Apportioning the Future

September 25, 2014

The OECD’s base erosion and profit shifting (BEPS) initiative promises an integrated, streamlined tax system across the OECD. The initiative, which should be completed in September of 2015, will provide guidelines for member countries to follow when implementing domestic tax policy or negotiating a tax treaty. The initiative is intended to reduce double non-taxation of corporate profits, which in turn should reduce conflict between tax authorities.

One of the major concerns is how intra-firm transactions are priced, which is also known as transfer pricing. It’s a concern because firms can shift profits from a high tax jurisdiction to a low tax jurisdiction by charging its subsidiaries fees for goods and services.

Say that a parent firm in Ireland has a subsidiary in France, which earned €20 million in profit after paying its local expenses. The French subsidiary would have to pay €6.6 million in corporate taxes, a third of its profit, to the French tax authorities. But first, the Irish parent firm sends a bill to the French subsidiary for services in the amount of €10 million, which reduces the French subsidiary’s profit to $10 million. If the cost of providing these services were zero, the Irish parent firm pays $1.25 million, the Irish tax of 12.5 percent of the profit, to the Irish tax authorities and the French subsidiary pays €3.33 million to the French tax authorities, a tax reduction of €2 million.

To prevent such profit shifting, tax authorities have established an “arm’s length” standard for pricing intra-firm transaction. That is, firms must price intra-firm goods and services as if they were a transaction between two unrelated firms. In practice, this means finding at least two similar transactions by unrelated firms and using those prices as an approximation.

The problem arises when the goods or services have no equivalent in the economy. The royalties from a new drug patent has never been in the economy before and is therefore difficult to price. In these cases, the tax authorities may rely on a defined formula for apportioning the amount of profit that belong to each entity.

The OECD BEPS preliminary recommendations released in early September have set off a debate on whether the arm’s length principle should be replaced with a formulary apportionment approach, which is commonly used in China and India.

Proponents of formulary apportionment argue that it would provide more certainty for firms and reduce compliance costs. Moreover, they argue it reduces the incentive for firms to game the system by manipulating the definition of what is considered a similar transaction. Opponent of the formulary apportionment approach warn that removing the arm’s length standard could introduce a host of unintended consequences. In other words, removing decades of established legal precedence, administrative experience, and compliance infrastructure could expose firms to a multitude of new cost with a rather unknown benefit.

Although the debates are primarily over application, there is a more profound difference between the arm’s length standard and the formulary apportionment approach. It is true that firms spend a considerable amount of resources determining a market equivalents for a good or service, and it is likely that some firms have bent the truth to reduce their tax burden. But the arm’s length standard allows the tax code to change as the international economic system evolves by adjusting prices as markets develop. The adaptive efficiency of the arm’s length standard has allowed tax authorities to adjust to rapid globalization over the past three decades without major incident.

If a formulary apportionment approach was to be implemented, formulas for apportionment would need to be updated every couple of years to account for changes in the economic climate, such as new categories of goods and services. These formula adjustments will most likely be contentious as each tax authority attempts to garner more tax revenues for their jurisdiction.

The OECD admits that it is unlikely all member countries would implement a formulary apportionment approach due to a lack of international consensus and possible systemic problems, but they are considering a formulary apportionment for particular categories of good and services. Implementing such rules may have short-term advantages but at what cost to long-term international stability? In some instances, it’s best to ignore the short-term inefficiencies to enjoy long-term benefits.

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