Residual profit allocation by income

This paper is a draft chapter of a forthcoming book on the taxation of international business profit by the authors of this paper, to be published by Oxford University Press. The group has been meeting regularly for five years, to identify and discuss the key problems of the existing international tax system, and to develop potential options for reform. The book will study two proposals for reform in depth. One is the destinationbased cash flow tax – a draft chapter on this proposal has already been released.1 The second proposal – for a form of residual profit allocation - is presented here.  This paper is largely self-standing and can be read without necessarily reading the rest
of the book, although it does refer in places to arguments set out in other draft chapters. We hope to make these other chapters available shortly. We invite comments on the contents of the two draft chapters which have been made available; they can be made to the chair of the group, Michael Devereux,2 or to any of the group members.

We refer to the proposal set out in this paper as a Residual Profit Allocation by Income, or RPA-I. It is one of a family of schemes based on separating the total profit of a multinational enterprise (MNE) into two parts – the “routine” profit and the “residual” profit. This distinction is familiar from the existing system in the context of profit splits. The proposal here goes considerably further than the existing system; nevertheless, it is based on existing features and concepts. As such, although the RPA-I would involve substantial departures from the existing system, we believe that the transition to it could be achieved broadly within the context of the existing system. 
The RPA-I allocates the right to tax routine profit to the country where functions and activities take place. It allocates the right to tax residual profit to the market, or destination, country where sales are made to third parties.

We argue that the RPA-I has attractive properties – while it is far from perfect, it matches well the criteria by which we aim to evaluate proposals for tax reform: economic efficiency, fairness, robustness to avoidance, ease of implementation, and incentive compatibility. The RPA-I’s superior performance under these criteria relative to the existing system stems primarily from allocating taxing rights for residual profit to the destination country. The relative immobility of the third-party purchaser of goods and services sold by the company – especially in the case of individuals, rather than businesses – implies that the location of the taxation of residual profit is not easily manipulated. This is true of manipulation by shifting real economic activity – which creates economic distortions and hence inefficiencies – and also of the manipulation of the location of taxable profit. Thus the introduction of the RPA-I would be likely to result in a significant improvement in the performance of the existing system, both in terms of economic efficiency and robustness to avoidance.

Yet the RPA-I is based firmly on concepts employed by the existing system. “Routine” profit is the profit a third party would expect to earn for performing a particular set of functions and activities on an outsourcing basis. In this outsourcing model the third party functions essentially as a service provider; it does not share in the overall risk of the MNE, and earns no return based on the overall success or failure of the product or business to which its activities relate. The routine profit for an affiliate would be based on the rate of profit earned by a comparable third party, applied to an appropriate cost base, although other transfer pricing approaches could also be used. In this sense, the RPA-I would not discriminate between activities that are undertaken within the business as opposed to outsourced to an independent business.

The residual profit of a MNE can be calculated in two ways. The first, bottom-up approach, identifies the residual gross income (RGI) earned in each destination country. This is measured as the value of sales to third parties in that jurisdiction, less the costs of goods sold, including expenses incurred in that country plus the transfer value of goods and services purchased from other parts of the MNE. The transfer value is based on the costs incurred in the relevant functions and activities of the selling party together with any routine profit associated with those costs. Costs that cannot be directly allocated to specific sales would then be apportioned to each destination country based on that country’s share of total RGI, and the apportioned costs would be deducted to determine the residual profit in each destination country. This approach can be structured to yield identical results to a top-down approach by which the total residual income – calculated simply as total profit less total routine profit - is apportioned directly by RGI. The RPA-I would apply irrespective of the nature of the presence of the MNE in the destination country. Residual profit is allocated to destination countries whether there is a subsidiary, branch, or simply a remote sale there. 

The RPA-I thus adheres to existing transfer pricing rules where they are generally deemed to work reasonably well (to calculate routine profit) and departs from these rules in the context of residual profit, where these rules are generally deemed to struggle. This RPA-I proposal differs from other RPA options proposed in the literature in two important ways. First, routine profit is determined by common transfer pricing techniques, instead of being based on a fixed mark-up over costs. That makes it more able to reflect the specific conditions faced by individual businesses and aims at neutrality of treatment between activities undertaken within the business and those outsourced to an independent business. Second, the apportionment of residual profit is based on the location of RGI, rather than sales. This has advantages in terms of both economic efficiency and robustness to avoidance.

Towards fundamental reform of the international taxation of business

The Oxford International Tax Group of economists and lawyers, chaired by Michael Devereux, has spent some years discussing options for the fundamental reform of the international system for taxing business profit. The Group will publish their work as an Oxford University Press book in 2020.  

One proposal which they have developed is for a new system that they identify as Residual Profit Allocation by Income, or RPAI. This has been published in advance of the book as a working paper. The proposal is one of a family of schemes based on separating the total profit of a multinational enterprise (MNE) into two parts – the ‘routine’ profit and the ‘residual’ profit. This distinction is familiar in the context of profit splits. The RPAI allocates the right to tax routine profit to the country where functions and activities take place. It allocates the right to tax residual profit to the market, or destination, country where sales are made to third parties.  

This proposal has echoes in the OECD’s current work on ‘Pillar 1’ of its consideration of the challenges arising from the digitalisation of the economy. However, the RPAI is more comprehensive and consistent than the ideas that the OECD is considering.  

The group argues that the RPAI has attractive properties – while it is far from perfect, it matches well reasonable criteria for evaluating proposals for tax reform: economic efficiency, fairness, robustness to avoidance, ease of implementation, and incentive compatibility. The RPAI is based firmly on concepts employed by the existing system.  Its superior performance under these criteria relative to the existing system stems primarily from allocating taxing rights for residual profit to the destination country. The relative immobility of the third-party purchaser of goods and services sold by the company – especially in the case of individuals – implies that the location of the taxation of residual profit is not easily manipulated. This is true of manipulation by shifting real economic activity – which creates economic distortions and hence inefficiencies – and also of the manipulation of the location of taxable profit.  Thus the introduction of the RPAI would be likely to result in a significant improvement in the performance of the existing system, both in terms of economic efficiency and robustness to avoidance.  

Michael Devereux, Alan Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schön and John Vella ‘Residual Profit Allocation by Income’, Oxford University Centre for Business Taxation Working Paper 19/01