 For instance, income from the trade of taxpayer's products. On the other hand, functional income refers to 'income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations'.91 For example, income from the sale of a fixed asset that the taxpayer uses in its production.92 Both sorts of income constitute the pre-apportioned profits.
3.1.4. The US states formula
After determining the pre-apportioned profits, each state determines the portion of that income that corresponds to the tax base in that state according to the factors and the weight of each of them in its formula.
The UDITPA Model proposed an apportionment formula based on property, payroll and sales being equally weighted.93 On the one hand, the property and payroll factors attempt to reflect the contribution of the production factors of the taxpayer. On the other hand, the sales factor may reflect either the contribution of the supply-side or the demand-side of the market. However, each state is free to determine its formula.
Nonetheless, there are some limitations. The US Constitution requires that the state's apportionment formulas must be 'fair' and 'non-discriminatory'.94 The US Supreme Court has understood that a formula is fair when it is internally and externally consistent. On the one hand, a formula is internally consistent when 'if applied, it would result in no more than all of the unitary business' income being taxed.' In this sense, this principle tries to avoid multiple taxations. However, US states do not apply the same formula and therefore the multiple taxations (or non-taxation) exist in practice.95 This is considered the main
86 The non-business income is the income not related to the operations of the taxpayer’s business. This sort of
income is allocated through direct allocation rules. For example, income or gain for a non-business physical asset is normally allocated to the state where the asset is physically located. Weiner, ‘Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at the International Level’ (n 33) 10; Sicilian and Huddleston (n 36) 42.
87 Sicilian and Huddleston (n 36) 48.
88 Uniform Law Commission, ‘Uniform Division of Income for Tax Purposes Act (UDITPA)’ s 1(a).
89 Other states use the definition developed by the Multistate Tax Commission (MTC). According to the MTC
model, the apportionable income includes ‘all income that is apportionable under the Constitution of the United States’. The aim of this definition is to keep the definition broader after that some state court decisions applying the transactional test to functional income. Multistate Tax Commission, Model Multistate Tax Compact Article IV (MTC Art.IV). Sicilian and Huddleston (n 36) 48.
90 Uniform Law Commission (n 88) s 1(a). 91 Ibid.
92 Sicilian and Huddleston (n 36) 48. 93 Uniform Law Commission (n 88) s 9.
94 US Supreme Court, ‘Container Corporation of America v. Franchise Tax Board’ para 170. 95 Ibid 169.
shortcoming of the US system.96
On the other hand, external consistency means that 'the factor or factors used in the apportionment formula must reflect a reasonable sense of how income is generated'.97 In this regard, the formula in one way or another should consider factors that contribute to the making of profits.98 However, it is evident that a formula will never reflect properly how the income is generated. Because as it was said, it is impossible.
The Supreme Court recognised this weakness of the formulary apportionment method. Against this background, it affirmed that when a state 'has adopted a method not intrinsically arbitrary, it will be sustained until proof is offered of an unreasonable and arbitrary application in particular case'.99 The Supreme Court recognised that the Massachusetts three-factor formula is not perfect, but is fair regarding its purpose.100 After some hesitation, it even recognised that a single factor formula can provide a practical 'rough approximation'. It finally states: 'The single factor formula used by Iowa, therefore, generally will not produce a figure that represents the actual profits earned within the State. But the same is true of the Illinois three factor formula. Either may over-reflect or under-reflect income attributable to the taxing State'.101
This judgement of the Supreme Court produced a large impact in the US states formulas. By 1978, every US state, except Iowa applied the Massachusetts formula.102 Currently, only nine states still apply it. Most states have changed their formula and have changed it in the same direction: increasing the weight of the sales factor. Thirty-seven states now at least double the sales factor. And twenty-four of them apply a formula based solely on the sales factor.103
The justification for the reduction of the weight of both the property and payroll factors is mainly to encourage economic activity in the state. The reduction of the property and payroll factors makes the state more attractive to place a business there. The business can hire employees or install a factory at a lower cost because these factors will produce now less taxation in the state.104 In this regard, the use of property and payroll in the formula converts the state corporate income tax into an excise tax on these factors, similar to a payroll tax or property tax.105 Some empirical analyses have shown that the reduction of the payroll weight in the formula increased employment in the state.106 Others have shown that the reduction of the property factor stimulates additional investments.107 States make a trade-off between tax revenue and economic activity. However, if all states use the same formula, the incentive to
96 Kobetsky (n 50) 207.
97 US Supreme Court, ‘Container Corporation of America v. Franchise Tax Board’ (n 94) para 169.
98 From a general view, this means that the factors considered in the formula must be elements that in one way or
another contribute to produce income. But the requirements goes further: they not only require that the elements formally contributes, but also that this contribution is materialised. In this regard, if a tangible property is not used in the business and therefore does not contribute to the production of income, it should not be considered in the property factor. Hellerstein (n 83) 150.
99 US Supreme Court, ‘Hans Rees’ Sons, Inc. v. North Carolina’ para 133.
100 US Supreme Court, ‘Container Corporation of America v. Franchise Tax Board’ (n 94) para 184. 101 US Supreme Court, ‘Moorman Manufacturing Co. v. Bair’ para 273.
102 Mayer (n 33) para 3.2.1.3. 103 Sicilian and Huddleston (n 36) 52.
104 Institute of Taxation and Economic Policy, ‘Corporate Income Tax Apportionment and the “Single Sales Factor”’
3, 2–3.
105 Charles E McLure, ‘State Corporate Income Tax: Lambs in Wolves’ Clothing?’ (1977) US Treasury Department
30, 2.
106 Austan Goolsbee and Edward L Maydew, ‘Coveting Thy Neighbor’s Manufacturing: The Dilemma of State
Income Apportionment’ (2000) 75 Journal of Public Economics 26, 19. Sebastian Eichfelder, Frank Hechtner and Jochen Hundsdoerfer, ‘Formula Apportionment: Factor Allocation and Tax Avoidance’ (2018) 27 European Accounting Review 48, 29.
107 Joann Martens Weiner, ‘The Dream Is Alive EU Tax Policy with a Common Consolidated Corporate Tax Base
and Formulary Apportionment’, The allocation of multinational business income: reassessing the formulary
reallocate its production factors is limited to the difference of the effective tax rates among the jurisdictions.
After all these considerations, each state determines the proportion of factors the business has in its state in comparison to the whole unitary business. According to this proportion and the weight of the factors in the formula, each state determines the tax base from the apportioned profits. Then each state applies its own tax rate on the tax base to establish the tax liability of the business in the state. In this regard, a business may have the obligation to file 45 different tax returns that are not uniformed, producing multiple taxations (or non-taxation).
3.1.5. How the US states take into account the market contribution
The US states consider tangible property, payroll or sales as factors in their formulas to apportion business profits among them. Each state weight each factor differently. The factors represent relevant elements for the production of income located in the state.108
The tangible property and payroll factors represent the production factors of the business, which work as proxies of the contribution of the supply-side of the production of income. Because their weight in the formula provides taxing rights to the jurisdiction where these elements are located. On the other hand, the sales factor typically reflects the contribution of the demand-side of the production of income.109 Sales are usually allocated by the states to the jurisdiction of destination, at the market of the business. States apply different 'sourcing' rules depending on the sort of sale. They regularly distinguish among the following kinds of operations:
1) Sales of tangible property. Most states would include the sale of these sorts of goods in their sales factor only if the property was delivered to a purchaser in that state.110 However, if the business does not have nexus in that state or the purchaser is the US government, a 'throw-back' rule applies, and the sale is considered to be sourced in the state of origin.111
2) Sales of services. Most states consider that this income is 'sourced' where the customer received the benefit of the service. Other states consider where the service is delivered, where the customer is located or where the service is received.112 All of them work as proxies of the demand-side.
3) Sales or licensing of intangible property. Half of the states consider that this income is sourced where the intangible property is used.113 If it is not possible to determine where the intangible is used, the transaction is typically 'thrown out' of the formula.114 Therefore the allocation of this income is left to the other elements of the formula.
As it can be seen, the 'sourcing' determination of the sales factor provides taxing rights to the market
108 Sicilian and Huddleston (n 36) 42.
109 However it may reflect the supply-side of the production activity as well. It depends on the definition of sale in
each state. Most states uses the UDITPA model definition of sale which considers transactional income and functional income. Regarding that functional income may consider the sales of a fixed asset of the business, the sales factor would not only reproduced the market of the taxpayer’s product but also double count the property factor and the supply-side. It enlarges the representation of the contribution of the production states. That is why some states consider only in the sales definition the transactional income. Ibid 53–54.
110 Uniform Law Commission (n 88) s 16(a).
111 In a way this may overestimate the contribution of the supply-side. Ibid 16(b). 112 Sicilian and Huddleston (n 36) 56.
113 Ibid 57.
114 Multistate Tax Commission, ‘Model General Allocation & Apportionment Regulations’ para Art. IV.
