Formulary Apportionment
A commonly proposed alternative to transfer pricing based on the Arm’s-Length Principle is Formulary Apportionment. Under this approach, the total corporate profit is allocated among different tax jurisdictions according to objective measures of business activity.
The factors used for profit allocation may include sales, number of employees, and fixed assets. Instead of determining an arm’s-length price for each transaction between related enterprises, formulary apportionment uses a predetermined formula to divide the total profits of a business among the jurisdictions in which it operates.
Some countries, including Canada and the United States, use this type of approach to allocate taxing rights among their political subdivisions. The European Commission has also recommended the use of a formulary approach within the European Union.
Unitary Apportionment Method
Formulary apportionment is also known as the Unitary Apportionment Method. This approach considers a multi-jurisdictional business as an integrated or unitary economic enterprise rather than treating each part of the business as a completely independent entity.
A unitary business may create additional wealth and value because of the economic interdependence of its different units, functional integration, centralized management, and economies of scale.
The different parts of a multinational or multistate enterprise may also share important intangible values. These may include business reputation, goodwill, customers, and other business relationships.
Therefore, the unitary approach attempts to recognize the economic value created by the integrated nature of the entire business.
Advantages of the Unitary Apportionment Method
One major advantage of the unitary method is that it recognizes the additional value created through the integration of different business units. Large multinational enterprises often obtain economic benefits because their operations are functionally connected and centrally managed.
The method also considers the benefits arising from economies of scale. A large integrated enterprise may be able to reduce costs or increase efficiency because of the scale of its combined operations.
Another important advantage is the recognition of shared intangible values, such as reputation, goodwill, customer relationships, and other business connections. These intangible benefits may contribute to the profitability of the entire group and may not belong exclusively to a single business unit.
Formulary Apportionment and Separate Accounting
The Separate Accounting System treats different parts of a multinational or multi-jurisdictional business as if they were separate and independent entities.
Under separate accounting, the focus is on identifying the income arising from activities within a particular jurisdiction. However, this approach may fail to recognize the value created by the integrated nature of the overall business.
A significant part of the wealth, economic power, and profitability of large multinational enterprises may arise because they operate as integrated and unitary businesses.
Therefore, critics of separate accounting argue that treating the different units of a multinational enterprise as completely independent businesses may not properly reflect the economic reality of the organization.
In contrast, the unitary apportionment method considers the enterprise as a whole and allocates its profits according to objective business factors.
Transfer Pricing and Differences in Corporate Tax Rates
Corporate tax rates differ between countries. This difference may create an incentive for multinational corporations to allocate a greater portion of their worldwide profits to countries with lower tax rates.
A company seeking to minimize its overall tax burden may use transfer prices in a manner that shifts profits from a high-tax jurisdiction to a low-tax jurisdiction.
Many countries impose penalties and transfer pricing adjustments where they believe that a corporation has reduced the taxable profits that should properly be reported in their jurisdiction.
However, controlling international tax avoidance is difficult because the countries involved are independent sovereign jurisdictions.
Obtaining information from other countries and taking coordinated action against international tax avoidance may therefore be difficult.
Importance of Transfer Prices for Taxation
According to the OECD, transfer prices are important for both taxpayers and tax administrations.
Transfer prices determine a significant part of the income and expenses of associated enterprises operating in different tax jurisdictions.
Since taxable profit is calculated on the basis of income and expenses, transfer prices directly influence the amount of taxable profit reported in each country.
Therefore, transfer pricing plays an important role in determining how the worldwide profits of multinational enterprises are allocated among different tax jurisdictions.
Key Exam Points
Formulary Apportionment is an alternative to the Arm’s-Length Principle-based transfer pricing system.
Under formulary apportionment, corporate profits are allocated according to objective factors such as sales, employees, and fixed assets.
Formulary apportionment is also known as the Unitary Apportionment Method.
The unitary method recognizes value created through functional integration, centralized management, economies of scale, reputation, goodwill, and customer relationships.
The Separate Accounting System treats different business units as independent entities, while the unitary method considers the integrated nature of the entire enterprise.
Differences in corporate tax rates may encourage multinational corporations to allocate more profits to lower-tax countries.
Transfer prices affect the income, expenses, and taxable profits of associated enterprises in different tax jurisdictions.
International transfer pricing enforcement may be difficult because countries are independent sovereign jurisdictions and cross-border information collection may be challenging.