Ius Gentium

University of Baltimore School of Law's Center for International and Comparative Law Fellows discuss international and comparative legal issues

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Getting Global Tax into Top Gear: Part II Formulary Apportionment in the Context of Transfer-Pricing Regimes

Julia Brent

In my first post, I defended a much-criticized theory of tax reform,[1] called “formulary apportionment (FA),” by examining two tax dynamics in the oil industry in Russia.  My conclusion was that the potential for market distortion when implementing a tax regime is so high that to cite that possibility as a weakness of FA is an over-generalized attack, and therefore invalid.  I also pointed out that the industry chose to reinvest in low-return crude oil rather than investing in refinery upgrades during the time taxes had been lowered on crude oil exports.  This example of “short term thinking” supports the premise of FA, namely that multi-national corporations (MNCs) gravitate to low-tax areas, even against their own long term interests.  This week, I address another attack leveled at FA: that FA is weak in comparison with a solid modificaiton of the current system that allows transfer pricing.  There are two variations of this critism, first in the form of a scholastic opinion from Professors at the University of Michigan Law. They say if the current system of residual taxation in the U.S. were properly applied, FA would not hold its own when stacked up against a “properly applied” worldwide regime.[2]  The second variation is in the form of an actual proposal by the OECD, which makes recommendations to modify, but still keep, the current separate entity approach based in transfer pricing.[3]  Credible advocates of FA cite the weakness of both the “properly applied” plan and the OECD proposal as efforts to ‘tweak’ a system that will still support aggressive profit-shifting.  Interestingly, some believe that implementation of the OECD proposal will actually result in an eventual adoption of FA.[4]

A few readers may be aware of the groundswell toward international reform driven by the highly-distortive market effects of transfer pricing.  If you aren’t, here is short version.  Business dealings across boundaries raise the question—what income will be taxed by which government? The current system for most MNEs is to employ “the arms-length” method, which permits transactions between parent and subsidiary companies (“transfer-pricing”), though located in different countries as independent, taxable events.

JB Blog2 1

Tax credits to prevent double taxation would apply in accordance with the applicable international treaties, and the tax bases can be aggressively affected as corporations seek to maximize after-tax profits by constructing the transactions in such a way that income shows up in low or zero tax countries.[5]  FA, a “unitary” system, regards a company as a single unit, and then formulates  a top-down division of its income into countries based on agreed-upon factors.[6]  The goal of the reform is to prevent base erosion and eliminate complexity.

Some scholars claim that if the U.S. had proper enforcement and clarity in the law regarding its residual tax, the value of low-taxed foreign-source income would be neutralized.  U.S. residual tax is the liability applied to the balance of income not covered by a foreign tax credit.  At present, deferral and cross-crediting features of the U.S. system allow its residual tax to be eliminated or substantially reduced.   Ideally, tax would be imposed on low-taxed foreign income of U.S. residents as the income was earned, thus removing the impetus to defer the repatriation of foreign income.  While still seeing some distortion, it cancels FA as a unique solution, since both (the well-enforced system and FA) would run about neck-in-neck with negative, distortive effects of base eroding deferrals and cross-crediting.[7]   A properly applied system, it is argued would make the U.S. a true “territorial” regime, whereas with deferrals, cross-crediting, and other features of the U.S. system make it so badly flawed that it is not a true worldwide regime.

However, Joseph Stiglitz, a Nobel-prize winner and one of the most outspoken critics of global economic inequality recommends scrapping the arms-length principle.  He argues that small tweaks will not prevent aggressive, artificial moves of earnings and profits to low-tax countries.  For example, the evolution of intangibles in a global, digital economy makes the arm-length pricing impossible.  Where the cost of a barrel of oil for the purpose of an arm’s length transaction can be determined using “comparables,”  one cannot fix a comparable for an iPhone in which the camera feature alone has 279 patents.[8]  Another downside, he states, is that countries who lack the ability to keep up with high-stakes profit manipulation are exploited.[9]  It is hard to imagine Eritrea coming out as a winner against a Pfiezer or a Siemens!

Drafters of the OECD current proposal for model rules and treaty creation doubt that FA’s formula-based system would encourage investment decisions that are more efficient and tax-neutral than under a separate entity approach.  The Secretary-General of the OECD states its  proposal will drain the motivation to shift profits by re-aligning taxation with economic activity and value creation and put an end to double non-taxation.[10]  For example, the proposal kicks-off negotiations towards synchronicity within the global network of bilateral tax treaties with the goal of implementing treaty-based BEPS measures.[11]

Critics of the OECD proposal argue that “Luxleaks-type” tax avoidance facilitated by tax rulings is still possible.  Implementation of the proposal will not only not eliminate the practice of using secret tax rulings, it will increase the complexity of the international tax system.[12]

Surprisingly, some experts claim that certain approaches called for by the OECD may have an unintended consequence:  specifically, regarding the proposed call for country-by-country reporting for taxpayers and that income be tied to “significant people functions” (a way to apply tax to non-financial services sector).[13]  These experts assert that these OECD proposals will incentivize a formulary approach among multinationals.[14]  To the extent a boots-on-ground implementation of the OECD requirements begins, we may see a move to a formulary system, even absent a comprehensive overhaul.

In my next blog I will discuss how the recent Russian bunker oil pricing continues the global tax reform analysis. Stay tuned!

Julia Brent is a third year law student at the University of Baltimore, focusing on International Tax (candidate for J.D. 2016). Julia graduated from the University of Hawaii with a B.A. in political science. As a CICL student fellow, she is interested in the tax impact of cross-border transactions on medium to large businesses. Julia has extensive experience in the management of high volume cases, including handling distributions related to a multi-million dollar art estate and managing all expert witness contracts for the Savings & Loan (WINSTAR) litigation, a $30 billion dispute involving 125 cases, on-site at the Department of Justice.

[1] J. Clifton Fleming, Formulary Apportionment In The U.S. International Income Tax System: Putting Lipstick On A Pig?, 36 Mich. J. Int. L. 1.

[2] J. Clifton Fleming, Formulary Apportionment In The U.S. International Income Tax System: Putting Lipstick On A Pig?, 36 Mich. J. Int. L. 5.

[3] http://www.oecd.org/ctp/beps-2015-final-reports.htm

[4] http://www.bna.com/voice-formulary-apportionment-b17179891148/

[5] http://www.taxpolicycenter.org/briefing-book/key-elements/international/formulary-apportionment.cfm

[6] http://www.bna.com/voice-formulary-apportionment-b17179891148/

[7] J. Clifton Fleming, Formulary Apportionment In The U.S. International Income Tax System: Putting Lipstick On A Pig?, 36 Mich. J. Int. L. 5.

[8] http://ip-science.thomsonreuters.com/m/pdfs/iphone-report.pdf

[9] http://www.bna.com/voice-formulary-apportionment-b17179891148/

[10] https://euobserver.com/economic/130565

[11] https://www.asil.org/insights/volume/19/issue/24/emergence-new-international-tax-regime-oecd’s-package-base-erosion-and

[12] https://euobserver.com/economic/130565

[13] http://www.pwc.com/us/en/transfer-pricing-strategies/assets/transfer_pricing_and_permanent_establishments_oecd_view.pdf

[14] http://www.bna.com/voice-formulary-apportionment-b17179891148/


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Displacing Santa: Russia Claims the North Pole

Matthew Matechik

Russia Asserts Exclusive Economic Rights to Massive Section of Arctic Ocean

Russia owns the North Pole. At least… Russia claims it owns the resources of the North Pole. When it comes to expanding its territorial influence, Russia has been busy lately. Invade a neighbor here,[i] illegally annex some territory there,[ii] and violate airspace elsewhere. [iii] Russian President Vladimir Putin’s latest foray is a resource claim to a vast swath of the Arctic Ocean, including North Pole.

Russia North Pole

To be fair, Russia is at the moment making this grab via lawful means unlike, for example, its illegal annexation of the Crimean peninsula. Russia has made its claim under the 1982 U.N. Convention on the Law of the Sea (UNCLOS).[iv]  UNCLOS defines coastal states’ claims to adjacent waters. Under the treaty, a coastal state has exclusive economic rights, meaning sole access to and control of all the resources, in waters extending 200 nautical miles from its coast. UNCLOS also allows a coastal state to claim exclusive economic rights over any part of the ocean over the continental shelf protruding from the coastal state. Continental shelf rights can exist beyond the EEZ up to 350 nautical miles from the coast if the coastal state can establish that the foot of the continental slope exists that far out[v]. The EEZ and continental shelf areas are not part of the state’s territory, although they are immensely valuable to the state because the state alone has access to all the resources, such as oil and fish, and can prohibit other states from accessing those resources.

Russia claimed in August that the foot of its continental slope exists 350 nautical miles, and possibly even further, from its coast. Therefore, Russia is entitled to exclusive economic rights that far from its coast.[vi] The claim far exceeds current understandings of arctic exclusive economic rights, which limits Russia to the outer limit of the EEZ. If Russia’s claim is valid then Russia has exclusive economic rights to over 460,000 square miles of the Arctic Sea, including the North Pole, all of which is currently classified as international waters. The area is estimated to contain up to 10 billion tons of oil and gas deposits, as well as large fisheries, and vast reserves of diamonds and valuable metals such as gold, tin and platinum.[vii] In addition, major potential shipping routes are emerging as global warming melts the polar ice caps. It’s not surprising that Russia wants to control this area itself given its significant economic importance, strategic advantage, and increasing accessibility.

Russia North Pole 2

Russia has been building toward this claim since at least 2002 when it filed a similar UNCLOS claim which was rejected for lack of scientific evidence.[viii] Since that time Russia has been amassing what its Foreign Ministry claims is “a broad range of scientific data collected over many years of Arctic exploration” to support its argument that the continental foot exists 350 miles from shore.[ix] Russia was not shy about asserting its North Pole presence while it was gathering all that evidence. In 2007, Russia dispatched a well-known Russian explorer in a submarine to the seabed directly below the North Pole where he took a soil sample and planted a Russian flag made of titanium.[x] More recently, last March Russia asserted its military strength in the area with a massive exercise involving over 40,000 servicemen, 41 warships, and 14 submarines.

The U.N. Commission on the Limits of the Continental Shelf will deliberate Russia’s claim at its next session.[xi] The Commission must consider if Russia’s newly presented evidence is enough to grant Russia the exclusive economic rights it desires. Russia will likely have to have a far more convincing case than it did in 2002.

Russia North Pole 3

Not to be outdone in the race for a treasure of resources and shipping routes, the United States, Canada, Norway, and Denmark all have their own claims to exclusive economic rights in the Arctic, many of which extend beyond the EEZ. (It should be noted that the United States has not ratified UNCLOS.) As the ice melts, all the bordering states are looking to take advantage. The competing interests make the cold North Pole a potential hot spot for violent conflict.[xii] The potential for Arctic conflict is certainly amplified if the U.N. denies Russia’s claim as expected. Or, for that matter, if the claim is approved, then the United States, Canada, Norway, and Denmark will be forced to do something to hang on to their power in the Arctic. Russia is certainly capable of using force, or at least forceful deterrent, to protect what it views as its exclusive Arctic resources. Russia has proven in Crimea that it is willing to violate international law to expand its territory and power even in the face of punitive sanctions. Amidst increasing tensions in the Ukraine, Syria, the Balkans, and elsewhere, Cold War rivalries might finally heat up to hostilities in the Arctic.

Matthew Matechik is an Evening J.D. student at the University of Baltimore School of Law (Class of 2016). He currently works full-time as a Counterterrorism Analyst. He has a Bachelors of Arts (Magna Cum Laude, 2008) from Florida State University.


[i] http://knowmore.washingtonpost.com/2014/03/05/a-map-of-the-last-time-russia-invaded-one-of-its-neighbors/

[ii] http://www.cnn.com/2014/03/18/world/europe/ukraine-crisis/

[iii] http://www.nytimes.com/2015/10/07/world/europe/russian-violations-of-airspace-seen-as-unwelcome-test-by-the-west.html

[iv]  http://www.un.org/Depts/los/convention_agreements/convention_overview_convention.htm

[v] http://www.un.org/Depts/los/clcs_new/continental_shelf_description.htm

[vi] http://www.cnbc.com/2015/08/06/move-over-santa-putin-claims-the-north-pole.html

[vii] http://www.livescience.com/4584-russia-claims-north-pole-global-race-oil.html

[viii] http://www.smithsonianmag.com/smart-news/russia-might-own-north-pole-180956208/?no-ist

[ix] http://www.nytimes.com/2015/08/05/world/europe/kremlin-stakes-claim-to-arctic-expanse-and-its-resources.html?rref=collection%2Fsectioncollection%2Fscience&action=click&contentCollection=science&region=stream&module=stream_unit&contentPlacement=3&pgtype=sectionfront&_r=0

[x] http://www.nytimes.com/2007/08/03/world/europe/03arctic.html?_r=0

[xi] http://www.un.org/depts/los/clcs_new/commission_submissions.htm

[xii] http://blogs.reuters.com/great-debate/2015/10/04/russia-and-america-prep-forces-for-arctic-war/