The Global Apportionment Alternative

5. The Global Apportionment Alternative

It is not hard to see the reasons for the vehement opposition which global apportionment has aroused in business circles. Its adoption would require TNCs to produce accounts covering their worldwide operations, calculated according to the tax rules of each country requiring them; the tax authorities would then be free to apply to these accounts whatever formula for apportionment they might consider suitable. Overlapping taxation would be the inevitable result of the many possible divergences between national approaches. Differences in both accounting and currency conversion rules would produce a very different tax base Kopits and Muten, 1984, while variations in the formula used would obviously result in duplicative allocation. Nevertheless, the difficulties can be exaggerated: currency conversion differences and difficulties exist anyway under separate accounting, and international harmonization of accounting rules is itself a desirable goal. 1 Indeed, one of the advantages of moving to a consolidated tax base for international corporate groups would be that taxation could rely more closely on financial accounts, and it would require the countries concerned to agree on consistent currency conversion rules Vann 1991, p.159. The feasibility and desirability of unitary taxation depend on the degree of economic and political integration at the federal, confederal, regional or global level at which its introduction is considered. Increased economic integration will undermine the workability of separate accounting in the allocation of income McLure 1989. Thus, although US states have been obliged to retreat from worldwide unitary taxation, there is no question of abandoning the unitary approach within the US, up to the `waters edge ¶ Similarly, within the European Community, the increasing integration of the operations of establishments and subsidiaries within the internal market will lead to pressure to tax integrated corporate groups on a single tax base, probably consolidated accounts rather than the `combined report ¶ used in the US. Initially, separate national tax systems and rates could be retained, perhaps within an agreed band, but it is only a short step to a single European corporate tax, although it is one that involves more obvious abandonment of national sovereignty. 2 However, although economic integration may undermine taxation based on separate accounts, any move towards a unitary base raises political problems, since it requires explicit agreement on what constitutes a unitary business and, above all, on the apportionment formula. Although the problems of when and how to apply formula apportionment raise issues of principle, in practice they would need to be resolved ad hoc in relation to each firm, and would therefore require a central administrative and representative body. 1 See the criticism by Peggy B. Musgrave of Kopits and Muten in McLure 1984, p.282; see also Bird 1988. 2 Commentators are uncertain as to the speed with which such moves are possible: compare Devereux and Pearson 1989, ch.4, Weiss and Molnar 1988, and Vann 1991, pp.155, 158­160. There is considerable controversy on the test to apply in determining unity: a narrow definition based on the existence of a flow of goods would apply mainly to vertically­ integrated firms, while a broader test of interdependence which includes shared costs and synergy advantages would include virtually any corporate group unless limited to `substantial ¶interdependence. 1 There would also be problems of legal definition and administrative enforcement, to cope with the evasion of legal ownership rules by concealment of beneficial ownership through secrecy havens, and avoidance of such ownership requirements by the use of contractual relationships. In practice, a joint central body would be needed to decide which firms, and perhaps which parts of firms, should be treated as unitary. Similarly, the appropriate formula would require adjustment on a case­by­case basis, to take into account wide variations in the labour and capital intensity not only between different types of business but even individual firms, as well as problems of valuing assets for the purposes of the formula Linde 1977, p.116; P.B. Musgrave 1984, p.240. Adequate arrangements would be necessary to provide reviewability of these decisions and guarantees of due process for the taxpayer. The main arguments against formula apportionment have been that international political processes were insufficiently developed to resolve the issues that would be posed. Global apportionment, in particular the need to agree on the formula, would much more directly pose the issue of the basis of entitlement of each state in the allocation of the tax base. The allocation of tax rights under the present treaty system originated as we have seen in Chapter 1 above in the debates in the 1920s, which concluded that from both a theoretical and practical perspective tax jurisdiction could not be allocated on the basis of a single principle. The allocation to the state of residence of the investor of the right to tax returns on investment was justified on the grounds that these were `personal ¶taxes based on ability to pay; they should therefore be based on personal allegiance, and take into account the investors worldwide earnings, both to ensure fairness and to discourage choice of investment location based on tax rates. On the other hand, taxation of business profits at source was justified both in practical terms of effectiveness, and because the geographical link with the location of the wealth generated was considered appropriate for `real ¶taxes. This distinction between `personal ¶ and `real¶ taxes was undermined in relation to business taxation by the growth of foreign direct investment. Meanwhile, TNCs developed many mechanisms for avoiding the assertion by some of their home countries of the right to tax their worldwide profits, first by taking maximum advantage of tax deferral, and then by locating service functions in low­tax base­ havens Chapter 6 above. 1 See Section 2 above, and for arguments for the two perspectives see the papers by J. Hellerstein and C. McLure in McLure ed. 1984. Consolidation of the accounts of an integrated corporate group would at a stroke eliminate most of the problems of characterization and pricing of intra­firm transactions Vann 1991, pp.158­9. Global apportionment would also automatically provide greater tax neutrality for investment decisions. At the same time, however, it would bring squarely to the fore the issue of the basis for allocation of tax entitlements between the various `source ¶ states. The fiction of `residence¶ of a corporation could be abandoned, since the factors on which it is based primarily, location of top management would simply become one of the corporate functions to be evaluated in allocating tax rights, so that residence taxation would revert to having relevance only for portfolio investment, for states of residence of shareholders. Difficult questions would remain, however, in quantifying the elements of the formula to be used, which depends also on evaluation of the basis of the states rights to tax. The taxation of corporate earnings might be considered to be a levy in return for the benefits provided by the state, not merely for infrastructure in the narrow sense, but more broadly, e.g. for reproduction of the labour­force, including housing, transportation, social security, education and training. 1 Alternatively, it could be considered to be a tax on the earnings of capital, which should be allocated according to the location of the use of capital. The first, it has been suggested, would imply a formula based on valued added less profits, plus depreciation of capital, plus margin on sales; whereas the latter would imply as factors the value of fixed and working capital, including cost of wages Musgrave and Musgrave 1972. A particular difficulty is that very large differences in costs of production factors would disadvantage underdeveloped as against developed countries. This might be overcome by using actual units rather than monetary values for appropriate factors, such as employees Harley 1981, p.382, or by adjusting an asset­based formula to take into account differences in capitallabour ratios Musgrave 1972, p.400. More ambitiously, it has been suggested that an internationally­agreed system might provide some redistribution to compensate for unequal resource endowments and per capita income, by applying a schedule of tax rates increasing in inverse relation to per­capita income Musgrave and Musgrave 1972, p.74. Although some aspects of such proposals seem utopian, their advocates argue they are at least as practicable as the alternative, taxation of integrated TNCs on the basis of separate accounts and arms length prices. There are also broader considerations: Vann states perceptively that separate accounting is defended so vehemently against arguments of principle because `the debate is the hostage of the bilateral treaty network ¶ Vann 1991, p.105, although for him this adds a further reason to the inflexibility of the treaty network for a new approach to be made. In fact, some 1 Although it might be argued that profits taxation is not appropriate for this purpose, user charges can only be approximately correlated to benefits even for utilities, and are difficult to establish for general infrastructure such as labour reproduction costs. supporters of the existing system stress that the important principle is separate accounting, and they accept that a formula approach has a part to play in the arms length procedure, although a subordinate part. 1 Indeed, as has been pointed out in Chapter 8, business representatives who are otherwise hostile to formula apportionment of profits have argued for formula allocation of fixed costs; while the difficulties of operating the arms length principle have meant in practice that tax authorities rely on profit­split either as a check or as the primary criterion. The growth of administrative cooperation in taxation of international corporate groups to be discussed in detail in the next chapter has facilitated agreed solutions on a case­ by­case basis of such allocation issues. What has been lacking, however, is an adequate basis of legitimacy for this process. Hence, the basis for a transition to formula apportionment has been laid. Still lacking are the all­important elements of legitimacy: openness and fairness of procedures and transparency of criteria. 1 This was the view expressed by Ian Hunter, the UK `competen WDXWKRULW\¶RPSHWHQWXWKRULWLHV 1986, p.594 cited in Chapter 8 section 3aii above. 10 T HE I NTERNATIONALIZATION OF T AX A DMINISTRATION Administrative cooperation has increasingly come to play a key role in the co­ ordination of national taxes on international business. As has been stressed in previous chapters, governments have preferred to avoid the political problems of trying to agree principles for the definition and allocation of the international tax base, and they have consequently relied on the more pragmatic development of ad hoc solutions by administrative processes. When problems of international taxation became prominent again in the 1970s, both policy discussion and practical coordination between tax administrators assumed even more importance. International administrative cooperation has been more highly developed in tax matters than in other areas of business regulation, although in a partial and patchy way due to the unevenness of the treaty network. But it has not proved easy to resolve the underlying issues of principle through administrative procedures. Indeed, the problem of legitimacy has also arisen in relation to the procedures themselves, since the lack of adequate substantive criteria has made it harder for governments and officials to accept procedural fairness, while business organizations have opposed proposals for the strengthening of administrative cooperation because of their lack of confidence in the fairness of either the principles or procedures of international taxation.

1. The Development of Administrative Co­operation.