By Kash Mansori, WTP Advisors
Posted: February 04, 2016

Last week The Economist devoted one of its leaders to the topic of transfer pricing. From the January 30th issue:

Going after Google

Britain’s tax men struck a poor deal. But the real problem lies with flawed corporate-tax rules.

It was meant to win plaudits for clawing more money out of cunning, tax-shy multinationals. Instead, a deal between Google and the Britsh government, in which the tech giant will pay £130m ($185m) in back taxes covering a ten-year period, has
attracted only opprobrium.

…Britain may well have been too generous to Google. But the bigger problem with the deal is what it says about international efforts to crack down on corporate-tax avoidance.

The Economist’s leaders typically highlight major economic and political issues of the day, and transfer pricing and corporate taxation is certainly one of them right now; that’s exactly what BEPS was all about, after all. Unfortunately, in this case the conclusion reached by The Economist is not helpful:

The problem is…  a damaging fiction which is ingrained in the current system [of corporate taxation]: that a multinational can be seen as a cluster of separate companies to be treated as if they are trading with each other at arm’s length. The “transfer pricing” rules that police this system are complex and flawed. Keeping this approach, but toughening up the policing, means creating yet more rules — and loopholes.

Better to think of each firm as a single entity. Then countries could either agree to share the tax on companies’ worldwide profits according to a formula that takes account of their sales, employees, assets and so on; or allow the entire worldwide profits to be taxed by the home country, with a tax-credit mechanism for countries where the work actually goes on or revenue is earned — but, crucially, not brass-plate jurisdictions — in order to avoid double taxation. In both cases, the incentives and opportunities to move profits into tax havens would be greatly reduced.

This is essentially a call for a move to formulary apportionment. And The Economist is not alone in calling for such a fundamental change to the international tax landscape: advocates include prominent tax policy organizations and Nobel Prize-winning economists.

And to be honest, a part of me wishes that they were right. Much could be said in its favor if one could magically endow the world with a coherent and consistent worldwide formulary apportionment system. But in the absence of such supernatural intervention, trying to switch to a formulary apportionment system would probably be worse than the alternatives.

An earlier post (“There Must Be Better Way, Right?“) provides a fuller description of the reasons formulary apportionment is not as attractive an option in the real world as it is in theory. But in brief:

• The transition from the current system to a system of global formulary apportionment would be difficult to coordinate and come to any international agreement about, making it chaotic and extremely costly for global businesses in terms of double-taxation and compliance.
• A formulary apportionment system would create new incentives for multinationals to manipulate their business activities for tax reasons; current tax planning strategies would be replaced with new types of tax planning strategies that could be equally or more economically harmful.
• Fluctuating exchange rates and arbitrary apportionment schemes would mean that global companies would see their tax bills in various countries oscillate randomly in ways that have nothing to do with their underlying business in those countries, imposing further real costs on global businesses.

I really do wish that there was a better way to figure out the tax bills of today’s global businesses than our current reliance on the arm’s length standard. But as nice as it sounds in theory, formulary apportionment is simply not a practical, workable improvement on the current system right now.