Apportionment — AccountingTools
A single sales factor apportionment formula undercuts one of the fundamental rationales for a corporate income tax, which is that a corporation should pay taxes to a state as compensation for the benefits it receives from state services. Corporations benefit from a wide range of governmental services that specifically relate to the extent of property and payroll in a state. States often underwrite local government police and fire protection for the corporation’s property and employees.
Most states have learned that their best economic development strategy is to focus on providing the high-quality public services that underpin business growth in as cost-effective a manner as possible. State officials should not find it difficult to identify and implement much more cost-effective economic development strategies than the enactment of a single sales factor formula, which provides tax breaks to corporations without regard to their in-state job creation and investment decisions. Changing to a single sales factor formula could be counterproductive to economic development in at least one additional respect. As will be discussed below, the adoption of a sales-only formula can significantly reduce a state’s corporate income tax receipts.
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A business does not have to create a single new job or make even one dollar’s-worth of new investment to reap the benefits of the tax cut. Indeed, as Massachusetts discovered soon after enacting single sales factor legislation, companies can be laying-off employees and still obtain tax savings. (See the text box on the next page.) If single sales factor apportionment is adopted to promote economic development, much of the corporate income tax revenue forgone by this switch is likely to be captured by companies that are not contemplating expansion because demand for their products does not warrant it.
The higher a state’s corporate income tax rate, the higher will be the loss of corporate income tax revenues resulting from adoption of a sales-only formula, since the formula reduces the amount of corporate profit that is subject to tax in the state. At least 11 states have recently estimated the revenue loss attributable to adoption of a sales-only formula.
How do you calculate apportionment?
An apportionment is the separation of revenues, expenses, or profits, which are then assigned to different accounts, departments, or subsidiaries.
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The estimates indicate that the revenue loss from adopting a single sales factor formula ranges from 1.1 percent to 16.7 percent of a state’s total corporate income tax collections, with four of the eleven states estimating losses exceeding nine percent of corporate income tax revenue. Where states fall in this range depends upon how significant export-oriented businesses are to the state’s economy and the types of corporations that are eligible to apportion their profits on a sales-only basis.
According to Site Selection Magazine, 71 facilities valued at $700 million or more were placed in states with corporate income taxes from 1995 through 2004. Three of the five states that had a single sales factor formula in effect (or phasing in) during this period — Iowa, Missouri, and Nebraska — did not capture a single one of these major plant locations/expansions. In four others — Connecticut, Maryland, Oregon, and Wisconsin — the facilities that made the Site Selection list were announced before the enactment of the sales-only formula.
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Assume the Ohio company has a substantial share of its sales in Wisconsin but no facilities or employees in the state and thus no nexus that allows Wisconsin to tax it. If the Ohio company sited the lab in Wisconsin, it would become subject to Wisconsin’s corporate income tax for the first time.
If corporations are not taxable outside their home states, they typically are not permitted to apportion any of their profits to other states for tax purposes. Small corporations are less likely than large corporations to be taxable in more than one state; either all of their customers are in their home state or their out-of-state customers are served without setting up the out-of-state physical facilities that would obligate the business to pay corporate taxes to other states. If a corporation is not permitted to apportion some of its profit to other states, then by definition it pays tax on 100 percent of its profit to its home state and is not affected by changes in the apportionment formula. Since small corporations are more likely than large ones to fall into this category, large corporations are likely to obtain a disproportionate share of the tax savings that flow from the switch to a single sales factor formula. A change to a single sales factor formula also can render a state a less desirable location in which to locate a new facility and the jobs that come with it.
In some states a sales-only formula is limited to manufacturers and/or other narrow classes of corporations. Changing from a three factor apportionment formula to a sales-only formula heightens tax inequities among other groups of corporations as well. For example, large corporations are much more likely to reap tax savings from a sales-only formula than are smaller corporations, many of which may be family-owned.
- Corporations benefit from a wide range of governmental services that specifically relate to the extent of property and payroll in a state.
- States often underwrite local government police and fire protection for the corporation’s property and employees.
- A single sales factor apportionment formula undercuts one of the fundamental rationales for a corporate income tax, which is that a corporation should pay taxes to a state as compensation for the benefits it receives from state services.
Functions of Apportionment
A state experiencing a large decline in revenues either would have to reduce some spending or increase another tax. Depending on the choice, the loss of corporate tax revenue that results from the formula shift could interfere with the ability of an adopting state to provide high-quality public services sought by businesses when they contemplate locating or expanding in a state.
This possibility must be weighed carefully against the purported positive investment incentive effects of changing to a sales-only formula. The loss of corporate income tax revenue arising from adoption of a single sales factor formula can be quite large in dollar terms. Massachusetts estimates that its adoption of a sales-only formula for just a segment of its corporations — manufacturers, defense contractors, and mutual funds — reduced its FY 2006 corporate tax receipts by $178 million. New York estimates it will forgo $130 million in annual revenue when the single sales factor formula is in place in 2009.
States provide roads and other transportation services to allow access to factories by suppliers and employees and the shipment of goods to markets. States also fund K-12 and higher education services that enable many businesses to find workers with adequate skills. The change from a property-payroll-sales formula to a sales-only formula substantially reduces the corporate tax burden of businesses that arguably are benefiting the most from public services in a state and unfairly shifts the tax burden to out-of-state businesses that benefit from state services to a lesser extent. These are just some of the reasons that switching from the traditional three factor apportionment formula to a sales-only formula is likely to be a relatively ineffectual economic development tool for a state and a potential threat to the revenue-raising capacity and fairness of its corporate tax as well. Beyond its specific shortcomings, the single sales factor formula is an example of the scattershot approach to economic development that most states abandoned long ago.
In sum, to the extent that some corporations that would be expected to pay higher taxes under a sales-only formula are able to counteract this impact, the net loss of corporate income tax revenues resulting from the change in formulas will be higher than forecasted. It certainly is legitimate for a state in which a business’ customers are located to tax a share of its profit even if the business does not engage in production in that state. After all, “market states” also provide services that benefit out-of-state companies — such as the roads they use to transport their goods to their customers and a judicial system that ensures that customers pay their debts. But a single sales factor formula goes too far in imposing corporate income tax liability solely on the basis of customer location rather than in proportion to both customer and production location.
The eighth state, Illinois, captured two major plants, actually somewhat less than what would be expected given Illinois’ share of the national economy. Finally, it may also be instructive to take a longer-term view of the experience of Iowa and Missouri, both of which have had a sales-only formula in place for decades. A reasonable starting point for such an examination might be 1979, when manufacturing employment in the U.S. as a whole reached its post-War peak. (The ending point of this analysis must be 2000 due to a change in the government’s method of classifying manufacturing employment after that year.) Manufacturing employment in Iowa did rise between 1979 and 2000, but only by a modest amount.
Personal and Sales Taxes
The switch to a single sales factor formula does cut taxes for businesses that sell a relatively large share of their output outside the states where the goods are produced. Even assuming that changes in corporate tax liability resulting from the change to a single sales factor formula could be large enough to influence some corporate location decisions, the fact that the formula imposes tax increases on many corporations renders it a double-edged sword. A state’s adoption of a sales-only formula could just as easily lead to net job losses as to net job gains. Companies facing tax increases from the change to a sales-only formula in a state but unable to eliminate their taxability in the state may be able to change their legal structures and their methods of operation to mitigate the tax increases.
Assume that the lab would represent a small share of the manufacturer’s total nationwide property and payroll. In that case, Wisconsin’s single sales factor formula would cause the Wisconsin tax liability arising from the company’s decision to locate the facility in Wisconsin to be higher than it would have been had the state retained the current three factor formula. In other words, Wisconsin’s adoption of a sales-only formula would be a disincentive rather than an incentive for the Ohio company — with significant sales in Wisconsin — to choose Wisconsin as the place to locate the R&D facility. Switching to a single sales factor formula automatically provides an immediate tax savings to any in-state business that sells a large share of its goods or services in other states.
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For example, an out-of-state manufacturer facing a tax increase in a state adopting a sales-only formula could separately incorporate a sales subsidiary in that state. The manufacturer could charge the sales subsidiary an artificially-high price for the manufactured goods, which — in most states — would result in the sales subsidiary having relatively little taxable profit to report. Implementing these kinds of income-shifting strategies entails some additional costs and operational complexities for any corporation.
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If the tax bill of a corporation increases due to adoption of a single sales factor formula, however, implementing these income-shifting techniques becomes more attractive. The change to a single sales factor formula is likely to reduce corporate income tax revenue substantially in any state where the economic base includes a significant number of corporations that export their wares to national or international markets. Implementing the single sales factor formula in New Mexico will not accomplish its stated goal of improving the business climate. There is no clear relationship between SSFF and manufacturing employment, and the evidence that corporate location decisions are linked to SSFF is also insubstantial. Instead, SSFF will be expensive, costing the state as much as half of its annual corporate income tax revenue, which would no doubt result in job losses in state government services such as health care, education, and public safety.
What is apportionment tax?
The apportionment percentage is determined by adding the taxpayer’s receipts factor (as described in Section 3 of this article), property factor (as described in Section 4 of this article), and payroll factor (as described in Section 5 of this article) together and dividing the sum by three.