Any system of apportioning income has to rely on simple rules, but whether intellectual property (IP) assets would be covered is open to how theory is put into practice.
“Any proposal I have seen does not recognise the value of intangible assets in determining where the income is allocated,” said Bill Sample, chair of the tax committee at the US Council of International Business (USCIB).
“In a digitalised world, intellectual property plays a major role and this is a serious defect in formulary apportionment,” Sample said, describing formulary apportionment as “brutally simple”.
The OECD laid out a possible version of formulary apportionment, taking assets, payroll, revenue and users as the keys to allocate income to the different jurisdictions where the company operates. This would be a radical break with transfer pricing norms.
Sample told TP Week that the problem with formulary apportionment is the rigid structure it requires. “IP is not always something you can easily standardise or simplify,” he said.
Although the finance ministers of the G20 countries have approved the OECD proposals for digital tax reform, the OECD now faces a struggle of holding their support as it attempts to tie-up all the loose ends because the two pillars of proposals are still quite abstract and open to interpretation.
There are serious obstacles to finding a one-size-fits-all solution, especially in the timeframe the OECD has set itself. However, there has to be an agreement on how to determine the pool of income before the formula is applied. If there is no consensus, then there will likely be no equal playing field.
“We’ve seen how difficult this is,” Sample said. “Just look at how much trouble the EU has had with the common consolidated corporate tax base [CCCTB].”
One possibility is that the countries with the biggest stakes in the digital tax debate – namely, the US, China, India and Brazil – will take the lead on these issues. However, what works for India will not necessarily work for Ireland.
Many countries already practice forms of this apportionment system, though. The examples include the Swiss cantonal system, the German federal model and the US tax code. It now looks like India is moving to adopt its own version, which would include user data as an extra key.
Every system has its own drawbacks and advantages, but each works in practice. The problem is that even if the Inclusive Framework moves to embrace fractional apportionment, the rest of the details are still open to interpretation and debate.
“If you look at formulary apportionment at the US state level, the basic factors the states have to choose from are the same in every state,” Sample said. “No matter what industry you are working in. It’s brutally simple.”
Meanwhile, technology companies fear the proliferation of special tax regimes designed just to tax the digital economy will make the price of doing business unaffordable.
“If you want tech companies to do business in this world then you should not make it too difficult for such companies to do business,” the tax director said.
“Some governments believe they need to single out and target certain kinds of companies to ensure that they pay more tax or pay taxes in a different way,” the director told TP Week. “This is the wrong approach to taxation.”
Defending the arm’s-length principle
What happens next will reshape the international tax system and define its course for decades to come. Taxpayers fear the rise of fractional apportionment means the end of transfer pricing as they know it because it would discard the arm’s-length principle (ALP).
“A principled approach like arm’s length is a more viable way of ensuring compliance rather than going on a different path that might create a disincentive to go into business or trade in a certain country,” one tax director at a US chemical company told TP Week.
If the principle is so fundamental, it seems odd that the OECD would be happy to overhaul it and replace it. This is despite the fact that the principle underpins a vast amount of transactions and structures in the global economy.
One head of tax at a Russian tech company suggested the role of the ALP in financial arrangements might have contributed to this.
“The arm’s-length principle has been used to justify very high levels of debt,” the head of tax said. “You had hugely leveraged businesses and you had independent banks lending to those businesses. So you have massive amounts of gearing.”
“The principle question is how to allocate profits and get the right price,” the head of tax said. “You can get some good answers, but the issue is: what are the right comparables? Two different tax authorities will be using two different sets of comparables.”
The next big fight
When it comes to the residual profit, the tax authorities will have to fight for their slice of the pie. As more countries decide to take unilateral measures, the world becomes more uncertain for businesses.
“You want horizontal and vertical equity running through your structure wherever you are in the world,” the chemical company’s tax director said. “You want people to feel that they are on an equal playing field and that they are going to be treated equally in a given country.”
As many IP owners are American groups and the US has been rather generous in allowing its taxpayers to move IP outside the country to offshore entities under cost-share R&D arrangements, the practical outcome of all this is very often that the residual profit is not being taxed anywhere.
A group of academics led by Professor Michael Devereux from Oxford’s Saïd Business School came up with the destination-based cash flow tax (DBCFT) as a way of resolving this problem. Again, this would remove the need for arm’s-length pricing.
“This has the attraction of certainty – but, in my view and that of others, it runs against economic sense because no one buying a business would be content to pay a huge premium for the distribution if they did not get the IP,” Edge said.
“They might well be prepared to pay for the IP and either use their own distribution or build it up from scratch,” he explained.
Many tax professionals fear that the shift away from arm’s-length pricing will produce the wrong answers for taxpayers, just as the tax authorities think this shift will deliver the right answers for governments looking to raise more revenue.
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