Formulary apportionment

What Is Formulary Apportionment?

Formulary apportionment is a method used primarily in corporate taxation to determine how much of a multinational enterprise's total income should be taxed by a particular tax jurisdictions. Instead of relying on individual transactions between related entities, as with separate accounting, formulary apportionment allocates a portion of a multinational enterprises' total worldwide or consolidated taxable income to each jurisdiction where it operates. This allocation is based on a predetermined formula, often incorporating factors such as sales, property, and payroll within that jurisdiction. The aim of formulary apportionment is to align taxing rights with the real economic activity taking place in a given location, thereby reducing opportunities for profit shifting.

History and Origin

The concept of formulary apportionment has roots in the late 19th century in the United States. As transcontinental railroads grew, states faced challenges in taxing companies with mobile assets and operations spanning multiple state lines. To address this, states began to adopt formulary methods to divide the corporate income tax base. By the early 20th century, its use became more widespread, particularly in determining state-level tax liabilities for multistate companies⁹. The "Massachusetts Formula," which equally weighed sales, payroll, and property within each jurisdiction, became a common standard by the mid-20th century. While historically a domestic solution within federal systems like the U.S. and Canada, formulary apportionment has gained increasing attention in international tax discussions as an alternative to existing global tax rules.

Key Takeaways

• Formulary apportionment is a method for allocating a company's total income among different tax jurisdictions.
• It typically uses a formula based on factors such as sales, property, and payroll within each jurisdiction.
• Historically, it has been widely used by U.S. states to tax multistate businesses.
• In international taxation, formulary apportionment is considered an alternative to the arm's length principle to combat profit shifting.
• The system aims to align a company's tax burden more closely with its economic activities in each taxing jurisdiction.

Formula and Calculation

Formulary apportionment relies on a specific formula to calculate the percentage of a company's global or consolidated income attributable to a particular jurisdiction. While the exact weighting of factors can vary significantly by jurisdiction, a common approach, historically, is the "three-factor formula." This formula typically incorporates property, payroll, and sales.

The general concept can be represented as:

Where:

• (w_P), (w_{PL}), and (w_S) are the weights assigned to the property, payroll, and sales factors, respectively. The sum of these weights equals 1 (or 100%).
• Property refers to the value of tangible assets owned or rented by the business within the jurisdiction, relative to its total assets everywhere.
• Payroll represents the compensation paid to employees within the jurisdiction, relative to total compensation paid globally. This factor considers the geographical distribution of a company's workforce.
• Sales (or receipts) refer to the gross receipts from sales or services sourced to the jurisdiction, relative to total global sales. The sourcing of sales can be complex, often based on the destination of the goods or services.

Many U.S. states have moved from an equally weighted three-factor formula to formulas that give greater weight to the sales factor, or even a single sales factor formula, to emphasize a "destination-based" approach to income allocation⁸.

Interpreting Formulary Apportionment

Interpreting formulary apportionment involves understanding how the calculated percentage determines a business's tax liability within a specific economic nexus. Once the apportionment percentage is derived, it is applied to the company's apportionable tax base (its total business income) to ascertain the portion subject to taxation in that state or country.

For example, if a company's global taxable income is $100 million and the formulary apportionment calculation for State A results in a 10% apportionment percentage, then $10 million of that income would be subject to State A's corporate income tax. The chosen factors in the formula (property, payroll, sales) are intended to serve as proxies for the real economic activity and value creation occurring within a jurisdiction. Different weighting of these factors can significantly alter how profits are attributed, impacting tax revenues for various jurisdictions. Jurisdictions often choose weights that maximize their own revenue or reflect their economic priorities.

Hypothetical Example

Consider "Global Innovations Inc.," a multinational technology company. Global Innovations operates in three countries: Alpha, Beta, and Gamma. For simplicity, assume a global consolidated profit of $500 million.

Each country uses a formulary apportionment system with a varying emphasis on three factors: Property, Payroll, and Sales.

Data for Global Innovations Inc.:

Country Alpha's Formula: Equally weighted (1/3 for each factor)

• Property Factor: (300 / 1000 = 0.30)
• Payroll Factor: (80 / 200 = 0.40)
• Sales Factor: (700 / 2000 = 0.35)

Apportionment Percentage for Alpha = ((0.30 + 0.40 + 0.35) / 3 = 0.35) or 35%
Taxable Income in Alpha = ( $500 \text{ million} \times 0.35 = $175 \text{ million})

Country Beta's Formula: Double-weighted sales (Property: 1/4, Payroll: 1/4, Sales: 1/2)

• Property Factor: (500 / 1000 = 0.50)
• Payroll Factor: (70 / 200 = 0.35)
• Sales Factor: (800 / 2000 = 0.40)

Apportionment Percentage for Beta = ((0.50 \times 0.25) + (0.35 \times 0.25) + (0.40 \times 0.50) = 0.125 + 0.0875 + 0.20 = 0.4125) or 41.25%
Taxable Income in Beta = ( $500 \text{ million} \times 0.4125 = $206.25 \text{ million})

Country Gamma's Formula: Single sales factor

• Sales Factor: (500 / 2000 = 0.25)

Apportionment Percentage for Gamma = (0.25) or 25%
Taxable Income in Gamma = ( $500 \text{ million} \times 0.25 = $125 \text{ million})

This example illustrates how varying apportionment formulas can lead to different allocations of the same global profit across jurisdictions, impacting the final tax liability in each country.

Practical Applications

Formulary apportionment is most prominently applied in subnational taxation within federal systems. In the United States, all states that impose a corporate income tax use some form of formulary apportionment to determine the portion of a multistate corporation's income subject to tax within their borders⁷. This ensures that businesses operating across state lines contribute their fair share of taxes to each state where they conduct economic activity.

Beyond domestic applications, there is growing international discussion regarding the adoption of formulary apportionment to address challenges posed by the digitalization of the global economy and concerns over profit shifting by multinational enterprises. The Organisation for Economic Co-operation and Development (OECD) and the G20, through their Inclusive Framework on Base Erosion and Profit Shifting (BEPS), have explored and integrated elements of formulary apportionment into proposed international tax reforms, particularly under Pillar 1. This pillar aims to reallocate a portion of the residual profits of the largest and most profitable multinational enterprises to market jurisdictions, regardless of physical presence, using a formula based partly on sales⁶. This move reflects a broader shift towards taxing value where it is created, rather than solely where a physical presence exists, which is particularly relevant for digital businesses with extensive customer bases but limited physical supply chain infrastructure in certain countries.

Limitations and Criticisms

Despite its potential advantages, formulary apportionment faces several limitations and criticisms, particularly when considered for international application. One significant challenge lies in achieving global consensus on a uniform apportionment formula, as each country would naturally seek a formula that maximizes its own tax revenue⁵. This could lead to intense political disagreements and potentially result in double taxation if formulas are not harmonized⁴.

Another critique is the potential for new distortions. If factors like property and payroll are heavily weighted, companies might still have an incentive to shift real activities to low-tax jurisdictions, perpetuating tax competition among nations³. Furthermore, accurately measuring and sourcing certain factors, especially sales, can be complex in a digital economy where the location of the final consumer or user may be difficult to pinpoint². The treatment of intangible assets, which often represent a significant portion of value for modern corporate groups, also poses a challenge since they are not typically included as explicit factors in traditional apportionment formulas¹. Implementing formulary apportionment globally would require fundamental changes to existing international tax treaties and domestic laws, a monumental undertaking that poses significant political and administrative hurdles.

Formulary Apportionment vs. Arm's Length Principle

Formulary apportionment and the arm's length principle are two distinct methodologies for allocating the profits of multinational enterprises among different tax jurisdictions.

The arm's length principle (ALP), the long-standing international standard, treats each entity within a multinational group as if it were a separate, independent entity dealing with other group members at market prices. This requires complex transfer pricing rules to ensure that intra-group transactions (e.g., sales of goods, services, intellectual property) are priced as if they occurred between unrelated parties. The underlying assumption is that profits are earned where value is created by distinct legal entities. Critics argue that ALP is prone to tax avoidance through manipulation of transfer prices, especially for unique or highly integrated transactions where no clear market comparable exists.

In contrast, formulary apportionment views a multinational enterprise as a single, unitary business. It consolidates the total profits of the entire enterprise and then allocates a portion of those profits to each jurisdiction based on a predetermined formula (e.g., using factors like sales, payroll, and property). This method aims to eliminate the need for intricate transfer pricing rules for intra-group transactions, as the focus shifts from individual entity profits to the overall group's profitability and its geographical distribution of economic activity. While ALP focuses on separate entities and market prices, formulary apportionment emphasizes a holistic view of the multinational enterprises and a formulaic division of its global taxable income.

FAQs

What is the primary goal of formulary apportionment?

The primary goal of formulary apportionment is to allocate a portion of a company's total income to different tax jurisdictions for taxation, based on a formula that reflects its economic activity in each location. This aims to ensure that profits are taxed where value is genuinely created and to reduce opportunities for artificial profit shifting.

How is formulary apportionment different from traditional international tax rules?

Traditional international tax rules, based on the arm's length principle, treat each part of a multinational company as a separate entity for tax purposes. Formulary apportionment, conversely, treats the multinational as a single, unified business and divides its total income among jurisdictions using a set formula.

What factors are typically used in a formulary apportionment calculation?

Common factors include a company's property (assets), payroll (employee compensation), and sales (revenue) within a specific jurisdiction, compared to its total amounts globally. The weighting of these factors can vary by jurisdiction.

Is formulary apportionment used internationally?

While it has been widely used in federal systems like the United States to divide corporate income among states, its broader adoption in international taxation among countries is still a subject of ongoing debate and reform efforts. Recent OECD proposals, such as Pillar 1, incorporate elements of formulary apportionment for specific parts of multinational profits.

What are the main benefits of formulary apportionment?

Proponents argue that formulary apportionment can simplify the international tax system by reducing reliance on complex transfer pricing rules, decrease tax avoidance opportunities, and better align taxing rights with real economic activity and value creation across different countries.