Luxembourg Leaks –

the European Commission vows that no country will be spared in the ongoing fight against tax avoidance

On Nov. 5, 2014, the International Consortium of Investigative Journalists (ICIJ) published an investigatory analysis based on a confidential cache of tax agreements approved by Luxembourg tax authorities.

The publication was followed by an immediate outcry by journalists and politicians. The headlines were sensational – “Tax Storm” New York Times, “Rising Furore” Reuters – and the verdict was more or less unanimously hostile.  

The Guardian, for instance, wrote that Luxembourg, by “rubber stamping tax avoidance on an industrial scale […] helped multinationals to save millions in tax, to the detriment of its neighbors and allies.”
Now that the initial dust seems to have settled it is time to move beyond sensational headlines and address some of the more fundamental issues at stake. 

The tax perspective – much ado about nothing

An idiosyncratic feature of the Luxembourg Leaks is that the investigation neither exposed any criminal activities nor did it discover substantially new information. Throughout the world it is an established practice for taxpayers to obtain advance agreements (or tax rulings) from local tax authorities regarding specific tax structures and transfer pricing systems.

For taxpayers these agreements reduce uncertainty and thus tax risks, while the respective tax authorities are in turn provided with detailed information enabling them to make informed decisions. These agreements are thus an effective legal instrument for ensuring an efficient tax audit process providing a sensible balance of interest between taxpayers and tax authorities. 

The generalized stigmatization of these agreements as facilitating sinister collusion appears misleading and blown out of proportion. To be sure, there is no denying that advance agreements have been utilized to implement tax avoidance schemes. This realization, however, neither justifies wholesale stigmatization of advance agreements nor would it appear to be worthy of headlines– particularly since the European Commission is already in the process of investigating several APAs (see previous issue of Cayman Financial Review). 

On a more technical note, as correctly pointed out by the ICIJ, most avoidance structures are based on prevailing international tax mismatches that allowed companies to avoid taxes both in Luxembourg and elsewhere by utilizing so-called hybrid loans. The Organization for Economic Cooperation and Development, however, has addressed the issue of so-called hybrid mismatches in the context of the arguably over-extensive Action Plan on Base Erosion and Profit Shifting (specifically Action 2).

In this context, a large scale revision of international taxation, e.g. revision of the OECD model tax convention, as well as domestic law provisions is already underway, targeted at neutralizing the effects of hybrid instruments. A sober and worthwhile consequence of the Luxembourg Leaks would be to address the question, whether respective tax structures would still be feasible once the BEPS measures are implemented. The outcome of the analysis would allow a rational assessment of whether any additional initiatives are required to address the issue of hybrid mismatches.

It is further somewhat intriguing to contemplate whether the Luxembourg Leaks significantly contribute to quantifying the effects of BEPS. At least up to this point such a contribution is not evident. A corresponding analysis could be worthwhile in order to ensure that BEPS measures are focused on the most pertinent issues. A credible analysis would demand a detailed assessment of the arm’s length nature of each advance agreement. 

While there are likely be clear cases of tax avoidance, it appears equally likely that a substantial number of the agreements would be found to be commensurate with the arm’s length principle. Other agreements would likely have to be classified as in-between cases. Taking one example here, looking at the agreement of British American Tobacco, in which the company details the outsourcing (streamlining) of its factoring activities in Luxembourg, there is no glaringly evident case of tax avoidance.

The rationale of the structure appears sensible (i.e. not artificial) from a business perspective with an, at least at first glance, arm’s length remuneration for the Luxembourg subsidiary. There is no immediate evidence, let alone a quantifiable tax gap, of this particular agreement facilitating tax avoidance to the detriment of any neighbors and allies of Luxembourg. 

Purely from a tax perspective the Luxembourg Leaks are certainly relevant, but may be regarded as being not quite sensational. International taxation is certainly a complex issue and let’s be frank many people, including journalists and politicians, probably perceive it as being a little dull. It is thus not surprising that the Luxembourg Leaks are first and foremost a political issue.

The politics perspective – no one will be spared

When accessing the Luxembourg Leaks on the ICIJ website, even the casual visitor presumably will encounter the following disclaimer: “ICIJ does not intend to suggest or imply that any companies or other entities included in this interactive application have broken the law or otherwise acted improperly.” Credit to the ICIJ, they did not hide the disclaimer in the fine print.

Alas, virtually nobody seems to have bothered to dwell on this. On the homepage of accountants daily, the PwC response to the ICIJ publication was cited as follows: “Today’s reports in the media on tax advice […] are based on partial, incomplete information dating back four years or more, which was illegally obtained.” The statement was probably intended for the record, but it is virtually irrelevant – nobody cares about nuances.

So it is back to the headlines. Initially much attention was focused on Jean-Claude Juncker, the newly “elected” president of the EU-Commission. There is seldom need (and cause) to feel sympathy for a figurehead of the EU bureaucracy – with Juncker being no exception. The rather harsh nature of the criticism, however, was somewhat curious, especially considering that Juncker has not been accused of having committed an illegal act.

The essence of criticism against him was rather nicely summed-up by the New York Times that: “Mr. Juncker dominated Luxembourg’s economic policy for more than two decades, a time when the country became one of the world’s leading banking centers and a low-tax hub.” People generally regarding international tax competition as being beneficial are likely to consider the preceding citation as being an accolade rather than criticism. An increasing number of politicians, however, offer quite a different interpretation.

An illustrious example is provided by a MEP of the Green Party (again cited in the New York Times): “The fact that E.U. Commission President Juncker served as Luxembourg’s finance and prime minister throughout this period makes him directly complicit in this mass corporate tax avoidance.” 

Now, forget about Juncker. It is the moral vilification of tax avoidance of that is increasingly characteristic of the public reaction to international taxation. From this vantage point fundamental long term implications dawn upon us. Politicians and institutions pronouncing to fight avoidance are increasingly likely to garner broad support for implementing stricter transfer pricing regulation (including country-by-country reporting), harmonizing taxation regimes as well as curtailing tax competition (e.g. abolishing patent boxes). Never mind that the effects of tax avoidance are not precisely known. 

What is known is that the effects of tax avoidance certainly are rather insignificant compared to the effects of tax evasion – as acknowledged, amongst others, by Richard Murphy, founder of the Tax Justice Network and zealous supporter of increased tax harmonization.  During a hearing that took place in the House of Commons Treasury Committee on the 29th of June 2011, he gave oral evidence regarding his tax gap calculations, which were, despite their questioned quality, highly influential for tax policy in the EU. Asked whether the disproportionate focus on tax avoidance amounts to a misallocation of resources (and bad policies), he replied as follows:

“It depends on for what purpose you are asking about that allocation of resources.
We can’t remove this from a political context. Tax is inherently political.
In the sense that we are trying to change sentiment about tax, so that people pay their tax, then it is appropriate to bring the issue to the public’s attention by using high-profile cases of avoidance where people will recognize the issue. […] That does very much depend upon grabbing headlines, and avoidance does do that whereas evasion doesn’t.” 

Indeed. This is arguably exactly the effect the Luxembourg Leaks are likely to have – a further significant shift in the political momentum towards increased regulation and stronger harmonization, in the name of curtailing tax avoidance.

It is safe to assume that combating tax avoidance will remain high on the political agenda, irrespective of the outcome of any in-depth analysis of the Luxembourg Leaks documents. Among others Margrethe Vestager, the new EU commissioner in charge of competition, will make sure of it.

In a recent interview with the German newspaper Handelsblatt, she announced that in addition to the pending three cases of state aid investigations against Luxembourg, the Netherlands and Ireland, she already has sent requests for additional information on APAs to the UK, Belgium, Malta and Cyprus. Vestager made it clear that nobody should make the mistake to think that the EU Commission would focus on Luxembourg – emphasizing that “no country will be spared.”