US Taxation of Multinational Enterprise: Part VIII

Your posts make it clear that I should say more about how a multinational can have “extra” value. But, tomorrow. Today, as promised, formulary apportionment.

“Formulary apportionment” is the most talked about alternative to the arm's-length method discussed yesterday. Most US states use formulary apportionment to attribute a multistate business' income to the taxing state. As the name suggests, a formula is used to figure out how much income a business earns in a taxing jurisdiction. The classic formula allocates on the basis of three factors: the business' property, payroll, and sales. Each year, the business figures out what percentage of its property, payroll, and sales are located in the taxing state. These percentages are averaged. This average percentage is applied to the business' income to figure out the portion of the income to be taxed.

Many US states apply formulary apportionment on a “unitary” basis: Corporate shells — including foreign corporate shells — of a group of companies under common control are ignored. When one corporation in the group does business in a state, the income of the entire group of corporations is allocated to the state based on the worldwide factors of the group.

There are substantial problems with formulary apportionment: It can be as difficult to situate the factors as to situate income. Where are intangibles located? How does one value property? Where is the payroll of employees that work in various jurisdictions? Where are sales? Where delivered? Where title passed? And so on.

There is nothing magic about the three factors. To get revenues, some US states use inconsistent formulas. In particular, some non-manufacturing states give extra or complete weight to the sales factor. This demonstrates a broader concern: formulary apportionment turns an income tax into as much a tax on the factors as on income. This is not a particularly good thing.

In the international context, there is another problem with formulary apportionment (noted in some prior comments on posts in this series): To work, apportionment must be applied on a unitary basis. Otherwise, prices could be rigged to hide income in corporations not subject to apportionment. The piercing of corporate veils under the unitary method would violate international custom and all bilateral tax treaties. Consequently, it would be extremely difficult to move away from an international regime rooted in the arm's-length method.

Tomorrow: This and that