United States General Accounting Office

GAO Report to the Honorable

Byron L. Dorgan, U.S. Senate

July 1995 TAX POLICY AND

ADMINISTRATION

California Taxes on

Multinational

Corporations and

Related Federal Issues

GAO/GGD-95-171

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-260129 

July 11, 1995

The Honorable Byron L. Dorgan

United States Senate

Dear Senator Dorgan:

This report responds to your request for information on (1) California’s

experience in conducting formulary apportionment audits of multinational

corporations and (2) issues that would have to be considered before

adopting a formulary system at the federal level.

For tax purposes, states generally use a formula to apportion the income

of corporations among the states in which they do business. The formula

typically is based on the amount of a corporation’s property, payroll, and

sales within a state compared with the amount within the United States as

a whole. A percentage is calculated for each of the three factors, and the

average of the three is generally applied against a corporation’s income to

determine the amount the state will tax.

The formulary approach can be applied to a single corporation or to a

group of related corporations.1

 In the latter case, the formula is applied to

the combined income of affiliated corporations in a corporate group that

have been determined to be unitary. This determination is based on the

degree to which the activities of the affiliated companies are

interdependent.

Through much of the 1980s, California applied its formula for apportioning

income on a worldwide basis. This required multinational enterprises to

apportion a share of their worldwide income to California, including the

income of foreign parent and subsidiary corporations if their operations

were closely integrated or unitary with California business activity.

Beginning in 1988, taxpayers in the state were allowed to choose to

exclude the income of most foreign affiliates from apportionment if the

taxpayers paid a fee and met other requirements. In 1993 California

enacted legislation that eliminated the fee and modified other

requirements. Unless taxpayers choose not to do so, however, they can

still file their tax returns on a worldwide basis.

In contrast to a unitary tax system that combines the income of related

corporations within a multijurisdictional enterprise for tax purposes, the

1

Corporations that are connected through stock ownership with a common parent corporation are

considered to be related.

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U.S. government and the governments of other countries use a “separate

accounting” method that treats each corporation as a separate entity.

Under separate accounting, the income of related corporations is

determined on the basis of “transfer prices” charged for transactions with

other corporations in the enterprise. If prices set for transactions between

a corporation and its affiliate operating in a different country are set too

high or too low, income is, in effect, shifted from one country to another,

and taxes may as a result be avoided in one country and be higher in

another.

To mitigate this situation, the Internal Revenue Service (IRS) applies an

“arm’s length” standard that requires that the results of a transaction

between related corporations be consistent with the results that would

have been realized if unrelated taxpayers had engaged in the same

transaction under similar circumstances. In previous products, we have

discussed the difficulties that IRS faces in administering the arm’s length

standard.2 IRS examiners must collect a great deal of data and use

considerable subjective judgment to determine the appropriate transfer

prices and have had difficulty sustaining their findings. For example, we

reported that, in its appeals and legal processes in 1993 and 1994, IRS

sustained less than 30 percent of the $1.9 billion in proposed adjustments

related to the Internal Revenue Code section covering transfer pricing.

Legislative and regulatory changes have been made in recent years in

trying to alleviate transfer pricing problems.

Worldwide formulary apportionment avoids transfer pricing problems by

using a formula rather than transfer prices to determine each corporation’s

share of the combined income of related corporations. Consequently,

some state tax officials and other tax experts have advocated formulary

apportionment as an alternative to the existing federal arm’s length or

separate accounting tax system. However, worldwide formulary

apportionment has been controversial. Some tax experts believe that it is

not a viable alternative to the existing tax system. Further, many foreign

governments and multinational corporations are opposed to it.

In our discussion of issues that would need to be considered before a

federal formulary apportionment system could be adopted, we considered

the views of tax experts on worldwide formulary apportionment.

Separately, we discuss the policies and procedures of the California

2

International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices

(GAO/GGD-92-89, June 15, 1992); International Taxation: Updated Information on Transfer Pricing

(GAO/T-GGD-93-16, Mar. 25, 1993); and International Taxation: Transfer Pricing and Information on

Nonpayment of Tax (GAO/GGD-95-101, Apr. 13, 1995).

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Franchise Tax Board (FTB), which is the state agency responsible for

administering individual and corporate income tax law in California. On

the basis of data we collected from our case studies and a random sample

of FTB audits, we provide information about FTB on matters such as how it

deals with foreign accounting standards.

Results in Brief Under worldwide formulary apportionment, a key issue that FTB auditors

had to determine was whether California corporations that were part of a

multinational enterprise were engaged in a unitary business with affiliated

U.S. and foreign corporations. This determination was based on a complex

analysis of the enterprise’s ownership and business operations. Auditors

then used the parent corporation’s audited financial statements, federal

tax returns, and other records to ensure that state tax was based on the

income and the apportionment factors for all corporations comprising the

unitary business.

In the audits of foreign-controlled corporations that we reviewed,3 FTB

adjusted income and other apportionment data to account for differences

between U.S. and foreign accounting standards and record keeping. FTB

auditors focused on differences that they considered to have a material

impact. They made six adjustments in the five audits that we selected for

in-depth case studies. Auditors reviewed the annual audited financial

statements of the foreign parent corporation and requested, but did not

always obtain, additional data from taxpayers that were needed to

determine the effects of different accounting standards and record

keeping. As a result, auditors sometimes made determinations on the basis

of available data and used estimates and assumptions in making

adjustments.

Although we do not discuss in this report whether formulary

apportionment should be adopted at the federal level, we do describe

matters that would need to be addressed before this practice could be

adopted. These matters include the design and administration of a federal

unitary system. For example, unitary business and apportionment factors

would have to be defined and the United States would also have to

consider the international feasibility of formulary apportionment, a system

that generally is opposed by other countries. Tax experts disagree on

whether the problems associated with such issues can be resolved in a

federal unitary system.

3

For purposes of this report, a foreign-controlled corporation is a corporation incorporated in the

United States that has 50 percent or more of its voting stock owned by a foreign parent corporation.

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Objectives, Scope,

and Methodology

Our objectives were to obtain information on (1) California’s experience in

conducting formulary apportionment audits of multinational corporations

and (2) issues that would have to be considered before adopting a

formulary system at the federal level.

To obtain information on California’s experience in conducting audits

under worldwide formulary apportionment, we first needed to identify

multinational enterprises with parent or subsidiary corporations doing

business in California. Since FTB officials did not know which of the

roughly 24,000 California corporations that apportion income were part of

multinational enterprises, we decided to focus on large corporations that

we determined to be multinational and in California. We determined this

by first comparing the 1,656 corporations in the IRS’ Coordinated

Examination Program with those in the state’s audit database.4

 After

matching the data and further researching corporate affiliations to verify

multinational status, we identified 870 multinational corporations doing

business in California. According to a state analysis, these corporations

and their California affiliates accounted for $11.4 billion of the $18.2 billion

in net income that was apportioned to California for the 1991 tax year.

Our detailed examination of audit files was based on a sample of 124

audits. This random sample included audits of large corporate tax returns

conducted by FTB primarily for tax years 1980 to 1989. Since FTB policy is

to audit returns that it believes are especially likely to yield additional

taxes, our sample is not representative of all corporate unitary tax returns.

We obtained the 124 audit files for our examination by first randomly

selecting 277 of the previously identified 870 large corporations. Of the 277

corporations, 157 were determined to be eligible for our study because

they had been audited by FTB and had not filed on a “water’s-edge” basis.5

We requested files for the most recent audits of all 157 corporations to

obtain information on audit hours, apportionment issues such as

determining if affiliated corporations should be included in a unitary

business, and the impact of the audits on corporate tax liability. Files for

4

The Coordinated Examination Program audits the country’s largest and most complex corporations,

usually those with more than $250 million in assets.

5

In a water’s-edge situation, a taxpayer’s liability stops at the borders of the United States since

generally only the income of U.S.-affiliated corporations, and not foreign affiliates, is subject to

apportionment.

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B-260129 

33 audits were incomplete or could not be located in time for our review,

so we ultimately reviewed a total of 124 audit files.6

We also selected five U.S.-controlled and five foreign-controlled

corporations for more in-depth case studies to enhance our understanding

of apportionment audit issues and procedures, including the state’s

method of dealing with foreign accounting standards and record keeping.

We randomly selected our initial cases. However, after determining that

audits of some foreign-controlled corporations did not meet our selection

criteria, we judgmentally substituted three corporations that included

different countries and types of businesses.7

 We also reviewed FTB’s

analysis of unitary business relationships in an additional audit of a

U.S.-controlled corporation identified by FTB to better understand that

process.8

In general, we also discussed with FTB officials their audit process and

views on administering a worldwide formulary apportionment system. In

addition, we reviewed audit manuals that described California’s

apportionment audit procedures, and we analyzed reports on the results of

the state’s audit and appeals processes.

To identify issues that would need to be considered before a federal

unitary system could be adopted, we analyzed articles and surveys of state

tax laws. Our review of the California audits identified difficult issues that

we concluded might also arise in a federal system and the procedures that

the state used to address these issues. We also discussed the issues with

experts who favored formulary apportionment and those who did not.

These included academicians, state and federal government officials,

representatives of multinational corporations, and attorneys advocating

opposing positions.

Proponents of the unitary system asserted that it would be easier to

administer the unitary system at the federal level than to administer the

arm’s length approach. In this report, we do not evaluate this claim

because we did not compare a federal unitary system with the arm’s length

6

FTB had difficulty providing us with all of the audit files because they were being used by their staff in

places such as Chicago, Houston, and New York or for postaudit activities such as protest, appeals,

settlement, litigation, or collections. For 32 corporations where files were incomplete, we substituted

audits of other years.

7

FTB audit records indicated the corporations originally selected either were not foreign-controlled or

had not been audited during the timeframe of our sample.

8

FTB’s analyses of unitary business relationships for the U.S.-controlled corporations originally

selected generally were limited because a unitary analysis was done in previous audits.

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approach. A proper comparison would require that we specify a federal

system in some detail and that we overcome considerable data problems.

For example, our review of how California audits corporations for

membership in a unitary group would not accurately describe such audits

in a federal system if the federal government adopted a different definition

of the unitary business. Our discussion focuses instead on the issues that

would need to be considered in designing, administering, and moving to a

federal unitary system.

Appendix I discusses FTB audits of U.S.- and foreign-owned multinational

corporations under worldwide formulary apportionment. It includes

information on audit issues, California’s treatment of foreign accounting

standards, the average hours state auditors spent per audit, and the impact

of audits on California corporate tax liability. Appendix II summarizes our

case studies, and appendix III discusses some issues that would need to be

addressed in a federal formulary system such as (1) definitions of unitary

businesses, apportionment factors, and apportionment formulas; (2) the

need to reconcile financial and tax accounting rules; and (3) the need to

coordinate internationally any movement to a formulary system.

As requested, the Department of the Treasury and California’s FTB

provided written comments on a draft of this report, which are reprinted

in appendixes IV and V. We discuss their comments as well as those of the

Multistate Tax Commission (MTC)9

 on pages 12 through 16.

We did our work in Washington, D.C., and Sacramento, California, from

August 1993 through March 1995 in accordance with generally accepted

government auditing standards.

Background California administers the largest formulary apportionment program

among the states, according to MTC officials. At the time of our review, FTB

had 116 audit staff in Chicago, Houston, and New York offices that did

apportionment audits and another 242 staff in California district offices

that did some apportionment work but who were also responsible for

other types of audits. An FTB official estimated that a total of about 127

staff years were used for apportionment audits in FTB’s 1992/1993 fiscal

year, resulting in $438 million in additional tax assessments. Overall, FTB

completed 1,084 apportionment audits during the year.

9

MTC is an administrative agency of the Multistate Tax Compact. The compact has been entered into

by 20 states and the District of Columbia as full members and 15 additional states as associate

members.

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For the 1991 tax year, 24,650 domestic and multinational corporations

apportioned $18.2 billion in net income to California. Although these

corporations represented only 5.7 percent of the 432,242 corporations that

filed tax returns in California, they accounted for 95.4 percent of the total

$19 billion in corporate net income that was reported. Corporations

apportioned an average of 8.6 percent of their unitary income to California

on the basis of average factors of 10.5 percent for property, 10.3 percent

for payroll, and 5.1 percent for sales.

California has made changes to its worldwide formulary apportionment

tax requirements in recent years, partly in response to the concerns of the

federal government and the domestic and international business

communities. In 1986, the state enacted legislation that generally allowed

taxpayers to exclude the income of foreign affiliates from apportionment

for 1988 and later if the taxpayer paid a water’s-edge election fee and met

certain other requirements. This legislation was enacted partly in response

to the conclusions of a U.S. Treasury-sponsored working group composed

of representatives of the federal and state governments and the business

community.10 In 1993, California enacted legislation allowing taxpayers to

make the water’s-edge election beginning in 1994 without paying a fee.

Beginning in 1993, state legislation also modified the apportionment

formula by double-weighting the sales factor.

U.S. and foreign multinational corporations have challenged the

constitutionality of worldwide formulary apportionment in state and

federal courts. In 1994, the U.S. Supreme Court considered the claims of

Barclays Bank PLC, a foreign multinational, and Colgate-Palmolive

Company, a U.S. multinational. Barclays contended that California’s

worldwide unitary tax system unconstitutionally burdened foreign-based

multinationals by imposing an inordinate compliance burden and by

creating an enhanced risk of double taxation, violating the commerce and

due process clauses of the U.S. Constitution. Barclays and Colgate

contended that application of California’s tax system for worldwide

operations offended the commerce clause by impeding the federal

government’s ability to “speak with one voice when regulating commercial

relations with foreign governments.”11

10The final report of the Worldwide Unitary Taxation Working Group, released in 1984, made

recommendations for the states to mitigate the international effects of formulary apportionment,

including limiting its use to the water’s-edge.

11In 1983, the U.S. Supreme Court had upheld worldwide combined reporting for U.S.-based companies

in Container Corporation of America v. Franchise Tax Board of California, 463 U.S. 159 (1983).

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In a June 20, 1994, decision, however, the U.S. Supreme Court upheld

California’s right to tax on a worldwide combined reporting basis.12 The

Supreme Court found that California’s system did not violate the

commerce or due process clauses of the U.S. Constitution. The Supreme

Court found that Barclays had not shown that California’s system imposes

inordinate compliance burdens on foreign-based multinationals and that

the system does not expose multinationals to constitutionally intolerable

multiple taxation. The Supreme Court stated that multiple taxation is not

the inevitable result of California’s system and that separate accounting

cannot eliminate, and in some cases may even enhance, the risk of double

taxation. The Supreme Court also found that California’s system does not

prevent the federal government from speaking with “one voice” in

international trade. The Supreme Court noted that Congress, which has

the role of regulating foreign commerce under the Constitution, has not

prohibited the states from using worldwide combined reporting. Although

the Supreme Court ruled in favor of California, state officials have since

said they have no intention of reinstating requirements for mandatory

worldwide formulary apportionment.

California Audit

Practices

A key issue in FTB audits of California corporations that were part of

multinational enterprises that we reviewed was determining if these

corporations were engaged in a unitary business with affiliated U.S. and

foreign corporations. To make unity determinations, auditors reviewed a

wide range of information on corporate ownership and business

operations. The analyses were complex because they required auditors to

obtain and analyze information on the management and business

relationships of the parent and subsidiary corporations that comprised a

multinational enterprise. For example, the analyses could consider the

extent of intercompany sales and purchases, the existence of common

advertising and marketing functions, the transfer of technical knowledge

between affiliated corporations, and intercompany transfer of personnel.

According to FTB officials, obtaining information to make this

determination sometimes was harder in the case of foreign-owned

multinationals than for U.S.-owned firms. In appendix I, we discuss the

criteria FTB used to determine unity as well as its data sources and

examples of its unity analyses.

If corporations comprising a multinational enterprise were found to be

unitary, FTB auditors used the parent corporation’s audited financial

12Barclays Bank PLC v. Franchise Tax Board of California and Colgate-Palmolive Company v.

Franchise Tax Board of California, 114 S. Ct. 2268 (1994).

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statements, federal tax returns, and other records to audit income and the

apportionment factors. FTB auditors recalculated taxable income and

assessed additional taxes, if necessary, when California taxpayers did not

include the unitary business income of affiliated domestic and foreign

corporations on their tax returns. Auditors also heavily relied on

information obtained from federal tax returns and audited annual financial

statements to check the accuracy of unitary income and other

apportionment data. FTB audits of unitary income and property, payroll,

and sales apportionment factors are discussed in appendix I.

For our random sample of 124 California audits of large multinational

corporations targeted for their additional tax potential, FTB used an

average of 511 audit hours—although the hours per audit varied

widely—and proposed a total of $176.9 million in additional tax

assessments. Of the $176.9 million, taxpayers agreed to pay $33.8 million

and contested $143.1 million through the state’s protest, appeals, or

settlement process. FTB also proposed additional taxes of $28.9 million on

the basis of IRS audits of these taxpayers. Since similar income and

expenses are reported on state and federal tax returns, according to FTB

officials, FTB generally depends on IRS for auditing them.

FTB auditors cited unity as one reason for proposing additional taxes of

$134.7 million in 68 audits, or $2 million per audit, compared with

$42.2 million for the 56 audits without a unity issue, or $0.8 million per

audit. Unity was also the auditors’ most complicated and time-consuming

task. The 68 audits involving unity issues took 603 hours on average

compared with 399 hours for 56 audits that did not involve unity issues.

The importance of the composition of the unitary business was further

demonstrated in our 10 in-depth case studies of FTB audits. Unitary

determinations were the key issue in six case studies that resulted in

$12 million in additional proposed tax assessments compared with

$2.4 million in proposed assessments for the four case studies that did not

involve a unity issue.

In the five case studies involving foreign-controlled corporations, FTB

auditors also reviewed the annual audited financial statements of the

parent corporations to determine if foreign accounting standards and

record keeping affected income and other data used for apportionment

purposes. They adjusted income and other apportionment data when the

differences between U.S. and foreign accounting standards and record

keeping had a material impact on them. The auditors requested additional

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data in instances when foreign financial statements did not provide the

data they needed. However, foreign-controlled taxpayers sometimes stated

that the information was difficult to obtain and thus did not provide it. As

a result, the auditors had to decide if an adjustment was necessary and

could be made on the basis of available data and their own estimates and

assumptions. In two of the five cases, taxpayers formally protested FTB

adjustments for differences in accounting standards and record keeping.

Issues to Be

Considered Before

Adopting a Federal

Unitary Tax System

Adopting a federal unitary system would require resolving issues in the

design and administration of a unitary tax and issues involving the

transition from separate accounting to a unitary system. Issues identified

as difficult in the California audits and by state tax administrators and

multinational corporations provided the starting point for analyzing issues

that would need to be addressed in a federal system. However, California

audit practices may not show how the federal system could deal with

these issues because the federal system might differ in significant ways

from the California system. For example, the federal government might

choose to adopt a different definition of the unitary business or define

apportionment formulas and factors differently. These choices could

affect the enforcement costs of the federal government and the

compliance costs of corporations.

California’s definition of a unitary business illustrates some of the choices

the federal government would face in designing its own system. In

California, FTB determined the members of a unitary group by using a

complex analysis that stemmed from the state’s definition of a unitary

business based on a greater-than-50-percent ownership requirement and

additional criteria related to the business’ management and operation. A

federal system with the same criteria for defining a unitary business might

require a similar analysis. However, a federal system might use only the

ownership criterion and thereby avoid most of the complexity of unitary

audits. Such a simple definition, however, could give rise to other

problems, such as the possibility of combining companies without

intercompany transactions or shared executive and staff functions and the

possibility of manipulation by taxpayers who buy or sell stock to change

the unitary group’s makeup and reduce tax liability. In defining a unitary

business, the federal government would have to consider this trade-off

between a simple definition and the potential for combination of diverse

companies and for manipulation by taxpayers.

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Administrative issues of reconciling accounting rules and obtaining and

verifying information affect the potential enforcement and compliance

challenges of a unitary tax. California requires that only material

differences between U.S. and foreign accounting rules be adjusted and

permits the use of reasonable approximations when data are not readily

available. As the Supreme Court found in the Barclays case, this practice

may have limited the compliance burden for multinational corporations

operating in California. The costs of reconciling accounting rules in a

federal unitary system would depend, in part, on the materiality and

reasonable approximation provisions adopted in a federal system.

The costs of reconciling accounting rules also depend on the kinds of

adjustments that might have to be made by corporations in a federal

unitary system. Fifty-four percent of foreign corporations in a survey

conducted by the Securities and Exchange Commission (SEC) reported

that their financial statements differed materially from U.S. generally

accepted accounting principles (GAAP).13 These foreign corporations had to

reconcile items, such as depreciation, deferred or capitalized costs, and

deferred taxes. Although U.S. corporations currently are required to keep

financial records according to U.S. GAAP, these U.S. corporations would

need to reconcile accounting rules for all the countries in which their

subsidiaries operate if a unitary system became the international norm.

The federal government would need to consider the effect on compliance

burden of differences in international accounting rules and the degree to

which reasonable approximations can be used in a federal system to

reconcile material differences.

Transition issues concern moving from the current separate accounting

system to a unitary system. These issues include the need for international

agreement on the decision to change to a unitary system and the

coordination of unitary tax rules to avoid double taxation and to facilitate

the administration of the unitary system. Many other nations and the

Organization for Economic Cooperation and Development (OECD) oppose

the unitary method. The recently issued OECD draft guidelines on transfer

pricing specifically reject global formulary apportionment as a solution to

transfer pricing problems. The federal government could seek to

coordinate a change to unitary taxation, but obtaining international

agreement might be difficult given the oft-stated opposition of many

countries.

13Survey of Financial Statement Reconciliations by Foreign Registrants (U.S. Securities and Exchange

Commission, Division of Corporate Finance, May 1, 1993).

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Considerable disagreement existed among the tax experts that we

interviewed and whose views we analyzed about whether the problems

associated with these issues and others discussed in appendix III can be

resolved in a federal unitary system. The federal government would need

to address these issues of designing and administering a unitary tax and

coordinating it with other countries before adopting a unitary tax at the

federal level.

Agency Comments At our request, the Department of the Treasury and California’s FTB

provided comments on a draft of this report. The full text of their

comments are presented in appendixes IV and V. We also received written

comments from MTC. The following section summarizes our evaluation of

all these comments.

Although FTB understood that this report was not intended to evaluate the

claim that formulary apportionment would be easier to administer than

the arm’s length approach, it nevertheless expressed its disappointment

that we did not make a greater effort to undertake this task. It suggested

that we could obtain information on the costs of reconciling accounting

rules in a formulary system by canvassing accounting firms that routinely

convert the consolidated financial statements of multinational businesses

from the accounting principles of their home country to those of another

country. FTB noted the fact that such conversions are often done means

that there will be no additional compliance costs for companies that have

already incurred these costs. FTB believed that we should note that the

compliance burden would be mitigated to the extent that foreign

corporations already use U.S. GAAP to prepare consolidated financial

statements for filings with SEC, obtaining credit in the United States, and

meeting the record-keeping requirements of section 6038A of the Internal

Revenue Code.

We state in this report that a comparison of the administrative costs of the

arm’s length and formulary approaches is beyond the scope of the report

because it would require that we specify the federal formulary system in

some detail. The survey of accounting firms suggested by FTB would

produce useful results to the extent the items that need to be converted in

a federal system could be identified, and the audit approach adopted by IRS

could be determined. For example, the survey would need to specify what

factors would be in the formula and how they would be defined as well as

the degree of reasonable approximation that would be acceptable to IRS.

Such a survey would be difficult to devise and would exceed the time and

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resources available for completing this report. However, we agree, and the

draft report recognized, that compliance burden is reduced to the extent

that companies already prepare consolidated financial statements and

reconcile accounting rules for regulatory and business reasons. As

suggested by FTB, we have included the record-keeping requirements of

section 6038A among the regulatory reasons that records are now kept in

conformance with U.S. GAAP.

FTB also believed that the report should note that in many circumstances

the arm’s length method encounters difficulties that are similar to those

that would be entailed in a federal unitary system, difficulties that should

be explained so readers can draw their own conclusions. We noted in our

draft report that GAO’s previous work had discussed difficulties with the

arm’s length method and that some of the difficulties with formulary

apportionment are similar. However, we made no detailed comparison of

the two approaches. The purpose of appendix III of our report was to

identify the issues that would need to be considered regarding designing,

administering, and moving toward a federal formulary system. In our view,

a useful comparison of the two approaches would depend on determining

relative administrative and compliance costs, which is beyond the scope of

this report for the reasons described above.

FTB also suggested that we note that some authorities have advocated

relatively simple tests for attributes of a unitary business using a minimum

percentage of intercompany transactions. We revised the report to clarify

that definitions of the unitary business can include these tests. We agree

that such tests may be relatively simple to administer, but we note the

trade-off between simplicity on one hand and the risks of manipulation by

taxpayers and of combining diverse companies on the other. We also agree

with FTB’s comment that commentators have noted that “rough justice” is a

feature of the formulary and the arm’s length approaches. We have revised

this report to make clear that rough justice is an issue in arm’s length

pricing.

FTB noted that the location of sales receipts can also cause significant

problems for the federal government. However, our discussion of the

complexity and ambiguity of rules for determining the location of sales

receipts refers to the rules for sourcing receipts from intangibles, not all

receipts as discussed by FTB. We do not compare the rules for sourcing

receipts in a formulary system with the rules for sourcing income under

the current arm’s length approach, and we do not evaluate whether the

sourcing rules under one system would be more or less difficult to

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administer than the rules under the other. Our purpose is to indicate that

developing simple and administrable sourcing rules for receipts from

intangibles would be an issue to be addressed in designing and

administering a federal system.

FTB mentioned several studies that measured the effect of changing to the

unitary method on the income of foreign-owned U.S. subsidiaries

operating in the United States. We are aware of these studies. However,

we do not believe that these are comprehensive studies that can be used to

estimate accurately the revenue effects of a change to a federal formulary

system. These studies are not comprehensive because (1) they rely on data

from U.S. corporations only or from corporations based in only one state,

(2) the data are from a single year, and/or (3) the data are not tax data and

may not be good proxies for tax data. Our purpose is to indicate that the

revenue effects are uncertain and that a study using the best data and

methodology would be needed to produce improved estimates of the

revenue effects.

FTB commented that IRS must obtain and verify foreign-held records to

evaluate transfer prices. We agree. The point that we emphasize in our

report is that California has had problems obtaining foreign data but that

the federal government under a formulary system, as evidenced by

initiatives like section 6038A, may have better access to foreign-held data

than the states.

Treasury commented that this report makes a valuable contribution to

understanding how one state has implemented a formulary apportionment

system and identifies some of the issues that the federal government

would have to address in a formulary system. However, Treasury stated

that the draft did not discuss in detail the broader difficulties of moving to

formulary apportionment, such as how to define worldwide income and

how IRS would verify a company’s worldwide accounts.

Regarding Treasury’s first point, the report discusses the adjustments

required to reconcile accounting rules when computing worldwide

income. Because countries are unlikely to agree to a common definition of

income, we believe that the need to make these adjustments would be one

of the major issues confronting taxpayers and tax administrators when

determining worldwide income in a federal unitary system.

Regarding how IRS would verify worldwide accounts in a formulary

system, the report discusses in detail how California verified companies’

Page 14 GAO/GGD-95-171 Taxes on Multinational Corporations
B-260129 

worldwide accounts and discusses obtaining and verifying information as

an issue that would need to be addressed in a federal system. Although

California relies on IRS to obtain and verify some information, we do not

agree with Treasury’s view that this reliance on IRS is important for

assessing the difficulties of administering a federal formulary system.

Under a federal formulary system, IRS could continue to audit the items in

a company’s worldwide accounts that California found useful and incur no

additional cost. The administrative issues that would need to be addressed

include how IRS would audit a formulary system and what data sources IRS

would find acceptable.

Treasury also wished to stress our report’s view that a move to a

formulary system would best be made on a cooperative, multilateral basis.

Treasury stated that agreement to move to a new system is necessary to

(1) ensure cooperation in gathering and sharing information, (2) solve

international tax disputes, (3) avoid double taxation, and (4) prevent

retaliation by countries against companies doing business within their

borders. According to Treasury, a unilateral move would make it nearly

impossible to verify a company’s income and would lead to excessive,

double taxation that would severely disrupt the flow of international

commerce. This report recognizes that coordination of the move to a

formulary system is desirable to avoid double taxation and to make the

administration of the system easier. However, we did not evaluate the

effect of a unilateral change on the flow of international commerce or how

much more difficult the system would be to administer if the United States

alone adopted a formulary system.

Treasury noted that for the United States to lead a multilateral move

toward formulary apportionment would be difficult because it had already

taken the lead in endorsing and developing the arm’s length system. As we

noted in this report, this history would complicate a move toward a

unitary system.

In its comments on our draft report, MTC urged that the information in

appendix I on California audit resources devoted to worldwide combined

reporting be put into context by comparing it to the level of resources

used by IRS in transfer pricing audits. We do not make this comparison

because factors such as California’s reliance on IRS as previously

mentioned mean that federal and state audits are not directly comparable.

California’s audit costs will not reflect the full cost of an audit to the

extent that information used in the audit is collected and verified by IRS.

Page 15 GAO/GGD-95-171 Taxes on Multinational Corporations
B-260129 

MTC commented that our report should have been an explicit, comparative

evaluation of the formulary and separate accounting methods that would

allow the reader to evaluate whether formulary apportionment is

sufficiently better tax policy to justify the costs of changing from separate

accounting. The MTC commented that criticisms of the federal use of

formulary apportionment have been answered more effectively than the

report implies. Our reasons for not making the explicit comparative

evaluation of formulary apportionment and separate accounting were

explained earlier in our response to FTB’s comments. The purpose of

appendix III of our report is to identify issues that would need to be

addressed in a federal formulary system. We did not evaluate whether

these issues can be effectively addressed in a federal system.

MTC also provided comments that describe its view of where the arm’s

length standard encounters difficulties similar to, but more severe than,

problems under formulary apportionment. The difficulties mentioned by

MTC include complicated and subjective judgments required to assign a

price to potentially every commodity and service traded between related

parties; double taxation that can result from disagreements about pricing

methodologies; increased compliance burden from countries’ nonuniform

income sourcing rules; the determination of arm’s length royalties for

intangibles; and the location of development costs for intangibles under

cost sharing agreements. Our report recognizes that some of the

difficulties encountered with formulary apportionment are also

encountered with separate accounting. However, for the reasons

described earlier in response to a similar comment by FTB, we do not

compare the two approaches in detail or evaluate which problems are

more severe. MTC also provided other detailed comments on our draft

report, which we have incorporated where appropriate.

As agreed with you, unless you publicly announce the contents of this

report earlier, we plan no further distribution for 30 days. At that time, we

will send copies to the Secretary of the Treasury and other interested

parties. We also will make copies available to others upon request.

Page 16 GAO/GGD-95-171 Taxes on Multinational Corporations
B-260129 

The major contributors to this report are listed in appendix VI. If you have

any questions concerning this report, please contact me at (202) 512-9044.

Sincerely yours,

Natwar M. Gandhi

Associate Director, Tax Policy

 and Administration Issues

Page 17 GAO/GGD-95-171 Taxes on Multinational Corporations
Contents

Letter 1

Appendix I 

California Audits of

Multinational

Corporations

20

Audit Policies 20

Audit Issues 22

State Methods of Dealing With Currency Translations and

Foreign Accounting Standards

30

Level of Audit Effort 33

Audit Results 34

Appendix II 

Narrative Summary of

10 California

Franchise Tax Board

Audits of

Multinational

Corporations

37

Appendix III 

Issues That Would

Need to Be

Considered Before

Federal Adoption of

Formulary

Apportionment

41

Design Issues 41

Administration Issues 48

Transition Issues 52

Appendix IV 

Comments From the

Franchise Tax Board

of California

56

Page 18 GAO/GGD-95-171 Taxes on Multinational Corporations
Contents

Appendix V 

Comments From the

Department of the

Treasury

59

Appendix VI 

Major Contributors to

This Report

61

Tables Table I.1: Summary of GAO Case Studies of Five Franchise Tax

Board Audits of U.S.-Controlled Multinational Corporations

23

Table I.2: Summary of GAO Case Studies of Five Franchise Tax

Board Audits of Foreign-Controlled Multinational Corporations

24

Table I.3: Analysis of GAO Sample of 124 Franchise Tax Board

Audits of Large Multinational Corporations Comparing Audits

With Unity Issues With Audits Without Unity Issues

26

Table I.4: Audit Hours for GAO Sample of Franchise Tax Board

Apportionment Audits of Large Multinational Corporations

34

Table I.5: Proposed Additional Tax Assessments for the GAO

Sample of Franchise Tax Board Audits

35

Table I.6: Resolution of Proposed Tax Assessments for GAO

Sample of Franchise Tax Board Audits That Were Contested and

Resolved

36

Abbreviations

FTB Franchise Tax Board

GAAP generally accepted accounting principles

IRS Internal Revenue Service

MTC Multistate Tax Commission

OECD Organization for Economic Cooperation and Development

SEC Securities and Exchange Commission

UDITPA Uniform Division of Income for Tax Purposes Act

Page 19 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

This appendix discusses the results of our review of 124 California audits

of multinational corporations that were required to apportion a share of

their worldwide unitary business income to the state. Most audits were for

tax years 1980 to 1989. This appendix also covers the policies governing

Franchise Tax Board (FTB) audits, the issues encountered, the methods

used, the level of effort expended, and the results obtained. Policies and

procedures are still applicable for FTB audits of those corporations that

choose to file tax returns on a worldwide combined basis.

Audit Policies Important state policies applied in formulary apportionment audits

included (1) focusing on additional tax potential in selecting corporations

for audit, (2) considering materiality in planning and carrying out work,

and (3) using reasonable approximations when precise data were not

available.

FTB policy was to audit the multinational corporations with the greatest

additional tax potential.1

 Its staff were to examine all multinational tax

returns for possible referrals for either desk or field audits.2

 Generally, the

tax returns of large corporations and those with potential tax adjustments

greater than $10,000 that could not be resolved through correspondence

were referred to a field office.

Field auditors reviewed the corporate tax returns to test for potential audit

issues and to see if the potential tax increase warranted committing audit

resources. For example, they compared sales reported on a multinational

corporation’s tax return with the company’s worldwide sales reported

elsewhere to determine if all its affiliated corporations were included in

the unitary business. Financial data, such as sales and information on the

organization and operations of multinational corporations, appeared in

various publications used by the state, such as Moody’s International

Manual.

Auditors also reviewed earlier audit reports to identify tax issues that

could be applied to the current return and to determine if they could limit

their audit effort on the basis of previous work. For example, an extensive

review of a multinational corporation’s unitary business relationships in a

1

FTB’s audit policies focus on “multistate” tax returns that include purely domestic U.S. corporations

as well as multinational enterprises.

2

Desk audits are conducted in the office on the basis of information on the tax return and from

correspondence with the taxpayer, whereas field audits generally involve examination of taxpayers’

records.

Page 20 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

previous audit might have allowed an auditor to limit current work in this

area.

Another FTB policy was to notify a corporation if auditors’ preliminary

tests of unitary business relationships during the audit indicated a

potential refund. However, because of FTB’s position of allocating audit

resources to the audits producing the most tax, it believed the taxpayer

should be responsible for developing unitary facts and figures to support a

refund claim. If for some reason the taxpayer did not file a claim, as

occurred in prior years for two audits we reviewed, the unity issue was not

pursued.

The effect of FTB’s audit selection and tax refund policies was twofold. FTB

focused on audits of corporations that had been the least compliant with

formulary apportionment requirements and tried to maximize the resulting

tax revenue.

The principle of materiality was also extremely important in state

apportionment audits. According to a state audit guide, auditors usually

should not pursue immaterial items and should do more work to resolve

material differences. They must judge an item’s materiality on the basis of

the facts and circumstances of each case. Decisions on materiality can

limit audit work and adjustments. For example, according to FTB’s policy,

no adjustments for differences between U.S. and foreign accounting

standards need to be made unless they are material.

In doing their work, FTB auditors tried to obtain annual reports, federal tax

returns, and other documents from taxpayers as sources of the data

needed to verify and/or calculate tax liability under formulary

apportionment. Where an adjustment was likely to be material and the

necessary data could not be developed from financial records maintained

in the regular course of business, FTB could accept reasonable

approximations. In particular, audit guidance indicated FTB auditors

sometimes had difficulty obtaining information from foreign parent

corporations that were part of a unitary business operating in California.

They might have been obliged to use estimates or other methods to

determine the income of the foreign affiliates. Moreover, when data were

not readily available to adjust for differences between U.S. and foreign

accounting standards, auditors may have either used reasonable

approximations or accepted such approximations from the taxpayer.3

3

FTB officials said that they will accept reasonable approximations that benefit the taxpayer as well as

those that benefit the state.

Page 21 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

Audit Issues Audits of multinational corporations focused primarily on formulary

apportionment issues, such as determining unitary business relationships

and related income and calculating the property, payroll, and sales factors.

Except for ensuring that corporations comply with state requirements for

reporting income and expenses, FTB generally relied on Internal Revenue

Service (IRS) audits to verify the accuracy of income and expense items,

since similar data are reported on both federal and state tax returns. It also

relied on data from federal tax returns and the annual audited financial

statements of a company to verify income and other data used in

determining the apportionment factors.4

Determining Unitary

Business Relationships

Determining unitary business relationships among affiliated members of

multinational corporations was the most complex and time-consuming

issue that state auditors had to develop. At the same time, this

determination significantly affected corporate tax liability and was an

important issue in audits we reviewed and in related protests and appeals.

Affiliated corporations in a multinational enterprise were considered to be

unitary if they met one of two sets of criteria. One set of criteria entails

(1) determining if the part of a business in California depended upon or

contributed to the business as a whole and (2) determining if unity of

ownership existed as demonstrated by more than 50 percent of the voting

stock of the members of the corporate group being owned by the same

interests. Dependence or contribution was most easily established by the

presence of intercompany sales of tangible property, according to state

guidance, but might have been based on other factors. A business was also

considered unitary if it met the second set of criteria, that is, if (1) it met

the ownership criterion; (2) unity of operation was evidenced by central

purchasing, advertising, accounting, management, etc.; and (3) unity of use

was demonstrated by a centralized executive force and general system of

operations.

Generally, the most difficult segment of a multinational audit was

developing the facts needed to assess unitary relationships on the basis of

these criteria. Auditors obtained information on unity from documents

provided by the taxpayer, such as annual reports, federal tax returns and

supporting workpapers, board of directors’ minutes, internal newspapers,

corporate telephone directories, organization charts, and policy manuals.

4

Financial statement data for public corporations are generally available in a company’s annual

reports, filings with the Securities and Exchange Commission (SEC), and some business publications.

Page 22 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

To confirm or expand on this information, they requested corporate

responses to a questionnaire on unity issues.

The five domestic audit case studies we reviewed did not include a typical

example of a complete unitary analysis. In four cases, the analysis was

limited because it was based on the results of prior audits. In one case, for

example, the auditor agreed that the parent corporation and 12

subsidiaries were part of a unitary business. This analysis was based on

the prior audit, a limited review of audited financial statements, and other

data, which ensured that no major changes had occurred in their

operations. According to FTB officials, auditors commonly limit their

analysis to changes when prior work establishes basic unitary business

relationships. Although the remaining case included a unitary analysis, it

was unusually drawn out and complicated by a total lack of taxpayer

cooperation and had other problems, according to an FTB official. The

results of the five domestic case studies are included in table I.1 and

appendix II. The five case studies of foreign-owned companies are

presented in table I.2 and appendix II.

Table I.1: Summary of GAO Case

Studies of Five Franchise Tax Board

Audits of U.S.-Controlled Multinational

Corporations

Case

number

Audit

hours

Key audit

issue

Number of

years audited

Taxpayer

action

1 1,026 Unity 3 Paid tax

2

600

State

adjustmentsa 4 Paid tax

3

161

State

adjustmentsb 3 Protested

4

153

IRS audit

adjustmentc 2 Protested

5 2,386 Unity 4 Protested

aMajor items included nonbusiness gains and losses, excess depreciation, income taxes, and a

federal deduction not allowable for state tax purposes.

bThe major item was federal deduction that was not allowable for state tax purposes.

cFTB adjusted state income tax on the basis of the results of an IRS audit.

Source: California FTB audit files.

Page 23 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

Table I.2: Summary of GAO Case

Studies of Five Franchise Tax Board

Audits of Foreign-Controlled

Multinational Corporations

Case

number

Audit

hours

Key audit

issue

Number of

years audited

Taxpayer

action

1 118 Unitya 3 Protested

2 689 Unitya 3 Protested

3 538 Unitya 4 Protested

4 554 Unitya 2 Protested

5 295 Payroll 3 Paid tax

aThe key audit issue was unity with a foreign parent corporation and affiliates.

Source: California FTB audit files.

For a better example of a complete unitary analysis of a U.S. multinational

corporation, we reviewed another audit identified by FTB officials. It

involved a large multinational enterprise and took 1,366 hours to

complete. In this case, the auditor analyzed the unitary business

relationship between the parent corporation and its subsidiaries along

different product lines. The analysis was based on information obtained

from a variety of sources including (1) a prior audit, (2) the taxpayer’s

response to a unitary questionnaire, (3) corporate board minutes and other

internal documents, (4) meetings with taxpayer representatives, and

(5) newspaper articles.

The auditor determined that the parent corporation had a unitary business

relationship with the subsidiaries and divisions formed along two product

lines.5

 For example, he cited the following features as a basis for the

parent corporation’s unity with one product line group:

• intracompany sales and purchases,

• common advertising and marketing,

• common technology and personnel,

• budgetary controls by the parent corporation,

• transfer of technical knowledge between divisions,

• intracompany transfer of personnel,

• joint internship programs,

• quality control by the parent corporation, and

• common pension plans.

5

The auditor initially made a unitary determination in a third product line, but FTB dropped this

finding after further review of the facts with the taxpayer.

Page 24 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

For each of these features, the auditor cited specific evidence to support

his determination of a unitary business relationship. For intracompany

sales and purchases, for example, based on the taxpayer’s response to a

unitary questionnaire, he noted that the parent corporation and its product

line group supplied each other with key manufacturing parts of significant

value. He did similar analyses of unitary features for all product lines he

reviewed.

Evaluating unitary relationships of foreign-controlled corporations

sometimes is more difficult than evaluating unitary relationships for

U.S.-controlled multinationals because unity information is harder to

obtain from foreign parent corporations, according to FTB officials. In an

audit of several California subsidiaries of the same foreign parent

corporation, for example, the taxpayers failed to provide documentation

on their unitary ties with the foreign parent and other affiliated

corporations. As a result, the auditor relied on alternative sources such as

the taxpayers’ financial statements and annual reports to perform a unitary

analysis. From these sources he determined that the different corporations

were in a unitary business with their foreign parent corporation on the

basis of the following features:

• the foreign parent corporation owned more than 50 percent of the

subsidiaries,

• the foreign parent corporation and its subsidiaries were in a similar line of

business,

• the foreign parent corporation and its subsidiaries shared a common

name,

• an intercompany flow of goods existed,

• the foreign parent corporation guaranteed obligations and provided

financing for U.S. operations, and

• the foreign parent corporation transferred information and technical

know-how to its subsidiaries.

Such analyses of unitary relationships take additional audit time and can

significantly affect tax liability. For the 124 FTB audits we reviewed, table

I.3 shows that 68 audits with unity issues took an average of 603 hours to

complete compared with 399 hours for 56 audits that did not include unity

issues. It also shows that audits with unity issues resulted in an average

$2.0 million in proposed additional tax assessments compared with an

average $0.8 million for audits that did not have a unity issue. Similarly, in

6 of 10 in-depth case studies we conducted, unitary determinations were

the key issues, resulting in a total of $12 million in proposed tax

Page 25 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

assessments, compared with $2.4 million in total for the 4 case studies that

did not involve a unitary issue.

Table I.3: Analysis of GAO Sample of 124 Franchise Tax Board Audits of Large Multinational Corporations Comparing

Audits With Unity Issues With Audits Without Unity Issuesa

Audits with unity issue Audits without unity issues

Dollars in millions

U.S.-

controlled

Foreigncontrolled TotalU.S.-

controlled

Foreigncontrolled Total

Number 50 18 68 55 1 56

Total audit hours 28,439 12,582 41,021 21,917 417 22,334

Average audit hours 569 699 603 398 417 399

Sampling error for average audit hours (plus or minus)b 142 350 135 95.5 c 94

Total proposed additional tax $97.7 $37.0 $134.7 $41.9 $0.3 $42.2

Average proposed additional tax $2.0 $2.1 $2.0 $0.8 $0.3 $0.8

Sampling error for average proposed additional tax

(plus or minus)b $1.2 $2.3 $1.0 $0.4 c $0.4

aThe FTB selects corporations with the greatest additional tax potential for audit. Therefore, our

sample does not represent all large multinational corporate tax returns.

bSampling error computed at 95-percent confidence level.

cSampling error was not applicable since only one audit was involved.

Source: GAO analysis of FTB audit files.

Unity was the dominant issue in audits of foreign-controlled corporations

in our sample, occurring in 18 of 19 cases. It occurred in 50 of the 105

audits of U.S.-controlled corporations.

Determining Unitary

Income

Another major issue for state auditors is determining a reporting

corporation’s total unitary income. They must review the income reported

by multinational corporations to ensure it includes, as required, all U.S.

and foreign income related to the unitary business and is reported in

accordance with state requirements, which may differ from federal

requirements. If necessary, auditors recalculate reported income to

determine tax liability under worldwide formulary apportionment.

In our 10 case studies, FTB auditors used the parent corporation’s

consolidated or worldwide income as a starting point for calculating

unitary business income. For U.S. multinational corporations, they used

Page 26 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

taxable income from the federal tax returns. For foreign-owned

multinationals, auditors used pretax “book” income from the parent

corporation’s audited annual financial statements and replaced the book

income of U.S. subsidiaries with taxable income from their federal tax

returns.6

FTB auditors then made other adjustments to worldwide income. For

example, they added the income of subsidiaries that multinational

corporations should have included in the unitary business but did not.

Once the auditors identified income for all components of the unitary

business, they adjusted it for differences in state and federal reporting

requirements and, in audits of foreign-controlled corporations, for

differences in U.S. and foreign accounting standards and record keeping,

as will be discussed later in this appendix. In addition, FTB guidance

required auditors to examine certain types of income, such as interest and

rental income that may not have been related to the unitary business to

ensure they were correctly treated for apportionment purposes. If income

items were considered as “nonbusiness income,” they were not included in

apportionable income.7

To make these adjustments, auditors generally used corporate audited

financial statements, federal tax returns, and taxpayer workpapers. For

example, beginning with taxable income reported on one U.S.

multinational corporation’s consolidated federal tax return, the auditor

• eliminated the income of subsidiaries that were not part of the unitary

business on the basis of supporting schedules to the federal tax return,

• added the income of unitary foreign subsidiaries from audited financial

statements of the company,

• added the income of domestic international sales corporations that were

part of the unitary business on the basis of federal tax return data,8

 and

• eliminated foreign subsidiary income to avoid double counting that was

included with the parent corporation’s income in the consolidated federal

6

Income information is available from the federal tax returns of U.S. subsidiaries but is not available

for foreign subsidiaries because they do not file federal tax returns.

7

Business income is, generally, income arising from transactions and activities in the regular course of

a taxpayer’s trade or business. It is assigned to a location through formulary apportionment.

Nonbusiness income is all other income and is specifically assigned to a particular location.

8

Domestic international sales corporations were U.S. corporations which were exempt from income

tax and whose shareholders were permitted a partial deferment of U.S. tax on certain export receipts.

They were replaced by foreign sales corporations after Dec. 31, 1984. Foreign sales corporations are

foreign corporations set up by U.S. parents to handle export activities. The foreign sales corporation

provisions were designed to ensure that the exemption from tax was not a prohibited subsidy under

the General Agreement on Tariffs and Trade.

Page 27 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

tax return and in the financial statements from which income data were

originally obtained.

In a foreign-controlled corporation case, the auditor began with income

reported in the parent corporation’s audited financial statements and

• added back income taxes identified in the report that were not deductible

under state reporting requirements,

• substituted the taxable income of U.S. subsidiaries from their federal tax

returns for their “book” income, and

• eliminated reserve and amortization deductions identified in the financial

statements that were not allowed for U.S. tax purposes.

Auditors also took steps to ensure that income was adjusted for

differences between state and federal tax reporting requirements. For

example, California does not allow certain accelerated methods of

depreciation that the federal government permits. Although such

differences are not formulary apportionment issues, per se, they can have

a significant effect on unitary income for tax purposes and therefore on

corporate tax liability. For example, as the result of state adjustments for

10 different items, the net income of a U.S. multinational increased by

several hundred million dollars over a 4-year period.

Determining

Apportionment Factors

A third major area for FTB on apportionment audits is determining if the

apportionment factors are correct. Because the property, payroll, and

sales factors used to apportion multinational income can significantly

affect state tax liability, FTB auditors are to verify the California and

worldwide amounts that underlie the three factors. They are to compare

factor amounts with similar data in audited annual financial statements,

federal tax returns, and taxpayer workpapers and do detailed checks to

ensure that the numbers are reported consistently and comply with state

requirements. When necessary, the auditors use these sources to make

adjustments.

One domestic case illustrates how FTB used this approach to audit the

property factor.9

 Total property in this case was the sum of the annual

average cost of fixed assets in 7 categories plus the capitalized rent for

more than 20 subsidiary corporations. Historical costs of most of the fixed

9

The property factor consists of the annual average of real and tangible personal property. Owned

property is valued at its original cost and rental property is valued at eight times the annual rental

expense. Property includes inventory, buildings less construction in progress, equipment, and other

tangible assets.

Page 28 GAO/GGD-95-171 Taxes on Multinational Corporations
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California Audits of Multinational

Corporations

assets came directly from the financial statements. Some fixed asset costs,

rent, and the California property amounts were obtained from supporting

taxpayer workpapers.

FTB had to consider potential property valuation differences in auditing

foreign-controlled corporations. For example, the value of land in one

foreign parent corporation’s audited financial statements was based on its

appraised value rather than on its historical cost. Consequently, the

auditor asked the California subsidiary to get historical cost information

from its parent corporation and then used it to compute total unitary

property. Although the auditor could not verify land and fixed assets

containing historical cost using the annual report, he compared total

property to the total property amount in the prior audit and concluded that

it appeared to be reasonable. California property value was verified using

the California subsidiary’s “state report,” which allocated property cost

and rent to each state.10

FTB also used many sources to verify and, if necessary, adjust the payroll

factor. The payroll factor consisted of employee compensation, including

wages, salaries, and commissions related to business income. It also

included employee benefits, such as room and board that are taxable

under the Internal Revenue Code. If the taxpayer uses the cash basis of

accounting to calculate the payroll factor, FTB can verify the state payroll

using amounts reported on California unemployment insurance quarterly

returns.11 FTB can verify the U.S. component of worldwide payroll to

federal payroll returns filed annually or quarterly.12 If the taxpayer uses the

accrual basis of accounting to calculate the payroll factor, supporting

taxpayer payroll records may provide the necessary data. For foreign

corporations, FTB can obtain payroll data from financial statements or

from information provided by the foreign corporation.

One of our U.S.-controlled multinational case studies illustrates how the

auditor compared the California payroll amount with supporting taxpayer

records, including a state-by-state allocation of its total payroll, and with

the sum of the taxpayer’s California unemployment insurance returns for a

10In our 10 case studies, FTB auditors generally reviewed corporate workpapers that allocated

property, payroll, and sales to California and other states as one means of verifying California factor

amounts. According to FTB officials, corporations commonly perform this analysis because the

information is needed to apportion income among the states.

11Taxpayers may elect to determine the payroll factor using the cash method even if they use the

accrual method for financial statement and income tax purposes.

12U.S. payroll is reported on Form 940, Federal Employer’s Annual Federal Unemployment Tax Return,

and on Form 941, Employer’s Quarterly Federal Tax Return.

Page 29 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

particular year. The auditor also compared total corporate payroll to

taxpayer records along with payroll data from both its federal payroll and

tax returns. Using data from these sources, the auditor eliminated the

payroll of subsidiaries that had been incorrectly included in the unitary

business and added the payroll of subsidiaries that were incorrectly

excluded.

Foreign-controlled corporations or foreign affiliates of U.S. corporations

may require additional payroll adjustments, since some of them include

employee benefits that are not taxable compensation under the Internal

Revenue Code. In one case study, for example, the auditor eliminated a

foreign parent corporation’s contribution to staff retirement and pensions,

which was not income to its recipients under the Internal Revenue Code.

According to FTB guidance, to verify the sales factor, which consists of a

taxpayer’s gross receipts that result in business income, the auditor must

make sure that other business receipts, such as rent and royalties, are

included if they are material and related to the unitary business. In our

case studies, auditors primarily used (1) sales and other receipts from

audited financial statements to verify total sales and (2) taxpayer

workpapers that allocated sales by state to verify California sales. They

adjusted sales factor amounts in all 10 case studies. In a U.S.-controlled

corporation case, for example, the auditor (1) eliminated sales related to

subsidiaries that were not part of the unitary business on the basis of sales

data in the taxpayer’s workpapers and financial statements and (2) added

interest income, which the auditor concluded should be considered

business income, from data in the taxpayer’s workpapers and federal tax

return.

State Methods of

Dealing With

Currency Translations

and Foreign

Accounting Standards

FTB sometimes had to make currency conversions and adjustments for

differences in accounting standards and record keeping. This was done

because foreign financial data were not reported in U.S. dollars or were

not based on the same accounting or tax principles as U.S. data. Further,

foreign financial statements and records may not always provide the data

FTB needs to apportion unitary business income. Currency conversion and

differences in accounting standards and record keeping are issues related

primarily to foreign-controlled California corporations, since U.S.

multinational corporations must report financial data for their U.S. and

foreign subsidiaries in dollars based on U.S. generally accepted accounting

principles (GAAP). However, according to an FTB official, to some extent

currency conversion is also an issue for U.S. multinational corporations

Page 30 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

because the California regulations on currency conversions may vary from

U.S. GAAP.

FTB has established policies and procedures for dealing with currency

conversion and differences between U.S. and foreign accounting standards

and record keeping. When a California corporation’s financial data are in

dollars and the foreign parent corporation’s data are in another currency,

California data are converted to the foreign currency at an average annual

exchange rate to calculate apportioned income, which is then reconverted

to dollars. Since California valued fixed assets at their historical cost,

converting U.S. assets to the currency of a foreign parent corporation

required additional calculations.13 FTB requires adjustments for differences

in U.S. and foreign accounting standards and record keeping when they

are material. FTB’s policy allows reasonable approximations of the

differences.

Differences in U.S. and foreign accounting standards and record keeping

vary by country, according to state audit guidance. For example,

• Foreign financial statements may include additions to various reserves to

reduce income that may not be allowed under U.S. GAAP and/or are not

allowable tax deductions for U.S. purposes.

• U.S. GAAP requires inventory to be valued at historical cost for accounting

purposes unless its market value is lower. Foreign countries may allow

other inventory valuation methods. For example, some foreign

corporations may use net realizable value, defined as the estimated selling

price minus reasonably predictable costs, as a basis for writing up

inventory so that it exceeds its value on an historical cost basis.

• Foreign countries sometimes allow unrealized gains or losses from foreign

currency translations to be included in the income statement. In contrast,

U.S. GAAP generally requires such gains or losses to be reported in a

separate component of equity instead of being included in determining net

income.

Such differences can affect unitary business income or the formula

factors. For example, France permits corporations to increase inventory

valuations when fair market value exceeds cost, which can affect both

income and the property factor. If the increase is material, auditors must

adjust inventory to a cost basis for property factor purposes. They may

13Average annual exchange rates were applied to the cost of fixed assets for an initial year and then to

yearly acquisitions and dispositions. Each year’s changes were “layered” or added into the value of

fixed assets from the previous year to arrive at a value expressed in a foreign currency at estimated

historical exchange rates.

Page 31 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

also have to adjust the cost of goods sold expense, which would be

overstated because of the higher inventory value.

FTB guidance indicates that information in the consolidated income

statement of the foreign parent corporation can be used to identify

differences in U.S. and foreign accounting standards. In our five

foreign-controlled corporation case studies, FTB auditors made six

adjustments for differences in U.S. and foreign accounting standards and

record keeping. Five of these adjustments were based on audited financial

statements. For example, the auditor increased income in one case by

adding back amounts identified in the annual audited financial statements

of the foreign parent corporation as reserves for special purposes and for

write-down of financial investments, since both are not allowed for U.S.

tax purposes.

We also found that auditors made assumptions or estimates when the

foreign financial statements they used did not provide the data they

needed, and taxpayers did not provide supplemental data that the auditors

requested. In our foreign-controlled corporation case studies, for example,

• When a taxpayer did not provide financial data to substantiate its

contention that certain subsidiaries were not part of the unitary business,

the auditor used information from the annual financial statements of the

foreign parent corporation without excluding those subsidiaries from the

report.

• When a taxpayer did not provide information on the unrealized portion of

foreign exchange gains or losses included in the annual financial

statements of the foreign parent corporation, the auditor accepted the

data, since he believed the amount of unrealized gains or losses would

most likely be immaterial.

The audit files indicated that foreign taxpayers sometimes believed FTB’s

requests for more data on their foreign operations were unreasonable and

their adjustments were unfair. For example,

• In the case where FTB adjusted the income of the foreign parent

corporation for its write-down of financial investments, the taxpayer

formally protested the adjustment. While acknowledging that write-downs

cannot be realized for U.S. purposes until the items are sold or written off

as worthless, the taxpayer said that it was unfair to disallow the entire

expense included in the annual financial statements of the parent

corporation, since the expense reflected different accounting and

Page 32 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

consolidation methods from subsidiaries located in many different

countries. The taxpayer further said that it was unreasonable to expect its

foreign parent corporation to review all of the transactions in foreign

countries to identify the payments that were deductible.

• Another taxpayer protested FTB eliminating deductions for payments to a

special reserve for employee severance pay. The taxpayer argued that a

deduction should be allowed because the labor law of the foreign parent’s

country required the reserve payments to be set aside even if the ultimate

beneficiary might not receive them for some time. Therefore, the taxpayer

contended that the severance payments were not subject to any

contingencies and should be deductible.

• In another case, the auditor noted the taxpayer’s bitter and extreme

uncooperativeness when asked to recalculate depreciation expenses of its

foreign parent corporation on the basis of a method the state allowed.

According to the taxpayer, the only available data to do this were from the

annual financial statements of the foreign parent corporation, which were

written in a foreign language. The taxpayer was not sure it could get the

data needed.

Although corporations formally protested FTB adjustments for differences

in accounting standards and record keeping in the two cases we have

mentioned, an FTB official told us that protests of accounting standard and

record keeping issues might have been limited by foreign corporations

focusing almost exclusively on the constitutional issue in the Barclays

Bank case before the U.S. Supreme Court. According to an FTB official,

now that the Barclays case has been resolved, the great majority of related

constitutional protest cases should be resolved by June 30, 1995, the end

of the state fiscal year.

Level of Audit Effort The level of effort devoted to a particular audit varied considerably. Table

I.4 shows audit hours for our sample of 124 U.S.- and foreign-controlled

corporations.

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Appendix I 

California Audits of Multinational

Corporations

Table I.4: Audit Hours for GAO Sample of Franchise Tax Board Apportionment Audits of Large Multinational Corporationsa

Number of hours

Level of audit hours

For 105 audits of

U.S.-controlled

corporations

For 19 audits of

foreign-controlled

corporations

For all 124

apportionment

audits

Average 480 684 511

Sampling error for average audit hours (plus or minus)b 84.5 331.5 86

Minimum 70 146 70

Maximum 2,386 3,158 3,158

1st quartile 70 - 173 146 - 322 70 - 197

2nd quartile 185 - 356 335 - 417 198 - 363

3rd quartile 360 - 583 461 - 896 366 - 627

4th quartile 604 - 2,386 1,030 - 3,158 628 - 3,158

aThe FTB selects corporations with the greatest additional tax potential for audit. Therefore, our

sample does not represent all large multinational corporate tax returns.

bSampling error computed at 95-percent confidence level.

Source: GAO analysis of FTB apportionment audits.

According to state officials, factors that can affect audit hours include

(1) the size and complexity of multinational corporations, (2) the potential

impact of the audit issues on tax liability, (3) the results of previous audits,

and (4) the cooperativeness of the taxpayer. We previously discussed how

FTB auditors consider potential tax effect when selecting corporations and

planning the scope of their audits and how they sometimes limit audit

work on the basis of the results of prior audits. FTB officials also told us

that the lack of taxpayer cooperation occurred more often and may be one

reason that audits take longer for foreign-controlled corporations than for

U.S.-controlled corporations.

Audit Results FTB auditors are to discuss audit results with taxpayers and also give them

a written summary of their audit findings. If an audit results in increased

tax liability, FTB is to issue the taxpayer a Notice of Proposed Assessment

indicating the amount of the additional tax.14 For the 124 audits we

reviewed, table I.5 shows total and average amounts of initial tax liability

and additional tax assessments.

14Audits may also identify overassessments for some tax years.

Page 34 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

Table I.5: Proposed Additional Tax

Assessments for the GAO Sample of

Franchise Tax Board Audits

U.S.-controlled

corporations

Foreigncontrolled

corporations Total

Dollars in millions

Number of audits 105 19 124

Total tax before

audita $641.9 $38.7 $680.6

Total additional tax proposedb $139.6 $37.3 $176.9

aThe total tax before audit was not available from FTB records for 6 of the audited years in three

audits. The related amount of additional tax proposed for those 6 years was $5.9 million.

bFTB also notified taxpayers of $14.8 million in proposed overassessments for the 124 audits.

Source: GAO analysis of FTB data.

FTB obtained copies of IRS audit results and, if changes were applicable for

state purposes, made related adjustments to state income taxes. Of the

$176.9 million proposed additional tax assessments in table I.5,

$41.1 million was partially the result of IRS audits of federal tax returns. An

additional $28.9 million in proposed tax assessments, not included in the

$176.9 million, was entirely or substantially the result of IRS audits.

According to FTB officials, they generally rely on IRS audits to ensure that

taxpayers report accurate income and expense data on their federal tax

returns.

Taxpayers may agree with the additional tax, or they can contest it

through the state’s protest and appeals process and/or through the court

system. Taxpayers can file a protest with the FTB if they disagree with the

proposed tax assessment and, if they disagree with FTB’s decision on their

protest, they can appeal it to the California State Board of Equalization.

The Board’s decisions are final unless the taxpayer pursues the case

through the court system. Taxpayers have other options, which include

litigating their cases or submitting cases in the protest and appeals stage to

a settlement process.15

Taxpayers agreed with $33.8 million of the $176.9 million in proposed

additional tax assessments from our sample of 124 FTB audits and

contested $143.1 million through the protest, appeals, and/or settlement

processes. Of the $143.1 million contested, FTB had not resolved

15California enacted legislation that gave FTB authority for a limited period to negotiate a settlement of

civil tax disputes existing as of July 1, 1992. That authority was extended by further legislation.

Page 35 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix I 

California Audits of Multinational

Corporations

$89.3 million at the time of our review. Table I.6 shows the disposition of

the $53.8 million in proposed assessments that were resolved.

Table I.6: Resolution of Proposed Tax

Assessments for GAO Sample of

Franchise Tax Board Audits That Were

Contested and Resolved

Dollars in millions

U.S.-

controlled

corporations

Foreigncontrolled

corporations Total

Number of proposed additional tax

assessments 16 3 19

Proposed additional tax $50.2 $3.6 $53.8

Final assessed tax $27.2 $2.0 $29.2

Percentage of proposed tax sustained 54% 55% 54%

Source: GAO analysis of FTB data.

Page 36 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix II 

Narrative Summary of 10 California

Franchise Tax Board Audits of Multinational

Corporations

Our case studies of FTB audits involving five U.S-controlled (domestic) and

five foreign-controlled corporations are briefly described in the following

summaries.

Domestic Case Number 1 The key audit issue in this case was the unity of a U.S. parent corporation,

the California taxpayer, with its subsidiaries. The auditor included a

domestic subsidiary in a unitary business with the taxpayer, then realigned

the taxpayer and its divisions and subsidiaries into several unitary

businesses consistent with an agreement between the taxpayer and FTB in

a prior audit. The auditor recalculated taxable income for each unitary

business, relying primarily on the consolidated federal tax return to

determine unitary income and on the parent corporation’s financial

statements and workpapers to recalculate apportionment factors. The

auditor made no adjustments for differences between U.S. and foreign

accounting standards and record keeping.

Domestic Case Number 2 The audit focused primarily on state audit adjustments. The California

taxpayer, the parent corporation in a U.S. multinational enterprise,

included domestic and foreign subsidiaries in the unitary business, as

agreed with FTB in the previous audit. The auditor revised the

corporation’s taxable income primarily on the basis of federal tax return

data, audited financial statements, and taxpayer workpapers. There were

several adjustments for differences in state and federal tax reporting

requirements that increased unitary business income by hundreds of

millions of dollars for the 4 years audited. The auditor made no

adjustments for differences between U.S. and foreign accounting

standards and record keeping.

Domestic Case Number 3 The key audit issue in this case related to a federal tax deduction that was

not allowed under state tax reporting requirements. Unity between the

California taxpayer, the parent corporation in a U.S. multinational

enterprise, and its domestic and foreign subsidiaries had been established

in the previous audit, and the taxpayer included all affiliated corporations

in its unitary business. The auditor primarily relied on information in the

federal tax return, annual report, and taxpayer workpapers in doing his

work. The auditor made no adjustments for differences between U.S. and

foreign accounting standards and record keeping.

Page 37 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix II 

Narrative Summary of 10 California

Franchise Tax Board Audits of Multinational

Corporations

Domestic Case Number 4 The key issue in this case was a deduction for legal fees that FTB

disallowed on the basis of the results of an IRS audit. The California

taxpayer, the U.S. parent corporation in a multinational enterprise,

included all its subsidiaries as part of its unitary business, although the

previous audit had determined that one subsidiary was not unitary with

the taxpayer. There were no annual reports or Securities and Exchange

Commission (SEC) forms 10-K available to use in recalculating tax liability,

because the taxpayer was a privately held corporation. As a result, the

auditor recalculated taxable income to exclude the subsidiary corporation

primarily on the basis of information in the federal tax return and taxpayer

workpapers as well as the results of a federal audit. The auditor made no

adjustments for differences between U.S. and foreign accounting

standards and record keeping.

Domestic Case Number 5 The key issue in this case was the unity of the taxpayer with its domestic

subsidiaries. The taxpayer did not respond to the auditor’s request for

information needed to make a unitary determination, so the auditor relied

on the taxpayer’s SEC Form 10-K and the taxpayer’s annual reports. The

auditor revised taxable income primarily on the basis of information from

the federal tax return, annual reports, and taxpayer workpapers. An FTB

official noted that the number of hours spent on this audit was atypical,

because of the complexity of the relationships between the taxpayer and

its affiliates, the lack of taxpayer cooperation, and other problems. The

auditor made no adjustments for differences between U.S. and foreign

accounting standards and record keeping.

Foreign Case Number 1 The key audit issue in this case was the unity of the California taxpayer

with its foreign parent corporation and affiliates. Although the taxpayer

was first combined worldwide with its foreign parent corporation in the

late 1960s, the taxpayer included only its domestically owned subsidiaries

in its unitary business. Since the taxpayer stated that no facts had changed

since the previous audit, the auditor limited his unitary business analysis

to examining intercompany transactions between the taxpayer and its

parent corporation and foreign affiliates. The auditor recalculated taxable

income primarily on the basis of information contained in the foreign

parent corporation’s annual report, federal tax return, and taxpayer

workpapers. In computing one of the apportionment factors, the auditor

accepted certain information without verification because it could not be

obtained from the parent corporation. The auditor made two adjustments

Page 38 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix II 

Narrative Summary of 10 California

Franchise Tax Board Audits of Multinational

Corporations

for differences between U.S. and foreign accounting standards and record

keeping based on details in the annual report.

Foreign Case Number 2 The key audit issue in this case was the unity of several California

taxpayers with their foreign parent corporation. Each taxpayer filed

separate tax returns and none included the foreign parent corporation as

part of the unitary business. The different California taxpayers failed to

provide requested information on the unitary ties between the parent

corporation and any of its affiliates, so the auditor based his determination

on the parent corporation’s annual report, taxpayer financial statements,

federal tax returns, and taxpayer books and records. The auditor could

make no determination regarding the unity of unconsolidated foreign

entities mentioned in the parent corporation’s annual report. The auditor

recalculated taxable income primarily on the basis of the parent

corporation’s annual report, federal tax returns, taxpayer’s financial

statements, and workpapers and made one adjustment for differences

between U.S. and foreign accounting standards and record keeping on the

basis of information in the parent corporation’s annual report. One

taxpayer did not provide requested information that was needed to

determine the historical cost of property, which the taxpayer valued on a

different basis for some foreign subsidiaries. As a result, the auditor

accepted the taxpayer’s property values from the annual report.

Foreign Case Number 3 The key audit issue in this case was the unity of several California

taxpayers with their foreign parent corporation and affiliates. Each of the

different taxpayers filed separate tax returns, and none included the

parent corporation in the unitary business. The auditor combined the

taxpayers with their foreign parent corporation and its affiliates in the

unitary business and recalculated taxable income primarily on the basis of

information in the parent corporation’s annual report, federal tax return,

and taxpayer workpapers. However, the auditor noted that while the

taxpayers supplied some information, they did not supply documents

regarding sales needed to evaluate the nonunitary aspects between the

taxpayer and parent. The auditor made no adjustments for differences

between U.S. and foreign accounting standards and record keeping.

Foreign Case Number 4 The key issue in this case was the unity of the California taxpayer with its

foreign parent corporation and other U.S. subsidiaries. Although FTB had

combined the taxpayer with its parent corporation in a unitary business

Page 39 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix II 

Narrative Summary of 10 California

Franchise Tax Board Audits of Multinational

Corporations

during the previous audit, the taxpayer filed a domestic combined tax

return that did not include the parent corporation. The auditor determined

that the taxpayer should be included with its foreign parent corporation

and domestic affiliate in a unitary business, and the auditor recalculated

taxable income for 2 years primarily on the basis of information in the

parent corporation’s annual report. However, the auditor also determined

in his preliminary analysis of unity that the taxpayer potentially could

receive a large refund for the previous 2 tax years. The auditor notified the

taxpayer of a potential refund if it filed an amended return, but the

taxpayer did not file a refund claim. The auditor made two adjustments for

differences between U.S. and foreign accounting standards and record

keeping.

Foreign Case Number 5 In this case, the California taxpayer was a foreign multinational

corporation with business offices in California. Initially, the key audit

issue in this case was whether to include subsidiaries of the foreign parent

corporation in the unitary business. As in the past, the taxpayer included

one subsidiary but not others in the unitary business. Relying on

information in the annual report, the auditor determined that the taxpayer,

the foreign parent corporation in this case, was unitary with its

subsidiaries. However, since the auditor believed that a determination of

worldwide unity would result in a tax refund, FTB notified the taxpayer of a

potential refund if it filed revised tax returns. The taxpayer did not file a

return on this basis and the auditor reviewed the apportionment data

reported on the original tax return. Amounts for all factors were accepted

as reported on the tax return, except the auditor added back the

taxpayer’s staff retirement and pension contributions because this

deduction was not allowable for U.S. tax purposes.

Page 40 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix III 

Issues That Would Need to Be Considered

Before Federal Adoption of Formulary

Apportionment

Adopting formulary apportionment at the federal level would require

designing and administering a new system, one featuring a unitary tax and

addressing transition issues like coordination with other countries. A

unitary tax system combines the income of corporations that are

determined to be members of a unitary group and applies a formula to

divide the net income of the unitary group among taxing jurisdictions. This

approach avoids transfer pricing problems by using a formula rather than

transfer prices to determine each corporation’s share of the combined

income of related corporations. As a result, some state tax officials and

other tax experts have advocated formulary apportionment as an

alternative to the existing federal system. However, other tax experts

believe that it is not a viable alternative to the existing tax system.

This appendix does not discuss whether formulary apportionment should

be adopted at the federal level. Rather, it describes the design,

administration, and international coordination issues that would need to

be addressed before such a system could be adopted. We do not evaluate

whether these issues can be effectively addressed in a federal system or

whether problems with the formulary approach are more severe than the

problems with the arm’s length approach.

Design Issues Design issues that would need to be resolved center on specifying the

basic features of the unitary tax. These issues include (1) defining the

unitary business, (2) determining the apportionment formulas that divide

the unitary group’s income, and (3) defining the factors in the formulas

and the rules for valuing them and assigning them to specific tax

jurisdictions. In addition, the revenue implications of moving to formulary

apportionment would need to be addressed.

Defining the Unitary

Business

The definition of a unitary business has been continually controversial in

the states, and the lack of a uniform and clear definition has been a major

source of administrative complexity. As explained in appendix I, for

California, determining the members of the unitary group has been a

difficult and frequently audited issue. In examining a unitary business,

auditors require a great deal of data and must make subjective judgments.

As we noted in our previously cited 1992 and 1995 transfer pricing reports

and 1993 testimony, the arm’s length standard also requires taxpayers and

IRS to collect a great deal of information and use considerable subjective

judgment to compute arm’s length prices.1

11GAO/GGD-92-89, GAO/GGD-95-101, and GAO/T-GGD-93-16.

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Appendix III 

Issues That Would Need to Be Considered

Before Federal Adoption of Formulary

Apportionment

Thus, the ease of administering a unitary tax at the federal level would

depend on a uniform definition with clear criteria for identifying

businesses belonging to a unitary group. The definitions used by California

and other states test whether the activities of affiliated corporations

contribute to and depend on each other and, if so, to what degree. These

definitions use criteria such as the degree that accounting, advertising, and

management activities are integrated among businesses to identify

members of the unitary group. As our review of California audits shows,

identifying the unitary group using such definitions can involve complex

and detailed examination of the corporations’ management and

operations. If a federal system used the same criteria for defining a unitary

business, it might require a similar analysis.

Some academic experts and state tax officials argue that a federal system

would not need such complicated tests. They argue that a federal system

could use a simpler definition because the state complications result from

constitutional requirements that may not apply at the federal level.2

Although a simple definition would minimize administrative burden and

uncertainty, a definition that is too simple would risk combining diverse

companies or being manipulated by taxpayers. Thus, whether the unitary

business concept would be any easier to define and administer at the

federal level than at the state level is unclear.

One relatively simple way to define the unitary group would be to use a

“bright line” test based on ownership. The definition would include a

company in a unitary group if members of the group owned at least a

combined minimum percentage of the company’s stock. However, this

approach might combine companies that had very little connection in

terms of intercompany transactions or shared executive or staff functions.

It might therefore result in dividing income that did not flow from the

integrated activities of a unitary group. Some tax experts contend that

when arm’s length prices can be determined, separate accounting is more

appropriate. Further, the ownership test might be manipulated by

taxpayers buying or selling company stock to change the unitary group’s

makeup and reduce tax liability.

2

The courts have required that the definition of unitary and other state tax rules be consistent with the

due process and commerce clauses of the U.S. Constitution. Tax experts that we interviewed agreed

that the commerce clause restrictions on state taxation would not apply to the federal system but

disagreed about restrictions required by the due process clause. These due process restrictions might

limit the extent to which simple tests like ownership could be used in a federal system to identify a

unitary group.

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Appendix III 

Issues That Would Need to Be Considered

Before Federal Adoption of Formulary

Apportionment

To avoid problems like these, other experts have suggested alternative

bright line tests for the definition of the unitary group. One such test

would include corporations in the unitary group that have a minimum

share of the flow of goods and services between the controlled

corporations. Another test would be based on a minimum flow of value

between corporations that also meet a minimum percentage ownership

test, where the flow of value can arise from shared expenses, economies

of scale, and other economic interdependencies, as well as the exchange

of goods and services. Under either of these tests, increased administrative

complexity would have to be traded off against the reduced risk of

manipulation by taxpayers and combination of diverse companies.

Alternatively, a single test like ownership could be used if combined with a

workable relief procedure for cases where the test combined clearly

diverse companies. However, taxpayers have complained that state tax

administrators have been reluctant to employ relief procedures.

Defining the

Apportionment Formulas

To reduce the possibility of double taxation in a formulary apportionment

system, countries—like states—would need to use the same formula as

each other when dividing a company’s income. If countries use different

formulas (or if some countries use separate accounting), the same income

might be taxed by more than one country. With different formulas, the sum

of the income apportioned by the formulas to all countries might exceed

100 percent of the corporations’ income. The sum might also be less than

100 percent, resulting in some income escaping taxation in any country.

Neither the arm’s length system nor the unitary system can guarantee

eliminating double taxation, and the unitary system might undertax as well

as overtax. According to the U.S. Supreme Court’s opinion in the Barclays

case, the current arm’s length system might also involve double taxation.

Procedures for relief from double taxation, like the federal government’s

competent authority mechanism, would still have to be in place, and

guidelines for resolving differences in formulas would have to be

developed.3

Countries would also have to use consistent formulas (and consistent

definitions of the factors within the formulas) to reduce economic

inefficiencies that may result when differences in tax rules cause

companies to make investment decisions that they would otherwise not

3

Many countries enter into tax treaties with each other to avoid double taxation of multinational

corporations doing business in both jurisdictions and to prevent evasion of either’s income taxes.

Countries have generally appointed officials referred to as those countries’ “competent authorities” for

dealing with tax treaty matters covering related parties.

Page 43 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix III 

Issues That Would Need to Be Considered

Before Federal Adoption of Formulary

Apportionment

make. When the tax system interferes with investment decisions, capital

may not be employed in its most productive use. Differences in

apportionment formulas may encourage corporations to shift assets across

borders to reduce tax liabilities. Supporters of formulary apportionment

point out that because the formulary method recognizes that the

multinational corporation is an integrated enterprise and does not require

corporations to price transfers as if they were unrelated, it is less likely to

interfere with business decisions than the arm’s length standard. In any

case, the federal government would need to minimize interference by

promoting consistent formulas and factor definitions in a federal unitary

system.

Consistent formulas might be hard to achieve because countries, like

states, have incentives to vary their formulas. The majority of the states

use the equally weighted three factor formulas comprising sales, payroll,

and property to divide the income of companies except in some

designated industries.4

 The remaining states double weight sales, use other

weighting schemes, or permit formulas with fewer than three factors.

States may depart from the standard formula to provide tax incentives. For

instance, some states, with the recent addition of California, double weight

the sales factor because they believe that double weighting sales

encourages corporations to locate within their boundaries.

Countries too might adopt inconsistent formulas by weighting the factors

differently to exploit local conditions, such as differences in countries’

labor costs, or to create tax incentives. Countries might try to enforce

consistency through agreements and model laws. Although many states

recognize the need for uniformity and have tried to achieve it through laws

and agreements, the results of their efforts have been mixed. For example,

the number of states that double weight the sales factor grew from 4 in the

early 1980s to 18 in 1994.

In addition to being consistent, different formulas might have to be

designed for different industries, as is the case in some states. Also, relief

provisions might be needed in cases where standard or industry formulas

produce distortions. Because even a system of formulas tailored to

industry characteristics might not avoid distortions in all cases, companies

and IRS and tax authorities in other countries might have to settle for rough

justice by accepting a tax liability that is approximately correct.

4

Many states use different formulas for industries such as banking and finance to reflect the varying

importance of different factors in those industries’ activities.

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Some opponents of formulary apportionment are skeptical that rough

justice will be acceptable to taxpayers and tax authorities. Supporters of

the formulary approach point out that the arm’s length approach also

entails rough justice because it produces an approximation of the correct

tax liability. They note that arm’s length pricing requires that subjective

judgment be used to determine what price, within a range of prices, is the

correct price to apply.

Defining the

Apportionment Factors

Again, to reduce double taxation and ease administrative burden, a unitary

tax would require clearly specifying the elements in the apportionment

formula factors. The elements of the factors, such as the types of property

in the property factor, would need to be defined similarly in each country.

Location and valuation rules would need to be applied consistently

throughout a company that operates in different tax and accounting

jurisdictions. These rules would need to be defined so they are not easily

manipulated to avoid tax but at the same time do not impose unreasonable

compliance and enforcement burdens.

The states do not uniformly define apportionment factors. Although most

have adopted the Uniform Division of Income for Tax Purposes Act

(UDITPA) three-factor formula, some have introduced exceptions to the

prescribed rules for defining the factors in the formulas. Of the 45 states

with a corporate income tax, almost half have substantially adopted the

UDITPA provisions. However, some states have adopted such departures

from the UDITPA rules as valuing property at other than historical cost and

excluding executive compensation from the payroll factor. This lack of

uniformity creates difficulties for corporations complying with the state

tax and increases the risk of double taxation.

In addition to the issue of uniform factor definitions, other policy issues

specific to each factor have been the source of continuing controversy in

the states and would likely be raised in a federal system as well. The

following sections describe these policy issues for each apportionment

factor.

The Sales Factor The sales factor poses problems for tax administrators determining the

location of sales receipts. Most states assign receipts from sales of tangible

property to the state which is the destination of the sales. The location of

the sales may be shifted by altering the method or place of delivery. Many

states have used a “throwback rule” to limit the potential manipulation of

the sales factor by allocating sales in a state without a corporate tax to the

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state in which the sales originated. The rule helps to ensure that all income

of a corporation is subject to state tax. Like the states, a federal system

could use throwback rules to prevent the undertaxation of income.

Some commentators have criticized as complex and ambiguous the states’

rules for locating the receipts from selling or licensing intangible property.

Under UDITPA, the receipts are assigned on the basis of the location of

income-producing activities such as the sale, licensing, or other use of the

intangible. The rules have been criticized because they provide insufficient

guidance for applying complicated methods for determining the location

of these activities. In a federal system, an effort might be needed to make

these rules simpler and clearer.

The Payroll Factor Compensation is often defined differently inside and outside the United

States. Some countries include fringe benefits in compensation that the

United States does not include. Also, it may be difficult to distinguish

between employee compensation and payments to independent

contractors that may not be included in the payroll factor under a U.S.

definition of compensation. In a federal system, some adjustments for

these differences would have to be made and might be difficult when

foreign corporate records are not comparable with U.S. payroll records.

The California audits illustrate how one state now makes adjustments to

payroll figures.

The Property Factor The main controversies with the states’ definition of the property factor

center on using original cost valuation and excluding intangible property.

Both issues would need to be addressed in designing a federal unitary

system. One analysis would be determining whether the states’ approaches

are administrable and can be adopted at the federal level. Because people

disagree on these issues at the state level, the arguments of both

opponents and supporters of the state practice are important

considerations.

Opponents assert that valuing property at historical cost as most states do

may distort income apportionment. This is because comparable properties

acquired at different times will have different costs due to changes, such

as inflation, in the economic environment. Supporters counter that any

income distortion resulting from using historical value will usually not be

significant because property is only one of three factors that are averaged

to approximate the share of total income.

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Opponents maintain that the historical cost valuation method may impose

a substantial compliance burden on taxpayers. The start-up costs for

corporations of a unitary system might be substantial because they would

include determining the original value of assets worldwide. Unlike the

case in the United States, most foreign accounting systems are based on

market value and, in developing countries, historical costs may not be

available. Supporters contend that historical cost is generally available in

developed countries, even if it is not the primary method of valuation, and

that historical cost can frequently be calculated from information

appearing in financial statements. Also, supporters assert that the specific

valuation method is unimportant as long as the same method is used

consistently throughout the unitary group.

Opponents assert that excluding intangibles from the property factor, as

the states do, may distort the income apportionment of companies with

substantial intangible property. For example, most of the income of a

corporation with a unique, high-valued patent may be due to the patent,

but the corporation’s share of the unitary group’s income, as determined in

part by the property factor, would not be affected by the patent. Including

the intangible in the property factor would be difficult because historical

costs would be hard to determine. If market value were used rather than

historical value, determining the arm’s length market value of the

intangible would reproduce in the unitary system the valuation problems

plaguing the administration of section 482 of the Internal Revenue Code.

The states exclude intangibles from the property factor because they

recognize the impracticality of determining the location of intangible

assets. Supporters of the state practice maintain that trying to place the

intangible in any one jurisdiction is inappropriate in most cases. In their

view, the value of an intangible, like a trademark, extends to the entire

corporation and cannot be limited to a specific location. Nevertheless,

they contend that intangibles still influence income apportionment

because the factors reflect the activities that give rise to the intangible. For

instance, the spending on research salaries and equipment will increase

the payroll and property factors for a unitary group’s research member

and therefore the share of income from a patent that is apportioned to that

member.

Revenue Another issue that would have to be addressed before a federal unitary

system could be adopted is the impact on the tax revenue received by the

federal government. The studies that we have examined are not

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comprehensive, and the revenue implications of a change to a unitary

system are uncertain. Further study would be needed to produce estimates

of the revenue effects of a change to a federal formulary system.

The revenue gains and losses of moving from the arm’s length approach to

the formulary method depend on several factors. For example, if property

and payroll cost less abroad than at home and if management

systematically requires higher profit from offshore operations to

compensate for risk, the shift from the arm’s length approach to the

unitary approach is likely to increase taxable income apportioned to the

home country. However, if costs in the foreign countries are higher, a

greater share of income is likely to be apportioned abroad.

Although studies have shown that total U.S. multinational income

apportioned to the United States would increase if a unitary tax were

adopted, they also showed the increase depending on a few industries. For

example, one study found that changing to a worldwide unitary tax would

increase U.S. income by 13.5 percent for all industries, but when the

petroleum and coal industries were excluded from the study, the change

would decrease U.S. income by 2.4 percent.5

These studies were not comprehensive for several reasons:

• Some used data only for U.S. corporations or for corporations based in a

single state.

• Some relied on data for a single year and therefore did not reflect how the

U.S. share of total income might change with the business cycle.

• Some also based their estimates on data from the Department of

Commerce and on financial statement information, which might not be

accurate proxies for taxable income.

A comprehensive study of the revenue effects of the change to formulary

apportionment would be based on tax data for several years and cover

U.S. corporations and U.S. subsidiaries of foreign parent corporations

operating in the United States.

Administration Issues Administration issues concern the challenges taxpayers would face in

complying with a unitary tax and that tax administrators would face

enforcing it. These issues arise from the differences in financial

5

Robert Tannenwald, “The Pros and Cons of Worldwide Unitary Taxation,” New England Economic

Review, (July/Aug. 1984), pp. 17-28.

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accounting systems among countries, taxpayers’ need to gather

information on their worldwide activities, and tax administrators’ need to

verify this information.

Reconciling Accounting

Rules

A federal unitary system would require taxpayers and IRS to adjust for

differences among various countries’ accounting rules. Adjustments are

needed to make values consistent when computing worldwide income and

apportionment factors. To some extent, companies already make

adjustments for regulatory or internal business reasons. However, we

cannot be sure how many companies would face an added compliance

burden under a unitary system.

Besides converting foreign financial accounting principles to U.S.

generally accepted accounting principles (GAAP), companies might also be

required to make complex and time-consuming efforts to reconcile

financial accounting to tax accounting rules for items such as inventory

accounting methods and depreciation. We do not have comprehensive

data on the costs of making these adjustments. Supporters of the unitary

method assert that the costs of accounting adjustments at the state level

have not been excessive. Critics contend that developing data on a unitary

group’s worldwide activities and reconciling countries’ diverse accounting

rules can be extremely burdensome.

In its recent Barclays decision, the U.S. Supreme Court found that

Barclays had not shown that the California worldwide unitary system

imposed inordinate compliance costs that would make the California

system unconstitutional. This finding was made even though Barclays

maintained that it was required to convert financial and accounting

records from around the world to conform to U.S. principles. Barclays

argued that California would require the company to gather and present

much information not maintained by the unitary group in the normal

course of business. However, because, as alluded to in appendix I,

California allows companies to use “reasonable approximations” when

they do not normally keep the needed data, the court found that Barclays

avoided large compliance costs.

Companies may already adjust records to U.S. rules for regulatory reasons

or to facilitate doing business in the United States. For example,

companies listed on U.S. stock exchanges are required by the Securities

and Exchange Commission (SEC) to prepare financial statements

according to U.S. GAAP or quantitatively reconcile to GAAP the materially

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Apportionment

different items on their foreign-based financial statements. Also, IRS

regulations specify that record-keeping requirements under section 6038A

of the Internal Revenue Code will be satisfied if, among other records,

profit and loss statements that are directly or indirectly related to

transactions between related parties are maintained in accordance with

GAAP or deviations from GAAP are explained. Companies may also prepare

financial statements according to GAAP to make their U.S. business easier

to transact. For example, U.S. lenders may need financial statements done

according to GAAP in order to have records that they can understand.

Although the costs of reconciling accounting rules in a federal unitary

system would depend on many things, as described later in this appendix,

an indicator of additional costs is the adjustments that foreign companies

now make to conform to U.S. GAAP. According to an SEC survey of 528

foreign corporations filing annual SEC reports or registration statements

from 1991 through the first 2 months of 1993, 46 percent already prepared

financial statements according to GAAP or reported no material effect on

their original statements due to deviations from GAAP. The other

54 percent, however, reported material deviations and therefore had to

make various reconciliations. Depreciation and amortization, deferred or

capitalized costs, and deferred taxes were the most common reconciling

items. The corporations included in the survey were from the countries

supplying most of the foreign direct investment in the United States, and

most of the corporations used those countries’ accounting principles.

Therefore, the survey illustrates the kinds of adjustments going from

foreign accounting rules to U.S. GAAP that might be made by foreign

corporations in a federal unitary system.

If the unitary system became the international norm, foreign corporations

and U.S.-based companies would be reconciling accounting rules for all

the countries that adopt a unitary system. Although U.S. multinational

corporations already reconcile foreign accounting rules to U.S. GAAP, they

could also be required to reconcile U.S. accounting rules to those of the

countries in which their subsidiaries operate and which have adopted a

unitary system. The overall cost would depend on the number and type of

reconciliations required. For each country involved, relevant questions

would include (1) how much the foreign accounting system differs from

GAAP, (2) what materiality and reasonable approximation provisions are

adopted in the federal system, and (3) to what extent the subsidiaries of

U.S. companies already keep records according to foreign rules for

regulatory or business reasons. In adopting a unitary system, the federal

government would have to consider the effect on compliance burden of

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differences in international accounting rules and the degree to which

reasonable approximations could be used in a federal system to reconcile

material differences.

Obtaining and Verifying

Information

A federal unitary system would require companies to compile information

on their worldwide activities. To some extent, companies already do this

for regulatory and business reasons. We do not know the start-up costs for

companies that do not, nor do we know what new information a federal

system would require of all companies. Also, how IRS would audit a unitary

system is uncertain. IRS might not rely on the same data sources as

California, and the federal system might introduce rules not used by

California that simplify or complicate audits.

Whether companies with global operations would incur substantial

start-up costs under a unitary tax depends on whether they already

prepare consolidated financial statements. If they do, and supporters of

the unitary system contend that most foreign-controlled corporations do,

their start-up costs would not be as great. However, depending on the

approximation and materiality rules already discussed, they might still

need to collect data not on the statements or make adjustments for

accounting rules. As discussed in appendix I, California auditors sought

information on the historical cost of land owned by a foreign parent

corporation—information not found on the parent corporation’s financial

statement.

Under a unitary system, IRS would need to verify the value of companies’

worldwide property, payroll, and receipts. The costs of administering such

a tax would depend on the system design and the level of audit effort IRS

finds acceptable. Our review of California audit practices showed

California relying, to a great extent, on financial statements audited by

private accounting firms to verify worldwide income and apportionment

factors. In a federal unitary system, IRS would need to determine whether

to rely on audited financial statements to the same extent as California or

whether to go further in verifying apportionment factors and worldwide

income.

IRS may be better able than the states to compel information from

companies and may have better access to information collected by foreign

tax authorities, but we are not sure how these advantages would work out

in a federal unitary system. For example, section 6038A of the Internal

Revenue Code requires extensive record keeping relating to

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Apportionment

foreign-controlled businesses in the United States. IRS provided us with

examples of many taxpayers that have become more compliant as a result

of the requirements of section 6038A. By using such provisions, IRS may

have more success than the states acquiring foreign data under a unitary

system.

Transition Issues Transition issues concern the process of moving from the current arm’s

length system of taxing multinational corporate income to formulary

apportionment. They include the international coordination needed for a

unitary system and the changes required in the U.S. tax code to

accommodate a unitary tax.

International Coordination In our 1992 report,6

 we said that getting international agreement for a

change to a unitary system would be difficult. We continue to believe that.

On the basis of information presented in this report, we also believe that

international agreement for a unitary system design may be very hard to

achieve and that administering a unitary system would be easier if

countries shared information and procedures for keeping countries’ tax

systems consistent. Thus, coordination would mean obtaining agreement,

not only on the change to a unitary method but also on the new method’s

design and administration.

A primary reason that coordination is desirable is to avoid double

taxation. Companies that operate in countries that adopt a unitary system

may have the same income taxed by different countries when, as

previously described, countries use different definitions of unitary

businesses, formulas, and factors. Double taxation may also occur when

companies operating in countries that adopt a unitary system also operate

in countries that continue separate accounting.

Obstacles would have to be overcome to foster increased international

cooperation in favor of formulary apportionment. Countries and

organizations throughout the world oppose the unitary method. Nearly

every country has adopted the arm’s length standard (separate

accounting) as the general principle governing transfer pricing. The United

Nations and the Organization for Economic Cooperation and Development

(OECD) recommend its use. The recently issued OECD draft guidelines on

transfer pricing specifically reject global formulary apportionment as the

6

GAO/GGD-92-89.

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Before Federal Adoption of Formulary

Apportionment

international standard.7 Although the guidelines are not binding on

member states, they guide countries and corporations in setting proper

arm’s length prices.

Furthermore, the United States has a long history of supporting the arm’s

length method—a history that complicates a move toward a unitary

system. The United States first incorporated the arm’s length standard in

regulations in 1935 and articulated a detailed approach in 1968. U.S.

adoption of the arm’s length method influenced other countries to adopt it

as well. Further, according to the Department of the Treasury, the United

States is obligated under virtually all of its bilateral tax treaties to apply

the arm’s length standard to transfer pricing adjustments to the profits of

related companies. However, some commentators contend that the

treaties do not prohibit the use of a formulary apportionment system.8

The states’ experience with unitary systems shows the importance of early

rather than late coordination for limiting administrative and compliance

costs. Initially, the states adopted unitary systems independently of each

other, with little coordination of definitions and tax rules.9

 The resulting

nonuniformity in state taxation was seen as a source of compliance and

enforcement burden. Given this experience, some experts contend that

solving federal design problems at the outset would be better than trying

to correct them later.

Methods that could be used to coordinate a change to a unitary system

include working through a supranational organization like OECD or

gradually introducing specific provisions into bilateral tax treaties. Both

approaches would be difficult because of the OECD’s opposition to the

unitary system. The OECD published the OECD Model Tax Convention on

Income and Capital, which many countries have adopted as the basis of

their bilateral tax treaties. The OECD also publishes guidelines to help tax

7

The OECD draft defines global formulary apportionment as the allocation of the global profits of a

related group of companies among the companies in different countries on the basis of a

predetermined or mechanistic formula. The OECD draft does not reject the selected application of

formulas developed by taxpayers and tax administrators, such as might be used in advanced pricing

agreements. See Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators,

Discussion Draft Part I: Principles and Analysis, OECD Committee on Fiscal Affairs, (July 8, 1994).

8

See, for example, Louis Kauder, “The Unspecific Federal Tax Policy of Arm’s Length: A Comment on

the Continuing Vitality of Formulary Apportionment at the Federal Level,” Tax Notes, (Aug. 23, 1993),

pp. 1147-1155.

9

As mentioned earlier, states have tried to achieve uniformity through model laws such as UDITPA and

organizations such as the Multistate Tax Commission. UDITPA’s purpose is to make state income

taxation simple and fair by addressing nonuniformities in the states’ allocation and apportionment

rules. The Commission has taken the lead in developing and interpreting the goals and provisions of

UDITPA.

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Before Federal Adoption of Formulary

Apportionment

administrators and multinational corporations find solutions to transfer

pricing problems. The convention and the guidelines reflect the OECD’s

strong support of separate accounting and opposition to formulary

apportionment.

A successful unilateral change to a unitary system would require that most

countries quickly follow the U.S. lead, an unlikely prospect given the

stated resistance of many countries. If the United States alone taxed

multinationals using the unitary tax, it would expose U.S. companies to

double taxation while limiting their ability to obtain relief in a competent

authority process that adhered to the arm’s length standard.

Other Changes in the

Internal Revenue Code

Other aspects of international taxation may need to change to be

consistent with a unitary tax. For example, a credit for taxes paid on

foreign-source income might not be needed in a unitary system. The extent

of the change required in the tax code would depend on whether the

system were adopted within the framework of residence- or source-based

taxation.

The current federal system of taxing international income is primarily

residence based. The United States taxes a corporation organized in the

United States on all of its income, regardless of where it is earned.

However, taxes on income earned in foreign countries are deferred until

the income is repatriated, or sent to the United States, and, even at that

time, a credit against the taxes is generally allowed for foreign taxes paid.

An exception to this deferral of taxes exists for certain passive income,

which is taxed as soon as it is earned. Thus, the United States defers tax

on non-U.S.-source income but taxes all the income of U.S. residents

wherever it is earned.

The current system is not a pure residence-principle tax in that it also has

features of a source-based tax. The use of the foreign tax credit and

deferral of tax recognizes that the country that is the source of the income

has the first claim to tax the income. The United States does not tax

foreign-source income until it has been repatriated and only to the extent

of any residual U.S tax after subtracting the foreign taxes paid.

Formulary apportionment is consistent with either residence or source tax

principles. As a residence tax, a unitary system would tax the

U.S.-apportioned share of income currently and tax the

foreign-apportioned share when and if it is repatriated. As a source tax, a

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unitary system would exempt from taxation income that is not

apportioned by formula to the United States.

The choice of tax principle, however, would have major consequences for

the administrative burden of the tax system. A source tax would eliminate

many of the complexities of the current system, such as the foreign tax

credit, while adding the complexities described earlier that are specific to

the unitary tax. A residence-principle tax would retain the current

complexities while adding the complexities specific to the unitary tax.

The effect on administrative burden can be illustrated by the different

roles of the foreign tax credit in a source-based versus a residence-based

unitary system. If a new unitary system were source based, the income

apportioned to the United States would be U.S.-source income. The United

States would not tax foreign-source income and therefore would not need

to provide a foreign tax credit to avoid double taxation. However, double

taxation could still occur if countries disagreed on the apportionment

formulas and therefore the definition of foreign-source income and if they

then taxed what other countries deemed to be their apportioned share of

worldwide income. Disputes about double taxation are currently resolved

in competent authority and presumably would continue to be resolved

there under a unitary system.

If the United States retained the residence principle in a unitary system,

income apportioned to foreign sources would still be subject to U.S. tax.

Therefore, an administratively complex foreign tax credit would still be

required when the foreign-source income was repatriated to prevent

double taxation. Congress might choose to retain the residence tax,

despite the administrative complexity, to better protect the U.S. revenue

base.

Congress would need to address the proper role of the foreign tax credit,

along with other features of the Internal Revenue Code. These other

features include withholding taxes on dividend, interest, and royalty

income; income sourcing rules; and the continued use of the provisions of

subpart F of the Code, which limit deferral of U.S. tax on foreign income.

Congress could resolve these issues in different ways. As under the

current system, a federal system might have features of either a

source-based or a residence-based tax, or both. Important considerations

include the effect of alternative choices on administrative complexity and

on protecting the U.S. revenue base.

Page 55 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix IV 

Comments From the Franchise Tax Board of

California

See pp. 5-6, 12-13.

See pp. 12-13.

Page 56 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix IV 

Comments From the Franchise Tax Board

of California

See pp. 13, 49-50.

See pp. 13, 42-43.

See pp. 13, 44-45.

See pp. 13-14, 45-46.

Page 57 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix IV 

Comments From the Franchise Tax Board

of California

See pp. 14, 47-48.

See pp. 12, 49-50.

See pp. 14, 50-52.

Page 58 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix V 

Comments From the Department of the

Treasury

See p. 14.

See pp. 14-15.

Page 59 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix V 

Comments From the Department of the

Treasury

Page 60 GAO/GGD-95-171 Taxes on Multinational Corporations
Appendix VI 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Jose R. Oyola, Assistant Director, Tax Policy and Administration

 Issues

Lawrence M. Korb, Assignment Manager

Kevin E. Daly, Senior Economist

San Francisco

Regional Office

Ralph Block, Assistant Director

Dennis Day, Senior Evaluator

Dylan A. Jones, Evaluator

Susan Malone, Evaluator

Samuel H. Scrutchins, Technical Advisor

(268613) Page 61 GAO/GGD-95-171 Taxes on Multinational Corporations
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