Tax Policy and Administration: California Taxes on Multinational
Corporations and Related Federal Issues (Letter Report, 07/11/95,
GAO/GGD-95-171).

Pursuant to a congressional request, GAO provided information on: (1)
California's experience in conducting formulary apportionment audits of
multinational corporations; and (2) issues that would have to be
considered before adopting a formulary system at the federal level.

GAO found that: (1) under worldwide formulary apportionment, California
first had to determine whether California corporations that were part of
a multinational enterprise were engaged in a unitary business with
affiliated U.S. and foreign corporations based on an analysis of the
enterprise's ownership and business operations; (2) auditors then used
the parent enterprise's financial records, particularly its federal tax
returns and audited financial statements, to ensure that state tax was
based on the income and the apportionment factors for all corporations
comprising the unitary business; (3) California assessed millions of
dollars of additional state taxes based on unity determinations, but
corporations contested most of the additional assessments; (4)
California adjusted for U.S. and foreign accounting standards and
recordkeeping differences that had material impacts on its audits; (5)
because taxpayers did not always supply requested information, the
auditors used estimates and assumptions in making their adjustments; (6)
matters that need to be considered before adopting formulary
apportionment at the federal level include the design and administration
of a federal unitary system, how to reconcile accounting rules
differences and obtain and verify financial information, and the
transition from a separate accounting system to a unitary system; and
(7) tax experts do not agree on whether problems associated with a
unitary system could be resolved.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-95-171
     TITLE:  Tax Policy and Administration: California Taxes on 
             Multinational Corporations and Related Federal Issues
      DATE:  07/11/95
   SUBJECT:  State taxes
             Multinational corporations
             Accounting procedures
             Financial records
             Tax administration
             Income taxes
             Tax law
             Tax administration systems

             
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Cover
================================================================ COVER


Report to the Honorable
Byron L.  Dorgan, U.S.  Senate

July 1995

TAX POLICY AND ADMINISTRATION -
CALIFORNIA TAXES ON MULTINATIONAL
CORPORATIONS AND RELATED FEDERAL
ISSUES

GAO/GGD-95-171

Taxes on Multinational Corporations


Abbreviations
=============================================================== ABBREV

  FTB - Franchise Tax Board
  GAAP - generally accepted accounting principles
  IRS - Internal Revenue Service
  MTC - Multistate Tax Commission
  OECD - Organization for Economic Cooperation and Development
  SEC - Securities and Exchange Commission
  UDITPA - Uniform Division of Income for Tax Purposes Act

Letter
=============================================================== LETTER


B-260129

July 11, 1995

The Honorable Byron L.  Dorgan
United States Senate

Dear Senator Dorgan: 

This report responds to your request for information on (1)
California's experience in conducting formulary apportionment audits
of multinational corporations and (2) issues that would have to be
considered before adopting a formulary system at the federal level. 

For tax purposes, states generally use a formula to apportion the
income of corporations among the states in which they do business. 
The formula typically is based on the amount of a corporation's
property, payroll, and sales within a state compared with the amount
within the United States as a whole.  A percentage is calculated for
each of the three factors, and the average of the three is generally
applied against a corporation's income to determine the amount the
state will tax. 

The formulary approach can be applied to a single corporation or to a
group of related corporations.\1 In the latter case, the formula is
applied to the combined income of affiliated corporations in a
corporate group that have been determined to be unitary.  This
determination is based on the degree to which the activities of the
affiliated companies are interdependent. 

Through much of the 1980s, California applied its formula for
apportioning income on a worldwide basis.  This required
multinational enterprises to apportion a share of their worldwide
income to California, including the income of foreign parent and
subsidiary corporations if their operations were closely integrated
or unitary with California business activity.  Beginning in 1988,
taxpayers in the state were allowed to choose to exclude the income
of most foreign affiliates from apportionment if the taxpayers paid a
fee and met other requirements.  In 1993 California enacted
legislation that eliminated the fee and modified other requirements. 
Unless taxpayers choose not to do so, however, they can still file
their tax returns on a worldwide basis. 

In contrast to a unitary tax system that combines the income of
related corporations within a multijurisdictional enterprise for tax
purposes, the U.S.  government and the governments of other countries
use a "separate accounting" method that treats each corporation as a
separate entity.  Under separate accounting, the income of related
corporations is determined on the basis of "transfer prices" charged
for transactions with other corporations in the enterprise.  If
prices set for transactions between a corporation and its affiliate
operating in a different country are set too high or too low, income
is, in effect, shifted from one country to another, and taxes may as
a result be avoided in one country and be higher in another. 

To mitigate this situation, the Internal Revenue Service (IRS)
applies an "arm's length" standard that requires that the results of
a transaction between related corporations be consistent with the
results that would have been realized if unrelated taxpayers had
engaged in the same transaction under similar circumstances.  In
previous products, we have discussed the difficulties that IRS faces
in administering the arm's length standard.\2 IRS examiners must
collect a great deal of data and use considerable subjective judgment
to determine the appropriate transfer prices and have had difficulty
sustaining their findings.  For example, we reported that, in its
appeals and legal processes in 1993 and 1994, IRS sustained less than
30 percent of the $1.9 billion in proposed adjustments related to the
Internal Revenue Code section covering transfer pricing.  Legislative
and regulatory changes have been made in recent years in trying to
alleviate transfer pricing problems. 

Worldwide formulary apportionment avoids transfer pricing problems by
using a formula rather than transfer prices to determine each
corporation's share of the combined income of related corporations. 
Consequently, some state tax officials and other tax experts have
advocated formulary apportionment as an alternative to the existing
federal arm's length or separate accounting tax system.  However,
worldwide formulary apportionment has been controversial.  Some tax
experts believe that it is not a viable alternative to the existing
tax system.  Further, many foreign governments and multinational
corporations are opposed to it. 

In our discussion of issues that would need to be considered before a
federal formulary apportionment system could be adopted, we
considered the views of tax experts on worldwide formulary
apportionment.  Separately, we discuss the policies and procedures of
the California Franchise Tax Board (FTB), which is the state agency
responsible for administering individual and corporate income tax law
in California.  On the basis of data we collected from our case
studies and a random sample of FTB audits, we provide information
about FTB on matters such as how it deals with foreign accounting
standards. 


--------------------
\1 Corporations that are connected through stock ownership with a
common parent corporation are considered to be related. 

\2 International Taxation:  Problems Persist in Determining Tax
Effects of Intercompany Prices (GAO/GGD-92-89, June 15, 1992);
International Taxation:  Updated Information on Transfer Pricing
(GAO/T-GGD-93-16, Mar.  25, 1993); and International Taxation: 
Transfer Pricing and Information on Nonpayment of Tax
(GAO/GGD-95-101, Apr.  13, 1995). 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

Under worldwide formulary apportionment, a key issue that FTB
auditors had to determine was whether California corporations that
were part of a multinational enterprise were engaged in a unitary
business with affiliated U.S.  and foreign corporations.  This
determination was based on a complex analysis of the enterprise's
ownership and business operations.  Auditors then used the parent
corporation's audited financial statements, federal tax returns, and
other records to ensure that state tax was based on the income and
the apportionment factors for all corporations comprising the unitary
business. 

In the audits of foreign-controlled corporations that we reviewed,\3
FTB adjusted income and other apportionment data to account for
differences between U.S.  and foreign accounting standards and record
keeping.  FTB auditors focused on differences that they considered to
have a material impact.  They made six adjustments in the five audits
that we selected for in-depth case studies.  Auditors reviewed the
annual audited financial statements of the foreign parent corporation
and requested, but did not always obtain, additional data from
taxpayers that were needed to determine the effects of different
accounting standards and record keeping.  As a result, auditors
sometimes made determinations on the basis of available data and used
estimates and assumptions in making adjustments. 

Although we do not discuss in this report whether formulary
apportionment should be adopted at the federal level, we do describe
matters that would need to be addressed before this practice could be
adopted.  These matters include the design and administration of a
federal unitary system.  For example, unitary business and
apportionment factors would have to be defined and the United States
would also have to consider the international feasibility of
formulary apportionment, a system that generally is opposed by other
countries.  Tax experts disagree on whether the problems associated
with such issues can be resolved in a federal unitary system. 


--------------------
\3 For purposes of this report, a foreign-controlled corporation is a
corporation incorporated in the United States that has 50 percent or
more of its voting stock owned by a foreign parent corporation. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :2

Our objectives were to obtain information on (1) California's
experience in conducting formulary apportionment audits of
multinational corporations and (2) issues that would have to be
considered before adopting a formulary system at the federal level. 

To obtain information on California's experience in conducting audits
under worldwide formulary apportionment, we first needed to identify
multinational enterprises with parent or subsidiary corporations
doing business in California.  Since FTB officials did not know which
of the roughly 24,000 California corporations that apportion income
were part of multinational enterprises, we decided to focus on large
corporations that we determined to be multinational and in
California.  We determined this by first comparing the 1,656
corporations in the IRS' Coordinated Examination Program with those
in the state's audit database.\4

After matching the data and further researching corporate
affiliations to verify multinational status, we identified 870
multinational corporations doing business in California.  According
to a state analysis, these corporations and their California
affiliates accounted for $11.4 billion of the $18.2 billion in net
income that was apportioned to California for the 1991 tax year. 

Our detailed examination of audit files was based on a sample of 124
audits.  This random sample included audits of large corporate tax
returns conducted by FTB primarily for tax years 1980 to 1989.  Since
FTB policy is to audit returns that it believes are especially likely
to yield additional taxes, our sample is not representative of all
corporate unitary tax returns.  We obtained the 124 audit files for
our examination by first randomly selecting 277 of the previously
identified 870 large corporations.  Of the 277 corporations, 157 were
determined to be eligible for our study because they had been audited
by FTB and had not filed on a "water's-edge" basis.\5 We requested
files for the most recent audits of all 157 corporations to obtain
information on audit hours, apportionment issues such as determining
if affiliated corporations should be included in a unitary business,
and the impact of the audits on corporate tax liability.  Files for
33 audits were incomplete or could not be located in time for our
review, so we ultimately reviewed a total of 124 audit files.\6

We also selected five U.S.-controlled and five foreign-controlled
corporations for more in-depth case studies to enhance our
understanding of apportionment audit issues and procedures, including
the state's method of dealing with foreign accounting standards and
record keeping.  We randomly selected our initial cases.  However,
after determining that audits of some foreign-controlled corporations
did not meet our selection criteria, we judgmentally substituted
three corporations that included different countries and types of
businesses.\7 We also reviewed FTB's analysis of unitary business
relationships in an additional audit of a U.S.-controlled corporation
identified by FTB to better understand that process.\8

In general, we also discussed with FTB officials their audit process
and views on administering a worldwide formulary apportionment
system.  In addition, we reviewed audit manuals that described
California's apportionment audit procedures, and we analyzed reports
on the results of the state's audit and appeals processes. 

To identify issues that would need to be considered before a federal
unitary system could be adopted, we analyzed articles and surveys of
state tax laws.  Our review of the California audits identified
difficult issues that we concluded might also arise in a federal
system and the procedures that the state used to address these
issues.  We also discussed the issues with experts who favored
formulary apportionment and those who did not.  These included
academicians, state and federal government officials, representatives
of multinational corporations, and attorneys advocating opposing
positions. 

Proponents of the unitary system asserted that it would be easier to
administer the unitary system at the federal level than to administer
the arm's length approach.  In this report, we do not evaluate this
claim because we did not compare a federal unitary system with the
arm's length approach.  A proper comparison would require that we
specify a federal system in some detail and that we overcome
considerable data problems.  For example, our review of how
California audits corporations for membership in a unitary group
would not accurately describe such audits in a federal system if the
federal government adopted a different definition of the unitary
business.  Our discussion focuses instead on the issues that would
need to be considered in designing, administering, and moving to a
federal unitary system. 

Appendix I discusses FTB audits of U.S.- and foreign-owned
multinational corporations under worldwide formulary apportionment. 
It includes information on audit issues, California's treatment of
foreign accounting standards, the average hours state auditors spent
per audit, and the impact of audits on California corporate tax
liability.  Appendix II summarizes our case studies, and appendix III
discusses some issues that would need to be addressed in a federal
formulary system such as (1) definitions of unitary businesses,
apportionment factors, and apportionment formulas; (2) the need to
reconcile financial and tax accounting rules; and (3) the need to
coordinate internationally any movement to a formulary system. 

As requested, the Department of the Treasury and California's FTB
provided written comments on a draft of this report, which are
reprinted in appendixes IV and V.  We discuss their comments as well
as those of the Multistate Tax Commission (MTC)\9 on pages 12 through
16. 

We did our work in Washington, D.C., and Sacramento, California, from
August 1993 through March 1995 in accordance with generally accepted
government auditing standards. 


--------------------
\4 The Coordinated Examination Program audits the country's largest
and most complex corporations, usually those with more than $250
million in assets. 

\5 In a water's-edge situation, a taxpayer's liability stops at the
borders of the United States since generally only the income of
U.S.-affiliated corporations, and not foreign affiliates, is subject
to apportionment. 

\6 FTB had difficulty providing us with all of the audit files
because they were being used by their staff in places such as
Chicago, Houston, and New York or for postaudit activities such as
protest, appeals, settlement, litigation, or collections.  For 32
corporations where files were incomplete, we substituted audits of
other years. 

\7 FTB audit records indicated the corporations originally selected
either were not foreign-controlled or had not been audited during the
timeframe of our sample. 

\8 FTB's analyses of unitary business relationships for the
U.S.-controlled corporations originally selected generally were
limited because a unitary analysis was done in previous audits. 

\9 MTC is an administrative agency of the Multistate Tax Compact. 
The compact has been entered into by 20 states and the District of
Columbia as full members and 15 additional states as associate
members. 


   BACKGROUND
------------------------------------------------------------ Letter :3

California administers the largest formulary apportionment program
among the states, according to MTC officials.  At the time of our
review, FTB had 116 audit staff in Chicago, Houston, and New York
offices that did apportionment audits and another 242 staff in
California district offices that did some apportionment work but who
were also responsible for other types of audits.  An FTB official
estimated that a total of about 127 staff years were used for
apportionment audits in FTB's 1992/1993 fiscal year, resulting in
$438 million in additional tax assessments.  Overall, FTB completed
1,084 apportionment audits during the year. 

For the 1991 tax year, 24,650 domestic and multinational corporations
apportioned $18.2 billion in net income to California.  Although
these corporations represented only 5.7 percent of the 432,242
corporations that filed tax returns in California, they accounted for
95.4 percent of the total $19 billion in corporate net income that
was reported.  Corporations apportioned an average of 8.6 percent of
their unitary income to California on the basis of average factors of
10.5 percent for property, 10.3 percent for payroll, and 5.1 percent
for sales. 

California has made changes to its worldwide formulary apportionment
tax requirements in recent years, partly in response to the concerns
of the federal government and the domestic and international business
communities.  In 1986, the state enacted legislation that generally
allowed taxpayers to exclude the income of foreign affiliates from
apportionment for 1988 and later if the taxpayer paid a water's-edge
election fee and met certain other requirements.  This legislation
was enacted partly in response to the conclusions of a U.S. 
Treasury-sponsored working group composed of representatives of the
federal and state governments and the business community.\10 In 1993,
California enacted legislation allowing taxpayers to make the
water's-edge election beginning in 1994 without paying a fee. 
Beginning in 1993, state legislation also modified the apportionment
formula by double-weighting the sales factor. 

U.S.  and foreign multinational corporations have challenged the
constitutionality of worldwide formulary apportionment in state and
federal courts.  In 1994, the U.S.  Supreme Court considered the
claims of Barclays Bank PLC, a foreign multinational, and
Colgate-Palmolive Company, a U.S.  multinational.  Barclays contended
that California's worldwide unitary tax system unconstitutionally
burdened foreign-based multinationals by imposing an inordinate
compliance burden and by creating an enhanced risk of double
taxation, violating the commerce and due process clauses of the U.S. 
Constitution.  Barclays and Colgate contended that application of
California's tax system for worldwide operations offended the
commerce clause by impeding the federal government's ability to
"speak with one voice when regulating commercial relations with
foreign governments."\11

In a June 20, 1994, decision, however, the U.S.  Supreme Court upheld
California's right to tax on a worldwide combined reporting basis.\12
The Supreme Court found that California's system did not violate the
commerce or due process clauses of the U.S.  Constitution.  The
Supreme Court found that Barclays had not shown that California's
system imposes inordinate compliance burdens on foreign-based
multinationals and that the system does not expose multinationals to
constitutionally intolerable multiple taxation.  The Supreme Court
stated that multiple taxation is not the inevitable result of
California's system and that separate accounting cannot eliminate,
and in some cases may even enhance, the risk of double taxation.  The
Supreme Court also found that California's system does not prevent
the federal government from speaking with "one voice" in
international trade.  The Supreme Court noted that Congress, which
has the role of regulating foreign commerce under the Constitution,
has not prohibited the states from using worldwide combined
reporting.  Although the Supreme Court ruled in favor of California,
state officials have since said they have no intention of reinstating
requirements for mandatory worldwide formulary apportionment. 


--------------------
\10 The final report of the Worldwide Unitary Taxation Working Group,
released in 1984, made recommendations for the states to mitigate the
international effects of formulary apportionment, including limiting
its use to the water's-edge. 

\11 In 1983, the U.S.  Supreme Court had upheld worldwide combined
reporting for U.S.-based companies in Container Corporation of
America v.  Franchise Tax Board of California, 463 U.S.  159 (1983). 

\12 Barclays Bank PLC v.  Franchise Tax Board of California and
Colgate-Palmolive Company v.  Franchise Tax Board of California, 114
S.  Ct.  2268 (1994). 


   CALIFORNIA AUDIT PRACTICES
------------------------------------------------------------ Letter :4

A key issue in FTB audits of California corporations that were part
of multinational enterprises that we reviewed was determining if
these corporations were engaged in a unitary business with affiliated
U.S.  and foreign corporations.  To make unity determinations,
auditors reviewed a wide range of information on corporate ownership
and business operations.  The analyses were complex because they
required auditors to obtain and analyze information on the management
and business relationships of the parent and subsidiary corporations
that comprised a multinational enterprise.  For example, the analyses
could consider the extent of intercompany sales and purchases, the
existence of common advertising and marketing functions, the transfer
of technical knowledge between affiliated corporations, and
intercompany transfer of personnel.  According to FTB officials,
obtaining information to make this determination sometimes was harder
in the case of foreign-owned multinationals than for U.S.-owned
firms.  In appendix I, we discuss the criteria FTB used to determine
unity as well as its data sources and examples of its unity analyses. 

If corporations comprising a multinational enterprise were found to
be unitary, FTB auditors used the parent corporation's audited
financial statements, federal tax returns, and other records to audit
income and the apportionment factors.  FTB auditors recalculated
taxable income and assessed additional taxes, if necessary, when
California taxpayers did not include the unitary business income of
affiliated domestic and foreign corporations on their tax returns. 
Auditors also heavily relied on information obtained from federal tax
returns and audited annual financial statements to check the accuracy
of unitary income and other apportionment data.  FTB audits of
unitary income and property, payroll, and sales apportionment factors
are discussed in appendix I. 

For our random sample of 124 California audits of large multinational
corporations targeted for their additional tax potential, FTB used an
average of 511 audit hours--although the hours per audit varied
widely--and proposed a total of $176.9 million in additional tax
assessments.  Of the $176.9 million, taxpayers agreed to pay $33.8
million and contested $143.1 million through the state's protest,
appeals, or settlement process.  FTB also proposed additional taxes
of $28.9 million on the basis of IRS audits of these taxpayers. 
Since similar income and expenses are reported on state and federal
tax returns, according to FTB officials, FTB generally depends on IRS
for auditing them. 

FTB auditors cited unity as one reason for proposing additional taxes
of $134.7 million in 68 audits, or $2 million per audit, compared
with $42.2 million for the 56 audits without a unity issue, or $0.8
million per audit.  Unity was also the auditors' most complicated and
time-consuming task.  The 68 audits involving unity issues took 603
hours on average compared with 399 hours for 56 audits that did not
involve unity issues. 

The importance of the composition of the unitary business was further
demonstrated in our 10 in-depth case studies of FTB audits.  Unitary
determinations were the key issue in six case studies that resulted
in $12 million in additional proposed tax assessments compared with
$2.4 million in proposed assessments for the four case studies that
did not involve a unity issue. 

In the five case studies involving foreign-controlled corporations,
FTB auditors also reviewed the annual audited financial statements of
the parent corporations to determine if foreign accounting standards
and record keeping affected income and other data used for
apportionment purposes.  They adjusted income and other apportionment
data when the differences between U.S.  and foreign accounting
standards and record keeping had a material impact on them.  The
auditors requested additional data in instances when foreign
financial statements did not provide the data they needed.  However,
foreign-controlled taxpayers sometimes stated that the information
was difficult to obtain and thus did not provide it.  As a result,
the auditors had to decide if an adjustment was necessary and could
be made on the basis of available data and their own estimates and
assumptions.  In two of the five cases, taxpayers formally protested
FTB adjustments for differences in accounting standards and record
keeping. 


   ISSUES TO BE CONSIDERED BEFORE
   ADOPTING A FEDERAL UNITARY TAX
   SYSTEM
------------------------------------------------------------ Letter :5

Adopting a federal unitary system would require resolving issues in
the design and administration of a unitary tax and issues involving
the transition from separate accounting to a unitary system.  Issues
identified as difficult in the California audits and by state tax
administrators and multinational corporations provided the starting
point for analyzing issues that would need to be addressed in a
federal system.  However, California audit practices may not show how
the federal system could deal with these issues because the federal
system might differ in significant ways from the California system. 
For example, the federal government might choose to adopt a different
definition of the unitary business or define apportionment formulas
and factors differently.  These choices could affect the enforcement
costs of the federal government and the compliance costs of
corporations. 

California's definition of a unitary business illustrates some of the
choices the federal government would face in designing its own
system.  In California, FTB determined the members of a unitary group
by using a complex analysis that stemmed from the state's definition
of a unitary business based on a greater-than-50-percent ownership
requirement and additional criteria related to the business'
management and operation.  A federal system with the same criteria
for defining a unitary business might require a similar analysis. 
However, a federal system might use only the ownership criterion and
thereby avoid most of the complexity of unitary audits.  Such a
simple definition, however, could give rise to other problems, such
as the possibility of combining companies without intercompany
transactions or shared executive and staff functions and the
possibility of manipulation by taxpayers who buy or sell stock to
change the unitary group's makeup and reduce tax liability.  In
defining a unitary business, the federal government would have to
consider this trade-off between a simple definition and the potential
for combination of diverse companies and for manipulation by
taxpayers. 

Administrative issues of reconciling accounting rules and obtaining
and verifying information affect the potential enforcement and
compliance challenges of a unitary tax.  California requires that
only material differences between U.S.  and foreign accounting rules
be adjusted and permits the use of reasonable approximations when
data are not readily available.  As the Supreme Court found in the
Barclays case, this practice may have limited the compliance burden
for multinational corporations operating in California.  The costs of
reconciling accounting rules in a federal unitary system would
depend, in part, on the materiality and reasonable approximation
provisions adopted in a federal system. 

The costs of reconciling accounting rules also depend on the kinds of
adjustments that might have to be made by corporations in a federal
unitary system.  Fifty-four percent of foreign corporations in a
survey conducted by the Securities and Exchange Commission (SEC)
reported that their financial statements differed materially from
U.S.  generally accepted accounting principles (GAAP).\13 These
foreign corporations had to reconcile items, such as depreciation,
deferred or capitalized costs, and deferred taxes.  Although U.S. 
corporations currently are required to keep financial records
according to U.S.  GAAP, these U.S.  corporations would need to
reconcile accounting rules for all the countries in which their
subsidiaries operate if a unitary system became the international
norm.  The federal government would need to consider the effect on
compliance burden of differences in international accounting rules
and the degree to which reasonable approximations can be used in a
federal system to reconcile material differences. 

Transition issues concern moving from the current separate accounting
system to a unitary system.  These issues include the need for
international agreement on the decision to change to a unitary system
and the coordination of unitary tax rules to avoid double taxation
and to facilitate the administration of the unitary system.  Many
other nations and the Organization for Economic Cooperation and
Development (OECD) oppose the unitary method.  The recently issued
OECD draft guidelines on transfer pricing specifically reject global
formulary apportionment as a solution to transfer pricing problems. 
The federal government could seek to coordinate a change to unitary
taxation, but obtaining international agreement might be difficult
given the oft-stated opposition of many countries. 

Considerable disagreement existed among the tax experts that we
interviewed and whose views we analyzed about whether the problems
associated with these issues and others discussed in appendix III can
be resolved in a federal unitary system.  The federal government
would need to address these issues of designing and administering a
unitary tax and coordinating it with other countries before adopting
a unitary tax at the federal level. 


--------------------
\13 Survey of Financial Statement Reconciliations by Foreign
Registrants (U.S.  Securities and Exchange Commission, Division of
Corporate Finance, May 1, 1993). 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :6

At our request, the Department of the Treasury and California's FTB
provided comments on a draft of this report.  The full text of their
comments are presented in appendixes IV and V.  We also received
written comments from MTC.  The following section summarizes our
evaluation of all these comments. 

Although FTB understood that this report was not intended to evaluate
the claim that formulary apportionment would be easier to administer
than the arm's length approach, it nevertheless expressed its
disappointment that we did not make a greater effort to undertake
this task.  It suggested that we could obtain information on the
costs of reconciling accounting rules in a formulary system by
canvassing accounting firms that routinely convert the consolidated
financial statements of multinational businesses from the accounting
principles of their home country to those of another country.  FTB
noted the fact that such conversions are often done means that there
will be no additional compliance costs for companies that have
already incurred these costs.  FTB believed that we should note that
the compliance burden would be mitigated to the extent that foreign
corporations already use U.S.  GAAP to prepare consolidated financial
statements for filings with SEC, obtaining credit in the United
States, and meeting the record-keeping requirements of section 6038A
of the Internal Revenue Code. 

We state in this report that a comparison of the administrative costs
of the arm's length and formulary approaches is beyond the scope of
the report because it would require that we specify the federal
formulary system in some detail.  The survey of accounting firms
suggested by FTB would produce useful results to the extent the items
that need to be converted in a federal system could be identified,
and the audit approach adopted by IRS could be determined.  For
example, the survey would need to specify what factors would be in
the formula and how they would be defined as well as the degree of
reasonable approximation that would be acceptable to IRS.  Such a
survey would be difficult to devise and would exceed the time and
resources available for completing this report.  However, we agree,
and the draft report recognized, that compliance burden is reduced to
the extent that companies already prepare consolidated financial
statements and reconcile accounting rules for regulatory and business
reasons.  As suggested by FTB, we have included the record-keeping
requirements of section 6038A among the regulatory reasons that
records are now kept in conformance with U.S.  GAAP. 

FTB also believed that the report should note that in many
circumstances the arm's length method encounters difficulties that
are similar to those that would be entailed in a federal unitary
system, difficulties that should be explained so readers can draw
their own conclusions.  We noted in our draft report that GAO's
previous work had discussed difficulties with the arm's length method
and that some of the difficulties with formulary apportionment are
similar.  However, we made no detailed comparison of the two
approaches.  The purpose of appendix III of our report was to
identify the issues that would need to be considered regarding
designing, administering, and moving toward a federal formulary
system.  In our view, a useful comparison of the two approaches would
depend on determining relative administrative and compliance costs,
which is beyond the scope of this report for the reasons described
above. 

FTB also suggested that we note that some authorities have advocated
relatively simple tests for attributes of a unitary business using a
minimum percentage of intercompany transactions.  We revised the
report to clarify that definitions of the unitary business can
include these tests.  We agree that such tests may be relatively
simple to administer, but we note the trade-off between simplicity on
one hand and the risks of manipulation by taxpayers and of combining
diverse companies on the other.  We also agree with FTB's comment
that commentators have noted that "rough justice" is a feature of the
formulary and the arm's length approaches.  We have revised this
report to make clear that rough justice is an issue in arm's length
pricing. 

FTB noted that the location of sales receipts can also cause
significant problems for the federal government.  However, our
discussion of the complexity and ambiguity of rules for determining
the location of sales receipts refers to the rules for sourcing
receipts from intangibles, not all receipts as discussed by FTB.  We
do not compare the rules for sourcing receipts in a formulary system
with the rules for sourcing income under the current arm's length
approach, and we do not evaluate whether the sourcing rules under one
system would be more or less difficult to administer than the rules
under the other.  Our purpose is to indicate that developing simple
and administrable sourcing rules for receipts from intangibles would
be an issue to be addressed in designing and administering a federal
system. 

FTB mentioned several studies that measured the effect of changing to
the unitary method on the income of foreign-owned U.S.  subsidiaries
operating in the United States.  We are aware of these studies. 
However, we do not believe that these are comprehensive studies that
can be used to estimate accurately the revenue effects of a change to
a federal formulary system.  These studies are not comprehensive
because (1) they rely on data from U.S.  corporations only or from
corporations based in only one state, (2) the data are from a single
year, and/or (3) the data are not tax data and may not be good
proxies for tax data.  Our purpose is to indicate that the revenue
effects are uncertain and that a study using the best data and
methodology would be needed to produce improved estimates of the
revenue effects. 

FTB commented that IRS must obtain and verify foreign-held records to
evaluate transfer prices.  We agree.  The point that we emphasize in
our report is that California has had problems obtaining foreign data
but that the federal government under a formulary system, as
evidenced by initiatives like section 6038A, may have better access
to foreign-held data than the states. 

Treasury commented that this report makes a valuable contribution to
understanding how one state has implemented a formulary apportionment
system and identifies some of the issues that the federal government
would have to address in a formulary system.  However, Treasury
stated that the draft did not discuss in detail the broader
difficulties of moving to formulary apportionment, such as how to
define worldwide income and how IRS would verify a company's
worldwide accounts. 

Regarding Treasury's first point, the report discusses the
adjustments required to reconcile accounting rules when computing
worldwide income.  Because countries are unlikely to agree to a
common definition of income, we believe that the need to make these
adjustments would be one of the major issues confronting taxpayers
and tax administrators when determining worldwide income in a federal
unitary system. 

Regarding how IRS would verify worldwide accounts in a formulary
system, the report discusses in detail how California verified
companies' worldwide accounts and discusses obtaining and verifying
information as an issue that would need to be addressed in a federal
system.  Although California relies on IRS to obtain and verify some
information, we do not agree with Treasury's view that this reliance
on IRS is important for assessing the difficulties of administering a
federal formulary system.  Under a federal formulary system, IRS
could continue to audit the items in a company's worldwide accounts
that California found useful and incur no additional cost.  The
administrative issues that would need to be addressed include how IRS
would audit a formulary system and what data sources IRS would find
acceptable. 

Treasury also wished to stress our report's view that a move to a
formulary system would best be made on a cooperative, multilateral
basis.  Treasury stated that agreement to move to a new system is
necessary to (1) ensure cooperation in gathering and sharing
information, (2) solve international tax disputes, (3) avoid double
taxation, and (4) prevent retaliation by countries against companies
doing business within their borders.  According to Treasury, a
unilateral move would make it nearly impossible to verify a company's
income and would lead to excessive, double taxation that would
severely disrupt the flow of international commerce.  This report
recognizes that coordination of the move to a formulary system is
desirable to avoid double taxation and to make the administration of
the system easier.  However, we did not evaluate the effect of a
unilateral change on the flow of international commerce or how much
more difficult the system would be to administer if the United States
alone adopted a formulary system. 

Treasury noted that for the United States to lead a multilateral move
toward formulary apportionment would be difficult because it had
already taken the lead in endorsing and developing the arm's length
system.  As we noted in this report, this history would complicate a
move toward a unitary system. 

In its comments on our draft report, MTC urged that the information
in appendix I on California audit resources devoted to worldwide
combined reporting be put into context by comparing it to the level
of resources used by IRS in transfer pricing audits.  We do not make
this comparison because factors such as California's reliance on IRS
as previously mentioned mean that federal and state audits are not
directly comparable.  California's audit costs will not reflect the
full cost of an audit to the extent that information used in the
audit is collected and verified by IRS. 

MTC commented that our report should have been an explicit,
comparative evaluation of the formulary and separate accounting
methods that would allow the reader to evaluate whether formulary
apportionment is sufficiently better tax policy to justify the costs
of changing from separate accounting.  The MTC commented that
criticisms of the federal use of formulary apportionment have been
answered more effectively than the report implies.  Our reasons for
not making the explicit comparative evaluation of formulary
apportionment and separate accounting were explained earlier in our
response to FTB's comments.  The purpose of appendix III of our
report is to identify issues that would need to be addressed in a
federal formulary system.  We did not evaluate whether these issues
can be effectively addressed in a federal system. 

MTC also provided comments that describe its view of where the arm's
length standard encounters difficulties similar to, but more severe
than, problems under formulary apportionment.  The difficulties
mentioned by MTC include complicated and subjective judgments
required to assign a price to potentially every commodity and service
traded between related parties; double taxation that can result from
disagreements about pricing methodologies; increased compliance
burden from countries' nonuniform income sourcing rules; the
determination of arm's length royalties for intangibles; and the
location of development costs for intangibles under cost sharing
agreements.  Our report recognizes that some of the difficulties
encountered with formulary apportionment are also encountered with
separate accounting.  However, for the reasons described earlier in
response to a similar comment by FTB, we do not compare the two
approaches in detail or evaluate which problems are more severe.  MTC
also provided other detailed comments on our draft report, which we
have incorporated where appropriate. 


---------------------------------------------------------- Letter :6.1

As agreed with you, unless you publicly announce the contents of this
report earlier, we plan no further distribution for 30 days.  At that
time, we will send copies to the Secretary of the Treasury and other
interested parties.  We also will make copies available to others
upon request. 

The major contributors to this report are listed in appendix VI.  If
you have any questions concerning this report, please contact me at
(202) 512-9044. 

Sincerely yours,

Natwar M.  Gandhi
Associate Director, Tax Policy
 and Administration Issues


CALIFORNIA AUDITS OF MULTINATIONAL
CORPORATIONS
=========================================================== Appendix I

This appendix discusses the results of our review of 124 California
audits of multinational corporations that were required to apportion
a share of their worldwide unitary business income to the state. 
Most audits were for tax years 1980 to 1989.  This appendix also
covers the policies governing Franchise Tax Board (FTB) audits, the
issues encountered, the methods used, the level of effort expended,
and the results obtained.  Policies and procedures are still
applicable for FTB audits of those corporations that choose to file
tax returns on a worldwide combined basis. 


   AUDIT POLICIES
--------------------------------------------------------- Appendix I:1

Important state policies applied in formulary apportionment audits
included (1) focusing on additional tax potential in selecting
corporations for audit, (2) considering materiality in planning and
carrying out work, and (3) using reasonable approximations when
precise data were not available. 

FTB policy was to audit the multinational corporations with the
greatest additional tax potential.\1 Its staff were to examine all
multinational tax returns for possible referrals for either desk or
field audits.\2 Generally, the tax returns of large corporations and
those with potential tax adjustments greater than $10,000 that could
not be resolved through correspondence were referred to a field
office. 

Field auditors reviewed the corporate tax returns to test for
potential audit issues and to see if the potential tax increase
warranted committing audit resources.  For example, they compared
sales reported on a multinational corporation's tax return with the
company's worldwide sales reported elsewhere to determine if all its
affiliated corporations were included in the unitary business. 
Financial data, such as sales and information on the organization and
operations of multinational corporations, appeared in various
publications used by the state, such as Moody's International Manual. 

Auditors also reviewed earlier audit reports to identify tax issues
that could be applied to the current return and to determine if they
could limit their audit effort on the basis of previous work.  For
example, an extensive review of a multinational corporation's unitary
business relationships in a previous audit might have allowed an
auditor to limit current work in this area. 

Another FTB policy was to notify a corporation if auditors'
preliminary tests of unitary business relationships during the audit
indicated a potential refund.  However, because of FTB's position of
allocating audit resources to the audits producing the most tax, it
believed the taxpayer should be responsible for developing unitary
facts and figures to support a refund claim.  If for some reason the
taxpayer did not file a claim, as occurred in prior years for two
audits we reviewed, the unity issue was not pursued. 

The effect of FTB's audit selection and tax refund policies was
twofold.  FTB focused on audits of corporations that had been the
least compliant with formulary apportionment requirements and tried
to maximize the resulting tax revenue. 

The principle of materiality was also extremely important in state
apportionment audits.  According to a state audit guide, auditors
usually should not pursue immaterial items and should do more work to
resolve material differences.  They must judge an item's materiality
on the basis of the facts and circumstances of each case.  Decisions
on materiality can limit audit work and adjustments.  For example,
according to FTB's policy, no adjustments for differences between
U.S.  and foreign accounting standards need to be made unless they
are material. 

In doing their work, FTB auditors tried to obtain annual reports,
federal tax returns, and other documents from taxpayers as sources of
the data needed to verify and/or calculate tax liability under
formulary apportionment.  Where an adjustment was likely to be
material and the necessary data could not be developed from financial
records maintained in the regular course of business, FTB could
accept reasonable approximations.  In particular, audit guidance
indicated FTB auditors sometimes had difficulty obtaining information
from foreign parent corporations that were part of a unitary business
operating in California.  They might have been obliged to use
estimates or other methods to determine the income of the foreign
affiliates.  Moreover, when data were not readily available to adjust
for differences between U.S.  and foreign accounting standards,
auditors may have either used reasonable approximations or accepted
such approximations from the taxpayer.\3


--------------------
\1 FTB's audit policies focus on "multistate" tax returns that
include purely domestic U.S.  corporations as well as multinational
enterprises. 

\2 Desk audits are conducted in the office on the basis of
information on the tax return and from correspondence with the
taxpayer, whereas field audits generally involve examination of
taxpayers' records. 

\3 FTB officials said that they will accept reasonable approximations
that benefit the taxpayer as well as those that benefit the state. 


   AUDIT ISSUES
--------------------------------------------------------- Appendix I:2

Audits of multinational corporations focused primarily on formulary
apportionment issues, such as determining unitary business
relationships and related income and calculating the property,
payroll, and sales factors.  Except for ensuring that corporations
comply with state requirements for reporting income and expenses, FTB
generally relied on Internal Revenue Service (IRS) audits to verify
the accuracy of income and expense items, since similar data are
reported on both federal and state tax returns.  It also relied on
data from federal tax returns and the annual audited financial
statements of a company to verify income and other data used in
determining the apportionment factors.\4


--------------------
\4 Financial statement data for public corporations are generally
available in a company's annual reports, filings with the Securities
and Exchange Commission (SEC), and some business publications. 


      DETERMINING UNITARY BUSINESS
      RELATIONSHIPS
------------------------------------------------------- Appendix I:2.1

Determining unitary business relationships among affiliated members
of multinational corporations was the most complex and time-
consuming issue that state auditors had to develop.  At the same
time, this determination significantly affected corporate tax
liability and was an important issue in audits we reviewed and in
related protests and appeals. 

Affiliated corporations in a multinational enterprise were considered
to be unitary if they met one of two sets of criteria.  One set of
criteria entails (1) determining if the part of a business in
California depended upon or contributed to the business as a whole
and (2) determining if unity of ownership existed as demonstrated by
more than 50 percent of the voting stock of the members of the
corporate group being owned by the same interests.  Dependence or
contribution was most easily established by the presence of
intercompany sales of tangible property, according to state guidance,
but might have been based on other factors.  A business was also
considered unitary if it met the second set of criteria, that is, if
(1) it met the ownership criterion; (2) unity of operation was
evidenced by central purchasing, advertising, accounting, management,
etc.; and (3) unity of use was demonstrated by a centralized
executive force and general system of operations. 

Generally, the most difficult segment of a multinational audit was
developing the facts needed to assess unitary relationships on the
basis of these criteria.  Auditors obtained information on unity from
documents provided by the taxpayer, such as annual reports, federal
tax returns and supporting workpapers, board of directors' minutes,
internal newspapers, corporate telephone directories, organization
charts, and policy manuals.  To confirm or expand on this
information, they requested corporate responses to a questionnaire on
unity issues. 

The five domestic audit case studies we reviewed did not include a
typical example of a complete unitary analysis.  In four cases, the
analysis was limited because it was based on the results of prior
audits.  In one case, for example, the auditor agreed that the parent
corporation and 12 subsidiaries were part of a unitary business. 
This analysis was based on the prior audit, a limited review of
audited financial statements, and other data, which ensured that no
major changes had occurred in their operations.  According to FTB
officials, auditors commonly limit their analysis to changes when
prior work establishes basic unitary business relationships. 
Although the remaining case included a unitary analysis, it was
unusually drawn out and complicated by a total lack of taxpayer
cooperation and had other problems, according to an FTB official. 
The results of the five domestic case studies are included in table
I.1 and appendix II.  The five case studies of foreign-owned
companies are presented in table I.2 and appendix II. 



                         Table I.1
          
            Summary of GAO Case Studies of Five
            Franchise Tax Board Audits of U.S.-
           Controlled Multinational Corporations

                                 Number of
Case       Audit  Key audit          years  Taxpayer
number     hours  issue            audited  action
------  --------  ----------  ------------  --------------
1          1,026  Unity                  3  Paid tax

2            600  State                  4
                  adjustment                Paid tax
                  s\a

3            161  State                  3
                  adjustment                Protested
                  s\b

4            153  IRS audit              2
                  adjustment                Protested
                  \c

5          2,386  Unity                  4  Protested
----------------------------------------------------------
\a Major items included nonbusiness gains and losses, excess
depreciation, income taxes, and a federal deduction not allowable for
state tax purposes. 

\b The major item was federal deduction that was not allowable for
state tax purposes. 

\c FTB adjusted state income tax on the basis of the results of an
IRS audit. 

Source:  California FTB audit files. 



                         Table I.2
          
            Summary of GAO Case Studies of Five
           Franchise Tax Board Audits of Foreign-
           Controlled Multinational Corporations

                                 Number of
Case       Audit  Key audit          years  Taxpayer
number     hours  issue            audited  action
------  --------  ----------  ------------  --------------
1            118  Unity\a                3  Protested

2            689  Unity\a                3  Protested

3            538  Unity\a                4  Protested

4            554  Unity\a                2  Protested

5            295  Payroll                3  Paid tax
----------------------------------------------------------
\a The key audit issue was unity with a foreign parent corporation
and affiliates. 

Source:  California FTB audit files. 

For a better example of a complete unitary analysis of a U.S. 
multinational corporation, we reviewed another audit identified by
FTB officials.  It involved a large multinational enterprise and took
1,366 hours to complete.  In this case, the auditor analyzed the
unitary business relationship between the parent corporation and its
subsidiaries along different product lines.  The analysis was based
on information obtained from a variety of sources including (1) a
prior audit, (2) the taxpayer's response to a unitary questionnaire,
(3) corporate board minutes and other internal documents, (4)
meetings with taxpayer representatives, and (5) newspaper articles. 

The auditor determined that the parent corporation had a unitary
business relationship with the subsidiaries and divisions formed
along two product lines.\5 For example, he cited the following
features as a basis for the parent corporation's unity with one
product line group: 

  intracompany sales and purchases,

  common advertising and marketing,

  common technology and personnel,

  budgetary controls by the parent corporation,

  transfer of technical knowledge between divisions,

  intracompany transfer of personnel,

  joint internship programs,

  quality control by the parent corporation, and

  common pension plans. 

For each of these features, the auditor cited specific evidence to
support his determination of a unitary business relationship.  For
intracompany sales and purchases, for example, based on the
taxpayer's response to a unitary questionnaire, he noted that the
parent corporation and its product line group supplied each other
with key manufacturing parts of significant value.  He did similar
analyses of unitary features for all product lines he reviewed. 

Evaluating unitary relationships of foreign-controlled corporations
sometimes is more difficult than evaluating unitary relationships for
U.S.-controlled multinationals because unity information is harder to
obtain from foreign parent corporations, according to FTB officials. 
In an audit of several California subsidiaries of the same foreign
parent corporation, for example, the taxpayers failed to provide
documentation on their unitary ties with the foreign parent and other
affiliated corporations.  As a result, the auditor relied on
alternative sources such as the taxpayers' financial statements and
annual reports to perform a unitary analysis.  From these sources he
determined that the different corporations were in a unitary business
with their foreign parent corporation on the basis of the following
features: 

  the foreign parent corporation owned more than 50 percent of the
     subsidiaries,

  the foreign parent corporation and its subsidiaries were in a
     similar line of business,

  the foreign parent corporation and its subsidiaries shared a common
     name,

  an intercompany flow of goods existed,

  the foreign parent corporation guaranteed obligations and provided
     financing for U.S.  operations, and

  the foreign parent corporation transferred information and
     technical know-how to its subsidiaries. 

Such analyses of unitary relationships take additional audit time and
can significantly affect tax liability.  For the 124 FTB audits we
reviewed, table I.3 shows that 68 audits with unity issues took an
average of 603 hours to complete compared with 399 hours for 56
audits that did not include unity issues.  It also shows that audits
with unity issues resulted in an average $2.0 million in proposed
additional tax assessments compared with an average $0.8 million for
audits that did not have a unity issue.  Similarly, in 6 of 10
in-depth case studies we conducted, unitary determinations were the
key issues, resulting in a total of $12 million in proposed tax
assessments, compared with $2.4 million in total for the 4 case
studies that did not involve a unitary issue. 



                                    Table I.3
                     
                     Analysis of GAO Sample of 124 Franchise
                     Tax Board Audits of Large Multinational
                     Corporations Comparing Audits With Unity
                         Issues With Audits Without Unity
                                     Issues\a

                              (Dollars in millions)


                                          Foreig                  Foreig
                                   U.S.-      n-           U.S.-      n-
                                  contro  contro          contro  contro
                                    lled    lled   Total    lled    lled   Total
--------------------------------  ------  ------  ------  ------  ------  ------
Number                                50      18      68      55       1      56
Total audit hours                 28,439  12,582  41,021  21,917     417  22,334
Average audit hours                  569     699     603     398     417     399
Sampling error for average audit     142     350     135    95.5      \c      94
 hours (plus or minus)\b
Total proposed additional tax      $97.7   $37.0  $134.7   $41.9    $0.3   $42.2
Average proposed additional tax     $2.0    $2.1    $2.0    $0.8    $0.3    $0.8
Sampling error for average          $1.2    $2.3    $1.0    $0.4      \c    $0.4
 proposed additional tax (plus
 or minus)\b
--------------------------------------------------------------------------------
\a The FTB selects corporations with the greatest additional tax
potential for audit.  Therefore, our sample does not represent all
large multinational corporate tax returns. 

\b Sampling error computed at 95-percent confidence level. 

\c Sampling error was not applicable since only one audit was
involved. 

Source:  GAO analysis of FTB audit files. 

Unity was the dominant issue in audits of foreign-controlled
corporations in our sample, occurring in 18 of 19 cases.  It occurred
in 50 of the 105 audits of U.S.-controlled corporations. 


--------------------
\5 The auditor initially made a unitary determination in a third
product line, but FTB dropped this finding after further review of
the facts with the taxpayer. 


      DETERMINING UNITARY INCOME
------------------------------------------------------- Appendix I:2.2

Another major issue for state auditors is determining a reporting
corporation's total unitary income.  They must review the income
reported by multinational corporations to ensure it includes, as
required, all U.S.  and foreign income related to the unitary
business and is reported in accordance with state requirements, which
may differ from federal requirements.  If necessary, auditors
recalculate reported income to determine tax liability under
worldwide formulary apportionment. 

In our 10 case studies, FTB auditors used the parent corporation's
consolidated or worldwide income as a starting point for calculating
unitary business income.  For U.S.  multinational corporations, they
used taxable income from the federal tax returns.  For foreign-owned
multinationals, auditors used pretax "book" income from the parent
corporation's audited annual financial statements and replaced the
book income of U.S.  subsidiaries with taxable income from their
federal tax returns.\6

FTB auditors then made other adjustments to worldwide income.  For
example, they added the income of subsidiaries that multinational
corporations should have included in the unitary business but did
not.  Once the auditors identified income for all components of the
unitary business, they adjusted it for differences in state and
federal reporting requirements and, in audits of foreign-controlled
corporations, for differences in U.S.  and foreign accounting
standards and record keeping, as will be discussed later in this
appendix.  In addition, FTB guidance required auditors to examine
certain types of income, such as interest and rental income that may
not have been related to the unitary business to ensure they were
correctly treated for apportionment purposes.  If income items were
considered as "nonbusiness income," they were not included in
apportionable income.\7

To make these adjustments, auditors generally used corporate audited
financial statements, federal tax returns, and taxpayer workpapers. 
For example, beginning with taxable income reported on one U.S. 
multinational corporation's consolidated federal tax return, the
auditor

  eliminated the income of subsidiaries that were not part of the
     unitary business on the basis of supporting schedules to the
     federal tax return,

  added the income of unitary foreign subsidiaries from audited
     financial statements of the company,

  added the income of domestic international sales corporations that
     were part of the unitary business on the basis of federal tax
     return data,\8 and

  eliminated foreign subsidiary income to avoid double counting that
     was included with the parent corporation's income in the
     consolidated federal tax return and in the financial statements
     from which income data were originally obtained. 

In a foreign-controlled corporation case, the auditor began with
income reported in the parent corporation's audited financial
statements and

  added back income taxes identified in the report that were not
     deductible under state reporting requirements,

  substituted the taxable income of U.S.  subsidiaries from their
     federal tax returns for their "book" income, and

  eliminated reserve and amortization deductions identified in the
     financial statements that were not allowed for U.S.  tax
     purposes. 

Auditors also took steps to ensure that income was adjusted for
differences between state and federal tax reporting requirements. 
For example, California does not allow certain accelerated methods of
depreciation that the federal government permits.  Although such
differences are not formulary apportionment issues, per se, they can
have a significant effect on unitary income for tax purposes and
therefore on corporate tax liability.  For example, as the result of
state adjustments for 10 different items, the net income of a U.S. 
multinational increased by several hundred million dollars over a
4-year period. 


--------------------
\6 Income information is available from the federal tax returns of
U.S.  subsidiaries but is not available for foreign subsidiaries
because they do not file federal tax returns. 

\7 Business income is, generally, income arising from transactions
and activities in the regular course of a taxpayer's trade or
business.  It is assigned to a location through formulary
apportionment.  Nonbusiness income is all other income and is
specifically assigned to a particular location. 

\8 Domestic international sales corporations were U.S.  corporations
which were exempt from income tax and whose shareholders were
permitted a partial deferment of U.S.  tax on certain export
receipts.  They were replaced by foreign sales corporations after
Dec.  31, 1984.  Foreign sales corporations are foreign corporations
set up by U.S.  parents to handle export activities.  The foreign
sales corporation provisions were designed to ensure that the
exemption from tax was not a prohibited subsidy under the General
Agreement on Tariffs and Trade. 


      DETERMINING APPORTIONMENT
      FACTORS
------------------------------------------------------- Appendix I:2.3

A third major area for FTB on apportionment audits is determining if
the apportionment factors are correct.  Because the property,
payroll, and sales factors used to apportion multinational income can
significantly affect state tax liability, FTB auditors are to verify
the California and worldwide amounts that underlie the three factors. 
They are to compare factor amounts with similar data in audited
annual financial statements, federal tax returns, and taxpayer
workpapers and do detailed checks to ensure that the numbers are
reported consistently and comply with state requirements.  When
necessary, the auditors use these sources to make adjustments. 

One domestic case illustrates how FTB used this approach to audit the
property factor.\9 Total property in this case was the sum of the
annual average cost of fixed assets in 7 categories plus the
capitalized rent for more than 20 subsidiary corporations. 
Historical costs of most of the fixed assets came directly from the
financial statements.  Some fixed asset costs, rent, and the
California property amounts were obtained from supporting taxpayer
workpapers. 

FTB had to consider potential property valuation differences in
auditing foreign-controlled corporations.  For example, the value of
land in one foreign parent corporation's audited financial statements
was based on its appraised value rather than on its historical cost. 
Consequently, the auditor asked the California subsidiary to get
historical cost information from its parent corporation and then used
it to compute total unitary property.  Although the auditor could not
verify land and fixed assets containing historical cost using the
annual report, he compared total property to the total property
amount in the prior audit and concluded that it appeared to be
reasonable.  California property value was verified using the
California subsidiary's "state report," which allocated property cost
and rent to each state.\10

FTB also used many sources to verify and, if necessary, adjust the
payroll factor.  The payroll factor consisted of employee
compensation, including wages, salaries, and commissions related to
business income.  It also included employee benefits, such as room
and board that are taxable under the Internal Revenue Code.  If the
taxpayer uses the cash basis of accounting to calculate the payroll
factor, FTB can verify the state payroll using amounts reported on
California unemployment insurance quarterly returns.\11 FTB can
verify the U.S.  component of worldwide payroll to federal payroll
returns filed annually or quarterly.\12 If the taxpayer uses the
accrual basis of accounting to calculate the payroll factor,
supporting taxpayer payroll records may provide the necessary data. 
For foreign corporations, FTB can obtain payroll data from financial
statements or from information provided by the foreign corporation. 

One of our U.S.-controlled multinational case studies illustrates how
the auditor compared the California payroll amount with supporting
taxpayer records, including a state-by-state allocation of its total
payroll, and with the sum of the taxpayer's California unemployment
insurance returns for a particular year.  The auditor also compared
total corporate payroll to taxpayer records along with payroll data
from both its federal payroll and tax returns.  Using data from these
sources, the auditor eliminated the payroll of subsidiaries that had
been incorrectly included in the unitary business and added the
payroll of subsidiaries that were incorrectly excluded. 

Foreign-controlled corporations or foreign affiliates of U.S. 
corporations may require additional payroll adjustments, since some
of them include employee benefits that are not taxable compensation
under the Internal Revenue Code.  In one case study, for example, the
auditor eliminated a foreign parent corporation's contribution to
staff retirement and pensions, which was not income to its recipients
under the Internal Revenue Code. 

According to FTB guidance, to verify the sales factor, which consists
of a taxpayer's gross receipts that result in business income, the
auditor must make sure that other business receipts, such as rent and
royalties, are included if they are material and related to the
unitary business.  In our case studies, auditors primarily used (1)
sales and other receipts from audited financial statements to verify
total sales and (2) taxpayer workpapers that allocated sales by state
to verify California sales.  They adjusted sales factor amounts in
all 10 case studies.  In a U.S.-controlled corporation case, for
example, the auditor (1) eliminated sales related to subsidiaries
that were not part of the unitary business on the basis of sales data
in the taxpayer's workpapers and financial statements and (2) added
interest income, which the auditor concluded should be considered
business income, from data in the taxpayer's workpapers and federal
tax return. 


--------------------
\9 The property factor consists of the annual average of real and
tangible personal property.  Owned property is valued at its original
cost and rental property is valued at eight times the annual rental
expense.  Property includes inventory, buildings less construction in
progress, equipment, and other tangible assets. 

\10 In our 10 case studies, FTB auditors generally reviewed corporate
workpapers that allocated property, payroll, and sales to California
and other states as one means of verifying California factor amounts. 
According to FTB officials, corporations commonly perform this
analysis because the information is needed to apportion income among
the states. 

\11 Taxpayers may elect to determine the payroll factor using the
cash method even if they use the accrual method for financial
statement and income tax purposes. 

\12 U.S.  payroll is reported on Form 940, Federal Employer's Annual
Federal Unemployment Tax Return, and on Form 941, Employer's
Quarterly Federal Tax Return. 


   STATE METHODS OF DEALING WITH
   CURRENCY TRANSLATIONS AND
   FOREIGN ACCOUNTING STANDARDS
--------------------------------------------------------- Appendix I:3

FTB sometimes had to make currency conversions and adjustments for
differences in accounting standards and record keeping.  This was
done because foreign financial data were not reported in U.S. 
dollars or were not based on the same accounting or tax principles as
U.S.  data.  Further, foreign financial statements and records may
not always provide the data FTB needs to apportion unitary business
income.  Currency conversion and differences in accounting standards
and record keeping are issues related primarily to foreign-controlled
California corporations, since U.S.  multinational corporations must
report financial data for their U.S.  and foreign subsidiaries in
dollars based on U.S.  generally accepted accounting principles
(GAAP).  However, according to an FTB official, to some extent
currency conversion is also an issue for U.S.  multinational
corporations because the California regulations on currency
conversions may vary from U.S.  GAAP. 

FTB has established policies and procedures for dealing with currency
conversion and differences between U.S.  and foreign accounting
standards and record keeping.  When a California corporation's
financial data are in dollars and the foreign parent corporation's
data are in another currency, California data are converted to the
foreign currency at an average annual exchange rate to calculate
apportioned income, which is then reconverted to dollars.  Since
California valued fixed assets at their historical cost, converting
U.S.  assets to the currency of a foreign parent corporation required
additional calculations.\13 FTB requires adjustments for differences
in U.S.  and foreign accounting standards and record keeping when
they are material.  FTB's policy allows reasonable approximations of
the differences. 

Differences in U.S.  and foreign accounting standards and record
keeping vary by country, according to state audit guidance.  For
example,

  Foreign financial statements may include additions to various
     reserves to reduce income that may not be allowed under U.S. 
     GAAP and/or are not allowable tax deductions for U.S.  purposes. 

  U.S.  GAAP requires inventory to be valued at historical cost for
     accounting purposes unless its market value is lower.  Foreign
     countries may allow other inventory valuation methods.  For
     example, some foreign corporations may use net realizable value,
     defined as the estimated selling price minus reasonably
     predictable costs, as a basis for writing up inventory so that
     it exceeds its value on an historical cost basis. 

  Foreign countries sometimes allow unrealized gains or losses from
     foreign currency translations to be included in the income
     statement.  In contrast, U.S.  GAAP generally requires such
     gains or losses to be reported in a separate component of equity
     instead of being included in determining net income. 

Such differences can affect unitary business income or the formula
factors.  For example, France permits corporations to increase
inventory valuations when fair market value exceeds cost, which can
affect both income and the property factor.  If the increase is
material, auditors must adjust inventory to a cost basis for property
factor purposes.  They may also have to adjust the cost of goods sold
expense, which would be overstated because of the higher inventory
value. 

FTB guidance indicates that information in the consolidated income
statement of the foreign parent corporation can be used to identify
differences in U.S.  and foreign accounting standards.  In our five
foreign-controlled corporation case studies, FTB auditors made six
adjustments for differences in U.S.  and foreign accounting standards
and record keeping.  Five of these adjustments were based on audited
financial statements.  For example, the auditor increased income in
one case by adding back amounts identified in the annual audited
financial statements of the foreign parent corporation as reserves
for special purposes and for write-down of financial investments,
since both are not allowed for U.S.  tax purposes. 

We also found that auditors made assumptions or estimates when the
foreign financial statements they used did not provide the data they
needed, and taxpayers did not provide supplemental data that the
auditors requested.  In our foreign-controlled corporation case
studies, for example,

  When a taxpayer did not provide financial data to substantiate its
     contention that certain subsidiaries were not part of the
     unitary business, the auditor used information from the annual
     financial statements of the foreign parent corporation without
     excluding those subsidiaries from the report. 

  When a taxpayer did not provide information on the unrealized
     portion of foreign exchange gains or losses included in the
     annual financial statements of the foreign parent corporation,
     the auditor accepted the data, since he believed the amount of
     unrealized gains or losses would most likely be immaterial. 

The audit files indicated that foreign taxpayers sometimes believed
FTB's requests for more data on their foreign operations were
unreasonable and their adjustments were unfair.  For example,

  In the case where FTB adjusted the income of the foreign parent
     corporation for its write-down of financial investments, the
     taxpayer formally protested the adjustment.  While acknowledging
     that write-downs cannot be realized for U.S.  purposes until the
     items are sold or written off as worthless, the taxpayer said
     that it was unfair to disallow the entire expense included in
     the annual financial statements of the parent corporation, since
     the expense reflected different accounting and consolidation
     methods from subsidiaries located in many different countries. 
     The taxpayer further said that it was unreasonable to expect its
     foreign parent corporation to review all of the transactions in
     foreign countries to identify the payments that were deductible. 

  Another taxpayer protested FTB eliminating deductions for payments
     to a special reserve for employee severance pay.  The taxpayer
     argued that a deduction should be allowed because the labor law
     of the foreign parent's country required the reserve payments to
     be set aside even if the ultimate beneficiary might not receive
     them for some time.  Therefore, the taxpayer contended that the
     severance payments were not subject to any contingencies and
     should be deductible. 

  In another case, the auditor noted the taxpayer's bitter and
     extreme uncooperativeness when asked to recalculate depreciation
     expenses of its foreign parent corporation on the basis of a
     method the state allowed.  According to the taxpayer, the only
     available data to do this were from the annual financial
     statements of the foreign parent corporation, which were written
     in a foreign language.  The taxpayer was not sure it could get
     the data needed. 

Although corporations formally protested FTB adjustments for
differences in accounting standards and record keeping in the two
cases we have mentioned, an FTB official told us that protests of
accounting standard and record keeping issues might have been limited
by foreign corporations focusing almost exclusively on the
constitutional issue in the Barclays Bank case before the U.S. 
Supreme Court.  According to an FTB official, now that the Barclays
case has been resolved, the great majority of related constitutional
protest cases should be resolved by June 30, 1995, the end of the
state fiscal year. 


--------------------
\13 Average annual exchange rates were applied to the cost of fixed
assets for an initial year and then to yearly acquisitions and
dispositions.  Each year's changes were "layered" or added into the
value of fixed assets from the previous year to arrive at a value
expressed in a foreign currency at estimated historical exchange
rates. 


   LEVEL OF AUDIT EFFORT
--------------------------------------------------------- Appendix I:4

The level of effort devoted to a particular audit varied
considerably.  Table I.4 shows audit hours for our sample of 124
U.S.- and foreign-controlled corporations. 



                                    Table I.4
                     
                     Audit Hours for GAO Sample of Franchise
                     Tax Board Apportionment Audits of Large
                           Multinational Corporations\a


                                             For 105
                                           audits of  For 19 audits
                                               U.S.-    of foreign-  For all 124
                                          controlled     controlled  apportionme
Level of audit hours                    corporations   corporations    nt audits
-------------------------------------  -------------  -------------  -----------
Average                                          480            684          511
Sampling error for average audit                84.5          331.5           86
 hours (plus or minus)\b
Minimum                                           70            146           70
Maximum                                        2,386          3,158        3,158
1st quartile                                 70 -173       146 -322      70 -197
2nd quartile                                185 -356       335 -417     198 -363
3rd quartile                                360 -583       461 -896     366 -627
4th quartile                              604 -2,386   1,030 -3,158   628 -3,158
--------------------------------------------------------------------------------
\a The FTB selects corporations with the greatest additional tax
potential for audit.  Therefore, our sample does not represent all
large multinational corporate tax returns. 

\b Sampling error computed at 95-percent confidence level. 

Source:  GAO analysis of FTB apportionment audits. 

According to state officials, factors that can affect audit hours
include (1) the size and complexity of multinational corporations,
(2) the potential impact of the audit issues on tax liability, (3)
the results of previous audits, and (4) the cooperativeness of the
taxpayer.  We previously discussed how FTB auditors consider
potential tax effect when selecting corporations and planning the
scope of their audits and how they sometimes limit audit work on the
basis of the results of prior audits.  FTB officials also told us
that the lack of taxpayer cooperation occurred more often and may be
one reason that audits take longer for foreign-controlled
corporations than for U.S.-controlled corporations. 


   AUDIT RESULTS
--------------------------------------------------------- Appendix I:5

FTB auditors are to discuss audit results with taxpayers and also
give them a written summary of their audit findings.  If an audit
results in increased tax liability, FTB is to issue the taxpayer a
Notice of Proposed Assessment indicating the amount of the additional
tax.\14 For the 124 audits we reviewed, table I.5 shows total and
average amounts of initial tax liability and additional tax
assessments. 



                          Table I.5
           
           Proposed Additional Tax Assessments for
            the GAO Sample of Franchise Tax Board
                            Audits

                    (Dollars in millions)


Number of audits                     105          19     124
-------------------------  -------------  ----------  ------
Total tax before                  $641.9       $38.7  $680.6
 audit\a
Total additional tax              $139.6       $37.3  $176.9
 proposed\b
------------------------------------------------------------
\a The total tax before audit was not available from FTB records for
6 of the audited years in three audits.  The related amount of
additional tax proposed for those 6 years was $5.9 million. 

\b FTB also notified taxpayers of $14.8 million in proposed
overassessments for the 124 audits. 

Source:  GAO analysis of FTB data. 

FTB obtained copies of IRS audit results and, if changes were
applicable for state purposes, made related adjustments to state
income taxes.  Of the $176.9 million proposed additional tax
assessments in table I.5, $41.1 million was partially the result of
IRS audits of federal tax returns.  An additional $28.9 million in
proposed tax assessments, not included in the $176.9 million, was
entirely or substantially the result of IRS audits.  According to FTB
officials, they generally rely on IRS audits to ensure that taxpayers
report accurate income and expense data on their federal tax returns. 

Taxpayers may agree with the additional tax, or they can contest it
through the state's protest and appeals process and/or through the
court system.  Taxpayers can file a protest with the FTB if they
disagree with the proposed tax assessment and, if they disagree with
FTB's decision on their protest, they can appeal it to the California
State Board of Equalization.  The Board's decisions are final unless
the taxpayer pursues the case through the court system.  Taxpayers
have other options, which include litigating their cases or
submitting cases in the protest and appeals stage to a settlement
process.\15

Taxpayers agreed with $33.8 million of the $176.9 million in proposed
additional tax assessments from our sample of 124 FTB audits and
contested $143.1 million through the protest, appeals, and/or
settlement processes.  Of the $143.1 million contested, FTB had not
resolved $89.3 million at the time of our review.  Table I.6 shows
the disposition of the $53.8 million in proposed assessments that
were resolved. 



                          Table I.6
           
            Resolution of Proposed Tax Assessments
            for GAO Sample of Franchise Tax Board
           Audits That Were Contested and Resolved

                    (Dollars in millions)

                                   U.S.-    Foreign-
                              controlled  controlled
                              corporatio  corporatio
                                      ns          ns   Total
----------------------------  ----------  ----------  ------
Number of proposed                    16           3      19
 additional tax assessments
Proposed additional tax            $50.2        $3.6   $53.8
Final assessed tax                 $27.2        $2.0   $29.2
Percentage of proposed tax           54%         55%     54%
 sustained
------------------------------------------------------------
Source:  GAO analysis of FTB data. 


--------------------
\14 Audits may also identify overassessments for some tax years. 

\15 California enacted legislation that gave FTB authority for a
limited period to negotiate a settlement of civil tax disputes
existing as of July 1, 1992.  That authority was extended by further
legislation. 


NARRATIVE SUMMARY OF 10 CALIFORNIA
FRANCHISE TAX BOARD AUDITS OF
MULTINATIONAL CORPORATIONS
========================================================== Appendix II

Our case studies of FTB audits involving five U.S-controlled
(domestic) and five foreign-controlled corporations are briefly
described in the following summaries. 


      DOMESTIC CASE NUMBER 1
------------------------------------------------------ Appendix II:0.1

The key audit issue in this case was the unity of a U.S.  parent
corporation, the California taxpayer, with its subsidiaries.  The
auditor included a domestic subsidiary in a unitary business with the
taxpayer, then realigned the taxpayer and its divisions and
subsidiaries into several unitary businesses consistent with an
agreement between the taxpayer and FTB in a prior audit.  The auditor
recalculated taxable income for each unitary business, relying
primarily on the consolidated federal tax return to determine unitary
income and on the parent corporation's financial statements and
workpapers to recalculate apportionment factors.  The auditor made no
adjustments for differences between U.S.  and foreign accounting
standards and record keeping. 


      DOMESTIC CASE NUMBER 2
------------------------------------------------------ Appendix II:0.2

The audit focused primarily on state audit adjustments.  The
California taxpayer, the parent corporation in a U.S.  multinational
enterprise, included domestic and foreign subsidiaries in the unitary
business, as agreed with FTB in the previous audit.  The auditor
revised the corporation's taxable income primarily on the basis of
federal tax return data, audited financial statements, and taxpayer
workpapers.  There were several adjustments for differences in state
and federal tax reporting requirements that increased unitary
business income by hundreds of millions of dollars for the 4 years
audited.  The auditor made no adjustments for differences between
U.S.  and foreign accounting standards and record keeping. 


      DOMESTIC CASE NUMBER 3
------------------------------------------------------ Appendix II:0.3

The key audit issue in this case related to a federal tax deduction
that was not allowed under state tax reporting requirements.  Unity
between the California taxpayer, the parent corporation in a U.S. 
multinational enterprise, and its domestic and foreign subsidiaries
had been established in the previous audit, and the taxpayer included
all affiliated corporations in its unitary business.  The auditor
primarily relied on information in the federal tax return, annual
report, and taxpayer workpapers in doing his work.  The auditor made
no adjustments for differences between U.S.  and foreign accounting
standards and record keeping. 


      DOMESTIC CASE NUMBER 4
------------------------------------------------------ Appendix II:0.4

The key issue in this case was a deduction for legal fees that FTB
disallowed on the basis of the results of an IRS audit.  The
California taxpayer, the U.S.  parent corporation in a multinational
enterprise, included all its subsidiaries as part of its unitary
business, although the previous audit had determined that one
subsidiary was not unitary with the taxpayer.  There were no annual
reports or Securities and Exchange Commission (SEC) forms 10-K
available to use in recalculating tax liability, because the taxpayer
was a privately held corporation.  As a result, the auditor
recalculated taxable income to exclude the subsidiary corporation
primarily on the basis of information in the federal tax return and
taxpayer workpapers as well as the results of a federal audit.  The
auditor made no adjustments for differences between U.S.  and foreign
accounting standards and record keeping. 


      DOMESTIC CASE NUMBER 5
------------------------------------------------------ Appendix II:0.5

The key issue in this case was the unity of the taxpayer with its
domestic subsidiaries.  The taxpayer did not respond to the auditor's
request for information needed to make a unitary determination, so
the auditor relied on the taxpayer's SEC Form 10-K and the taxpayer's
annual reports.  The auditor revised taxable income primarily on the
basis of information from the federal tax return, annual reports, and
taxpayer workpapers.  An FTB official noted that the number of hours
spent on this audit was atypical, because of the complexity of the
relationships between the taxpayer and its affiliates, the lack of
taxpayer cooperation, and other problems.  The auditor made no
adjustments for differences between U.S.  and foreign accounting
standards and record keeping. 


      FOREIGN CASE NUMBER 1
------------------------------------------------------ Appendix II:0.6

The key audit issue in this case was the unity of the California
taxpayer with its foreign parent corporation and affiliates. 
Although the taxpayer was first combined worldwide with its foreign
parent corporation in the late 1960s, the taxpayer included only its
domestically owned subsidiaries in its unitary business.  Since the
taxpayer stated that no facts had changed since the previous audit,
the auditor limited his unitary business analysis to examining
intercompany transactions between the taxpayer and its parent
corporation and foreign affiliates.  The auditor recalculated taxable
income primarily on the basis of information contained in the foreign
parent corporation's annual report, federal tax return, and taxpayer
workpapers.  In computing one of the apportionment factors, the
auditor accepted certain information without verification because it
could not be obtained from the parent corporation.  The auditor made
two adjustments for differences between U.S.  and foreign accounting
standards and record keeping based on details in the annual report. 


      FOREIGN CASE NUMBER 2
------------------------------------------------------ Appendix II:0.7

The key audit issue in this case was the unity of several California
taxpayers with their foreign parent corporation.  Each taxpayer filed
separate tax returns and none included the foreign parent corporation
as part of the unitary business.  The different California taxpayers
failed to provide requested information on the unitary ties between
the parent corporation and any of its affiliates, so the auditor
based his determination on the parent corporation's annual report,
taxpayer financial statements, federal tax returns, and taxpayer
books and records.  The auditor could make no determination regarding
the unity of unconsolidated foreign entities mentioned in the parent
corporation's annual report.  The auditor recalculated taxable income
primarily on the basis of the parent corporation's annual report,
federal tax returns, taxpayer's financial statements, and workpapers
and made one adjustment for differences between U.S.  and foreign
accounting standards and record keeping on the basis of information
in the parent corporation's annual report.  One taxpayer did not
provide requested information that was needed to determine the
historical cost of property, which the taxpayer valued on a different
basis for some foreign subsidiaries.  As a result, the auditor
accepted the taxpayer's property values from the annual report. 


      FOREIGN CASE NUMBER 3
------------------------------------------------------ Appendix II:0.8

The key audit issue in this case was the unity of several California
taxpayers with their foreign parent corporation and affiliates.  Each
of the different taxpayers filed separate tax returns, and none
included the parent corporation in the unitary business.  The auditor
combined the taxpayers with their foreign parent corporation and its
affiliates in the unitary business and recalculated taxable income
primarily on the basis of information in the parent corporation's
annual report, federal tax return, and taxpayer workpapers.  However,
the auditor noted that while the taxpayers supplied some information,
they did not supply documents regarding sales needed to evaluate the
nonunitary aspects between the taxpayer and parent.  The auditor made
no adjustments for differences between U.S.  and foreign accounting
standards and record keeping. 


      FOREIGN CASE NUMBER 4
------------------------------------------------------ Appendix II:0.9

The key issue in this case was the unity of the California taxpayer
with its foreign parent corporation and other U.S.  subsidiaries. 
Although FTB had combined the taxpayer with its parent corporation in
a unitary business during the previous audit, the taxpayer filed a
domestic combined tax return that did not include the parent
corporation.  The auditor determined that the taxpayer should be
included with its foreign parent corporation and domestic affiliate
in a unitary business, and the auditor recalculated taxable income
for 2 years primarily on the basis of information in the parent
corporation's annual report.  However, the auditor also determined in
his preliminary analysis of unity that the taxpayer potentially could
receive a large refund for the previous 2 tax years.  The auditor
notified the taxpayer of a potential refund if it filed an amended
return, but the taxpayer did not file a refund claim.  The auditor
made two adjustments for differences between U.S.  and foreign
accounting standards and record keeping. 


      FOREIGN CASE NUMBER 5
----------------------------------------------------- Appendix II:0.10

In this case, the California taxpayer was a foreign multinational
corporation with business offices in California.  Initially, the key
audit issue in this case was whether to include subsidiaries of the
foreign parent corporation in the unitary business.  As in the past,
the taxpayer included one subsidiary but not others in the unitary
business.  Relying on information in the annual report, the auditor
determined that the taxpayer, the foreign parent corporation in this
case, was unitary with its subsidiaries.  However, since the auditor
believed that a determination of worldwide unity would result in a
tax refund, FTB notified the taxpayer of a potential refund if it
filed revised tax returns.  The taxpayer did not file a return on
this basis and the auditor reviewed the apportionment data reported
on the original tax return.  Amounts for all factors were accepted as
reported on the tax return, except the auditor added back the
taxpayer's staff retirement and pension contributions because this
deduction was not allowable for U.S.  tax purposes. 


ISSUES THAT WOULD NEED TO BE
CONSIDERED BEFORE FEDERAL ADOPTION
OF FORMULARY APPORTIONMENT
========================================================= Appendix III

Adopting formulary apportionment at the federal level would require
designing and administering a new system, one featuring a unitary tax
and addressing transition issues like coordination with other
countries.  A unitary tax system combines the income of corporations
that are determined to be members of a unitary group and applies a
formula to divide the net income of the unitary group among taxing
jurisdictions.  This approach avoids transfer pricing problems by
using a formula rather than transfer prices to determine each
corporation's share of the combined income of related corporations. 
As a result, some state tax officials and other tax experts have
advocated formulary apportionment as an alternative to the existing
federal system.  However, other tax experts believe that it is not a
viable alternative to the existing tax system. 

This appendix does not discuss whether formulary apportionment should
be adopted at the federal level.  Rather, it describes the design,
administration, and international coordination issues that would need
to be addressed before such a system could be adopted.  We do not
evaluate whether these issues can be effectively addressed in a
federal system or whether problems with the formulary approach are
more severe than the problems with the arm's length approach. 


   DESIGN ISSUES
------------------------------------------------------- Appendix III:1

Design issues that would need to be resolved center on specifying the
basic features of the unitary tax.  These issues include (1) defining
the unitary business, (2) determining the apportionment formulas that
divide the unitary group's income, and (3) defining the factors in
the formulas and the rules for valuing them and assigning them to
specific tax jurisdictions.  In addition, the revenue implications of
moving to formulary apportionment would need to be addressed. 


      DEFINING THE UNITARY
      BUSINESS
----------------------------------------------------- Appendix III:1.1

The definition of a unitary business has been continually
controversial in the states, and the lack of a uniform and clear
definition has been a major source of administrative complexity.  As
explained in appendix I, for California, determining the members of
the unitary group has been a difficult and frequently audited issue. 
In examining a unitary business, auditors require a great deal of
data and must make subjective judgments.  As we noted in our
previously cited 1992 and 1995 transfer pricing reports and 1993
testimony, the arm's length standard also requires taxpayers and IRS
to collect a great deal of information and use considerable
subjective judgment to compute arm's length prices.\1

Thus, the ease of administering a unitary tax at the federal level
would depend on a uniform definition with clear criteria for
identifying businesses belonging to a unitary group.  The definitions
used by California and other states test whether the activities of
affiliated corporations contribute to and depend on each other and,
if so, to what degree.  These definitions use criteria such as the
degree that accounting, advertising, and management activities are
integrated among businesses to identify members of the unitary group. 
As our review of California audits shows, identifying the unitary
group using such definitions can involve complex and detailed
examination of the corporations' management and operations.  If a
federal system used the same criteria for defining a unitary
business, it might require a similar analysis. 

Some academic experts and state tax officials argue that a federal
system would not need such complicated tests.  They argue that a
federal system could use a simpler definition because the state
complications result from constitutional requirements that may not
apply at the federal level.\2 Although a simple definition would
minimize administrative burden and uncertainty, a definition that is
too simple would risk combining diverse companies or being
manipulated by taxpayers.  Thus, whether the unitary business concept
would be any easier to define and administer at the federal level
than at the state level is unclear. 

One relatively simple way to define the unitary group would be to use
a "bright line" test based on ownership.  The definition would
include a company in a unitary group if members of the group owned at
least a combined minimum percentage of the company's stock.  However,
this approach might combine companies that had very little connection
in terms of intercompany transactions or shared executive or staff
functions.  It might therefore result in dividing income that did not
flow from the integrated activities of a unitary group.  Some tax
experts contend that when arm's length prices can be determined,
separate accounting is more appropriate.  Further, the ownership test
might be manipulated by taxpayers buying or selling company stock to
change the unitary group's makeup and reduce tax liability. 

To avoid problems like these, other experts have suggested
alternative bright line tests for the definition of the unitary
group.  One such test would include corporations in the unitary group
that have a minimum share of the flow of goods and services between
the controlled corporations.  Another test would be based on a
minimum flow of value between corporations that also meet a minimum
percentage ownership test, where the flow of value can arise from
shared expenses, economies of scale, and other economic
interdependencies, as well as the exchange of goods and services. 
Under either of these tests, increased administrative complexity
would have to be traded off against the reduced risk of manipulation
by taxpayers and combination of diverse companies.  Alternatively, a
single test like ownership could be used if combined with a workable
relief procedure for cases where the test combined clearly diverse
companies.  However, taxpayers have complained that state tax
administrators have been reluctant to employ relief procedures. 


--------------------
\1 \1 GAO/GGD-92-89, GAO/GGD-95-101, and GAO/T-GGD-93-16. 

\2 The courts have required that the definition of unitary and other
state tax rules be consistent with the due process and commerce
clauses of the U.S.  Constitution.  Tax experts that we interviewed
agreed that the commerce clause restrictions on state taxation would
not apply to the federal system but disagreed about restrictions
required by the due process clause.  These due process restrictions
might limit the extent to which simple tests like ownership could be
used in a federal system to identify a unitary group. 


      DEFINING THE APPORTIONMENT
      FORMULAS
----------------------------------------------------- Appendix III:1.2

To reduce the possibility of double taxation in a formulary
apportionment system, countries--like states--would need to use the
same formula as each other when dividing a company's income.  If
countries use different formulas (or if some countries use separate
accounting), the same income might be taxed by more than one country. 
With different formulas, the sum of the income apportioned by the
formulas to all countries might exceed 100 percent of the
corporations' income.  The sum might also be less than 100 percent,
resulting in some income escaping taxation in any country. 

Neither the arm's length system nor the unitary system can guarantee
eliminating double taxation, and the unitary system might undertax as
well as overtax.  According to the U.S.  Supreme Court's opinion in
the Barclays case, the current arm's length system might also involve
double taxation.  Procedures for relief from double taxation, like
the federal government's competent authority mechanism, would still
have to be in place, and guidelines for resolving differences in
formulas would have to be developed.\3

Countries would also have to use consistent formulas (and consistent
definitions of the factors within the formulas) to reduce economic
inefficiencies that may result when differences in tax rules cause
companies to make investment decisions that they would otherwise not
make.  When the tax system interferes with investment decisions,
capital may not be employed in its most productive use.  Differences
in apportionment formulas may encourage corporations to shift assets
across borders to reduce tax liabilities.  Supporters of formulary
apportionment point out that because the formulary method recognizes
that the multinational corporation is an integrated enterprise and
does not require corporations to price transfers as if they were
unrelated, it is less likely to interfere with business decisions
than the arm's length standard.  In any case, the federal government
would need to minimize interference by promoting consistent formulas
and factor definitions in a federal unitary system. 

Consistent formulas might be hard to achieve because countries, like
states, have incentives to vary their formulas.  The majority of the
states use the equally weighted three factor formulas comprising
sales, payroll, and property to divide the income of companies except
in some designated industries.\4 The remaining states double weight
sales, use other weighting schemes, or permit formulas with fewer
than three factors.  States may depart from the standard formula to
provide tax incentives.  For instance, some states, with the recent
addition of California, double weight the sales factor because they
believe that double weighting sales encourages corporations to locate
within their boundaries. 

Countries too might adopt inconsistent formulas by weighting the
factors differently to exploit local conditions, such as differences
in countries' labor costs, or to create tax incentives.  Countries
might try to enforce consistency through agreements and model laws. 
Although many states recognize the need for uniformity and have tried
to achieve it through laws and agreements, the results of their
efforts have been mixed.  For example, the number of states that
double weight the sales factor grew from 4 in the early 1980s to 18
in 1994. 

In addition to being consistent, different formulas might have to be
designed for different industries, as is the case in some states. 
Also, relief provisions might be needed in cases where standard or
industry formulas produce distortions.  Because even a system of
formulas tailored to industry characteristics might not avoid
distortions in all cases, companies and IRS and tax authorities in
other countries might have to settle for rough justice by accepting a
tax liability that is approximately correct. 

Some opponents of formulary apportionment are skeptical that rough
justice will be acceptable to taxpayers and tax authorities. 
Supporters of the formulary approach point out that the arm's length
approach also entails rough justice because it produces an
approximation of the correct tax liability.  They note that arm's
length pricing requires that subjective judgment be used to determine
what price, within a range of prices, is the correct price to apply. 


--------------------
\3 Many countries enter into tax treaties with each other to avoid
double taxation of multinational corporations doing business in both
jurisdictions and to prevent evasion of either's income taxes. 
Countries have generally appointed officials referred to as those
countries' "competent authorities" for dealing with tax treaty
matters covering related parties. 

\4 Many states use different formulas for industries such as banking
and finance to reflect the varying importance of different factors in
those industries' activities. 


      DEFINING THE APPORTIONMENT
      FACTORS
----------------------------------------------------- Appendix III:1.3

Again, to reduce double taxation and ease administrative burden, a
unitary tax would require clearly specifying the elements in the
apportionment formula factors.  The elements of the factors, such as
the types of property in the property factor, would need to be
defined similarly in each country.  Location and valuation rules
would need to be applied consistently throughout a company that
operates in different tax and accounting jurisdictions.  These rules
would need to be defined so they are not easily manipulated to avoid
tax but at the same time do not impose unreasonable compliance and
enforcement burdens. 

The states do not uniformly define apportionment factors.  Although
most have adopted the Uniform Division of Income for Tax Purposes Act
(UDITPA) three-factor formula, some have introduced exceptions to the
prescribed rules for defining the factors in the formulas.  Of the 45
states with a corporate income tax, almost half have substantially
adopted the UDITPA provisions.  However, some states have adopted
such departures from the UDITPA rules as valuing property at other
than historical cost and excluding executive compensation from the
payroll factor.  This lack of uniformity creates difficulties for
corporations complying with the state tax and increases the risk of
double taxation. 

In addition to the issue of uniform factor definitions, other policy
issues specific to each factor have been the source of continuing
controversy in the states and would likely be raised in a federal
system as well.  The following sections describe these policy issues
for each apportionment factor. 


         THE SALES FACTOR
--------------------------------------------------- Appendix III:1.3.1

The sales factor poses problems for tax administrators determining
the location of sales receipts.  Most states assign receipts from
sales of tangible property to the state which is the destination of
the sales.  The location of the sales may be shifted by altering the
method or place of delivery.  Many states have used a "throwback
rule" to limit the potential manipulation of the sales factor by
allocating sales in a state without a corporate tax to the state in
which the sales originated.  The rule helps to ensure that all income
of a corporation is subject to state tax.  Like the states, a federal
system could use throwback rules to prevent the undertaxation of
income. 

Some commentators have criticized as complex and ambiguous the
states' rules for locating the receipts from selling or licensing
intangible property.  Under UDITPA, the receipts are assigned on the
basis of the location of income-producing activities such as the
sale, licensing, or other use of the intangible.  The rules have been
criticized because they provide insufficient guidance for applying
complicated methods for determining the location of these activities. 
In a federal system, an effort might be needed to make these rules
simpler and clearer. 


         THE PAYROLL FACTOR
--------------------------------------------------- Appendix III:1.3.2

Compensation is often defined differently inside and outside the
United States.  Some countries include fringe benefits in
compensation that the United States does not include.  Also, it may
be difficult to distinguish between employee compensation and
payments to independent contractors that may not be included in the
payroll factor under a U.S.  definition of compensation.  In a
federal system, some adjustments for these differences would have to
be made and might be difficult when foreign corporate records are not
comparable with U.S.  payroll records.  The California audits
illustrate how one state now makes adjustments to payroll figures. 


         THE PROPERTY FACTOR
--------------------------------------------------- Appendix III:1.3.3

The main controversies with the states' definition of the property
factor center on using original cost valuation and excluding
intangible property.  Both issues would need to be addressed in
designing a federal unitary system.  One analysis would be
determining whether the states' approaches are administrable and can
be adopted at the federal level.  Because people disagree on these
issues at the state level, the arguments of both opponents and
supporters of the state practice are important considerations. 

Opponents assert that valuing property at historical cost as most
states do may distort income apportionment.  This is because
comparable properties acquired at different times will have different
costs due to changes, such as inflation, in the economic environment. 
Supporters counter that any income distortion resulting from using
historical value will usually not be significant because property is
only one of three factors that are averaged to approximate the share
of total income. 

Opponents maintain that the historical cost valuation method may
impose a substantial compliance burden on taxpayers.  The start-up
costs for corporations of a unitary system might be substantial
because they would include determining the original value of assets
worldwide.  Unlike the case in the United States, most foreign
accounting systems are based on market value and, in developing
countries, historical costs may not be available.  Supporters contend
that historical cost is generally available in developed countries,
even if it is not the primary method of valuation, and that
historical cost can frequently be calculated from information
appearing in financial statements.  Also, supporters assert that the
specific valuation method is unimportant as long as the same method
is used consistently throughout the unitary group. 

Opponents assert that excluding intangibles from the property factor,
as the states do, may distort the income apportionment of companies
with substantial intangible property.  For example, most of the
income of a corporation with a unique, high-valued patent may be due
to the patent, but the corporation's share of the unitary group's
income, as determined in part by the property factor, would not be
affected by the patent.  Including the intangible in the property
factor would be difficult because historical costs would be hard to
determine.  If market value were used rather than historical value,
determining the arm's length market value of the intangible would
reproduce in the unitary system the valuation problems plaguing the
administration of section 482 of the Internal Revenue Code. 

The states exclude intangibles from the property factor because they
recognize the impracticality of determining the location of
intangible assets.  Supporters of the state practice maintain that
trying to place the intangible in any one jurisdiction is
inappropriate in most cases.  In their view, the value of an
intangible, like a trademark, extends to the entire corporation and
cannot be limited to a specific location.  Nevertheless, they contend
that intangibles still influence income apportionment because the
factors reflect the activities that give rise to the intangible.  For
instance, the spending on research salaries and equipment will
increase the payroll and property factors for a unitary group's
research member and therefore the share of income from a patent that
is apportioned to that member. 


      REVENUE
----------------------------------------------------- Appendix III:1.4

Another issue that would have to be addressed before a federal
unitary system could be adopted is the impact on the tax revenue
received by the federal government.  The studies that we have
examined are not comprehensive, and the revenue implications of a
change to a unitary system are uncertain.  Further study would be
needed to produce estimates of the revenue effects of a change to a
federal formulary system. 

The revenue gains and losses of moving from the arm's length approach
to the formulary method depend on several factors.  For example, if
property and payroll cost less abroad than at home and if management
systematically requires higher profit from offshore operations to
compensate for risk, the shift from the arm's length approach to the
unitary approach is likely to increase taxable income apportioned to
the home country.  However, if costs in the foreign countries are
higher, a greater share of income is likely to be apportioned abroad. 

Although studies have shown that total U.S.  multinational income
apportioned to the United States would increase if a unitary tax were
adopted, they also showed the increase depending on a few industries. 
For example, one study found that changing to a worldwide unitary tax
would increase U.S.  income by 13.5 percent for all industries, but
when the petroleum and coal industries were excluded from the study,
the change would decrease U.S.  income by 2.4 percent.\5

These studies were not comprehensive for several reasons: 

  Some used data only for U.S.  corporations or for corporations
     based in a single state. 

  Some relied on data for a single year and therefore did not reflect
     how the U.S.  share of total income might change with the
     business cycle. 

  Some also based their estimates on data from the Department of
     Commerce and on financial statement information, which might not
     be accurate proxies for taxable income. 

A comprehensive study of the revenue effects of the change to
formulary apportionment would be based on tax data for several years
and cover U.S.  corporations and U.S.  subsidiaries of foreign parent
corporations operating in the United States. 


--------------------
\5 Robert Tannenwald, "The Pros and Cons of Worldwide Unitary
Taxation," New England Economic Review, (July/Aug.  1984), pp. 
17-28. 


   ADMINISTRATION ISSUES
------------------------------------------------------- Appendix III:2

Administration issues concern the challenges taxpayers would face in
complying with a unitary tax and that tax administrators would face
enforcing it.  These issues arise from the differences in financial
accounting systems among countries, taxpayers' need to gather
information on their worldwide activities, and tax administrators'
need to verify this information. 


      RECONCILING ACCOUNTING RULES
----------------------------------------------------- Appendix III:2.1

A federal unitary system would require taxpayers and IRS to adjust
for differences among various countries' accounting rules. 
Adjustments are needed to make values consistent when computing
worldwide income and apportionment factors.  To some extent,
companies already make adjustments for regulatory or internal
business reasons.  However, we cannot be sure how many companies
would face an added compliance burden under a unitary system. 

Besides converting foreign financial accounting principles to U.S. 
generally accepted accounting principles (GAAP), companies might also
be required to make complex and time-consuming efforts to reconcile
financial accounting to tax accounting rules for items such as
inventory accounting methods and depreciation.  We do not have
comprehensive data on the costs of making these adjustments. 
Supporters of the unitary method assert that the costs of accounting
adjustments at the state level have not been excessive.  Critics
contend that developing data on a unitary group's worldwide
activities and reconciling countries' diverse accounting rules can be
extremely burdensome. 

In its recent Barclays decision, the U.S.  Supreme Court found that
Barclays had not shown that the California worldwide unitary system
imposed inordinate compliance costs that would make the California
system unconstitutional.  This finding was made even though Barclays
maintained that it was required to convert financial and accounting
records from around the world to conform to U.S.  principles. 
Barclays argued that California would require the company to gather
and present much information not maintained by the unitary group in
the normal course of business.  However, because, as alluded to in
appendix I, California allows companies to use "reasonable
approximations" when they do not normally keep the needed data, the
court found that Barclays avoided large compliance costs. 

Companies may already adjust records to U.S.  rules for regulatory
reasons or to facilitate doing business in the United States.  For
example, companies listed on U.S.  stock exchanges are required by
the Securities and Exchange Commission (SEC) to prepare financial
statements according to U.S.  GAAP or quantitatively reconcile to
GAAP the materially different items on their foreign-based financial
statements.  Also, IRS regulations specify that record-keeping
requirements under section 6038A of the Internal Revenue Code will be
satisfied if, among other records, profit and loss statements that
are directly or indirectly related to transactions between related
parties are maintained in accordance with GAAP or deviations from
GAAP are explained.  Companies may also prepare financial statements
according to GAAP to make their U.S.  business easier to transact. 
For example, U.S.  lenders may need financial statements done
according to GAAP in order to have records that they can understand. 

Although the costs of reconciling accounting rules in a federal
unitary system would depend on many things, as described later in
this appendix, an indicator of additional costs is the adjustments
that foreign companies now make to conform to U.S.  GAAP.  According
to an SEC survey of 528 foreign corporations filing annual SEC
reports or registration statements from 1991 through the first 2
months of 1993, 46 percent already prepared financial statements
according to GAAP or reported no material effect on their original
statements due to deviations from GAAP.  The other 54 percent,
however, reported material deviations and therefore had to make
various reconciliations.  Depreciation and amortization, deferred or
capitalized costs, and deferred taxes were the most common
reconciling items.  The corporations included in the survey were from
the countries supplying most of the foreign direct investment in the
United States, and most of the corporations used those countries'
accounting principles.  Therefore, the survey illustrates the kinds
of adjustments going from foreign accounting rules to U.S.  GAAP that
might be made by foreign corporations in a federal unitary system. 

If the unitary system became the international norm, foreign
corporations and U.S.-based companies would be reconciling accounting
rules for all the countries that adopt a unitary system.  Although
U.S.  multinational corporations already reconcile foreign accounting
rules to U.S.  GAAP, they could also be required to reconcile U.S. 
accounting rules to those of the countries in which their
subsidiaries operate and which have adopted a unitary system.  The
overall cost would depend on the number and type of reconciliations
required.  For each country involved, relevant questions would
include (1) how much the foreign accounting system differs from GAAP,
(2) what materiality and reasonable approximation provisions are
adopted in the federal system, and (3) to what extent the
subsidiaries of U.S.  companies already keep records according to
foreign rules for regulatory or business reasons.  In adopting a
unitary system, the federal government would have to consider the
effect on compliance burden of differences in international
accounting rules and the degree to which reasonable approximations
could be used in a federal system to reconcile material differences. 


      OBTAINING AND VERIFYING
      INFORMATION
----------------------------------------------------- Appendix III:2.2

A federal unitary system would require companies to compile
information on their worldwide activities.  To some extent, companies
already do this for regulatory and business reasons.  We do not know
the start-up costs for companies that do not, nor do we know what new
information a federal system would require of all companies.  Also,
how IRS would audit a unitary system is uncertain.  IRS might not
rely on the same data sources as California, and the federal system
might introduce rules not used by California that simplify or
complicate audits. 

Whether companies with global operations would incur substantial
start-up costs under a unitary tax depends on whether they already
prepare consolidated financial statements.  If they do, and
supporters of the unitary system contend that most foreign-controlled
corporations do, their start-up costs would not be as great. 
However, depending on the approximation and materiality rules already
discussed, they might still need to collect data not on the
statements or make adjustments for accounting rules.  As discussed in
appendix I, California auditors sought information on the historical
cost of land owned by a foreign parent corporation-- information not
found on the parent corporation's financial statement. 

Under a unitary system, IRS would need to verify the value of
companies' worldwide property, payroll, and receipts.  The costs of
administering such a tax would depend on the system design and the
level of audit effort IRS finds acceptable.  Our review of California
audit practices showed California relying, to a great extent, on
financial statements audited by private accounting firms to verify
worldwide income and apportionment factors.  In a federal unitary
system, IRS would need to determine whether to rely on audited
financial statements to the same extent as California or whether to
go further in verifying apportionment factors and worldwide income. 

IRS may be better able than the states to compel information from
companies and may have better access to information collected by
foreign tax authorities, but we are not sure how these advantages
would work out in a federal unitary system.  For example, section
6038A of the Internal Revenue Code requires extensive record keeping
relating to foreign-controlled businesses in the United States.  IRS
provided us with examples of many taxpayers that have become more
compliant as a result of the requirements of section 6038A.  By using
such provisions, IRS may have more success than the states acquiring
foreign data under a unitary system. 


   TRANSITION ISSUES
------------------------------------------------------- Appendix III:3

Transition issues concern the process of moving from the current
arm's length system of taxing multinational corporate income to
formulary apportionment.  They include the international coordination
needed for a unitary system and the changes required in the U.S.  tax
code to accommodate a unitary tax. 


      INTERNATIONAL COORDINATION
----------------------------------------------------- Appendix III:3.1

In our 1992 report,\6 we said that getting international agreement
for a change to a unitary system would be difficult.  We continue to
believe that.  On the basis of information presented in this report,
we also believe that international agreement for a unitary system
design may be very hard to achieve and that administering a unitary
system would be easier if countries shared information and procedures
for keeping countries' tax systems consistent.  Thus, coordination
would mean obtaining agreement, not only on the change to a unitary
method but also on the new method's design and administration. 

A primary reason that coordination is desirable is to avoid double
taxation.  Companies that operate in countries that adopt a unitary
system may have the same income taxed by different countries when, as
previously described, countries use different definitions of unitary
businesses, formulas, and factors.  Double taxation may also occur
when companies operating in countries that adopt a unitary system
also operate in countries that continue separate accounting. 

Obstacles would have to be overcome to foster increased international
cooperation in favor of formulary apportionment.  Countries and
organizations throughout the world oppose the unitary method.  Nearly
every country has adopted the arm's length standard (separate
accounting) as the general principle governing transfer pricing.  The
United Nations and the Organization for Economic Cooperation and
Development (OECD) recommend its use.  The recently issued OECD draft
guidelines on transfer pricing specifically reject global formulary
apportionment as the international standard.\7 Although the
guidelines are not binding on member states, they guide countries and
corporations in setting proper arm's length prices. 

Furthermore, the United States has a long history of supporting the
arm's length method--a history that complicates a move toward a
unitary system.  The United States first incorporated the arm's
length standard in regulations in 1935 and articulated a detailed
approach in 1968.  U.S.  adoption of the arm's length method
influenced other countries to adopt it as well.  Further, according
to the Department of the Treasury, the United States is obligated
under virtually all of its bilateral tax treaties to apply the arm's
length standard to transfer pricing adjustments to the profits of
related companies.  However, some commentators contend that the
treaties do not prohibit the use of a formulary apportionment
system.\8

The states' experience with unitary systems shows the importance of
early rather than late coordination for limiting administrative and
compliance costs.  Initially, the states adopted unitary systems
independently of each other, with little coordination of definitions
and tax rules.\9 The resulting nonuniformity in state taxation was
seen as a source of compliance and enforcement burden.  Given this
experience, some experts contend that solving federal design problems
at the outset would be better than trying to correct them later. 

Methods that could be used to coordinate a change to a unitary system
include working through a supranational organization like OECD or
gradually introducing specific provisions into bilateral tax
treaties.  Both approaches would be difficult because of the OECD's
opposition to the unitary system.  The OECD published the OECD Model
Tax Convention on Income and Capital, which many countries have
adopted as the basis of their bilateral tax treaties.  The OECD also
publishes guidelines to help tax administrators and multinational
corporations find solutions to transfer pricing problems.  The
convention and the guidelines reflect the OECD's strong support of
separate accounting and opposition to formulary apportionment. 

A successful unilateral change to a unitary system would require that
most countries quickly follow the U.S.  lead, an unlikely prospect
given the stated resistance of many countries.  If the United States
alone taxed multinationals using the unitary tax, it would expose
U.S.  companies to double taxation while limiting their ability to
obtain relief in a competent authority process that adhered to the
arm's length standard. 


--------------------
\6 GAO/GGD-92-89. 

\7 The OECD draft defines global formulary apportionment as the
allocation of the global profits of a related group of companies
among the companies in different countries on the basis of a
predetermined or mechanistic formula.  The OECD draft does not reject
the selected application of formulas developed by taxpayers and tax
administrators, such as might be used in advanced pricing agreements. 
See Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrators, Discussion Draft Part I:  Principles and Analysis,
OECD Committee on Fiscal Affairs, (July 8, 1994). 

\8 See, for example, Louis Kauder, "The Unspecific Federal Tax Policy
of Arm's Length:  A Comment on the Continuing Vitality of Formulary
Apportionment at the Federal Level," Tax Notes, (Aug.  23, 1993), pp. 
1147-1155. 

\9 As mentioned earlier, states have tried to achieve uniformity
through model laws such as UDITPA and organizations such as the
Multistate Tax Commission.  UDITPA's purpose is to make state income
taxation simple and fair by addressing nonuniformities in the states'
allocation and apportionment rules.  The Commission has taken the
lead in developing and interpreting the goals and provisions of
UDITPA. 


      OTHER CHANGES IN THE
      INTERNAL REVENUE CODE
----------------------------------------------------- Appendix III:3.2

Other aspects of international taxation may need to change to be
consistent with a unitary tax.  For example, a credit for taxes paid
on foreign-source income might not be needed in a unitary system. 
The extent of the change required in the tax code would depend on
whether the system were adopted within the framework of residence- or
source-based taxation. 

The current federal system of taxing international income is
primarily residence based.  The United States taxes a corporation
organized in the United States on all of its income, regardless of
where it is earned.  However, taxes on income earned in foreign
countries are deferred until the income is repatriated, or sent to
the United States, and, even at that time, a credit against the taxes
is generally allowed for foreign taxes paid.  An exception to this
deferral of taxes exists for certain passive income, which is taxed
as soon as it is earned.  Thus, the United States defers tax on
non-U.S.-source income but taxes all the income of U.S.  residents
wherever it is earned. 

The current system is not a pure residence-principle tax in that it
also has features of a source-based tax.  The use of the foreign tax
credit and deferral of tax recognizes that the country that is the
source of the income has the first claim to tax the income.  The
United States does not tax foreign-source income until it has been
repatriated and only to the extent of any residual U.S tax after
subtracting the foreign taxes paid. 

Formulary apportionment is consistent with either residence or source
tax principles.  As a residence tax, a unitary system would tax the
U.S.-apportioned share of income currently and tax the
foreign-apportioned share when and if it is repatriated.  As a source
tax, a unitary system would exempt from taxation income that is not
apportioned by formula to the United States. 

The choice of tax principle, however, would have major consequences
for the administrative burden of the tax system.  A source tax would
eliminate many of the complexities of the current system, such as the
foreign tax credit, while adding the complexities described earlier
that are specific to the unitary tax.  A residence-principle tax
would retain the current complexities while adding the complexities
specific to the unitary tax. 

The effect on administrative burden can be illustrated by the
different roles of the foreign tax credit in a source-based versus a
residence-based unitary system.  If a new unitary system were source
based, the income apportioned to the United States would be
U.S.-source income.  The United States would not tax foreign-source
income and therefore would not need to provide a foreign tax credit
to avoid double taxation.  However, double taxation could still occur
if countries disagreed on the apportionment formulas and therefore
the definition of foreign-source income and if they then taxed what
other countries deemed to be their apportioned share of worldwide
income.  Disputes about double taxation are currently resolved in
competent authority and presumably would continue to be resolved
there under a unitary system. 

If the United States retained the residence principle in a unitary
system, income apportioned to foreign sources would still be subject
to U.S.  tax.  Therefore, an administratively complex foreign tax
credit would still be required when the foreign-source income was
repatriated to prevent double taxation.  Congress might choose to
retain the residence tax, despite the administrative complexity, to
better protect the U.S.  revenue base. 

Congress would need to address the proper role of the foreign tax
credit, along with other features of the Internal Revenue Code. 
These other features include withholding taxes on dividend, interest,
and royalty income; income sourcing rules; and the continued use of
the provisions of subpart F of the Code, which limit deferral of U.S. 
tax on foreign income.  Congress could resolve these issues in
different ways.  As under the current system, a federal system might
have features of either a source-based or a residence-based tax, or
both.  Important considerations include the effect of alternative
choices on administrative complexity and on protecting the U.S. 
revenue base. 




(See figure in printed edition.)Appendix IV
COMMENTS FROM THE FRANCHISE TAX
BOARD OF CALIFORNIA
========================================================= Appendix III



(See figure in printed edition.)



(See figure in printed edition.)




(See figure in printed edition.)Appendix V
COMMENTS FROM THE DEPARTMENT OF
THE TREASURY
========================================================= Appendix III



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Jose R.  Oyola, Assistant Director, Tax Policy and Administration
 Issues
Lawrence M.  Korb, Assignment Manager
Kevin E.  Daly, Senior Economist

SAN FRANCISCO REGIONAL OFFICE

Ralph Block, Assistant Director
Dennis Day, Senior Evaluator
Dylan A.  Jones, Evaluator
Susan Malone, Evaluator
Samuel H.  Scrutchins, Technical Advisor

