BONUS CONTENT: The Arm's-Length Standard and Formulary Apportionment

Midway through “The Dark Knight,” the 2008 Batman opus, the Caped Crusader and Joker engage in a brutal interrogation at the Gotham City Police Department. Between harsh questioning and blows from Batman, Joker hisses to him, “You….complete me!”

It’s a brief “Jerry Maguire” reference, but it gets at something in the heart of the 80-year-old Batman mythology–as his complete and total opposite, Joker needs Batman to exist. And maybe, in a weird way, Batman also needs Joker.

If international taxes has a Batman/Joker rivalry, it’s undoubtedly the arm’s-length principle and formulary apportionment. The first calls for the income of multinational corporations to be allocated across borders based on the market values of its assets–the “arm’s-length” price–while the latter calls for profit to be apportioned based on measurable factors such as sales or workforce.

Two diametrically opposed, mutually incompatible systems, almost like religions to their adherents and advocates on both sides, who passionately argue against each other for their preferred visions of global taxes.

And yet, in the past decade–and especially since the Organization for Economic Cooperation and Development’s two projects on international tax avoidance–the two philosophies have been forced into an awkward embrace. The system might now be more accurately called a hybrid, and it will become more so if those reforms are fully implemented. The arm’s-length principle is still intact, at least on paper. But formulary apportionment, once confined to the chalkboard in academia, is a clear part of the framework, surrounding the arm’s-length principle but also supporting it.

And just as Gotham may not be big enough for Batman and the Joker to co-exist, the open question in international taxes is whether one of these systems is bound to eventually consume the other.

Oddly enough, the United States–one of the strongest supporters of the status quo when it comes to international taxes–may have played a bigger role than anyone else in smuggling formulary aspects into the global system.

In 2013, countries at the Organization for Economic Cooperation and Development first embarked to shore up the global tax norms and attempt to address international corporate tax avoidance, in the OECD’s Base Erosion and Profit Shifting project. During the next two years of negotiations, the U.S. strongly pushed for revamped controlled foreign company rules as the answer.

Other countries wanted to fine-tune the arm’s-length principle to better price intangibles, the valuable nonphysical assets such as IP or branding which are often involved in tax planning because of their mobile and subjective nature. U.S. officials claimed this was not only impossible but unnecessary–just give countries the tools to tax their own companies with stronger measures like the U.S.’s own Subpart F, to sweep up foreign royalty and interest income. Rather than trying to come up with a perfect new arm’s-length principle, just take the pressure off of it with simple, blunt tools.

But the U.S. lost. While the 2015 BEPS Action Plan included some new recommendations for CFC rules, the heart of the plan was a new country-by-country reporting system, and refined language for the valuation of intangibles. Those rules mandated that entities entitled to returns from intangibles must either have the staffing to develop or use those intangibles, or the capacity to bear the financial risks involved in their development. It’s aimed at the heart of the problem with intangibles-based transfer pricing, but it uses a fact-specific and subjective determination which many doubted could work in the real world.

The debates over international tax reform continued. When Republicans in Congress unveiled their federal tax overhaul in 2017, it included new CFC rules meant to curb abuse and ensure that shifting to a territorial system which exempted most offshore income did not lead to an outflow of cash. Chief among these was the tax on global intangible low-taxed income, GILTI, which targeted offshore income from intangible assets at half of the overall 21% rate.

The GILTI tax diverged from the OECD BEPS model in a significant way, however. Rather than try to define intangible assets or intangible income, it used a formulaic proxy based on depreciable tangible property. That would be easier to identify and measure–and harder for companies to hide–than mobile, immaterial assets.

In contrast to the stiff reaction the U.S. received during the BEPS project, Europe responded enthusiastically to the concept when it was enacted through the TCJA. It became part of Pillar Two, the 15% global minimum tax that was part of the package of reforms that the OECD created, initially as a response to digital taxation. The global minimum tax works in a similar way to GILTI--so similar, in fact, that at one point there were hopes that GILTI would be "grandfathered" into the system--and it includes a "substance-based carveout" with not only tangible assets but payroll.

Already, it’s starting to look like a formulary model.

At first, the formula was only being used to characterize income, not allocating it between jurisdictions–the province of the arm’s-length principle. But it didn’t take long to cross that threshold, as well. When the OECD released updated guidance and commentary in 2022, it included a new allocation key for countries to decide how to divide the under-taxed profits rule between themselves, when applied to a single jurisdiction. The formula would comprise the same two factors–assets and payroll.

The UTPR once stood for the under-taxed payment rule, and was based on many anti-abuse rules around the world that work by reducing deductions on outbound, related-party payments if those payments have been deemed abusive through some criteria. The concept dropped the connection to payments (though not the acronym), and can now be levied as a simple tax. This apparently made administration easier, but it also opened the floodgates on who could apply it. The rule needed a system for dividing the income and preventing double taxation, and it made sense to use the same formula it was already using.

The next question will be, can these systems really cohabitate? Can formulary remain as only a part of the system, its scaffolding, without eventually consuming it all?

What’s attractive about a formula is that it’s a rules-based approach. There’s no deeper principle to it, and that can be a plus. No doubt, some innocent taxpayers will be caught under it–many already have, with GILTI–and there isn’t much to say except “tough luck.” And likewise some transactions which could seem like abuse or tax avoidance may slip around them–in and of itself, that isn’t right or wrong, it just is. (Until the system can be changed.)

But that very arbitrary nature is what scares formulary critics the most. With no deeper principle, can formulary be contained? If it works for X% of the system, why not 2X%, or 10X%? Why not different factors, and who decides which ones? (Developing countries would prefer workforce headcount over payroll, for instance.) If the OECD thought the Two Pillars were hard, negotiating a new formula satisfying all nations would likely make them look like a picnic.

Contact the author at amparkerdc@gmail.com.