Leave Worldwide Combined Reporting in the ‘80s, Where It Belongs

Given enough time, everything old is new again—including taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
ideas best consigned to history. But worldwide combined reporting, which a few states flirted with in the 1980s, is rearing its head again. It was nearly enacted in Minnesota this past session, and now lawmakers in New Hampshire are awaiting the analysis of a study commission formed to review the proposal.

States had good reason to scrap the idea in the ‘80s. And this is one product of the ‘80s that is absolutely not due for a revival.

It is easy to understand the superficial appeal of mandatory worldwide combined reporting. State officials fear that multinational companies are misusing transfer pricing—the prices one division or subsidiary of a major corporation charges another for goods or services—in low-tax foreign jurisdictions, reducing the share of domestic profits for tax purposes. But worldwide combined reporting is dramatically out of proportion to the issue, like taking a sledgehammer to a tack.

Domestically, states are divided on whether they use separate accounting or combined reporting—that is, whether they only tax companies that have nexus in their state, or whether they tax all of their affiliates and subsidiaries as well. At first glance, it might sound like the latter approach taxes far more income, but that’s not the case, given how corporate apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders.
works at the state level.

Each state with a corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.

apportions corporate activity to the state for tax purposes based on some combination of the share of sales, payroll, and property in the state. Increasingly, many states rely exclusively on sales (known as “single sales factor”). Imagine a company with two subsidiaries, one operating entirely in Wisconsin, and the other doing business only in Iowa. They have the same volume of sales and the same level of profitability. Wisconsin, with combined reporting, would tax half the profits of both subsidiaries, while Iowa, with separate accounting, would tax all the profits of the Iowa entity but none of the profits of the other company in the unitary group.

In our example, these two different approaches yield the same amount of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
. But if the Wisconsin entity was more profitable than the Iowa one, then Wisconsin would lose out by having combined reporting (since these profits are averaged with the less profitable Iowa affiliate), whereas Iowa would generate more revenue if it adopted combined reporting.

Sometimes subsidiaries and affiliates may be closely interrelated. Other times they may reflect different regional divisions or different products with distinct markets. If the Wisconsin company has no sales in Iowa and vice versa, it doesn’t make much sense that Iowa would aggregate the sales. It’s a model based in part on the idea that companies may house their intellectual property in one entity in a more favorable jurisdiction, but it’s a broad, blunt approach, combing all corporate activity—often imposing the wrong tax, in the wrong place, at the wrong rate.

But whatever one thinks of the pros or cons of mandatory unitary combined reporting across states, there are extremely strong reasons to ensure that this regime ends at the water’s edge. Currently, while a few states allow companies to opt into worldwide combined reporting, no state mandates it. They are right not to.

States apportion corporate income, as mentioned above. Countries do not. Multinational corporations are taxed abroad not only on a separate accounting basis, but without any sort of formulary apportionment based on the location of sales, payroll, or property. Instead, countries tax companies based within their borders, and activity taking place within their boundaries, and extend credits for taxes paid to other countries. In this way, tax treatment is much like how state individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.
es (but not corporate income taxes) work in the United States. Adopting worldwide combined reporting is a mix-and-match approach, apportioning income that is also being taxed under a different regime elsewhere, without offering credits for taxes paid to other jurisdictions. The U.S. apportionment system has its own problems with double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income.
, but by mixing two radically different ways of determining the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
associated with a particular country or state, worldwide combined reporting elevates double taxation to an art form.

When states force companies to apportion some of the profits of their foreign subsidiaries, they also massively increase compliance costs for many businesses, since those subsidiaries’ books must be converted from local rules to align with U.S. and state accounting rules, and transactions recorded in different currencies must be standardized. Factors that do not matter for taxation elsewhere—like the payroll of all affiliates in all countries, even for subsidiaries that do no business in the United States—must be tracked to comply with a single state’s apportionment regime.

Unfortunately, some policymakers have been enticed by highly inaccurate projections of potential revenue gains by adopting worldwide combined reporting. An analysis by one progressive group, which we have critiqued previously, takes two high estimates of the amount of profit-shifting to foreign countries and simply allocates shares of those foreign-shifted profits to each state. All projections have to make certain simplifying assumptions, but the fundamental assumption here is indefensible, and policymakers should understand that the projections are completely divorced from how worldwide combined reporting actually works.

Profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens.
does happen, but, overwhelmingly, the international activity by multinational corporations is not profits shifted out of the U.S., but actual business activity in other countries. The U.S. is not the only country where goods and services are produced or sold. Worldwide combined reporting would aggregate all the activity—profits and losses—of all affiliated entities worldwide, and then apportion a state-specific share of it.

Imagine, for instance, that a company had $10 million worth of sales in New Hampshire and $990 million in sales in Europe. Whether under the current regime or worldwide combined reporting, New Hampshire is still only able to tax the share associated with $10 million in sales. The question is whether the activity they’re taxing is the entire portion actually associated with New Hampshire, or whether it is one percent of the worldwide activity. New Hampshire gains from worldwide combined reporting—at substantial administrative and compliance costs—if the foreign activity has higher profit margins than the New Hampshire activity, and loses if it’s the other way around.

What categorically does not happen: New Hampshire doesn’t continue to tax all the New Hampshire activity, then any share of profits that U.S.-based companies shifted to foreign subsidiaries. (For more on this, click here.) Regrettably, estimates based on this fundamentally flawed model of worldwide combined reporting continue to be taken seriously.

About four decades ago, the last brief experiment with worldwide combined reporting came to an end, amidst well-founded concerns that the policy violated international treaty obligations, a widespread recognition that it imposed unacceptably high compliance and administrative costs, and an acknowledgment that most of the taxed activity had no real connection to the taxing state.

A U.S. Treasury working group was established in 1983. The Chairman’s report urged all states to adopt water’s edge reporting (not taxing earnings and activity abroad), and the state members of the working group concurred, a group that included signatories representing the National Conference of State Legislatures, the Multistate Tax Commission, and the National Association of Tax Administrators (since subsumed into the Federation of Tax Administrators). The other state elected representatives were the governors of California and Utah and the Speakers of the House of Florida and—notably—New Hampshire.

They got it right 40 years ago. There’s no good reason to turn back the clock to implement state tax bases so divorced from activity in any way connected to the taxing jurisdiction.

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