In today’s global environment in which profits are international whilst tax jurisdictions are domestic, there is an inevitable artificiality about allocating profits to a particular jurisdiction. The profits of an enterprise are not made up, like a jigsaw, of discrete pieces which can be cleanly allocated to one state for tax purposes, but instead requires judgement, informed by principle, economic effects and practicality.

       一、The arm’s length basis of allocation

       The historical basis of allocating profits of a cross border enterprise between jurisdictions has been on an arm’s length basis, whether the enterprise operates abroad though a permanent establishment or a separate company. The effect is to allocate to the jurisdiction the profits which would have arisen had the company operated on a stand alone basis.

       There is a limited amount of principled support for such a system. The taxation of companies itself is not entirely based on principle: ultimately companies are simply figments of the legal imagination and in an important sense, have no taxable capacity. The use of corporation tax to represent some notion of pre-payment of shareholders’ tax liabilities has been almost entirely abandoned in recent years, particularly in Europe, and the link between the taxation of the company and the shareholder has become much weaker. Finally, it is not clear to what extent the burden of taxation is shifted to others, for example consumers of the company’s products, or the workforce, rather than being borne by the owners of capital. Although the principle of taxing companies per se is not without its difficulties, it has become the international norm. If one accepts that companies are an appropriate target for taxation, the allocation of tax corporate profits to jurisdictions on the arm’s length basis is clearly not without justification. On the benefit principle of taxation at least, an enterprise should make some contribution to a jurisdiction from which it gains the benefits of infrastructure, educated work-force, legal system, natural resources and so-on. [1] On this basis, the treatment of the source nation as a partner on the profits of the activities of the enterprise in the state can be justified. This drawing of clear lines between jurisdiction, it is argued, protects sovereignty as the state can use whatever tax base and rates it chooses to apply to its identified profits.

       Separate accounting though brings with it serious problems, some based on principle, others arising out of practice. The principled objection to the arm’s length basis is that it is an artificial method of dissecting profits of a closely integrated enterprise and that it does not fairly represent economies of scale available to a MNE. More significant perhaps than the criticisms based on principle are the practical problems that separate accounting entails, brought about in large part by the need to prevent enterprises engaging in avoidance behaviour. The existence of separate accounting brings with it all the problems associated with transfer pricing, as it is necessary to identify arm’s length prices not only for goods moving between different parts of the same enterprise, which is relatively easy, but also services and the use of intangibles, which rather more difficult. In a recent survey of European companies with cross border activities, more than 82% of large companies mentioned transfer pricing, a necessary component of a system based on separate accounting, as a major tax obstacle.[2] Not only is it sometime difficult to find an appropriate transfer price, but where two or more companies are very substantially integrated, such a search may actually be inappropriate as the transaction might be unique for which no market based transfer price actually exists. Apart from the transfer pricing difficulties, a company must learn to deal with a different method of calculating profits for each member state in which it operates to any significant extent.

       Over and above the practical difficulties for the taxpayer lie the obligations on the tax authorities to monitor transfer prices. Tax systems require protection against tax arbitrage: the very existence of separate accounting enables profit shifting within MNEs from low tax authorities from high ones, sheltering profits in tax havens and gaining the advantage of tax deferral. Tax authorities must have the powers to scrutinise and, where necessary, adjust internal prices and this involves an enormous commitment of resources on the part of tax administrations. The complexity of tax systems is increased because transfer price and thin capitalisation rules are required. Furthermore, where the state of residence gives relief by credit rather than exemption, some form of protection against unjustified deferral in foreign companies through controlled foreign company legislation will also be implemented.

       A further obstacle mentioned by MNEs is the fact that different tax authorities frequently come to different decisions about the same set of facts. If the two jurisdictions concerned with the valuation of cross border flows of goods and services do not arrive at the same price, this renders enterprises vulnerable to double taxation (or rather less frequently, under-taxation). Companies have frequently reported that they have suffered double taxation as a result of lack of coordination in price setting and because the cost of fighting the decisions outweigh the benefits, so the extra cost of cross border transactions remains.

       The Commission’s proposals

       Against this background of dissatisfaction with separate accounting, the European Commission took the radical step of making proposals to move towards some form of common tax base for MNEs, followed by apportionment of profits on the basis of a formula[3] . Initially there were four proposals as to the common base of tax:

       1 Home state taxation (HST): this approach is based on “mutual recognition”; the European-wide profits of the enterprise are calculated on the base of tax used in the state of residence of the enterprise;

       2 Common consolidated tax base (CCTB): one pan-European definition of profits is agreed, and MNEs within Europe have the option of calculating total European profits according to this base.

       3 Harmonised tax base (HTB): compulsory harmonised tax base for all European companies, even domestic ones;

       4 European Corporate Income Tax (EUCIT): member states would no longer operate a domestic CT. The only CT within Europe would be the European Corporation tax, collected by the EU.

        The allocation of cross border profits to individual member states under options 1 – 3 will be according to a formula, who will then be free to tax those profits at whatever rate of corporation tax they wish.

       Of these, it is now clear that the first, HST, is most appropriate and is likely to be acceptable only in the context of cross border SMEs. A pilot study on HST for SMEs is about to take place. The latter two are politically unacceptable as they would result in considerable loss of sovereignty. So it is the CCTB has been identified both within the Commission and discussions elsewhere as the most appropriate way forward.

       Comment on CCTB and formula apportionment

        There are many advantages of using CCTB and formula apportionment as a substitute for separate accounting. These are well known and are only briefly noted here.

       Administrative advantages include:

       - profits only need to be calculated once, according to one set of rules;

       - no transfer pricing adjustments or cost allocations are required, so there is no need to make an assessment of transfers which are difficult (or impossible) to cost;

       - thin capitalisation rules are not required;

       - withholding taxes and tax credits on payments between related companies become irrelevant;

       - payments between parts of the same enterprise become irrelevant, including payments for use of intangibles, and the distinctions between interest/dividends, payments for goods/services (made particularly relevant as a result of e-commerce) disappear;

       - the absence of cross border loss relief ceases to be an issue as specific losses are automatically factored into the overall profit figure;

       - any tax-based distinctions between branches and subsidiaries are removed;

       - assuming that residence states give up their residual right to tax, the residence of a company becomes irrelevant.[4]

       The main economic advantage is that companies are less able to engage in the manipulation of profits by exploiting the weaknesses of separate accounting. A recent paper suggests that there is a reduced inclination to engage in transfer pricing behaviour when profits are allocated by formula rather than though separate accounting[5] . There are other economic advantages too: under separate accounting, there is the risk of both double taxation and double deduction caused by the lack of harmonisation of tax systems, leading to distortion in taxable profits. Whilst the allocation of the profits between jurisdictions may be less than perfect under formula apportionment, the computation of total enterprise profits on a consolidated base is likely to be more rational.

       At a political level, there is a perceived reduction in the sovereignty which member states can exercise over their tax systems. In particular, the need to agree a common base means that the use of the corporate tax system by countries as a tool to influence behaviour of businesses, or to control the economy as a whole, is severely limited. On the other hand, each state will continue to exercise control over rates as well as entire control over the domestic corporate sector, so there is still some considerable amount of autonomy retained by member states. In any event, it is arguable that in practice, member states are not as independent in the tax field as they might believe. In a global environment, each state must be aware of national practice elsewhere, and this is particularly true where other obstacles to a level playing field have been removed, as in the EU. In any event, separate accounting really only works well where there is a considerable degree of similarity over base and rates, otherwise the amount of effort required to both comply and police cross border firms becomes disproportionate to the return.[6]

       二、So, what are the problems with formula apportionment?

       So, if in practice there are such strong arguments for formula apportionment, why has it not yet been adopted in Europe? As a matter of principle, CCTB and formula apportionment, depending on the precise formulas used, is unlikely to be as accurate as separate accounting as identifying profits made within a jurisdiction, although there is the point that, conceptually, a highly integrated enterprise generates one set of profits, rather than artificially determined pockets of profits. There are also the political difficulties of reaching agreement over the various components. But it is in fact the practical problems with formula apportionment which are well known from the long experience in the US, Canada, Germany and Switzerland which are most significant.[7]

       Many of the issues faced by jurisdictions which use formula apportionment can be eradicated by the adoption of some form of common tax base and a common formula, which presupposes a high degree of political commitment from those concerned. The first is necessary to ensure that enterprises are only required to calculate their total profits under one set of rules rather than under several different sets and the second is required to ensure that when the total of disaggregated profits taxed in each jurisdiction are added up, the total is the same as the total profits for the enterprise.[8] It is clear that should the political will in the EU be in favour of a move to formula apportionment, any system would in fact incorporate a common tax base and adopt a common formula, so the problems experienced elsewhere by a lack of coordination on these matters are not discussed further. But not all the issues of formula apportionment are resolved even if one assumes that there will be agreement on the common base and the formula.

       The first problem is to determine the (single) base: Europe does not have a common federal base from which to develop, unlike the USA and Canada, and there will inevitably be disagreement over the measure of profits. The adoption of the IAS rules may provide a way forward here, although most commentators are not especially optimistic as to whether these rules, generated for accountancy purposes, will translate well into a determination of taxable profits and there are considerable differences across the member states as to how far taxable profits follow their accountancy cousins[9] . In addition there is the issue as to whether to include investment income in the aggregate figure to be apportioned, or to leave this taxed in the state of source, and how to treat income which the enterprise earns from outside the group which adopts formula apportionment. And, having decided upon the base, is use of the common base going to be compulsory for cross-border MNEs, which would make it harder to get the political acceptance of member states, or is it to be optional, in which case there is opportunity for the MNEs to engage in avoidance behaviour – if it suits them to be taxed as a domestic enterprises under separate accounting, they will no doubt choose separate accounting.

       There are also very difficult issues in determining the formula to be used. From an economic point of view, there is considerable divergence of opinion as to the optimum combination of factors to be used.[10] Traditionally, the Massachusetts formula was used in the USA, which gives equal weight to the factor of property, payroll and sales but over the years, states have shown a greater reliance on sales, as a way of attracting real investment without increasing the tax burden. A point to which I shall return can be made here: if one effectively ends up with an apportionment which depends only on sales, it would be far more sensible to tax sales directly rather than through CCTB and formula apportionment.

       Various issues arise in connection with the choice of formula: the economic effect of different formulas, how far they reflect the return to capital, which is that which the corporate tax is supposed to catch, the ability of firms to manipulate their tax bill and so on. Furthermore, it has to be decided whether the formula will be applied at the level of each individual enterprise (fairest, but encourages the enterprise to engage in avoidance behaviour), or at some industry wide basis or on the basis of some macro-economic formula (least relationship between actual profits and tax base, but least opportunity for manipulation).[11] The extent to which this should be a matter of concern might however be limited in the light of several studies which suggest that it does not matter very much which formula is adopted as profit allocation has, in some cases at least, proved to be insensitive to whatever formula adopted.[12]

       Finally, there is no magic wand for the identification of the “unit” for the purposes of tax.[13] The principle of certainty pulls in the opposite direction to the principle of economic reality. In order to achieve certainty, the definition of a group should be defined on a legal basis, for example a company is only a member of a group if it is owned 100%/75%/more than 50% by that group. This may not reflect economic reality (one company may have a completely separate business from the other members and therefore separate accounting for that part of the business might be preferable) and will encourage tax planning by enterprises seeking to exploit the definitions. On the other hand, to tax as a unit those parts of an enterprise which are sufficiently integrated to form in reality one economic unit is fraught with difficulties of subjective interpretation.

       In many ways, the greatest difficulty to be addressed with all the above is that of achieving agreement. Once matters have been sorted out and the system is in place, many of the difficulties are over, but not all. As noted above, the shift from separate accounting to formula apportionment will remove many of the opportunities for enterprises to manipulate profits, but some will remain. There will still be an incentive to locate factors where the lowest rates of tax apply. Whether this is regarded as an entirely good thing or bad depends on how one views tax competition which, in turn, depends in large part how one views the function of the state[14] , but no-one would publicly argue that the artificial shifting of profits is a good thing. For example, a company could contract out its labour requirements to avoid a high labour component in a member state, or warehouse its goods in a low tax jurisdiction to create a high property component.[15] There is no economic value to these choices other than reduction in the tax bill. Avoidance behaviour becomes particularly rewarding where the formula is based on only one component, due to the gearing effect. And of course, where tax planning is possible, measures by member states which might be regarded as attracting inward investment are likely to follow.

       Whatever the formula chosen, there will continue to be difficulties in the identification and valuation of factors (for example, does property include tangibles and intangibles, and how are intangibles to be valued? How are sales to third party states to be treated? If they are to be ignored (as otherwise the formula will apportion profits to that state which will remain untaxed) how does one identify where sales are made?

       Finally, because the system is designed to operate only in Europe, there will be a significant amount of economic activity for which separate accounting rules will be necessary. This involves duplication of effort for both taxpayers and tax authorities. All these problems are sufficient for some people to conclude that the difficulties make the project not worth the effort.[16]

       Apportioning on the basis of VAT

       One suggestion of the European Commission expert’s report which constitutes a departure from any method of apportionment that has ever been used in practice is that, instead of using a formula based on the traditional factors, further consideration should be given to the use of value added in a jurisdiction to allocate the global profits.[17] According to the Commission’s report,

       “Although similar to a profits based approach this has the advantage of additionally including labour costs – a large and relatively stable base and excluding financial costs, which removes any problems associated the thin capitalisation.”[18]

       The current VAT in Europe, the “destination based” system, would require adjustment. As it seeks to tax consumption, not profits, exports and imports are excluded from the VAT base. Under the destination system this is made up of the difference between sales (excluding exports) and purchases (including imports). This shifts the value added up to the point of export to the person making the acquisition. Unless an adjustment is made to the base so that it resembles an origin system of VAT, a jurisdiction in which part of an enterprise manufactured goods for export would be unable to tax any portion of the taxable profits of the enterprise have.

       In addition, because VAT does not distinguish between capital and revenue expenditure, it has been suggested that an adjustment may have to be made to reflect this fact in order that the VAT base is not unusually low or high in the years where capital receipts or payments are made[19] . However, in relation to large enterprises, the ones which will be subject to this system, the problem of “lumpiness” is unlikely to be as big as in relation to smaller companies, and it is doubted whether such an adjustment is in reality necessary.

       The use of value added, as adjusted, as the method of apportioning total profits has several advantages over formula apportionment:

       - It is a relatively large base and this significantly limits its susceptibility to manipulation. Evidence suggests that the VAT base of a large enterprise is between 4 and 7 times larger than its profits base[20] . The degree of avoidance required to make a dent in such a large base is far greater than in relation to a distribution based on two or even three factors. The inclusion of labour costs, whilst theoretically subject to criticism on the basis that tax on company profits should be related to returns from capital, not labour, can be defended on the basis that it renders the tax base very large and therefore harder to achieve meaningful shifts through tax arbitrage.

       - Virtually all large businesses in the EU are already required to keep information about taxable supplies made and received. Those which are too small to be subject to these requirements are unlikely to be engaged in cross border activity. The main difficulty is caused by financial institutions and insurance companies both of which make largely exempt supplies. For such enterprises, alternative methods of taxation might have to continue.

       - The base for VAT purposes would be likely to reflect at least some of the components which would be used in any formula, in particular labour and sales, although not, generally, property. It would also, as noted in the above quotation, have at least some similarity with the profits made in the jurisdiction or at least the benefits obtained. Profit, as conventionally determined, is made up of income less expenses of goods and services, less labour costs, less financial costs and with an allowance for depreciation. The VAT base would therefore be the profit base with no account for financial or labour costs or depreciation.

       - The irrelevance of financial factors makes the base less susceptible to manipulation and there would be no necessity for thin capitalisation rules.

       - There would be no need to develop formulas for particular industries.

       - Apart from transfer pricing, discussed next, the valuation issues which are associated with the use of property as a formula disappear, as VAT is a cash flow tax

       However, the main drawback to the VAT base is that the opportunity for engaging in tax base shifting through transfer pricing continues to exist, especially in the intra-enterprise use of hard-to-value services and intangibles. Whilst intra-enterprise payments of dividends and interest become irrelevant, other such payments do not.

       Attempts to manipulate the base by purchasing labour through consultancy services, which would have the effect of increasing deductions, in contrast to wages, would have to be subject to special rules.

       Whilst Hellerstein and McLure conclude that, “on balance, apportionment based on value added minus labour has both theoretical and practical advantages, relative to traditional apportionment factors”[21] , they appear less decided once they had considered the transfer pricing issues. Sorensen has described it as “paradoxical” to introduce a system which continues to requires the use of transfer pricing.[22]

       A leap into the unknown- sidestepping the concept of profit

       Now at this point I have to confess that my suggestions are very tentative and would require a considerable amount of further investigation as to the likely economic effects. But after outlining all the problems with the current system and the problems with the solution, it does seem worth taking a step back and considering matters from a slightly different angle. It can be argued that finding an acceptable common tax base, and then allocating it according to some surrogate of profit generating capacity, is to put too much effort into creating a perfect (or at least acceptably close) allocation of something which is so imperfect as to call into question the whole exercise. Identifying the profits of a business over a restricted time period is fraught with assumptions and uncertainties. There are almost as many formulas seeking to determine annual profits as there are tax jurisdictions in the world and the defects, especially in the treatment of the costs of capital, have been exposed on many occasions. One assessment of it is that,

       “Corporate income is a largely conventional accounting magnitude, whose definition varies depending on the purpose one wants to serve.”[23]

       And, as pointed out at the beginning of the paper, taxing companies rather than their shareholders is in principle rather dubious. The current proposals require us to take one surrogate for profits (our current tax base) and then allocate it on the basis of another surrogate, which is conceptually flawed whether it is done on the basis of formula apportionment or separate accounting. Formula apportionment, particularly if it includes labour costs, is not a particularly close surrogate for profit, and even separate accounting uses OECD approved transfer pricing methods, of which two are themselves based on formulas[24] . Could we not just take a short cut, miss out the stage where we identify profits, and subject the VAT base to corporation tax? [25]

       The base would be much larger than a profit base and the rates accordingly could be lower. All the advantages of using VAT as the method of apportionment would continue to be relevant, as of course would the disadvantage, transfer pricing. But to jump straight to VAT as a base would avoid the difficulties in coming to agreement on a common base, which would be required in the first stage of CCTB. It would also make the decision as to whether to identify an entity through a legal or an economic test irrelevant. There is no such thing as an entity, just units “adding value” in the jurisdiction. Given that the “consolidated” cross border unit is no longer a relevant concept, it is suggested that in principle and in practice, the same system should apply to all corporate taxes. It is conceded that, given that the VAT base in Europe is effectively harmonised, this means that there will be a considerable loss of sovereignty, although the power to set the rate would be retained. But to permit the traditional corporation tax assessment to be made on domestic companies whilst operating such a radically different system in the context of cross border companies would be to create considerable potential for distortion in the context of two units, one with foreign affiliations, the other entirely domestic, operating in the same jurisdiction. There would also be considerable potential for tax arbitrage, including a domestic company deliberately setting up a foreign branch or subsidiary in order to take advantage of any rules which only applied to a MNE.

       One of the limitations of the CCTB proposals is that it is hard to see how they could become a blueprint for any group of tax systems without a high degree of economic integration and political goodwill, although it is unfair to criticise them for this as they were not so intended. Could the allocation of profits on a VAT system be more likely to meet with acceptance as a way of proceeding on a world wide basis? In order to be acceptable outside Europe, the method would have to be able to withstand different VAT bases, unless, as seems unlikely third party countries adopt the EU VAT base. There is no doubt that enterprises would be able to exploit differences in VAT bases, so, for example a jurisdiction which gives a tax credit for certain types of expenditure which its neighbour did not recognise would be likely to attract business. However, the potential for unfair tax competition would be much more limited than in the context of a corporate tax alone. Corporate taxes are relatively small contributors to total tax income of states and it may be that a state is prepared to forego a small proportion of this in order to attract investment (and hopefully jobs and more income tax and more VAT on spending and so on). If a state diminishes its VAT base in order to attract investment, the magnitude of its revenue losses will be far greater. And, given that VAT is such a large base, some manipulation of profits could probably readily maintained, subject to the proviso that there is a reasonable degree of concordance between the different systems.

       Conclusion

       Whilst not perhaps particularly principled in approach, it is argued that the other approaches suffer from the same accusation on close examination. There are significant administrative gains to be made if there is no longer a need to calculate corporate profits, from the perspective of both the taxpayer and the tax authorities. From an economic perspective, there may be some incentive to engage in tax arbitrage (outside the EU), but with the VAT base being rather larger than the profits base, the gearing effect will dilute this. Further work would be required to find out what the effect would be on particular states. And, if the system can support differences in tax base and rates between jurisdictions without a significant degree of distortion, then the prospects of international acceptance become much greater.