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Mohanish Verma, IRS, Visiting Researcher, Georgetown University, Washington DC (2018)

Is the Global System Moving towards Formulary Apportionment as an alternative International Taxation approach?

The principles guiding transfer pricing and International Taxation for past several decades has been the ALP or Arm’s Length Price. However in recent times, the alternative principle of Formulary apportionment has also been discussed by many researchers, practitioners and also implemented by USA, Canada and Switzerland. Though the BEPS has retained the principle of ALP, some ideas of Formulary Apportionment (FA), have been gradually adapted in the BEPS resolutions and guidelines. It is worthwhile appreciating the merits and drawbacks of the FA approach in the context of changing International business environment, when global taxation regimes are poised to change drastically.


              FA approach has been used in Canada and USA quite extensively and even the recent common consolidated corporate tax base (CCCTB) Project in EU is based on the principle of Formulary apportionment. Historically different factors and elements have been used while arriving at a formula for deciding the apportionment of taxes[1]. Factors used included property, payroll, sales, manufacturing costs, purchases, expenditures for labor, accounts receivable, capital assets etc. Use of multiple factors resulted in complications and later by 1990’s the factors were reduced to 3 sales, payroll and assets, (Massachusetts Formula). This was used by 44 States in USA.

             Subsequently, it was further reduced to the use of only “sales” and other factors were discontinued, due to disincentives to some businesses. However in Canada, the factors used are gross revenue and payroll. Also other specific factors are used for different industries like Insurance, manufacturing etc. The Federal government in Canada has a stronger role in determining and implementing these apportionment rules and guidelines. The functioning of FA based system is quite smooth and effective in Canada[2].

            The European Commission (EU) proposed a common system of CCCTB, which was to be recommended for companies established within EU. This consisted of 3 parts (1) Common System of calculating the Tax Base (2) consolidated tax base of all qualifying subsidiaries and PE located within EU and (3) apportionment of consolidated tax base to group members on the basis of three factors, sales, labor and assets, given equal weightage[3]. This proposal however was not very successful and there were differences amongst countries. However this scheme was re launched in 2016, with the changes that CCCTB will become mandatory and also that the changes in tax base will be gradual.

          The experiences of implementing FA approach do not appear to be very discouraging, though there are challenges in arriving at the right formula and factors amongst different tax regimes and also analyzing the functions of any business model. In this context the move towards FA, as an alternative to ALP based methods appears possible and could be more effective.

Developing Standardized Models

Taking the case of MNE’s with global internet based business models, it is estimated that only about 5% of the MNE’s are controlling 95% of the internet transactions. Prominent platforms like Amazon, Google, Facebook, Flipkart and several others have global reach with major market share. In many other countries like China and India there are more such Internet based MNE’s like Alibaba, Quikr, Snapdeal which have also become global players. There is huge data available regarding the transactions and nature of business models which are functioning successfully. Just like on earlier occasions, USA, Canada and some other regions have decided on some factors for apportionment of profits, there are possibilities of analyzing data from top few internet based business models and develop standardized models for apportionment of taxes in different locations and regimes, after establishing some nexus principles for value addition. 

           For example the value addition activities of Amazon could be broken down into the value of intangibles which consists of research and development, investments and user contributions. Further the aspects of sales, advertisement incomes, incomes from related sites etc could be given weightage depending on data earlier collected. However such formula would also have to be dynamic since changes would be taking place on a regular basis. A periodic review may be built into a regulatory authority with technical and financial experts.

    It is possible to develop 15 to 20 models with typical features and for which some principles for apportionment could be recommended, based on data and experience of the immediate past. All internet and digital MNE’s could be given an option to adapt one of these standardized models of apportionment on a voluntary basis. This could be an initiative to run as a pilot for further modifications. The coordination for such functioning and dynamic models could be regulated through an International body of experts under OECD or “Inclusive Group”. All MNE’s could be given an option to adapt one of these models and reduce their uncertainty and compliance costs. However if they choose to provide a different model, the same would be subject to audit and scrutiny by different tax regimes. Such 3 tier documentation and CbC (Country by country) reporting has already been recommended by the OECD in the BEPS project.

         As it has also been observed in the Interim Report of OECD on digitalization, technical solutions will have to be explored to test the feasibility of different options[4]. In this context, the role of FA in developing standardized models and determining crucial factors in each model of business operation is of great interest.   

          The existing methods of Transfer pricing primarily based on the ALP principle have loopholes which are not able to cater to the changing global economic environment. The alternatives effectively used by China and some other countries including USA are the APA, APMA, Safe Harbor Rules. In reality, these arrangements are like standardized models on a case to case basis. These arrangements are effective since even if the profits or incomes agreed upon may not be accurate, it helps in retaining certainty and predictability to both the tax payer and the tax administration. It reduces litigation, complications and arbitrariness of administration and creates a positive business environment. It also ensures “non double taxation”.

        Developing standardized models based on the FA principle will result in extension of the APA or Safe harbor principle for a larger group of entities. What needs to be addressed is that such models can be more objective and data based, which will reduce arbitrariness and uncertainties both for tax administrations and MNE’s. It will be a step towards increasing fair taxes at different locations, even if physical presence of PE does not exist.

Data Base and Objectivity.

 The use of data on the international business transactions is of great value and the same has to be collected, analyzed and disseminated in an objective and transparent manner to ensure fairness in the International tax system. Presently the coordination amongst countries is sought to be increased as per BEPS actions and project. Many countries have already started collecting data from business portals. There are issues of getting data on peer to peer transactions as well. However, on availability of such data, some objective models can be developed by considering different factors for different industries or services or even for different tax regimes in a fair and objective manner.

        The recent voices in favor of FA are certainly not without sound arguments and logic and the decision of the US Supreme Court in the Mayfair case[5] will act as a game changer in view of its observations that we cannot rely on rules made in the nineteenth century and have to think in terms of the twenty first century.


About the Author: The author is an Indian Revenue Service Officer with over 30 years of experience in the field of taxation and economics, and has been associated with academics including a recent stint at Georgetown University, Washington DC, as a Visiting Researcher in 2018.  



Disclaimer: Above expressed are the personal views of the author, and the publisher or the author disclaim all, and any liability and responsibility, to any person on any action taken on reliance of it.



[1] Cottani, (2016)

[2] Stefan Mayer, Formulary Apportionment for the Internal Market, (IBFD 2009), Section 3.2: Existing Apportionment Systems - Canada.

[3] European Commission Proposal for Council Directive on a Common Consolidated Corporate Tax Base (CCCTB), COM (2011) 121/4.

[4] OECD Interim Report on Challenges of Digitalization, (2018).

[5] South Dakota Vs Wayfair, Inc., Supreme Court USA, 21 June, 2018

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