Multi-National Enterprises taxation in the European Union: some views on options for an overhaul

• Author: Stefano Micossi; Paola Parascandolo
• Pages: 1-15

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1. Shortcomings of the actual taxation system for Multi-National Enterprises in the Eu

As a rule, multi-national enterprises (MNEs)¹ are taxed separately by the countries in which they operate on the basis of the income produced in each jurisdiction (“source” taxation)². To this end, they must keep separate accounts for business units in each country (“separate accounting”, SA) ascribing each item of expenses and revenues to each business unit on the basis – by universally accepted convention – of “arm’s-length” pricing (ALP), that is of comparable or estimated prices for similar market transactions between unrelated companies.

While being in operation for several decades, the system has never worked satisfactorily³/⁴. Integration is amplifying these difficulties since intra-firm transactions take on increasing importance in the operations of MNEs, and financial market integration expands the opportunities for tax-planning in profit allocation and the debt-financing of capital spending.

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Concerning the ALP principle applied by tax authorities to prevent profit shifting manipulation, Devereux and Keuschnigg have recently developed and estimated a model that show that arm’s length prices systematically differ from independent party prices⁵. They conclude that the application of ALP distorts multinational activity by reducing debt capacity and investment of foreign affiliates and by distorting organizational choice between direct investment and outsourcing.

Conceptual difficulties are compounded by intractable monitoring problems, since each and every transaction has to be valued and controlled by tax authorities⁶. Of course, this is precisely where profit-shifting may arise. When tax authorities’ opinions differ on what may be the acceptable treatment of a particular transaction, double taxation or tax-loopholes may be engendered.

Double taxation and tax-loopholes may also result from the different combination of source and residence treatment of cross-border dividend and interest payments accruing to the parent company or shareholders. Loss offsetting is in general not allowed for subsidiaries, and only permitted within (varying) limits for branches. Deferral of taxation of profits of branches is normally not allowed whereas it is allowed for subsidiaries; conflicting tax claims may arise from control-foreign-companies (CFC) legislation enacted by several countries to counter the booking of profits in “tax heavens”.

In sum, MNEs in the EU are confronted with huge compliance costs in trying to meet the requirements of twenty-seven different tax systems and considerable uncertainty as to the correct application of the rules; tax authorities are confronted with similarly intractable problems in verifying the proper application of ALP; conflicting claims on tax bases, double taxation and tax loopholes are rife.

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Therefore, there are growing calls for an overhaul of the current rules on corporate taxation from EU companies and national tax authorities, not least in view of the stated goal of strengthening the global competitiveness of European companies and making the Union an attractive location for business.

The overhaul of the corporate taxation system should constitute an opportunity to reduce distortions and a consequent inefficiencies. A recent paper exhaustively reviews this topic, both from a domestic and an international point of view, and reports recent estimates of distortions in the economic literature. The paper ranks shifting between capital and labour income at the top of the list of distortions. Profit shifting among jurisdictions set up the second most relevant source of distortions. Finally, the effects of taxation on business location and foreign direct investment are a third source of distortions⁷.

The academic and expert debate has already identified and discussed a number of approaches to reform the actual rules that can be explored. Considerable support at EU level has developed for some kind of common-base, consolidated taxation of corporate income. Formula apportionment would then be used to allocate income among the different tax jurisdictions.

We will argue that a radically different approach may also be considered that offers great advantages of efficiency, simplicity and decentralisation. It entails abandoning corporate income as the relevant tax base and taxing at a moderate rate some broad measure of business activity.

2. Coordination of corporate taxation in the EU

The EC Treaty makes no explicit reference to the harmonisation of direct taxation, but Article 94 opens the way for Community initiatives “for the approximation of such laws, regulations or administrative provisions of thePage 4 member states as directly affect the establishment and functioning of the common market”⁸, which has provided the legal basis for existing directives in the field of direct taxation. Decisions require unanimity of votes in the Council.

However some proposals for the harmonization of corporate tax have been debated within the European Community for over 30 years⁹. On the whole the arguments for harmonisation of business taxation policies did not appear very convincing; at all events they didn’t find sufficiently broad support among the member states in the European Union. At the beginning of the nineties the Commission decided to concentrate on more limited measures essential for the implementation of the Single Market: several steps were taken to reduce the tax obstacles to cross-border operations, including the Merger Directive (90/434)¹⁰, the Parent-Subsidiary Directive (90/435)¹¹ and the Arbitration Convention on dispute resolution in transfer pricing (90/436)¹².

Harmful tax competition was first addressed by the OECD Committee on Fiscal Affairs in a Report submitted to the organisation’s Council of Ministers in 1998; the Council endorsed the proposed (non binding) Guidelines for restraining harmful tax practices and established a Forum for their implementation in member and non-member states. The OECD report focused on geographically mobile financial and service activities, not specifically on business taxation, and provides criteria for the identification of harmful preferential tax regimes as well as measures for counteracting their effects.

In the European Union, the European Council agreed in Dublin in December 1996 on the need to address the question of tax competition, which led a year later to the European Commission communication “Towards tax coordination in thePage 5 European Union – a package to tackle harmful tax competition” (European Commission 1997)¹³. The communication envisaged a coordinated set of measures, known as the ‘Monti package’: a Code of Conduct on harmful tax competition, measures to harmonise the taxation of savings and the elimination of withholding taxes on inter-firm payments of interest and royalties. The original package clearly had ambitions going beyond tackling harmful tax competition well into the domain of tax policy harmonisation but the ensuing negotiation has brought it back within its ‘headline’ goal. The Code of Conduct was approved in 1998, the rest of the package only in 2003.

In the Code of Conduct¹⁴, the factors for identifying harmful tax competition were basically the same as those proposed by the OECD, with certain additional details concerning discriminatory administrative practices. In some respects the scope of the Code was broader than the OECD Guidelines, while in others it was narrower. It was broader in that it applied to any measure capable of influencing the localisation of business activities, including those carried on within groups. It was narrower because, in conformity with Article 90 of the Treaty¹⁵, it focused on discriminatory preferential tax treatments and not on the level of tax rates. Even though the Code was not legally binding, it required member states to refrain from introducing new harmful competition measures concerning the taxation of business income and to remove the existing ones.

At the end of the nineties, member states asked to the Commission to prepare a an...