Formula Apportionment or Separate Accounting? Tax-Induced Distortions of Multinationals' Locational Investment Decisions

36 Pages Posted: 26 Feb 2016

See all articles by Regina Ortmann

Regina Ortmann

University of Paderborn; Vienna University of Economics and Business

Erich Pummerer

University of Innsbruck - Department of Accounting, Auditing and Taxation

Date Written: 2015

Abstract

We examine which tax allocation system leads to more severe distortions with respect to locational investment decisions. We consider separate accounting (SA) and formula apportionment (FA). The effects of both systems have been hotly debated in Europe in the past years. The reason is that the EU Member States are striving to implement a common European tax system that would lead to a switch from SA to FA. While existing studies focus primarily on the impact of taxes on locational decisions under either SA or FA, the main innovation of this paper is that it compares both systems with regard to the level of distortions they induce. We compare the optimal pre-tax investment decision with the optimal after-tax investment decision and infer from the difference in the allocation of investment funds which tax allocation system causes more severe distortions. We assume that the multinational group (MNG) has comprehensive book income shifting opportunities under SA. We find that the investment incentives under SA are opposed to those under FA for a profitable investment project. Whereas under SA as much as possible should be invested in a high-tax country, under FA as much as possible should be invested in a low-tax country. The distortions of locational investment decisions tend to be more severe under SA than under FA if a greater share of investment funds is to be invested in a low-tax country from a pre-tax perspective and the investment is profitable. Vice versa, locational decisions may be more distorted under FA if the optimal pre-tax investment decision requires investing a major share of funds in the high-tax country. In contrast to the often stated insensitivity of FA towards income shifting, we find the introduction of a tax allocation system based on FA in Europe could lead to a severe shift of economic substance to low-tax countries. The results of this paper are of particular interest for European policy makers and MNGs as our findings may induce European MNGs to reassess their recent locational investment decisions in the face of a potential future change in the applied tax allocation system.

Suggested Citation

Ortmann, Regina and Pummerer, Erich, Formula Apportionment or Separate Accounting? Tax-Induced Distortions of Multinationals' Locational Investment Decisions (2015). WU International Taxation Research Paper Series No. 2015-28. Available at SSRN: https://ssrn.com/abstract=2688090 or http://dx.doi.org/10.2139/ssrn.2688090

Regina Ortmann (Contact Author)

University of Paderborn ( email )

Warburger Str. 100
Paderborn, D-33098
Germany

Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien 1020
Austria

Erich Pummerer

University of Innsbruck - Department of Accounting, Auditing and Taxation ( email )

Universitätsstraße 15
Innsbruck, Innsbruck 6020
Austria
+43/512/507-7264 (Phone)

HOME PAGE: http://www.pummerer.at

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