Can formula apportionment really prevent multinational enterprises from profit shifting? The role of asset valuation, intragroup debt, and leases

Abstract

The European Commission has been supporting a transition from a system of separate accounting to formula apportionment. After its 2011 draft directive was rejected by the Council, the Commission presented two new draft directives in October 2016, one stipulating rules for a common tax base and another the terms for consolidation and apportionment. The aspired system of unitary taxation is considered more resistant to profit shifting and assumed to reduce compliance costs. However, there are also doubts about the extent, to which such a system will eradicate tax-planning activities of MNEs. Other concerns have arisen about the practical issue of enforcing uniform rules for asset valuation throughout the member states. We use a dynamic model of tax accounting based on neoclassical investment theory and effective tax rates to determine to what extent formula apportionment mitigates the efficiency of typical profit-shifting strategies. We focus on the roles of transfer pricing and intragroup debt financing (through loans and leases) under both separate accounting and formula apportionment. We also take into account a possible leeway for inconsistent valuation. Our results show that instead of eliminating tax planning strategies, the proposed system might simply induce a shift from manipulating reported profits to influencing the apportionment key. Inside the European Union, the CCCTB may be able to render thin capitalisation rules and transfer pricing documentation redundant. However, formula apportionment invites for new forms of tax planning. It is therefore essential to give credit to these new kinds of tax incentives when implementing a system of unitary taxation.

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Notes

  1. 1.

    In this case, transfer prices differ from prices set according to the ‘arm’s length principle’.

  2. 2.

    See, e.g., Egger and Eggert et al. (2010), who empirically examine the influence of taxes on debt financing in MNEs, pp. 97, 104. See also Mintz and Smart (2004).

  3. 3.

    EC (2011, p. 4).

  4. 4.

    EC (2011, 2016a).

  5. 5.

    UT is already implemented in the US and Canada, See, e.g., Weiner (1999), Stetter and Spengel (2006), and Mintz and Smart (2004).

  6. 6.

    EC (2016b).

  7. 7.

    EC (2016a).

  8. 8.

    The previous solely optional approach was criticised since it might allow for further tax planning strategies. See, e.g., Mintz (2004, p. 231); Oestreicher and Koch (2011). Consequently, European Parliament has voted for the CCCTB to be compulsory. See European Parliament (2012). This opinion was adopted by the EC.

  9. 9.

    For an examination of tax planning via strategic (non)consolidation, see Buettner et al. (2011).

  10. 10.

    EC (2011, p. 4).

  11. 11.

    See, e.g., Devereux (2004, p. 83), EC (2006, p. 3), Mintz (2004, p. 221).

  12. 12.

    See, e.g., Riedel and Runkel (2007), who show that a UT system with a water’s edge may lead to less profit shifting to tax havens compared to an ST system. According to Mintz and Weiner (2003, p. 698), shifting profits is more difficult under UT. Hines (2010, p. 117), mentions ‘the undeniable appeal of reducing certain opportunities of tax-motivated international income reallocation’ even though he is very sceptical towards UT.

  13. 13.

    EC (2011, p. 5).

  14. 14.

    EC (2016a, p. 10).

  15. 15.

    See e.g. Shackelford and Slemrod (1998), Devereux and Loretz (2008), Hines (2010), Spengel and Oestreicher (2011).

  16. 16.

    See Eichfelder et al. (2015, p. 1), based on data of the German Trade Tax (“Gewerbesteuer”).

  17. 17.

    Note that instead of ETRs, Kiesewetter and Mugler (2007) use after-tax NPVs. The two approaches are compatible. Dietrich and Kiesewetter (2011), in contrast, do not allow for any discretion in asset valuation for tax purposes and focus on simultaneous investment and finance decisions comparing different forms of debt-finance with related parties which may or may not be relevant for the allocation formula.

  18. 18.

    See Fuest et al. (2007), Devereux and Loretz (2008), and Oestreicher and Koch (2011).

  19. 19.

    Based on quasi-empirical estimations, Hines (2010) strongly criticises the explanatory power of the proposed apportionment formula. Anand and Sansing (2000) show that single jurisdictions have incentives to deviate from a harmonized formula to increase their welfare. See also Oestreicher and Koch (2011, pp. 83, ff) for a discussion. Ortmann and Sureth-Sloane (2016) investigate the effects, that arise from possibilities of cross-border loss-offset under UT.

  20. 20.

    See Nielsen et al. (2010, p. 122). Roggeman et al. (2013) argue, that more equal weights could distribute the tax base more equally.

  21. 21.

    See, e.g., Pethig and Wagener (2007) and Anand and Sansing (2000) for the tax competition implications of different allocation factors.

  22. 22.

    See, e.g., Sørensen (2004, p. 96), and Wellisch (2004, p. 37), who also note that such a formula would have far-reaching consequences for the nature of tax competition in the EU.

  23. 23.

    This approach is similar to the ‘Massachusetts formula’ applied in most US federal states for UT; see, e.g., Anand and Sansing (2000). In Canada, however, only sales and payroll are used in the formula, see, e.g., Mintz (2004, p. 223), Mintz and Smart (2004, p. 1150), and Stetter and Spengel (2006).

  24. 24.

    For a detailed discussion of the components of the apportionment formula as well as their ‘architecture’, see, e.g., EC (2007).

  25. 25.

    Gordon and Wilson (1986, p. 1357); McLure (1980).

  26. 26.

    The EC plans to implement a harmonized formula. For welfare effects caused by a non-harmonized formula, see Anand and Sansing (2000).

  27. 27.

    See Nielsen et al. (2003, pp. 429 and 435).

  28. 28.

    See Hellerstein and McLure (2004, p. 214), Lodin and Gammie (2001, p. 49) and Sørensen (2004, p. 97). Remember that UT is intended to abolish problems and costs arising from TP documentation.

  29. 29.

    See Wellisch (2004, p. 36).

  30. 30.

    See Sørensen (2004, pp. 95 f).

  31. 31.

    See Weiner (2005, p. 53).

  32. 32.

    See Weiner (1999, pp. 13–15), Eichfelder et al. (2015, p. 16 f).

  33. 33.

    See Eberhartinger and Petutschnig (2015).

  34. 34.

    See Bettendorf et al (2009, p. 8), Mintz and Weiner (2003, p. 700).

  35. 35.

    EC (2007, p. 2).

  36. 36.

    For a similar approach, see, e.g., Mintz and Smart (2004).

  37. 37.

    Other allocation factors may also be vulnerable to manipulation, as empirical studies have shown. See, e.g., Klassen and Shackelford (1998, pp. 400, 404), for empirical evidence of sales apportionment factor management under UT. See also Riedel (2010, pp. 238, 250, 257, f), for evidence of payroll formula distortion.

  38. 38.

    ETRs were first introduced by King and Fullerton (1984).

  39. 39.

    See EC (2001 and 2003).

  40. 40.

    See Schreiber et al. (2002, p. 3).

  41. 41.

    Alternatively, the return or the future value might be used as objective values.

  42. 42.

    Knirsch (2002, p. 17).

  43. 43.

    Ruf (2011).

  44. 44.

    See Devereux and Griffith (1998, pp. 353, 362).

  45. 45.

    See Ruf (2002, 2011).

  46. 46.

    See Knirsch (2002, p. 5).

  47. 47.

    See EC (2016b, p. 16).

  48. 48.

    See Council of the European Union (2011), ‘Parent-Subsidiary Directive’, or Art. 8 d) of the Draft Council Directive on a CTB of 2016.

  49. 49.

    An existing investment portfolio besides the project and its location would affect ETRs under UT and therefore would make it more difficult to interpret our results.

  50. 50.

    Although the assumption may irritate due to the uniform rate of return, it allows to separate tax effects from real economic effects.

  51. 51.

    This assumption indicates that the investment thoroughly consists of depreciable capital. Therefore, the results hold particularly true for high firm-specific capital intensity; see Oestreicher et al. (2009, p. 64).

  52. 52.

    See, e.g., Corbett and Jenkinson (1997) for the empirical relevance of finance by retained earnings.

  53. 53.

    Such room for discretion may result from ambiguity in legal texts or differences in their interpretation among Member States. Additionally, Art. 39 of the 2016 Draft Directive on a CCTB allows for ‘exceptional depreciation’, which may also be subject to some discretion of management.

  54. 54.

    Mintz and Weiner (2003, p. 702 f), claim that countries wish to offer tax incentives, which will be hampered under UT. The possibilities to offer tax incentives could increase under UT, as common depreciation rates are expected to broaden the tax bases on average [for broadening tax bases, see Spengel and Oestreicher (2011)].

  55. 55.

    EC (2016b), recital 19, p. 16 f.

  56. 56.

    Lamotte (2012, p. 277). For further doubts (here regarding a uniform interpretation of anti-abuse rules), see Panayi (2012, p. 258).

  57. 57.

    A heterogeneity of tax laws under FA can be also observed in the United States. Gupta and Mills (2002) show implications for tax planning opportunities.

  58. 58.

    The use of only tangible assets as the apportionment factor is stipulated by Art. 34, EC (2016a) and matches the US approach; see Weiner (2002, p. 526).

  59. 59.

    Note that we do not include a cost function for TP, as in, e.g., Nielsen et al. (2010).

  60. 60.

    Discriminatory taxation of dividends on equity capital compared to interest on debt capital is a common element of most Member States’ tax codes. (The ‘Notional Interest Deduction’ in the Belgian CIT is an exception.) Therefore, the ETR of an indebted firm can be below the STR even in a single country setting. Yet, the objective of UT is not to solve this problem (Devereux 2004, p. 83); thus, financial transactions between an MNE and its owners are ignored in this paper. We focus instead on financial transactions within the consolidated MNE. For tax planning via lending and borrowing, see also Mintz and Smart (2004). Note that Art. 11 of the EC (2016b) proposal offers limited allowance for corporate equity (‘Allowance for growth and investment’), that may reduce some of those additional distortive effects.

  61. 61.

    Mintz and Smart (2004, p. 1152 f).

  62. 62.

    Limitations to deductibility such as thin-cap rules or, e.g., the German ‘business income tax’ are neglected.

  63. 63.

    If the leasing object is accounted for in both countries (‘double-dip lease’), the possibility for the MNE to reduce its tax burden is evident; hence, this case will not be examined [see, e.g., Mehta (2005, p. 95 f)].

  64. 64.

    Such a condition could e.g. be met in cases investments carried out within the EU by non-consolidated MNEs from third countries.

  65. 65.

    Art. 35 no. 2 of EC (2016a) states that with respect to the allocation of assets, ‘except in the case of leases between group members, leased assets shall be included in the asset factor of the group member which is the lessor or the lessee of the asset. The same shall apply to rented assets’. It is not clear from this sentence or from Art. 36, no. 4, whether and how an intragroup lease should be taken into account. Note that in an older publication, the recommendation was to assign the leasing object to only one group member in case of intragroup leases; only for leases with third parties is an assignment to both possible (EC 2007, p. 11).

  66. 66.

    Taxation of profit distribution is irrelevant for the scenario of an investment financed by retained earnings used here: as can be seen in Eq. (4), all NPVs are cut proportionally by the factor \((1 - \tau^{D} )\).

  67. 67.

    However, specific national depreciation allowances may persist in the states. Alternatively, one could imagine an MNE with two very different activities in state F and state H that require completely different assets.

  68. 68.

    This assumption corresponds to the declared intention of the proposal for a CCCTB, EC (2016a). As we have argued above, we have doubts about the viability of such an assumption.

  69. 69.

    Whether the timing and tax rate effects act in concert depends on the specific constellation of input variables that are used for the calculations.

  70. 70.

    The EC tries to prevent a large-scale allocation by implementing provisions like Art. 22 Draft Council Directive on a CCCTB, EC (2016a).

  71. 71.

    EC (2007, pp. 11, 16).

  72. 72.

    See Weiner (2005, p. 21).

  73. 73.

    See Art. 36 no. 4 Draft Council Directive on a CCCTB, EC (2016a).

  74. 74.

    See Riedel and Runkel (2007) for the water’s edge problem. Buettner et al. (2011) provide empirical evidence for strategic consolidation under UT using formula apportionment.

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Kiesewetter, D., Steigenberger, T. & Stier, M. Can formula apportionment really prevent multinational enterprises from profit shifting? The role of asset valuation, intragroup debt, and leases. J Bus Econ 88, 1029–1060 (2018). https://doi.org/10.1007/s11573-018-0891-y

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Keywords

  • Effective tax rate
  • CCCTB
  • Formula apportionment
  • Tax planning
  • Profit shifting
  • Debt financing
  • Leasing

JEL classification

  • H20
  • F21, 23
  • D21