Formulary Apportionment: More Simple - on Balance Better?
Christensen, Steve, Law and Policy in International Business
In January 1996, the Department of the Treasury announced an upcoming conference to examine international tax issues and global formulary apportionment.(1) More specifically, the conference, held in December 1996, sought to explain the apparent international tax gap, to weigh the pros and cons of formulary apportionment compared to the arm's length approach, and to identify the problems of transitioning to a global formulary apportionment system. A special invitation to participate was extended to state governments, which, by and large, already practice formulary apportionment.(2) This Note examines the merits and shortcomings of the formulary apportionment system as contrasted to the arm's length system.(3) Because of its relative simplicity, formulary apportionment may be the better alternative for the future.
The issues addressed by the conference were especially difficult because "[m]ultijurisdictional companies are usually so thoroughly integrated that methods of dividing their income geographically are necessarily arbitrary and therefore controversial."(4) In fact, Justice Brennan has analogized the problem to "slicing a shadow."(5) With the growing global market, income attribution will become more complex and controversial. Formulary apportionment offers a striking theoretical contrast to the current arm's length approach.
II. HISTORY OF INCOME SOURCING
A. Formulary Apportionment as Applied by the States
In 1957, the National Conference of Commissioners on Uniform State Laws approved and recommended that states adopt the Uniform Division of Income for Tax Purposes Act (UDITPA). The principle endorsed by UDITPA was relatively simple: apportion income based on the factors of production. Thus, property owned or operated within the jurisdiction is used to measure capital employed by the entity, likewise, payroll is used to measure labor employed by the entity.(6) A third factor was added to represent the exploitation of the market--the sales factor.(7) Each factor is reduced to a fraction, the numerator of which is the activity within the jurisdiction and the denominator of which is the entity's entire activity. For example, the payroll fraction is the payroll within the jurisdiction divided by the entity's entire payroll. Each factor is equally weighted in determining a composite rate. The composite rate is then applied to apportionable income to determine the amount that is subject to the jurisdiction's income tax.
Although relatively simple in theory, UDITPA has generated considerable litigation in two areas.(8) First, how much activity within a state justifies the state taxing the activity in the first place? Second, what constitutes a unitary business, or in other words, how similar does the out-of-state activity have to be to the taxable in-state activity to be included within the apportionable tax base? The United States Supreme Court has addressed these questions several times, with results that vary with the Court's interpretation of the Due Process Clause and the Commerce Clause. Notwithstanding the litigation and the Constitutional challenges the unitary system has remained relatively stable and unchanged throughout its forty year history. The UDITPA apportionment system or some variation is currently used in every state that imposes income taxes.(9)
B. Arm's Length as Applied by the Federal Government
Soon after the development of UDITPA, the federal government faced a similar question of how to apportion income to multiple international jurisdictions. It fashioned a different solution to the same problem. Unlike the states' approach, the federal government developed an arm's length/separate accounting method of income attribution.(10) Rather than focus on the multi-jurisdictional entity as a whole, the separate accounting method breaks the entity into discrete taxable parts.(11) The method then determines an appropriate "arm's length" value for the transaction between related entities. …