Optimal Separate Accounting vs. Optimal Formula Apportionment

American states and Canadian provinces use formulas to allocate a multi-state company's national profit among the state-level jurisdictions. The formulas typically depend on the company's distribution of revenues and costs. In contrast, most countries allocate a multinational's global profit for the purposes of calculating national tax liabilities by treating each subsidiary as a separate corporation and requiring the multinational to use transfer prices to reflect the value of any trade between its divisions. Motivated in part by recent interest by the EU in replacing the current transfer price system with a formula apportionment system, this paper derives and compares the optimal transfer pricing regulation with the optimal apportionment formula in a model of multinational taxation that allows for both private information and unobservable investments. Conditions are derived under which the optimal transfer price regulation and the optimal apportionment formula are welfare equivalent. In the absence of the equivalence conditions, formula apportionment is shown to create a trade-off between inducing more efficient firm investment and rent extraction. The welfare implications of this trade-off are examined