Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at the International Level

Using the Experience in the U.S. States to Evaluate Issues in Implementing Formula Apportionment at the International Level Enterprises that do business in the United States and other countries and in several states of the United States have experience with two approaches for measuring their taxable income. For federal tax purposes, multinational enterprises follow a transaction-based approach that requires them to price their internal transactions to they can calculate the taxable income according to the separate accounts they maintain for their affiliates located in each country. The prices established for the internal transactions with affiliated foreign entities should be set as if the transactions had occurred with unrelated third parties. By contrast, for state tax purposes, multistate enterprises do not price each separate transaction but, instead, apportion the enterprise’s total income to each affiliate according to the share of total business activity located in each state. In computing total taxable income, the parent company treats its out-of-state affiliates as part of a single entity, netting out internal transactions. The approach used by the federal government is known as separate accounting, and the approach used by the states is known as formula apportionment. As background, the paper summarizes the states’ experience with the formula apportionment tax method. It discusses how the states adopted a generally uniform system, and provides basic information on the components of the system. The heart of the paper addresses issues relating to implementing formula apportionment at the international level. It identifies some problems the states have encountered in applying formula apportionment and discusses some of the ways they have solved these problems. It also notes cases where the states have not been able to come up with satisfactory solutions. This analysis highlights the fact that adopting formula apportionment would introduce a host of new problems that must be resolved before seriously considering moving to formula apportionment at the international level. The paper shows that formula apportionment has many advantages and that national governments can learn a great deal from the experiences of the U.S. states. Yet, it finds that despite the growing integration of the world economy, global economic conditions and the structure of international business have not yet undergone the transformations necessary to make the formulary system workable at the Federal level. For example, nations still maintain numerous tax barriers to cross-border expansion, apply disparate accounting conventions, and follow different corporate tax systems. Thus, it would be premature to abandon the current international arm's length standard in favor of global formula apportionment.