Allocating Business Profits for Tax Purposes: A Proposal to Adopt a Formulary Profit Split

Abstract

The current system of taxing the income of multinational firms in the United States is flawed across multiple dimensions. The system provides an artificial tax incentive to earn income in low-tax countries, rewards aggressive tax planning, and is not compatible with any common metrics of efficiency. The U.S. system is also notoriously complex; observers are nearly unanimous in lamenting the heavy compliance burdens and the impracticality of coherent enforcement. Further, despite a corporate tax rate one standard deviation above that of other OECD countries, the U.S. corporate tax system raises relatively little revenue, due in part to the shifting of income outside the U.S. tax base.In this proposal, we advocate moving to a system of formulary apportionment for taxing the corporate income of multinational firms. Under our proposal, the U.S. tax base for multinational corporations would be calculated based on a fraction of their worldwide incomes. This fraction would be the sum of (1) a fixed return on their expenses in the United States and (2) the share of their worldwide sales that occur in the United States. This system is similar in significant respects to the current “residual profit split” method of the U.S. transfer pricing regulations and the OECD Guidelines, as well as to the current method that U.S. states use to allocate national income across states. The state system arose due to the widespread belief that it was impractical to account separately for the economic activity supposedly earned in each state when states are highly integrated economically. Similarly, in an increasingly global world economy, it is difficult to assign profits to individual countries, and attempts to do so are fraught with opportunities for tax avoidance.