“USING GLOBAL FORMULARY APPORTIONMENT FOR INTERNATIONAL PROFIT ALLOCATION: THE CASE OF INDONESIA’S MINING INDUSTRY” Einsny Phionesgo Bachelor of Commerce Submitted in fulfilment of the requirements for the degree of Master of Business (Research) School of Accountancy Faculty of Business Queensland University of Technology November 2015 i Using global formulary apportionment for international profit allocation: The case of Indonesia’s mining industry Keywords Formulary Apportionment, Unitary Taxation, Transfer Pricing, International Profit Allocation Using global formulary apportionment for international profit allocation: The case of Indonesia’s mining industry ii Abstract Currently, separate accounting under the arm’s length principle fails to allocate the income of multinational entities to the jurisdictions that give rise to those profits. In light of this problem, this thesis examined an alternative approach, referred to as the unitary taxation approach to the allocation of profit, which arises from the notion that as a multinational group exists as a single economic entity, it should be taxed as one taxable unit. Thereafter, profits are allocated to the respective jurisdictions using a formulaic approach. However, the plausibility of a unitary taxation regime achieving international acceptance and agreement is highly contestable due to its implementation issues, and economic and political feasibility. Drawing on the experiences of the existing jurisdictions that have applied formulary apportionment at a national-level, this thesis contributes to the existing literature by examining the unitary taxation approach in the context of a developing country. Using a case-study approach focusing on Freeport-McMoRan and Rio Tinto’s mining operations in Indonesia, this paper compares both tax regimes against the criteria for a good tax system - equity, efficiency, neutrality and simplicity. This thesis evaluates key issues that arise when implementing a unitary taxation approach with formulary apportionment based on the context of mining multinational firms in Indonesia. These issues include: (1) the definition of a unitary business, (2) the definition and scope of the tax base, and (3) the formula design. Finally, the findings are discussed within the context of a case-study. iii Using global formulary apportionment for international profit allocation: The case of Indonesia’s mining industry Table of Contents Keywords ................................................................................................................................. ii Abstract ................................................................................................................................... iii Table of Contents .................................................................................................................... iv List of Figures ....................................................................................................................... viii List of Tables .......................................................................................................................... ix List of Abbreviations ................................................................................................................x Statement of Original Authorship ........................................................................................... xi Acknowledgements ................................................................................................................ xii Chapter 1: Introduction .......................................................................................1 1.1 Background .....................................................................................................................1 1.2 Motivation and research significance .............................................................................6 1.3 Expected Contributions ..................................................................................................8 1.4 Thesis Outline .................................................................................................................9 Chapter 2: Institutional Background ................................................................10 2.1 Introduction ..................................................................................................................10 2.2 Background ...................................................................................................................11 2.3 The arm’s length principle ............................................................................................15 2.4 The theoretical problems with separate accounting, the arm’s length principle ...........17 2.4.1 The artificiality of the arm’s length principle .....................................................19 2.4.2 The arm’s length principle fails to reflect the underlying economic substance of the multinational entities ...............................................................20 2.4.3 The arm’s length principle creates artificial incentive for multinational entities to engage in profit-shifting behaviour ....................................................22 2.5 Implementation issues in connection with the application of the arm’s length, separate accounting approach ...............................................................................................................27 2.5.1 The problem in applying the transfer pricing method ........................................27 2.5.1.1 Traditional transfer pricing method .................................................................28 2.5.1.2 Transactional profit method .............................................................................29 2.5.1.3 High complexity and uncertainty ......................................................................31 2.5.1.4 The arm’s length principle creates administrative burden ..............................33 2.6 General overview of Indonesian tax system .................................................................34 2.7 Uniqueness of mining multinational entities ................................................................37 2.8 Conclusion ....................................................................................................................42 Chapter 3: Literature Review ............................................................................44 3.1 Introduction ..................................................................................................................44 3.2 A Unitary Taxation Regime with Formulary Apportionment ......................................44 3.3 Origin and Destination Principles .................................................................................49 Using global formulary apportionment for international profit allocation: The case of Indonesia’s mining industry iv 3.4 Theoretical advantages of unitary taxation ...................................................................50 3.4.1 Better reflection of the underlying economic substance of multinational entities ................................................................................................................50 3.4.2 Eliminates the tax incentive to shift income to low-tax jurisdictions .................52 3.4.3 A simpler tax regime ..........................................................................................56 3.5 Theoretical drawbacks of unitary taxation with apportionment ...................................58 3.5.1 International agreement and co-operation ..........................................................58 3.5.2 Economic distortions ..........................................................................................60 3.6 Implementation issues: The design of a unitary taxation regime .................................65 3.6.1 Experiences of existing jurisdictions ..................................................................65 3.6.1.1 The United States experiences ..........................................................................65 3.6.1.2 The European Union Common Consolidated Tax Base (EU CCCTB) .............67 3.6.1.3 The Canadian Provinces ...................................................................................68 3.6.1.4 Swiss Cantons ...................................................................................................69 3.6.2 Defining the unitary business .............................................................................70 3.6.3 The scope of the tax base....................................................................................72 3.6.3.1 A combined tax base approach ........................................................................75 3.6.3.2 Activity-by-activity formulary apportionment approach .................................76 3.6.3.3 Business and non-business income ..................................................................77 3.6.4 The apportionment factors ..................................................................................78 3.6.4.1 The traditional three-factor apportionment formula .......................................82 3.6.4.2 The property factor ..........................................................................................83 3.6.4.3 The payroll or compensation factor .................................................................86 3.6.4.4 The sales factor ................................................................................................89