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Formulary apportionment, also known as unitary taxation, is a method of allocating 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 The arm's length principle (ALP) is the condition or the fact that the parties of a transaction are independent and on an equal footing. Such a transaction is known as an "arm's-length transaction". It is used specifically in contract law to ar ...
standard commonly used in
transfer pricing In taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because of the potential for cross-border controlled transactions to distort ...
. In contrast, formulary apportionment attributes the corporation's total worldwide 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 ''worldwide unitary taxation''. In the US, most states have adopted water's edge combined reporting which restricts the taxable group to just US domestic corporations and excludes "overseas business organization", i.e., unitary foreign affiliates and foreign parents.


In US 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 U.S. 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 latter is known as water's edge combined reporting. Worldwide unitary combined reporting was first approved by the US Supreme Court in 1983 in Container Corp. v. Franchise Tax Board (CA) by a vote of 5-3 (Justice Stevens did not participate). The court re-visited worldwide combined reporting in 1994 in Barclays Bank v. Franchise Tax Board (CA) and Colgate-Palmolive v. Franchise Tax Board (CA) and again approved its use by California but this time by larger majorities. The votes were 7-2 and 9-0, respectively. However, as a result of foreign retaliatory legislation and pressure from the federal government, all states have now abandoned mandatory worldwide combined reporting. 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 is a system of rights that gives people legal control of valuable things, and also refers to the valuable things themselves. Depending on the nature of the property, an owner of property may have the right to consume, alter, share, r ...
and capital stock taxes. With the growth of the
transcontinental railroad A transcontinental railroad or transcontinental railway is contiguous railroad trackage, that crosses a continental land mass and has terminals at different oceans or continental borders. Such networks can be via the tracks of either a single ...
s, state taxation authorities faced companies which had not just
immovable property In English common law, real property, real estate, immovable property or, solely in the US and Canada, realty, is land which is the property of some person and all structures (also called improvements or fixtures) integrated with or affixe ...
(tracks) but also non-trivial movable property (
rolling stock The term rolling stock in the rail transport industry refers to railway vehicles, including both powered and unpowered vehicles: for example, locomotives, freight and passenger cars (or coaches), and non-revenue cars. Passenger vehicles can b ...
) 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 () is a state in the upper Midwestern United States. Wisconsin is the 25th-largest state by total area and the 20th-most populous. It is bordered by Minnesota to the west, Iowa to the southwest, Illinois to the south, Lake M ...
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 ) , image_skyline = , image_caption = Clockwise from top left: the Washington Monument and Lincoln Memorial on the National Mall, United States Capitol, Logan Circle, Jefferson Memorial, White House, Adams Morgan, ...
) which imposed a corporate income tax in 1978, all but
Iowa Iowa () is a state in the Midwestern region of the United States, bordered by the Mississippi River to the east and the Missouri River and Big Sioux River to the west. It is bordered by six states: Wisconsin to the northeast, Illinois to the ...
used the Massachusetts Formula.; see also ''Moorman Mfg. Co. v. Bair''
437 US 267
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 In United States constitutional law, a Due Process Clause is found in both the Fifth and Fourteenth Amendments to the United States Constitution, which prohibits arbitrary deprivation of "life, liberty, or property" by the government except as ...
of the Fourteenth Amendment as well as the
Commerce Clause The Commerce Clause describes an enumerated power listed in the United States Constitution ( Article I, Section 8, Clause 3). The clause states that the United States Congress shall have power "to regulate Commerce with foreign Nations, and amon ...
of Article One; however, the
Iowa Supreme Court The Iowa Supreme Court is the highest court in the U.S. state of Iowa. The Court is composed of a Chief Justice and six Associate Justices. The Court holds its regular sessions in Des Moines in the Iowa Judicial Branch Building located at 1111 E ...
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 The Organisation for Economic Co-operation and Development (OECD; french: Organisation de coopération et de développement économiques, ''OCDE'') is an intergovernmental organisation with 38 member countries, founded in 1961 to stimulate e ...
member states beginning in the 1970s. In 2000 Joann Weiner and Charles E. McLure Jr. proposed the use of formulary apportionment within the
European Union The European Union (EU) is a supranational political and economic union of member states that are located primarily in Europe. The union has a total area of and an estimated total population of about 447million. The EU has often been des ...
. In 2001, the EU issued a communication advocating the use of formulary apportionment. In 2007 Kimberley A. Clausing and Reuven Avi-Yonah suggested that the US
Internal Revenue Service The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory ta ...
use formulary apportionment in the assessment of federal
corporate income tax A corporate tax, also called corporation tax or company tax, is a direct tax imposed on the income or capital of corporations or analogous legal entities. Many countries impose such taxes at the national level, and a similar tax may be imposed at ...
, 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 A tax treaty, also called double tax agreement (DTA) or double tax avoidance agreement (DTAA), is an agreement between two countries to avoid or mitigate double taxation. Such treaties may cover a range of taxes including income taxes, inheritance ...
signed in 1975 included a provision to prohibit US states from "tak nginto 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 A supreme court is the highest court within the hierarchy of courts in most legal jurisdictions. Other descriptions for such courts include court of last resort, apex court, and high (or final) court of appeal. Broadly speaking, the decisions of ...
explicitly held worldwide unitary combination as constitutional in separate cases in 1983 and 1994 (
Barclays Bank PLC Barclays () is a British multinational universal bank, headquartered in London, England. Barclays operates as two divisions, Barclays UK and Barclays International, supported by a service company, Barclays Execution Services. Barclays traces ...
v.
Franchise Tax Board The California Franchise Tax Board (FTB) administers and collects state personal income tax and corporate franchise and income tax of California. It is part of the California Government Operations Agency. The board is composed of the California ...
). 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.


Criticism

Advocates claim that transfer pricing issues increase compliance costs, formulary apportionment reduces those costs and treating associated enterprises in a unitary fashion more closely reflects the underlying operating realities of multinational enterprises. Critics argue: *Formulary apportionment leads to
double taxation Double taxation is the levying of tax by two or more jurisdictions on the same income (in the case of income taxes), asset (in the case of capital taxes), or financial transaction (in the case of sales taxes). Double liability may be mitigated i ...
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 like the location of mobile assets. *
Compliance costs A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
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 profit Taxable income refers to the base upon which an income tax system imposes tax. In other words, the income over which the government imposed tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. Th ...
s. Otherwise a separate calculation of worldwide group profits would be required under each jurisdiction's
tax accounting U.S. tax accounting refers to accounting for tax purposes in the United States. Unlike most countries, the United States has a comprehensive set of accounting principles for tax purposes, prescribed by tax law, which are separate and distinct from ...
rules. The issue is significantly reduced within the United States and Canada because variations among each jurisdiction's tax accounting methods are relatively minor. *If members of the group account in different currencies, currency
exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
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 that 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.


See also

* Combined Reporting *
Tax consolidation Tax consolidation, or combined reporting, is a regime adopted in the tax or revenue legislation of a number of countries which treats a group of wholly owned or majority-owned companies and other entities (such as trusts and partnerships) as a sin ...


Notes


References

* * * * *


Further reading

* * * *Devereux, M. P., & Loretz, S. (2008)
The Effects of EU Formula Apportionment on Corporate Tax Revenues
''Fiscal Studies'', ''29''(1), 1-33. {{DEFAULTSORT:Formulary Apportionment Corporate taxation