The digital economy has transformed the way traditional business is conducted. Advances in information and communications technology are powering digitalization, and these technologies are becoming more affordable and more prevalent. Countries must consider new taxation methods and models in light of rapid changes, and some taxing authorities might find the fractional apportionment to be their preferred method for handling digital transactions between related parties.
A Changing Economy
Digitalization affects all sectors of the economy. The business models proposed by the Organization for Economic Cooperation and Development’s (OECD’s) “Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalization of the Economy” prompted many differences of opinion and presented important challenges for the international taxation system.
Many corporations and various legal and consulting organizations have submitted comments on the OECD proposal, thus raising a series of questions and tax challenges that still need to be resolved, including viability of data (the lack of good quality data for developing countries) and the need to model dynamic effects of the proposals that would show how companies’ behavior might change over time. In the meantime, several countries have initiated various digital tax proposals that have created challenges and uncertainties for a wide range of companies across all industries. The new year commenced with new digital services taxes coming into effect in several countries with more on the way.
As the OECD continues to try to find a consensus among more than 130 countries, companies should stay informed about the various proposals for reform under consideration, model the potential impact of the existing proposals in their operating structure to assist in developing a point of view, develop a strategy to deal with various scenarios, and assess and address what consensus could mean for their respective business.
As governments reassess their approach to taxation in today’s increasingly globalized economy, companies should be prepared for various outcomes. The OECD articulated three proposals to develop a consensus based on how taxing rights on income generated from cross-border activities in the digital age should be allocated among countries. These strategies include user participation, which focuses on highly digitalized business through the establishment of a large social media platform and search engine; marketing intangibles, including allocating intangibles in proportion to the revenue share; and significant economic presence proposals, which go beyond the requirement of having a physical presence. The OECD provided three methods in connection with the new profit allocation rules, namely using one of the following: the modified residual profit split method, fractional apportionment method, or a distribution-based approach.
The fractional apportionment method simplifies the existing rules that determine how much tax multinationals owe using formulas and rules that depart from the current arm’s-length standard. As currently understood, the U.S. Department of the Treasury wants companies to have a choice to fully opt in or out of the OECD’s plan to overhaul the global tax rules. The outcome still remains uncertain.
The Fractional Apportionment Method
The purpose of the fractional apportionment method is to determine the amount of profit subject to the new taxing rights without making any distinction between routine and nonroutine profit. One possible approach to assessing the profit derived from a nonresident enterprise is to consider the overall profitability of the relevant group or business. The fractional apportionment approach follows three steps:
1. Determining the profit to be allocated.
2. Selecting the appropriate allocation key.
3. Applying a formula to allocate a fraction of the profit to the market jurisdiction. The formula should include several factors (employees, assets, sales, and users) along with weights for each of these factors to determine where taxable profits should be allocated.
Fractional apportionment is not a new concept. It ultimately allocates all the available income and the selection of fractions as a way of reflecting fundamental decisions about which nations should be accorded a primary right to tax based on the relation of the profits to the jurisdiction. Technically, even the residual profit split method (RPSM) adopts a fractional apportionment approach.
The RPSM determines the allocation of profits by first allocating to all contributions to the enterprise a marginal return and then dividing the residual based on the value of intangible property contributed by the various members of the group. That value, in turn, is determined in most cases by the costs of developing the intangible property incurred by the various members of the group. In effect, the RPSM is a fractional apportionment method that uses a single allocation factor—intangible property development costs—to accomplish the allocation of combined profit.
Alternatively, a more traditional transfer pricing determination of the profits allocable to the defined market activity could be undertaken. The workplan issued by the OECD notes that a determination must be made about whether the approach should be applied on an entity, group, or business-line basis. The fractional apportionment method can rely on various factors for determining profit allocation to a legal entity incorporated in a given country. Examples include:
- Sales. Sales can help capture the demand in a jurisdiction.
- Employees and wages. Considering employees and wages can help capture the functions performed in a jurisdiction.
- Assets. Assets can possibly correct for the fact that some entities might be more asset intensive than others.
- Research and development (R&D). R&D can help capture the development of technology and related intellectual property.
- Advertising and marketing. Advertising and marketing can help capture the development of marketing intangibles.
Digitalization and Taxation
Formulary apportionment has been in place in the U.S. for many years. States have the option to administer a corporate income tax and, if they do, they can choose what formula to use in determining how much corporate income would be subject to tax. These formulas generally are characterized by one of the following:
- A three-factor formula that includes receipts (or sales), property, and payroll, equally weighted
- Double-weighted receipts that include three factors with receipts double weighted
- Receipts only
In theory, all states would apply the same formula when determining taxable income, which was originally the case when a uniform standard was adopted in the 1950s. However, since that time, many states have moved away from a standard three-factor formula. Many states now use either receipts-only or extra-weighted receipts in their apportionment formulas.
Emphasizing the receipts factor effectively shifts the tax burden from in-state businesses―often with most of the property and payroll in that state―to out-of-state businesses. Similar incentives also would exist at the global level, and a lack of coordination in applying either factors or formulas across countries could result in significant tax uncertainty and potential double taxation. Hence, a formulaic approach should be considered, even though countries might have an incentive to increase their portion of taxable income by selecting the factors used for the allocation.
Digitalization has pushed governments to consider a simple formula for tax profits that would allow companies or industries, where more applicable, to manage the administrative function of the formulaic approach in order to achieve greater tax certainty. Alternatives such as the modified RPSM require complex mathematics to calculate the correct residual profit allocation, and they are also highly subjective.
Some companies look for a fair and more predictable business environment. For example, if the products sold require investments in R&D for many years, the fractional apportionment method does not account for more than one year of development. Hence, this method would not necessarily be favorable for a research-intensive industry.
The fractional apportionment approach provides a low but positive operating margin in which the market generates a value for the group through online sales based on customers in the country purchasing the products. The operating margin for an online distributor is lower than for a traditional distributor because of having zero assets and headcount.
Four Challenges of the Fractional Apportionment Method
The fractional apportionment method comes with various challenges. One of the challenges is that fractional apportionment can be arbitrary if the corporate income tax liability is considered solely on the extent of sales in a particular country. This approach focuses on the demand side of the value created by the corporation. For example, a market jurisdiction would levy the entire corporate income tax in the case of a multinational enterprise that produces in one country and sells in another.
The second challenge is how to determine the financial accounting regime and measure upon which the profit determination would be tested for this purpose. Formulary apportionment would remove complexities associated with sourcing income and expenses across locations, and it would eliminate the tax incentives to shift income to more lightly taxed jurisdictions.
Determining allocation factors such as sales, employees, assets, and users, as well as the formula used in apportionment is the third challenge of the fractional apportionment method. For example, implementing a sales-based formula depends on the ability of tax administrations to determine the sale of goods and services. In the case of the U.S., which maintains customs controls, establishing the destination of goods is not a significant problem and is already the basis of several tax code provisions. Furthermore, it must be decided if sales should be determined based on the location of the customer rather than the location of the production. A sales-based formula is less responsive to tax differences across markets given that customers are far less mobile than the firm assets or employment.
Finally, the fourth challenge involves how to apply rules. Parties must decide the process of coordination and integration with existing transfer pricing rules to address potential for double taxation or double nontaxation and to improve the competent authority or mandatory arbitration procedure.
Responding to Global Realities
The fractional apportionment method does not allow for routine returns to be earned if the group incurs an overall loss. Similar to an overall profit split within the group, the fractional apportionment method implies that a loss also should be split among the distribution affiliates and not shifted to an entrepreneur. Overall, it appears that every entity is an entrepreneur regardless of the investments in intellectual property and marketing and regardless of whether entities need to buy into the intangibles, similar to a cost-sharing arrangement.
The use of different weights introduces significant subjectivity and begs the question of which factor is most important in determining profits or losses for the group. A global agreement would be necessary. An EU approach alone would not be sufficient, as the method does not address exchange rate fluctuations and their impact on the factors and on the profitability. Furthermore, inefficient operations bring down consolidated profits and are rewarded.
The OECD workplan intended for the adoption of the fractional apportionment method to respond to the reality of an increasingly global environment wherein taxation brings simplicity to the process. One approach would be to allow corporations to elect into such a method selection. The fractional apportionment method could work if governments agree on what types of industries or business segments would benefit most from it, particularly as those industries and business segments evolve and derive more of their sales from online distribution.
For the fractional apportionment method to be broadly applicable, the apportionments will need to be derived based on economic analyses in which one can show various correlations. For example, a multinational corporation with distribution entities can select a fractional apportionment methodology to allocate its global profits by looking at the selling, general, and administrative expenses, sales intensity, and return on sales results for independent distributors.
If a multinational corporation is generating losses, it will be most likely due to various aspects of its supply chain (such as new product development and manufacturing recalls), and a local market distributor should not share in such losses. The OECD must not reduce innovation. Entities within the supply chain engaged in product development must have the resources to cover product development failures and start again.
The Method of the Future?
The fractional apportionment method raises many technical and political issues that the OECD will need to resolve before its implementation. The program of work acknowledges that the delivery of a final report by the end of 2020 is quite ambitious. Nevertheless, the application of an apportionment method in transfer pricing might become a practical method of the future for companies that opt into the program rather than being compelled to do so.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Selena Schneider, Ph.D., is a managing director at Crowe LLP. She can be reached at +1 646 231 7207 and firstname.lastname@example.org.