1 The current state of affairs in the international tax battlefield

In the last thirty years, two distinctive conceptual frameworks have been coexisting and featuring the debate in international tax field (Avi-Yonah, 2015; Clausing & Avi-Yonah, 2007). On the one hand, a received arm’s length approach based upon a market basis of taxation. On the other hand, a novel approach of ‘unitary taxation and formulary apportionment’ (Langbein 1986, p. 625)^[1] in search for theoretical foundations.

The received approach maintains the tradition embedded in articles 9 of international model treaties by both the UN (2011) and the OECD (2014). The central treaty provision governing taxation of a transnational corporate group states:

“Where:

(a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

(b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

This approach requires (i) identifying separate legal entities by jurisdiction of incorporation, and (ii) assessing their contractual transactions as if they were arm’s length transactions effectuated between independent parties (Picciotto 2012). Accordingly, legal entities belonging to the same group are separately liable for their taxable income and apply arm’s length prices to their mutual transactions. Consequently, when transactions are actually performed among related parties, including entities belonging to the same integrated corporate group, this approach develops and applies methods to adjust those transactions according to this imagined market basis through transfer pricing. This approach is also consistent with a formalistic legal perspective that considers each legal entity as an independent legal person, that is, an autonomous subject of law.^[2] It requires to identify (and then establish) legal entities in various jurisdictions, including tax heavens and offshore financial centres, transfer pricing among them, and allocation of economic and financial rights and obligations between them, including intangible and financial elements whose legal entitlements are easy to relocate. In this context, legal structures designed to obtain specific tax outcomes may exploit – among others – (iii) the privileged tax treatment that may exist for financial investments (including debt, equity, trust, fund, derivative, acquisition), including foreign ones (Aarnes, 2011; Kuźniacki, 2017; Picciotto, 2016; Summers, 2012).

Living in such an imaginary world has proved to be an expensive and then lucrative exercise. Application and enforcement of this international tax regulation framework, including its transfer pricing rules, has ‘spawn a huge industry of lawyers, accountants and economists whose professional role is to assist multinational companies’ (Avi-Yonah & Benshalom 2010, p. 8) in their tax regulation planning and compliance (Devereux 2006).^[3]

Tax authorities became increasingly wedded to the Arm’s Length Principle, as did professional advisors of the tax avoidance and compliance industry, which became even more heavily invested in the complex system and derived increasingly large fees from it. Hence, firm statements excluding the unitary approach were included in the OECD Transfer Pricing Guidelines, even while they increasingly accepted profit-split methods which go a long way towards unitary taxation

(Picciotto 2012, p. 3).

This regulatory process has been increasingly having recourse to arbitration, to resolve conflicts on adjustments, through arbitration procedures and outcomes that generally remain known only to the participants. Quite a consensus has progressively emerged that the working of international tax regulation has generated an overwhelmingly complex tax system that is ineffective in performing fair taxation (let us label it the ‘tax avoidance game’, hereafter). As a matter of fact, the application of the letter of the arm’s length approach has enabled structuring opportunities by sophisticated parties, leading to actual tax payment reduction and even double non-taxation for involved jurisdictions (Avi-Yonah, 2015; IMF, 2014; Kleinbard, 2013; Quentin, 2017; Ting, 2014). Already in 1981, the US Governmental Accountability Office (US GAO, 1981, pp. 52–53)^[4] concluded that:

Because of the structure of the modern business world, Internal Revenue Service (IRS) can seldom find an arm’s length price on which to base adjustments but must instead construct a price. As a result, corporate taxpayers cannot be certain how income on inter-corporate transactions that cross national borders will be adjusted and the enforcement process is difficult and time-consuming for both IRS and taxpayers. […] We recommend that the Secretary of the Treasury initiates a study to identify and evaluate the feasibility of ways to allocate income under s. 482 [dealing with allocation of income and deductions among taxpayers], including formula apportionment, which would lessen the present uncertainty and administrative burden created by the existing regulations.

The problem was addressed by the International Monetary Fund in a policy paper published in 2014 (IMF 2014, May 9, 39 ff.), arguing that:

That this approach [i.e., Formulary Apportionment (FA), which establishes a multijurisdictional enterprise’s tax base on a ‘unitary’ basis—that is, consolidated across the entire corporate group — and allocates this total across jurisdictions on a formulaic basis], rather than one based on Arm’s Length Principle, is so common at subnational level—indeed there seems to be no subnational Corporate Income Taxation [CIT] that does not use some form of Formulary Apportionment [FA] — suggests that it has at least some merit in taxing firms operating across highly integrated economies

Between 2013 and 2015, the OECD (2015) led its own reform process to deal with tax avoidance practice resulting in Base Erosion and Profit Shifting (BEPS) by transnational corporate groups. In fact, this project continues to endorse the received arm’s length principle while introducing a further set of adjustment rules (Buettner & Thiemann, 2017).

Critics of the received approach argue that it is its overarching principle to be flawed, not only its methods of implementation. They claim for an alternative approach based upon economic substance (Picciotto 2017 ed.; Avi-Yonah, 2015; Clausing & Avi-Yonah, 2007; Picciotto, 2012). It is an economic reality that, they argue, international transactions are mainly performed by integrated corporate groups. It has become meaningless to apply the received approach seeking for a market basis that does not and cannot exist. The received tax approach does grapple with this reality of business firms as they exist and function in economy and society. Business firms have been factually organised as enterprise groups (Blumberg 1993; Strasser & Blumberg, 2011) which do exist, combine a number of corporate and other legal arrangements, and maintain accounting systems as a mode of tracking their integrated enterprise process through time and circumstances. Therefore, tax authorities should consider this integrated corporate group to determine the corporate tax base through combined report (so-called unitary approach), and then apply some conventional methods to allocate the corporate taxable income across involved jurisdictions (so-called formulary apportionment).

In itself, such combined report is simply a transparency and accountability requirement concerned with the fundamental asymmetry between corporate insiders and outside stakeholders, including tax authorities. Recent advances in the theory of the firm develop distinctive understandings of this asymmetry and may help clarifying the current debate between the two tax approaches.

2 The unitary approach and recent advances in the theory of the firm

Recent advances in the theory of the firm may uphold this claim for an integrated enterprise approach to international taxation. The critical point is the featuring distinction between the inside corporate environment and the outside markets of reference for resources (productive factors). Three main theoretical perspectives may be distinguished here: the neoclassical theory of the firm; the contractual economic theories (such as agency theory, transaction cost theory, incomplete contracts theory, and property rights theory); and the systemic theory of the firm as an enterprise entity.

According to the neoclassical theory of the firm (the so-called ‘black box’), the enterprise entity can be reduced to its productive factors, each of them having its own market of reference. The enterprise entity is then seen as a shallow nexus of market transactions based upon benchmarking market prices. Each productive factor is expected to be paid at its market price of reference, while the resulting corporate income – factually generated by the combination of those factors - is supposedly exhausted by aggregating those payments over the period. Therefore, a market price system may be employed to determine this income.

Incomplete contract economic theories (including new institutional economics) have drawn upon this neoclassical background. These theories argue that contracts are never complete, and perfect pricing markets do not always exist for each resource that is employed in the business firm. Therefore, specific arrangements are designed and applied to assure its economic working. In fact, these theories maintain a contractual basis of reference and the market pricing as corporate benchmark. From their contractual perspective, the firm may still be understood as a nexus of in-complete market contracts submitted to possibly im-perfect market pricing. In this way, these theories do not definitely disentangle the market and the firm as specific institutional economic arrangements (Biondi, Canziani & Kirat, 2007). Generally speaking, specific (residual) corporate income may emerge as temporary or conditional gain or rent bound by outside market options, attached to each contractual transaction separately and especially attributed to the asset or function provided by shareholding investors. Therefore, these theories may justify either of the two tax base approaches,^[5] the one which has recourse to hypothetical market transactions, and the other one which argues for a conceptual departure toward an integrated enterprise entity.

In this context, the systemic theory of the firm as an enterprise entity backs and upholds the unitary approach by pointing to the business firm as a going concern. The firm is then seen as a socio-economic organisation and institution that establishes and maintains a specific economic coordination. Corporate transactions and arrangements within the firm – including contracts among related legal entities - are then framed and shaped by their belonging to the whole corporate field. This whole generates a specific economic process that requires management and control to be performed over time and circumstances. Corporate income is generated by the whole enterprise entity through time and space. Not a market price system, but an accounting system shall be employed to determine its income (Biondi, 2005; Biondi, 2013; Biondi, Canziani & Kirat, 2007).

The theory of the firm as an enterprise entity draws upon some traditions of thought (from economics, accounting, and law) that have aimed to understand the business firm and its impact on economy and society, including the first tradition of accounting and economics (Biondi & Zambon, 2012), and the old American and European institutional economics. All together, these theoretical perspectives offer some background for a systemic perspective on the firm as an entity, a whole, a dynamic system. For instance, Herbert Simon developed an organizational economic approach focusing on the firm as a dynamic system; Martin Shubik dealt with the relationship between accounting and the critique of equilibrium economics (neoclassical); Ronald Coase explored the accounting contribution to the theory of the firm; and Adolf Berle criticised the classical economic view of the proprietor-entrepreneur under the economic and financial conditions that have been characterizing business firms since the XX century. Berle further argued for considering the enterprise entity as an object of law, drawing upon the separation between investors (having limited liability and unlimited share transferability) and the ongoing business firm.^[6]

In this context, the notion of enterprise entity points to the collective and dynamic dimensions featuring the carrying on of ongoing economic activities, which comprise and have recourse to a stampede of legal-economic arrangements, including a layered web of related legal entities. Although formally separated by legal incorporation, these legal entities belong to the same legal-economic whole featuring integrated coordination, organisation and strategy. These entities are then substantially dependent on each other and often submitted to some hierarchical order. In a first approximation, the enterprise entity legal structure can be represented as a corporate group, that is, a corporation of corporations, but it usually involves a whole of ongoing activities that are better represented as an enterprise group.^[7]

This systemic perspective on the firm as an enterprise entity integrates law and economics with accounting. The business firm generates a specific economic coordination that is represented, controlled and governed through accounting systems, which facilitate its economic organisation through time and circumstances. According to the “black box” view, a market price system is sufficient to understand, organise and regulate the ongoing business activity. Business firms do not play an active role in economy and society, and the ‘institutional structure of production’ (in Coase (1992) ’s words) does not matter. Every corporate payment goes along with an arm’s length transaction at market prices of reference. These imagined market prices are assumed to deliver some magic that resolves and reduces all the other dimensions of the ongoing corporate process. Contractual economic theories do introduce some frictions and imperfections in this market mechanism, but they do still maintain an overarching market basis of reference for the corporate dynamics. However, the business firm (and its specific dynamics) plays an active specific role in the economic and monetary process. As a matter of fact, those imagined ‘prices’ are payments embedded in transactions that must be taken into account. Not every transaction has a market basis (or a market purpose) within the enterprise entity. Instead of a market price system, the business firm runs a corporate accounting system which deals with these transactions to determine revenues and costs of the period. The accounting system further defines the perimeter of the ongoing entity activity. Within the perimeter, non-market transactions and allocations occur through overheads imputation, resources sharing, transfer pricing, debt contracting, and service provision. At the perimeter margin, corporate insiders can play with related party transactions and special-purpose vehicles, including to obtain specific regulatory outcomes (such as tax avoidance).

In this context, a market-based contractual perspective may consider formulary apportionment as ‘arbitrary’, since it does not refer to actual or imaginary market prices. However, an accounting-based systemic perspective may understand formulary apportionment as a kind of simplified accounting mechanism aimed to split taxable income (and wealth) across various jurisdictions. In this way, formulary apportionment allocates the whole corporate income among its parts. Together with the unitary approach, it constitutes then an accounting institutional mechanism that represents, governs and performs firm-specific allocation of corporate income through space and time.

3 Caveats for international policy in accounting and taxation

Especially the first tradition of accounting and economics pointed to this connection between the concept of business firm as a going concern and its representation through the accounting system. Drawing upon forerunning advances in Germany and Italy, this tradition was jointly developed by continental European, North American and Japanese scholars, during the first half of XX century (Biondi & Zambon, 2012). It is certainly not by hazard that financial accounting systems and tax systems were closely related together in continental Europe and Japan at that time.^[8]

This historical root stresses the role of accounting in the institutional structure of production and it may be further explored to derive insightful lessons for current tax regulation. According to Ting (2014, p. 63), the application of the enterprise approach as an anti-avoidance measure has a long history and it was already described as a general rule by the Fiscal Committee of the League of Nations coordinated by the US lawyer Mitchell B. Carroll in 1932–33. Their 1933 report addressed the international taxation issues of transnational enterprises as follows:

If [a subsidiary’s] income is diverted to other units of the enterprise in any manner, the tax authorities, as a general rule, have only to examine the inter-company transactions, appraise their terms and results in the light of sound legal and business principles … and recapture any profit that may be shown to have been diverted. (Carroll 1933, p. 627).

As a matter of fact, an integrated reporting system is already in place for financial accounting under international financial reporting standards (IFRS). Generally speaking, transnational corporate groups do already prepare consolidated reporting for public information provision. However, this theoretical connection between accounting and tax does not imply that international policy should seek for adopting international financial accounting standards for tax purposes,^[9] delegating the latter to the current international financial accounting standards-making.

Claims for this adoption point to its potential capacity to effectively reduce structuring opportunities. Supporters of the unitary approach may argue that convergence between tax and financial accounting would limit the current disconnection that enables corporate management to declare one consolidated result to corporate investors, and several ones to national tax authorities, the sum of the latter remaining (much) lower than the consolidated result (Avi-Yonah 2015; see also Sunder, 2011; Desai, 2005; Hanlon, 2003; Slemrod, 2005; Heltzer & Waller-Shelton, 2011).

Such changes would also have the advantage of more closely aligning book income and tax income. This could act as damper of both the under-reporting of income for tax purposes as well as the overstatement of income for the purpose of signalling profitability to financial markets

(Avi-Yonah 2015, p. 299).

More generally speaking, both accounting systems may benefit from comprehensive financial transparency on the structure of corporate groups and from country-by-country disclosure (Murphy 2012), measures that respond to the fundamental information asymmetry between corporate insiders and outside stakeholders, including tax authorities (Ting 2014).

This public policy outcome may occur if financial accounting and tax accounting systems were carefully designed, consistently applied, and effectively enforced to obtain it. However, a straightforward adoption of existing international financial accounting standards for tax purposes would imply granting the international financial accounting standards-making with the public policy mission to determine the tax base. This delegation may involve a hazardous move in the current institutional setting (CONVIVIUM, 2013). Instead of importing the concept of consolidated reporting entity into the tax base, international policy-making might end-up exporting the overwhelming tax avoidance game into financial reporting. Up to date, the international accounting standards-setting body, the International Accounting Standards Board (IASB), has formally refused to consider concerns of public policy and national jurisdictions, limiting its mission to information provision to financial market investors. Moreover, its most influential constituencies include the very same international accounting firms that hold vested interests in the tax avoidance game. And its international accounting standards IAS/IFRS have raised concerns on consolidation (accounting perimeter) and evaluation, topics which raise the very same issues that feature the tax avoidance game. In particular, in the aftermath of the North-Atlantic Financial Crisis of 2007–2008, those standards were criticised to have enabled material off-balance sheet activities and subjective mark-to-model evaluations that paved the ways to structuring opportunities (Biondi, 2016). Two recent cases illustrate this concern for international policy. In 2006, the IASB reformed its standard for segment reporting (IFRS 8), factually enabling transnational corporate groups to avoid country-by-country disclosure, notwithstanding strong resistance by a coalition of stakeholders which clearly expressed their concern throughout the IASB’s formal standard-making process^[10]. Moreover, an ‘investment entity exception’ was explicitly introduced - which validates excluding some corporate entities from full consolidation - by the recently issued International Financial Reporting Standards (IFRS) 10 to 12 and subsequent amendments.

4 Conclusive remarks

The international tax avoidance game is not new, but it has recently raised public debate on suitable courses of action to cope with it. The actual response to tax avoidance is ultimately a political affair. Recent cases clearly show how tax avoidance has been finding its roots in facilitating policies by some policy-makers, including those in Panama, Luxembourg and Ireland,^[11] and an overall political distain concerning taxation.

Notwithstanding this political dimension, tax avoidance is also the result of a regulatory process that makes reference to overarching concepts and representations. The current debate is featured by two overarching principles of ‘negative’ and ‘positive’ taxation under the law: the one arguing for the right to minimise the tax payment, the other one for the duty to pay a fair tax amount. This debate is further featured by two distinctive approaches to tax base determination: the market basis coupled with the legal person basis, and the economic substance basis.

The economic substance approach argues that the received approach grapples with economic reality featured by integrated transnational corporate groups. These groups operate across jurisdictions and have the capacity to reshape their legal-economic structuring to obtain specific tax results. An adequate response urges then to consider these groups as consolidated units (unitary approach), allocating the consolidated result across involved jurisdictions through formulary apportionment.

This unitary approach is upheld by recent advances provided by the theory of the firm as enterprise entity, which combines law and economics with accounting. The business firm is then understood as a specific economic coordination backed by its institutional structure of production, including its accounting system. This theoretical consistency is appealing and deserves further investigation, including to foster cross-fertilisation and harmonisation of financial and tax accounting systems.

However, this does not imply a straightforward claim to adopt current international accounting standards (IAS/IFRS) for tax purposes. International accounting standards-making has been formally disconnected by national jurisdictions and it currently excludes public policy concerns. It may be substantially unable to avoid the very same ‘specifications’ on the letter of the law that have been already paving the way to loopholes and structuring opportunities in tax regulation.