Fiscal barriers and/or fiscal incentives? What determines the use of different tax policy instruments by European countries?

Masterarbeit , 2016 , 95 Seiten , Note: 1.7

BWL - Rechnungswesen, Bilanzierung, Steuern

The thesis analyzes how European countries deploy different fiscal instruments (i.e., fiscal barriers and incentives) in the context of tax competition.

The first part of the thesis (International Taxation) gives a brief introduction to the aspects of international taxation which are relevant for the subsequent analysis. The second part (Fiscal instruments in the context of tax competition) provides a detailed overview of the fiscal incentives and fiscal barriers that are used in the context of tax competition. Moreover, through the application of a scoring system, it provides a detailed assessment of each country‘s positioning (i.e., competitive vs. defensive) with respect to individual instruments as well as on an aggregate basis. Building on these findings, the third part (Quantitative analysis) of the thesis provides a further, quantitative analysis. It analyses the correlation of fiscal instruments with one another as well as with selected attributes of the countries (e.g., the size of the economy).

Thirty European countries were analyzed: Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, Switzerland and the United Kingdom.

Table of contents

1. Introduction
1.1. Motivation
1.2. Research question & approach

2. International Taxation
2.1. Principles of international taxation
2.2. The role of multinational enterprises
2.3. The role of governments

3. Fiscal instruments in the context of tax competition
3.1. Tax rate and base
3.2. Fiscal barriers
3.2.1. Transfer pricing
3.2.1. Thin-capitalization rules & limitation on interest
3.2.2. Withholding taxes
3.2.3. Controlled foreign company legislation
3.2.1. Exit taxation
3.2.2. Exemption rules & switch-over clauses
3.2.3. General anti-avoidance rules
3.2.4. Exchange of information
3.3. Fiscal incentives & non-enforcement
3.3.1. Tax incentives
3.3.2. Non-recognition of permanent establishments
3.3.3. Facilitation of hybrid-mismatch arrangements
3.3.4. Advance pricing agreements & other tax rulings
3.3.5. Non-enforcement
3.4. Conclusion

4. Quantitative analysis
4.1. Methodology and data
4.2. Selection of variables
4.3. Conclusion

5. Final conclusion

6. Appendix
Appendix 1 – OECD/European Council initiatives on harmful tax competition
Appendix 2 – Transfer pricing
Appendix 3 – Thin-capitalization rules & limitation on interest
Appendix 4 – Withholding taxes
Appendix 5 – Controlled foreign company legislation
Appendix 6 – Exit taxation
Appendix 7 – Exemption rules & switch-over clauses
Appendix 8 – General anti-avoidance rules
Appendix 9 – Exchange of information
Appendix 10 – Tax incentives
Appendix 11 – Non-recognition of permanent establishments
Appendix 12 – Facilitation of hybrid-mismatch arrangements
Appendix 13 – Advance pricing agreements & other tax rulings
Appendix 14 – Non-enforcement
Appendix 15 – Overview of results of scoring model
Appendix 16 – Dataset for correlation analysis
Appendix 17 – Correlation analysis

7. Bibliography

8. Affidavit

List of tables and figures

Table 1: Strategy options for tax competition modeled as prisoner’s dilemma

List of abbreviations

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1. Introduction

1.1. Motivation

Throughout the last couple of decades, the global economy has changed in fundamental ways. The liberalization of markets has made the movement of goods, services and capital easier than ever. Especially economies in Europe have achieved a degree of integration that is unprecedented. Among others, the political and economic integration of large part of the European continent has led to the creation of a single currency and the European Single Market.

Especially Multinational Enterprises (MNE) benefit from this development, as they become more mobile and can serve larger markets with their products and services. Next to the liberalization of markets, MNE benefit from another fundamental change – the development of modern information and communication technologies (ICT) (e.g., the internet). ICT not only allows MNE to become more mobile but also to spread their value chains across multiple countries, making targeted use of locational advantages (e.g., low labor cost) and serving customers from remote locations (e.g., via online services). This development is closely connected to the shift away from physical goods to intangible ones with intellectual property as a primary value driver.

For governments, these developments have brought many challenges, especially with regards to taxation. Governments need to generate tax revenues to finance the provision of public goods (e.g., infrastructure and stable legal system). MNE, on the other hand, while benefiting from these public goods, regard taxes fundamentally as a cost factor which they seek to reduce. Making use of their mobility, MNE minimize tax liabilities through the exploitation of gaps and loopholes in existing legislation and tax differentials across countries.

Moreover, governments are increasingly competing over tax matters, as they try to attract and retain MNE. This competition has put downward pressure on corporate income taxes (CIT). Among Western European countries, for instance, average CIT rates dropped from 46% in 1980 to 40% in 1990 to 28% in 2007.¹ This development has raised concerns among scholars and politicians about the so-called “race-to-the-bottom” with regards to CIT rates.

Despite these concerns, however, it seems that the alleged “race-to-the-bottom” with regards to CIT rates has slowed down, if not stopped.² There is evidence, however, that the observed development does not signify the end of tax competition, but merely a change in the way it is conducted – away from simple changes to general tax rates and bases towards a subtle competition over non-rate/non-base aspects (e.g., through the creation of specific preferential tax regimes). While there is a rich body of literature on the “traditional” forms of tax competition, little research exists on this new form of tax competition, also referred to as targeted or smart tax competition. Even though studies exist on individual measures which are used in the context of smart tax competition (e.g., certain preferential regimes), there is little research available that takes a holistic approach and regards it as a bundle of multiple measures.³ The aim of this thesis is to help close this gap in the academic literature, by providing an analysis of smart tax competition⁴ among selected European countries.

1.2. Research question & approach

The research question that this thesis seeks to address is the question of how European countries deploy different fiscal instruments (i.e., fiscal barriers and incentives) in the context of tax competition. The first part of the thesis (International Taxation) gives a brief introduction to these aspects of international taxation which are relevant for the subsequent analysis. The second part (Fiscal instruments in the context of tax competition) provides a detailed overview of the fiscal incentives and fiscal barriers that are used in the context of tax competition. Moreover, through the application of a scoring system, it provides a detailed assessment of each country’s positioning (i.e., competitive vs. defensive) with respect to individual instruments as well as on an aggregate basis. Building on these findings, the third part (Quantitative analysis) of the thesis provides a further, quantitative analysis. It analyses the correlation of fiscal instruments with one another as well as with selected attributes of the countries (e.g., the size of the economy).

Thirty European countries, hereafter jointly referred to as “the analyzed countries,” were analyzed in this context. These countries are: Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, Switzerland and the United Kingdom. Initially, Iceland and Liechtenstein were also included but had to be removed due to lack of data availability. Also for Switzerland, issues with regards to data availability exist, mainly because many aspects of taxation are regulated on a cantonal, rather than a national level. Nevertheless, the decision was made to retain Switzerland among the analyzed countries, as it is regarded as a major player in the arena of international taxation.

2. International Taxation

2.1. Principles of international taxation

The levying of taxes is the fundamental right of each sovereign state. From a government perspective, the primary goal of raising taxes is the collection of funds for the provision of public goods. Next to this, considerations of equity (i.e., a fair distribution of the tax burden) and economic efficiency are playing an important role in the design of tax systems.

A state’s right to levy taxes rests on two fundamental principles. The power over its residents, which is embodied in the residence-based taxation, and the power over its territory, which is embodied in the source-based taxation.⁵ In the case of corporations, residence in a country is usually established through the place of incorporation or the place of effective management. In the event of residence-based taxation, residents are typically subject to tax on their global income (i.e., domestic and foreign). In the case of source-based taxation, on the other hand, taxation is typically limited to income which is deemed to have arisen within the territory of the country, irrespective of the residential status of the taxpayer.

In an international context, the coexistence of these two systems inevitably leads to the incidence of double taxation, i.e., conflicting claims for taxation on the incidence of profits. Moreover, many countries employ a combination of both systems, operating a residence-based tax system, but extending source-based taxation to particular types of income (e.g., dividends, interest, and royalties).

Given the risk of double taxation, and its potentially detrimental effect on cross-border business activities, governments deploy different methods to avoid or at least reduce the effects of double taxation. Most governments provide unilateral double tax relief to prevent double taxation of their residents’ foreign-sourced income. This can be done either through the exemption method, in which income that has been subject to tax abroad already is exempted from domestic taxation, or through the credit method, in which tax that has been paid abroad can be set off against the domestic tax liability for the respective income. Bilateral measures for the avoidance of double taxation are usually taken in the form so-called Double Taxation Treaties (DTT), which identify and categorize the types of income which can be subject to double taxation and then assign the right for taxation to one of the treaty countries. The most widely used format for such DTT is the OECD Model Tax Convention, which is used by 27 of the analyzed countries.⁶ Additionally, multilateral agreements on the prevention of double taxation exist. In the European context, the most important measures are the Parent-Subsidiary Directive (2011/96/EC) and the Interest and Royalties Directive (2003/49/EC) which stipulate the relief from withholding taxes for payments among member states.

2.2. The role of multinational enterprises

MNE play a central role in today’s global economy. According to UNCTAD, in the years from 1992 to 2008, the number of MNE rose from 3,600 to 82,000.⁷ For MNE, as for companies in general, taxation is a cost factor impacting after-tax profits. Given the goal of after-tax profit maximization, they naturally seek to minimize their tax liability. Unlike purely national companies, which are confined to their respective national tax environments, MNE can make use of their international set-up to strategically exploit disparities in the international tax system and thereby avoid taxes.⁸ This can be done either through substantive tax planning, in which a company relocates (part of) its operations to lower-tax jurisdiction (e.g., by shifting the production of physical goods) or through formal tax planning (e.g., by strategic use of debt or shifting profits through the manipulation of transfer pricing). Especially formal tax planning is often regarded as harmful as it allows companies to effectively “free-ride” on countries’ public goods. That is, they benefit from the provision of local public goods (e.g., infrastructure and legal systems) when creating value, but fail to contribute to their financing by avoiding taxes. The practices which MNE use in the context are subsumed under the term Base Erosion and Profit Shifting (BEPS).⁹

The liberalization of global markets, modern ICT and increased reliance on intangibles assets as primary value drivers, have further broadened the opportunities for BEPS in recent years.¹⁰ Today’s MNE are highly adaptive to changes in tax systems and are usually advised by professional auditing or law firms, many of which are demonstrating an increasing degree of aggressiveness in their tax planning schemes.¹¹ Moreover, MNE are also exerting pressure on local governments, lobbying for the creation and preservation of preferential tax regimes.¹² Governments, on the other hand, are often susceptible to those demands because they are particularly keen on attracting and retaining MNE as they typically possess superior production technology which allows them to realize above-average returns, compared with purely national companies.¹³ Moreover, the presence of MNE is also regarded as desirable due to expected positive externalities (e.g., the creation of highly skilled jobs and knowledge spillover to domestic companies). Given these aspects, it is fair to say that MNE are not only at the center of global tax competition, but in large part also the reason for its existence.

2.3. The role of governments

As they try to attract and retain MNE, governments see themselves increasingly in competition with each other. Studies show that this competition intensifies as markets integrate and capital mobility increases.¹⁴ This finding is particularly relevant for Europe as it moves towards a closer political and economic union.

With respect to tax competition, governments are faced with a dilemma. If they maintain high levels of taxation, they risk an erosion of their tax revenues through BEPS by MNE. If on the other hand, they lower taxes to attract and retain MNE, they are also cutting into their tax revenues, particularly, if the decrease in tax rate does not lead to a corresponding increase in tax base (e.g., through the immigration of MNE). Moreover, when trying to attract and retain MNE by simply lowering CIT rates, governments also reduce taxation on purely national companies which are not at risk of leaving and, thus, need to be incentivized. Therefore, many governments have adopted a strategy of selective advantages, whereby they create special incentives for MNE. These incentives are typically aimed at the attraction of mobile capital (i.e., foreign direct investment by MNE) and mobile income (i.e., book profits).

Various stances towards tax competition are possible. While some governments might make the conscious decision to compete actively over taxes by creating fiscal incentives, others might adopt a clear defensive strategy trying to meet the competitive pressure with fiscal barriers. Yet others might be reluctant to compete but still follow the competition, because they are not powerful enough to maintain an effective defensive position (e.g., because they have a competitive disadvantage due to their small size).¹⁵ High-tax countries might deliberately leave gaps and loopholes that allow MNE to reduce their effective level of taxation, and thereby prevent them from relocating to low-tax jurisdictions altogether.

From a strategic perspective, governments find themselves in a situation that is resembling a prisoners’ dilemma or a Bertrand competition.¹⁶ The question they are faced with is whether they should retain current tax levels or whether they should compete, i.e., lower taxes. The rationale behind a competing strategy is that the reduction in tax revenues caused by a cut in tax rates is recouped through the attraction of additional tax base and the benefits from positive externalities.

The following example illustrates the competitive dynamics of this situation as a single period game. In this game, it is assumed that the global economy consists of only two countries which are completely identical (e.g., offer same returns on capital). In line with this, both countries start out by charging exactly the same amount of CIT. In both economies, n number of corporations are active and pay taxes. These corporations are assumed to be completely mobile, i.e., incur zero cost in moving from one country to another and are completely sensitive to CIT rates. At the beginning of the game, given that both countries are completely identical, companies are randomly distributed with n/2 companies operating in each country. As part of the game, both countries need to decide whether to keep current tax levels (i.e., standstill) or whether to reduce taxes (i.e., compete). In the case of a reduction, both countries can reduce taxes by a predefined percentage (x%), which is equal for both countries. During the game, no coordination among the players is possible.

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Table 1: Strategy options for tax competition modeled as prisoner’s dilemma

Given the absence of a possibility for coordination, each country’s dominant strategy in the above example is to compete. This results in a suboptimal outcome in which both countries end up generating x% fewer tax revenues than before. When extending the game by allowing multiple stages and giving countries the opportunity to set tax rates at random, both countries would enter a Bertrand-type of competition resulting in the so-called “race-to-the-bottom,” whereby countries gradually undercut each other’s tax rates until all tax revenues have been competed away. Another implication of the Bertrand-model is that competition intensifies as the number of players increases.

While the above example contains numerous simplifying assumptions, it provides valuable insights which hold true, also when assumptions are being relaxed (e.g., recognizing different returns on capital across countries, assuming positive costs for companies to move from one country to another, increasing the number of players, and recognizing various instruments of tax competition). The model shows that tax competition, at least in theory, leads to a race-to-the-bottom. In the European context, a similar dynamic was observable with regards to a downward ‘race’ in statutory CIT, although the development seemed to have come to a halt before reaching the ‘bottom,' which is typically defined as the point at which the provision of public goods falls to an inefficiently low level.¹⁷

Another finding of the model is that only through complete coordination an optimal solution can be achieved from a government perspective.¹⁸ Governments have realized this and, since the end of the 1990s, have initiated numerous initiatives to harmonize tax systems and combat harmful tax competition. The most important initiatives include the OECD’s Project on Harmful Tax Competition (OECD (1998)), the work of the European Council’s Code of Conduct Group (1999), the OECD’s Action Plan on Base Erosion and Profit Shifting (OECD (2013), hereafter referred to as “OECD BEPS Project”), and, most recently, the Action Plan on Corporate Taxation by the European Commission (EC) which was initiated in 2015.

The reports which were created during the 1998/1999 initiatives of the OECD and the European Council are a valuable source of information, as they both provide a detailed inventory of the harmful tax measures that were deployed by European countries at the end of the 1990s. The European Council’s initiative identified a total of 66 harmful measures, 40 of which were available in EU member states and 26 in EU territories (e.g., Gibraltar (UK)) as well as associated or dependent territories (e.g. British Virgin Islands (UK)). The OECD report identified 47 preferential tax regimes across OECD member states as well as 34 non-cooperative tax havens. While the focus areas of both initiatives slightly differed, there is a substantial overlap in the harmful measures which were identified. Both initiatives can be regarded as successful as they led to the subsequent adjustment or abolishment of practically all preferential regimes, which had been identified as harmful. For an overview of the findings of both initiatives, please refer to Appendix 1.

The more recent OECD BEPS Project is focusing on the development and international coordination of measures to combat formal tax planning by MNE. The initiative, which was started in 2013, identified the 15 action areas or work streams with the aim to analyze the existing situation and develop recommendations for improvements. The work streams include, among others, multiple recommendations to improve the effectiveness and transparency of transfer pricing regulations, the neutralization of hybrid-mismatch arrangements, the strengthening of controlled foreign company rules, the prevention of treaty abuses and the artificial avoidance of PE. For each work stream, detailed final reports were issued in 2015. The findings of these reports, as well as the tracking of countries’ progress with regards to the implementation of recommendations made in them, provide valuable information about the positioning of countries with regards to tax competition.

The EC’s Action Plan on Corporate Taxation, which also features an Anti-Tax-Avoidance Package, is a bundle of measures that were initiated in 2015. As part of the package, the Commission issued a Directive (2016/1164) on July 12, 2016, which mandates member states to introduce several anti-avoidance measures, namely, controlled foreign company legislation, switchover rules, exit taxation, interest on limitation and general anti-abuse rules, by 1 January 2019 at the latest. Moreover, a proposal was made on October 25, 2016, to amend the existing EU Directive on hybrid mismatch arrangements (2016/1164) to make it more effective.¹⁹

3. Fiscal instruments in the context of tax competition

In the context of tax competition, governments have a multitude of instruments at their disposal which extend beyond mere changes in tax rate and base. Some of these instruments, fiscal incentives, serve the purpose of conducting tax competition, e.g., to attract book profits or substantial investment by profitable companies. Other instruments, fiscal barriers, have been devised to provide protection against such actions. The aspect of enforcement plays another important role, as it ultimately determines the effectiveness of fiscal instruments (i.e., a strict rule which is laxly enforced can have the same effect as a rather lenient rule which is strictly enforced). It should be noted, however, that the classification of instruments in incentives and barriers is largely a matter of interpretation and depends on the way they are deployed. For instance, the absence of a fiscal barrier which is otherwise common (e.g., CFC legislation), can serve as an incentive. Nevertheless, the analysis of all instruments follows the same method, so that the classification itself does not impact the findings of this thesis.

Although the focus of this chapter is on fiscal instruments and enforcement, it starts off with a brief overview of the development of tax rates and bases as this information is instrumental in developing an integrated understanding of the subject of the subsequent passages. These passages, divided into “fiscal barriers” and “fiscal incentives & non-enforcement,” are dedicated to the analysis of fiscal instruments. They all follow roughly the same structure. The first part gives an overview of the context in which each instrument is deployed. The second part explains its aims and properties. The third part describes the use of the instrument among the analyzed countries and concludes with a detailed scoring indicating each country’s positioning. Each passage is accompanied by a detailed overview table which can be found in the Appendices 1 through 14. Moreover, Appendix 15 provides a compact overview of all countries’ positioning with regards to each instrument.

The scoring that is deployed can take values between 0%, indicating absolute competitiveness (i.e., maximum level of fiscal incentives/minimum level of fiscal barriers), and 100%, indicating absolute defensiveness (i.e., minimum level of fiscal incentives/maximum level of fiscal barriers). This holds true for the scoring of both fiscal barriers and incentives. The scoring does not only capture the existence or absence of certain instruments, but it also analyses their design features. The inclusion of design features is crucially important because the effectiveness of instruments typically depends on this. In the context of fiscal barriers, for instance, a scenario is imaginable where one country implements a barrier that is designed for maximum effectiveness, whereas another country might introduce the same kind of barrier, but does so in a halfhearted and ineffective manner, and only because of pressure from other governments. While a simple binary scoring that only accounts for the existence or absence of a certain measure would be entirely oblivious to the difference, the detailed scoring model will reliably capture it.

It should be noted, however, that the detailed scoring model also has its risks and drawbacks. While the mere existence or absence of a certain instrument can usually be established with certainty and in an objective manner, it is much harder to make a reliable assessment of its effectiveness. Since it is hardly possible to capture all aspects of an instrument, the analysis seeks to make an approximation by analyzing a limited number of relevant features. The selection of these features and the way in which they are factored into the overall score requires the making of numerous implicit assumptions which can introduce unintended bias. Moreover, since the analyzed instruments differ in significant ways, there cannot be a one-fits-all scoring model. Instead, specific models had to be developed to capture the unique features of each instrument. Nevertheless, even when considering these potential risks and drawbacks, the detailed scoring model still appears superior to the binary scoring model which, by design, ignores a substantial amount of information.

When deploying the detailed scoring model, a country’s score with respect to an instrument is typically calculated through the aggregation of multiple “sub-scores” using a simple average. This aggregate value is referred to as the “Overall score.” The “Overall score” is then normalized to the scale from 0% to 100%, resulting in the “Normalized score.”

The sub-scores are typically calculated by one of two methods. These can be referred to as “item-count method” and as “relative-assessment method.” In the case of the item-count method, the score is determined as a percentage of the number of applicable items out of a list of total items. For example, if a country’s fiscal barrier meets two out of five recommended design features, the resulting score is 40%.

The relative-assessment method, which is typically used to transform numeric values (e.g., tax rates) into scores, is making an assessment relative to the numeric values of the other analyzed countries. Thereby, a score of 100% is assigned to the maximum value achieved among all countries, and a score of 0% is assigned to an absolute value of zero. Using absolute zero, rather than the minimum value achieved among all countries, seems justifiable since the method is only applied to positive numeric values that have zero as the natural minimum (e.g., tax rate or item count).

To maintain the general direction of the scoring system (i.e., 0% = absolute competitiveness and 100% = absolute defensiveness), a reversal of the calculated sub-scores was required in some cases. For instance, when applying the item-count method to a list of items which indicate competitiveness, a calculation as per the regular method would yield a score of 100% if all items were applicable. This, however, would be contrary to the general direction of the scoring. To mend this problem, a reversal of the sub-score is conducted in these cases. This is done by subtracting the calculated score from 100%. For the above example, the reversed score would be 100% minus 100% = 0%, which is again in line with the general direction of the scoring system.

In a selected few cases, sub-scores had to be calculated in ways other than the ones described above. For these cases, additional information can be found in the footnotes of the respective appendices. In all cases, however, the general scoring systems was preserved so that all scores can be interpreted in the same way.

For instances of missing data (indicated in the overview tables by grayed out cells), scores were calculated without the affected items/sub-scores. For example, if a particular score is usually calculated as ((“Sub-score 1” + “Sub-score 2” + “Sub-score 3”)/3) = Overall score, but for a particular country “Sub-score 1” is missing, then the score for this country is calculated as ((“Sub-score 2” + “Sub-score 3”)/2) = Overall score. While this potentially leads to some level of distortion, the disadvantages still seem minor compared to those of alternative approaches (e.g., completely excluding the country from the analysis or assuming some default value for missing data).

3.1. Tax rate and base

Since the 1980s the adjustment of tax rates has been the major instrument for tax competition. Among Western European countries, average CIT rates dropped from 46% in 1980 over 40% in 1990 to 28% in 2007.²⁰ With the eastern enlargement of the European Union (EU) in 2004,²¹ competition intensified, as many of the new member states had aggressively cut their tax rates prior to their joining. From 1996 to 2004, for instance, Poland gradually reduced its CIT rate from 40% to 19%.²²

This trend in reduction of statutory tax rate was generally accompanied by adjustments to tax accounting rules (e.g., the reduction of depreciation allowances), leading to a broadening of tax bases. Overall, however, the broadening of tax bases did not suffice to recoup the revenue reduction caused by the cut in tax rates, leading to an overall decrease in effective average tax rates (EMTR) throughout the 1980s and 1990s.²³

From a government perspective, however, competing through rate-cutting and base-broadening measures has a significant weakness. While a lowering of taxes has the potential to draw in mobile capital from other countries; it also reduces taxes on immobile capital, which is neither at risk of migrating to other countries nor can be attracted from them. Hence, the prospect of attracting mobile capital, at the expense of ‘cannibalizing’ revenues from the immobile domestic capital, seems suboptimal. This might be the reason why countries are moving towards smart tax competition, which comprises instruments that specifically target non-resident mobile capital while leaving the countries domestic (immobile) tax base unaffected.

3.2. Fiscal barriers

Fiscal barriers are defensive measures designed to counter the effects of tax competition by other countries. While hardly any measure can completely prevent companies from avoiding taxes, they at least impede their ability to do so. Moreover, designing barriers that provide complete protection against tax avoidance might not be desirable from a fiscal perspective, as stricter rules often entail substantial administrative costs for governments and compliance costs for companies. Therefore, governments’ objective is rather to strike a right balance, than trying to prevent tax avoidance at any expense. The OECD has put forth numerous recommendations for the design of effective fiscal barriers both in its 1998 report on Harmful Tax Practices and, in very detailed form, as part of its BEPS Project. The level of adoption of the recommendations provides valuable insights into the positioning of countries.

3.2.1. Transfer pricing

Transfer pricing, next to financing structures, represents the most important channel through which MNE conduct profit shifting. According to a study by Heckemeyer and Overesch (2013), non-financial inter-company transactions account for roughly two-thirds of overall BEPS activity.²⁴ Consequently, the OECD BEPS project puts a strong focus on this topic, with 4 of its 15 action areas specifically addressing it.

The principle behind profit shifting via transfer prices is simple. Given that value chains of MNE are typically spread across multiple countries, transactions between individual entities of the group take place on an ongoing basis. It is estimated that intragroup transactions account for around 60% of global trade.²⁵ Through the manipulation of transfer prices for these intra-group transactions (i.e., pricing transactions differently from their actual economic value), MNE can shift profits between their entities. Intermediate goods and services, which form the basis for these transactions, can take varied forms, reaching from simple physical goods and basic services (e.g., rendered by regional service centers) over the provision of intangible assets (e.g., through licensing) to the provision of capital and the assumption of risks.

There is direct evidence from studies of US MNE that, intragroup goods and services that are sold to high-tax (low-tax) entities are priced higher (lower).²⁶ In a similar vein, a meta-study by Heckemeyer and Overersch (2013), examining 25 studies on the subject of profit shifting, shows that the incidence of profits within a group is strongly correlated with tax rates, with entities located in low-tax countries being significantly more profitable.²⁷ A similar effect is observable with regards to the propagation of earnings shocks (e.g., unexpected profits) through low-tax and high-tax entities of a group, with the low-tax entities absorbing most of the positive effects.²⁸ This, along with other research, provides ample evidence of how transfer pricing is used for profit shifting.

Effective transfer pricing rules seek to prevent this type of profit shifting by ensuring that transactions within MNE take place at arm’s length, meaning that they are priced in the same way as a transaction between unrelated third parties. Multiple methods exist that attempt to reproduce the pricing mechanism of such third-party transactions.²⁹ While this seems straightforward in theory, it poses substantial difficulty in practice. At the core of the problem lies the information asymmetry between MNE and tax authorities. While MNE typically have detailed knowledge about the value of their goods and services, tax authorities only have an outsider’s view, both in terms of the restricted access to information as well as the lack of industry expertise. Especially with regards to intangible assets, valuations are difficult as they are often unique and their contribution to the company’s overall profits is hard to asses.

To prove that transactions are made at arm’s length, companies are required to produce transfer pricing documentation. Based on this information, tax authorities can assess the pricing and, if needed, make corrections (i.e., disregard or recharacterize a certain transaction). When doing so, tax authorities usually follow a substance-over-form approach, meaning that economic reality, rather than formal arrangements between entities forms the basis for the assessment. For instance, tax authorities might disregard agreements (and related payments) in which entities of a group assume substantial risk (and charge premia for it), even though they are neither able to control the risk nor to assume financial responsibility for it (e.g., due to lack of capitalization). Similarly, tax authorities might not accept it, if the right to all future profits from an intangible asset are transferred to another entity, especially if the latter was not involved in the production of the asset or takes part in its ongoing improvement.

If tax authorities find a transfer pricing arrangement to be not reflective of economic reality, there are two consequences. First, an adjustment to the transfer price is made to ensure that it meets arm’s length principles. When doing so, tax authorities might use the latitude that existing regulations provide them with – which can be substantial, especially in the case of hard to value goods and services –, to set the new price in a way that significantly increases tax liability for the company. Secondly, additional penalties might apply.

With regards to the positioning of countries, the analysis of their compliance with the recommendations of the OECD BEPS project provides valuable information. Please refer to Appendix 2 for a detailed overview. The OECD has made 22 detailed recommendations, covering the general application of arm’s length principles and documentation requirements as well as specific transfer pricing areas (i.e., commodity transactions, intangibles, low-value-added intra-group services and cost contribution arrangements). When assessing countries compliance with these recommendations the countries that score highest are the United Kingdom (#1/19: 100%)³⁰, Denmark (#2/19: 85%), Austria (#3/19: 83%), Estonia (#4/19: 78%) and Norway (#5/19: 72%).

It should also be noted, however, that a country’s decision to implement all of the OECD recommendations does not only require a willingness to crack down on profit shifting, but also to expend substantial administrative resources for the enforcement of these rules and to burden companies with additional documentation requirements, producing compliance costs. This might also explain why some countries have refrained from introducing extensive transfer pricing rules so far.

3.2.1. Thin-capitalization rules & limitation on interest

Financing structures and interest payments within MNE is the second most important channel through which companies conduct profit shifting. According to a study by Heckemeyer and Overesch (2013), these activities account for one-third of BEPS activity.³¹ At the core of this kind of profit shifting mechanism lies the strategic use of debt, whereby funds are centered in the hands of entities which are subject to lower taxation. These low-tax entities then extend loans to group members in high-tax countries, which are often thinly capitalized, i.e., use a high degree of leverage to fund their operations. Through interest payments, which are paid in return for the loans, profits are drawn away from the high-tax towards the low-tax entities. While effective transfer pricing legislation can avoid overpricing of such loans by ensuring that the interest charged meets arm’s length standards, it does not provide any protection against the strategic use of debt.

Therefore, countries have enacted so-called thin-capitalization legislations. Please refer to Appendix 3 for a detailed overview. The principle behind this legislation is to put a limit on the deductibility of interest which is paid to entities of the same group. Thin-capitalization rules disallow the deduction of interest payments for tax purposes if they exceed a predefined limit. The way in which this allowable limit is determined depends on the kind of thin-capitalization rules that are employed. Of the analyzed 30 countries, ten do not have any thin-capitalization legislation. Among the ones which do, two broad approaches can be distinguished.

Ten, predominantly Eastern European, countries operate what can be referred to as thin-capitalization legislation, in the stricter sense of the word. This legislation defines the allowable debt-to-equity ratio which can also be expressed as a minimum percentage of equity, below which capitalization is regarded as too “thin.” These countries are the following (equity requirements in percent of total assets are given in brackets): Belgium (17%), Bulgaria (25%), Czech Republic (20%), Denmark (20%), Hungary (25%), Latvia (20%), Lithuania (20%), Poland (50%), Romania (25%) and Slovenia (20%).

Seven countries deploy limitation on interest rules, whereby the allowable amount of net interest (i.e. interest expense minus interest income) is defined as a percentage of EBITDA. This way, the rule is implicitly setting a limit on the allowable level of debt. These countries are Germany (30% of EBITDA), Finland (25% of EBITDA), Greece (30% of EBITDA, from 2017), Italy (30% of EBITDA), Portugal (30% of EBITDA, from 2017), Slovakia (25% of EBITDA) and Spain (30% of EBITDA). Notable in this context is that this kind of thin-capitalization legislation, which is also in line with the recommendations of the OECD, is a rather recent model. Germany and Italy pioneered its adoption in 2008 and were followed by Spain (2012), Portugal (2013), Finland (2014), Greece (2014) and Slovakia (2015).

Next to these two broad approaches, a few countries have developed differing models. France combines both of the above-mentioned legislations by applying a three-step approach, in which thin-capitalization legislation is triggered if the debtor’s equity is below 40%, intragroup interest expense exceeds a level of 25% of EBITDA and intragroup net interest expense for the entity is positive. In case the legislation is triggered, the allowable interest is capped at the higher value that is determined through the debt-to-equity and the EBITDA threshold. Croatia is operating a type of thin-capitalization legislation which is different from the ones mentioned above, defining the limit of debt in relation to the creditor’s shareholding in the debtor. For Switzerland, no general statement can be made with regards to thin capitalization rules, since tax laws differ across cantons.

For interest, which is not deductible in a given year, regulations typically allow for a carry forward to subsequent tax periods. Moreover, several countries provide certain exceptions. These include safe harbor rules, which allow the general deductibility of interest up to certain fixed levels and escape clauses, which allow companies to make full deduction of interest despite the crossing of relevant thresholds, provided that they can prove that the group’s overall capitalization is equal to or below that of the local entity. Moreover, some countries exempt certain types of businesses (e.g., finance and leasing companies) from the application of the rule altogether.

When assessing countries’ positioning, based on the existence of thin-capitalization rules and their compliance with the recommendations of the OECD BEPS project, the highest scores are achieved by Italy and Spain (#1/8: 100%, each) as well as Finland and Germany (#2/8: 90%, each), followed by the Czech Republic, France, Portugal and Slovakia (#3/8: 80%, each).

3.2.2. Withholding taxes

MNE tend to use their international structures to reduce the group’s overall tax liabilities. One mean of achieving this is to relocate mobile capital to low-tax jurisdictions and have taxable profits accrue there. Two of the most common methods are the pooling of funds, which then produces passive interest income on loans that are extended, and the relocation of intangible assets which produces passive income (i.e., license fees and royalties) when the exploitation rights are licensed out to others. Also, participations in other companies, which produce dividend income, can be utilized in this context.

Given the mobile nature of income from dividends, interest and royalties they lend themselves to tax planning structures. In recognition of this fact, governments typically take a source-based approach for such types of income if they are generated within their territories but accrue to foreign residents. Thereby, the tax is imposed in the form of a withholding tax (WHT).

Since the government is usually not aware of the exact economic circumstances of the recipient, who resides outside the area of its jurisdiction, a simplifying approach is taken. Instead of taking a net approach, as it is typically the case in national taxation and whereby the tax base is determined as the company’s revenues minus all deductible expenses, a gross approach is taken whereby the tax rate is directly applied to the outgoing gross payment. The lack of deductibility of actual expenses is thereby accounted for through a lowering of the overall tax rate. While countries stipulate the rate of WHT on outgoing payments in their national tax laws, most of the withholding rates applicable to payments between countries are governed by DTT. The OECD Model Tax Convention, which forms the basis for most DTT, assigns the right to taxation of dividends (Art. 10) and interest (Art. 11) to the source country.³² WHT on dividends are limited to 5% and 15%, for qualifying participations (i.e., if direct shareholding is at least 25%) and non-qualifying participation, respectively. Withholding tax on interest payments is limited to 10%. For royalties, however, the convention assigns the right of taxation to the residence state of the owner of the intellectual property (Art. 12).

Within the EU, of which all analyzed countries – except for Norway and Switzerland – are member states, two Directives govern WHT. These are the Parent-Subsidiary Directive (2011/96/EC, and its amendment 2015/121/EU) as well as the Interest and Royalties Directive (2003/49/EC). With the intention of further strengthening the European Single Market, these Directives effectively eliminated the WHT among all EU member states. Switzerland and the EU have also agreed on the mutual elimination of WHT on the basis of bilateral treaties.

While this step towards a harmonization of tax systems among EU member states seems to be conducive to a more efficient tax system – or at least not harmful to it –, it produced an unintended side-effect. While the Directive eliminates WHT on payments between member states, it does not govern the tax rates on outbound relations, i.e., between individual member states and third countries. This has significant implications with regards to tax avoidance by MNE and tax competition among member states.

The following example demonstrates how MNE can exploit the existing regulation to minimize tax liabilities on interest payments, using conduit loans: MNE X possesses substantial funds in the offshore tax haven A. From these funds, X wants to extend a loan to its subsidiary Z, located in high-tax EU country C. However, given the absence of a (favorable) DTT between A and C, and, therefore, C’s rather high WHT outgoing interest payments, the extension of a loan seems unattractive to X. However, due to the absence of WHT within the EU and the existence of another, very favorable DTT between A and EU country B, X can develop a workaround. Rather than providing the loan directly to Z, X first establishes a subsidiary, Y, in EU country B. X then extends a loan to subsidiary Y, which in turn lends it on to subsidiary Z. The interest that is paid from Z to Y is, due to the EU Directive, not subject to any holding tax. Y then passes on the proceeds to X, in a transfer which is subject only to the very favorable withholding tax rates of the DTT between A and B. Thus, MNE X has significantly reduced its tax liability by using a conduit loan.

The above example shows that, given the absence of other anti-avoidance measures, the EU Directives on WHT provide an opportunity for substantial tax avoidance by MNE. Moreover, the above model can also be applied to similar conduit structures for income from dividends or royalties. Maybe even more important, however, are its implications for tax competition among EU member states. The above example shows that, given the absence of internal barriers (i.e., the elimination of WHT), individual countries are lacking an effective defense mechanism against tax avoidance strategies. Moreover, similar to the prisoner’s dilemma, there is the risk of a race-to-the-bottom with regards to WHT.³³ As companies adapt to this weakness in the European tax system, they will pick the country with the lowest external barrier (i.e., the lowest WHT on payments to tax haven) as an entry point to the EU. Countries have an incentive to be this entry point because, as long as withholding tax rates on outgoing payments are positive, they benefit from the additional tax base from mobile income that is funneled through them. As countries compete for the position as an entry point, however, they will, at least in theory, gradually lower their withholding tax rates down to the level where taxation of income has reached the same level as that of tax havens, which is typically zero. Given this competitive scenario, the complete elimination of WHT between EU member states seems suboptimal. An optimal solution could only be achieved through complete harmonization which is including external barriers. As a second-best scenario, countries should be able to freely set withholding tax rates also with regards to other EU members, so that they can defend themselves against such conduit structures.³⁴

It appears, however, that the EC has recognized the shortfalls of this complete elimination of WHT. Therefore, it has issued the EU Directive 2015/121/EU which is an amendment to the Parent-Subsidiary Directive and is designed to deny the benefits of dividend exemption in the context of tax avoidance schemes. Nevertheless, for interest and royalty payments, the tax avoidance scheme outlined above still seems possible.

The positioning of the analyzed countries was assessed based on the overall number of DTT, as well as the number of tax treaties with these countries that had been identified as non-cooperative tax havens in the OECD’s 1998/2000 analysis on harmful tax competition.³⁵ Moreover, the level of WHT for qualifying dividends, interest and royalties were assessed for three scenarios. These are the general withholding tax rates in the absence of DTT (i) on payments to regular jurisdictions and (ii) tax-haven, as well as (iii) the average withholding tax rates for these DTT which have been concluded with jurisdictions that were identified as tax havens in the OECD’s 1998/2000 report. Please refer to Appendix 4 for a detailed overview.

The highest scores, indicating the highest level of defensiveness (i.e., a low number of DTT and high level of withholding tax rates) were achieved by Slovenia (#1/30: 100%), Slovakia (#2/30: 97%), Denmark (#3/30: 95%), Greece (#4/30: 89%) and Latvia (#5/30: 89%).

3.2.3. Controlled foreign company legislation

MNE often use subsidiaries in low-tax countries as hosts for shifted profits, which can lead to the accumulation of vast amounts of funds. A particularly striking example, which provides valuable insights that hold true also with respect to European companies, is given by US MNE.³⁶ According to estimates by the US rating agency Moody’s, at the end of 2014, only five US MNE (i.e., Apple, Microsoft, Google, Pfizer, and Cisco) held as much as USD 439 billion in cash in their overseas subsidiaries. The overall amount of funds held abroad by US MNE was estimated to be USD 1.73 trillion.³⁷ This is equivalent to roughly 10% of the country’s 2014 GDP. Most of these funds were held in offshore subsidiaries, to which they had been channeled through tax avoidance schemes, and where they were only subject to nominal levels of taxation, if at all. Had the income been booked as profit with the US parent company instead, it would have been subject to the full level of taxation applicable to US companies.

Given the current US legislation, tax authorities are only able to levy taxes on these offshore funds upon their repatriation (i.e., when subsidiaries distribute them as dividends to the US parent company). At least in the case of US MNE, however, the vast amount of funds held abroad indicates that companies usually refrain from such repatriations. Instead, businesses can conveniently channel these funds directly from their offshore subsidiaries into their global operations (e.g., by extending loans to other entities). From a business perspective, the effect of this non-repatriation of funds constitutes an indefinite tax deferral. From a fiscal standpoint, the country in which the parent company is located suffers, at least temporarily, from a loss of tax revenues.

In response to this problem, which is also existing with respect to European MNE, governments have enacted so-called controlled foreign company rules (CFC). The principle behind is that in specific cases, usually with a focus on passive income, subsidiaries of MNE may be treated as transparent from a tax perspective. This means that (passive) income which accrues to the subsidiary is taxed as if it were part of the parent company’s income. Moreover, base eroding payments from the parent to the subsidiary (e.g., for certain services) might be disregarded. The legal justification for the application of CFC rules flows from the residence-based principle of taxation, which is extended to include the non-resident subsidiary, which would otherwise be exempted. The overall effect is, that the tax-deferring effect is eliminated and the foreign subsidiary effectively rendered useless, as it does not shield income from current taxation in the parent company’s country of residence anymore. To avoid a double taxation, however, profits which have already been taxed on a current basis due to the application of the CFC rule are typically exempted from taxation upon actual repatriation.

Among the analyzed 30 countries, 14 are operating CFC rules. Please refer to Appendix 5 for a detailed overview. Among these, the triggering of the rule typically depends on the cumulative fulfillment of three criteria (though some countries’ legislations only list two). First, the degree of capital ownership or voting power must be regarded as sufficient for the exercising of effective control over the decisions of the foreign subsidiary. Thresholds for this vary between 25% and 50%. Second, the level of taxation that the foreign subsidiary is subject to, which also includes taxation under certain preferential tax regimes (e.g., IP boxes) must be below a certain threshold. Here the strictest threshold is set by Spain (19%) and the most generous by Hungary (10%). Third, the percentage of the subsidiary’s income that is regarded as passive must exceed a certain level. This level ranges between 15% (Spain) and 50%. An addition the general CFC rule that is particularly strict exists in the case of Germany, whereby CFC legislation can be triggered even if a German resident shareholder only holds 1% of the share capital or voting power of a foreign entity if the foreign entity generates passive income with investment character.

Interestingly, the case of CFC legislation provides a vivid example of how the absence of tax barriers that are otherwise common among countries, can serve as a fiscal incentive. In 2008, more than a dozen UK companies, among it the FTSE 100 listed pharmaceutical company Shire, relocated their headquarters to Ireland. According to observers, a significant motivation for the move was Ireland’s lack of CFC legislation, which allowed companies to engage in tax deferral and profit shifting at their new headquarters location. The move happened at a time where the UK government contemplated a tightening of existing CFC rules. A plan which was later abolished.³⁸

With regards to the application of CFC rules among EU member countries the European Court of Justice (ECJ) set a significant limitation with its 2006 landmark decision in the Cadbury-Schweppes case.³⁹ Background of the case was a legal dispute between the UK inland revenue department and the UK-based Cadbury Schweppes Plc., about some of its Irish subsidiaries, which were located in the Dublin International Financial Service Center and subject to a preferential tax rate of 10%. Given these circumstances, the UK revenue department regarded the conditions for an application of its CFC legislation as met, resulting in a current taxation of the subsidiaries’ profits. Cadbury Schweppes, however, disputed the decision, arguing that it was in violation of the articles on the right of establishment, laid out in the Treaty on the Functioning of the European Union. When the case was brought before the ECJ, it ruled that the effective restriction on freedom of establishment caused by the application of CFC rules could only be justified for cases “of wholly artificial arrangements which do not reflect economic reality”, whereby the subsidiary is regarded as “fictitious establishment” (e.g., lacking premises, staff, and equipment) and “not carrying out any genuine economic activity”. For the subsidiaries of Cadbury Schweppes, the ECJ did not see these conditions as met.⁴⁰

The implications of this ECJ ruling are that MNE can avoid the application of CFC legislation by bestowing an otherwise purely artificial subsidiary with a nominal level of real economic activity. This case bears some resemblance to the EU Directives on WHT (i.e., Parent-Subsidiary Directive and Interest and Royalties Directives), in the sense that official bodies of the EU have, in their effort to promote the European Single Market, eliminated or at least severely impeded the effectiveness of fiscal barriers created by individual member states.⁴¹ Moreover, there is evidence that the EJC’s limitation on the applicability of CFC legislation contributed to the emergence of IP box regimes, which are regarded as a means of tax competition, among European countries.⁴²

With regards the effectiveness of CFC rules, which was assessed based the compliance with recommendations laid out by the OECD BEPS project, the highest scores are achieved by Denmark, Finland, Norway and Sweden (#1/11: 100%, each), followed by France and Spain (#2/11: 99%, each).

3.2.1. Exit taxation

In their effort to minimize their overall tax burden, MNE do not simply rely on BEPS, but also use substantial tax planning, which includes the relocation of certain assets, whole entities or even headquarters to take advantage of preferential tax rates.

Between 1997 and 2007, about 6% of MNE relocated their headquarters to other countries.⁴³ While there are motives other than tax reductions for a relocation of headquarters, there is evidence that these decisions were significantly influenced by tax considerations. A study by Voget (2011) shows that repatriation taxes (i.e., those payable upon the distribution of dividends to the parent company) as well as the existence of CFC legislation significantly increase the likelihood of MNE relocating to other countries. For the government of the country from which the company is emigrating, the relocation typically leads to a complete loss of tax revenues, because the company’s residence-status, to which taxation is typically tied, is coming to an end.

However, even without a relocation of headquarters, MNE can restructure their international operations in substantial ways, thereby eroding the taxable basis in their country of residence. Typically, these restructurings are made through the transfer of profit generating assets to foreign PE. From the fiscal perspective of the residence country, the transfer of the asset typically ends the right to taxation on future profits as these are generated outside its jurisdiction. In line with this, also the OECD Model Tax Convention assigns the right to taxation of profits from PE to the country in which they are located.⁴⁴ More importantly, however, in cases where the transfer of assets takes place at book value, rather than fair value, hidden reserves (i.e., capital gains that have accrued to this asset over time) are not taxed. From a fiscal perspective this is problematic, because these capital gains have been generated in the country that the asset is being transferred from and, just as all other profits generated by the asset up to the time of the transfer, should also be subject to tax there.

In response to this problem, an increasing number of governments is applying a so-called exit taxation. Its introduction is also part of the so-called Anti-Tax Avoidance Directive (EU/2016/1164) which was issued in 2016. The aim of exit taxation is to ensure that capital gains on a company’s assets are taxed upon exit. The “exit” in this case does not necessarily mean the physical relocation of an asset to another country, but rather the end of the right to taxation on future profits generated by this asset.

Exit taxation deems all ‘exiting’ assets to have been transferred at fair value. The fictitious capital gains resulting from this deemed transfer (i.e., the uncovered hidden reserves) are then subject to tax. In the case of corporate emigration, taxation is typically made based on a fictitious transfer of all domestic assets, although exceptions are possible (e.g., for assets that remain subject to domestic tax as part of PE). From a company perspective, exit taxes can be a significant challenge, because cash payments must be made for capital gains which have not been realized. To account for this problem, the exit tax legislation of European countries typically allows for a staggered payment of the resulting tax liability.

Eleven of the analyzed 30 countries are operating exit tax regimes. The countries’ positioning with regards to exit taxation was assessed based on the general possibility of corporate migration and the existence of exit taxation legislation. Thereby, the highest scores were achieved by Denmark, Germany, Ireland, Norway and Sweden (#1/4: 100%, each).

3.2.2. Exemption rules & switch-over clauses

To provide protection from double taxation and to encourage international activity of their resident companies, many countries provide double tax relief in the form of the exemption method (i.e., completely exempt foreign income from domestic taxation) even if they otherwise follow the principle of residence taxation (i.e., a system that, in principle, subjects a resident’s world income to taxation).⁴⁵ This double tax relief can be granted on a unilateral, bilateral (e.g., as part of DTT) or multilateral (e.g., through agreements such as the EU Parent-Subsidiary Directive) basis.

From a company perspective, the exemption of foreign income not only protects from a possible double taxation but also allows for an exploitation of tax differentials across countries. If another country offers the same positive pre-tax return on a certain investment and, at the same time, is charging a lower tax rate on income therefrom, the company can invest in that country and benefit from the reduced tax rate.⁴⁶ By comparison, a double tax relief through the credit method would eliminate the advantage of a lower foreign tax rate by subjecting foreign-sourced income to the domestic tax rate upon repatriation, only allowing for a deduction of foreign taxes from the domestic tax liability. Moreover, credit methods typically only allow for a crediting of foreign taxes up to the level of the domestic tax liability. This means that in the case of a lower foreign tax, liability is increased to the domestic level, but in the event of a higher foreign tax, liability remains at the higher foreign level.

From a fiscal perspective, a possible negative side effect of the complete exemption of foreign income, is that it encourages location of investment based on tax motives, rather that pre-tax real economic returns. On the other hand, however, countries which are granting full exemptions on foreign income are used by MNE as preferred locations for conduits and treaty shopping arrangements.⁴⁷ Moreover, in the absence of other anti-avoidance measures, a full exemption also allows companies to repatriate income from tax havens.

To tackle the misuse of exemption rules as part of tax schemes, many countries which are generally granting exemptions for particular types of foreign income operate so-called switch-over rules. If a switch-over rule is triggered, the provided double tax relief switches from the exemption method to a less favorable type of relief, typically the credit method. The most common criteria for the triggering of a switch-over are the existence of an only nominal level of foreign taxation or the fact that income is derived from tax haven or non-cooperative jurisdictions (i.e., jurisdictions that do not meet appropriate transparency or exchange of information requirements).

Among the 30 analyzed countries, 20 are offering unilateral tax relief through exemption for particular types of income (i.e., active income, dividends, interest or royalties). Fifteen of these countries have additional switch-over rules limiting the application of these exemption rules. Please refer to Appendix 7 for detailed information.

The score to assess the countries’ positioning was determined based on two criteria and assuming the absence of DTT. First, it was analyzed whether countries offer any form of tax exemption at all, and if so, the types of income for which they do. Secondly, it was analyzed whether these countries operate switch-over rules. The highest scores were achieved by Austria, Denmark, Germany, Greece, Hungary, Latvia, Luxembourg, Slovenia, Spain, and Sweden (#1/5: 100%, each).

It should be noted, however, that for an exhaustive analysis of the topic, also switch-over rules with regards to bilateral and multilateral treaties (e.g., the EU Parent-Subsidiary Directive) would have to be considered. For our analysis, however, we take the countries’ positioning with regards to unilateral tax relief as a proxy for their overall positioning.

3.2.3. General anti-avoidance rules

Despite the effective design of fiscal barriers, the complexity and ambiguity of tax laws often allow MNE, which are supported by highly professional tax advisory companies or law firms, to devise tax schemes that circumvent these barriers. These tax schemes are usually legal, yet they achieve exactly the tax avoiding effect which the barriers were designed to prevent. The constant innovation on the part of MNE and their legal advisors as well as the complexity of tax legislation makes it almost impossible for governments to design fiscal barriers which cannot be circumvented.

[...]

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¹ See Heinemann/Overesch/Rincke (2010), p. 498.

² See Mendoza/Tesar (2005), pp. 163 f. and Streif (2015), p. 20.

³ As per the author’s knowledge, the only attempt to a holistic analysis of smart tax competition was made by Pasquale Pistone in his 2012 paper titled Smart Tax Competition and the Geographical Boundaries of Taxing Jurisdictions. See Pistone (2012).

⁴ For the sake of better readability, in the following, the author will simply refer to “tax competition.”

⁵ See OECD (2015a), pp. 22 f.

⁶ Only exceptions are Belgium, Germany, and the Netherlands, which use their own model tax convention. Nevertheless, also those conventions are strongly oriented on the OECD format.

⁷ See UNCTAD (2010), p. 17.

⁸ There is an important distinction between tax avoidance and tax evasion. Tax evasion is an illegal practice in which a taxpayer fails to make payment for an existing tax liability, e.g. by concealing taxable profits from the authorities. Tax avoidance, on the other hand, constitutes a practice that is legal and is exploiting existing laws to avoid taxation (e.g. through the creation of artificial arrangements). The analysis in this thesis is mainly focused on the subject of tax avoidance.

⁹ See Dharmapala (2014) for a review of empirical studies on the evidence of BEPS.

¹⁰ See Dischinger/Riedel (2011), p. 691.

¹¹ See Oxfam (2016), p. 22.

¹² See OECD (1999), p. 17.

¹³ See Devereux/Griffith/Klemm (2002), p. 488.

¹⁴ See Egger/Raff (2015), p. 777.

¹⁵ See Schön (2002), p. 496.

¹⁶ Alternative theories exist, which are trying to explain the dynamics behind the observed reduction in corporate tax rates. These include, among others, yardstick competition, and theories that economic and political convergence within countries causes them to behave in similar ways, i.e. move to some common lower level of taxation (See Slemrod (2004)). Nevertheless, it is not within the purview of this thesis to critically evaluate different theories of tax competition. The model of tax competition as Prisoner’s dilemma / Bertrand competition is used, because it is the most widely accepted theory and provides plausible explanations on all aspects of tax competition that are relevant in the context of this thesis.

¹⁷ See Mendoza/Tesar (2005), pp. 163 f. and See Streif (2015), p. 20.

¹⁸ An alternative, although less popular, view is that tax competition is generally positive as it forces governments to become leaner and more efficient in the provision of public goods and, therefore, lowers the cost of doing business. See Hong/Smart (2010) for more information on this.

¹⁹ Detailed information on the Action Plan on Corporate Taxation is available on the official website of the European Council under the following URL: http://ec.europa.eu/taxation_customs/business/company-tax/action-plan-corporate-taxation_en (access date: 28.11.2016)

²⁰ See Heinemann/Overesch/Rincke (2010), p. 498.

²¹ The 2004 EU enlargement included the countries Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. In 2007, also Bulgaria and Romania joined the EU.

²² See Overesch/Rincke (2011), pp. 581 ff. for a detailed overview of trends in CIT rates in Europe.

²³ See Devereux/Griffith/Klemm (2002), p. 487.

²⁴ See Heckemeyer/Overesch (2013), p. 27.

²⁵ See OECD (2013)

²⁶ See Clausing (2003), p. 2222.

²⁷ See Heckemeyer/Overesch (2013), pp. 26 ff.

²⁸ See Dharmapala/Riedel (2013), p. 106.

²⁹ All the analyzed countries possess transfer pricing rules and generally accept the pricing methods define by the OECD. Those include uncontrolled comparable price, resale price, cost plus, profit split and transactional net margin method.

³⁰ Read, number 1 out of 19 with a Normalized score of 100%. The listing of the total number of ranks (here: 19) is required because frequently the same rank is achieved by two or more countries. To allow for a proper interpretation of a certain rank, also the total number of ranks needs to be known.

³¹ See Heckemeyer/Overesch (2013), p. 27.

³² See OECD (2014)

³³ See Johannesen (2012), pp. 408 f.

³⁴ See Johannesen (2012), p. 402.

³⁵ The majority of the 34 non-cooperative tax haven which had been identified by the OECD in its 2000 report, subsequently made commitments to more transparency and effective exchange of information. Thus, the 2004 update report listed only five countries remaining as tax haven (i.e., Andorra, Liechtenstein, Liberia, Monaco and the Marshall Islands). The OECD was criticized for this move, however, as it let the mere commitment, rather than concrete action, suffice for a removal from its list of tax haven. Therefore, the use of the list from the 2000 report seems justified.

³⁶ For a thorough analysis of the topic, also the implications of the so-called “check-the-box” option, provided within the US tax code, would need to be considered. However, the author refrains from further analysis in this direction, as the example in its current form suffices to outline the problem and to illustrate the benefits of the application of a controlled foreign company legislation.

³⁷ See Moody's Investor Service (2015)

³⁸ See Voget (2011), p. 1067.

³⁹ See ECJ, 12.09.2006, C-196/04, 2006 ECR I7995

⁴⁰ See ECJ, 12.09.2006, C-196/04, 2006 ECR I7995, margin no. 55 ff.

⁴¹ See Bräutigam/Spengel/Streif (2016), pp. 6 f. for an overview of the development of CFC rules among European countries between 2004 and 2014.

⁴² See Bräutigam/Spengel/Streif (2016), p. 21.

⁴³ See Voget (2011), p. 1067.

⁴⁴ See OECD (2014), Art. 7 (1).

⁴⁵ In the case of a territorial tax system, income generated outside a country’s territory is generally exempt from taxation.

⁴⁶ This example is making the simplifying assumption that there are no additional costs involved in changing the place of investment and in the repatriation of profits.

⁴⁷ See OECD (1999), p. 32.

• Hochschule: Universität Mannheim
• Veranstaltung: International Taxation
• Note: 1.7
• Autor: Cord Weirich (Autor:in)
• Erscheinungsjahr: 2016
• Seiten: 95
• Katalognummer: V442574
• ISBN (eBook): 9783668826632
• ISBN (Buch): 9783668826649
• Sprache: Englisch
• Schlagworte: Steuerwettbewerb, tax competition, international taxation, EU, European Union, Europäische Union, internationale Besteuerung