Another Voice for Formulary Apportionment

The debate over whether and how to fix the international corporate income tax system just added another prominent, Nobel Prize-winning voice.

Joseph Stiglitz, the former chief economist for the World Bank and one of the most outspoken critics of global economic inequality, published a white paper through the Roosevelt Institute, a left-leaning think thank, arguing that changing the tax code is key to resolving the growing gap between the rich and the poor in the United States.

Aside from hiking corporate tax rates and giving broad tax incentives to invest in the United States, Stiglitz calls for scrapping the arm's-length principle--the current global benchmark used for the taxation of multinational corporations. He joins a small but growing number of critics who claim that tweaks aren't the answer--a broad overhaul is needed in how the world taxes multinational corporations, to prevent large corporations from using aggressive tax planning to artificially move profits into low-tax countries.

(Stiglitz also appeared on Moyers & Company to elaborate.)

Some readers of this blog probably are aware of the international debate over the arm's-length standard and formulary apportionment. But for those who aren't, here's a quick primer.

Each country taxes corporate profits a little bit differently, as a matter of sovereign prerogative. But at some point, international coordination is needed to allocate the tax base--which income can be taxed by which government?

Broadly speaking, there are two major methods to approach that question. One is to respect the internal divisions that multinational corporations create--subsidiaries, holding companies, parent companies, and so forth--and attempt to regulate transactions between them. The other is to disregard all of those legal distinctions and simply look at a company as a large, single unit, and then attempt a top-down division of its income into countries based on agreed-upon factors.

As it stands now, the world has mostly agreed upon the first approach--the arm's-length principle. A company is free to divide itself into two subsidiaries, or as many as it likes. But if it attempts to move assets from one to another, it must ensure that the price of the transaction is near the price independent parties would agree upon--that is, as if the deal were happening with a party unrelated to the taxpayer, one that is being kept at arm's length (hence the phrase).

In theory, this system ensures that corporations doing business in multiple countries aren't taxed twice on the same income, while also ensuring that governments have a tax base rooted in economic reality.

A formulary system disregards all of this, and instead looks at the business as a whole. Where are its sales? Where are its resources? Where are its workers? Where are its functions? Based on whatever factors are agreed upon, the system then divides income among various taxing jurisdictions.

This isn't necessarily a crazy or radical idea. Already, some U.S. states use a similar system to divvy up their tax revenue.

Pros and Cons 

What are the pros and cons? Well, for the arm's-length standard--and this is a big one--it's already in place. It's the basis for taxation in all countries involved in international trade, except one--Brazil. It's relatively simple, at least in concept. (The U.S. legal code for this area is barely over 100 words.) Switching over to a new system could create chaos, which could not only stifle international trade, but potentially create even more opportunities for distortion.

But there are also many criticisms of the arm's-length standard, especially in this age of highly valuable intangible properties in a largely digital and online economy. It's easy enough to discover the arm's-length price of, say, a gallon of crude oil. There are plenty of comparable assets ("comparables," in the lingo of transfer pricing.) But what's a comparable for, say, the patent of the iPad? For Google's search algorithm? For the rights to use the intellectual property of Batman? These are all properties which, by their very nature, are highly unique. (And, of course, it's rarely just one intangible. It was said that 200 patents went into the original iPhone. Imagine the difficulty of trying determine the correct value of each one.)

While there are transfer pricing methods that try to estimate these prices, critics claim the net effect is a highly distortive system that ultimately causes huge amounts of income to be allocated to low-tax jurisdictions. And furthermore, transfer pricing enforcement often requires a degree of sophistication and aggressiveness that is often beyond the capabilities of many developing countries, leaving them easy victims for profit manipulation.

Formulary apportionment has its critics as well, who claim that aside from being chaotic and difficult to enforce, it may not really produce a system that is any more fair to countries than the current one. Conceivably, it could be just as difficult for developing countries to enforce as the arm's-length standard. And reaching an agreement on a universal formula among all of the world's nations seems like a daunting, if not impossible, task.

One issue that's important to keep in mind is that there isn't, as of yet, an international authority to decide these matters. The Organization for Economic Cooperation and Development, based in Paris, has model legislation and model treaty language, to which countries often look. But it's a recommendation, not an enforcement--although many countries around the globe, including non-OECD members, follow them. The OECD is an outlet for countries to debate and advocate on these issues, without any particular country finding itself out of step from the international norm.

OECD BEPS Project 

Currently, the OECD is well into its Action Plan on Base Erosion and Profit Shifting (BEPS), which is addressing many of the issues critics of the arm's-length system have raised. Already, the OECD is on its way to several proposals that aim to stem tax base erosion.

At this point, the OECD remains committed--at least on paper--to the arm's-length principle.

"There is consensus among governments that moving to a system of formulary apportionment of profits is not a viable way forward; it is also unclear that the behavioral changes companies might adopt in response to the use of a formula would lead to investment decisions that are more efficient and tax-neutral than under a separate entity approach," the organization's BEPS Action Plan, released in July of 2013, states.

But some critics have claimed that some of the approaches being considered by the OECD--such as requirements for country-by-country reporting for taxpayers, and requirements that income be tied to "significant people functions"--will have the practical effect of incentivizing a formulary approach among multinationals, even if there is no set change.

As for Stiglitz, he claims that a formulaic approach is an "obvious" answer to the issues that arise in a globalized economy.

"The current system cannot work in a world of globalization," Stiglitz stated. "Firms are asked to assess what they would have received for the goods that they produced in a particular place, if they had sold the products in an arm's-length transaction--even if there are not markets anywhere for the half-finished goods that may be shipped from one jurisdictions to another."

Stiglitz also would create a special provision for intellectual property, which would ensure that those intangibles largely developed within the U.S. would be considered to be U.S. assets. He also says he supports a global minimum tax, an idea that is being tossed around a bit (on both sides of the aisle) in the Congressional debate over a corporate tax overhaul.

The ideas he's promoting aren't especially new. But he's a high-profile advocate for them. And at the international level, these issues are normally debated with rather clinical terms such as aligning taxable income with economic activity or reducing double non-taxation. Stiglitz, on the other hand, frames his argument in stark moral terms--the need to combat vast economic inequality, at home and abroad.


Alex Parker, Staff Writer, Transfer Pricing Report