Formulary apportionment
Encyclopedia
In corporate taxation, formulary apportionment is a method of allocating the profit earned, or loss incurred, by a corporation or corporate group to a particular tax jurisdiction in which the corporation or group has a taxable presence. It is an alternative to separate entity accounting, under which a branch or subsidiary within the jurisdiction is accounted for as a separate entity, requiring prices for transactions with other parts of the corporation or group to be assigned according to the arm's length
standard commonly used in transfer pricing
. In contrast, formulary apportionment attributes profit or loss to each jurisdiction based on factors such as the proportion of sales, assets or payroll in that jurisdiction.
When applied to a corporate group, formulary apportionment requires combined reporting
of the group's results. The parent and all of its subsidiaries are viewed as though they were a single entity (unitary combination), and the method is then also known as unitary taxation.
The use of formulary apportionment in the United States dates back to the late 19th century. At that time, there was no state or federal corporate income tax, but the states did assess property
and capital stock taxes. With the growth of the transcontinental railroad
s, state taxation authorities faced companies which had not just immovable property
(tracks) but also non-trivial movable property (rolling stock
) operating across state lines. The property value of a company assessable to state tax was thus assessed by examining the proportion of value of railway lines within the state, and then taking that proportion of the company's total value (including the movable property) as the portion of value located within a certain state. When Wisconsin
adopted a state income tax in 1911, it also used formulary apportionment (based on property, cost of manufacture, and sales), pointing to the impracticality of otherwise calculating separate accounts for companies operating in multiple states.
By the mid-20th century, the "Massachusetts Formula" had become a commonly-used standard of formulary apportionment. The formula placed an equal weight on three factors: group sales, payroll, and property within each jurisdiction. Out of the forty-four states (plus one more jurisdiction, the District of Columbia) which imposed a corporate income tax in 1978, all but Iowa
used the Massachusetts Formula. Iowa's formula ignored payroll and property, looking solely at sales; the constitutionality of this formula was challenged in the Moorman case in Iowa, and it was held invalid by a trial court under the Due Process Clause of the Fourteenth Amendment
as well as the Commerce Clause
of Article One
; however, the Iowa Supreme Court
reversed the trial court in 1978. This marked the beginning of a trend towards increasing weight on sales at the expense of the other two factors; by 2004, there were only twelve states still using an equally-weighted formula.
. In 2007 Kimberley A. Clausing and Reuben Avi-Yonah suggested that the US Internal Revenue Service
use formulary apportionment in the assessment of federal corporate income tax
, believing it would lead to increased tax revenue in the face of a trend for multinational corporations to use transfer pricing to shift profits out of the US into low-tax countries. None of these suggestions has been adopted.
Several US states allow, but do not mandate, that a corporate group include foreign entities for the purpose of assessing factors used in formulary apportionment ("worldwide unitary combination"). California, for example, began to accept worldwide unitary combination in the 1940s. However, its attempt to require such combination led to strong protests from US trading partners. The UK-US double taxation treaty signed in 1975 included a provision to prohibit US states from "tak[ing] into account the income, deductions, receipts, or out-goings of a related enterprise" in the United Kingdom or any other country for the purpose of determining tax liability. However, the US Senate, whose consent was required to ratify the treaty, rejected this provision, and the treaty was amended by a protocol in 1979. The Supreme Court
explicitly held worldwide unitary combination as constitutional in separate cases in 1983 and 1994 (Barclays Bank PLC v. Franchise Tax Board). In 1985 the United Kingdom passed retaliatory legislation which would have overridden the UK-US tax treaty and denied significant UK tax benefits to corporations headquartered in US states which applied worldwide unitary taxation. This and further pressure from foreign governments, the executive branch and multinational corporations led US states to adopt a "water's edge" limitation on unitary combination, allowing taxpayers to decide for themselves whether or not to include foreign entities in their combined reporting.
Critics argue that
Arm's length principle
The arm's length principle is the condition or the fact that the parties to a transaction are independent and on an equal footing. Such a transaction is known as an "arm's-length transaction"...
standard commonly used in transfer pricing
Transfer pricing
Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between related parties for goods, services, or use of property . Transfer prices among components of an enterprise may be used to reflect allocation of resources among such components, or for other...
. In contrast, formulary apportionment attributes profit or loss to each jurisdiction based on factors such as the proportion of sales, assets or payroll in that jurisdiction.
When applied to a corporate group, formulary apportionment requires combined reporting
Combined Reporting
Some jurisdictions permit or require combined reporting or combined or consolidated filing of income tax returns. Such returns include income, deductions, and other items of multiple related corporations, and may compute tax as if such multiple entities were a single taxpayer. Most rules require...
of the group's results. The parent and all of its subsidiaries are viewed as though they were a single entity (unitary combination), and the method is then also known as unitary taxation.
In domestic taxation
Formulary methods are used in both the United States and Canada to apportion income of corporations between the sub-national jurisdictions in which they operate. In many US states formulary apportionment is also used to apportion the combined income of a related group of companies. Tax in each US state is thus assessed based on the unitary combination of all related entities. The related entities included in the unitary combination may be worldwide entities or only entities within the United States, depending on the state.The use of formulary apportionment in the United States dates back to the late 19th century. At that time, there was no state or federal corporate income tax, but the states did assess property
Property tax
A property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...
and capital stock taxes. With the growth of the transcontinental railroad
Transcontinental railroad
A transcontinental railroad is a contiguous network of railroad trackage that crosses a continental land mass with terminals at different oceans or continental borders. Such networks can be via the tracks of either a single railroad, or over those owned or controlled by multiple railway companies...
s, state taxation authorities faced companies which had not just immovable property
Immovable property
Immovable property is an immovable object, an item of property that cannot be moved without destroying or altering it - property that is fixed to the Earth, such as land or a house. In the United States it is also commercially and legally known as real estate and in Britain as property...
(tracks) but also non-trivial movable property (rolling stock
Rolling stock
Rolling stock comprises all the vehicles that move on a railway. It usually includes both powered and unpowered vehicles, for example locomotives, railroad cars, coaches and wagons...
) operating across state lines. The property value of a company assessable to state tax was thus assessed by examining the proportion of value of railway lines within the state, and then taking that proportion of the company's total value (including the movable property) as the portion of value located within a certain state. When Wisconsin
Wisconsin
Wisconsin is a U.S. state located in the north-central United States and is part of the Midwest. It is bordered by Minnesota to the west, Iowa to the southwest, Illinois to the south, Lake Michigan to the east, Michigan to the northeast, and Lake Superior to the north. Wisconsin's capital is...
adopted a state income tax in 1911, it also used formulary apportionment (based on property, cost of manufacture, and sales), pointing to the impracticality of otherwise calculating separate accounts for companies operating in multiple states.
By the mid-20th century, the "Massachusetts Formula" had become a commonly-used standard of formulary apportionment. The formula placed an equal weight on three factors: group sales, payroll, and property within each jurisdiction. Out of the forty-four states (plus one more jurisdiction, the District of Columbia) which imposed a corporate income tax in 1978, all but Iowa
Iowa
Iowa is a state located in the Midwestern United States, an area often referred to as the "American Heartland". It derives its name from the Ioway people, one of the many American Indian tribes that occupied the state at the time of European exploration. Iowa was a part of the French colony of New...
used the Massachusetts Formula. Iowa's formula ignored payroll and property, looking solely at sales; the constitutionality of this formula was challenged in the Moorman case in Iowa, and it was held invalid by a trial court under the Due Process Clause of the Fourteenth Amendment
Fourteenth Amendment to the United States Constitution
The Fourteenth Amendment to the United States Constitution was adopted on July 9, 1868, as one of the Reconstruction Amendments.Its Citizenship Clause provides a broad definition of citizenship that overruled the Dred Scott v...
as well as the Commerce Clause
Commerce Clause
The Commerce Clause is an enumerated power listed in the United States Constitution . The clause states that the United States Congress shall have power "To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." Courts and commentators have tended to...
of Article One
Article One of the United States Constitution
Article One of the United States Constitution describes the powers of Congress, the legislative branch of the federal government. The Article establishes the powers of and limitations on the Congress, consisting of a House of Representatives composed of Representatives, with each state gaining or...
; however, the Iowa Supreme Court
Iowa Supreme Court
The Iowa Supreme Court is the highest court in the U.S. state of Iowa. As constitutional head of the Iowa Judicial Branch, the Court is composed of a Chief Justice and six Associate Justices....
reversed the trial court in 1978. This marked the beginning of a trend towards increasing weight on sales at the expense of the other two factors; by 2004, there were only twelve states still using an equally-weighted formula.
In international taxation
Formulary apportionment is not used as a method of attributing profit between (rather than within) national tax jurisdictions. The adoption of formulary apportionment has been advocated at various times since the 1970s. The matter has been hotly debated by OECD member states beginning in the 1970s. In 2000 Joann Weiner and Charles E. McLure Jr. proposed the use of formulary apportionment within the European UnionEuropean Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
. In 2007 Kimberley A. Clausing and Reuben Avi-Yonah suggested that the US Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
use formulary apportionment in the assessment of federal corporate income tax
Corporate tax in the United States
Corporate tax is imposed in the United States at the Federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Federal tax rates on corporate taxable income vary from 15% to 35%. State and local taxes and rules vary by jurisdiction, though many...
, believing it would lead to increased tax revenue in the face of a trend for multinational corporations to use transfer pricing to shift profits out of the US into low-tax countries. None of these suggestions has been adopted.
Several US states allow, but do not mandate, that a corporate group include foreign entities for the purpose of assessing factors used in formulary apportionment ("worldwide unitary combination"). California, for example, began to accept worldwide unitary combination in the 1940s. However, its attempt to require such combination led to strong protests from US trading partners. The UK-US double taxation treaty signed in 1975 included a provision to prohibit US states from "tak[ing] into account the income, deductions, receipts, or out-goings of a related enterprise" in the United Kingdom or any other country for the purpose of determining tax liability. However, the US Senate, whose consent was required to ratify the treaty, rejected this provision, and the treaty was amended by a protocol in 1979. The Supreme Court
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
explicitly held worldwide unitary combination as constitutional in separate cases in 1983 and 1994 (Barclays Bank PLC v. Franchise Tax Board). In 1985 the United Kingdom passed retaliatory legislation which would have overridden the UK-US tax treaty and denied significant UK tax benefits to corporations headquartered in US states which applied worldwide unitary taxation. This and further pressure from foreign governments, the executive branch and multinational corporations led US states to adopt a "water's edge" limitation on unitary combination, allowing taxpayers to decide for themselves whether or not to include foreign entities in their combined reporting.
Critiques of formulary apportionment
Advocates claim that transfer pricing issues increase compliance costs, that formulary apportionment reduces those costs and that treating associated enterprises in a unitary fashion more closely reflects the underlying operating realities of multinational enterprises.Critics argue that
- formulary apportionment leads to double taxation of the same profits unless there is agreement among all the jurisdictions on the formula to be used and the composition of the combined group
- tax could be avoided by manipulation of the components of the formula, for example the location of mobile assets
- compliance costs would be increased by the need to calculate each component of the formula in each jurisdiction
- compliance costs would be much higher unless all jurisdictions adopted a common method of calculating taxable profits. Otherwise a separate calculation of worldwide group profits would be required under each jurisdiction's tax accounting rules. This issue is significantly reduced within the United States and Canada because variations between each jurisdiction's tax accounting methods are relatively minor.
- where members of the group account in different currencies, currency exchange rate movements could distort the results of the apportionment
- formulary apportionment does not reflect the economic profit or loss of each entity. For example, a profitable group which incurs a loss in a particular territory has taxable profit apportioned to that territory, and conversely a loss-making group which makes profits in a particular territory has no taxable profits in that territory.