Three lessons in international taxation

It was “one of these days” at the office. I was writing a transfer pricing memo for defending one of my clients against a challenge made by some rather aggressive tax auditor, when I looked at my bookshelf and noted that my copy of Henry Hazlitt’s classic “Economics in One Lesson” had gathered its fair share of dust. I have always enjoyed reading Hazlitt’s attack of economic policies based on Keynesian economics (exposing the many variants of broken window fallacy, etc.) but could not readily recall specific examples on fallacies in the realm of taxation. Shame on me, but easily remedied. I decided to reread selected chapters of Economics in One Lesson and to apply its insights to some contemporary issues of international taxation: BEPS, CCCTB and most recently “digital taxation.”

The special pleading of selfish interests of high tax government are driving recent tax reforms

Hazlitt starts his lesson by emphasizing that the inherent difficulties in economics are multiplied a thousandfold by the special pleading of selfish interests. This is a timeless truth and should not be underestimated. Regarding taxation the interests driving the debate on the side of tax authorities, the European Union and non-governmental organizations seem clear: maximize tax revenues – to the effect that the beginning of Chapter 4 could be written in 2018: “There is no more persistent and influential faith in the world today than the faith in government spending. Everywhere government spending is presented as a panacea for all our economic ills … we can examine here the mother fallacy that has given birth to this fallacy …. The world is full of so-called economists who in turn are full of schemes for getting something for nothing. They tell us that the government can spend and spend without taxing at all, that it can continue to pile up debt without ever paying it off, because ‘we owe it to ourselves.’”

That statement constitutes an appropriate narrative of the Leitmotiv of the economic policies of the EU. In respect to taxation, the EU no longer suggests that tax is unnecessary, it rather emphasized that the tax needs to be “fairer.” Based on tax gap estimates (see previous CFR contributions for details) they argue that by eliminating these “tax gaps,” i.e., taxes avoided by multinational enterprises (MNEs) through transfer pricing and other “legal but immoral” tools, the level of government spending could be sustained (enhanced). Aside from ballooning the tax gap estimates, the advocates of fair taxation also resort to obscuring the distinction between tax avoidance and tax evasion to dramatize the extent of tax avoidance and to mobilize public support for stricter tax regulation. As thankfully pointed out by Maya Forstater, such a narrative “bundles together a large swathe of international investment, finance and professional services as being ‘by definition’ on the same side as drug cartels, kleptocrats and money launderers.” Alas, very few commentators recognize the importance of delineating between concepts such as tax avoidance and tax evasion. The effect is that the political anti-avoidance measures of the OECD and EU enjoy wide support. The extent to which the cartel of high tax governments succeeds to advocate every stricter tax regulation is amongst others evidenced by the Common Corporate Consolidated Tax Base (CCCTB) and the proposals for digital taxation (see below).

By cautiously hiding under the weasel-word “fair,” the advocates of higher taxes have indeed convinced the general public that their case is sound and convinced policymakers that they need not even attempt to follow the reasoning of opposing arguments because they are only “capitalist apologetics.”

One-sided anti-abuse policy proposals overlook secondary consequences

As pointed out by Hazlitt (Chapter 1, Section 3) the success of high tax bureaucracies to dominate the agenda in international taxation ought not to be mysterious.

“The reason is that the demagogues and bad economists are presenting half-truths. They are speaking only of the immediate effect of a proposed policy or its effect upon a single group. As far as they go they may often be right.”

It is perhaps the most important part of Hazlitt’s work to expose the detrimental effects originating in the fallacy of overlooking secondary consequences. In the case of Base Erosion and Profit Shifting (BEPS), the OECD focused on modernizing the transfer pricing guidelines (based on the arm’s length principle) to improve the alignment between the place where value is created and where taxes are paid. That Apple and Starbucks utilized aggressive legal structures to take advantage of the existing regulations and that the reforms were arguably overdue shall not be contested here. The point is rather that the BEPS Action Plan was a targeted (mostly proportionate) measure for improving the practical application of the arm’s length principle. BEPS comprised 15 complex Action Points and was completed between 2013 and 2015 with some actions still being followed-up on.

The reforms resulting from the BEPS process are currently being integrated into national tax laws and will doubtless have a substantial impact on transfer pricing in the years to come. There cannot be any doubt, at least none that is supported by any empirical assessment, that the BEPS project will largely succeed in facilitating a closer alignment between the place where value is created and where taxes are paid.

The EU, however, is not content to merely implement BEPS reforms and evaluate the success based updated, more realistic, tax gap measures. Instead, the EU continues to push for the adoption of the CCCTB. The CCCTB is presented as a panacea to effectively close all tax gaps (i.e., by abolishing transfer pricing) and thus to ensure “fair taxation” and (obviously most importantly from the perspective of its advocates) secure public spending. According to the proposals advanced the competences to tax should ideally be enhanced and delegated to the EU level. Eerily, the effects of the CCCTB on MNEs are scarcely discussed. Apparently, the MNEs are merely assumed to pay the tax they owe (us) anyway. End of story? What about those MNEs whose subsidiaries are not only located within the EU but globally? They would have to apply two conceptually irreconcilable paradigms of taxation, i.e., CCCTB (formulary apportionment) within the EU and arm’s length-based transfer pricing throughout the rest of the world. In other words, double-taxation will be systemic; i.e., unavoidable and endemic. It is further unclear whether the introduction of CCCTB will really be efficient in counteracting aggressive tax-planning by MNEs. Based on what we can observe for intra-U.S. trade this seems to be far from guaranteed and will require far reaching harmonization (additional regulation) of accounting practices. For the taxpayer’s perspective, the announcement of the EU to couple the CCCTB with the adoption of minimal tax rates and link the proceeds to the EU budget might well sound “alarming.” To be clear, some member states which embrace the concept of tax competition such as Ireland or the Netherlands oppose the CCCTB. The most influential one of those member states, the U.K., is, however, merely watching from the sidelines from now on. As soon as Macron & Co. manage to open taxation to “qualified majority voting,” and the adoption of the CCCTB no longer requires unanimity, the CCCTB will become a reality in the EU, sounding the death knell for tax competition and any restraint on hiking tax rates. In sum, the secondary consequences of adopting the CCCTB do not look appealing at all and perhaps it is time people took a much closer look and voice their opposition against the CCCTB.

Digital taxation, the pinnacle of fairness?

The measures proposed by the EU Commission for reforming digital taxation are explicitly aimed to “ensure that all companies pay fair tax in the EU.” The figurehead of the new initiative, Valdis Dombrovskis (vice-president for the Euro and Social Dialogue), emphasizes the drastic lack of fairness and the pressing need for action when rationalizing the need for the EU to, once again, act as a forerunner of stricter tax regulations: “We would prefer rules agreed at the global level, including at the OECD. But the amount of profits currently going untaxed is unacceptable. We need to urgently bring our tax rules into the 21st century by putting in place a new comprehensive and future-proof solution.”

Text quoted from the main article: "There cannot be any doubt ... that the BEPS project will largely succeed in facilitating a closer alignment between the place where value is created and where taxes are paid."His sidekick Pierre Moscovici, Commissioner for Economic and Financial Affairs, Taxation and Customs, merely evokes the image of the tax gap mutating into a new dimension (“black hole”) when talking about digital business: “Our pre-internet rules do not allow our Member States to tax digital companies operating in Europe when they have little or no physical presence here. This represents an ever-bigger black hole for Member States, because the tax base is being eroded ….”

Digital companies generally pay their taxes and Dombrovskis and Moscovici do not, at least not explicitly, accuse these companies of engaging in tax avoidance. One cannot help the impression of two well-fed toddlers screaming at their mother to give them a piece of the pie that is sitting on the plate of their older sister. Both seem to agree that the digital business is ripe with juicy profits and they really do not care about anything but securing a larger share of the pie. It goes without saying that the alleged tax gap has not been quantified, nor have the value creating (taxable) activities taking place in the EU been clearly delineated. At the core of the proposals is the notion that “profits made through lucrative activities, such as selling user-generated data and content” are based on the “activity” (data) of the “users,” i.e., not the economic activity of the digital businesses is to be taxed here, but rather the mere fact that we have a Facebook or LinkedIn account.

Pursuant to the European Commission, the policy proposal to “reform corporate tax rules” will enable member states to tax profits that are generated in their territory, even if a company does not have a physical presence there – based on a “digital presence” or a “virtual permanent establishment” that is deemed to exist as soon as one of the following criteria is fulfilled:

  • It exceeds a threshold of €7 million in annual revenues in a member state
  • It has more than 100,000 users in a member state in a taxable year
  • Over 3,000 business contracts for digital services are created between the company and business users in a taxable year.

The profits attributable to this virtual permanent establishment would then be allocated among the member states (or the EU budget?) – in this context the EU Commission already point out that the measure could eventually be integrated into the scope of the CCCTB – in other words economic activity in the sense of “significant people functions” would not be required to attribute profits to a digital presence (quite opposed to the rules applied to conventional permanent establishments). It is also not addressed, why this proposal is deemed superior to waiting for (and contribute to) a less restrictive but consensual solution at the OECD level – with the secondary consequences being highly ominous (like for the CCCTB).

Anticipating that the proposal to “reform corporate tax rules” will take some time to gain traction, the European Commission also proposals an immediate interim taxation. The tax will apply to revenues created from activities where users play a major role in value creation and which are the hardest to capture with current tax rules (e.g. selling online advertising space and sale of data generated from user-provided information). The EU Commission concludes by outlining the tasty spoils of “estimated 5 billion euro in revenues a year could be generated for Member States if the tax is applied at a rate of 3 percent.” To sugarcoat this proposal, the EU Commission proposes to apply thresholds that apply only to comparatively big companies, but how often have you seen that such a threshold is sustained? Who will prevent that the applicable rate is adjusted to 6 percent at a later point in time (especially in case there is no competition within the EU) – would the member states not realize 10 billion euro? And, more importantly, how likely is it that the tax is truly temporary?

The proposed interim tax is nothing but arbitrary expropriation – at least for those who do not succumb to the lullaby of fair taxation. What we can learn from Hazlitt here is that we must question and expose the selfish interest of high tax governments and bureaucracies. We also should not tire of pointing to secondary consequences of the proposed policies.

While the additional tax intake must be enticing to policymakers, we need to bring to their attention that taxes discourage production. The proposed taxes will ultimately divert investments and further erode the competitiveness of the EU in the digital economy. As pointed out by Hazlitt:

“When the total tax burden grows beyond a bearable size, the problem of devising taxes that will not discourage and disrupt production becomes insoluble.”