Profit split: a crowbar for unitary taxation of multinational corporations

Update: see our new Transfer Pricing page here.

Marty Sullivan has an article in Tax Analysts’ Worldwide Tax Daily today, entitled “How to Prevent the Great Escape of Residual Profits” (unfortunately it’s behind a paywall at present). He picks up from a comment by TJN Senior Adviser Sol Picciotto, in his article analysing the OECD’s Base Erosion and Profit Shifting (BEPS) project, which seeks to create some fixes for the cracks (or, more accurately, the gaping chasms) in the international tax system. Sol pointed out that even in the OECD’s own work on the thorny issue of transfer pricing of intangibles such as intellectual property, that ‘‘apparently reluctantly, yet inexorably, we are led to profit split’’. (See Note 1 below for a brief explanation of what 'profit split' means.)

Sullivan then refers to a recent working paper by Brett Wells and Cym Lowell, putting forward a proposal for reforming US tax laws (which they call a “mandatory two-sided transfer pricing methodology). The authors offer their proposal as nothing less than "a straightforward and unique cure to a problem that has plagued our nation since the end of the post-World War I era."

Wells' and Lowell's approach is, essentially a profit-split method, which involves a unitary taxation approach (see note 2 for a brief explanation of unitary taxation, and its contrast with the OECD's fatally flawed 'separate entity' and 'arm's length' approach). We at TJN have explained in great detail why unitary taxation is so superior to the OECD's approach. As Picciotto explains:

"The power of the argument for a unitary approach is that it would provide a more sound foundation for the international tax system, one that matches the economic reality of TNCs as integrated firms. In contrast, the [OECD's] separate entity/arm’s-length principle cannot provide a comprehensive basis for taxation of TNCs, since it limits states to taxing their various parts."

He describes the OECD's BEPS project as one of "repair" rather than "redesign" - which is what is ultimately called for in this hopelessly flawed system.

We predict that the momentum will continue to grow for this perspective, which even the OECD will have to consider sooner or later, even if they refuse to accept the terms “formulary apportionment” or “unitary taxation”.

Note 1: Profit Split.
Under the profit-split method, the total combined profits from a transaction or transactions are split between jurisdictions based on the genuine economic activity in different jurisdictions. The split is determined by the geographical division that independent parties would expect to realise from
those transactions. This is not full-blooded unitary taxation, but it is potentially a building block for it.

Note 2: Unitary taxation.
The present international tax system treats transnational corporations (TNCs) as if they were loose collections of separate entities operating in different countries, with each part transacting with the others supposedly at an 'arm's length' price as if they were independent entities operating in a free market - which plainly they are not. There is currently only weak coordination between tax authorities, so this ‘separate entity’ approach gives TNCs tremendous scope to manipulate their internal 'transfer prices' to shift their profits around the globe to suit their tax affairs. Under unitary taxation, by contrast, they would be taxed not according to the legal forms that their tax advisers create for them, as is currently the case, but according to the genuine economic substance of what they do and where they do it. This would be far more legitimate and simpler to implement than the current system.

For more on this broad subject, see Picciotto's briefing paper, Towards Unitary Taxation of Transnational Corporations.

Update: for more on Corporate Tax see here.