The Global South needs financial resources to improve health and education, reduce inequality, and spur economic growth. Corporate taxation is a significant source of revenue for developing nations, helping them achieve these goals. However, the collection is generally lower than in developed nations, partly due to aggressive tax practices, such as transfer pricing by multinational corporations.
Our recently published article in the eJournal of Tax Research poses the question of whether developing nations would be better off under a formulary apportionment model for allocating taxing rights compared to the traditional arm’s length pricing requirement of the existing transfer pricing regime. We attempt to shed light on this question by relying on data contained in publicly available country-by-country reports to estimate the likely fiscal effects and potential increases or decreases in revenue collected using different formulas.
Transfer pricing: A system designed for another era
The current international tax regime allocates profits to domestic jurisdictions using a system known as transfer pricing, which requires transactions between entities within a multinational group to be valued at an arm’s length price. This system has been in place for more than a century and essentially treats each part of a multinational group, whether a branch or subsidiary, as if it were a separate, unrelated entity.
While both domestic laws and double tax agreements adopt transfer pricing rules that require internal transactions to be valued as if they were conducted between unrelated third parties on standard commercial terms, multinational corporations can engage in aggressive tax planning strategies by exploiting these rules. Developing nations are particularly susceptible to profit shifting due to transfer pricing manipulation and have limited capacity to address the issues.
In the 21st century, four significant problems have arisen from this traditional approach, which depletes a nation’s tax revenue.
First, the system was designed when physical presence was a key feature of multinational corporations, and expansion from a home country tended to occur through horizontal integration which involves replicating domestic operations abroad through factories, offices, capital investment, and the employment of staff. This is often no longer the case, as vertical integration, with companies controlling multiple stages of production and distribution across different jurisdictions, is becoming the dominant business model for multinationals.
Second, intangible assets and cross-border services such as marketing and advertising are much more prevalent in modern multinationals and are particularly hard to value. Service hubs, established in low-tax jurisdictions, compound this problem as they provide support activities that are also difficult to value.
Third, digitisation means that multinational corporations do not require physical presence to generate profits. Multinationals can engage with clients and consumers and deliver goods and services directly from overseas.
Fourth, there is a disconnect between the jurisdiction where profits are recognised for tax purposes and where the activities that generate those profits are located.
Global formulary apportionment as a modern alternative
Global formulary apportionment offers an alternative approach. Instead of treating the different parts as separate entities, global formulary apportionment recognises the business reality that multinational enterprises operate as a single global enterprise. This approach has been used successfully for decades in the United States and Canada to allocate profits between states and provinces, and is part of the BEFIT (Business in Europe: Framework for Income Taxation) proposal developed by the European Union.
Under this model, a multinational’s global profits are calculated on a consolidated basis. The profits are then allocated to jurisdictions using a predetermined formula that is based on real economic factors. Each jurisdiction then applies its own corporate tax rate to its allocated share of the profits.
A formulary apportionment approach recognises that profits should be taxed in the location of economic activity and typically includes both input and output factors. Input factors which contribute to profits are generally represented by assets and labour and are located at the place of origin, essentially where goods and services are made. Output factors are generally represented by sales at destination which represent demand for a product or service. Genuine economic activity is represented by sales where customers are located, employees where people work, and tangible assets where physical investment occurs. As such, sales, physical assets, and labour are the most commonly used allocation bases.
The rationale for a global formulary apportionment model is compelling.
First, it is a system that better aligns the allocation of profits with a multinational’s real economic activity. This means that corporate tax would be paid in the jurisdictions where the entity generates profits, rather than in specific parts, based on a legal notion of location.
Second, global formulary apportionment completely ignores intra-group transactions. In doing so, the fiction of the arm’s length price is removed, and there is no longer a need to value internal transactions. The use of no- or low-taxed jurisdictions is no longer an incentive as very little real activity occurs in those locations.
Third, the overall ability of multinationals to shift profits is significantly reduced as the allocation keys represent real activity and investment in a jurisdiction. The only way to shift profits to another jurisdiction is to shift allocation keys, such as labour and capital.
Testing formulary apportionment
To test whether formulary apportionment would actually benefit developing nations, we analysed 231 country-by-country reports voluntarily disclosed by 75 large multinational corporations between 2015 and 2023. This data is provided by the multinationals themselves and is now available because taxpayers elect to provide additional publicly available data as part of its annual reporting responsibilities.
We then applied four different formulas to see how they would redistribute profits from high-income countries to low-income countries. The formulas consisted of different combinations of sales, employee numbers, and tangible assets.
Overall, we found that developing nations would benefit from a formulary apportionment system. Depending on the formula used, developing nations could benefit from a pre-tax profit distribution increase of between 38 to 91 per cent. The largest gain was found when a formula had equal weighting of employee numbers and tangible assets.
These findings suggest that developing nations perform better when there is a heavier weighting to real economic factors, which are less mobile and therefore less susceptible to manipulation.
The path forward
Our research indicates that global formulary apportionment is not only theoretically superior but could make a real difference in terms of increased revenue for nations in the Global South to improve health and education, reduce inequality, and spur economic growth. It offers a path toward a simpler, fairer system that could help developing nations capture their appropriate share of tax revenue from multinationals operating within their borders.
However, a wholesale shift away from the traditional arm’s length transfer pricing regime would be monumental and, as such, incremental change is more probable.
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