Sales Factor Apportionment is a territorial tax system designed to tax business profits based on where the sales of the company are located. So, the tax on a company’s profits are based (apportioned) on the proportion of worldwide sales made in the U.S. If a company sells 10% of its worldwide sales in the U.S., the company need only pay U.S. taxes on 10% of its worldwide profit. Sales Factor is also known as Destination-Based Profit Tax or Destination-Based Sales Factor Apportionment.
This is different from the Destination-Based Cash Flow Tax proposed by Speaker Ryan and Rep. Brady. The Cash Flow Tax uses a Border Adjusted Tax that will tax importers on the full value of their imports. It taxes the full value of the sale, not the profit from the import. Destination-Based Sales Factor Apportionment only taxes profits.
Both systems are destination-based because that refers to where the tax liability (taxes owed) are established. But the technical difference is in how the tax deductions and/or credits are established. The Cash Flow Tax uses an origin-based system to establish what value can be deducted from the taxes owed. This distorts the model and requires an unproven economic theory to argue that it will have no impact. Sales Factor Apportionment uses a destination-based system for value deductions in addition to keeping the calculations simple and efficient.
The US uses a “universal” system to tax US-based multinational companies. All of a US-based multinational’s worldwide income is subject to US income tax, less a credit for income taxes paid in the foreign countries in which the company operates. It is called “universal” because it attempts to collect US tax on income earned in all countries. However, there is one big loophole: tax on income earned in foreign countries is not subject to US income tax as long as it is “permanently invested” outside the U.S. It is only subject to U.S. tax when it is brought back to the U.S.in a process called “repatriation”. So foreign earnings are often kept abroad, untaxed by the US. These foreign, untaxed earnings now total about two trillion dollars.
In contrast to our “universal” system, foreign-based multinationals almost all use a “territorial” system of taxation. Under that system, companies only owe income tax on profits earned in their home country. For instance, a German multinational with income in Germany, Italy, France and the US would only owe German income tax on income earned in Germany.
A territorially based tax system only taxes profits earned in the state or country levying the tax. For instance, California would only tax profits earned in California.
Success has been illusive because of the increasing success of multinationals in moving earnings from high tax to low or no tax countries.
Placing intellectual property such as patents or trademarks to low tax countries and then charge the high tax subsidiary for their use, borrowing large sums in the high tax country, charging the high tax country high prices for intermediate products that are domiciled in the low tax country. There are many other more sophisticated methods of earnings stripping from high tax country operations.
Critics assert that US-based multinationals are at a competitive disadvantage compared with foreign-based multinationals because the US universal system is more burdensome than the territorial system used by foreign multinationals. However, others assert that since the multinationals pay greatly reduced taxes, it is the domestic companies that are at a competitive disadvantage.
When states began taxing corporations over a hundred years ago, individual states developed formulas for determining how much of a company’s profit was attributable to their jurisdictions. The most common formula was a combination of corporate assets, payroll and sales. Over time, sales became more prominent, and now many states rely solely on their proportionate share of sales in determining how much of a company’s total sales is subject to their state’s corporate income tax. In the 1980s California proposed to tax part of a company’s worldwide profits based on the percentage of the company’s worldwide sales occurring in California. This tax relied on a unitary principle that started with worldwide corporate profits. Barclays Bank sued to overturn the legislation allowing taxation of a proportionate share of worldwide income, but ultimately California’s legislation was upheld by the US Supreme Court. Earlier Prime Minister Margaret Thatcher exerted pressure on Ronald Reagan to in turn pressure states to adopt a water’s edge system that limited taxation to stated domestic profits. The states all complied after being threatened with federal legislation, but recently some states have moved to expand their income calculations to include a proportion of worldwide income.
We suggest the U.S. follow the lead of many states and tax profits based on the proportion of worldwide sales made in the U.S. The logic of worldwide taxation is questionable and because virtually all countries have changed to territorial systems, making the U.S. increasingly out of step with the rest of the world.
When US states first adopted formulary income tax systems over a hundred years ago they started with a three factor approach. There is an old adage that says to reduce something, tax it! No state or country would want to reduce either corporate assets or payroll.1 A company is unlikely to give up sales when a country decides to tax the profit from those sales because some profit is better than no profit. However, companies discovered that they could lower their total income tax obligations by exporting workers and factories to low-tax or no-tax states. In response, starting in the 1950s, states began to change their apportionment formulas from three factor formulas to either sales-only, or sales-weighted formulas.2 As Joseph Stiglitz has pointed out,3 tax policy should avoid taxing activities that are good. Employment and investment are beneficial activities, and SFA avoids taxing them. Currently, 35 of the 46 states that have an income tax have adopted sales-weighted or “single sales” formulas.4 Moreover, sales are the best proxy for economic activity, because income, unlike sales, can be easily shifted for accounting purposes to other countries. Virtually all economists believe that it is important to tax inelastic factors and sales are extremely inelastic and far more difficult to manipulate than other factors. Furthermore, sales are the output while assets and payroll are inputs or expenses. Every company will strive to maximize sales while minimizing expenses. Around the world there is renewed interest in various formulary apportionment proposals. The U.S trade deficit makes determining pretax profit based on sales by far the most advantageous formula for our country to use.
1 However, some states with major industries have been pressured to switch to the single sales factor by powerful state industries that use this leverage to reduce their tax bills.
2 Mazerov, Michael “The ‘Single Sales Factor” Formula for State Corporate Taxes” Center on Budget and Policy Priorities, March 27, 2001
3 Billmoyers.com, Seven Key Takeaways From Joseph E. Stiglitz’s Tax Plan for Growth and Equality, May 30, 2014.
4 Bernthal et. Al. “Single Sales-Factor Corporate Income Tax Apportionment: Evaluating the Impact in Wisconsin” The Robert M. La Follette School of Public Affairs University of Wisconsin–Madison, Pg 6. 2012
Sales Factor Apportionment is a system for taxing firms that operate in multiple tax jurisdictions. It is territorial, because it seeks to tax only the profits from activity that takes place within the US. Sales are used because they create the profits. Companies pay income tax in order to support the social infrastructure that makes economic activity possible. The US and most other countries have been using earnings as a proxy for economic activity. But this proxy has proven to be ineffective, because companies developed sophisticated accounting techniques for shifting earnings to tax havens.
The SFA system, based on economic principles, calculates taxable income territorially based on a simple, elegant, watertight formula. It deserves recognition beyond academic circles.
No. SFA is a method of determining income tax on companies only, based on their sales in the US. It would not change the way in which individual income is taxed.
SFA is not a sales tax; it is method of allocating income for tax purposes. It uses sales to determine how much of a US company’s worldwide income should be taxed here. For example, if half of a firm’s sales are in the US, then half of its worldwide income would be taxed in the US. With SFA, foreign sales, operations, and profits are not taxed, exactly the same as with a conventional territorial system.
Companies that do business only in the US would not be affected by SFA, since 100% of their sales are US sales. However, domestic-only companies would probably benefit from SFA, because it would level the competitive playing field between them and their multinational competitors. Currently, their multinational competitors often pay a much lower tax rate, due to the many loopholes in the current system.
The states of the US have been using SFA or a variant of it for many years. When states began taxing corporations over a hundred years ago, individual states developed formulas for determining how much of a company’s profit was attributable to each state. The most common formula was a combination of corporate assets, payroll and sales. Over time, sales became more prominent. Now many states rely solely on sales to determine how much of a company’s total income is subject to that state’s corporate income tax. This real-world experience is backed up with settled case law.
Yes. SFA would apply equally to foreign-based multinationals. For example, if a German company had 20% of its sales in the US, it would owe the US treasury income tax (at the US rate) on 20% of its world-wide income. This assumes that the German company has a Permanent Establishment (PE) here in the US.
International treaties define what does and does not constitute PE. It can be sales offices, warehouses, headquarters, etc. These definitions are less helpful in the digital age and Professor Reuven Avi-Yonah suggests that sales over a certain amount should create PE for tax purposes. Although Avi-Yonah suggested $1 million, we believe that a more defensible number is $2.5 million.
In the first instance, SFA rules would assume that all sales occur in the U.S. Then a company could make an affirmation, supported by documentation that some sales were made outside the U.S., and were not intended for sale here. The burden of proof would be on the company claiming non-US sales. That company’s CEO and CFO (upper management) would be required to personally attest to those facts. There would be a number of “safe harbor” methods that would establish that sales would remain outside the U.S. The rules would allow for a small amount of unintended “leakage”. This is a situation in which the International Harmonized Tariff System5 (HTS) would be useful. If the imported product had a different HTS code from the product this would clearly indicate that this was not a conduit sale.
5 “Harmonized Tariff Schedule of the United States” U.S. Publication 1401 c85, Chapter 85, http://www.usitc.gov/publications/docs/tata/hts/bychapter/1400c85.pdf, 2014.
The US could act on its own to adopt SFA. It is likely that other countries would follow the US lead, because all but low or no income tax global tax havens are suffering from base erosion. European countries through the EEC and others are showing renewed interest in several forms of formulary apportionment.
No. It is neither necessary nor beneficial that all countries adopt the same apportionment formula. For example, countries with natural resource based economies might want to include property or employment in their formulas. In the US, which has used apportionment for over a hundred years, the states use a variety of formulas. North Dakota uses a three-part formula, while California uses a sales-only formula. The US experience has proven that a system with diverse formulas can operate effectively and profitably. The same would be true on the international level.
The justification is the same as for the states that tax out-of-state corporations selling in that state, even though the out-of-state corporations lack headquarters or even substantial assets in that state. A company can operate, and earn profit, only if an infrastructure of security, judicial system, highways, education and other public services is provided. That infrastructure costs money, and those benefiting should contribute to its support. Legal precedent for apportionment taxation was established at the state level many years ago and most recently reaffirmed by the US Supreme Court in 1994.
Some have proposed grafting territorial taxation on top of our present broken system. However, doing so would only make aggressive tax avoidance by multinationals even worse. With a conventional territorial system, income could be more easily shifted to foreign subsidiaries where it would be immune from any US income tax. Since the US rate is 35%, a company could shift income to a tax haven such as Cayman Islands, where the corporate income tax rate is zero. The US Treasury is currently suffering a hemorrhage of lost tax revenue due to aggressive tax avoidance by multinationals. Grafting traditional territorial taxation onto our broken system would only increase the flow of lost revenue.
Yes. Sales Factor Apportionment (SFA) is advocated by well known tax specialists, including Kimberly Clausing from Reed College and Reuven Avi-Yonah of the University of Michigan. They have written several papers advocating sales determined profit allocation. One of these papers was published by the Hamilton Project. A short compilation is also available at the Tax Policy Center.
Recently Michael Udell and Aditi Vashist of the District Economics Group published research on potential revenues under various assumptions: Sales Factor Apportionment of Global Profits as an Alternative Construction of a Corporate Income Tax Base. Their study documents that there could be substantial revenue increases using the present rate and allowing all present tax expenditures or a decreased tax rate or any combination of the two.
The International Accounting Standards Board’s (IASB) International Financial Reporting Standards (IFRS) are required in over 90 countries and optional in many more. The US is committed to converge US GAAP with IASB and its IFRS as soon as 2015. IASB and IFRS will ensure that companies’ financial reports accurately reflect economic realities. GAAP allows LIFO (Last in First Out) inventory valuation and IFRS does not. When inflation is low the differences in annual income would be minor. Outside of inventory valuation the differences between GAAP and IFRS are not major. Some congressional proposals for business taxation propose eliminating LIFO. Companies are already reporting their results to shareholders and the SEC using GAAP. The combination of GAAP and IFRS has an additional benefit in that there would be not just the company and the IRS looking at the stated income, but also shareholders a key corporate constituency that wants to see greater rather than lower earnings. This third party surveillance not only provides a check on stated income, but would also greatly simplify reporting because the SEC, independent auditors and the shareholders all would monitor the results.
Put simply, GAAP is based on rules whereas IAS is based on principles. This difference means that GAAP has thousands of rules for transactions, and new ones must be created for changes in circumstances. Thus both from a financial reporting standard as well as for tax reporting, GAAP has many more rules and regulations than the principles-based IFRS. Given GAAP’s rules based philosophy, it seems logical that it could never be adopted in the more than 90 countries that require IFRS. Although IFRS may provide more flexibility than GAAP, their results should be roughly the same. From a practical standpoint there should be little difference between them in the future as they both work toward convergence. The differences are mainly in how assets are either expensed or depreciated over time and both systems have logical reasons for the methods they mandate.
Because reporting for tax purposes have been subject to powerful political pressures for many years, it has become encrusted with many arcane rules that have little or no basis in accounting theory, but give special privileges to various businesses and their practices. By calculating taxable income with GAAP and IFRS, almost all the special tax expenditures would be removed and the resulting taxable income calculations would be greatly simplified. This change alone should encourage a lower tax rate that would keep the revenue from IRS rules and GAAP roughly the same. Using Sales Factor Apportionment or Multi-Factor Apportionment as the method for determining what portion of a multi-national corporations’ pre-tax income should be subject to U.S. income taxation works equally well using either GAAP rules or IASB principles to calculate the multi-national corporation’s total pre-tax income.
Yes. The IASB starts with very important advantages. Because it is a new system, it isn’t weighted down with historical baggage that pulls accounting away from its basic purpose of presenting profit fairly and accurately stated. Because it is based on bedrock principles instead of ever-changing rules, and because those principles mandate that accounting reflect the underlying economic transaction and valuation, it keeps accounting from being pulled in unfortunate directions. Also, because it is required in over ninety countries and optional in more than 35, no single country or industry is likely to sway the principles upon which the system is based. Both systems have their adherents and both GAAP and IFRS may differ in interpretation between countries.
Company compliance costs would be drastically reduced because international companies have already been filing IFRS statements for foreign governments and GAAP statements for the SEC and separate IRS accounting would no longer be required. The IRS would also see a substantial cost reduction as well.
A major benefit would be that the SFA system does not tax exports. This will encourage export sales, which will help to reduce our chronic balance of trade deficit. Furthermore, since the U.S. historically imports substantially more goods and services than it exports, taxing foreign companies on their sales in the U.S. would more than offset any revenue loss from losing revenues from export sales.
SFA would make ineffective most of the tax avoidance schemes that have allowed companies to shift profit overseas. SFA would solve this problem for the future, but it would not affect the two trillion dollars accumulated in the past under current law, that now sits untaxed overseas. That is a separate problem.
Some have suggested a “repatriation tax holiday” in which companies that now hold untaxed foreign income could bring it back to the US and pay a very low rate. This was done in 2004 with a maximum rate of 5.25%. The intent of Congress at that time was that this money would be used to increase US jobs. However, most of the repatriated money was used for other purposes,sometimes to the detriment of their purely domestic competitors.
An alternative to a tax holiday is to treat overseas untaxed income in much the same way as current income would be taxed under SFA. One way to do that would be to take the historical ratio for the last ten years of the company’s domestic sales to its worldwide sales and multiply that ratio times the company’s worldwide pretax profits. Then compare the company’s historical domestic profits as reported to the IRS to its historical worldwide profits as reported to the IRS. If the domestic profit ratio was equal to or higher than the domestic sales ratio, then no back taxes would be owed. If the reported domestic profits were less than the calculated domestic profits, then tax would be owed on the deficiency. The tax rate and payment terms would be approximately the same as the future tax rate on domestic profits. For these companies, the good news is that they have avoided paying taxes at substantially higher rates on many years of profits and that now that they must pay up, they have two major advantages: a portion would be completely tax exempt and they have benefitted from many years of an interest free government loan on the balance.
A formula illustrates the concept:
TL = [(USR/WWR) – (USP/WWP)] x WWP x CT
- TL = tax liability
- USR = 10 year United States revenue
- WWR = 10 year worldwide revenue
- USP = 10 year pretax domestic profits
- WWP = 10 year pretax worldwide profits
- CT = corporate tax rate
Subtracting the profit proportion of U.S to worldwide profits from the revenue proportion of U.S revenues to worldwide revenues gives the proportion of overseas earnings to be taxed. If the proportion is negative then no tax would be owed.
Inversions would stop because most of the incentive for them would disappear. Since SFA taxes only the US sales portion of world-side profits, it does not matter where a company is domiciled.
Because domestic companies and U.S. multinationals would no longer be at a tax disadvantage in world markets the tax rate could be chosen for other reasons. Thus, the tax rate would be independent of competitive needs and determined by other factors. Under SFA Congress would have the choice either to lower rates, or to use the additional revenue to meet national needs such as infrastructure, or some combination of the two. This would be a purely political decision.6 Research has shown that if all the additional revenue was allocated to rate reduction and no existing tax expenditures eliminated, the US corporate income tax rate could be lowered from 35% to 28% absent any behavioral changes which might occur because of the new tax system.
6 Economics would suggest that congress could even raise rates without disadvantaging U.S. businesses!
Companies that are paying at or close to the 35% rate will benefit from the lower rates that SFA make possible. These are largely domestic companies and small businesses. These same companies will also benefit because the competitive playing field between them and their multinational competitors will be leveled. Others that will benefit are companies that export much of their product, as export sales are not taxed under SFA. However, companies that have hired armies of tax lawyers and accountants to exploit the many loopholes in our current system, and that therefore pay little or no tax now, would see their tax obligation increased.