Corporate Income Taxes in the EU: An Economic Assessment of the Role of the ECJ

Corporate Income Taxes in the EU:An Economic Assessment of the Role of the ECJ Steve Bond (Nuffield College, Oxford and IFS) Malcolm Gammie (TLRC, IFS) Socrates Mokkas (University of Oxford) ETPF/IFS Conference The Impact of Corporation Tax Across Borders London, 24 April 2006

Goals • To review implications for EU corporate income taxes of case law at the ECJ • To provide an economic assessment of the changes to EU corporate income taxes resulting from these ECJ rulings

Background • “The ECJ has no rival as the most effective supranational judicial body in the history of the world” (Alec Stone Sweet) • The ECJ has decided over 100 cases involving income taxation • Mostly ruling against tax provisions of member states

Legal Background • Four freedoms – free movement of goods, persons, services and capital – and freedom of establishment enshrined in EC/EU treaties • Member states retain competence in direct taxation (and veto over direct tax proposals), subject to EU law • Commission and national courts can refer cases to the ECJ

ECJ Case Law • Non-discrimination – tax measures of one EU country should not discriminate against nationals of another member state • Market access – tax measures of one EU country should not act as barriers to the exercise of Treaty freedoms • Justifications • Cohesion/proportionality • Prevention of tax evasion/avoidance

Economic Background • Capital Export Neutrality (CEN) – requires same tax treatment for domestic investment and outbound foreign investment • Capital Import Neutrality (CIN) – requires same tax treatment for domestic investment and inbound foreign investment • Taxes will distort international investment decisions (location or ownership) unless both CEN and CIN hold

Economic Background • With different tax rates, CEN would require all countries to adopt pure residence-based taxation • And CIN would require all countries to adopt pure source-based taxation • Neither can be achieved unilaterally • Achieving both (no tax distortions) would require a common tax base and common tax rates

Small Open Economy Results • Small open economy (SOE) – production/consumption of goods and services have no effect on world prices • Perfect capital mobility – investment/saving have no effect on world interest rate • Source-based taxation of capital income can be inefficient in a small open economy with perfect capital mobility

Small Open Economy Results • Source-based taxation of capital income deters investment in the source country • In a small open economy, incidence is shifted fully onto (relatively immobile) domestic workers • post-tax return to owners of capital unaffected • less capital per worker implies lower wages • More efficient to tax labour income directly • avoiding distortion to capital-labour ratio

The Big Picture How would economists with a blank sheet of paper design a corporate income tax system for the EU?

Two Extreme Views • Assuming • No obstacles to coordination • EU large enough for SOE results not to apply • Single EU corporate income tax • Consolidated tax base • Single tax rate • Caveat • Some economists would advocate no taxation of income from capital even in a closed economy context

Two Extreme Views • Assuming • No chance of coordination • Individual EU countries small enough for SOE results to apply • No (source-based) corporate income taxes • Caveats • Location-specific rents • Backstop to personal income tax

The Big Picture • We do not endorse either of these extreme positions • We assess the impact of the ECJ on corporate income taxes in the EU both from the perspective of an observer who favours harmonization; and from the perspective of an observer who favours abolition

Requirements of EU law • No reason to believe that full compliance with EU law will produce effective harmonization of corporate tax treatments • i.e. single level playing field across all 25 EU countries • Nor make it impossible or prohibitively expensive for national governments to raise significant revenues from corporate taxes

A compliant system • Consider a territorial system, with all member states exempting foreign-source income • No discrimination within national markets then implies a level playing field within each country

A compliant system • But member states determine own tax rules and own tax rates, subject to EU law • Effect would be not a single level playing field, but a patchwork of 25 level playing fields • different heights primarily reflecting different tax rates applied within national markets

A compliant system • This would satisfy capital import neutrality but not capital export neutrality • Firms investing in member states with low tax rates treated more favorably than firms investing in member states with high tax rates • Effective harmonization not required for EU corporate taxes to comply with EU law • Likely that significant tax revenues could be raised in a compliant system of this kind

Requirements of EU law • EU law does not even require that two participants in a domestic market face equal tax burdens • Provided differences result only from interactions between different national taxes, not from discrimination within tax rules of a single member state

Requirements of EU law • Parent-Subsidiary Directive allows credit method as well as exemption method for relieving double taxation of foreign-source income • UK firm investing in Ireland may face higher overall tax rate than German firm investing in Ireland, or domestic Irish firm • Some departures from capital import neutrality are permitted, if they result from interactions between tax rules in different countries

The Influence of the ECJ • 10 years ago, the impact of the ECJ on UK corporation tax had been minimal • Since then: • Abolition of ACT • Effective abolition of imputation • Changes to transfer pricing and thin capitalisation rules • Changes to treatment of finance leases • Cross-border losses • Concern over future of CFC rules and credit system

The Influence of the ECJ • EU member states are now in responsive mode • Revising national corporate income taxes in response to actual or prospective ECJ rulings • At least in the UK, the government’s agenda for corporate tax reform has been replaced by firefighting legislation – patching up corporation tax to make it comply with EU law

The Big Picture • EU corporate taxes are very different now than they were 10 years ago • But there is no clear trend, or obvious pressure, towards either harmonization or abolition • Viewed from either extreme position, neither the corporate taxes we have now nor those we could be heading towards are clearly superior to the corporate taxes we had before

The Big Picture • More generally, full compliance with EU law is likely to leave intact some of the most significant distortions to efficient allocation of business activity within the EU • Investment attracted to countries with low CT rates • Cross-border business structured in tax-efficient ways • Shifting of profits into countries with low CT rates • Location of headquarters and R&D also affected

The Big Picture • Mainly due to differences in corporate tax rates, substantial departures from capital export neutrality persist within the EU • At this macro level, hard to discern any great improvement stemming from the volume of litigation at the ECJ • Not the role of the ECJ to produce an efficient corporate tax system for the EU

Specific Changes We focus on four areas where the ECJ has been, or is likely to be, influential: • Integration of personal and corporate income taxes • Transfer pricing and thin capitalisation • Source or residence-based corporate taxation • Credit or exemption systems of double tax relief

Integration • Imputation systems used historically by many EU member states were discriminatory • Dividend tax credits not given for foreign corporate income taxes • Dividend tax credits not given to foreign shareholders • Additional tax imposed on firms with insufficient domestic taxable income (e.g. surplus ACT)

ECJ Influence • Key cases • Metallgesellschaft (1998) • Verkooijen (2000) • Lenz (2004) • Manninen (2004) • ACT GLO (pending) • Meilicke (pending)

Recent Changes • Imputation system replaced by classical system in Ireland, and by forms of (partial) exclusion (from personal income tax) in (e.g.) Germany, France, Italy and the UK • In (e.g.) Ireland, Germany and the UK, higher personal taxation of dividend income was explicitly linked to reductions in corporate income tax rates

Economic Assessment • In closed economies, dividend taxation raises cost of capital for investment financed by new equity • Already relatively unimportant for investment decisions of mature firms • But more important for investment decisions of high growth firms and start-ups • Favours retained earnings over new equity finance

Economic Assessment • In small open economies with perfect capital mobility, link between dividend taxation and investment and financial decisions is weaker • Stock market valuation of corporate dividends insensitive to dividend taxes paid by domestic shareholders

Economic Assessment • As economies become more open and more integrated, case for relieving double taxation of dividend income (e.g. by imputation) becomes weaker (Boadway-Bruce, 1992; Devereux-Freeman, 1995; Fuest-Huber, 2000) • Switch from (source-based) corporate income tax towards (residence-based) dividend taxation has some advantages

Transfer Pricing and Thin Capitalisation • Opportunities to shift taxable profits from high tax rate to low tax rate jurisdictions using transfer pricing or thin capitalisation are relevant only in cross-border context • Traditional anti-avoidance rules therefore applied only to cross-border transactions • Thus discriminating between domestic and international transactions

ECJ Influence • Key cases • Lankhorst-Hohorst (2000) • Thin Capitalisation GLO (pending) • Response (e.g.) in Germany and UK has been to extend the scope of these anti-avoidance rules to also cover domestic transactions

Economic Assessment • This outcome raises administrative and compliance costs, without any substantive effect on the application of these rules • Open question as to whether the new rules are fully compliant with EU law • If not, there could be significant erosion of corporate income tax bases, and (hence) more incentive for EU countries to coordinate (e.g. on some form of formula apportionment)

Source or Residence Taxation • Within corporate income taxes, pending cases at the ECJ may favour a shift towards source-based taxation • Two areas where existing departures from pure source-based taxation are at risk: • Controlled foreign corporation (CFC) rules • Credit system for relief of international double taxation

CFC Rules • Key cases • Cadbury Schweppes (pending) • CFC and Dividend GLO (pending) • Like imputation systems, CFC rules tend to discriminate between domestic and foreign investments, and between different foreign investments • (Without harmonization of CFC rules), restrictions on application of CFC rules within EU would significantly weaken effectiveness of CFC rules against non-EU tax havens

Credit Systems • Standard operation of credit systems appears to be discriminatory • Dividends from foreign subsidiaries are liable to tax, while dividends from domestic subsidiaries are not • Key case • Franked Investment Income GLO (pending) • AG Opinion (6 April) supports principle of credit method, but not its operation in the UK

Possible Responses • Replacement of credit method by exemption method • Extension of credit method to dividends received from domestic subsidiaries • Open question as to whether an extended credit system would be fully compliant with EU law • Less doubt about compliance of exemption system

Economic Assessment • Economic analyses do not decisively favour the credit method over the exemption method, or vice versa (Horst, 1980; Janeba, 1995; Mintz-Tulkens, 1996; Devereux-Hubbard, 2003; Davies, 2003) • And some favour deduction over credit or exemption (Feldstein-Hartman, 1979) • Simplicity of exemption system may be a major advantage (Federal Tax Commission, 2005)

Conclusions • The ECJ is now a major influence on the direction of corporate income taxes within the EU • Compliance with EU law is unlikely to produce either effective harmonization of corporate tax treatments within the EU • Or the abandonment of corporate income taxes

Conclusions • A plausible outcome is a territorial system, with exemption of foreign-source income, no discrimination on the basis of nationality, but different tax rates in different EU countries • A patchwork of 25 level playing fields, each at different heights, not a single level playing field • Question as to whether playing fields are even required to be level within countries, if differences reflect interactions between two tax systems (e.g. credit rather than exemption)

Conclusions • The areas of corporate taxation that have been the focus of ECJ cases (imputation systems, anti-avoidance rules, systems of double tax relief) are not the chief suspect for significant economic distortions (which remains differences in corporate tax rates) • The legal pressure that is currently driving changes to corporate income taxes within the EU is a poor substitute for serious political debate on corporate tax reform

Conclusions • It is not the role of the ECJ to produce a more efficient corporate income tax system for the EU • There are powerful long term pressures toward either more uniform corporate tax treatments within the EU, or lower corporate tax rates • But these stem from increased mobility of capital and business activities, not from the ECJ

Corporate Income Taxes in the EU: An Economic Assessment of the Role of the ECJ