The Multinational Monitor

SEPTEMBER 1980 - VOLUME 1 - NUMBER 8


F I N A N C E

Unitary Method Curbs Tax Shenanigans

An Alternative to Arms-Length

by Jonathan Rowe

A frontier issue for the nations of the world is the problem of disentangling the incredibly complex accounting arrangements of multinational corporations and determining how much of their profits should be reported where.

Despite the importance of the problem, most tax jurisdictions are still confronting it with essentially eighteenth century tools. The first installment of this article described how the U.S. Treasury has been promoting an antiquated tax enforcement device called the "arms-length" or "separate accounting" method, which pretends that the subsidiaries and divisions of a multinational corporation are really independent businesses, and thus caters to the accounting schemes by which the multinational squirrels away its profits in tax havens and low-tax jurisdictions. The complexity of this approach has relegated the smaller developing countries of the world, in particular, to virtual helplessness in this arena.

The present installment describes a promising alternative, called the "unitary" method, which is spreading despite the U.S. Treasury's attempts to suppress it. Pioneered by the states of the United States, it could give the nations of the world the ability, on financial matters, to keep the multinationals of the world under the rule of law.


Instead of holding fast to the arms-length method, many states are doing something simpler-looking to the company's actual business activities, instead of to the accounting disguises in which these activities are clothed. They take three major indexes of business activity in their jurisdiction-property, payroll and sales-and apportion the income of that business on the basis of these indices.

For example, if one-fiftieth of a company's property, payroll and sales were in a particular state, or nation, then that state or nation would be entitled to tax one-fiftieth of the corporation's income. This approach, called the "unitary business" method, frees corporate income tax enforcement in large measure from the arbitrary and shifting winds of corporate accounting, reducing the possibilities for manipulation.

That the states have been -on the cutting edge of this issue is not really surprising. Lacking the federal government's mammoth bureaucracy, and its ability to print money to finance deficits, the states have been pushed by necessity towards leaner, more effective ways of collecting taxes.

Moreover, the states had a big head start on the issue. Decades before multinationals were a major item of concern for the Internal Revenue Service, the states were grappling with the enforcement problems posed by corporations operating across political borders.

It began in the last century, when railroads were spanning the continent. Back then, the major state tax was the property tax, and assessors faced, a vexing, and high-stake, dilemma: how to value the railroad tracks that ran across their jurisdictions.

The railroad agents had a ready answer. The tracks were really just so much iron and wood, they said. Therefore, this property should be valued, or assessed, according to the salvage value of the materials of which they were made.

To the assessors, that made about as much sense as saying a part interest in a racehorse should be valued on the basis of what its hooves would fetch if sold for glue. Clearly, the railroad tracks were not just so much iron and wood. They were integral parts of a thriving enterprise, the feet of a corporate body which included freight yards, terminals, headquarter buildings, and the like. One simply could not set a fair value on the railroad tracks without reference to the corporate body, the whole business, of which these were a part.

Spreading the value of the whole business out over its constituent parts, on a strict accounting basis, would be a computational quagmire. Thus the states developed a shorthand approach, based on a formula. The "unit rule," or "unitary method" was born.

When the states began to adopt corporate income taxes early in this century, the unitary enforcement concept was ready and waiting. Applying this approach to the income tax was a natural step. The use of accounting tricks to divert income from a particular state was just a more sophisticated version of the old railroad poor-mouthing which would have reduced the value of their -tracks in many states to so much iron and wood.

It was California which pioneered the two great advances which really brought corporate tax enforcement into the twentieth century. First, responding to the growing complexity of American corporations, California took the step of treating a company as a single, or unitary business, even if the company's lawyers had divided this business up into hundreds of legally separate subsidiaries, as the oil companies and others do. And secondly, in the early sixties, California began regularly to include the worldwide activities of a multinational, not just the U.S. operations, in the unitary "pie" to which the formula is applied.

The unitary method has many advantages:. It brings corporate tax enforcement within reach of jurisdictions lacking massive resources, and cuts bureaucracy. It reduces the advantages out-of-state (or foreign) corporations can have over instate (or domestic) businesses through their ability to shift their profits away from the state or nation's tax collectors.

Moreover, the method offers the only practical hope of uniform standards among the taxing jurisdictions of the world. The Treasury's arms-length approach has failed utterly on this score because the accounting adjustments made by one state or nation may be unacceptable to others.

Most multinationals have vehemently opposed the unitary method, attacking it in courts, legislatures, and in the media. Through a Chamber of 'Commerce adjunct called the Committee on State Taxation (COST), they have badgered the U.S. Congress for 15 years to rein in the uppity states. Failing there, and in the courts as well, they resorted in 1976 to exerting influence on the Nixon-Ford Treasury Department to slip a ban on the unitary method, unbeknownst to the states, into an obscure tax treaty then being negotiated with the United Kingdom. (Tax treaties are supposed to merely harmonize the tax systems of the nations involved so that corporations doing business in each are not taxed twice, but they can become virtual multinational loophole swaps.) This ploy also failed when the U.S. Senate rejected the unprecedented move.

Corporate attacks on the unitary method have been couched in terms of legal and economic arguments which sound plausible but don't stand up to close scrutiny.

Corporations argue, for example, that the unitary method imposes "impossible" record-keeping burdens upon them. But the record-keeping requirements of the arms-length method probably far outpace those of unitary. That aside, corporations seem to have no problem at all producing the necessary information when the unitary method works to their financial advantage, as it occasionally does.

Illinois Tax Commissioner James Zagel, one of the brighter lights in this field, tells of the auditors in his department who worked previously for multinational companies. "They used to figure out their company's taxes on both a unitary and arms-length basis," Zagel says. "Then they would report on whichever basis saved their company' the most money." (Vague laws or casual tax officials in some states permit this flexibility.) "The paperwork argument is thus not very persuasive," Zagel adds dryly.

Beneath such blue-suited arguments, however, are more basic corporate concerns.

For one thing, corporate managers simply are not familiar with the unitary system, and this makes many of them nervous. "For them, the known is always better than-the unknown," says tax attorney Richard Pomp. For another thing, by undercutting much legal and accounting rigmarole, unitary threatens the employment of lawyers and . accountants who practice those obfuscatory arts.

A third factor is clarity. As mentioned in the first part of this article, the Treasury's arms-length approach is so arbitrary and capricious that most cases end up in quiet negotiations between the corporation and the revenue agents. Corporate taxpayers like this. "The real fear [of unitary]," Oregon Tax Commissioner John Lobdell told the Senate Foreign Relations Committee, "is compliance with uniform legal requirements-the end of negotiated settlements."

The bottom line, of course, is money. After lengthy wrangling over the legal and economic esoterica with corporate representatives and congressional staffers, the author put the question to a rather candid oil company lobbyist.

"Look, tell me the truth. Are we really arguing over economic theories or are we talking about money?"

"We are talking about money," the oilman replied, without missing a beat.

Indeed we are. Lots of money. Simplicity and fairness are the basic appeal of the method, and some states adopt it solely for these reasons. The fact remains, however, that the unitary method tends to flush out profits that otherwise would disappear into foreign tax havens and accounting black holes.

California, for example, realizes an additional one-half billion dollars a year (and growing) through the unitary method, and one half of this arises from multinational oil companies. Smaller states have benefitted in similar proportion. Idaho, for example, doubled its corporate collections by going unitary.

The method is particularly effective in exposing oil company accounting ploys. Two recent Supreme Court cases upheld the states' authority to use the unitary method on corporations reporting little or no profit to the states.

One of these cases concerned Mobil's use of separate accounting to pay only $1900 in taxes to Vermont for three years in which it sold over $27 million worth of products in the state. For two of those years, Mobil actually had claimed losses in the state. I n the second case, Exxon was caught using separate accounting to report almost $4 million in losses to Wisconsin for four years in which its sales there came to over $60 million.

In both instances, the states applied the unitary method to exact at least some tax from the oil companies. And in both cases, the Supreme Court rejected the companies' arguments that the states' assessments were unconstitutional or unfair.

Corporate opposition to unitary is fairly predictable. But why has the U.S. Treasury joined the corporations at the barricades? They argue that the arms-length method is the "internationally accepted norm" and that consistency among nations must be built on this foundation. Fair enough. What Treasury omits, however, is that the arms-length system is the "international norm" primarily because Treasury itself has proselytized it as such; that the unitary system could be promoted just as easily; and that in fact this system would be vastly more conducive to international uniformity.

Then too, Treasury lawyers and economists have a genuine intellectual attachment to the arms-length approach, which pays homage to the corporate forms and free marketplace assumptions in which they were respectively schooled. Moreover, the automatic revolving door between the international tax posts at Treasury and the corresponding suites in corporate lobbying offices and law firms has not enhanced the likelihood of Treasury making any waves on this issue.

What really seems to worry Treasury, however, is what haunts the multinationals-the spectre of developing countries finding a tax enforcement system that actually works for them. This fear is a major recurring theme of the candid, private conversations of Treasury officials. "If the developing nations ever got a hold of this system they would tax the hell out of our companies," one Treasury official said. This fear of Third World governments catching onto the unitary system is a major reason the Treasury has tried to use the tax treaty process to build a legal Maginot Line to block the system's spread.

To date, they've been successful. The separate accounting, arms-length method, is still the reigning international practice.

Treasury's resistance has not daunted the states, however. Attracted by its simplicity, the revenues it can help generate, the potential for uniformity among jurisdictions, the states have been embracing unitary, cautiously but .steadily. The Multistate Tax Commission, a cooperative tax enforcement body currently composed of 19 member states, has been recommending it to its members, and close to 10 are now using the system regularly.

Scholarly opinion, for once, is giving such states a hand, as highly respected journals and authors endorse the unitary method as technically superior to the alternatives. The Harvard Law Review, for example, concluded an exhaustive comparison of the unitary and arms-length approaches by asserting that the former "deserves serious consideration as a formalized alternative to current (arms length) practice." A comprehensive Brookings Institution study of U.S. multinationals concluded that the unitary method may be "ultimately the only satisfactory solution" to tax enforcement problems.

Tax practitioners ate getting on board as well. Brian Augiers, of the London Branch of Peat, Marwick, and Mitchell, wrote in Tax Planning International magazine that the unitary method "may represent the wave of the future."

A future, however, that many multinationals are trying to forestall. COST and its cohorts are working the halls of Congress more diligently than ever. Beaten and slightly embarrassed on the U.K. Treaty flop, the corporate lobbyists are determined to redeem themselves in the next session of Congress. They are mustering their forces behind legislation to this end sponsored by Senator Charles Mathias (R-Md.) and Representative Barber Conable (R-N.Y.) and James Jones (DOk.).

Possibly the most interesting part of the whole confrontation, however, is the growing division within the corporate ranks.

Some companies are at least open to the possibility that the Treasury's arms-length method is more nuisance than it is worth, even though it saves them money in the short-term. As far back as 1972, in a report of the corporate-sponsored Conference Board, managers complained that justifying their intricate accounting schemes to a bunch of nosey IRS auditors was an excessive annoyance.

"It takes an inordinate amount of time" said one. "Repetitious, laborious and time-consuming," said another.

Sam Stewart, the maverick tax head at Union-Pacific Railroad and a former Oregon State Tax Commissioner, unsettled COST when he put his company squarely behind unitary (domestic, not worldwide) on the grounds that it was the only way his company could ever get uniform treatment in all the states in which it operated. Stewart wanted, among other things, to cut his company's accounting burden.

More important, in particular circumstances, the unitary method can work in a company's favor. This is due to technical factors and occurs primarily when the company is based in the state or nation in question. Standard Oil of California is one such company. The unitary system spreads the company's substantial ARAMCO dividends out over all the states in which it operates, instead of treating all these dividends as taxable in its home state. SOCAL, not surprisingly, has been a prime booster of the unitary method in California.

SOCAL attorneys actually helped the state of Vermont defend the unitary approach against Mobil's attack there. "We just want a tax system that is rational and that treats everybody fairly," a SOCAL attorney says. (Cynics might dismiss such pronouncements as self-serving. Yet SOCAL has behaved much more responsibly on state tax matters than most of its corporate fellows.)

One of the more bizarre episodes in corporate tax history is unfolding before the Illinois Supreme Court, where a group of corporations, led by the Caterpillar Corporation, that favors the unitary method is squaring off against another group, led by Coca-Cola, that doesn't.

Even though there are corporate "winners" as well as "losers" under unitary, every state that has adopted the' method has greatly increased its corporate income tax collections overall.

Corporate "winners," moreover, might be supporting unitary for the wrong reasons. What a company gains in one state or nation under this system, it might lose in another were the system to spread. The question does not end there, however. As Union Pacific realized, the simplicity of the unitary approach cuts legal and accounting costs, and for at least some corporations these savings might easily outweigh, in the long term, any short term tax avoidance booty the corporation tan gain under the complicated arms-length approach.

In Washington, corporate lobbyists are grumbling that COST's confrontation style is self-defeating. These lobbyists see the handwriting on the wall in the Mobil and Exxon decisions, and think that, for political reasons if none other, it's time to start compromising with the states instead of attacking unitary broadside.

The softening of the corporate opposition is coming none too soon. COST's Armageddon tactics have forced the states into an equally hardline defensive posture, precluding constructive discussion of the remediable, but still significant, bugs in the unitary system as now applied.

Particularly pressing is the need for a clear definition of a "unitary business" (a conglomerate may consist of several) and for reasonable rules for foreign-based multinationals, which may have genuine problems adjusting to the unitary system. Also needed is some special provision, perhaps a grace period, for the start-up years of a new branch or subsidiary, during which time there may be genuine losses which are not mere bookkeeping contrivances.

The unitary system is not without defects. Rather, its defects are more easily corrected than are those of the alternatives.

We must start to make these corrections. Multinational enterprise is growing geometrically, and along with it, the legal and accounting swamps through which tax officials must wade. Present methods are increasingly ineffective.

This is shortchanging the public treasuries of the world and shifting more tax burden on those who can least afford it. The arms-length approach to taxes is draining government and corporate energies away from more productive pursuits. We need to simplify. The unitary method can help us do that. It can help developing nations deal with unfathomable business organizations. And it can make life easier for industrialized nations as well.


Jonathan Rowe is associate director of Citizens for Tax Justice, a public interest tax reform action group in Washington, D.C. From 1977 to 1979, he served as deputy director of the Multi-State Tax Commission,


The Oil Company Shuffle

In the controversy over the arms-length vs. unitary methods, the oil companies in particular have reduced themselves to almost Chaplinesque self parody arguing first that they are unitary, then that they are not, as the occasion suites their self interest.

In the mid-1970s, for example, confronted with Congressional proposals to break them up into their constituent parts, the oil companies responded with horror at the savage dismemberment such "divestiture" bills would wreak on their unitary, finely integrated corporate structures. Mobil ran television ads showing a man hacking up a garden hose to illustrate the point. Exxon rebuffed a request from the late Senator Phillip Hart for a breakdown of its profits by function (drilling, refining, etc.) with the assertion that such a separate accounting analysis was impossible.

"The petroleum business is unitary in nature," the company's comptroller wrote to Senator Hart. "Exxon's corporate financial records are not maintained on a segmented basis.

Consistent with these assertions, Exxon took out full page newspaper ads up and down the state of Alaska, praising that state's unitary tax enforcement method, when the state legislature was considering modifications that would have taxed the oil industry more heavily.

Yet, at the same time in other forums, Exxon was saying the exact opposite.

When Wisconsin tax officials took Exxon at its word and treated the company as what it told Congress it was - a unitary business - Exxon said "Nothing doing." It had filed a tax return with the state showing $4 million in losses from its marketing division there for four years in which it had sold $60 billion worth of products.

Defending the accountants' picture of poverty, Exxon's lawyers argued in court that "our evidence will show that none of (Exxon's) functional departments are integrated parts of a unitary business… " and that Wisconsin therefore could look no further than the marketing division reporting losses there.

Exxon argued almost exactly the same thing in a similar litigation in South Carolina.

These inconsistencies promoted Senator Edward Kennedy (D-Mass.) to declare on the Senate floor, "The multinational corporations cannot have it both ways."


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