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Corporate Profits: An Elusive and Problematic Tax Base

Written by , Morss Global Finance

Introduction

There are frequent reports of corporations paying 10% tax rates (or less) on profits – legally. And it certainly pays for large corporations to employ teams of lawyers to find ways to minimize their global profit tax liabilities. And predictably, politicians are angry and have called hearings in hopes of tightening up the tax code. But most are missing the point. The reality is that while income makes sense as a tax base for individuals, profits are not a good tax base for companies doing business worldwide.

Why is this? Consider first where people work (measured by payrolls), physical property, and equipment. All are situated somewhere; they all have a geographic location. Most agree that the state/region where they are located has the legal jurisdiction to levy a tax on the value of the payrolls or property located within their borders. Sales are a bit more complex: are you talking about sales from the factory or location of the buyer. But again, there is a definable locus giving states or regions the legal jurisdiction to levy a sales tax.

But business/corporate profits are different. Profits are generated by two separate actions: production and sales. Both are necessary conditions for profits to be generated. Profits only occur when a good is both produced and sold. Suppose a good is produced in one state and sold to a customer in another. There is no theoretical or practical way to determine where the profits were generated. Let me qualify this statement slightly: after years of work by economists, lawyers, accountants and government officials, there is no agreement on how profits of companies should be allocated among regions for tax purposes.

Legal Definitions

Lawyers have offered concepts such a where a company was incorporated, headquarters, and several other factors they say gives a company a tax domicile or nexus. But in essence, they are all hollow. And the problem is getting worse as a result of the information revolution. A “headquarters” case in point:

…A friend who works in a venture capital company with global activities. The VC used to have its “headquarters” in a Manhattan office building. No longer. Most of their business is conducted on cell phones and laptops: when they want to meet, they rent a hotel room in a convenient city.

The US Experience

The global corporate tax base problem has a predicate in the US. A US state is allowed by the U.S. Constitution to tax the income of a multistate corporation if a formula is used that fairly apportions a percentage of the corporation’s income attributable to business activities inside and outside the state. Internal and external consistency are required. Internal consistency means the tax has to be structured so that every jurisdiction could impose an identical tax and no multiple taxation would occur. An apportionment formula has external consistency if the factors used in the formula reflect a reasonable sense of how income is generated.

Back in the ’60s, I took a summer job working for the Special Subcommittee of State Taxation of Interstate Commerce of the US House Judiciary Committee. My Ph.D. dissertation ended up being “A Study of How Corporate Income Should Be Apportioned for Taxation by States.” Efforts by US states to tax corporate profits face the same problems nations face when trying to tax the profits of global companies. Many corporations do business in all 50 US states, so there is an issue as to how their profits should be divided among states for taxation. The Subcommittee tried to get states to adopt a uniform formula to allocate profits among states. If they had succeeded, all corporate profits would have at least been taxable in one or another state.

The Subcommittee favored a three-factor formula: the average of the shares of a corporation’s payrolls, property, and sales within the state.

If P = Payrolls, A = Property, and S = Sales with subscripts S and T designating state and total, a state’s share of a company’s tax base would be (Ps/Pt + As/At + Ss/St)/3).

Does it sound simple? It is not. Definitions for payrolls and property located in a state can be worked out. But the sales factor is a very different story. When I did my dissertation in 1961, the sales factor definitions being used by states included: “origin (manufactured in state)”, “destination (shipped into state)”, “sales activities”, “sales office”, “receiving office”, “acceptance office”, “location of goods”, and “shipments from warehouse(s) within the state”.

Efforts were made to get states to sign a compact to use this formula. And at least early on, there was some success. I quote from the CCH State Tax Handbook (2013):

“At one time, most states utilized the evenly weighted three-factor apportionment formula promulgated under the Uniform Division of Income for Tax Purposes Act (UDITPA), which consists of property, payroll, and sales (or receipts) factors.”

But hopes for uniformity are waning: The reality: it is not just companies working to minimize taxes paid. Governments are also manipulating definitions in hopes of getting to tax a larger share of corporate profits. I quote again from the CCH Handbook:

“…the number of states that still weight each factor equally is decreasing. Many states have an apportionment formula with a double-weighted sales factor. In addition, the number of states that have adopted a one-factor sales formula is growing.”

Implications of US Experience for Global Taxation

Increasingly, US states are moving to allocation factors that favor production locales. They are doing this by overweighting sales from production sites in their allocation formulas. That is, the share of a corporation’s income taxable is a state is increasingly dependent of the share of the company’s production in that state. This is an admittedly pragmatic solution. But it at least has some merit: production has environmental and other costs, so a production-based tax offers some compensation.

In a recent New York Times article, David Leonhardt said:

“In Singapore, Coca-Cola recently opened a plant with the capacity to produce the underlying ingredient for 18 billion cans of soda a year. In Cork, Ireland, PepsiCo has located its ‘worldwide concentrate headquarters,’ which until 2007 had been in New York. More than half of all PepsiCo soda sold around the world starts, as concentrate, in Ireland.”

Why is this so troubling? If Coke and Pepsi choose to produce the high value ingredient of their products in these countries, should these countries not have the right to tax the corporate profits of these companies? Let me ask this differently: if not the share of a company’s production in a country, how should corporate profits of a company be allocated among nations for taxation? Headquarters? Location of a company’s think tanks? Or what?

Tax Harmonization

Tax harmonization” has a nice ring to it. Can’t we get the near-200 countries of the world to agree on a corporate profits allocation formula? Forget it: if the 50 US states cannot not agree….

A Modest Proposal

Trying to decide how corporate income should be allocated among nations as a tax base is just as problematic as in the US case with states. Since there is no allocation method nations can agree on, over and under taxation of corporate income will continue. And we can expect:

  • Nations will take steps to increase their share of the corporate tax base, and
  • Corporations will go on hiring teams of lawyers to minimize their corporate tax liabilities.

Personal income taxes are justified on equity grounds: that is, a person’s income reflects ability to pay. The same equity argument does not hold for corporations.

However, if there is a global consensus that corporate income should be taxed, I recommend a single global corporate tax to be collected by some international organization – maybe the International Monetary Fund. The proceeds could then be distributed back to countries in accordance with their GDP shares. The tax could be made progressive vis-à-vis countries if the allocation formula included a factor that resulted in countries with lower per capita incomes getting larger shares.

How much could be collected? According to the US Bureau of Economic Analysis, US corporate profits in 2011 were $1.9 trillion. The US share of global GDP is 22%. US corporate profits as a share of GDP is probably higher than for the world, so let’s assume global corporate profits are 8% of global GDP, or $6 trillion. That would mean a 20% corporate profits tax would generate $1.2 trillion annually. The cost savings to corporations and governments no longer trying to minimize/maximize taxes would be large.

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One Response to Corporate Profits: An Elusive and Problematic Tax Base

  1. Kudos Elliott – it is seldom we read analysis from real experts – and this post added to my knowledge base.
     
    It does beg the question would a VAT or general sales tax be a better way for a government to get revenues / income from business products – instead of trying to apportion a profit based tax between localities, states and countries.
     
    My experience from the business side says companies take profits in the lowest tax based point in the supply chain.  Many countries refund taxes on export.  We live in a free trade world that seems to have little tax harmony (even between USA states).  A VAT is relatively easy to administer, and can be done in isolation without agreement between countries.
     
    My major problem with corporations is that we continue to view them as quasi-people. Humans exist in specific locals and can be quantified – while corporate activities are omnipresent.  I would not tax corporate profits but tax point of sale instead.
     
    Again, a great post Elliott – and I am forwarding it to others for a better understanding of corporate taxation.
     
    steven hansen