*From:* Karl Sauvant <[log in to unmask]>
*Sent:* Monday, December 22, 2014 9:40 AM
*Subject:* Locating production and income within MNEs: An alternative
approach based on formulary apportionment (Columbia FDI Perspective No 137)

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         *Columbia FDI Perspectives*
Perspectives on topical foreign direct investment issues
No. 137   December 22, 2014
Editor-in-Chief: Karl P. Sauvant ([log in to unmask])
Managing Editor: Adrian P. Torres ([log in to unmask])
         *Locating production and income within MNEs:  *
*An alternative approach based on formulary apportionment*
Dylan G. Rassier* <#14a735e87092a553__edn1>

Economic accountants, who are responsible for measuring gross domestic
product (GDP), and tax authorities, which are responsible for collecting
tax revenues, face similar challenges with respect to multinational
enterprises (MNEs): economic accountants want to know where within an MNE
production is taking place and, thus, where to attribute GDP; tax
authorities want to know where income from production is earned. Current
global guidance on economic accounting and international taxation generally
require transactions within MNEs to be recognized at market (or “arm’s
length”) values as if the transactions are taking place among unrelated
entities. However, the values of transactions within MNEs may not reflect
economic reality because related entities may exchange unique products with
no active markets, and because MNEs may be structured with one or more
entities that exist for purposes other than production. As a result,
transactions within MNEs may distort economic accounting statistics and tax

Given the complexity and subjectivity associated with applying the arm’s
length standard, recent and past discussions on international taxation
suggest formulary apportionment as an alternative solution for attributing
income for tax purposes within MNEs. Under formulary apportionment, income
earned by an MNE is attributed to tax jurisdictions based on prescribed
apportionment factors, such as sales, employment and tangible property,
which arguably reflect an MNE’s presence in each jurisdiction.

In the United States (US), formulary apportionment is commonly required by
state tax authorities to determine the taxable income attributable to a
state for a business that operates in multiple states. Under the European
Commission’s proposed directive for a common consolidated corporate tax
base, formulary apportionment is an option for determining tax liabilities
by country for MNEs operating within the European Union (EU). Additionally,
the Organisation for Economic Co-operation and Development (OECD) is
currently working on a project at the request of the G20 finance ministers
to address tax base erosion and profit shifting (BEPS). One recommendation
under the BEPS action plan is documentation that includes
country-by-country reporting. Under country-by-country reporting, MNEs are
required to report, by country, earnings, revenues, number of employees,
tangible assets, etc. to provide tax authorities with indicators regarding
the location of economic activity. Respondents to the BEPS project have
expressed strong concern that country-by-country reporting is suggestive of
formulary apportionment, but the OECD asserts that the purpose of
country-by-country reporting is for tax authorities to target audit risk
rather than to replace the arm’s length standard recommended in the OECD
transfer-pricing guidelines, which explicitly reject formulary
apportionment as a substitute for the arm’s length standard.[1]

Opponents of formulary apportionment present evidence that suggests
formulary apportionment may distort actual income attributable to a given
country due to income that is unexplained by apportionment factors and may
lead to an inefficient allocation of productive resources due to
differences in tax rates across countries.[2] <#14a735e87092a553__edn3> As
a result, formulary apportionment may yield political and administrative
complexity that would require an unrealistic level of international
cooperation.[3] <#14a735e87092a553__edn4>

Proponents of formulary apportionment concede the approach is challenged by
political and administrative complexity, but point out that the arm’s
length standard is challenged, too, as demonstrated by the BEPS project.
However, proponents argue that formulary apportionment is more relevant in
a global economy, in addition to creating a stable revenue source and
promoting competitive tax policies.[4] <#14a735e87092a553__edn5> The bottom
line for proponents is that formulary apportionment better reflects
economic conditions in integrated markets such as the US or the EU.

Formulary apportionment has also been proposed as an alternative to the
current method of separate accounting for attributing income-based
value-added measures to foreign affiliates of US MNEs for statistical
purposes.[5] <#14a735e87092a553__edn6> Previous work reveals distortions in
the value-added measures, which are supplemental and do not affect core
measures of production and income in US economic accounts.[6]

Using formulary apportionment to measure economic accounting statistics on
MNEs does not face the concerns described above for international taxation
because MNEs presumably do not make operating or investment decisions based
on data collected for statistical purposes. However, formulary
apportionment may affect statistics on MNEs and the related picture of
global production. In fact, the distortions in the supplemental measures
are considerably reduced under a method of formulary apportionment. Thus,
the international tax discussions on formulary apportionment may lend
useful insight for more accurate economic accounting statistics on MNEs and
for trade and FDI policy informed by the statistics.

* <#14a735e87092a553__ednref1> Dylan G. Rassier ([log in to unmask]) is
an economist with the United States Bureau of Economic Analysis. The views
expressed in this *Perspective* are solely those of the author and do not
necessarily reflect those of the United States Department of Commerce or
the Bureau of Economic Analysis. The author is grateful to Reuven
Avi-Yonah, Sol Picciotto and Joann Weiner for their helpful peer reviews. *The
views expressed by the author of this Perspective do not necessarily
reflect the opinions of Columbia University or its partners and supporters.
Columbia FDI Perspectives (ISSN 2158-3579) is a peer-reviewed series.*
[1] <#14a735e87092a553__ednref2> OECD, *Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations* (Paris: OECD, 1995),
paras. 3.58-3.74.
[2] <#14a735e87092a553__ednref3> James R. Hines, “Income misattribution
under formula apportionment”, *European Economic Review*, vol. 54 (2010),
pp. 108-120.
[3] <#14a735e87092a553__ednref4> OECD, *op. cit.*, para. 3.66.
[4] <#14a735e87092a553__ednref5> Joann Martens-Weiner, *Company Tax Reform
in the European Union: Guidance from the United States and Canada on
Implementing Formulary Apportionment* (New York:  Springer, 2006).
[5] <#14a735e87092a553__ednref6> Dylan G. Rassier and Jennifer
Koncz-Bruner, “A formulary approach for attributing measured production to
foreign affiliates of U.S. parents,” in Susan Houseman and Michael Mandel,
eds., *Measuring the Effects of Globalization* (Kalamazoo, MI: Upjohn
Institute for Employment Research, forthcoming).
[6] <#14a735e87092a553__ednref7> Robert E. Lipsey, “Measuring the location
of production in a world of intangible productive assets, FDI, and
intrafirm trade,” *Review of Income and Wealth*, vol. 56 (2010), pp.
         *The material in this Perspective may be reprinted if accompanied
by the following acknowledgment: “Dylan G. Rassier**,** ‘Locating
production and income within MNEs: An alternative approach based on
formulary apportionment**,’ Columbia FDI Perspectives, No. 137, December,
22 2014. Reprinted with permission from the Columbia Center on Sustainable
Investment ( <>).” A copy
should kindly be sent to the Columbia Center on Sustainable Investment at
[log in to unmask] <[log in to unmask]>.*
For further information, including information regarding submission to the
*Perspectives*, please contact: Columbia Center on Sustainable Investment,
Adrian Torres, [log in to unmask] or [log in to unmask]

*Most recent Columbia FDI Perspectives*

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*All previous FDI Perspectives are available at
<>**. *

*Other relevant CCSI news and announcements:*

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         Karl P. Sauvant, Ph.D.
Resident Senior Fellow
Columbia Center on Sustainable Investment
Columbia Law School - Earth Institute
Ph: (212) 854-0689
Fax: (212) 854-7946 <%28212%29%20854-7946>
              *Copyright © 2014 Columbia Center on Sustainable Investment
(CCSI), All rights reserved.*
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