In his recent article, “A Cursory Analysis of the Impact of Combined Reporting in the District”, Dr. Eric Cook claims that the District of Columbia’s (D.C. or the District) newly implemented combined reporting tax regime is an effective means of increasing tax revenue from corporate taxpayers, but it will have little overlap with D.C.’s ongoing federal-style section 482 tax enforcement. Dr. Cook is chief executive officer of Chainbridge Software LLC, whose company’s product and services have been utilized by the District to analyze corporations’ inter-company transactions and enforce arm’s length transfer pricing principles. Combined reporting, (i.e., formulary apportionment, as it is known in international tax circles) and the arm’s length standard, are effectively polar opposites in the treatment of inter-company taxation. It is inappropriate for the District (and other taxing jurisdictions) to simultaneously pursue both. To do so seriously risks overtaxing District business taxpayers and questions the coherence of the District’s tax regime.
Both combined reporting and 482 adjustments have had a renaissance in the past decade. Several tax jurisdictions, including the District, enacted new combined reporting requirements to increase tax revenue and combat perceived tax planning by businesses. At the same time, some tax jurisdictions, once again including the District, have stepped up audit changes based on use of transfer pricing adjustment authority. This change is due in part to new availability of third-party consultants and the interest in the issue by the Multistate Tax Commission (MTC). States have engaged consultants, such as Chainbridge, to augment state capabilities in the transfer pricing area. At the request of some states, the MTC is hoping to launch its Arm’s Length Audit Services (ALAS) program. States thus have increasing external resources available for transfer-pricing audits.
A similar discussion regarding how to address inter-company income shifting is occurring at the international level, but with a fundamentally important different conclusion. The national governments of the Organization for Economic Cooperation and Development (OECD) and the G-20 are preparing to complete (on a more or less consensual basis) their Base Erosion and Profit Shifting action plan. This plan will reject formulary apportionment as a means of evaluating and taxing inter-company transactions. Thus, in the international context, formulary apportionment and transfer pricing adjustment authority are not seen as complementary, but instead are seen as mutually exclusive alternatives. The history of formulary apportionment in international context sheds light on why states make a mistake when they seek to use both combined reporting and transfer pricing adjustments.
A combined reporting basis of taxation seeks to treat the members of a consolidated group as a single entity, consolidating financial accounts of the member entities and allocating a portion of the consolidated income to the taxing jurisdiction based on some formula or one or more apportionment factors. Under the arm’s length approach, individual entities of a consolidated group within a single jurisdiction are treated (generally) as stand-alone entities and taxed according to the arm’s length value (the value that would be realized by independent, third party entities) of their inter-company transactions.
National governments have for decades wrestled with the taxation of inter-company transactions amongst the largest corporations and the most complex transfer pricing arrangements. Going back to the earliest days of corporate income taxation, the “economic experts” to the League of Nations rejected formulary apportionment for cross-border taxation, having found, “the methodology has no fundamental basis in economic theory which is capable of easy application”.
Arguments in favor of combined reporting (formulary apportionment) generally center on simplicity of concept, administrative ease and reduced compliance burden, along with increased, comprehensive (and thereby, effective?) revenue collection. These arguments are generally from the perspective of the taxing authorities—who struggle with lack of resources, information and a complexity of rules and corporate structures.
And, yet, as is evident from the eight-part article authored by Michael Durst, former Director of the Internal Revenue Service (IRS) Advance Pricing Agreement program—devising and implementation of a formulary apportionment regime is anything but simple, or its results anything but certain or effective. Aside from the structural issues of determining the tax base (in terms of the inclusion of income categories and the disallowance of deductions, as well as inclusion/exemption of corporate members) and the selection of apportionment factors, there is the entire political issue of jurisdictional consensus. Then there are the economic issues, both theoretical and practical—in terms of tax incidence, incentives and economic substance, to name a few. In terms of today’s most vexing transfer pricing problem facing both state and national tax authorities—matching tax receipts with economic activity/value creation— combined reporting offers an imprecise and spurious solution.
States Should Make a Choice
Because transfer pricing adjustments and combined reporting are alternatives, not complements, states should choose which system to adopt. States that seek to utilize both lack a coherent tax imposition policy and create significant risk that their business taxpayers will be double taxed.
The international context explains why states with existing transfer pricing adjustment programs should reject adopting combined reporting. In the case of the District’s combined reporting regime, Dr. Cook’s claim that the program is both more effective (increases tax revenue) and efficient (non-overlapping) is both unlikely and one-sided. From the District’s standpoint, it may be true that they experienced an increase in tax revenue, but what is more likely that this is a “shift” (or more accurately, a double count) in tax liability from one jurisdiction to the next. One of the (other) problems with implementing combined reporting, especially on a unilateral basis, is defining the tax base and segmenting economic activity that originates in one jurisdiction and culminates in another, so as to ensure a single tax on the same unit of economic activity.
It is likely that the reported increased tax revenue cited by Dr. Cook is nothing more than an expanded reporting of revenue among entities established and operating outside of the District and selling into the District—that is, entities whose physical presence and economic talents (activity) are outside of the District but whose products are sold within or with nexus to the District. Unless the District’s program has some mechanism to identify (and inter-state agreement to credit) the increased tax liability associated with economic activity (value creation) in other tax jurisdiction(s), it will only be taxpayers that will realize a “real” increase in (double) tax.
Dr. Cook incorrectly asserts that combined reporting and transfer pricing should co-exist. The fact that additional revenue can be earned from imposing both regimes does not mean that both regimes should be implemented. He specifically notes that 30 taxpayers, or 10 percent of his sample, would have tax increases based partially on the effects of combined reporting and partially as a result of transfer pricing adjustments. This is an unacceptable overlap of competing tax regimes. Furthermore, Dr. Cook supports imposing both systems because most of the companies sampled did not have an increase in tax under the combined reporting regime but did under a transfer pricing analysis. This does not suggest that both regimes are necessary to properly calculate tax, but rather that both regimes are attractive to state revenue authorities because it increases their odds of finding new tax money. If someone asks us if we would like a cookie, a bowl of ice cream or both, we are always going to take both. This does not mean it is the appropriate thing to do.
Finally, while Dr. Cook does not directly address the issue, it is likely that any valid transfer pricing adjustment in a combined reporting regime is a result of international, rather than purely domestic, inter-company transactions. If this is true, this causes additional problems for Dr. Cook’s position. Many subnational tax jurisdictions, including the District, may not have the authority to make transfer pricing adjustments affecting international transactions if the IRS has declined to make such modifications. Furthermore, the taxation of international transactions on an arm’s length basis and domestic transactions on a formulary apportionment basis raise significant commerce clause issues for certain taxpayers. Thus, jurisdictions like the District that use these contrary regimes risk undermining the validity of their entire inter-company tax program.
 We love this acronym so much, we are thinking of getting T-shirts made.
 See Bloomberg BNA, “OECD’s Saint-Amans Says BEPS Debate Over Formulary Apportionment is Finished”, Transfer Pricing Report, April 3, 2014.
 See Wells, B. and C. Lowell, “Tax Base Erosion and Homeless Income: Collection at the Source is the Linchpin”, 65 Tax Law Review 535, University of Houston Public Law and Legal Theory Series, 2011 A-6, pg. 549
 See Michael Durst, “Starting the Conversation: A Formulary System For Dividing Income Among Taxing Jurisdictions,” 22 Transfer Pricing Report 98, 5/16/13; “Analysis for Dividing Income, Part II: Examining Current Formulary and Arm’s-Length Approaches,” 22 Transfer Pricing Report 270, 6/27/13; “Analysis of a of a Formulary System Formulary System for Dividing Income, Part III: Comparative Assessment of Formulary, Arm’s-Length Regimes,” 22 Transfer Pricing Report 653, 9/5/13; and “Analysis of a Formulary System, Part IV: Choosing a Tax Base,” 22 Transfer Pricing Report 771, 10/17/13, Analysis of a Formulary System, Part V: Apportionment using a Combined Tax Base,” 22 Transfer Pricing Report 972, 11/28/13, Analysis of a Formulary System, Part VI: Building the Formula,” 22 Transfer Pricing Report 1180, 1/23/14, Analysis of a Formulary System, Part VII: The Sales Factor,” 22 Transfer Pricing Report 1414, 3/20/14, Analysis of a Formulary System, Part VIII: Suggested Statutory, Regulatory Language for Implementing Formulary Apportionment,” 23 Transfer Pricing Report 70, 5/1/14.
 See Garry Stone and Elif Ekmekci-Taskiran, “Formulary Apportionment: The Case of Missing Income”, 22 Transfer Pricing Report 867, 11/14/2013.