This paper is a draft chapter of a forthcoming book on the taxation of international business profit by the authors to be published by Oxford University Press. The book will study two proposals for international tax reform — one is the destination based cash flow tax, and the second, which is offered in this paper, is a new form of residual profit allocation for transfer pricing analysis.
The authors refer to the new residual profit allocation method as a "Residual Profit Allocation by Income," or RPA-I. It is a category of profit-based methodology that allocates the total profit of a multinational enterprise (MNE) into two parts — the "routine" profit, and the "residual" profit.
"Routine" profit is the profit a third party would expect to earn for performing a particular set of functions and activities on an outsourcing basis. Such third party does not share in the overall risk of the MNEs and earns no return based on the overall success or failure of the product or business to which its activities relate. Thus, affiliates of MNEs that take limited risk are assigned such routine profit. On the other hand, "residual" profit is an excess return that is associated with the entrepreneurial success or failure of the enterprise. Thus, only entrepreneurial affiliates may participate in the residual profit of the overall enterprise.
The RPA-I follows such distinction of routine and residual profit. However, it departs from the existing transfer pricing rules with respect to how to allocate the right to tax such profits, particularly the "residual" profit. The existing rules allocate the right to tax "routine" profit to the country where functions and activities take place. The RPA-I adheres to such allocation of routine profit rule, where the existing transfer pricing system is deemed to work reasonably well. On the other hand, the existing transfer pricing rules are generally deemed to struggle when it comes to allocating taxing rights over "residual” profit. The existing rules allocate the right to tax "residual" profit on an asset or activities basis, whereas the RPA-I allocates the right to tax "residual" profit to the market country (i.e., destination country) where a MNE makes sales to independent, third-party customers. For this purpose, the RPA-I offers two ways to calculate the residual profit of a MNE. First is the bottom-up approach which identifies the residual gross income (RGI) earned in each destination country. Second is a top-down approach where the total residual income, calculated simply as total profit less total routine profit, is apportioned directly by RGI.
Furthermore, the RPA-I differs from other RPA proposals in two ways. First, “routine” profit is determined by common transfer pricing techniques, instead of being based on a fixed mark-up over costs. Second, the apportionment of “residual” profit introduces some elements of formulary apportionment, but it is based on the location of RGI, rather than sales.
The authors argue that the RPA-I has advantages in achieving economic efficiency, fairness, robustness to avoidance, ease of implementation, and incentive compatibility, compared to the existing system. Such strength stems primarily from allocating taxing right for residual profit to the destination country. An important goal of the RPA-I is to combat profit shifting activities which have exploited the mobility of proprietary intangibles and the difficulty in valuing them. The RPA-I takes full advantage of relative immobility of the location of final sales. The destination country is where a third-party customer of goods and services sold by the company is located. Considering that the consumers in destination country are relatively immobile, allocating the residual profit taxation to that country is likely to result in less manipulation of the location of economic activity and taxable profit. Furthermore, the RPA-I allocates residual profit by RGI, and thus is less vulnerable to tax planning opportunity available under an alternative allocation of residual profit by sales revenue, which one can easily manipulate.
There might be a potential pushback from the losers under the authors' proposal. For example, the RPA-I allocates parts of profits from remote sales to the market country in a way that is not done at present. Currently, if a MNE resident in country A sells directly through a digital platform to customers in country B, without any physical presence in B, then its profit will be taxed in A. By contrast, the RPA-I allocates taxing right for routine profit to A and that for residual profit to B. This is a significant departure from current practice, which would require change to existing double tax treaties. Not to mention the expected difficulties in implementation, the authors' proposal would confront the backlash from the countries that are in country A's shoes as well as MNEs which are likely to have chosen low-tax countries as country A.
Although the authors' proposal moves toward destination basis of taxation, one should note that the proposal stops short of full allocation to destination countries. It aims at departing the existing system as little as possible, but partially, though coherently, moves to a destination basis. In this regard, the authors' proposal is wise, normatively superior, and practical, because allocating more taxing right to destination country seems to be inevitable especially in the digital economy. I applaud the authors' efforts devoted to this project and look forward to reading the new book.