Another Step Towards Unitary Taxation?
TJN supports unitary taxation with formula apportionment of the income of transnational corporations (TNCs), as outlined in our Action Programme `Ending the Offshore Secrecy System' and our submission to UK Revenue and Customs in 2007.
Unitary taxation would greatly help to end tax avoidance, by treating the TNC as a single entity for tax purposes, and allocating its tax base among the jurisdictions where it does business according to an agreed formula. Apportioning according to a formula like this is sometimes known in the jargon as "formula apportionment". The formula would be based on real factors (employees, physical assets, and sales) so this approach would eliminate artificial tax avoidance based on using paper entities in tax havens. It would also deal with the transfer pricing problem, since internal transfers would simply be factored out of the unitary accounts.
We are therefore greatly heartened that legal developments in the US seem to have brought international agreement on unitary taxation one step nearer. The decision of the US federal court of appeals for the 9th Circuit (which covers California and other western states) in the case of Xilinx Inc. v. Commissioner again confirms that the approach currently favoured by the OECD based on the "Arm's Length" standard is often unworkable.
Arm's Length involves treating the subsidiaries and other affiliates of a TNC in different countries as if they were separate and independent, and treating the "trade" between these parts inside a TNC as if this were normal trade between different companies. This flies against business reality, since the existence of TNCs depends on the synergy of the group as a whole, and trade between different entities of a group clearly is nothing like trade between independent entities in a market. Arm's Length also enables and encourages TNCs to avoid tax by allocating costs and shifting profits internally among their various affiliates, especially those formed in tax havens.
The Xilinx decision is important, because the Appeals Court supported the Revenue in requiring that the cost of stock options be included in the pool of costs to be allocated within a TNC, even though independent firms would not do so. Xilinx did not want to allocate a portion of the cost of stock options to its affiliate in Ireland, which has a low corporate tax rate, preferring to use those costs to reduce its higher US tax liability. The Court decided that the US transfer pricing regulations are aimed at preventing tax avoidance, and for that purpose the Arm's Length approach is not the only method.
Indeed, it has long been clear that Arm's Length is especially inappropriate for allocating the costs and benefits from intangibles, which includes not only intellectual property rights, but also in this case stock options, which are especially popular and important for high-tech firms and in service industries. It was for this reason that the US made a major change to its transfer pricing rules in 1986. This change resulted in a major international conflict, as business lobbies campaigned against any move towards a unitary approach. The result was a compromise, in which the OECD's transfer pricing rules accepted a form of allocation of costs and profits, known as the `transactional net margin method'.
Still, it is argued by many that existing tax treaties require the Arm's Length principle. The Court in Xilinx said that this is not so for US treaties, because they include a savings clause allowing US law to apply to US persons.
The Xilinx decision should make the OECD re-examine its approach to transfer pricing, and reconsider the unitary tax alternative. This is the view of Reuven Avi-Yonah, expressed in a June 8th article for Tax Analysts (unfortunately, available only on subscription). Avi-Yonah is a long-time advocate of unitary taxation, and has argued for it in various academic and policy papers, including one jointly authored with Kimberley Clausing for the Brookings Institution in 2007.
Avi-Yonah now argues that the Xilinx decision provides an opportunity for the US to move towards a unitary approach. If this were done unilaterally, he advocates an allocation based on sales, which he considers would be more politically acceptable in the US, and is and is in line with the principle used for VAT, which is usually charged by the country of destination of goods, i.e. where they are sold. However, in the context of the OECD, Avi-Yonah now says he would:
"prefer a more balanced formula with three components: payroll, tangible assets, and sales".
Such a formula is already familiar in the US, as the traditional basis for allocation between US states. It is also used by the US and other OECD countries for the allocation of financial trading book profits. It is also likely to be the favoured formula for allocation for the EU's Common Consolidated Corporate Tax Base, on which the European Commission has been working for some time.
We would add only one rider. In our view a shift to unitary taxation is also very important for developing countries, which at present find it hard or impossible to combat international tax avoidance by TNCs. The aim should therefore be for a global standard, not just one for the OECD. This is crucial. This means that there should be some consideration for international inequalities of wage rates, as well as market size. A formula based on payroll costs, rather than headcount of employees, would obviously favour high-wage countries. Equally, the sales factor would favour those with large markets. It is hard to see China, for example, accepting a formula based on payroll, physical assets, and sales. Hence, to counterbalance the sales factor, the employee factor should be based on headcount rather than payroll costs.
But this is a detail, though important, which could be resolved, given the enormous advantages which all countries would derive from unitary taxation. The momentum for it is growing, as many TNCs also recognise that they also lose from the enormous expenditures of resources devoted to tax avoidance (`planning'), and then to arguing with the revenue authorities around the world. The losers would be the tax specialists and accountancy firms, whose vested interests in the present crazy international tax `system' is now the main barrier to reform.
Read more about unitary taxation in our A-Z document archive.