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International Taxation: How would formulary apportionment work?

Under the current U.S. system of international taxation, U.S. resident multinational firms must determine their profits separately in each tax jurisdiction in which they operate. A system of formulary apportionment would replace this separate accounting method with a formula that allocates a multinational firm’s worldwide income across countries. The formula would reflect the distribution of the firm’s worldwide economic activity, as measured by some combination of sales, payroll, and capital stock. The firm would then pay U.S. taxes only on the share of world income that is allocated to the United States.

Moving to formulary apportionment would address many problems of the current U.S. system. It would dramatically reduce incentives to shift economic activity or income to low-tax countries, it would treat similar firms similarly regardless of where they are incorporated, and it would eliminate much administrative complexity. But because it would have major effects on virtually all multinational firms, any shift to formulary apportionment should occur in cooperation with other countries.

  • Under formulary apportionment, the U.S. tax base for a multinational firm would equal a formula-based fraction of the firm’s worldwide income. The fraction could be an average of U.S. shares of the firm’s worldwide sales, assets, and payroll, or it could be simply the fraction of worldwide sales destined for U.S. customers. Reuven Avi-Yonah and Kimberly Clausing have proposed one such system.
  • Formulary apportionment is similar to the method that U.S. states already use to allocate national income across states. The state system was motivated by the widespread perception that states are so highly integrated economically that it is impractical to try to determine how much of a firm’s income is earned in one state and how much in another. Similarly, in an increasingly globalized world economy, it is ever more difficult to assign profits to individual countries, and attempts to do so are fraught with opportunities for tax avoidance.
  • Formulary apportionment would remove the current artificial incentives to shift reported income to low-tax locations, because it would base firms’ tax liabilities on a measure or measures of their real economic activity in each location. These measures are far more difficult to manipulate for tax purposes than the location of income.
  • The United States and other high-tax countries would gain substantial revenue under formulary apportionment, because under the current system firms’ shares of real economic activity in such countries typically exceed the shares of income they report as originating there. The move to formulary apportionment could be made revenue neutral by substantially reducing the corporate tax rate.
  • Because it would make an operation’s tax liability independent of both its legal residence and its legal form (for example, branch or subsidiary), formulary apportionment would also remove any incentive for corporate inversion.
  • Formulary apportionment would reduce the tax system’s complexity and the administrative burden it imposes on firms. Firms would no longer have to allocate income or expenses across countries, or worry about subpart F and the foreign tax credit (because there would be no deferral and no U.S. taxation of foreign-source income), or cope with cumbersome transfer pricing regimes.
  • A U.S. shift to formulary apportionment could result in double taxation (or exemption of some income in both the U.S. and overseas) if other countries do not adopt similar schemes. However, other countries might well choose to follow a U.S. lead for two reasons. First, the European Union is already considering a move to formulary apportionment, and joint leadership by the United States and the European Union could spur still broader cooperation. Second, a multinational firm operating both in countries with and in countries without formulary apportionment would have an incentive to shift reported income to the former, because their tax liability in such countries would no longer depend on the income reported there. The consequent loss of tax revenue in the nonadopting countries would give them a strong incentive to adopt formulary apportionment.
  • The transition to and some permanent aspects of formulary apportionment could prove complicated. Potential problems include defining the unitary business, determining the appropriate apportionment formula, insulating against possible behavioral responses to the chosen formula weights, creating common accounting standards (or reconciling differences between standards), and handling international tax treaty issues.
 
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