The harmonization, or at least convergence, of taxes within the EU has been high on the political agenda ever since the start of the Single Market project in 1985. The degree of harmonization, however, was always constrained by the fact that decisions of fiscal matters require unanimous consent. Within the EU, building consensus often takes time, sometimes decades.
Given the increasingly heterogeneous composition of the EU this should not come as a surprise. However, one should not be fooled; the institutions of the EU, particularly the European Commission, have proven to be rather persistent and successful when it comes to shifting prerogatives from the national to the supranational level.
In the field of international taxation the respective efforts to facilitate harmonization have culminated in the European Commission’s proposal to adopt the so-called Common Consolidated Corporate Tax Base (CCCTB) in March 2011. The CCCTB would equate to implementing a single tax system for the EU in terms of calculation and allocation of the tax base, while the member states would retain the authority to set their tax rates.
According to the proposal, the CCCTB would co-exist alongside national corporate tax systems and firms could decide whether to adopt it or not. It appears, however, doubtful whether the CCCTB would remain “optional,” as many advocates lobby for the CCCB being implemented on a mandatory basis.
As of today, the CCCTB proposal has not been adopted, but that hardly renders it irrelevant. In April 2013, referring to the CCCTB, the head of tax with PwC was quoted in the Irish Times as follows: “A bad idea never really goes away in Europe.” Indeed, chances are that the CCCTB will remain on the agenda for quite some time.
While so far reaching consensus proved futile, the recent prominence of debate on base erosion and profit shifting (BEPS) generates significant momentum for the advocates of tax harmonization. Even if the CCCTB proposal should not be adopted, it is sensible for multinational enterprises to anticipate a higher degree of harmonization as well as tougher regulation of their cross-border transactions. Reason enough to take a closer look at some of the more intriguing issues.
Political shenanigans vs. economic realities
In order to appreciate the highly political nature of the BEPS debate, it is rather instructive to take a look at the general economic background. It appears to be a rather undisputable fact that on average the level of spending of European governments relative to GDP has not dramatically decreased, despite the recent debates about excessive austerity measures. In 2012, total government expenditure of the EU27 at 49.4 percent was slightly below the pre-crisis peak reached in 2009 (51 percent), but still comfortably above the 45.5 percent in 2007. A significant part of the expenditure was financed by public debt, the level of which finally seems to finally exceed the comfort zone of (some) political leaders. Instead of fundamentally questioning the expenditure, the attention is primarily focused on the revenue side.
While total general government revenue in 2012 was at the highest level in over a decade, the EU identified an ever widening tax gap as arguably the most pressing problem to be addressed. The EU cites estimates according to which the tax gap amounts to €1,000 billion. Flanked by a respective (highly emotionalized) image campaign, titled “the missing part,” the EU vows to fight tax fraud and tax evasion and proposed a corresponding “Action Plan” in December 2012. In this context the following should be noted:
- The estimates cited by the European Commission are controversial. Here it is somewhat telling that the EU relies on a study compiled by Richard Murphy on behalf of the Group of the Progressive Alliance of Socialists & Democrats (Murphy Report). The report has been challenged on account of significantly overestimating the tax gap by (amongst others) the British government. It is also noteworthy that the OECD has refrained to publish an estimate on the extent of tax avoidance, as calculating a reliable estimate was deemed unfeasible.
- The European Commission fails to clearly differentiate between “tax evasion” and “tax avoidance.” While the former is illegal, the second refers to legal tax planning by MNEs. The corresponding rhetoric adopted by the EU leaves little doubt that it considers tax avoidance to be highly immoral. Here it is somewhat curious that the European Commission fails to clearly point out that only 15 percent of the tax-gap calculated by the Murphy Report is attributable to tax avoidance.
- While the OECD, in its assessment regarding BEPS, made it clear that the share of corporate taxation of total tax revenues has not declined in recent years (thus providing no evidence of BEPS), the European Commission is ominously silent on this issue.
- The European Commission does not leave any doubt that it considers the individual member states to be unable to cope with the respective challenges; hence the prerogative should be shifted to the EU – ignoring the fact that the extent to which EU member states are affected by BEPS is significantly smaller than, e.g., the USA.
To be sure, there is arguably ample scope to improve the regulations regarding international taxation. One of the main issues, correctly identified by the OECD, is to be seen in finding adequate approaches to value intellectual property rights (IPRs) in the context of transfer pricing. Considering that EU governments enjoy rather higher comfortable levels of public spending as well as the questionable economic “evidence” regarding the effects of tax avoidance, one could reasonably expect the EU to adopt a kind of wait-and-see attitude – in a sense of taking a backseat and contributing to the OECD’s BEPS initiative.
Instead, the EU adopts a rather harsh rhetoric and appear’s poised to take the lead, as announced by the European Parliament: “an estimated and scandalous €1 trillion of potential tax revenue is lost to tax fraud, tax evasion, tax avoidance and aggressive tax planning every year in the EU, […], without appropriate measures being taken in response […] this loss represents: a danger for the safeguarding of a EU social market economy based on quality public services.” In communicating this issue to the public, politicians and media are keen on referring to specific MNEs (e.g. Starbucks and Google) and demand that MNEs should contribute their “fair” share to the tax revenues required for providing the quality public services referred to by the Parliament. Without going further into details, it should be evident that political considerations may potentially override any economic rationale on this issue.
The CCCTB no panacea against BEPS
One, mildly disturbing, element of the debate is the rather naïve assumption of CCCTB advocates that introducing formulary apportionment would effectively eliminate the opportunity for MNEs to implement aggressive tax structures. They mainly base their argument on the fact that, under the CCCTB, the allocation of the tax base would be calculated on a three-factor formula (⅓ sales + ⅓ (½ payroll + ½ employees) + ⅓ tangible assets), which allegedly would be immune to manipulations through transfer pricing. For empirical support, they often refer to the success of formulary apportionment regimes in the U.S. or Canada.
A more critical analysis of the respective literature, however, clearly shows that even outspoken critics of the arm’s length principle are highly skeptical whether formulary apportionment would prove to be superior in practice. As Julie Roin (University of Chicago, 2007) admitted; “Formulary taxation has been touted as a mechanism for making sure that they [MNEs] pay their fair share.
Unfortunately, even the best designed formulary system will be incapable of living up to its billing.
Indeed, it remains open to question whether formulary taxation will be even a net improvement over the present arm’s length pricing method based system […] stated simply, many of the real economic factors are no more real, or less susceptible to manipulation, than are the factors used to determine source of income under the current arm’s length based system.”
Formulary apportionment does not fail to provide a panacea against BEPS, an implementation of the CCCTB would have fundamental ramifications that are not even addressed in the public debate. One ramification may be deduced from the advice offered by the famous Walter Hellerstein: “If there is one lesson for the European Union in the U.S. states‘ experience with the choice of apportionment formulas, perhaps it is the manifestation of the strong tension that exists between what might be regarded from a collective viewpoint as a defensible formula for fairly dividing the income tax base among the states and a formula that maximizes an individual state’s economic interests.”
He might just as well have added, “good luck with that” – I am not referring to the concept of a ‘collective viewpoint’ at this point.
But jokes aside, what we are looking at here is nothing less than a potential watershed in international taxation. The “battle” of the arm’s length principle vs. formulary apportionment has lasted for almost a century. While the arm’s length principle has been established as the paradigm in international taxation, it is not feasible to argue that one approach would be superior to the other on theoretical grounds.
In the end of the day, the question of which approach is to be applied is an ideological question. While the arm’s length range essentially simulates a market process in order to identify the economic value of a specific transaction and to allocate the tax base accordingly, formulary apportionment is based on a value judgment regarding a “fair distribution.” As explained by Hellerstein:
“If one rejects […] that the purpose of income allocation is to determine the ’true’ source of income, and embraces instead the view that the purpose of income allocation is to effectuate an equitable division of income, then the theoretical question becomes which of the competing methods better serves this objective.
From a theoretical perspective, it would appear to be no more difficult – and probably easier – to translate one’s judgments about an equitable division of income into a formula the apportionment factors of which reflect those judgments […].” This, by the way, is also the reason why arguments claiming that the CCCTB would result in a more “accurate” or “objective” identification of the economic value added contributed by related companies must be dismissed as being completely misleading. Even to the casual observer, it should be evident that the importance of intangible assets in the economy is hard to overestimate. To claim that a formula, which is excluding intangible assets, will result in a more accurate identification of value added contributions than a simulation (however imperfect) of market processes is ludicrous.
Without addressing this issue further, it should be evident that those having a bad feeling about basing international taxation on a governmental value judgment about an equitable division of income would be well advised to start expressing their respective concerns.
Naturally, one must be careful when formulating thoughts on future tax harmonization within the EU – particularly in light of the upcoming elections to the European Parliament in May. It appears, however, uncontroversial to state that the BEPS debate has created a significant political momentum in favor of stricter regulation, further tax harmonization and, possibly, introduction of the CCCTB. The following points summarize the state of play and provide some indication of possible developments:
The Report – on Fight against Tax Fraud, Tax Evasion and Tax Havens – published by the European Parliament Committee on Economic and Monetary Affairs, (2013/2060(INI)), May 2013 contains the following highlights:
- “Deplores the fact that the member states have not yet managed to reach an agreement on key legislative proposals such as […] the 2011 Proposal for a Council Directive on a Common Consolidated Corporate Tax Base”
- “Stresses the importance of a Common Consolidated Corporate Tax Base (CCCTB), and calls on the member states to agree and implement the directive on a CCCTB by moving gradually from an optional to a compulsory scheme, as defined in its legislative resolution of 19 April 2012 on the proposal for a Council directive on a CCCTB”
- “Considers it of paramount importance that member states authorize the Commission to negotiate tax agreements with third countries on behalf of the EU instead of continuing with the practice of bilateral negotiations producing sub-optimal results”
- “Points out that legal proceedings against tax fraud are cumbersome and lengthy, and that those found guilty receive, in the end, relatively mild sentences, making tax fraud something of a risk-free crime”
CCCTB will feature prominently on the political agenda and implementation by some countries under “enhanced cooperation” procedure could be possible.
- In this context one EU diplomat, on condition of anonymity, stated the following: “Certainly I expect the work on the CCCTB to be taken forward under the Greek presidency, we might also see an [EU financial ministers] discussion for the first time on the dossier.” (Source: EurActiv)
There are some indications that the OECD’s advocacy of the arm’s length principle may weaken and that tax authorities will demand access to increasingly comprehensive information. In this context, the following aspects of the discussion draft on Transfer Pricing Documentation and CBC Reporting published in January 2014 are noteworthy.
- The information on financial and tax positions the taxpayer is required to report include: “country-by-country reporting of certain information relating to the global allocation of profits, the taxes paid, and certain indicators of the location of economic activity (tangible assets, number of employees and total employee expense) among countries in which the MNE group operates” (sec.20). In other words, all the inputs required to apply the CCCTB.
- Consequences of non-compliance are likely to become more severe; “another way for countries to encourage taxpayers to fulfill transfer pricing documentation requirements is by designing compliance incentives such as penalty protection or a shift in the burden of proof” (sec.40).