Towards an Internal Market without tax obstacles - Communication from the Commission

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COUNCIL OF Brussels, 5 November 2001

THE EUROPEAN UNION

13365/01 ADD1

FISC 224

COVER NOTE

from : Mr Bernhard ZEPTER, Deputy Secretary-General of the European Commission

date of receipt : 30 October 2001

to : Mr Javier SOLANA, Secretary-General/High Representative

Subject : Towards an Internal Market without tax obstacles

– Communication from the Commission

Delegations will find attached a Commission Staff Working Paper on Company Taxation in the

Internal Market (document SEC(2001) 1681).

________________________

Encl.: SEC(2001) 1681

EN

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 23.10.2001 SEC(2001) 1681

COMMISSION STAFF WORKING PAPER

Company Taxation in the Internal Market

{COM(2001)582 final}

Preface

Origin of the study

This study has been prepared by the services of the European Commission in compliance with an official mandate by the Council of Ministers. It is accompanied by a communication from the Commission to the Economic and Social Committee, the European Parliament and the Council.

Mandate to the Commission for a study on company taxation in the European Community

The Commission is invited to present an analytical study of company taxation in the European Community. This study will be undertaken in the general context of the Vienna European Council conclusions emphasizing the need to combat harmful tax competition whilst taking into account that cooperation in the tax policy area is not aiming at uniform tax rates and is not inconsistent with fair tax competition but is called for to reduce the continuing distortions in the single market also in view of stimulating economic growth, and enhancing the international competitiveness of the Community, to prevent excessive losses of tax revenue or to get tax structures to develop in a more employment-friendly way. This study will also be undertaken on the basis of the ECOFIN Council conclusions asking to illuminate existing differences in effective corporate taxation in the Community and the policy issues that such differences may give rise to. This study should also highlight remaining tax obstacles to cross-border economic activity in the Internal Market.

The study will analyze differences in effective levels of corporate tax in Member States, taking into account, inter alia, the results of the report of the Ruding Committee (1992). Attention should be given to the influence of corporate tax bases on effective levels of taxation. Moreover, the study should also identify the main tax provisions which may hamper cross-border economic activity in the Single Market. On this basis, an assessment should be undertaken of the effects on the location of economic activity and investment. The Commission should highlight the tax policy issues involved in reducing tax–induced distortions and examine possible remedial measures, taking account of the respective spheres of competence of the Member States and the Community.

The Commission should endeavour to complete the study to enable a report to be presented to the ECOFIN Council during the first half of 2000.

Background and history of the mandate

The mandate for this study goes back to the call by the EU Ministers of Finance at their informal meeting of 26 September 1998 in Vienna for a comprehensive study on company taxation in the European Community. At that meeting, among other things, the Ministers discussed the Code of Conduct for business taxation and some suggested that further measures in the field of company taxation might be necessary in the future and asked the Commission to examine this question. The ECOFIN Council of 1 December 1998 in Vienna, in approving the first progress report of the Code of Conduct group, formally agreed to ask the Commission for this study on company taxation in the European Community. Moreover, it asked the Permanent Representatives Committee to define the concrete terms of the mandate for the study and requested the Taxation Policy Group to be consulted thereon. The European Council in Vienna on 11 and 12 December 1998 explicitly confirmed this agreement of the ECOFIN Council.

After preparatory discussions in the Taxation Policy Group and in the Council Financial Questions Group of 14 June 1999 and 24 June 1999, the Permanent Representatives Committee agreed on 22 July 1999 the official mandate to the Commission for a study on company taxation in the European Community.

Two panels of experts

In preparing the study, the Commission has been assisted by two specifically created panels of experts. The task of the first panel was to advise the Commission services on the choice of methodology for the evaluation of the effective tax rates in Member States as well as the interpretation of the qualitative and quantitative results of the analysis. The task of the second panel was to advise the Commission services on the remaining company tax obstacles to the proper functioning of the Single Market and to analyse these taxation obstacles from the point of view of the European business community and social partners.

The first panel was composed of academics and experts who have previously been involved in theoretical and empirical work related to the evaluation of effective level of company taxation. They were chosen on the grounds of their outstanding reputation and proven ability in this area. The members of panel I were

Prof. Krister Andersson (Swedish Institute for Economic Research)

Prof. Jacques Le Cacheux (Université de Pau and OFCE)

Prof. Michael Devereux (Warwick University)

Prof. Silvia Giannini (Università degli Studi di Bologna)

Dr. Christoph Spengel (Universität Mannheim)

Maître Jean Marc Tirard

Prof. Frans Vanistendael (Universiteit Leuven)

The secretariat of the panel was ensured by Carola Maggiulli (European Commission).

The second panel was composed of experts from among the business community and social partners at the Community level. The Commission services contacted a variety of leading business associations, trade unions and accountancy associations and invited them to designate a member of the panel. The members of panel II were:

Dr. Carlo-H. Borggreve and Roland Walter for CEEP (European Centre of Enterprises with Public

Participation)

Prof. Bruno Gangemi for CFE (Conféderation Fiscale Européenne)

Dr. Piergiorgio Valente for EFFEI (European Federation of Financial Executives Institutes)

RA Alfons Kühn for Eurochambres (Association of European Chambers of Commerce and Industry);

as from April 2000 Eurochambres was represented by Dr. Harald Hendel

Wilfried Rometsch for Eurocommerce

Philip Gillett for ERT (European Round Table of Industrialists)

Prof. Sven-Olof Lodin for IFA (International Fiscal Association)

Prof. Sylvain Plasschaert for TEPSA (Trans European Policy Study Association)

Dr. Fidelis Bauer for UEAPME (European Association of Craft, Small- and Medium-Sized

Enterprises); as from May 2000 UEAPME was represented by Dr. Peter Zacherl

Jos W. B. Westerburgen for UNICE (Union of Industrial and Employer’s Confederations of Europe)

Christophe Quintard and Marina Ricciardelli for ETUC (European Trade Union Confederation)

Madeleine Lindblad Woodward from the Fédération des Experts Compatbles Européens took part in one meeting of the panel. The secretariat of the panel was ensured by Dr. Rolf Diemer (European Commission).

Operation of the panel work

Both panels operated under the Chair of the Commission (Michel Aujean).

Panel I met five times (in July and October 1999; in February and May 2000).

Panel II met nine times (in July and September 1999; in January, February, March, April, May, June and July 2000).

Two joint meetings took place (September 2000 and January 2001).

The calculations for the determination of the effective levels of taxation were contracted out to the Institute for Fiscal Studies (IFS – London), the Centre for European Economic Research (ZEW – Mannheim) and the University of Mannheim. Thus, two external studies have been produced which are available on request.

Acknowledgements

The Commission is indebted to the members of the two panels and their very helpful oral and written contributions.

The Commission is very grateful to Dr. Joann Martens Weiner (former economist, Office of Tax Policy, U.S. Department of the Treasury) and John Neighbour (OECD secretariat) who made very valuable presentations to panel II.

The Commission also wishes to acknowledge the very helpful submissions by the Fédération des Experts Comptables Européens .

In accordance with the mandate, the Commission services bear the sole responsibility for the study and its contents. Therefore, the present report does not necessarily represent the views of all or individual members of the panels of experts.

C OMPANY T AXATION IN THE I NTERNAL M ARKET

Executive Summary

Introduction

(1) The conclusions of the ECOFIN Council in December 1998 requested the Commission to carry out an analytical study on company taxation in the European Union. This study should illuminate differences in the effective level of corporate taxation and identify the main tax provisions that may hamper cross-border economic activity in the Single Market. On this basis an assessment should be undertaken of the effects on the location of economic activity and investments. In July 1999 the Permanent Representatives Committee (COREPER) refined this request into a formal mandate for the Commission asking for a factual analysis and a policy assessment with a view to EU company taxation.

(2) The Commission has been assisted by two specifically created panels of experts one focussing on the method for calculating the effective tax rates in Member States and the other on the remaining tax obstacles to the proper functioning of the Single market. The first panel was composed of academics with appropriate experience and scientific reputation in relevant theoretical works. The second panel included experts from among the business community and social partners at the Community level. The individual members of the second panel were designated by the respective organisations.

The Ruding report and the impact of the Internal Market

(3) This study takes the report of the Committee of Independent experts on Company Taxation into account that was asked by the Commission in 1990 to determine whether differences in business taxation and the burden of business taxes among Member States lead to major distortions affecting the functioning of the Single Market and to examine all possible remedial measures (Ruding Committee). The underlying analysis of this earlier study is mostly still topical. In this context it has to be noted that little progress has been achieved in the field of company taxation as a result of its findings and recommendations. However, the context for studying company taxation in the EU has since then changed in various ways. Moreover, the mandate given to the Commission by the Council for the present study is broader than that given by the Commission to the expert committee in 1990 as it explicitly requests the analysis of tax obstacles in the Internal Market.

(4) The overall economic framework has changed significantly since the early nineties. An unprecedented wave of international mergers and acquisitions, the emergence of electronic commerce and the increased mobility of factors with the growing development of "tax havens" all change the scenery under which European Member States levy taxes on company profits. These general global developments are still on-going and are particularly strong within the Internal Market.

(5) Most significantly, the Internal Market had not been established yet in 1990. The same holds for Economic and Monetary Union. Both developments impact on how the functioning of company tax systems within the EU has to be evaluated. As economic integration in the Internal Market proceeded, the economic, technological and institutional barriers to cross-border trade continued to wane. At the same time, taxation systems adapted to this process only very gradually. The pattern of international investments is therefore likely to be increasingly sensitive to cross-border differences in corporate tax rules in an environment now characterised by full mobility of capital. Moreover, while considerable progress has been made in the removal of the wide range of barriers to the establishment of the Internal Market (including the recent agreement on the European Company Statute), the tax impediments to cross-border activities within the Internal Market are becoming increasingly important. These elements describe important specific EU dimensions on company taxation which did not exist in the same way in 1990.

(6) EU businesses are presently confronted with a single economic zone in which 15 different company tax systems apply. This causes losses of economic efficiency, generates specific compliance costs, and contributes to a lack of transparency. The Internal Market and Economic and Monetary Union also strongly impact on the way EU companies carry out business in the Community and set the - intended - incentive to create effective pan-European business structures. This is because EU companies increasingly no longer define one Member State but rather the whole EU as their "home market". The resulting structural changes lead to the EU-wide re-organisation and centralisation of business functions within a group of companies, many of which were traditionally present in many or even all Member States. Such re-organisation can be achieved via internal realignments, via mergers and acquisitions or through the creation of foreign branches. These tendencies, in turn, impact on the taxation of these companies. EU companies argue that their perception of the EU as their "home market" generally does not correspond to a tax reality, unlike the USA for US companies. Thus, a variety of legal and economic factors define a specific "EU dimension" for analysing company taxation.

The effective level of company taxation in the EU

(7) From the point of view of economic efficiency, tax systems should ideally be "neutral" in terms of economic choices. In such an analytical framework, the choice of an investment, its financing or its location should in principle not be driven by tax considerations. From this perspective, and in an international context, similar investments should not face markedly different effective levels of taxation purely because of their country location. Differences in the effective levels of corporate taxation may in fact imply welfare costs because economic activity may not take place in the lowest (pre-tax) cost location by the lowest cost producers. If the impact of differences in tax regimes favours one location over another, or one producer over another, then goods may be produced at a higher pre-tax cost. Therefore, the size of these tax differentials and dispersions deserves attention.

(8) However, a full welfare cost assessment of differences in effective corporation tax rates would require a broader analysis, taking into account the existence of other taxes and other economic parameters, as well as national preferences for equity and the provision of public goods. Moreover, to the extent that there are pre-existing distortions and/or imperfections in the market economy (market failures), taxes may be used to internalise these externalities (e.g. pollution), thereby enhancing economic efficiency. It is impossible to precisely quantify the size of tax differentials needed to correct or mitigate market failures. However, the larger the tax differentials, the larger the market failure must be unless there is to be a loss of efficiency and welfare. It should be stressed that this study has not attempted to quantify the size of any efficiency loss or welfare cost that might be associated with existing differences in effective corporation tax rates in the European Union.

(9) In any event, taxation ultimately involves a political choice and may entail a trade-off between pure economic efficiency and other legitimate national policy goals and preferences. Furthermore, in the Community context, the subsidiarity principle and Member States' competences in the field of taxation have to be taken into account when assessing differences in effective tax rates between Member States.

(10) The purpose of the analysis of differences in the EU corporations' effective level of taxation is twofold. First, it gives summary measures of the overall relative incentive (or disincentive) provided by each country's tax law to undertake various types of investments at home or in another EU Member State. Second, it identifies the most important tax drivers influencing the effective tax burdens, that is the weight of each of the most important elements of the tax regimes in the effective tax burden.

(11) The analysis does not provide evidence of the impact of taxation on actual economic decisions. Although empirical studies show that there is a correlation between taxation and location decisions, because of the weaknesses of the existing methodologies and their limitations due to lack of available data, it has been considered that none of the existing approaches could have been usefully adopted in the current study without considerably extending the range of the work.

(12) Taxation is, of course, only one of the determinants of investment and financing decisions. The existence and quality of economic infrastructures, the availability of qualified work, as well as the short and medium-term outlook in different markets and countries are among the other important determinants of investment behaviour. The geographical accessibility of markets, transport costs, environmental standards, wage levels, social security systems and the overall attitude of government all play an important role too. Which of these factors are relatively the more important very much depends on the individual type of investment decision. Nevertheless, as economic integration in the EU proceeds in the context of the Economic and Monetary Union and the Internal Market, in an environment where capital is fully mobile, the pattern of international investment is likely to be increasingly sensitive to cross-border differences in corporate tax rules.

(13) The study presents estimates of effective corporate tax rates on domestic and transnational investments in the 15 EU countries (as well as the US and Canada in certain cases) taking the tax systems in operation as of the year 1999. In addition, it presents estimates of effective corporate tax rates on domestic investments for the EU Member States in 2001. In view of the structure and

magnitude of the German tax reform approved in 2000, the effects of this reform, as of the 1 st

January 2001, are separately analysed. The calculations consider primarily corporation taxes in each country, but also include the effect of personal income taxation of dividends, interest and capital

gains.

(14) The most commonly used indicators for analysing the impact of taxation on investment behaviour are based on forward-looking approaches which permit international comparisons and are especially tailored to provide an indication of the general pattern of incentives to investment that are attributable to different national tax laws as well as on the most relevant tax drivers that influence the effective tax burdens. In this study, the main body of the computation of the effective corporate tax burden builds on the methodology involving calculating the effective tax burden for a hypothetical future investment project in the manufacturing sector. In technical terms, the analysis relies on a revised and extended methodology of the so-called King & Fullerton approach, set out by Devereux and Griffith (1998). This computation is supplemented by data arising from the application of the "European Tax Analyzer" model which utilises the model-firm approach set out by the University of Mannheim and ZEW (1999). Considering that each methodology is based on different hypotheses and restrictions, the comparison of the results of these approaches permits the testing and, possibly, confirmation of the general trends arising from the computations.

(15) The results of the application of these approaches depend heavily on the assumptions underlying both the definition of the hypothetical investment in terms of assets and financing or of the future firm behaviour in terms of total cash receipts and expenses, assets and liabilities over time and of the economic framework. As far as the economic framework is concerned, the value of the real interest rate is a crucial element. The existing studies based on these approaches assume different hypotheses in relation to the economic framework and the definition of the investment. This study, for example, like the Ruding report, calculates effective tax rates at a given post-tax rate of return, whereas other studies 1 compute the effective tax rate for a given pre-tax rate of return. Differences in the assumptions underlying the hypothetical investment and the economic framework can give rise to somewhat different numerical results.

(16) These approaches do not permit, for methodological reasons, taking into consideration in the computation all the relevant features linked to the existence and functioning of different tax systems. For instance, the effects of consolidating profits and losses throughout the EU are not included because the model assumes all investments are profitable. Neither is it possible to quantify or include compliance costs. However, the most important features of taxation systems such as the rates, major elements of the taxable bases and tax systems are included. The results produced should therefore be understood as summarising and quantifying the essential features of the tax system.

(17) Effective tax rates can be calculated for a so-called "marginal" investment (where the post-tax rate of return just equals the alternative market interest rate) or for a "infra-marginal" investment project (i.e. one that earns an extra-profit). This study has analysed both marginal and infra-marginal (average) effective company tax indicators. These reflect different hypotheses related to the underlying methodology, as well as to the domestic or international localisation of the investment, the profitability of the investment or of the firm considered, and the size and behaviour of the companies. The computations have been supplemented by "sensitivity analysis" which tests the impact of different hypotheses on the results.

(18) The broad range of data computed does not intend to present "universally valid values" for the effective tax burden in different countries, but rather to give indicators, or illustrate interrelations, in a series of relevant situations. In fact, effective tax rates in a particular Member State depend on the characteristics of the specific investment project concerned and the methodology applied.

(19) A number of general conclusions regarding both the differences in the effective tax burdens and the identification of the most relevant tax drivers which influence these tax burdens, can nevertheless be formulated on the basis of the results. Therefore, explanations can be given on how Member States tax regimes create incentives to allocate resources. A striking feature of the quantitative analysis is that, across the range of different situations, the relevant conclusions and interpretations remain relatively constant.

(20) When domestic investments are considered, the analysis for 1999 suggests that there is considerable variation in the effective tax burden faced by investors resident in the various EU Member States, depending on the type of investment and its financing. However, the Member States' tax codes tend to favour the same forms of investment by assets and sources of finance. The range of the differences in national effective corporate taxation rates, when personal taxation is not taken into account is around 37 points in the case of a marginal investment (between -4.1% and 33.2%) and around 30 points in the case of more profitable investments (between 10.5% and 39.1% when the hypothetical investment methodology is applied and between 8.3% and 39.7% when the "Tax Analyser" model is applied). The introduction of personal taxation substantially increases the effective tax burdens and the observed differences. Moreover, the analysis suggests that, in practically every situation analysed tax systems tend to favour investment in intangibles and machinery and debt is the most tax-efficient source of finance.

4

A recent study by Baker and McKenzie conducted under different hypotheses concerning the economic context and the applied tax codes, shows that in the most similar economic situation to that considered in this study (pre-tax rate of return of 6% as against a post-tax rate of return of 5% considered in the Commission study), the range of variation is 32 points in the case of a marginal investment (from 4.9% to 36.8%). When the pre-tax rate of return is fixed at 10% (base case in the Baker and McKenzie computation), the range of variation is 23 points (from 6.8 to 30.1). This study also shows that the most tax efficient method of finance is debt and that the tax systems tend

to favour investments in intangibles and machinery.

(21) Differences between the effective tax burden in the EU Member States may be important for two reasons. First, differences in effective tax rates faced by companies located in different countries, but competing in the same market, may affect their international competitiveness: two different companies, competing in the same market, may face two different tax rates. Second, when multinational companies face only the tax rate of the country where the activity takes place then differences in the effective tax rates between countries could also affect the location choice of individual activities. This can occur either as a result of the provisions of international tax codes, for example when the repatriation of profits by way of dividend from a subsidiary to a parent results in no further taxation because the dividend is exempt, or as a result of tax planning. A multinational company may therefore face different tax rates, depending on where its activities are located. As indicated, this economic reasoning is based on pure tax considerations and cannot, on its own, explain the actual behaviour of companies.

(22) Clearly, the EU wide spread cannot be explained by one single feature of the national tax system. However, the analysis of general regimes tends to show that – leaving aside preferential tax regimes - the different national nominal tax rates on profits (statutory tax rates, surcharges and local taxes) can explain many of the differences in effective corporate tax rates between countries. Although tax regimes are designed as more or less integrated systems (in general high tax rates on profits seem to correlate with a narrower taxable base and vice versa), tax rate differentials tend to outweigh the differences in the tax bases. The quantitative analysis also shows that the relative weight of rates in determining the effective tax burden of companies rises when the profitability of the investment rises and that, consequently, any compensatory effects of a lower tax base on effective tax rates tend to disappear when the profitability rises. The study conducted by Baker and McKenzie concluded that, in general, the composition of the tax base does not have a great impact on the effective tax burden and that the level of the tax rate is the truly important factor for the difference in the tax burden.

(23) When transnational investments are considered, the results for 1999 show variations in the way each country treats investments in or from other countries. Thus, the effective tax burden of a subsidiary of a parent company in one country depends crucially on where that subsidiary is located. On the basis of the assumptions considered in this study, the range of variations of the effective tax burdens of subsidiaries located in different host countries can rise above 30 points regardless of the method of financing of the subsidiary. This provides an incentive for companies to choose the most tax-favoured locations for their investment, which may not be the most favourable location in the absence of taxes. Similarly, subsidiaries operating in a given country face different effective tax burdens depending on where their parent company is located. Even in this case the range of variation can reach more than 30 points.

(24) The analysis of the effective tax burden of transnational investment also gives an indication of the allocation effects of international taxation by capturing the extent to which the tax treatment of

Corporate Tax Rates 1999 - Statutory, and Effective Average at pre tax returns of 20% & 40%

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transnational investments gives incentives to undertake transnational, as opposed to domestic, investment. The data show that, on average in the EU, outbound and inbound investment are more heavily taxed than otherwise identical domestic investments and, therefore, the additional

components of the transnational system add somewhat to the effective tax rates on investment.

(25) But, to the extent that companies are free to choose the most tax-favoured form of finance, then the international tax system works such that foreign multinationals operating in a host country are likely to face a lower effective tax burden than domestic companies. This seems to be true even when the treatment of multinationals is compared with the more favourable domestic treatment allowed for small and medium sized companies.

(26) The spreads observed between the effective rates of taxation in the international analysis are the results of complex interactions between different tax regimes and cannot be explained by just one feature of taxation. However, as was the case for the domestic investment, the analysis tends to show that the most relevant tax component which provides an incentive to locate cross border and to choose a specific form of financing is the overall nominal tax rate. This is, in general, an important tax driver when the incentives of taxation to use particular sources of finance and specific locations are considered. The tax base does however have a greater impact in specific situations when a country applies, for instance, particularly favourable depreciation regimes.

(27) It is worth noting that across the range of domestic and cross-border indicators presenting the effective tax burden at the corporate level, there is a remarkable consistency as far as the relative position of Member States, notably at the upper and the lower ranges of the ranking, is concerned. In general, Germany, and France tend to show the highest tax burdens while Ireland, Sweden and Finland tend to be at the lower range of the ranking. Only Italy's ranking changes materially when the profitability of the investment changes. Due to the working of the dual income system, marginal investments are, in fact, subsidised, whereas more profitable investments suffer an effective tax burden which is in the middle range of the ranking.

(28) When the domestic analysis is updated to take into account the 2001 tax regimes, the overall picture is broadly unchanged in comparison to 1999. However, as a consequence of a pattern of generally declining statutory tax rates (albeit with relatively small reductions apart from Germany), more profitable investments benefited from reductions in effective tax rates in a number of countries. As a result, the range of differences in domestic effective tax rates in the case of a more profitable investment decreased from 30 to 26 percentage points.

(29) The German tax reform that entered into force at 1.1.2001 is a significant reform which implies a substantial cut in the corporation tax rate and in income tax rates, partly financed by the broadening of the tax base, including the abolition of the split rate system and the imputation system. However, despite these changes the German tax reform has only minor effects on the relative position of Germany in the EU country ranking and both the overall national corporate tax rate and the effective tax burden remains among the highest in the EU.

(30) Simulating the impact of a hypothetical harmonisation of particular features of taxation systems in isolation on effective tax rates shows that:

Introducing a common statutory tax rate in the EU would have a significant impact by decreasing the dispersion - both between parent companies and between subsidiaries - of marginal and average effective tax rates across the EU countries. To the extent that taxation matters such a scenario

would be likely to go some way in reducing locational inefficiencies within the EU.

By comparison, no other scenario would have such an impact. For example, introducing a common tax base or a system consisting in applying the definition of the home country tax base to the EU- wide profits of a multinational tends to increase the dispersion in effective tax rates if overall

nominal tax rates are kept constant.

Moreover, two remarks have to be made concerning these results for a common tax base. First, the methodologies applied do not permit to take into consideration all the elements of the tax bases. However, the "Tax Analyser model", whose results are similar to those arising from the simulations of hypothetical investment, does consider a more significant number of elements of the tax bases. Second, benefits which would arise under either a common consolidated tax base or a home country tax base approach such as loss consolidation and simplified transfer pricing cannot be

modelled using the methodologies used in this report.

It is worth emphasising that these results are based on a static analysis and cannot capture the dynamic effects and reactions induced by the harmonisation of particular features of taxation in

isolation.

(31) The potential distortions in the allocation of resources reported in the analysis of transnational investments indicate that there can be an incentive for companies to alter their behaviour in order to minimise their global tax burden. Therefore the study has considered some stylised examples of tax optimisation strategy of companies by means of an intermediary financial company focusing the attention on the likely effects of an abolition of these tax reducing financing structures. However, the removing of these possibilities of optimisation strategy will not contribute, per se, to solving the problem of tax-induced resources mis-allocations. Since the main tax driver for effective tax rate differentials is the overall national tax rate, companies located in "high tax" countries will be able to compensate for the removal of these financial intermediaries by making greater use of differences in general tax rates and structuring their investments to take advantage of lower rates.

Tax obstacles to cross-border economic activities in the Internal Market

(32) The Council mandate also asks for a "highlighting [of the ] remaining tax obstacles to cross-border economic activity in the Internal Market" and calls for the identification of "the main tax provisions which may hamper cross-border economic activity in the Single Market". For this purpose the present study focuses on additional tax or compliance burdens which companies incur as a result of doing business in more than one Member State and which therefore represent a barrier to crossborder trade, establishment and investment.

(33) The underlying cause of those additional tax and compliance burdens is the existence within the Internal Market of 15 separate tax systems. First, the fact that each Member State is a separate tax jurisdiction has a number of consequences. In particular:

• companies are obliged to allocate profits to each jurisdiction on arm’s length basis by

separate accounting, i.e. on a transaction by transaction basis;

• Member States are reluctant to allow relief for losses incurred by associated companies

whose profits fall outside the scope of their taxing rights;

• cross-border reorganisations entailing a loss of taxing rights for a Member State are liable to

give rise to capital gains taxation and other charges;

• double taxation may occur as a result of conflicting taxing rights.

(34) Moreover, each Member State has its own sets of rules, in particular laws and conventions on financial accounting, rules for determining taxable profit, arrangements for collection and administration of tax and its own network of tax treaties. The need to comply with a multiplicity of different rules entails a considerable compliance cost and represents in itself a significant barrier to cross-border economic activity. The costs and risks associated with complying with more than one system may in particular discourage small and medium-sized enterprises from engaging in crossborder activity.

(35) These fundamental problems hamper cross-border economic activity in the Internal Market and adversely affect the competitiveness of European companies. In economic terms they result in a loss of potential EU welfare. The imminent enlargement of the EU makes it all the more urgent to find appropriate solutions.

(36) To some extent the problems faced by the EU reflect general difficulties in taxing international activities, and the work of the OECD and its forerunners has provided the basis for an extensive network of mainly bilateral double taxation treaties between Member States. The OECD has also published guidance on a range of international tax issues, in particular concerning the application of transfer pricing methods and on documentation requirements. In addition, the EU itself has taken several initiatives with a view to removing tax obstacles to cross-border co-operation and activity: Directive 90/434 ("merger directive"), providing for the deferral of taxation on cross-border reorganisation; Directive 90/435 ("parent-subsidiary directive"), eliminating double taxation on cross-border dividend payments between parent and subsidiary companies; and the Arbitration Convention (90/436), providing for a dispute resolution procedure in the area of transfer pricing. Although going some way to resolving the obstacles to cross-border activity they do not provide a solution which keeps pace with the growing integration in the Internal Market.

(37) A basic concern of companies operating within the Internal Market is the removal of tax obstacles to income flows between associated companies. The Parent-Subsidiary Directive abolishes withholding taxes on payments of dividends between associated companies of different Member States. However, its effectiveness is reduced by the fact that it does not cover all companies subject to corporation tax and applies solely to direct holdings of 25% or more.

(38) There is the further problem that - independent of the directive- certain systems of company taxation have an in-built bias in favour of domestic investment. For example, under imputation systems applied in a number of Member States a tax credit is granted to resident (individual or corporate) shareholders for the tax paid on company level; that credit is usually not available to non-resident shareholders and is not normally granted in respect of foreign dividends. There is evidence to suggest that such systems form a serious obstacle to cross-border mergers within the EU and can have an influence on related business decisions (e.g. location of corporate seat).

(39) Payments of interest and royalties between associated companies of different Member States are often still subject to withholding taxes that effectively create situations of double taxation. The Commission has already presented a proposal for a directive on this subject [COM(1998)67], and it is expected that this proposal will be adopted in the context of the "tax package".

(40) In addition to obstacles to income flows, corporate restructuring can also be affected by one-off costs more directly linked to the restructuring operation itself. The tax-cost induced by cross-border mergers, acquisitions and internal reorganisations in the form of capital gains tax and various transfer taxes is often prohibitively high and forces companies to choose economically sub-optimal structures. Such obstacles place existing EU companies at a disadvantage as non-EU companies as new entrants will generally be better placed to set up the most suitable structure.

(41) The merger directive provides for deferral of capital gains charges in a number of situations. However, a number of problems remain:

• First, not all situations are covered. Like the Parent-Subsidiary Directive, it does not include

all companies subject to corporate tax. It does not cover all types of tax charge (e.g. transfer taxes) that can arise upon a restructuring. Moreover, it does not cover all types of operation which may be involved in a restructuring, e.g. the centralisation of production or other activities. Furthermore, the conversion of existing operations (subsidiaries) into branches

may endanger the future absorption of tax losses accumulated pre-conversion.

• Second, the directive's usefulness is reduced by the fact that currently there is no EU

company law framework for cross-border mergers. Companies are therefore obliged to have recourse to share for share exchanges or transfers of assets. The recent agreement on the European Company Statute will change this situation in one respect and allow, as from 2004,

for companies to merge into a new legal structure.

• Third, the implementation of the directive differs significantly between Member States. Even

though such differences are to some extent intrinsic to the legal instrument of a "directive", the study identifies significant disparities which undermine the overall aims sought by the directive. In particular Member States, in implementing the Directive, have imposed varying conditions for the tax deferral provided for under the Directive with a view to preventing tax avoidance, in some cases significantly limiting the scope of the Directive and leaving

situations of double taxation unrelieved.

(42) The study identifies particular difficulties in relation to cross-border loss-compensation which, from a business perspective, constitute one of the most important obstacles to cross-border economic activity. The current rules in Member States generally allow only for the offsetting of losses of foreign permanent establishments but not for those of subsidiaries belonging to the same group but located in different EU countries. If available, the loss compensation often takes place only at the level of the parent company or is deferred in comparison to domestic losses (which creates significant interest cost). The differences which exist in Member States’ domestic loss compensation arrangements also impact on business decisions.

(43) The current loss compensation arrangements entail a risk of economic double taxation where losses cannot be absorbed locally. This situation provides an incentive in favour of domestic investment and of investment in larger Member States.

(44) In the area of transfer pricing, the tax problems for cross-border economic activity in the Internal Market have increased over the past years and are still growing. The problems consist essentially in high compliance costs and potential double taxation for intra-group transactions. A difficulty, according to business representatives, is that the transfer prices which are calculated for tax purposes often no longer serve any underlying commercial rationale in the Internal Market. There is in particular an increasing practice among larger companies to adopt, in EU intra-group trade, standard "euro" transfer prices for intermediate products, regardless of the production facility from which the goods are purchased within the group.

(45) There is also a tendency among Member States, fearing manipulation of transfer prices, to impose increasingly onerous transfer pricing documentation requirements. Moreover, the application of the various methods for determining the "correct" (i.e. "arm's length") transfer price for a determined intra-group transaction is becoming increasingly complex and costly. New technologies and business structures (which imply, inter alia , more emphasis on intangibles) cause growing difficulties to identify the comparable uncontrolled transactions often required for establishing the arm's length price. In addition, there are substantial divergences in the detailed application of transfer pricing methods between Member States. The same holds for their implementation of the relevant OECD guidelines. EU businesses therefore face uncertainty as to whether their transfer prices will be accepted by the tax administrations upon a subsequent audit. The study indicates that the combined effect of these difficulties for companies can be a significant increase in compliance cost for international activities.

(46) Double taxation in transfer pricing occurs when the tax administration of one Member State unilaterally adjusts the price put by a company on a cross-border intra-group transaction, without this adjustment being offset by a corresponding adjustment in the other Member State or States concerned. While inquiries made by the Commission services among Member States suggest that the number of transfer pricing disputes between Member States is fairly limited, a survey of multinational companies published by the accounting firm Ernst&Young 2 reports a significant number of instances of double taxation arising from transfer pricing adjustments. This is consistent with representations made by business representatives, who complain moreover that the cost and time relating to the current dispute settlement procedures are often too high for enterprises with the result that it is often less costly to accept the double taxation. In this context the present study finds that the Arbitration Convention 90/436/EEC, which seeks to provide a binding dispute resolution

10

procedure, is rarely used and that certain of its provisions may act as a deterrent for taxpayers to make use of it.

(47) In short, the study concludes that, while there is evidence for aggressive transfer pricing by companies, there are equally genuine concerns for companies which are making a bona fide attempt to comply with the complex and often conflicting transfer pricing rules of different countries. Such concerns are becoming the most important international tax issue for companies.

(48) The study also identifies the area of double taxation conventions as a potential source of obstacles and distortions for cross-border economic activities within the EU. Although the intra-EU network of double taxation treaties is largely complete, there nevertheless remain some gaps. Most treaties within the EU follow the OECD Model but there are significant differences in the terms of the various treaties and their interpretation. There are also instances of divergent application of treaties by the treaty partners, leading to double taxation or non-taxation. Business representatives also refer to the increasing complexity of treaty provisions as a source of compliance cost and uncertainty. What is more, the study shows that tax treaty provisions based on the OECD Model, in particular non-discrimination articles, are not adequate to ensure compliance with the EU law principle of equal treatment. Moreover, the lack of co-ordination in the treaty practice of Member States in relation to third countries, for example regarding limitation of treaty benefits, is liable to give rise to distortions and partitioning of the Internal Market.

(49) The study also notes that certain areas of taxation which do not form part of company taxation may nevertheless entail significant obstacles to cross-border economic activity in the EU. This notably relates to the taxation of fringe benefits and stock options, of supplementary pensions as well as VAT. It is important to note that together with the company tax obstacles these difficulties have a cumulative effect for the companies concerned. As regards VAT, this is particularly true for small and medium-sized enterprises for which the nature of the various tax obstacles to cross-border economic activity is generally identical but which suffer from disproportionately - and sometimes prohibitively - high compliance cost for dealing with them.

Remedies to the tax obstacles in the Internal Market

(50) There are essentially two approaches which could be envisaged for tackling the company tax obstacles in the Internal Market:

• Targeted solutions which seek to remedy individual obstacles

• More comprehensive solutions which seek to address the underlying causes of the obstacles.

(51) A comprehensive approach providing EU businesses with a single common consolidated tax base for their EU activities would address most of the tax obstacles to cross-border economic activity that have been identified. A piecemeal approach only is unlikely to achieve this in a comparable manner. It should also be noted that clearly all proposals raise a number of technical issues which would need to be explored in greater detail.

(52) Regardless of the basic approach of remedies, it is important to note that in the absence of political solutions taxpayers have been compelled to have recourse to the legal process to overcome discriminatory rules and other obstacles. In consequence, the European Court of Justice (ECJ) has developed a large body of case law on the compatibility of national tax rules with the Treaty. National courts are also increasingly being asked to give rulings in this area. While the ECJ has made a significant contribution to the removal of tax obstacles for companies, it is unlikely that the interpretation of the Treaty is sufficient to address all tax obstacles to cross-border activity. Moreover, ECJ rulings are confined to the particular case put to it and may therefore relate solely to individual aspects of a more general issue. The implementation of ECJ rulings is left to Member States, who often fail to draw the more general consequences which flow from them. There therefore seems to be scope for introducing a Community framework for exchanging views of the implications of significant ECJ rulings.

(53) One important example for the aforementioned principle is the problem of the bias in favour of domestic investment in certain systems of company taxation, notably imputation systems, for which the case law of the Court has particular significance. Recent rulings, such as Safir, Verkooijen and Saint-Gobain , suggest that tax systems which provide a disincentive to cross-border activity or investment may be contrary to the Treaty provisions on the fundamental freedoms. Such rulings raise important issues for the design of Member States’ tax systems for which more guidance on EU level would be desirable.

Targeted remedial measures

(54) The various problems relating to the divergence of application of (both the existing and future) EU Taxation Directives across Member States could be tackled via a regular exchange of best-practices and/or some form of peer review. This could also give the opportunity to develop a more common understanding of important concepts in EU company taxation, notably tax avoidance. Ensuring a more uniform application of EU tax law is an important step in order to reduce compliance costs and increase the efficiency of EU company taxation. At the same time, the need for litigation would be reduced.

(55) The shortcomings identified in the Merger Directive and the Parent-Subsidiary Directive suggest the need for amendment of those directives. The Commission has already presented proposals for amendment of the directives suggesting, in essence, that their scope be extended to cover other entities subject to company taxation [COM(93)293]. In addition to this and with a view to clarifying the scope of certain important provisions in the directives, notably those concerning avoidance and abuse, further amendments to the Directive and/or more detailed guidance on how those provisions should be implemented could help.

(56) As regards the merger directive, the study also identifies certain other areas where further amendments would facilitate cross-border restructuring. Within the logic of the existing Directive, it could first be examined to which extent specific transfer taxes arising on cross-border restructuring operations (notably on immovable property) could be taken into account. Second, the Directive could be clarified to make it clear that instances of economic double taxation should be avoided. One example for this could be to prescribe that capital gains arising on the sale of shares received in exchange for shares or assets are calculated on the basis of the market value at the time of the exchange, thus resolving previously accumulated "hidden reserves" without immediate tax consequences. A more radical change to the Directive would be to extend its scope so as to defer the triggering of tax charges where assets are moved to another Member State while preserving Member States’ tax claims. The parent-subsidiary directive could be amended to cover both direct and indirect shareholdings or, alternatively, provide for a lower minimum holding threshold.

(57) Finally, it may be noted that the recent agreement on the European Company Statute will provide a company law framework for cross-border mergers the absence of which has hitherto undermined the utility of the Merger Directive.

(58) As regards cross-border offsetting of losses, the Commission in 1990 presented a proposal for a directive [(COM(90)595] allowing parent companies to take into account the losses incurred by permanent establishments and subsidiaries situated in another Member State. The Council failed to adopt the proposal and has ceased discussion of it. A review of the proposal conducted as part of the present study suggests that a number of technical amendments could be made to the proposal. For example, it could be envisaged calculating losses according to the rules of the State of the parent company rather than that of the subsidiary as under the proposal.

(59) Alternatively, a similar result from the company's perspective could be achieved by devising a scheme similar to the Danish system of 'joint taxation'. In essence under the Danish arrangements a group of companies with a Danish parent company is taxed as if it were organised as a branch structure so that Denmark taxes the consolidated results of the group. The advantage of this approach over the Commission proposal lies in the greater symmetry between the taxation of profits and the offset of losses.

(60) There are a variety of measures available that would help remedy the various transfer pricing problems. The practical application of the Arbitration Convention could certainly be improved and its provisions made subject to interpretation by the Court. Moreover, Member States could be encouraged to introduce or expand bilateral or multilateral Advance Price Agreement programmes; such instruments, although costly, are an effective means of dealing with the uncertainty relating to transfer pricing. Subject to safeguards to prevent aggressive tax planning, a framework for prior agreement or consultation before tax administrations enforce transfer pricing adjustments could also be considered.

(61) More generally, the compliance costs and the uncertainty could be reduced by better co-ordination between Member States of documentation requirements and of the application of the various methods, for example by developing best practices. Such co-ordination could take place in the context of an EU working group and should build upon and complement the OECD activities in this field. It would be possible to develop that process further in order also to address the concerns of business. The establishment by the Commission of a Joint Forum on transfer pricing comprising representatives of tax authorities and business might allow the currently conflicting perspectives of the two sides to be reconciled. While on the one hand tax administrations view transfer pricing as a common vehicle for tax avoidance or evasion by companies and as a source of harmful tax competition between Member States, business on the other hand considers that tax authorities are imposing disproportionate compliance costs. The study finds that both sides have legitimate concerns to which it is necessary to seek a balanced solution through a dialogue on EU level. A more uniform approach by EU Member States would also contribute to a stronger position in relation to third countries.

(62) The filling of the few remaining gaps in the existing network of double taxation treaties within the EU would be helpful. Moreover, the current tax treaties of Member States could be improved in order to comply with the principles of the Internal Market, in particular in relation to access to treaty benefits. Better co-ordination of treaty policy in relation to third countries would also help. In addition, the study identifies a possible need for binding arbitration where conflicts arise between treaty partners in the interpretation and application of a treaty, leading to possible double taxation or non-taxation. The most complete solution to such problems would be the conclusion under Article 293 of the Treaty of a multilateral tax treaty between Member States, conferring interpretative jurisdiction on the Court. Another possibility, leaving intact the existing bilateral system, would be to elaborate an EU version of the OECD model convention and commentary (or of certain articles) which met the specific requirements of EU membership.

(63) Despite the fact that tax compliance costs are regressive to the size of the company, the study finds that the nature of the obstacles is essentially the same for all companies. Therefore specific tax initiatives for small- and medium-sized enterprises do not seem to be justified. There are however exceptions to this basic approach which could be usefully addressed mainly at Member State level. For instance, the administrative tax formalities, bookkeeping requirements etc. for small- and medium-sized enterprises should be less demanding than for bigger companies, also in cross-border situations. Moreover, the difficulties with the cross-border offsetting of losses hit small- and medium-sized enterprises particularly hard and therefore seem to deserve a specific remedy.

Comprehensive approaches on EU company taxation

(64) The study also examines more general remedial measures aimed at minimising or removing the obstacles in a more comprehensive manner and analyses a number of comprehensive approaches that have been presented to the Commission. All aim to address the various tax obstacles by providing multinational companies with a common consolidated tax base for their EU-wide activities:

• Under the mutual recognition approach of "Home State Taxation" the tax base would be

computed in accordance with the tax code of the company's home state (i.e. where the headquarter is based), thus building on the existing tax systems and the related experience and knowledge. This approach is conceived as an optional scheme for companies in Member

States with a sufficiently similar tax base.

• Another possibility would be to devise completely new harmonised EU rules for the

determination of a single tax base on European level. This again would be an optional scheme for companies existing as a parallel system alongside present national rules. Generally known as "Common (Consolidated) Base Taxation", this approach is advocated in

particular by some business representatives.

• A further model suggested in some literature would be a "European Corporate Income Tax".

This, although originally conceived as a compulsory scheme for large multinationals, could also be an optional scheme operating alongside national rules. Under this model the tax could

be levied at the European level and a part or all of the revenue could go directly to the EU.

• Finally, the more ‘traditional’ approach would be to harmonise national rules on company

taxation by devising a single EU company tax base and system as a replacement for existing

national systems.

(65) The most important fundamental advantages of providing EU businesses with a single consolidated tax base for their EU-wide activities, under whichever form, are as follows:

• The compliance cost resulting from the need to deal with 15 tax systems within the Internal

Market would be significantly reduced.

• Transfer pricing problems within the group of companies would disappear, at least within the

EU.

• Profits and losses would, in principle, be automatically consolidated on an EU basis.

• Many international restructuring operations would be fiscally simpler and less costly.

(66) The business representatives of the expert panel assisting the Commission emphasised these fundamental points. Under a comprehensive approach of whatever precise design compliance cost would be reduced, many situations of double-taxation would be avoided and many discriminatory situations and restrictions would be removed.

(67) By definition, an essential element of all the solutions is that there should be group consolidation on an EU-wide basis. At present not all Member States apply that principle even at the domestic level and only two at the international level. Under all approaches (with the possible exception of the European Corporate Income Tax) Member States would retain the right to set company tax rates.

(68) To a varying extent, all comprehensive approaches could potentially be designed such that not all Member States would have to participate. In this context, it is important to note that the Treaty of Nice extended the possibility for enhanced co-operation by a group of Member States where agreement by all 15 is not possible. This may be particularly appropriate for Home State Taxation, which presupposes the participation solely of Member States with a fairly close tax base. However, a group of Member States could equally take advantage of this mechanism in order to introduce any of the other approaches.

(69) A further key element of all the comprehensive approaches is a mechanism for allocating the common consolidated tax base to the various Member States. For this purpose the USA and Canada use a formula apportionment system which allocates the tax base according to a key composed of factors such as payroll, property and/or sales. Another solution available to the EU would be to apportion the tax base according to the (adjusted) value-added tax base of the companies involved. Under all of these Member States would be allocated a specific share of the overall tax base according to apportionment keys and apply their national tax rate to that share.

(70) All the above models would meet the concerns inasmuch as they remove the need to comply with up to 15 different tax systems, largely eliminate the transfer pricing problems arising from separate accounting and effectively provide for cross-border loss compensation. They would also provide a tax solution for the European Company. An appraisal of the various models should take account of their respective characteristics.

(71) An important point to note is that Home State Taxation does not require Member States to agree on a new common EU base because it is based on the principle of mutual recognition by Member States of each other’s tax codes. The other approaches all entail agreement on an entirely new tax code.

(72) By contrast with a compulsory harmonised base, Home State Taxation, Common (Consolidated) Base Taxation and European Corporate Income Tax operate alongside and do not fully replace existing national systems. In certain circumstances however this can have the disadvantage that competing enterprises in other Member States are subject to different taxation rules. For example, under Home State Taxation three competing retail shops in Germany would compute their tax base under Belgian, French or German rules according to whether the home state of the group to which they belonged was Belgium, France or Germany. However, the differences may be relatively small given that an underlying assumption of the Home State Taxation model is that participating States will have similar tax bases. Under Common (Consolidated) Base Taxation or European Corporate Income Tax competing businesses may be subject to either local or Common (Consolidated) Base Taxation / European Corporate Income Tax rules, which may be quite different. It may however be possible to permit local companies to opt into the scheme, for example, where there are competition issues.

(73) In addition the solutions based on a parallel rather than a single compulsory system raise a number of technical issues requiring further study. Among the main issues are those relating to restructuring, foreign income and double taxation treaties, and minority interests.

• First, as regards restructuring, since under Home State Taxation a company’s tax base is

determined in accordance with the rules of its parent’s state, each time the ownership of a company changes and its shares are sold the method by which it computes its tax base could change. This equates in current terminology to a potential change of residence and is potentially very costly. For example a Belgian subsidiary sold by its German Home State Taxation parent to a French parent could find its tax base changing from German to French, or if France were not participating in Home State Taxation, back to a Belgian base. In contrast, as under Common (Consolidated) Base Taxation there would only be one tax base such a sale within the Common (Consolidated) Base area would not involve such a change, and even if a company were sold to a new parent from a non participating state treatment

under the Common (Consolidated) Base system could perhaps be maintained.

• Second, the treatment of foreign income under Home State Taxation, Common

(Consolidated) Base Taxation or European Corporate Income Tax is complicated by the current situation of bilateral double taxation agreements, the co-existence of exemption and credit relief tax systems and the need for a system of allocation. For example, a subsidiary in

rd

a state which operates the credit system, with a 3 country branch may be entitled under its DTA to a credit for foreign tax paid by the branch. This could give rise to a claim under the DTA for the foreign tax credit even though the foreign income had been exempted under the

Home State Taxation rules.

• Third, minority shareholders might find themselves receiving dividends under a taxation

system which is incompatible with their existing local personal tax system. For example a minority shareholder might receive dividends paid under a Common (Consolidated) Base Taxation or European Corporate Income Tax imputation system whereas previously dividends had been paid under the local classical system. This can only be avoided if the payment of dividends by subsidiaries to minority shareholders remains subject to the local tax code which is the approach envisaged under Home State Taxation. This would imply

additional record keeping.

(74) These issues would not arise if Member States were to agree on the more traditional solution of a single harmonised company tax system, i.e. a common consolidated base with an agreed allocation system and method of dividend distribution. Nevertheless, despite their drawbacks, the other solutions meet the objectives of removing obstacles to cross-border activity without requiring such fundamental change. More generally, all the solutions would have the potential to contribute to greater efficiency, effectiveness, simplicity and transparency in EU company tax systems and remove the hiatuses between national systems which provide fertile ground for avoidance and abuse.

(75) The assessment of tax obstacles in the Internal Market reveals that many of the factors causing compliance cost also tend to increase the administrative cost for tax administrations. This is particularly evident with a view to transfer pricing. Moreover, the co-existence of 15 company tax systems in one Internal Market opens considerable room for tax evasion and tax avoidance. Therefore, many remedial measures will also to some extent benefit the efficiency and effectiveness of tax administrations. Finally, almost all remedial measures, targeted or comprehensive, call for more mutual assistance and administrative co-operation between Member States which provides reliable means for ensuring that tax audits will continue to be made in an appropriate way and that none of the remedies under consideration results in illegitimate and/or illegal tax evasion.

(76) In short, the report concludes that there are potentially significant benefits to be derived from providing, via a genuinely comprehensive solution, companies with a common consolidated tax base for the EU-wide activities. However, its findings are based mainly on the current stage of development of the research and further work would be necessary to implement any of the comprehensive approaches. Any solution going in this direction must obviously also take into account the competition rules laid down in the EC Treaty, in particular those concerning State Aids. Moreover, as already noted, the results of the quantitative analysis suggests that that the overall national tax rate is an important factor in determining the effective tax rate, and it is clear that a single or common base without further adaptations in practice would almost 'mechanically' accentuate this.

LIST OF TABLES

Table 1: Cost of capital and Effective Marginal Tax Rate

  • average across all 15 EU Member States - only corporation taxes

Table 2: Effective Average Tax Rates

  • average across all the 15 EU Member States - only corporation taxes

Table 3: Cost of Capital and Effective Marginal Tax Rate

  • average across all the 15 EU Member States - top-personal tax rate, qualified shareholder

Table 4: Cost of Capital

  • maximum and minimum across the EU - only corporation taxes

Table 5: Effective Average Tax Rate

  • maximum and minimum across the EU - only corporation taxes

Table 6: Cost of Capital

  • maximum and minimum across the EU - top-personal tax rate, qualified shareholder

Table 7: Cost of Capital and EMTR by country

  • by asset, source of finance and overall - only corporation taxes

Table 8: Effective Average Tax Rate by country

  • by assets, source of finance and overall - only corporation taxes

Table 9: Cost of Capital and EMTR by country

  • by asset, source of finance and overall - top-personal tax rate, qualified shareholder

Table 10: Germany Cost of Capital before and after the reform - only domestic investment

  • only corporation taxes

Table 11: Germany EATR before and after the reform

  • only domestic investment - only corporation taxes

Table 12: Germany Cost of Capital before and after the reform

  • only domestic investment - top-personal tax rate, qualified shareholder

Table 13: Cost of capital

  • average across all the 15 EU Member States - only corporation taxes

Table 14: Effective Average Tax Rate

  • average across all the 15 EU Member States - only corporation taxes

Table 15: Ranking of Member States by Average Cost of Capital

  • only corporation taxes

Table 16: Ranking of Member States by Average EATR

  • only corporation taxes

Table 17: Cost of Capital when subsidiary is financed by retained earnings - only corporation taxes

Table 18: Cost of Capital when subsidiary is financed by new equity

  • only corporation taxes

Table 19: Cost of Capital when subsidiary is financed by debt

  • only corporation taxes

Table 20: EATR when the subsidiary is financed by retained earnings

  • only corporation taxes

Table 21: EATR when subsidiary is financed by new equity

  • only corporation taxes

Table 22: EATR when the subsidiary is financed by debt

  • only corporation taxes

Table 23: Average Cost of Capital by Country

  • domestic, average inbound and outbound

Table 24: Effective Average Tax Rate by Country

  • domestic, average inbound and outbound

Table 25: "Tax Efficient" Average Cost of Capital by Country

  • domestic, average inbound and outbound - only most favoured source of finance for the subsidiary

Table 26: "Tax Efficient" Effective Average Tax Rate by Country

  • domestic, average inbound and outbound - only most favoured source of finance for the subsidiary

Table 27: Average Cost of Capital for Germany and EU average

  • domestic, average inbound and outbound

Table 28: Average EATR for Germany and EU average

  • domestic, average inbound and outbound

Table 29: Summary of Simulation Results: basis results for simulations of domestic elements of corporation tax

  • cost of capital and EATR

Table 30: Summary of Simulation Results: basic results for simulations of international elements of corporation tax

  • cost of capital and EATR

Table 31: Summary of Simulation Results: Interaction of Corporate and Personal Taxes

  • cost of capital and EATR

Table 32: Tax Optimisation in the case of Germany; distributions by parent out of the domestic earnings

  • cost of capital and EATR - most tax efficient way, BBC and DFC

Table 33: Tax Optimisation in the case of Germany: distributions by parent out of foreign earnings

  • cost of capital and EATR - most tax efficient way, BBC and DFC

Table 34: Tax Optimisation in the case of Germany: comparison of domestic and outbound investment

  • cost of capital and EATR - most tax efficient way, BBC and DFC

Table 35: Tax Optimisation in the case of UK

- cost of capital and EATR - most tax efficient way, Dutch mixer company and DFC

Table 36: Tax Optimisation in the case of uk: comparison of domestic and outbound investment - cost of capital and EATR

  • most tax efficient way, Dutch mixer company and DFC

Table 37: Cost of Capital and Effective Average Tax rate

  • zero-rate personal taxpayer - average over the 15 types of investment

Table 38: Cost of Capital and Effective Average Tax Rate

  • top-rate personal taxpayer - average over 15 types of investment

Table 39: Cost of Capital and Effective Average Tax Rate

  • medium-rate personal taxpayer - average over 15 types of investment

Table 40: Cost of Capital and EMTR by countries, tax codes of 2001

  • by assets, source of finance and overall - only corporate taxes

Table 41: Effective Average Tax Rate by countries, tax codes of 2001

  • by assets, source of finance and overall - only corporate taxes

Table 42: Cost of Capital for Domestic Investment

  • Ruding Report (1992) and Commission Study (2001)

Table 43: EMTR for domestic investment

  • Baker & McKenzie report (1999) and Commission Study (2001)

Table 44: EMTR for Domestic Investment: Baker and McKenzie Report (2001) and Commission Study (2001)

  • only corporate taxes

Table 45: Ruding Report (1992): Cost of capital for transnational investment

Table 46: Average Cost of Capital by Country

  • Ruding Report (1992) and Commission study (2001) - domestic, average inbound and outbound

Table 47: Mutual agreement procedures (MAP)

Table 48: The EU Arbitration Convention

Table 49: Total Mutual Agreement Procedures (including EU Arbitration Convention) of Member States

T ABLES CONTAINED IN THE BOXES "T AX A NALYSER "

Table A: Effective Average Tax Rate across 5 EU Member States and the USA

  • only corporation taxes

Table B: Effective Average Tax Rate across 5 EU Member States and the USA

  • corporate and personal taxes

Table C: Effective Tax Rate in Germany before and after the reform

  • only corporation taxes

Table D: German Tax Reform

  • increases and decreases attributed to different changes in taxation - only corporation taxes

Table E: Effective Average Tax Rate in Germany before and after the Reform

  • corporate and personal taxes

Table F: Results for simulations of reforming elements of the corporation tax base - effective average tax rates

Table G: Results for simulations of reforming tax rates and local taxes

  • effective average tax rates

Table H: Results for corporation tax system reform simulations

  • effective average tax rate

T ABLES OF C OMPANY T AX L AWS IN M EMBER S TATES

  • Belgium, the Netherlands, Finland and Austria
  • France, Greece, Ireland and Italy
  • Luxembourg, Portugal and the United Kingdom
  • Sweden, Denmark, Germany and Spain

LIST OF BOXES

Box 1 Tax Analyser: Effective Average Tax Rates (corporation level) across 5 EU Member States and the USA

Box 2 Tax Analyser: Effective Average Tax Rates (overall level: corporation and shareholders) across 5 EU Member States and the USA

Box 3 Tax Analyser: The effects of the German tax reform

Box 4 Tax Analyser: Testing the importance of the assumptions

Box 5 Tax Analyser: Impact of hypothetical tax reforms in the EU

Box 1: The globalisation of businesses

Box 2: Corporate income tax in the EU (as % of GDP)

Box 3: Properties of the measure of effective average tax rate used in the computation

Box 4: Tax provisions taken into account in the models

Box 5: The role of personal taxation

Box 6: Links between business taxation and companies' location decisions

Box 7: Description of the major tax changes in Germany

Box 8: Definition of simulations

Box 9: The impact of the equalisation tax in Finland and France

Box 10: Domestic reforms with personal taxes

Box 11: Impact of a limited credit system

Box 12: Possible financial arrangements

Box 13: Comparisons of the hypotheses and assumptions between the Commission study (2001) and the Ruding (1992) and the Baker & McKenzie (1999) reports

Box 14: The main provisions of the Parent-Subsidiary Directive

Box 15: Example of how the imputation system works

Box 16: Court of Justice judgement of 28 January 1986 in Case 270/83

Box 17: The imputation system and cross-border mergers: examples

Box 18: The Verkooijen judgement

Box 19: The main provisions of the Merger Directive

Box 20: Example of problems owing to the failure to update the list of companies contained in the Directive

Box 21: Example of cross-border restructuring not covered by the Directive

Box 22: Example on the taxation of exchanges of shares before the disposal of shares received in exchange

Box 23: Example of double taxation in the case of transfers of assets

Box 24: Example of the cost of a cross-border restructuring operation

Box 25: Example on restructuring operations and dividend taxation

Box 26: Loss-compensation on the domestic level

Box 27: Profit consolidation on the domestic level

Box 28: Treatment of losses of permanent establishments (foreign branches) - credit method

Box 29: Treatment of losses of permanent establishments (foreign branches) - deduction/reintegration method

Box 30: Treatment of losses of permanent establishments (foreign branches) - exemption method

Box 31: The definition of "losses"

Box 32: Cross-border consolidation of profits and losses

Box 33: Group consolidation and loss-compensation:

Acquisition of a start-up company at home and abroad

Box 34: Example on loss-compensation: Losses in a domestic branch vs. losses in a foreign branch

Box 35: Cross-border compensation of losses in permanent establishments: the Futura Participations case and the AMID case

Box 36: Survey of losses on cross-border activities within the EU by the

Federation of Swedish Industries

Box 37: Transfer pricing methods

Box 38: Transfer pricing as management tool

Box 39: The development of transfer pricing documentation rules in national legislation and practice

Box 40: The Mutual Agreement Procedure (MAP) According to Article 25 of the OECD Model Tax Convention

Box 41: The EU Arbitration Convention –comparison with the Mutual

Agreement Provisions in Double Tax Treaties

Box 42: Articles of the EC Treaty which impose obligations concerning non discrimination and the fundamental freedoms of the Internal Market

Box 43: The "Saint-Gobain" triangular case - far-reaching impact on tax treaties

Box 44: Tax-related labour compliance costs

Box 45: Example on stock options

Box 46: Difficulties for small and medium-sized enterprises to live up to the requirements of the present EU system of VAT

Box 47: How do multinational companies deal with differing requirements for financial accounts in 15 Member States and beyond?

Box 48: The tax treatment of leasing contracts

Box 49: The influence of accounting rules on business decisions: mergers and acquisitions

Box 50: Judgement of the Court of 17 July 1997 (Case C-28/95 Leur-Bloem)

Box 51: Article 8 of the Merger Directive

Box 52: Recapture of losses - which Member State should bear the tax-reducing effect of the loss of a subsidiary?

Box 53: Basic features of the Danish 'joint taxation' system

Box 54: "Check-the-box" - how the USA ensure that losses of foreign subsidiaries are offset as if they stemmed from foreign permanent establishments - an example for the EU?

Box 55: The OECD transfer pricing guidelines – including future working areas

Box 56: Examples of articles of the OECD Model Convention where bilateral tax treaties between EU Member States may need to be adjusted to bring

them into line with the Treaty

Box 57: Simple example on the functioning of Home State Taxation

Box 58: Simple example on the functioning of Common (Consolidated) Base

Taxation Box 59: Comparison of comprehensive approaches

Box 60: Example for reorganisations under Home State Taxation

Box 61: Example concerning the applicability of national double taxation treaties

Box 62: Example on the determination of tax credits

Box 63: Structures for analysis under Home State Taxation

Box 64: Home State Taxation and Double Taxation Agreements

Box 65: Are the obstacles removed by the comprehensive approaches?

Box 66: Example for potential differences

Box 67: USA – Use of Formula Apportionment

Box 68: Canada - Use of Formula Apportionment

Box 69: Example on revenue allocation via formula apportionment versus separate accounting

LIST OF FIGURES

Figure 1: Effective Average Tax Rate and Profitability in Belgium

Figure 2: Statutory Profit Tax Rates and Effective Average Tax Rates by Member States

Figure 3: German perspective of international financial arrangements

Figure 4: UK perspectives of international financial arrangements

Figure A: Comparison of overall corporation tax bases of 5 EU Member States and the USA

Figure B: Effective Average Tax Rate across 5 EU Member States and the USA

- variation of tangible fixed assets to total balance sheet ratio

Figure C: Effective Average Tax Rate across 5 EU Member States and the USA

  • variation of equity to total capital ratio

Figure D: Effective Average Tax Rate across 5 EU Member States and the USA

  • variation of rate of distribution

Figure E: Effective Average Tax Rate across 5 EU Member States and the USA

  • variation of equity to total capital ratio

    TABLE OF CONTENTS

PART I: THE NEED FOR A STUDY OF COMPANY TAXATION IN THE

EUROPEAN COMMUNITY

  • 1. 
    BACKGROUND TO THE MANDATE .................................................................. 12
  • 2. 
    SOME HISTORY AND THE IMPACT OF THE RUDING REPORT ................... 13

    2.1. Earlier Commission initiatives in the area of company taxation .................... 13

    2.2. The work of the Ruding Committee 1990/92 ................................................. 14

    2.3. The follow-up to the Ruding report ................................................................ 16

    2.4. Lessons from Ruding for the present study..................................................... 16

  • 3. 
    IMPORTANT GENERAL DEVELOPMENTS SINCE THE RUDING REPORT . 17

    3.1. Company taxation and "globalisation"............................................................ 17

    3.2. The achievement of the Internal Market ......................................................... 19

    3.3. The achievement of Economic and Monetary Union...................................... 21

    3.4. EU company law developments...................................................................... 21

  • 4. 
    BASIC ECONOMIC CRITERIA FOR ANALYSING COMPANY TAXATION IN THE EUROPEAN COMMUNITY ................................................................................... 22

    4.1. General principles for the design of company tax systems ............................. 23

    4.2. The economic welfare effects of company taxation systems .......................... 25

  • 5. 
    THE STRUCTURE OF THIS STUDY .................................................................... 27

PART II: QUALITATIVE AND QUANTITATIVE ANALYSIS OF COMPANY TAX

SYSTEMS IN THE EU

A. ANALYSIS OF THE COMPANY TAX LAW

  • 1. 
    INTRODUCTION..................................................................................................... 28

    1.1. Why a Qualitative Analysis?........................................................................... 28

    1.2. What can such a qualitative analysis reveal? .................................................. 29

    1.3. Findings........................................................................................................... 30

    1.3.1. Tax Rates........................................................................................... 30

    1.3.2. Accounting Rules .............................................................................. 30

    1.3.3. Depreciation ...................................................................................... 31

    1.3.4. Provisions.......................................................................................... 31

    1.3.5. Losses................................................................................................ 32

    1.3.6. Capital Gains..................................................................................... 33

    1.3.7. Mergers and Acquisitions ................................................................. 33

    1.3.8. Group Relief (‘Consolidation’)......................................................... 33

    1.3.9. Inter – Company Dividends .............................................................. 34

    1.3.10. Inventories......................................................................................... 34

    1.3.11. Expenses............................................................................................ 35

    1.4. Conclusions..................................................................................................... 35

    1.5. "Member State Tables" ................................................................................... 36

B. QUANTITATIVE ANALYSIS OF THE EFFECTIVE LEVELS OF COMPANY TAXATION IN MEMBER STATES

  • 2. 
    INTRODUCTION..................................................................................................... 85
  • 3. 
    METHODOLOGY.................................................................................................... 86

    3.1. Existing approaches to measure companies' effective tax burden: backward and forwardlooking concepts ............................................................................................. 86

    3.1.1. ...................................................................Backward-looking approaches 86

    3.1.2. Forward-looking approaches............................................................. 87

    3.2. The theoretical framework of this study ......................................................... 87

    3.2.1. The taxation of a hypothetical investment ........................................ 88

    3.2.2. The taxation of a model firm............................................................. 91

    3.3. The inclusion of the German corporate tax reform......................................... 93

  • 4. 
    THE TAXATION OF DOMESTIC INVESTMENTS ............................................. 94

    4.1. The influence of domestic tax regimes on the organisation of companies' investment by assets and sources of finance........................................................................... 96

    4.1.1. Relevant economic measures: cost of capital, EMTR and EATR averaged across the EU..................................................................................... 96

4.1.2. The introduction of personal taxation ............................................... 99

4.2. Differences across the EU............................................................................. 101

4.2.1. Relevant economic measures: range of the cost of capital and EATR values across the EU................................................................................... 105

4.2.2. The introduction of personal taxation ............................................. 107

4.3. The position of the EU Member States......................................................... 108

4.3.1. Relevant economic measures: cost of capital, EMTR and EATR by Member States ............................................................................................... 108

4.3.2. The introduction of personal taxation ............................................. 117

4.4. The impact of the German tax reform........................................................... 121

4.4.1. Relevant economic measures: cost of capital and EATR before and after the reform.............................................................................................. 122

4.4.2. The introduction of personal taxation ............................................. 125

4.5. Neutrality and distortion effects: concluding remarks from the domestic analysis ....................................................................................................................... 128

  • 5. 
    TESTING THE ASSUMPTIONS OF THE MODEL............................................. 130

    5.1. Sensitivity of the average EU cost of capital and EATR to the changes in the economic model or level of taxes .................................................................................. 130

    5.2. Impact of the sensitivity analysis on the relative position of Member States 136

  • 6. 
    THE TAXATION OF TRANSNATIONAL INVESTMENTS .............................. 143

    6.1. The tax treatment of transnational investments ............................................ 143

    6.2. Transnational effective tax rates: detailed positions (cost of capital and EATR) of the EU Member States ........................................................................................ 144

    6.3. Allocation effects of international taxation................................................... 156

6.3.1. Capital export and capital import neutrality.................................... 156

6.3.2. Relevant economic measures: average cost of capital and EATR by country ......................................................................................................... 157

6.3.3. The tax minimisation approach: "tax efficient" average cost of capital and EATR by country ............................................................................ 162

6.4. Restrictions on imputation systems for transnational investments ............... 166

6.5. Effects of the German tax reform on international investments ................... 166

6.6. Neutralities and distortions in transnational investments: concluding remarks from the international analysis..................................................................................... 171

  • 7. 
    THE IMPACT OF HYPOTHETICAL POLICY SCENARIOS IN THE EU......... 172

    7.1. Purpose of the simulations ............................................................................ 172

    7.2. Scenarios involving domestic elements of corporation tax........................... 174

7.2.1. The Base Case ................................................................................. 174

7.2.2. Approximation or harmonisation of tax rates ................................. 176

7.2.3. Harmonisation of capital allowances .............................................. 178

7.3. Scenarios involving international elements of corporation tax..................... 179

7.3.1. Abolition of withholding taxes on interest...................................... 181

7.3.2. Harmonising the treatment of foreign dividends............................. 181

7.3.3. Taxation according to the parent country rules ............................... 182

7.4. Scenarios involving the relationship between corporate and personal taxes 184

7.5. Conclusions................................................................................................... 187

  • 8. 
    SOME EFFECTS OF TAX OPTIMISATION BY MEANS OF FINANCIAL INTERMEDIARIES ON THE EFFECTIVE TAX RATES ON TRANSNATIONAL INVESTMENTS BY GERMAN AND UK COMPANIES.................................... 197

    8.1. Introductory remarks ..................................................................................... 197

    8.2. The German parent's approach for optimising international financial arrangements (1999) ..................................................................................................................

....................................................................................................................... 199

8.2.1. The legal framework of the analysis ............................................... 199

8.2.2. Relevant economic measures: cost of capital and EATR of a German parent and its EU subsidiaries........................................................................... 202

8.3. The UK parent's approach for optimising international financial arrangements (1999) ....................................................................................................................... 207

8.3.1. The legal framework of the analysis ............................................... 207

8.3.2 Relevant economic measures: cost of capital and EATR of a UK parent and its EU subsidiaries ............................................................................... 209

8.4. Final remarks................................................................................................. 213

  • 9. 
    EFFECTIVE TAX RATES FOR SMALL AND MEDIUM-SIZED ENTERPRISES IN GERMANY, ITALY AND THE UK IN 1999 ....................................................... 214

    9.1. Tax Regimes in Germany, Italy and the UK ................................................. 214

    9.2. Cost of Capital and Effective Average Tax Rate .......................................... 216

9.2.1. Zero rate shareholder....................................................................... 216

9.2.2. Top rate personal shareholder ......................................................... 218

9.2.3. "Medium" rate shareholder ............................................................. 219

9.3. Concluding remarks ...................................................................................... 220

  • 10. 
    MEMBER STATES’ EFFECTIVE TAX RATES IN 2001 ................................... 220
  • 11. 
    COMPARISON OF THE RESULTS WITH THOSE OF THE RUDING AND BAKER

    &MCKENZIE REPORTS ...................................................................................... 224

    11.1. Comparison of the methodology and the assumptions with those of the Ruding and Baker and McKenzie reports......................................................................... 224

    11.2. Comparisons of the results in the domestic case........................................... 227

    11.3. Comparisons of the results in the transnational case .................................... 235

    11.4. Comparison of the results of the simulations of hypothetical tax reforms ... 240

    11.5. Results from other studies............................................................................. 241

  • 12. 
    CONCLUSIONS..................................................................................................... 241

PART III : COMPANY TAX OBSTACLES TO CROSS-BORDER ECONOMIC ACTIVITY IN THE INTERNAL MARKET

  • 1. 
    INTRODUCTION................................................................................................... 247
  • 2. 
    DIVIDEND TAXATION........................................................................................ 249

    2.1. Double taxation of profits and dividends distributed to corporate and individual shareholders .................................................................................................. 249

    2.2. Dividends currently not covered by the Parent-Subsidiary Directive ........... 251

    2.2.1. Different methods for taxing dividend payments............................ 251

    2.2.2. Obstacles relating to the imputation system.................................... 252

    2.2.3. Obstacles relating to modified classical systems or shareholder relief systems ......................................................................................................... 254

    2.3. Dividends covered by the Parent-Subsidiary Directive ................................ 254

    2.3.1. Assessment of the functioning of the directive in practice ............. 254

    2.3.2. Problems related to the implementation of the directive by Member States ......................................................................................................... 256

    2.4. Conclusion .................................................................................................... 256

  • 3. 
    THE TAXATION OF CROSS-BORDER BUSINESS RESTRUCTURING OPERATIONS

    ................................................................................................................................. 256

    3.1. Company tax arrangements impeding cross-border business restructuring operations ....................................................................................................................... 256

    3.2. Limits to the tax solution regulated in the Merger-Directive........................ 258

    3.2.1. The lack of Community legislation on company law...................... 258

    3.2.2. The narrow scope of the Directive .................................................. 259

    3.2.3. Insufficient coverage of restructuring operations by the Directive . 260

    3.3. Unsatisfactory outcome of the application of the Merger Directive ............. 261

    3.3.1. Doubts concerning the incompatibility of some national legislation with the Directive.......................................................................................... 261

    3.3.2. Problems not resolved by the Directive .......................................... 262 3.4. Conclusion .................................................................................................... 265

  • 4. 
    CROSS-BORDER LOSS-COMPENSATION ....................................................... 266

    4.1. The tax treatment of domestic losses and foreign losses generated by permanent establishments and subsidiaries .................................................................... 266

4.1.1. Domestic losses............................................................................... 266

4.1.2. Losses in Permanent Establishments .............................................. 268

4.1.3. Losses in subsidiaries...................................................................... 270

4.1.4. The computation of losses............................................................... 270

4.1.5. Consolidation of profits and losses ................................................. 271

4.2. Problems created by the absence of cross-border loss-compensation........... 272

4.2.1. Differing loss-compensation arrangements as factor for localisation decisions ......................................................................................................... 272

4.2.2. The cost of the absence of cross-border loss-compensation ........... 276

4.3. Conclusion .................................................................................................... 279

  • 5. 
    TRANSFER PRICING ........................................................................................... 279

    5.1. The increasing importance of transfer pricing as an international company tax problem and in the Internal Market ............................................................................. 279

    5.2. Basic concepts of transfer pricing and the Internal Market........................... 280

5.2.1. The technicalities of transfer pricing and the OECD Guidelines.... 280

5.2.2. Fundamental tax issues of transfer pricing in the Internal Market.. 283

5.3. High compliance costs in relation to transfer pricing ................................... 287

5.3.1. The lack of comparables as reason for difficulties in the application of the arm's length principle................................................................................ 287

5.3.2. Different application of the OECD Guidelines and transfer pricing principles ......................................................................................................... 289

5.3.3. Documentation requirements .......................................................... 290

5.3.4. Concrete estimates of the resulting compliance costs..................... 291

5.4. Quantitative information on transfer pricing................................................. 291

5.4.1. The Ernst & Young transfer pricing survey .................................... 292

5.4.2. Commission Services questionnaire on dispute settlement mechanisms in the area of transfer pricing .................................................................... 293

5.5. Double taxation and dispute settlement mechanisms ................................... 298

5.5.1. The need to avoid or at least swiftly remove double taxation in transfer pricing ......................................................................................................... 298

5.5.2. Existing dispute settlement/avoidance mechanisms ....................... 298

5.5.3. Shortcomings of the arbitration convention.................................... 303

5.6. Conclusion .................................................................................................... 307 6. DOUBLE TAXATION CONVENTIONS.............................................................. 308

6.1. The requirement to avoid double taxation in the Internal Market................. 308

6.2. The incomplete treaty network within the EU and its insufficient scope ..... 309

6.3. Double taxation cases unresolved by double taxation treaties...................... 310

6.4. Conclusion .................................................................................................... 313

  • 7. 
    TAX-RELATED LABOUR COSTS ...................................................................... 313

    7.1. Tax-related labour costs as a tax obstacle in the Internal Market ................. 313

    7.2. Costs for occupational pension arrangements in cross-border situations ..... 314

    7.3. Employee Stock Option Plans....................................................................... 317

    7.4. Conclusion .................................................................................................... 321

  • 8. 
    SMALL AND MEDIUM-SIZED ENTERPRISES ................................................ 321

    8.1. The particular situation for small and medium-sized enterprises ................. 322

    8.2. Company tax obstacles and partnerships ...................................................... 324

    8.3. The cumulative effects of VAT difficulties for small and medium sized enterprises ....................................................................................................................... 326

    8.4. Conclusion .................................................................................................... 329

PART IV : REMEDIES TO THE COMPANY TAX OBSTACLES IN THE INTERNAL MARKET

IV.A THE FRAMEWORK FOR POSSIBLE REMEDIES

  • 1. 
    THE CASE FOR STUDYING BOTH TARGETED AND COMPREHENSIVE REMEDIAL MEASURES ........................................................................................................... 330
  • 2. 
    THE ROLE OF THE EUROPEAN COURT OF JUSTICE IN REMEDYING TAX OBSTACLES IN THE INTERNAL MARKET ..................................................... 331

    2.1. The particular position of Community law and the European Court of Justice331

    2.2. The principle of equal treatment and the four freedoms ............................... 333

    2.3. Conclusions................................................................................................... 341

  • 3. 
    THE IMPORTANCE OF FINANCIAL ACCOUNTING FOR REMEDYING TAX OBSTACLES IN THE INTERNAL MARKET ..................................................... 342

    3.1. Fundamentally different approaches in Member States ................................ 342

    3.2. New developments since the publication of the Ruding report .................... 344

    3.3. Conclusions and practical examples ............................................................. 346

  • 4. 
    MONITORING OF THE UNIFORM APPLICATION OF EU COMPANY TAX LAW

    ................................................................................................................................. 349

IV.B TARGETED ACTIONS IN SPECIFIC AREAS

  • 5. 
    REMEDIAL MEASURES IN THE AREA OF DIVIDEND TAXATION ............ 350

    5.1. The classical system vs. the imputation system ............................................ 350

    5.2. Remedial measures concerning the Parent-Subsidiary Directive.................. 351

5.2.1. Desirable changes to the Directive.................................................. 351

5.2.2. Closer monitoring of the implementation of the Directive ............. 353

  • 6. 
    REMEDIAL MEASURES TO THE TAX OBSTACLES HAMPERING CROSS-BORDER BUSINESS RESTRUCTURING OPERATIONS.................................................. 353

    6.1. Relaunching the work on the adoption of Community legislation on company law ....................................................................................................................... 353

    6.2. Remedial measures concerning the Merger Directive .................................. 354

6.2.1. Desirable changes to the Directive.................................................. 354

6.2.2. Closer monitoring of the implementation of the Directive ............. 354

6.3. Remedial measures concerning structuring operations not covered by the Merger Directive........................................................................................................ 356

6.3.1. "Freezing" the tax liability on the cross-border transfer of assets... 356

6.3.2. Implications of the reorganisation of companies for the Capital Duty Directive ......................................................................................................... 357

  • 7. 
    REMEDIAL MEASURES CATERING FOR CROSS-BORDER LOSS-COMPENSATION

    ................................................................................................................................. 357

    7.1. The Commission proposal for a Directive (1991)......................................... 358

    7.2. Fundamental issues for cross-border loss-compensation schemes ............... 359

7.2.1. Ownership threshold and indirect ownership.................................. 359

7.2.2. Recapture of losses.......................................................................... 360

7.2.3. Horizontal vs. vertical offsetting of losses...................................... 362

7.2.4. Which rules apply in computing the losses? ................................... 362

7.2.5. Related problem areas ..................................................................... 363

7.3. Possible ways forward................................................................................... 363

7.3.1. Re-assessment and completion of the proposal of 1991 ................. 363

7.3.2. More general EU loss-consolidation............................................... 364

  • 8. 
    REMEDIAL MEASURES FOR ADDRESSING THE TRANSFER PRICING TAX PROBLEMS IN THE INTERNAL MARKET....................................................... 368

    8.1. The relationship between the OECD and possible EU activities on transfer pricing tax problems..............................................................................................................

....................................................................................................................... 369

8.2. Reducing the compliance cost relating to transfer pricing taxation .............. 371

8.2.1. Documentation requirements .......................................................... 371

8.2.2. Comparables.................................................................................... 372

8.2.3. Work on the application of the various transfer pricing methods ... 374

8.2.4. Co-operation between tax administrations...................................... 374

8.3. Avoiding and removing double taxation on transfer prices .......................... 375

8.3.1. Introducing mechanisms to prevent double taxation into the Arbitration Convention ...................................................................................... 376

8.3.2. Improving the dispute settlement procedures of the Arbitration Convention ......................................................................................................... 377

8.3.3. Advance Pricing Agreements.......................................................... 379

8.4. Conclusion .................................................................................................... 380

  • 9. 
    CO-ORDINATION OF DOUBLE TAXATION TREATIES ................................ 381

    9.1. The need for co-ordinated EU double taxation treaties ................................ 381

    9.2. Possible instruments...................................................................................... 382

9.2.1. Multilateral Convention .................................................................. 382

9.2.2. EC Model Treaty............................................................................. 384

9.2.3. Work on specific EU concepts........................................................ 384

9.2.4. Tax treaties with third countries...................................................... 386

9.3. Conclusion .................................................................................................... 386

  • 10. 
    REMEDIAL MEASURES FOR ADDRESSING TAX-RELATED LABOUR COSTS

    ................................................................................................................................. 387

    10.1. Pensions .............................................................................................................. ....................................................................................................................... 387

    10.2. Stock options................................................................................................. 387

  • 11. 
    SPECIFIC REMEDIAL MEASURES IN FAVOUR OF SMALL AND MEDIUM-SIZED ENTERPRISES....................................................................................................... 389

    11.1. Company tax measures giving relief to small and medium-sized enterprises389

    11.2. Remedial measures in the area of value added tax ....................................... 391

IV.C APPROACHES FOR A COMPREHENSIVE SOLUTION

  • 12. 
    INTRODUCTION................................................................................................... 393

    12.1. The case for a comprehensive approach to tackle the tax obstacles in the Internal Market ....................................................................................................................... 393

    12.2. What a comprehensive approach must do..................................................... 394

  • 13. 
    OPTIONS FOR COMPREHENSIVE APPROACHES TO EU COMPANY TAXATION

    ................................................................................................................................. 396

    13.1. Home State Taxation..................................................................................... 396

    13.2. Common (Consolidated) Tax Base ............................................................... 398

    13.3. European Union Company Income Tax........................................................ 400

    13.4. A Single Compulsory ‘Harmonised Tax Base’............................................. 400 14. COMPARING THE DISTINGUISHING FEATURES OF CONCEPTUALLY DIFFERENT

    METHODS ............................................................................................................. 401

    14.1. Comparing a Home State ‘base’, a Common (Consolidated) Base, and a Harmonised Base.....................................................................................................................

....................................................................................................................... 401

14.2. Existing level of comparability ..................................................................... 405

14.3. Distinguishing between mutual recognition and harmonisation................... 405

14.4. Mutual Recognition as preparation for Harmonisation?............................... 405

  • 15. 
    A PRELIMINARY EVALUATION AND ASSESSMENT – ARE THE EXISTING OBSTACLES REMOVED? ................................................................................... 406

    15.1. Compliance Costs ......................................................................................... 407

    15.2. Group Taxation ............................................................................................. 408

15.2.1. Groups, mergers and acquisitions ................................................... 408

15.2.2. Cross Border Loss Compensation................................................... 409

15.2.3. Dividend Taxation........................................................................... 410

15.3. Transfer Pricing Issues .................................................................................. 411

15.4. Tax–related labour costs ............................................................................... 411

15.5. Double Tax Agreements ............................................................................... 412

15.6. Small and medium-sized enterprises............................................................. 413

15.7. The taxation of Partnerships ......................................................................... 414

15.8. Value Added Tax .......................................................................................... 414

15.9. Potential ‘new’ issues and related technical issues: Foreign Income and Double Taxation Agreements ................................................................................................... 414

15.10. Conclusion ................................................................................................... 421

  • 16. 
    MANAGING THE TRANSITION & IMPLEMENTATION ISSUES – THE DYNAMICS : A GRADUAL SERIES OF STEPS OR A SINGLE LEAP? ...................................... 422

    16.1. Changing from one tax system to another..................................................... 422

    16.2. Competitors subject to different tax treatment.............................................. 422

    16.3. General Dynamics ......................................................................................... 423

    16.4. Member State participation – enhanced co-operation by a core group of Member States ....................................................................................................................... 424

16.4.1. Establishing the core group............................................................. 424

16.4.2. Expanding the core group ............................................................... 424

16.5. Optional or compulsory for Corporate Tax payers?...................................... 425

16.5.1. Partial or total participation?........................................................... 425

16.5.2. Selection by Sector and/or Size?..................................................... 425

16.6. Speed of momentum ..................................................................................... 427 16.7. Uncertainty about tax yield ........................................................................... 427

16.8. Accounting .................................................................................................... 428

16.9. The European Company Statute.................................................................... 429

  • 17. 
    REVENUE ALLOCATION : THE DIFFERENT METHODS.............................. 430

    17.1. General Background – separate accounting and formula apportionment ..... 430

    17.2. Allocation on the micro level – formula apportionment............................... 432

17.2.1. The examples of USA and Canada ................................................. 432

17.2.2. Contrast to EU situation.................................................................. 433

17.2.3. Complications ................................................................................. 433

17.2.4. Despite complications in practice it works ..................................... 434

17.3. Allocation on the Micro Level – ‘value added’ ............................................ 437

17.4. Allocation on the Macro Level ..................................................................... 437

  • 18. 
    ECONOMIC EFFECTS AND THE RESULTS OF THE QUANTITATIVE ANALYSIS SIMULATIONS...................................................................................................... 438

    18.1. Base costs...................................................................................................... 438

    18.2. Redistribution of tax revenues between Member States ............................... 439

18.3. Quantitative Analysis Simulations – relevance for Comprehensive Approaches440

  • 19. 
    CONCLUSIONS..................................................................................................... 442

    19.1. Equity.................................................................................................................. ....................................................................................................................... 444

    19.2. Efficiency ...................................................................................................... 444

    19.3. Effectiveness ................................................................................................. 445

    19.4. Simplicity, certainty and transparency .......................................................... 445

    19.5. Economic Welfare......................................................................................... 446

  • Annexes
  • Bibliography

    PART I: THE NEED FOR A STUDY OF COMPANY TAXATION IN THE EUROPEAN

COMMUNITY

B ACKGROUND TO THE M ANDATE

The tasks given by the mandate to the Commission essentially ask for illuminating differences in the effective level of corporate taxation and, at the same time, identifying the main tax provisions that may hamper cross-border economic activity in the Single Market. The analysis should take into account, inter alia , the results of the report of the Ruding Committee (1992). The tax policy issues involved in reducing tax–induced distortions should be highlighted and possible remedial measures examined. In doing so, the analysis should take into account the respective spheres of competence of the Member States and the Community.

The general background to the mandate for this study and the reasons why the Council requested a comprehensive study on company taxation in the EU can be found in the discussions on tax policy at the Vienna European Council of 11 and 12 December 1998. At Vienna, the Heads of government, in endorsing the ECOFIN Council’s call for a study by the Commission on company taxation, concluded that "Cooperation in the tax policy area is not aiming at uniform tax rates and is not inconsistent with fair tax competition but is called to reduce the continuing distortions in the single market, to prevent excessive losses of tax revenue or to get tax structures to develop in a more employment-friendly way" 3 . The mandate for the study subsequently agreed by the Council explicitly refers to this common denominator between Member States. The statement condenses the current challenges for EU company tax systems: to achieve an efficient allocation of resources in an undistorted Internal Market, to ensure an equitable distribution of tax revenues among Member States and to guarantee the technical feasibility of taxing mobile tax factors. It thus also creates a link between the study and the general debate on tax competition and the efforts to curb harmful tax competition in the European Community, as well as the employment effects of taxation.

In March 2000, the European Council in Lisbon placed the mandate in a new perspective: "The Union has today set itself a new strategic goal for the next decade: to become the most competitive and dynamic knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion" 4 . This overall objective adds strong emphasis on the need to achieve economically sound taxation systems that contribute to the smooth operation of the Internal Market and, in addition, to increase the competitiveness of EU companies. In other words, EU company taxation should contribute to more economic welfare in the Community. This forms an important guideline for the study. As already correctly noted in the Ruding report, one of the basic objectives of the Treaty of Rome, founding the European Communities, was to raise the welfare in all Member States and through the abolition of all obstacles to the efficient allocation of resources in the Internal Market to be erected.

The mandate is thus very topical. Notwithstanding the achievement of the Internal Market and the advent of Economic and Monetary Union, the European Union still has to confront a number of tax problems. One focus of this study is the efficient allocation of resources within the European Community - in other words, the undistorted location of economic activity and investment. This objective has not yet been achieved and, in giving the mandate for this study, the Council emphasised that company tax problems are one of the main reasons for this failure. As non-tax impediments to the functioning of the Internal Market have been mostly removed and the EU markets for goods, labour and capital become integrated, the allocation of

3 Vienna European Council 11 and 12 December 1998, Presidency Conclusions, pt. 21

12

capital (economic activities and investment) is increasingly sensitive to taxation. Firms and individuals benefit from the freedom to move their capital to locations where the highest after-tax returns can be obtained and their investment decisions are thus more responsive to differences in effective tax rates between countries than without the Internal Market. At the same time, however, tax obstacles may still hamper the exercise of this freedom. It is therefore logical for the mandate to call for the analysis of these two - different but related - factors jeopardising allocational efficiency in the Internal Market. At the same time, it should not be overlooked that important general international developments have also significantly changed the view on international tax problems since the Ruding report was published.

Against this background, this part of the study briefly considers earlier initiatives to harmonise company taxation in the EU. It then, in accordance with the mandate, takes a look on the outcome of the work of the Ruding Committee (1990/92) and continues with an assessment of important developments which together form the framework for the subsequent analysis. Finally, some criteria for analysing company taxation in the European Community and the underlying economic considerations are explained. These criteria are used later in this study to evaluate possible solutions to the problems highlighted by the study.

S OME HISTORY AND THE IMPACT OF THE R UDING REPORT

Earlier Commission initiatives in the area of company taxation

Since the early years of the Community various committees and experts have put forward proposals for harmonising crucial elements of the corporate tax regimes of Members States. On the basis of the Treaty of Rome, the perspective was right from the start the objective to create within the Community conditions similar to a true Single Market. The first initiatives in the area of corporate income tax were thus marked by proposals for radical reform by establishing uniform rules for the core problem of the corporate income tax, e.g. the double economic taxation of companies and their shareholders. In 1962, the Neumark Committee developed concrete suggestions for the harmonisation of the company tax systems in the Community in the form of an imputation system with a split rate for retained and distributed profits 5 . At that time, harmonisation was seen as the appropriate "soft" approach as opposed to uniform rules. The Tempel report of 1970 suggested the introduction of a classical dividend taxation system 6 . Both reports thus identified, among other things, the tax treatment of cross-border dividend payments, unless harmonised, as a major problem within an internal market.

In 1975, having regard to the growing integration within the Community, the Commission put forward a proposal for a directive providing for the corporate tax rate to fall within a range of 45 % - 55 %, a partial imputation system and a common withholding tax of 25 % on dividends. The European Parliament did not give an opinion on the proposal, producing only an interim report in 1980, which said that the tax base should be harmonised at the same time. The proposal was withdrawn in 1990.

In 1984/85, the Commission proposed to harmonise the rules for the carry-over of losses (three years carry back and unlimited carry forward). This proposal was discussed in the Council only in 1985 and later withdrawn. In 1988, the Commission produced draft proposals on the harmonisation of the tax base for enterprises. It was considered at the time that the objective of optimal allocation of resources, important for the establishment of the Internal Market, would not be reached unless there was at least some

5 Europäische Wirtschaftsgemeinschaft – Kommission: Bericht des Steuer- und Finanzausschusses (Neumark Bericht),

Brüssel 1962

6 Tempel, A.J. van den: Impôt sur les sociétés et impôt sur le revenu dans les Communautés européennes, Luxembourg CE

1970.

approximation of the rules to determine the taxable profits of enterprises. It was suggested this measure would produce greater transparency by the abolition of special incentive measures inside the tax base. The stability of the rules would also make it easier for enterprises to plan their activities in future. However, the proposals would still leave the necessary flexibility to Member States. This draft was never officially presented due to the reluctance of most Member States to support them.

These initiatives were not all successful for various reasons one of the most important of which is no doubt the unanimity requirement. Recognising the marked lack of success in progressing the above initiatives, in its communication of 1990 7 the Commission focussed on a different approach based on three ideas: direct tax measures should be geared to the completion of the Internal Market; they should be consistent with the principle of subsidiarity and all initiatives should be defined through a consultative process with the Member States.

On that basis, and following Commission proposals, three measures - two directives and one convention - were adopted in July 1990. The Merger Directive

8 is designed to defer taxation of capital gains resulting from certain categories of business re-organisations, in order to create within the Community conditions similar to those of an internal market. The Parent-Subsidiary Directive

9 deals principally with the elimination of double taxation on distributed profits between a subsidiary and a parent company of another Member State. Both directives apply since 1 January 1992. They are considered in more detail below. The principal objective of the Arbitration convention 10 is to establish a procedure to resolve transfer pricing disputes giving rise to double taxation. The convention entered into force on 1 January 1995 but its application is currently suspended as its prolongation beyond 2000 still awaits ratification in several Member States.

Two further proposals were made, both in January 1991. The first proposal aimed to abolish withholding taxes levied on cross-border interest and royalty payments between companies of different Member States. After almost four years of negotiations in the Council, no rapid progress seemed possible on this proposal and the Commission decided to withdraw it so as to be able to carry out a comprehensive review of it (November 1994). The other, the imputation of foreign losses proposal 11 is designed to allow an enterprise to offset against its results the losses incurred by its foreign subsidiaries and permanent establishments. The proposal was discussed in the Council in 1992, but not since then. It is considered in detail below.

The work of the Ruding Committee 1990/92

Also following the above-mentioned communication, in 1990 Commissioner Scrivener gave the Committee of Independent Experts on Company Taxation under the Chair of Mr Onno Ruding a precise mandate for the analysis of company tax issues. The Committee were asked to evaluate the importance of taxation for business decisions with respect to the location of investment and the international allocation of profits between enterprises, in order to determine whether existing differences in corporate taxation and the

7 Commission communication to Parliament and the Council: Guidelines on company taxation [SEC(90)601]

8 Council Directive 90/434/EEC of 23 July 1990

9 Council Directive 90/435/EEC of 23 July 1990

10 Convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises

[COM(90/436/EEC]. The extension of the convention to Austria, Finland and Sweden [OJ C 26 of 31/1/1996] is still pending ratification in some Member States as does the prolongation of the convention via a protocol signed on 25/5/1999 at the Ecofin-Council [OJ C 202 of 16/7/1999]

11 Proposal for a Council Directive concerning arrangements for the taking into account by companies the losses of their

permanent establishments and subsidiaries situated in other Member States [COM(94)595] of 24 January 1991

burden of business taxes among Member States led to major distortions affecting the functioning of the Internal Market. The mandate was based upon three main questions:

  • 1) 
    Do differences in taxation cause distortions in the functioning of the Internal Market?
  • 2) 
    If such distortions arise, can they be eliminated through the interplay of market forces and tax competition or is Community action required?
  • 3) 
    In the event that Community action is deemed to be necessary, what specific measures should be taken?

Unlike the Council mandate given for the present study, the mandate given to the Ruding-Committee did not explicitly call for analysing the tax obstacles to cross-border economic activity in the Internal Market.

The Ruding-Committee produced its report on 18 March 1992

12 . Its main findings were that tax differences can affect the location of investment and cause distortion of competition (the average cost of capital in every Member State was lowest for purely domestic investments); and that some convergence had happened in the past but the main distortions could not be reduced solely through market forces or through independent action of Member States. The Committee issued recommendations that fell essentially into two categories: (i) on the elimination of double taxation and (ii) on corporation tax (rate, base, system).

Among other things, the Ruding recommendations were very favourable about the three measures agreed in 1990 and recommended the further extension of the two directives. The recommendations also welcomed the proposals for directives made in 1991. A detailed list of the recommendations of the Ruding report and the follow-up is presented in Annex 1.

The underlying approach of the recommendations appears to be one of a "soft" tax harmonisation designed to establish a level playing field for free and fair competition between Member States, by setting minimal standards for European tax legislation. The Community would thus not impose uniform rules, but only the basic standards which the Member States should observe in designing their tax system. This requires for example minimal standards with respect to the basic tax rate, and maximal standards with respect to what could be allowed for systems and rates of depreciation, provisions, and the treatment of stock in trade. These standards would only determine the limits beyond which Member States could not compete with their tax systems. Within these boundaries Member States would remain free to determine their own tax systems. In some cases such as depreciation of goodwill, harmonisation would mean that all Member States accept the same rule i.e. either a common positive or a common negative answer to the question of depreciation. This softer approach to harmonisation would still leave Member States with considerable room for manoeuvre.

These conclusions were, inter alia , based on a detailed comparison of the factual corporation tax systems of Member States. Under this approach, "tax obstacles" appear to be indirectly covered inasmuch they constitute either cases of double taxation or distortions of competition.

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The follow-up to the Ruding report

The Commission indicated in its response to the report of June 1992 13 that priority should be given to the elimination of double taxation on cross-border income flows. A more qualified assessment was given of the second part of recommendations, as some of these seemed to go beyond what was strictly necessary at Community level. It was suggested that the proposed measures could have the effect of reducing the tax base, which might in turn involve an increase in tax rates.

The Council conclusions on company taxation of November 1992 14 introduced a number of criteria that should be taken into account in deciding whether action was appropriate at Community level. The need to eliminate double taxation was however recognised. At the same time, the need to ensure effective single taxation was stressed.

On, among other things, the basis of the Ruding recommendations, in July 1993 the Commission published two proposals to amend the two Directives of 1990 15 which were designed to extend the scope of these directives and notably to include more legal forms of enterprises. Both proposals received a favourable opinion of the European Social and Economic Committee and the European Parliament and are pending in the Council. However, so far no unanimous agreement could be reached in the Council of Ministers.

Since the mid-nineties, given the limited success of the earlier initiatives, a more comprehensive approach to tax policy has been reflected in EU tax policy discussions. In the area of direct taxation, the "traditional" harmonisation approach was complemented by the notion of tax co-ordination. At the informal ECOFIN meeting at Verona in April 1996, the Commission, contrasting the need for progress on tax matters in the EU with the limited number of actual decisions adopted in this area thus far, proposed a new and comprehensive view of taxation policy. This approach resulted in the 1997 tax package 16 to eliminate harmful tax competition within the EU which to date forms the most important ongoing EU initiative in the area of direct taxation. As noted above, it is in this context that the Council asked for a comprehensive study on company taxation in the EU to be undertaken by the Commission.

Lessons from Ruding for the present study

Generally, the basic problems raised and most of the issues considered by the Ruding-Committee are still relevant. Any current analysis of EU company tax problems can therefore usefully take into account the work presented in the Ruding report. After ten years, however, the analysis needs to be updated in many respects. First and foremost, the Internal Market and, for most Member States, also Economic and Monetary Union is now a well-established reality whereas it was only a prospect for the Ruding – Committee. In combination with the relative lack of progress on company tax issues on EU level this means that the existing problems highlighted by Ruding have now become even more acute. The “tax package” of 1997 has shifted attention from distortion of market competition through basic structural elements of the tax system, to distortions caused by specific privileged tax regimes. At the same time the notions of “legitimate protection” of tax revenue and its equitable distribution Member States were introduced. Finally in fields closely related to taxation such as financial accounting law and company law

13 Commission Communication to the Council and to Parliament subsequent to the conclusions of the Ruding Committee

indicating guidelines on company taxation linked to the further development of the internal market" [Sec(92)1118] of 26 June 1992

14 see "Guidelines on Company Taxation linked to the Further Development of the Internal Market – Council Conclusions";

press release (10088/92 – Presse 216) after the ECOFIN Council meeting of 23 November 1992

15 Proposal for a Council Directive on 26 July 1993 [COM(93)293]

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new developments took place like the increasing influence of international accounting standards on tax accounting and the agreement on the European Company Statute.

Moreover, the economic framework and business strategies have significantly changed since 1992. Technological developments and more open and deeply-integrated markets impact on the behaviour of companies and it is necessary to look into possible repercussions this may have on the taxation of these companies, especially in cross-border situations.

In essence the basic analysis of the Ruding report still remains valid today. Because of deeper integration, because also of new developments in tax competition with more emphasis on specific tax regimes and the equitable distribution of tax revenue among Member States, the pressing need for tax co-ordination has become much clearer. However since the Ruding report very little has been achieved in the field of specific regulation, and in that respect its impact has been disappointing.

I MPORTANT GENERAL DEVELOPMENTS SINCE THE R UDING REPORT

Company taxation and "globalisation"

Although it sounds like a hackneyed phrase it is nevertheless true that the globalisation process has significantly gained momentum since the Ruding Committee produced its report. It has profoundly changed the international economic landscape and, subsequently, created new challenges for national company tax systems. Globalisation means, among other things, more integration of international markets due to new technological possibilities and the gradual reduction of market access barriers. This development is, as such, independent of the Internal Market, but not surprisingly its effects are particularly strong for countries that are already integrated in one market in which the liberalisation process is relatively advanced (e.g. telecommunications, energy, public procurement, financial services). The same holds for the companies that are based and operating in that integrated market. The result is increasing competition, both between market operators and between Member States. Tax competition is an increasingly important aspect of the latter.

Generally, the basic elements of the tax systems of most countries were established when economies were relatively closed, capital movements limited and information technologies less developed than today. Inasmuch as the tax systems of some countries do not yet reflect recent economic and technological developments there is scope for companies to exploit loopholes and for other countries to try to attract business from those countries. Hence, the opening of EU economies within the Internal Market and of that Internal Market towards the rest of the world makes a case for collective action, in particular on the coordination of EU company tax systems.

More specifically, the globalisation process has involved a significant increase in international mergers and acquisitions. Box 1 below explains the general trend, but this is particularly marked within the EU. Market integration in the EU favours the re-organisation of investment and production. This results in increasing flows of investment, goods and services both between related and non-related companies. In 1999, EU multinational enterprises accounted for $510 billion in foreign direct investment (FDI), i.e. almost twothirds of global FDI outflows. The number of mergers and acquisitions involving EU firms increased to 12.796 in 1999, compared to 10.024 in 1998 and 8.382 in 1997, an increase of more than 50% in two years 17 . Western European mergers and acquisitions totalled $354 billion in sales and $519 billion in

17

purchases in 1999 18 , representing more than two thirds of the value of all world-wide mergers and acquisitions.

This development impacts on the way in which companies and tax administrations confront the taxation of cross-border mergers and acquisitions. When the Ruding report was written, these trends were already marked but were far from being as strong as they are today.

Box 1

The globalisation of businesses 19

The following figures illustrate that companies increasingly operate, in various facets, on a multinational scale. Tax administrations however broadly continue operating on a national scale.

• The number of multinational enterprises has increased from some 7,000 parent firms in 15 developed (EU and non-EU)

countries at the end of the 1960s to some 40,000 at the end of the 1990s. There are now approximately 63,000 parent firms and 690,000 foreign affiliates operating world-wide.

• Accordingly, international production, trade and investment have increased significantly. Sales of foreign affiliates worldwide

accounted for an estimated $13.6 trillion in 1999, compared to about $2.5 trillion in 1980, a figure twice as high as that of global exports. Multinational enterprises now account for about one-tenth of global GDP, compared to one-twentieth in

1982.

• This corresponds to a broad increase in foreign direct investment (FDI). The ratio of world FDI inflows ($865 billion in

1999) to gross domestic capital formation is now 14 %, compared to 2 % twenty years ago. In the same period, the ratio of world FDI stock to world GDP increased from 5 % to 16 %.

• At the same time, both the number and the value of mergers and acquisitions have increased significantly. The value of all

mergers and acquisitions (cross-border and domestic) as a share of world GDP has risen from 0.3 % in 1980 to 8 % in 1999 while the value of completed cross-border mergers and acquisitions rose from less than $100 billion in 1987 to $720 billion

in 1999. The total number of all mergers and acquisitions world-wide has grown at 42% annually between 1980 and 1999.

Looking towards the future, the structural technological changes driving the globalisation process are creating new challenges for taxation and may introduce "tax termites" 20 into national tax systems. The increasing use of electronic commerce could become a fundamental problem for the correct taxation at a national level of company profits 21 . Electronic transactions leave far fewer identifiable traces than "real" transactions and many traditionally "physical" products are becoming virtual (e.g. software, music, films or educational services). This makes it increasingly difficult to identify the economic operators, the territory from which a transaction is made, etc.

The use of off-shore centres expanded during the 1990s. Indeed, the Ruding report expressed serious worries about the prospect of “increased tax competition in a Single Market without internal frontiers”. In recent years, both the EU and the OECD have been engaged heavily in efforts to curb harmful tax competition.

18 UNCTAD (2000), World Investment Report 2000. Cross-border mergers and acquisitions and developments , United

Nations, New-York and Geneva, Overview, p. 13.

19 These figures are presented in UNCTAD (2000), Overview, p.9-13

20 Tanzi, Vito (2000), Globalization and the future of social protection, IMF Working Paper, WP/00/12, January 2000.

21 Estimates of the European Information Technology Organisation indicate that the EU will have about 80 million internet

users by 2002, the US 110 million. The total global electronic commerce is expected to reach a value of $ 330 billion by 2001-2002 and $ 1 trillion by 2003-2005. For the time being, however, 95% of e-commerce transactions are pure business to business operations.

Some commentators suggest that the taxation of corporate profits – already today a relatively minor source of state revenue – could eventually vanish as it will no longer be enforceable. Others argue that there is ultimately no economic case for taxing company profits as only individuals eventually bear taxes. However, others see economic justifications in taxing companies that consume public goods and stresses the practical link in levying both a corporate tax and a personal income tax. This study does not attempt to rehearse those arguments further; it is written on the clear assumption that company taxes will continue to be levied in the EU for the foreseeable future.

In this context it is however worth noting that, generally, corporate income tax has been fairly stable source of revenues for European governments in the past 10 years, after a period of growth in the 1970s and 1980s. Thus, at this point in time, there seems to be little empirical evidence of a "race to the bottom". Corporate income tax as a percentage of GDP varies considerably between the Member States. The following box gives some information in this respect.

Box 2 Corporate income tax in the EU (as % of GDP)

1970 1980 1990 1996 1997 1998 1999 2000 2001* 2002*

Belgium 2,4 2,2 2,4 3,1 3,5 3,6 3,5 3,5 3,5 3,4

Denmark 1,1 1,5 2,6 3,4 3,7 3,6 3,6 3,5 3,5 3,5

Germany 1,7 1,8 1,8 1,7 1,9 1,9 2,0 2,1 1,9 1,9

Greece - 0,5 1,7 2,2 2,4 2,9 3,2 3,3 3,3 3,2

Spain - 1,2 3,1 2,1 2,1 2,1 2,1 2,1 2,1 2,1

France 2,2 2,1 2,4 1,9 2,2 2,7 2,9 2,9 2,8 2,8

Ireland 1,3 1,5 2,2 3,6 3,7 3,7 3,7 3,5 3,4 3,3

Italy 3,0 2,4 3,7 4,2 4,3 3,9 4,1 4,1 3,9 3,9

Luxem 5,9 7,6 6,6 6,9 8,3 8,3 8,2 8,2 8,0 7,6 bourg

Netherl. 2,5 3,0 3,4 4,1 4,6 4,5 4,5 4,4 4,2 4,2

Austria - 1,4 1,3 1,8 1,8 1,8 1,7 1,7 1,8 1,8

Portugal - 0,9 2,5 2,7 2,8 2,8 2,9 3,0 3,1 3,1

Finland - 1,2 2,0 3,0 3,7 3,7 3,7 3,8 3,6 3,5

Sweden - 1,2 2,0 3,1 2,8 2,9 2,9 2,8 2,7 2,6

U K 3,7 2,9 4,1 3,8 4,3 4,7 4,7 4,8 4,7 4,7

Europe 2,2 2,2 2,9 2,7 3,0 3,1 3,2 3,2 3,2 3,1

  • The figures for 2001 and 2002 are forecasts.

Source of the figures: European Commission/Eurostat

The achievement of the Internal Market

The introduction of the Internal Market in 1993 significantly changed the scenery for the company tax systems of Member States. The Ruding report expressed serious worries about the prospect of increased tax competition in a Single Market without internal frontiers. As indicated above, the current work on the tax package and notably the Code of Conduct for business taxation is addressing the issue of harmful tax competition. But in an increasingly integrated Single Market in which harmful forms of tax competition are being removed, the competition effects of the general features of EU company tax systems become significantly more important. The Internal Market thus accentuates general tax competition between Member States and it needs to be assessed which welfare effects this increased competition has. The analysis of part II of this study can be appraised in this context.

Moreover, the Internal Market has affected the perspective of EU companies: they now increasingly change their focus from the national state towards the Union as a coherent economic zone. This is evidence of the success of the Internal Market. However, it makes all the more urgent to address the remaining tax obstacles that prevent EU companies from exploiting its full benefits and that still bias companies towards national rather than multinational economic activity. EU businesses have to deal with 15 company tax systems and tax administrations in one market. This creates efficiency losses and unnecessary compliance costs. These run against the potentially high positive welfare effects relating to the opening of national markets via Internal Market integration and puts EU businesses at a relative competitive disadvantage (compared to third country operators). These issues are considered in part III.

More specifically, when EU multinational companies define the EU as their home market they generally wish to re-align their business structures accordingly by creating pan-European business units instead of country-based organisations. Small and certainly medium-sized companies can also face this problem. Although operating at a smaller scale and in fewer Member States, the basic idea of a market for goods and services extending beyond the domestic market (be it via e-commerce or distance selling) translates into practical business decisions and subsequent tax considerations for small and medium-sized enterprises. The Internal Market thus concretely determines the way EU companies carry out their business within the Community.

The creation of pan-European business structures can essentially be achieved by three means (which are not mutually exclusive): (i) cross-border intra-group restructuring and expansion within the EU by way of acquisitions or joint ventures, (ii) fully-fledged mergers and (iii) establishment of foreign branches. Within the EU, this trend is clearly driven by the Internal Market. However, in a broader perspective it is reinforced because businesses tend to concentrate their activities more and more on core activities (on EU level or beyond), thus disposing of non-related business units and in turn purchasing related ones from other companies. The result of this process of business re-alignment is that the number of cross-border mergers and acquisitions and of intra-group transactions cross-border can be expected to rise even further.

In the context of this transformation of traditional country-based organisations into more transnational organisations it is often necessary to move earning capacity cross-border, either by moving (parts of) the business itself (including intangibles like goodwill) or the shares of the company containing this business. Within a group of companies, both production facilities for final products or components and service functions are thus increasingly concentrated and relocated. This is because business functions are no longer organised according to national territories but along production lines and the value chain. Put simply: whereas a large company traditionally used to have production, marketing and R&D facilities in every EU Member State, it now typically concentrates the production in one country, marketing in another and R&D in a third.

As a consequence of the reduced number of production facilities, the cross-border intra-group trade between the few remaining manufacturing units and the associated marketing/sales organisations in other Member States will grow significantly, both in volume and value. Where in the past export to affiliated companies in other Member States was the exception rather than the rule, it is now not unusual that manufacturing units export most of their products to affiliates. OECD estimates of the early 1990s already indicate that over 60% of all international trade is trade between related companies. Thus, the tax problems relating to transfer pricing take on a new dimension. While this issue is now dominating large parts of the current discussions on international taxation it was hardly mentioned in the Ruding report.

As regards the re-alignment of other functions such as marketing, R&D and group financing, these generally will be centralised either at the head office or in designated countries throughout Europe. Consequently the costs of these functions have to be allocated through some sort of cost sharing mechanism. Such cost sharing arrangements, sometimes involving a large number of units, are becoming more and more complicated.

In short, the process of creating pan-European business structures is today at the root of many specific cross-border tax problems that did not have the same importance when the Ruding report was produced. These problems are considered in detail in part III.

The achievement of Economic and Monetary Union

The above trends are reinforced by the introduction of Economic and Monetary Union. For the euro-zone countries the question of tax competition is even more important now that monetary and exchange rate policy are no longer nationally available policy tools.

22

Moreover, the transparency achieved by the single currency intrinsically generates a tendency of price convergence (certainly for tangible goods) within the euro-zone. Consequently, it becomes logical for multinational enterprises to set intra-group transfer prices EU-wide as a single harmonised price in euro per product or product group, regardless from which production facility the goods are purchased.

This concept, which is often referred to as "euro pricing", can already be widely witnessed in business practice. Transfer pricing is a traditional management tool and there is good reason to believe that euro pricing is now also used similarly, its advantage being intra-group disputes about price levels and optimum efficiency in the structure should disappear. In fact this concept treats the various factories in Europe as production lines that happen to be based in different Member States but all belonging to the same single European manufacturing unit. It is evident that such new tendencies impact on many features of international company taxation, notably in the area of transfer pricing.

Economic and Monetary Union thus increases the integration achieved by the Internal Market even further and. It also raises a further question as to which tax problems hamper the completion of an integrated EU capital market. This somewhat separate problem is not specifically mentioned in the mandate for this study. Moreover, unlike most other goods and services markets, the EU capital market currently still suffers from relatively fundamental non-tax barriers. The Commission has recently put forward a number of measures to remove the barriers to the Internal Market for financial services, and good progress is being made here in collaboration with Member States

23 . For the purpose of this study, however, general tax problems within the Internal Market are the most relevant.

EU company law developments

The basic agreement on the principles of the European Company Statute (Societas Europaea – SE) at the European Council of Nice provides a genuinely new element for analysing company taxation in the

22 See, for instance: Vanistendael, F., Redistribution of tax law-making power in EMU? , EC Tax Review 1998/2

23 See, for instance, the basic Commission communication "Financial Services: Implementing the framework for financial

markets: action plan" [COM(1999)232] of 11 May 1999 and the subsequent progress reports.

European Union

24 . After the adoption of the appropriate legislative acts EU companies and specific other legal persons governed by the law of Member States will be able, as from 2004, to merge, create a holding company or form a joint subsidiary under the legal form of a European Company. Moreover, any public limited-liability company with a registered office and headquarter within the Community will be able to transform itself into a European Company without going into liquidation, provided it has a subsidiary or a branch in a Member State other than that of its registered office. This supplements the existing possibilities for co-operation between firms established in a number of Member States under the European Economic Interest Grouping (EEIG) 25 . Proposals for a European Company Statute have been on the Internal Market agenda since 1970. The agreement thus constitutes an important break-through.

The basic idea of the European Company Statute is to provide companies in the EU with an additional company law option as how to organise their activities at EU level. The existing national systems remain unchanged. As from 2004 EU corporations will thus be able to carry out their business free from the obstacles arising from the disparity and the limited application of national company laws. The registration of the new European Company, its formation and personality are governed by the domestic laws of Member States. The same holds for the subsidiary rules. It is however possible to transfer the registered office to another Member State without winding up the old or having to create a new legal person. The regulation deals with a significant number of legal issues encountered by the European Company. Those issues that are not covered are in principle subject to domestic laws.

As regards taxation, an earlier draft of the European Company Statute regulation 26 included provisions on loss-compensation within the European Company (parent - subsidiary and parent - permanent establishment). However, these provisions were dropped in 1991 in order to facilitate agreement on the statute.

Ultimately, the tax regime applicable to the European Company is that of the Member State in which the parent-company is headquartered and, according to the general tax rules of the Member States, where the related subsidiary or permanent establishment is based. This is coherent inasmuch the whole idea of the European Company Statute is to remove certain company law obstacles but at the same time to keep companies anchored in the legal system of a specific Member State (and not in, say, an EU register or similar). Nevertheless, it is imperative to examine the existing body of EU law on direct taxation in order to identify necessary adaptations and, to consider the necessity of an appropriate EU tax regime. These issues are, among other things, addressed in parts III and IV.

B ASIC ECONOMIC CRITERIA FOR ANALYSING COMPANY TAXATION IN THE E UROPEAN C OMMUNITY

It follows from the foregoing that company taxation constitutes one of the most important remaining issue for the completion of the Internal Market and the full integration of the economies of Member States. At the same time all major initiatives to tackle the underlying problems have met with little success so far, while new external developments increase the competitive pressure on the EU as an economic zone and on EU businesses.

24 Conclusions of the Presidency, European Council, Nice 7-9 December 2000, pt.22. See also the underlying legislative

acts as proposed by the Commission: Amended proposal for a Council Regulation (EEC) on the statute for a European Company [COM(91)174]; Amended proposal for a Directive [COM(91)174] complementing the Statute for a European Company with regard to the involvement of employees.

25 Council Regulation (EEC) No 2137/85 of 25 July 1985 on the European Economic Interest Grouping (EEIG), OJ l L 199, 31/07/1985 p.1 - 9.

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Against this background, this section briefly presents some criteria for the assessment of company tax systems. It then offers some basic considerations of how these criteria can be used in the context of this study for assessing the welfare effects of different effective levels of taxation and persisting tax problems in the Internal Market. They also serve as assessment criteria for the possible solutions to those problemss described in parts III and IV of the study.

General principles for the design of company tax systems

It is common ground between economists and tax experts that an "ideal" company tax system has to be equitable, efficient, simple, transparent, effective and provide certainty. These inter-related general criteria can usefully serve as basis for the analysis of company taxation in the EU to be carried out in this study.

Equity

The requirement of equity has two dimensions. "Vertical equity" refers to the re-distributive feature of a tax system, i.e. to its capacity to operate a distribution of the tax burden among taxpayers according to their contributive capacity ("ability-to-pay-principle"). "Horizontal equity" holds that taxpayers who are in the same economic circumstances should receive an equivalent tax treatment. The concrete perception of these concepts is strongly related to societal values such as solidarity and fairness. Vertical and horizontal equity therefore strongly condition the political acceptability of a tax system. In the context of international company taxation, equity mostly relates to the fair allocation of the tax base between states in which international companies operate.

Inter-country equity traditionally involves three main principles: source-country entitlement, nondiscrimination and reciprocity. Under the "principle of source-country entitlement" the source country has the prior right to tax profits earned within its jurisdiction. This principle can be justified for efficiency reasons and it can help to achieve some redistribution of resources across countries, since the proportion of foreign-owned businesses is generally higher in relatively poor countries than in richer ones. It is also sometimes justified as a quid pro quo for the provision of public infrastructure and services in the source country. The "principle of non discrimination" implies that countries agree, usually on a bilateral basis, not to discriminate against foreign firms and shareholders in their tax laws. This principle is strongly linked to horizontal equity, since the same tax treatment is applied to similar companies independently of nationality considerations. The "principle of reciprocity" can, for instance, be illustrated by the requirement of equality of the rates applied to any withholding tax levied on interest, dividends and royalties by states involved in a tax treaty. Reciprocity applies to any tax arrangement which leads to similar effective tax burdens on foreign-owned investments. This is particularly relevant when states have strongly differing tax rules and practices.

Efficiency

Generally, taxes should be neutral and influence in as limited a measure as possible economic decisions, for example the choice of location of an investment. Otherwise, economic activities may not take place in the lowest cost location by the lowest cost producers. Investing in a low tax jurisdiction may yield higher after-tax returns on capital than a similar investment in a high tax jurisdiction despite a lower productivity of the inputs used. The result of locational inefficiency is thus a lower level of productivity of capital, and reduced international competitiveness and growth for the EU as a whole. Therefore, an efficient tax system is in principle neutral to economic decision-making.

Tax systems can however be used to correct or mitigate a market failure. To the extent that there are other distortions or imperfections in the market economy, taxes may offset these externalities, thereby enhancing economic efficiency. A typical example would be negative environmental consequences, not fully taken into account by an individual agent, which an imposed tax would mitigate by decreasing the activities harmful for the environment. There are also other instances when national governments will try to reduce existing (non-tax) incentives through the use of the tax system. A good company tax system should avoid distortions with regard to location, etc., unless these are deliberately decided (e.g. in economic “free zones” which are designed to boost economic development).

The two main concepts for considering the international economic benefits of efficiency and neutrality are "capital export neutrality" and "capital import neutrality". Both concepts are considered in detail in the analysis of the effective tax rates in part II .

Under "capital export neutrality" a tax system does not affect the decision by any specific company as to in which country to invest. Resident investors in a given country have no incentive to invest at home rather than abroad, or vice versa. The domestic/foreign composition of the investment income does not influence the world-wide tax thereon. Other things being equal, capital mobility would then tend to equalise the required pre-tax rates of return on investment across Member States, thereby eliminating differences in the cost of capital, and thus distortions in the demand for capital in the EU. Capital export neutrality could be achieved if income were taxed only in the investors’ country of residence and if there were no discrimination between domestic and foreign-source income in the capital-exporting country. This could be achieved if all countries applied the "world-wide" or "residence" principle, that is, levied taxes on the income accruing to their residents regardless of the source of that income.

A tax system achieves "capital import neutrality" when all investors, both domestic and from foreign countries, investing in any one national economy face the same after-tax rate of return on similar investments. This implies that the cost of capital and the tax rate for any inbound investment must not depend on the home country, that is the country of residence of the investor. In fact, the application of the residence principle can lead to cases where a domestic company investing in a given country is placed at a competitive disadvantage compared to a similar foreign company investing in the same country - because the tax rates applied in their home countries are different. Therefore, in order to avoid distortions of competition and to achieve capital import neutrality, income should be taxed according to the "source" or "territorial" principle. According to this principle, a government should tax all income originating within its jurisdiction at the same rate, regardless of the origin of the beneficiary of the income.

Inefficiencies do not only arise due to different tax treatments of cross-border investments. There may also be distortions in the decisions for the types of investment, as tax treatments applied to the assets used by companies or to the sources of financing of investment may vary considerably within and across countries.

Effectiveness

The effectiveness of a tax system refers to its capacity to achieve its basic objectives - to generate the desired level of revenues and to set the desired economic incentives. The effectiveness of a given tax system strongly depends on its interactions with other tax systems. For instance, measures like reduced statutory rates, accelerated depreciation allowances or investment tax credits may improve the international competitiveness of a country both by reducing the overall tax burden of domestic firms and by attracting foreign investments. However, in the case of a foreign multinational firm taxed on a residence basis in its home country, tax cuts in the country of source would have no effect on their total tax burden and, therefore, on investment. It would merely shift tax revenues from the source country to the home country of this firm as, under the credit method usually linked to the residence principle, firms receive a full credit for taxes paid abroad. The reduction of the tax liability in the host country is thus simply compensated by an increase of the tax liability in the home country (via a smaller tax credit).

It is self-evident that tax incentives (e.g. for investment) will, when efficient, directly reduce tax revenues Although, depending on the type of measure, the revenue reducing effects may vary significantly. The indirect trade-off is more complex. Foregone tax revenues, i.e. "tax expenditures", may be partially or fully offset as a consequence of an increase in investment and in the international mobility of tax bases, which in turn directly and indirectly generate increased tax revenues.

Simplicity, certainty and transparency

The requirement of a "simple" tax system is relatively straightforward. It implies the minimisation of the costs linked to the operation of the tax system. These costs are "compliance costs" for the taxpayers and "administrative costs" incurred by the administration to enforce the law. Administrative and compliance costs are intrinsic to any tax system: governments have to raise revenues and taxpayers have to comply with tax rules. However, one might wonder which amount of cost is proportionate for meeting these objectives. Generally, these costs are higher for international transactions involving more than one tax administration than for purely domestic operations. For instance, even the mere co-existence of two simple but conflicting principles – source or residence taxation –in principle creates cases of double taxation or unintentional double exemption that can only be overcome by appropriate – usually complex and costly - international agreements. The criterion of simplicity is thus linked to efficiency and effectiveness. Simple tax systems do not only mean relatively low costs; they usually do not provide intentional preferential tax regimes or unintentional tax arbitrage or tax avoidance opportunities. They may, however, also imply a loss of equity.

The requirement of simplicity also requires that the rules according to which taxes are levied are certain and clear to the taxpayer. Certainty relates to the stability of a tax system and of tax practices in a country. The uncertainty resulting from frequent changes in tax legislation and its interpretation has, as such, a negative or delaying impact on investment decisions. Simplicity and certainty are generally linked to the criterion of transparency of the laws, regulations and administrative procedures of a tax system. Transparency usually supports equity. For instance, it can help to avoid the replacement of direct State aid by tax incentives offered by administrations on a discretionary basis. Moreover, the transparency of a tax system is generally important for ensuring accountability of the policy-makers.

The economic welfare effects of company taxation systems

Broadly, one can say that if a company tax system meets some or all of the above criteria it contributes to more economic welfare. However, for the purpose of the study, it is necessary to clarify how these general criteria work within the EU in the context of the Internal Market and which trade-offs may exist. So far, it has been shown that the study is necessary to deal with two basic company tax issues of relevance in the context of European integration: (i) company tax obstacles to the Internal Market and (ii) differences in effective tax company tax rates or tax competition in general.

If one looks at the current situation of company taxation in the EU from the perspective of the above criteria it is possible to identify the risk of distortions to business decisions, in particular location decisions. At the same time, one can point to distortions in the provision and financing of public goods and/or in the distribution of tax burdens for a given supply of public goods and transfers. Both may reduce the overall welfare in the EU and both may work in different directions. By measuring the magnitude of the welfare loss, one can estimate the probable efficiency gains that would be generated by eliminating such distortions. This sort of measurement is very difficult, but valuable and meaningful conclusions are still possible.

Distortions to business decisions

It is fairly evident that differences in effective tax rates across countries (or within countries) for different types of investment, financing mode etc. will influence the incentive structure of investors. As mentioned above, according to economic theory, optimal decisions in a market economy should be based on prices that are not distorted. Taxation will affect the rate of return and therefore the prices an investor faces for different investment opportunities. To what extent taxation has a negative impact on investment decisions, depends on to what extent taxes offset or reinforce other distortions in the economy. There are two different aspects that need to be considered for approaching this question and for evaluating the effects of different levels of taxation. First, the impact of taxation on economic efficiency depends on the economic environment in which the tax is imposed. As pointed out above, taxes are sometimes used to correct or mitigate a market failure and/or offset specific externalities. This increases economic efficiency. On the other hand taxes may be used to compensate for physical or locational disadvantages. This use of taxes often decreases over all economic efficiency, although it may increase local or regional social welfare. The second aspect is what could be called the “transmission mechanism”, i.e. to what extent incentives lead to changes in actual behaviour. To the extent that economic agents are not affected by the imposed taxes, there will be no negative effect stemming from the level of taxation.

It is essentially an empirical question to what extent investment decisions are affected by taxes, as predicted by economic theory. Consequently, the associated welfare implications are also to a large extent an empirical question. Despite these difficulties in assessing the precise effect on investment decisions and welfare levels for ordinary citizens, it is still possible to draw valuable conclusions. If there are really significant differences in the effective level of taxation, then one can certainly argue that there would have to be a very complex structure of externalities to justify such variation in tax structure and tax rates. For example, on pure economic grounds it is hard to imagine that debt financing should be favoured above equity financing, since the negative macro effects to the economy from excess debt levels are substantial, particularly in times of financial turbulence.

It is also hard to imagine that it would be desirable that similar investments face markedly different effective levels of taxation purely because of their country location. Even if one cannot on economic grounds rule out the need for different levels of taxation in various countries, given their natural resources and skill levels etc, one must question the size of the differences and their dispersion. To the extent that there are no convincing economic justifications for these variations in levels of taxation across countries, types of investments and modes of financing, it can be concluded that, overall, the tax systems distort investment allocations. Decreasing these distortions would hence enhance economic efficiency and growth in the Union. It would contribute to a better allocation of resources in the Internal Market that is based on real economic factors rather than tax considerations.

Furthermore, as mentioned above, the tax differences also entail large administrative costs and they foster tax planning behaviour with further costs to the business community and society at large. With reduced tax distortions, these efforts would be put to economically better use.

To some extent, one could compare the situation with unifying the tax structure to the creation of the single currency. Certainly, the benefits from lower transaction costs are substantial (but often assessed to a fraction of a percent of GDP) but the benefits of a single currency go beyond that. It enhances growth prospects, thereby promoting a more efficient economy. Removing obstacles and creating a level playing field in the area of taxation, would have its largest impact on enhanced competition and value added to European consumers.

Differences in effective tax rates and tax competition

One of the elements that has changed most drastically since the early 1990s is what is commonly called "tax competition". As indicated above, the effects of globalisation and the creation of the Internal Market and Economic and Monetary Union may have given rise to, on the one hand, more tax competition between countries, both within the Internal Market and world-wide, for different tax bases, and, on the other, to specific initiatives designed to combat harmful tax competition. Reference is notably made to the work carried out in the context of the EU Code of Conduct for business taxation and the OECD Forum on harmful tax practices. Moreover, the European Commission has stepped up its efforts in the control of fiscal State Aids under the EC Treaty.

For the purpose of this study it is not necessary to review the history and results of these initiatives in detail. However, it is most important to note that as a result of these efforts many preferential tax regimes for companies are being changed, abolished or phased out. It follows from this development that the general features of the company tax systems of Member States will become more important for economic decisions than today. Therefore, differences between Member States in (general) effective company tax rates also become more important in comparison to a situation where the recourse to preferential regimes is possible. This development provides a common thread for the present study. EU enlargement will compound the underlying trends.

The welfare implications of tax competition in general are manifold, as tax competition affects the tax structure, the tax burden and, ultimately, the financing and the provision of public goods. Tax competition may affect to different extents the various existing tax bases, thereby inducing differentiation or approximations of effective tax rates, and the corresponding increase or diminution of a number of tax distortions. At the same time, it may induce a change in the overall tax burden, in the form, for instance, of a downward pressure (a “cap”) on the overall tax level. Its effect on welfare will then depend on a number of factors, such as the State expenditures and revenues structures, the overall public finance position of the State, etc.

To sum up, taxation ultimately involves a political choice and a trade-off between some costs in terms of efficiency and other goals, such as redistribution or reduction of market failures and funding of public goods and services, being pursued through taxation. The same applies in the European context.

T HE STRUCTURE OF THIS STUDY

Part II of this study is devoted to the detailed analysis of the company tax systems in the European Community. This includes a comparative analysis of the qualitative features of the company tax systems in Member States and the detailed determination and calculation of the effective rates of company taxation in Member States under various scenarios.

Part III then examines company tax obstacles in the Internal Market how market operators are hampered in the exploitation of the "four freedoms" and how their decisions on the location of economic activity and investment is influenced by concrete tax rules.

Finally, part IV looks into possible remedial measures for the obstacles identified in part III. This includes an analysis of both targeted measures for resolving specific tax problems as well as more comprehensive approaches that would resolve a majority of these problems at a stroke.

PART II:

QUALITATIVE AND QUANTITATIVE ANALYSIS OF COMPANY

TAX SYSTEMS IN THE EU

A. ANALYSIS OF THE COMPANY TAX LAW

1. I NTRODUCTION

Why a Qualitative Analysis?

Effective Tax Rates are principally the product of the nominal tax rate and the rules governing the computation of the tax base. In some countries financial accounting standards may influence to a certain extent the rules governing the tax base and specific tax incentives over and above the general computational rules, may also have an impact. Where there are large differences between the nominal and the effective tax rate a comparison of the structural elements which make up the tax base between countries can assist in the identification of the causes.

The Quantitative Analysis in Part II B includes the results of two economic models based on a ‘forwardlooking’ concept. One is based on a hypothetical simple manufacturing investment with a well-defined but limited number of computational rules and covers all the Member States. The other is based on a hypothetical model firm in the manufacturing sector and uses more computational rules, but does not cover all the Member States. (Part II B explains the models and the results in detail.) Through sensitivities and simulations the models identify and quantify the effect of certain structural elements of the tax base, including the nominal tax rate, on the effective tax rate.

The Qualitative Analysis complements this to enable a comparison between more of the structural elements. To the extent that the relationship between nominal rates and effective rates is relatively constant (as is illustrated by the quantitative analysis) it should be possible to identify similarities and differences between Member States’ approach to company taxation by comparing a number of the major structural features of each Member State’s tax legislation.

Ten structural elements of a typical tax system were identified 27 as being the most material in determining a corporate entity’s tax liability and hence the effective tax rate. These were:

Statutory rate, tax accounting rules, depreciation, provisions, losses, capital gains, mergers and acquisitions, group relief/consolidation (including inter-group dividends), inventories and expense deductions.

Some of these categories were further subdivided and the tables prepared for each Member State include descriptions of thirty eight sub-categories.

27 Messrs Tirard and Vanistendael, members of Panel I prepared a detailed paper ‘Measuring effective rates of corporate

income tax in the EU - a qualitative report’ on which this section draws heavily. That paper in turn made extensive use of IBFD data concerning individual Member States’ tax legislation.

The ten structural elements were selected as the most important ‘common’ elements. Specific measures such as those identified by the Primarolo Group 28 as providing for a significantly lower effective level of taxation than those levels which generally apply in a particular Member State and regarded as potentially harmful were excluded as they are the subject of separate initiatives.

What can such a qualitative analysis reveal?

In the tables the basic structural elements of a tax system are identified and for each Member State the approach adopted by that Member State is briefly explained. It is therefore possible to classify the different approaches for each structural element and identify groups of Member States who follow a similar approach, i.e. apply the same or similar treatment to particular elements. Groups or individual Member States who apply a different treatment, outside this ‘average’ can also be identified.

As mentioned above the Quantitative Analysis models necessarily summarise the structural elements of each Member State tax system and this Qualitative Analysis includes a number of important elements which could not be included in the models, such as certain rules governing capital gains, the treatment of losses including carry back and carry forward rules, and domestic consolidation.

In addition to facilitating a comparison of the different treatments by Member States of the basic structural elements the analysis also permits comparisons within the Member States to understand how certain features interact. For example some Member States do not tax certain capital gains nor give relief for capital losses whereas others tax and permit loss relief.

The analysis does not attempt to identify which approach to a specific element is the ‘best’. Each Member State has established its rules with the aim of constructing a coherent tax system to meet its particular needs. Without quantifying the effects of the specific measures it is not possible to say, for example that one particular method of calculating depreciation is better than another. The Quantitative Analysis, in particular in some of the simulations, is where the effect of particular tax measures can be quantified. However, the Qualitative Analysis does reveal the range and complexity of methods in use for example in depreciation, where the overall aim of each Member State is likely to be broadly similar and might raise the question of why such a diversity is necessary.

The tables do not seek to explain every aspect of each Member State’s tax system. As explained above only the basic elements have been included, and within each sub-category only a summary description of the principle rules has been presented. In many instances there are exceptions and slight amendments to the main rules applicable in certain circumstances but unless these were considered material they have been excluded.

In the context of this report the Qualitative Analysis is also useful in the consideration of the comprehensive approaches. In Part IV some of these approaches to EU company taxation are discussed, one based on the mutual recognition of Member States of each other’s tax codes and others based on a common or harmonised tax base. Where a group of the same Member States consistently follows similar approaches to a number of the structural elements those Member States would appear to be more able to participate in any comprehensive approach based on mutual recognition than those who in general follow different approaches. Where particular structural elements are characterised by a wide range of different approaches, or fundamentally different approaches, it might suggest that mutual recognition in this particular area would be particularly difficult, for example in the treatment of foreign income.

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A common or harmonised base implies, at the very least, that the basic structural elements of the Member States’ existing tax systems be aligned, or in the event of the existing national systems remaining alongside the new system in parallel, that a new tax code be drafted. The tabulation of the basic structural elements of Member States’ current systems illustrates the number of features which would need to be harmonised and the identification of groupings of Member States who already have structural similarities.

Findings

Tax Rates

The tax rate is the most visible element determining the effective tax rate in any corporate income tax system. Rates vary considerably from one Member State to another and in addition to the main statutory or ‘headline’ rate details concerning reduced rates, surcharges, minimum rates and special rates are also given where applicable. Two Member States, Germany and Italy, at the 1999 reference date had a ‘dual rate’ system distinguishing between retained and distributed profits. A number of Member States assist small and medium enterprises by having a specific reduced rate for companies whose profits are below a certain threshold or via a system of progressive rates but there is no standard definition. Certain industries are also sometimes subject to rates other than the main statutory rate. Certain types of income, such as capital gains are also subject to different rates.

With the exception of Ireland these variations from the statutory rate, although important to the companies subject to them, are not considered to be material to an overall comparison of EU rates, as the majority of enterprises competing across the EU will be subject to main statutory rate, adjusted in some cases for ‘temporary’ surcharges. Ireland is a special case because although the main rate is 40% there is a special rate of 10% applicable to certain companies including those in the manufacturing sector and for the purposes of this study it is more appropriate to consider the rate of 10% as the ‘main’ rate.

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The range of statutory rates is substantial. Ireland’s rate of 10% is the lowest followed by a group of Member States with rates around 30% (Sweden 28%, Finland 29%, Luxembourg 30%, UK 30%, Denmark 32%). At the upper end there is a group with rates around 40% (Belgium 39%, Italy 37% + 4.25%, Greece 40%). Germany’s rate was in this grouping but as from 2001 the new statutory rate is 25% plus ‘Trade Tax’ typically at 12 to13%. The extent to which these differences in statutory rates are reflected in effective rates is covered in the Quantitative Analysis in Part II B.

Accounting Rules

Differences between financial accounting rules and tax accounting rules can have a significant effect on effective tax rates. With a few specific exceptions the rules applied within each Member State are applied to all companies and sectors. Part IV explains in some detail the two ‘traditions’ of ‘dependence’ and ‘independence’. The tables show how three Member States (Ireland, the Netherlands and UK) take a similar approach in permitting differences between the financial accounting and the tax treatment of certain items. In the remaining Member States there is a much closer relationship between the two. However, because the financial accounting rules in operation across the EU are not completely harmonised to a certain extent such comparisons are rather difficult as both the financial accounts and the tax accounts of any given enterprise could be prepared according to different rules in different Member States. The Quantitative Analysis necessarily effectively assumes a common definition of accounting profits for the purpose of calculating a effective rates although the Tax Analyser work does include certain sensitivities concerning different accounting conventions and this is also referred to the section on the Economic

29 The information is based on applicable legislation as at 30 June 1999. The developing rate structure in Ireland underlines

the appropriateness of basing any comparisons on the lower rate.

Effects and the results of the Quantitative Analysis in Part IV C in relation to the Comprehensive Approaches. A more detailed comparison would require not only the tax treatment of particular transactions in all the Member States to be compared, but also the normal accounting treatment of the same transactions to be compared.

Depreciation

The significance of the rules on tax depreciation as regards the effective tax rate varies depending on the capital asset intensity of particular sectors of activity. When the rate of depreciation permitted for tax purposes exceeds the true economic rate of depreciation there is effectively an tax incentive for investment. In many Member States this appears to be the case.

The initial depreciable base for capital assets is uniform across the EU in that it essentially equates to the cost. The only exception is Greece where an element of revaluation is permitted in certain cases. The most common methods in use are the reducing balance and straight line or a combination of the two. There are also sundry other methods in certain circumstances. However, it is in the rates where the greatest variations are seen with some Member States also providing a number of rates depending on the type of asset involved.

Given the range of methods, rates and asset categories it is difficult to compare the depreciation rules without carrying out a series of computations. When choice is also involved any comparison becomes even more complex. In contrast some Member States

30 have a relatively simple system, which when combined with group relief and an unlimited loss carry forward can give the same amount of flexibility as the more complex approach where the amount and timing of depreciation ‘claims’ is an important factor.

It is more straightforward to compare which assets are not eligible for depreciation. Member States take quite different approaches to the depreciation of intangibles. Concerning patents and trademarks a number of different rates and methods are applied but the biggest contrast concerns the treatment of goodwill. Twelve Member States permit some form of depreciation but four Member States (France, Ireland, Portugal and UK ) do not permit any depreciation. In principle land is treated as a non depreciating asset across the EU. Some Member States do however permit in certain circumstances a deductible provision for a permanent loss in value of some non-depreciable assets. The rules for the accounting for tax depreciation in general follow the overall rules governing financial and tax accounting in the sense that in most Member States depreciation is only deductible to the extent that it is provided for in the financial accounts, whereas in Ireland, the Netherlands and UK this is not a requirement.

Provisions

Provisions may be divided into two main categories. First, the type whose purpose is to ensure that the financial statements of the company accurately reflect the true position in accordance with the accounting principle of prudence, taking into account the necessity to ensure that assets are not overvalued and that expenses are allocated to the correct accounting period. Second, the type whereby profits may be transferred to what could be considered a tax free reserve which could be considered a kind of tax incentive. The categories compared in the tables are mainly of the first type with the exception of pension reserves.

There are three main possibilities for the rules governing bad debt provisions: general provisions, specific provisions and provisions limited in value and all three are used in the EU; sometimes in combination. In

30 Compare for example the complexity of Spain’s rules, with a 10 year loss carry-forward limit to the relative simplicity of

the UK’s rules, with an unlimited loss carry forward.

some sectors there are special rules reflecting the relative importance of debts to the business activity, such as in banking and other finance activities.

As regards provisions for future expenses in the most part these are deductible although in several Member States provisions for repairs are not, possibly to avoid this category being used as a type of tax free reserve.

The major differences appear in the category of Pension reserves which could be considered to be in the second category of provisions as outlined above, a type of tax free reserve. However, this particular category of reserve is heavily dependent on the method by which pensions in general are provided for in individual Member States.

One approach would be the example of the UK where provisions for pensions could generally be described as non deductible, but where the general system is that a company does not have a liability to pay pensions, but agrees to make contributions to a separate pension fund which will eventually pay the pensions. In this case the UK company would have no reason to make a provision for pensions, it would be required to make a payment to the pension fund to the extent required by the fund, and the payment would be deductible. An example of the contrasting approach would be the situation in Germany where the liability remains with the employing company and the pension fund assets are not separated from the company’s. Companies have the option to fund pensions by provisions (discounted at 6%) to what could be considered a tax free reserve. However, given the summarised nature of the tables it is difficult to comment in any detail on the detailed implications in each Member State.

The main effect of these different approaches to pension provisions is that in some Member States

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companies have the opportunity to obtain a tax deduction on the basis of a provision and can therefore retain the cash within the company, in others deductions are received only when the cash has been paid out. Whereas the actual tax situation of two similarly prudent companies who provide for the future pensions of their employees might be similar, one company might be able to retain the cash in the business, the other not.

Losses

The possibility of carrying losses forwards for relief against future profits is particularly important for new business start ups if they are unable to utilise the losses before they time expire. Seven Member States still retain time limits and these vary between 10 years (2 Member States) and 5 years (4 Member States). The possibility of carrying losses backwards against previous profits also varies across the EU with nine Member States not permitting carry back at all and the remainder permitting it for between 1 year (3 Member States) and 3 years (2 Member States).

The approach of Member States to losses illustrates how structural elements in a tax system can change over time. Until a few years ago losses were subject to time expiry in a number of Member States. However, there is now far more scope to carry losses forward for longer periods and the trend is moving towards more generous rules. Similarly loss carry back is now more widely available than in the past and both these factors can have a significant impact on the effective tax rates of companies in the EU. This development is particularly marked because the time expiry of losses is permanent. Other elements, such as depreciation, generally tend to concern timing differences: for asset categories eligible for depreciation it is only the speed at which relief for its loss of value is obtained where there are differences between Member States.

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Loss carry forward provisions also illustrate the parallelism between structural elements and specific tax incentives. The latter are not considered here but it is interesting to note that an unlimited loss carry forward (structural) could be considered equivalent to an extended tax holiday to new businesses (incentive), although in fact the structural element could prove more beneficial in cases where losses are incurred during a tax holiday but time expire before they can be offset against subsequent profits.

Capital Gains

The treatment of capital gains can be divided into two main areas: tangible assets and intangible assets such as shares. In general the rules relating to tangible assets have moved closer together. All Member States observe the realisation principle; although in certain circumstances some Member States permit unrealised permanent losses in value to be recognised. With the exception of Ireland, France and Greece the applicable rate 32 of tax is the same as for trading income. Only Denmark, France and Italy have no provision for rollover relief and only Ireland (related to the separate rate of tax) and the UK (possibly for historic reasons) treat capital losses differently from trading losses. Only Denmark, Spain (for immovable property), Ireland and the UK make allowances for inflation when computing capital gains. Overall the treatment of capital gains and losses is broadly similar between Member States and the rate is largely determined by the normal statutory rate.

With respect to intangibles, specifically shares, there is greater contrast in treatment. A growing number of Member States exempt gains (and losses) on the sale of shares, or apply a reduced rate of tax to gains (and losses) whereas some tax (and relieve) at the normal rate.

Mergers and Acquisitions

With respect to mergers and acquisitions the situation is relatively similar across the EU. All Member States permit, under certain conditions, some sort of deferral of gains on mergers. The deferral can be achieved by two means: a full deferral until subsequent realisation (similar in effect to rollover relief), or a deferral by means of an instalment plan for tax payments due on any gains arising as a result of the merger. The deferral also provides for the transfer of the existing tax base of the ‘old’ company although there are generally strict rules concerning the transfer of losses.

This area of taxation is very technical and other than identifying the broad similarities it is not possible to provide a detailed comparison between Member States on the basis of the summarised information presented in the tables. However, it is worth mentioning that some Member States have extended the deferral rules provided for in the Merger Directive 33 to domestic mergers.

Group Relief (‘Consolidation’)

Member States fall into one of three categories as regards group relief. Denmark, and in a more restricted way France provide group relief on a world wide basis. Belgium, Greece and Italy in contrast have no provision for group companies to offset gains and losses. The remaining Member States provide for group relief within their jurisdictions although the precise rules concerning eligibility and the actual method of achieving the relief vary widely.

These differences, like the ones concerning loss carry back and forward, create fundamental permanent differences between the taxation of enterprises in different Member States. Depending on the geographical

32 Italy also has a reduced rate but only for certain gains on assets held > 3years and no roll over relief as such.

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spread, and corporate structure of an international enterprise its overall effective tax rate can be significantly effected by the range of rules across the EU.

Inter – Company Dividends

The main distinction between Member States concerns whether they operate a credit system or an exemption system. In general the exemption system is considered more advantageous to the tax payer. The ‘generosity’ of a tax system can also be measured by considering to what extent the relief granted in a Member State is more generous than the minimum required by the ‘Parent Subsidiary’ Directive

34 . The majority of Member States (Belgium, Denmark, Finland, France, Germany, Ireland, Luxembourg, The Netherlands, and the UK) are more generous than required by the Directive and make no distinction between dividends from Member States, and from outside the EU. Spain provides more generous relief than required under the Directive, but makes a distinction between EU and non EU dividends. Austria provides the minimum relief in accordance with the Directive but extends this to non EU dividends and finally Greece, Italy, Portugal and Sweden apply only the Directive.

This illustrates that the Directive is essentially operating as a minimum standard, which a majority of Member States are prepared to go beyond. To the extent that the Directive sought to provide for the same treatment across the EU it has not achieved this aim.

Inventories

In periods of low inflation the rules relating to stock valuation are unlikely to have a decisive impact on effective tax rates. However, even when inflation is low individual sectors may be subject to large variations in stock valuations when particular commodity prices vary, such as crude oil which over very short periods has fluctuated from over US $30 per barrel, down to US $10 and back to US $ 30. The distinction between Member States who permit the LIFO method of valuation, and those who do not can therefore be an important factor. The majority of Member States do accept this basis for stock valuation but Finland, France, Sweden and the UK do not.

In certain industries the extent to which certain administrative and overhead expenses are included in stock valuations may have a impact on the final stock valuation and hence the taxable profit and effective tax rate for a given period but the summarised tables to do not permit a detailed comparison between policies in different Member States. Such considerations would only be applicable in certain industries.

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Expenses

The basic rules concerning expenses are broadly similar. Although differences tend to be permanent rather than simply timing, and therefore potentially more significant, where there are differences they tend to be very specific and in most cases concern relatively low value items such as entertaining and travelling. However, without going into a great deal of detail it is not possible to make a general distinction between Member States.

The treatment of interest, specifically thin capitalisation is an exception. Several Member States do not have formal rules on thin capitalisation and this could lead to substantially different effects on the effective tax rates in Member States when comparing those who do have protective rules and those who do not.

Conclusions

On the basis of the tables it is not possible to draw general conclusions concerning the quantitative impact of the variations in the structural elements. However, it is clear that there are substantial qualitative differences in certain areas. Within each category one can identify ‘clusters’ of Member States who approach specific elements in a similar manner. However, it is difficult to identify a group of Member States who consistently, across all the structural elements, form a coherent grouping on the basis of their current tax systems or a group or individual Member State who are consistently outside the ‘norms’. In a number of cases the changes which would be required to bring Member States closer together would not appear to be major and in a number of the categories one could question the ‘need’ for the detailed differences.

It has been suggested that the tax treatment of structural elements of the tax base is compensatory and in terms of the overall effective tax rate a high nominal tax rate is indicative of a ‘narrow’ tax base, and a low nominal tax rate is indicative of a ‘broad’ tax base. Analysing the individual structural elements reveals that there are differences and these may themselves be compensatory, for example within a Member State restrictive rules on the depreciation of goodwill might be ‘compensated’ for by generous tax depreciation of tangible assets. ‘Compensation’ could therefore exist at two levels – at the rate/base level, and within the different elements of the calculation of the base. The qualitative analysis helps in identifying the potential compensatory factors, and in identifying the different clusters of Member States. For example with respect to the statutory rate ‘clusters’ around 30% and around 40% can be identified and at the ‘extremes’ the tables show that the highest rate is currently four times the lowest rate. For a single market this is a wide range. However, without measuring the relative financial effect of each of the structural elements any statement concerning the degree to which one measure compensated for another would be subjective. It is for this reason that the Quantitative Analysis is necessary in order to place objective values on the structural elements and test the hypothesis that the treatment of the existing structural elements is compensatory and to quantify the respective impact of these on the effective tax rate.

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    .

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    28

     ( incl ov pr the f or

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    - T - T 8a.G

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    m o m of t e s ate tax e b tax co m

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     de s t co ff ectiv o

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     r ece or e than 25 % o xe m 1 nt co pt f n) e. D grou

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    aining m mu de xce s in a f atio es nds

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    ld pay r

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    e f r mi em ld de C- e t

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    ar ket ar anuf ed incipl D om div ho the re duce (34 % o the no D iv ho ar fo N on Id ho subje bur (unl CF Th m ye m us pr

    • et

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St 9 I - Va - A 10.D - G - N - T

B. QUANTITATIVE ANALYSIS OF THE EFFECTIVE LEVELS OF COMPANY TAXATION

IN MEMBER STATES

I NTRODUCTION

This part of the study presents effective corporate tax rates on domestic and transnational investments in the 15 EU Member States taking the tax systems in operation in 1999. Moreover, in view of the structure and magnitude of the German tax reform approved in 2000, the analysis developed in this section also

takes account of the effects of this reform as of the 1 st January 2001.

Effective tax rates are tax rates which take into account not only the statutory corporate tax rates but also other aspects of the tax systems which determine the amount of tax effectively paid. In other words, they take into account the tax base and the manner (if any) in which corporate and personal tax systems are integrated.

Systems of taxing profits are, however, far too complex to be encompassed fully in the methodologies developed so far in order to calculate effective tax rates. A number of the special features of individual tax systems thus have to be ignored, for instance special sectoral incentives. However, the main features of the national tax systems are captured in the calculations presented in this report. The methodologies used in this study build, on the one hand, on a revised and extended methodology from the so-called King & Fullerton approach, set out by Devereux and Griffith (1998) and, on the other, on the "European Tax Analyser model", set out by the University of Mannheim and ZEW (1999).

The purpose of the quantitative analysis developed in this part of the study is twofold. First, it gives summary measures of the overall relative incentive (or disincentive) provided by each country's tax law to undertake various types of investment at home or in the other EU countries. This provides an indication not only of the general pattern of incentives to investment that are attributable to Member States' tax law, but also of the extent to which taxation in each country discriminates in favour or against inward and outward investment. Second, it identifies the most important tax drivers influencing the effective tax rate, that is the weight of each of the most important elements of a tax regime. From the pure point of view of economic efficiency, decisions related to the location and the organisation of an investment in terms of choices of assets and sources of finances should not be driven by tax considerations. In order to highlight the policy issues involved in reducing potential tax-induced economic distortions to the allocation of resources, this part of the study investigates the contribution of particular features of taxation to the lack of neutrality in taxation systems.

Taxation is, of course, only one of the determinants of investment and financing decisions. Among the other determinants of investment behaviour are: the market size, the short and medium-term economic outlook in different markets and countries; the cost of capital in relation to the cost of other productive inputs; the profitability of investments; the availability of finance and government investment grants, the existence and quality of economic infrastructure, the availability of qualified labour. The geographical accessibility of markets, transport costs, environmental standards, wage levels, social security systems and the overall attitude of government all play an important role too. The relative importance of these determinants varies between countries and over the business cycle. Nevertheless, as economic integration in the EU proceeds in the context of Economic and Monetary Union and the internal market, in an environment where capital is fully mobile the pattern of international investment is likely to be increasingly sensitive to cross-border differences in corporate tax rules.

Other taxes, such as those on payroll and social security contributions or energy taxes may also affect costs, and thus the location of investment, particularly in the short to medium term. At national level, EU governments have a number of common concerns regarding the corporation tax which is the focus of the mandate given to the Commission by the Member States. The main focus of this report is corporation tax including its interaction with some elements of personal tax.

In this part of the report, the cost of capital, marginal effective tax rates and average effective tax rates are computed for different types of domestic and transnational investments in the manufacturing sector in each Member State. The contribution of various features of Member States' tax laws to the lack of neutrality of the tax regimes is assessed by means of a series of simulations. Some cases of the effective tax burden of SMEs as well as some cases of tax planning are analysed separately.

This quantitative analysis relies heavily on the report "The effective levels of company taxation in the Member States of the EU", produced for the Commission by the Institute for Fiscal studies, the University of Mannheim and the Centre for European Economic Research (ZEW) of Mannheim. The calculations presented in the boxes "Tax Analyser" are based on the report "Computing the Effective Average Tax Burden for Germany, France, the Netherlands, the UK, Ireland and the USA using the "European Tax Analyser" Model" produced for the Commission by the University of Mannheim.

M ETHODOLOGY

Existing approaches to measure companies' effective tax burden: backward and forwardlooking concepts

The existing approaches to measure the effective tax burden are based on two types of analysis implying either backward-looking concepts or, alternatively, forward-looking concepts. Both approaches have their respective advantages and disadvantages and can lead to different quantitative results. Even if the results of the application of different methodologies are not directly comparable, the existence of tax induced distortions seems to be confirmed by a variety of studies regardless of the particular approach adopted. Nevertheless, the size of the observed differences as well as the relative situations of countries do vary depending on the methodology applied.

Backward-looking approaches

One approach to measure the effective tax burden in policy-making is based on aggregated data from existing firms. As this looks at the capital stock, profits or other relevant data accumulated in the past it is called a backward-looking approach. By referring to the observation of ex-post data, it measures "actual" rather than "hypothetical" tax rates. Within this framework, one can distinguish between approaches based on firm-specific data or on aggregated economic data.

Approaches based on firm-specific data generally express the effective tax burden as a percentage of the tax liability relative to the profits from companies' annual accounts. Data can either be taken from individual financial statements or consolidated returns 35 . Although these measures have the advantage of showing the actual tax burden borne by companies, they could be misleading if they are used to assess and compare the effective domestic tax burden in international comparisons. This is because approaches based on ex post company-specific data do not take into account the interaction between personal and corporate taxation which is relevant when the marginal investor is domestic. In addition, they fail to measure the incentive for additional investment or to correctly consider the foreign source income from individual or consolidated company accounts. Moreover, the data sometimes tends to show significant yearly fluctuations depending on business cycle effects. For these reasons backward-looking profit based

35 Recent studies of Buijjnk et al (1999) and Nicodème (2001) applied a backward-looking approach based on the

financial data of EU companies in order to estimate effective tax rates in the manufacturing sector.

indicators are imprecise indicators of the investment incentives of taxation. But, they do permit an assessment of effective actual tax burdens by firm size, sector or industry, which may be useful in addressing equity concerns.

Measures for the tax burden using aggregate economic data from national accounts are computed as a percentage of domestic corporate taxes (in general only corporate income tax) relative to various income measures, such as aggregated domestic corporate profits or the corporate operating surplus. Although these formula are mathematically correct, it is hazardous to make an international comparison of corporate tax rates on the base of aggregated economic data. On the one hand, the methods and definition of the National Accounting Systems differ between countries and, on the other, these data are not sufficiently developed to distinguish different sources of taxation. Moreover, as is the case for tax rates based on firm-specific data, tax rates based on macroeconomic data sometimes tend to show significant fluctuations from one year to another due to business cycle effects.

Forward-looking approaches

Consequently, the most commonly used indicators for analysing the impact of taxation on investment behaviour are based on forward-looking concepts and involve calculating and comparing the effective tax burden for hypothetical future investment projects over the assumed life of the project or, alternatively, the effective tax burden for hypothetical future model firm behaviours, using the statutory features of the tax regimes.

These approaches permit international comparisons and are especially tailored to "isolate" the effects of taxation thus providing an indication on the general pattern of incentives to investment that are attributable to different national tax laws. It is worth noting that the results of the application of these approaches rely on the assumptions underlying the definition of the hypothetical investment in terms of assets and financing and of the future firm behaviour in terms of total cash receipts and expenses, assets and liabilities over time. Moreover, these approaches do not take into account in the computation all the features of a tax system.

The results produced by the application of these approaches summarise and quantify the essential features of the tax system in a relatively straightforward manner. They provide an estimate of the discrimination of Member States' tax law between various forms of investment and different sources of financing as well as of the discrimination in favour or against inward and outward investment. They also identify the most important tax drivers influencing the effective tax burden. Therefore, these approaches can illustrate the distortive effect on the allocation of resources of a tax system for typical investments or typical firm behaviour, which may be useful in assessing the investment incentives of taxation and addressing efficiency concerns.

Nevertheless, the actual effect of the tax system will, of course, vary according to the particular investment project which a company undertakes. Moreover, the measurement of effective corporate tax differentials does not provide evidence of the effects of taxation on actual business location.

The theoretical framework of this study

The approach taken in this study is based on the general forward-looking framework introduced above and is in part similar to that taken by previous studies of the international comparison of effective tax rates on capital income, and in particular by the OECD (1991), the Ruding Committee (1992), and Baker & McKenzie (1999) 36 .

The computation of the effective corporate tax rate builds on two different methodologies which involve calculating the effective tax burden either for a hypothetical future investment project or, alternatively, for a hypothetical model firm behaviour. In technical terms, the analysis relies on a revised and extended methodology from the so-called King & Fullerton approach, set out by Devereux and Griffith (1998) and on the "European Tax Analyser" model, set out by the University of Mannheim and ZEW (1999). The main computations are based on the hypothetical future investment approach and they are supplemented by the "European Tax Analyser" model, which utilises the model firm approach.

Considering that each methodology is based on different hypothesis and restrictions, it has been considered useful to compare the results of these two different approaches in order to test them and, possibly, to confirm the general trend arising from the computations.

It is worth noting, however, that the analysis of a hypothetical investment is more complete, in the sense that it covers a broader range of cases for all the European Union Member States. For technical reasons linked to the availability of data and the nature of the model, the "European Tax Analyser" only covers a limited numbers of countries and cases.

The main body of the quantitative study thus relies on the application of the analysis of a hypothetical investment and is complemented, where relevant and possible, by results arising from the computation of the behaviour of a hypothetical model firm.

The taxation of a hypothetical investment

The King and Fullerton approach (reviewed by Devereux and Griffith) is based on the assumptions that all markets, especially production factors markets, are competitive and the production function has the usual properties, notably constant return to scale. In this situation, the decision to invest and locate somewhere is influenced only by capital taxation, not by taxes or contributions on other factors such as wages, energy etc. and the incidence of these other elements of the tax system is borne by other agents (see Annex A for a more detailed description of the methodology).

This approach computes directly the tax "wedge" between the rate of return on investment of a series of hypothetical investments and a given alternative rate of return on savings. In the absence of taxes, when the decision taker invests money to finance a project he earns a rate of return equal to that earned on the project itself. When a tax is introduced, the two rates of return can differ. The size of the tax wedge depends, among others, upon the system of corporate taxation, the interaction of taxation and inflation, the tax treatment of depreciation and inventories, the treatment of different legal forms of income, and a number of other elements linked to the definition of the tax base. It is clear, therefore, that the effective tax rate on an investment project depends upon the industry, where it is located, the particular asset purchased, the way the investment is financed, and the identity of the investor who supplies the finance.

  • a) 
    Cost of capital and Effective Marginal Tax Rate

The basic approach for the computation is to consider an incremental "marginal" investment located in a specific country undertaken by a company resident either in the same country (domestic case), or in

36 Several studies have used forward-looking methodologies to analyse the impact of taxation on the incentives to invest.

Among them, see : Bovenberg et al (1989), the Report of the Canadian Department of Finance (1997), Bordignon et al (1997), Le Cacheux et al (1999), Bond and Chennels (2000).

another country (transnational case). A marginal investment is one whose expected rate of return is just sufficient to convince the investors that the project is worthwhile. This minimum rate of return is widely referred to as the "break-even" rate of return. Given a post-tax rate of return required by the company's shareholder (for instance on interest earned in some alternative use of the capital), it is possible to use the tax code to compute the pre-tax rate of return of the hypothetical investment, that would be required in order to obtain the minimum post-tax rate of return. This is known as the cost of capital.

A company that is contemplating a new investment project has, on the one hand, to compute the overall cost of the asset, taking into account not just the initial outlay, but also any reduction of that outlay due to tax relief received as a result of the investment. On the other hand, the company must also calculate the after-tax returns that it expects the investment to generate in the future. The company would undertake the investment provided the present value of the after-tax profits from the investment is greater than the initial cost of the asset minus the present value of any tax relief. Hence, the principal impact of taxation on investment is through the cost of capital. The difference between the cost of capital and the required post-tax rate of return (expressed as a percentage of the cost of capital) is known as the effective marginal tax rate (EMTR) that is, the rate applied to a marginal investment.

For example, if the minimum rate of return required by the company's shareholder is 5% and the company must earn 6.67% before tax (the cost of capital) in order to pay this 5% rate of return to the investor, then the effective marginal tax rate is 25% (6.67%-5%/6.67%). The difference between 6.67% and 5% represents the impact of taxation on the cost of capital.

This approach is based on the presumption that companies will undertake all investment projects which earn at least the required rate of return. For a given required post-tax rate of return, the more severe the tax system, the higher is the cost of capital, i.e. the required pre-tax rate of return, and hence the less likely that any specific investment project will be undertaken. In comparing such investments in alternative locations, the underlying economic model would predict that, ceteris paribus, locations with a higher cost of capital or EMTR would have less investment.

  • b) 
    Effective Average Tax Rate

The current study goes beyond this approach, however, to also consider the effective "average" tax rates (EATR) on various forms of incremental investment which are more profitable then the marginal investment explained above. The rationale for doing so is that often a company that has taken the decision to undertake a specific profitable investment has to choose between two or more mutually exclusive locations. Examples include the location decision of multinationals in choosing a site for one new factory, and the choice of investment projects in the presence of binding financial constraints. In this case, the impact of taxation on the choice is likely to be measured by the proportion of total income taken in tax in each location. The measure used in this study is computed as the net present value of tax revenue expressed as a proportion of the net present value of the income stream (excluding the initial cost of the investment). The literature commonly defines the effective average tax rate as the effective tax burden held by an infra-marginal (average) investment as opposed to the effective marginal tax rate, which is the effective tax burden held by a marginal investment.

In this study, two computations are therefore made for each of the alternative hypothetical investment projects with two different rates of profitability, which illustrate respectively:

  • I) 
    The EMTR, where the real before tax return is the minimum rate which is required to undertake the investment ("marginal investment"),

II) The EATR, where the incremental investment project is not marginal, but generates a considerably higher rate of return ("average investment")

Box 3: Properties of the measure of effective average tax rate used in the computation

The properties of this measure have been explored by Devereux and Griffith (1999).

One attractive feature of the measure is that, in the absence of personal taxes, the EATR for marginal investments is identical to the EMTR. At the other extreme, for extremely profitable investments, the EATR tends to the statutory tax rate. An example of this is given in Figure 1, which presents a range of values of the EATR for different levels of profitability for Belgium. The figure shows the average EATR for the investments analysed in this study.

Figure 1 Effective Average Tax Rate and Profitability in Belgium - only corporation taxes

- average across all forms of investments,

45%

40% Statutory

35% Tax Rate

30%

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20% EMTR

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5%

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Level of Profitability ( p )

The line begins at the marginal investment, where the EATR is the same as the EMTR. When the level of profitability of the investments rises, so does the EATR. The reason is that allowances against the cost of the investment become relatively less important when the cost of investment becomes smaller relative to the returns. At very high levels of profit, the stream of income from the project far exceeds the costs. In this case, virtually the only element of the tax regime to matter is the overall statutory tax rate. When profitability reaches very high levels, the EATR gets very close to the statutory Belgium tax rate of 39%.

The equivalent figure for each of the other 14 EU Member States is presented in Annex D.

  • c) 
    Hypotheses and assumptions

Estimates of the effective tax rates on domestic and transnational investments in the 15 EU Member States are presented as at June 30, 1999. In the transnational case, the analysis is extended to the case of investors located in the USA and in Canada. Calculations consider primarily corporation tax in each country, but also include the effects of personal income taxation of dividends, interest and capital gains.

Several assumptions need to be made in order to define the hypothetical investment project analysed, and the economic conditions under which it is assumed to take place. Besides these, the exercise is limited to parameters of the various tax regimes which can be captured in the context of the analysis of a hypothetical investment project. Thus, as in every study of this kind, the hypothetical investments analysed are rather simple manufacturing sector investments, and a number of detailed features of actual tax systems cannot be incorporated in the model as for instance different kind of provisions in the different Member States. The fact that the analysis is limited to the manufacturing sector is due to the impossibility to quantify, in the framework of the model the number of different specific provisions applying to the service sector across the EU Member States (e.g. the special provisions applying to the financial service sector). Moreover, this approach does not, for methodological reasons, take into consideration all the relevant features linked to the existence and functioning of different tax systems. It does not, for instance, quantify the effects on the tax burden of the possibility of consolidating profits and losses throughout the EU because, by definition, it only takes into account investments which make profits. The quantification of compliance costs is also impossible.

The computation is also based on the hypothesis that all taxes due are paid and therefore that the results are not affected by different levels of tax enforcement. In fact, there is no reason to believe, nor is there any empirical evidence, that possible shortcomings in the enforcement of tax laws have a significant impact on the location of business activities within the EU.

The assumptions and parameters underlying the computation are given in Annex B. Sensitivity analysis investigates the impact of the assumptions and of some elements of tax systems on the results.

It is worth noting that, for the sake of comparison, the definitions of investment and of the economic variables underlying the computations are the same for all countries considered. The purpose of the analysis is to understand how taxation influences the profitability of the same hypothetical investment in different countries and not to give a picture of the actual economic situation for each country.

Due to these assumptions and restrictions, the numerical estimates arising from the application of the model should be interpreted with caution and should be understood as summarising and quantifying the essential features of tax systems.

The taxation of a model firm

The conceptual framework of a model firm approach is significantly different. No explicit assumption is made about the competitive situation of production factor markets and therefore the incidence of factors others than capital taxation, but implicitly the reasoning is based on the assumption that some elements of the non-corporate tax system (for instance some payroll taxes) are in fact borne by companies. So this methodology differs from the Devereux and Griffith model as far as the incidence of some elements of tax systems on companies is concerned. It can be argued that it is somewhat arbitrary to consider that only some elements of the non-corporate tax system are borne by firms. Nevertheless, the purpose of the present study is not to test the empirical relevance of the "Tax Analyser" model hypotheses. As already mentioned, the data arising from the application of the Tax Analyser model are presented only with the purpose to test and, possibly, confirm the general picture arising from the application of the "hypothetical investment" approach. (The methodological framework and the hypotheses and assumptions of the Tax Analyser model are given in Annexes G and H).

The calculations are based on an industry-specific mix of assets and liabilities taking as a base case a typical medium-sized manufacturing company. Based on this (in general, existing) capital stock, the future pre-tax profits are derived on the basis of estimates for the future cash receipts and cash expenses associated with this initial capital stock. In order to determine the post-tax profits the tax liabilities are derived by taking into account the tax bases according to the national rules and then applying the national tax rates.

This approach does not need to characterise optimal investment behaviour but it relies heavily on the particular characteristics of the model firm, in particular the initial capital stock and the expected development of the capital stock over the simulation period.

  • a) 
    Average effective tax rates

The tax effects of infra-marginal investments, i.e. of investments that are more profitable than the marginal investment, are central to this model and the taxation of an existing capital stock is analysed. Consequently, this model only computes effective average tax rates which measure the effective tax burden of projects that earn more than the capital costs.

The effective average tax rate is expressed by the difference between the pre-tax and the post-tax return of the capital invested in the corporation divided by the pre-tax return.

  • b) 
    Hypothesis and assumptions

Estimates of the effective average tax rates for Germany, France, the Netherlands, the UK, Ireland and the USA are presented as at 1999. The calculations consider primarily corporation tax in each country, but also include the interaction of corporate and personal income taxes, the individual income tax rates including surcharges and capital taxes at the shareholder level. The effective average tax rate is derived by simulating the development of a medium-sized manufacturing company over a ten year period.

Several assumptions need to be made in order to simulate such a development, notably the company's initial total assets and liabilities and the expected development of the capital stock over the simulation period. The model firm's structure refers to a typical German medium-sized manufacturing company. With regard to investment, the assumptions ensure that the initial capital stock at least remains constant.

In contrast with the analysis of the taxation of a hypothetical investment, this model takes into account a large majority of the relevant tax provisions. (The assumptions and parameters are given in Annex H). Box 4 compares the tax provisions taken into account in the two models.

As already mentioned, the results of this model rely on the particular characteristics of the company. Sensitivity analysis investigates the impact of alternative rules for profit computation and different business data. Moreover, as is the case for the analysis of a hypothetical investment, the application of this methodology does not take into consideration some features linked to the existing and functioning of different tax systems, such as, for instance, loss consolidation or compliance costs.

For the sake of comparability and in order to isolate the effects of taxation, it is assumed that the model firm in each country shows identical data before any taxation. The purpose of the analysis is to understand how taxation influences the profitability of the same capital stock in the different countries and not to give a picture of the actual situation in each country.

Box 4 Tax provisions taken into account in the models

Hypothetical investment Tax Analyser

  • Depreciation (methods and tax period for all considered - Depreciation (methods and tax period for all considered assets); assets, extraordinary depreciation);
  • Inventory valuation (production costs, lifo, fifo, and - Inventory valuation (production costs, lifo, fifo and weighted weighted average); average, inflation reserves);
    • Development costs (immediate expenses or capitalisation);
    • Taxation capital gains (roll-over relief, inflation adjustment,

    special tax rates);

    • Employee pension schemes (deductibility of pension costs,

    contributions to pension funds, book reserves);

    • Provisions for bad debts;
  • Elimination and mitigation of double taxation of foreign source of income (exemption, foreign tax credit, deduction of
  • Elimination and mitigation of double taxation of foreign foreign taxes); source of income (exemption, foreign tax credit, deduction of foreign taxes); - Loss relief
  • Investment incentives (extraordinary depreciation, special tax credits, special tax incentives). These are considered only in the sensitivity analysis (section 5).

    The inclusion of the German corporate tax reform

The reference date for the computation of effective tax rates on domestic and international investments for all countries is 1999. In the meantime, a number of Member States have introduced some changes to their corporation tax codes.

In view of the fact that there is always a tax reform in progress in at least one Member State, it is inevitable that the data arising from the computation can only present a picture of a situation at some point in the past. Any comparison has to be made on a consistent basis and constantly updating the national tax codes is impracticable. Moreover, it is impossible to take into account in the application of the models the effect of tax reforms that are announced but not yet completely defined. However, the overall results of the analysis should not be fundamentally affected by reforms aimed at revising particular individual features of national tax systems.

That said, as the German corporate tax reform approved in 2000 addresses in both a quantitatively and qualitatively significant manner all the main relevant characteristics of the German corporate tax system, the analysis developed in this section also takes account of the effects of this reform.

Therefore, an additional separate set of effective tax rate data for Germany as at the 1 st January 2001

have been computed, as well as additional comparative tables which take into account the 2001 situation for Germany and the 1999 situation for the other countries (see annexes E and J). Where relevant for the analysis of the effects of effective tax rate differentials, the inclusion of the new German situation in the EU context is commented on in this section. All the tax reforms introduced in other Member States are less significant as far as corporate taxes are concerned, both quantitatively and qualitatively.

The simulations of the harmonisation of particular features of taxation are based on the 2001 situation for Germany and on the 1999 situation for the other countries. As such policy simulations refer to a hypothetical future situation, the use of a consistent basis is less relevant here and indeed to ignore the German reform would be highly misleading.

The effective tax burden of SMEs and the tax planning cases are analysed on the basis of 1999 data for all countries considered.

It is worth mentioning that France introduced a tax reform in 2000 aiming at abolishing the surcharges on corporation tax by the year 2003. Due to the particular structure of these surcharges, which are determined partly by the amount of wages and salaries, and the period over which the changes will be implemented, this reform has not been modelled. Section 10 of this part of the Study presents an updated computation of the effective tax rates on domestic investments for all Member States, taking into account the tax regimes of 2001. This permits an analysis of the impact of national reforms of the corporate tax regimes on the effective tax burdens.

T HE TAXATION OF DOMESTIC INVESTMENTS

This section considers the influence of domestic tax regimes on the organisation of companies' investments and the way in which national tax codes can affect the international competitiveness of resident companies and, under certain assumptions, the location choice of multinationals.

In the analysis, the case where all personal taxes are set to zero is first considered. In this case, any variation in effective tax rates is purely due to differences in corporate taxation. Then personal taxes on dividends, capital gains on the increase in the value of the shares and taxes on interest are added, on the assumption that companies act in the interest of their shareholders, to maximise the shareholders' wealth.

The economic rationale for including (or not) personal taxation and the difficulties arising in seeking to take into account personal taxes in the analysis are the subject of some controversy. There are good reasons both for including or excluding personal taxation (see Box 5). The current analysis presents separate computations of effective company tax rates which respectively take into account only corporate taxation and corporate taxation plus some elements of personal taxation.

Box 5: The role of personal taxation

The influence of personal taxation on company investment behaviour depends on the functioning of international capital markets and, in particular on the extent to which international portfolio capital is mobile. If companies can only raise money domestically, then changes in the personal tax treatment of investment income will alter company behaviour. Instead, if companies are able to finance their investments on the international capital markets, the influence of personal taxation on investment income varies according to the degree of integration of capital markets.

If this market is so integrated that the world interest rate is unaffected by the domestic amount of saving, personal taxes do not and should not affect the investment behaviour of companies. In fact, a personal tax on all forms of interest income will result in a lower post-tax return to savers; consequently they will save less. But assuming that domestic saving is small relative to the world supply of saving, the world interest rate will be unaffected, and so the investment decisions of the domestic corporate sector will be unaffected. In contrast, taxes on corporate income generated in a particular country will affect corporate behaviour, regardless of how the project is financed. In such a case, due to capital mobility, personal taxes in small open economies like the individual EU Member States do not affect investment decisions of companies. From this point of view the taxation of shareholders or more generally, the taxation of suppliers of finance, would not be relevant for a comparison of business tax burdens.

This conclusion, however, depends on the assumption that internationally mobile portfolio capital always exists. But this assumption could be questioned on the grounds that all companies raise at least some money domestically and small and medium sized companies may even have no access to international capital markets. The literature is not unanimous on whether the assumption of perfect international capital market mobility is pertinent for all type of economic agents.

Moreover, structural differences between national tax systems are mainly caused by the differing corporation tax systems and the different ways in which the corporation tax and income tax interact. For this reason, the level of taxation not only for retained, but also for distributed profits differs among countries.

A practical difficulty also arises in seeking to take into account personal taxes. That is, the company may have many shareholders, facing different rates of tax from each other. Which set of personal taxes should a company take account of in these circumstances? Economic theory suggests that a company should act in the interest of the "marginal" shareholder that is, the shareholder who is just indifferent between owning and not owning the company's share. Unfortunately, in practice, it could be impossible to identify "the" marginal shareholder.

In order to consider all these arguments, the present study shows a separate analysis of the impact of personal tax in the domestic case. The central case analysed takes into account only corporate taxes on the hypothesis that the company does not know the identity of the marginal shareholder. Then, in order to provide a comprehensive analysis of the impact of Member States' national tax systems on investment and financing decisions, personal taxes are added. However, as far as the effective average tax rate is concerned, since its main focus in this analysis is on the choice of location, an implicit underlying assumption for this case is that economies are open to flows of mobile capital. In this situation it is very difficult for firms to allow for the tax positions of their shareholders. Nevertheless in the framework of the "Tax Analyser" model, personal taxation is considered and average effective tax rates including the effects of personal taxation are separately presented.

The influence of domestic tax regimes on the organisation of companies' investment by assets and sources of finance

Domestic tax regimes can influence the organisation of companies' domestic investments by creating incentives both as to how to finance the investment and the overall mix of assets. In fact, different forms of investment or different sources of financing may face very different tax treatments. Such variations constitute a potential source of distortion in the allocation of resources and may therefore impact overall efficiency. If the impact of differences in tax treatment favours one particular form of investment or financing, then the economic activity may not be organised in the most efficient economic way. Although these differences may be secondary to the main focus of this section, which is the impact of taxation on the incentives to locate investments, it is useful to have an indication of the effects of tax regimes on the organisation of investments in the EU as a starting point.

Relevant economic measures: cost of capital, EMTR and EATR averaged across the EU

The first case analysed is the simplest case in which there are no personal taxes. Separate investments in five different assets are considered: intangibles (e.g. purchase of a patent), industrial buildings, machinery, financial assets and inventories. In presenting averages over different forms of investment, these assets are weighted equally. Three sources of finance for investment in each asset are separately considered: retained earnings, new equity and debt. The weights used are taken from OECD (1991): retained earnings 55%, new equity 10% and debt 35%. Thus, calculations are made for 15 different types of investments.

Tables 1 and 2 present the cost of capital, the effective marginal tax rate and the effective average tax rate for each type of investment averaged across the 15 Member States. This is an unweighted average. That is, it does not take into account differences in the size of each country (or any other factor). As such, it gives an indication of the average effect of tax regimes in the EU and it is not an attempt to measure the "average" taxes in Europe, where the size of countries and hence the numbers of investments facing each specific tax regime would need to be taken into account.

Tables 1 and 2 capture the extent to which corporate taxation in the EU affects the incentives to undertake particular kinds of investments by responding to the following questions, respectively for Table 1 and Table 2.

"Given a real interest rate of 5% in each country and assuming that the investments will not raise extraprofits, what is the required pre-tax rate of return (the cost of capital) for different types of investment financed by different methods, and what is the percentage difference between the pre-and post-tax rates of return (the effective marginal tax rate)?"or, alternatively, "Given a real interest rate of 5% and an assumed pre-tax rate of return of the investment of 20% in each country, which is the proportion of total income taken in tax in each type of investment financed by different methods (the average effective tax rate)?"

As pointed out above, in the first case it is assumed that the investors undertake all investment projects which earn, at least, the required rate of return before tax. For a given required post-tax rate of return, the more severe the tax system, the higher is the cost of capital, and hence the less likely that any project will be undertaken. In the second case it is assumed that companies may choose between mutually exclusive investments and that they will choose the project whose proportion of total income taken by tax is lower.

  • A) 
    The case of a marginal investment

    TABLE 1 Cost of Capital and Effective Marginal Tax Rate - average across all 15 EU member states

    - only corporation taxes

    Cost of Capital Intangibles Industrial Machinery Financial Inventories Mean (upper line) Buildings Assets

    EMTR (lower line)

    %

Retained 6.6 8.0 6.7 8.6 7.9 7.6

Earnings 20.0 35.2 23.3 39.9 35.5 32.6

New Equity 6.4 7.8 6.6 8.4 7.8 7.4

18.5 34.2 22.0 39.3 34.6 31.6

Debt 3.3 4.4 3.5 4.9 4.3 4.1

-67.3 -22.2 -50.9 -3.8 -16.8 -24.6

Mean 5.4 6.7 5.6 7.3 6.7 6.3

3.6 23.3 8.3 29.8 24.1 20.2

Note. Each number in the Table is an unweighted average over the equivalent number for each member state. This is true for both the cost of capital and the EMTR. For a specific investment in a specific country, the EMTR is the percentage difference between the equivalent cost of capital and the post-tax required rate of return of 5%. For example, a cost of capital of 7.5% generates an EMTR of (7.5-5)/7.5=33.3%. However, taking an average of the costs of capital, and a separate average of the EMTRs implies that the average EMTRs presented in the table are not precisely the percentage difference between the average cost of capital and 5%.

Generally, according to Table 1, there is considerable variation in the tax treatment of different forms of investment within the EU and, therefore, the EU tax regimes effectively seem to create incentives as to how to organise investment in the EU. Annex C (country tables) shows that there is a remarkably similarity between countries in the pattern of tax incentives for domestic investments even if the range of values across countries gives an indication of differences between EU Member States in their treatment of specific forms of investment (see sections 4.2 and 4.3).

As far as the source of finance is concerned, first, as shown by many other studies, corporate tax regimes tend to give a strong advantage to investment financed by debt. For debt-financed projects the EU cost of capital is always lower than 5%, and, consequently, the EMTR is negative in all cases. This means that at the margin corporation tax regimes subsidise the financing of investments by debt. This advantage arises because nominal interest payments on debt are deductible from corporation tax, and there is usually no comparable corporation tax relief for investment financed by new equity. Thus, from the point of view of the company, financing through new equity and retained earnings is disadvantageous, as no deduction from the taxable base for the corresponding payment is allowed.

Second, in the absence of personal taxation, there is almost no difference in the cost of financing the investment by giving up one unit of dividend income as opposed to contributing one extra unit of new equity 37 .

When considering the assets, considerable variation in the average treatment can be observed too.

Financial assets are the most heavily taxed. In fact, financial assets are assumed not to depreciate and hence not to benefit from any allowance. Any income generated from the asset is generally taxed at the full statutory tax rate. Moreover, this rate is applied to the nominal return defined as the real interest rate plus inflation rate (set at 2% for each country in this analysis), rather than to the real return, and for this reason the effective marginal tax rate exceeds the statutory tax rate. Hence, the higher the inflation rate, the higher the EMTR. In the case of financial assets financed by debt, the fact that nominal interest payments are deductible from tax generally compensates for the fact that the nominal interest receipt is taxable 38 . In such a situation, the value of both tax and economic parameters plays no role.

In general, the cost of the other assets can be offset against taxable profit over a period of time. Typically, the rate at which the cost can be offset is related to the economic depreciation rate of the assets. For a given true economic depreciation rate, the more quickly the cost can be set against tax, the more valuable the allowance and hence the lower the effective marginal tax rate. The EMTR thus reflects the difference between the true economic rate of depreciation and the rate of allowance permitted in the tax code.

Differences between the remaining four assets therefore reflect not only the generosity of the tax systems with respect to the allowance rates for the four assets, but also the assumptions made about the true rate of economic depreciation. However, even allowing for this dependence, significant differences seem to persist within the EU. In general, industrial buildings and inventories have the highest cost of capital and effective marginal tax rate, while intangibles and machinery are rather lower.

37 The slight differences of data in table 1 for retained earnings and new equity are only due to the German regime which

in 1999 had a split rate system which taxes distributions at a lower rate than retained earnings. In this case if the company reduces its dividend payment by one unit, the tax saving which would otherwise have been gained from paying the dividend is lost. In effect, the net income of the shareholder falls by more than one unit and this increases the cost of financing the investment by retained earnings.

38 Exceptions to this arise because of special provisions in the tax regimes in Germany and Italy, which have a slighter

higher cost of capital, and in Greece which taxes investment income at only 15% and hence has a significantly lower cost of capital.

  • B) 
    The case of a profitable (infra-marginal) investment

Table 2 presents estimates of the effective average tax rates for each of the same 15 investments analysed above under the assumption that the pre-tax real rate of return is 20%.

Table 2 Effective Average Tax Rate - average across all the 15 member states - only corporation taxes

EATR Intangibles Industrial

% Buildings

Machinery Financial

Assets Inventories Mean

Ret Earnings 30.6 35.1 31.0 35.6 34.9 33.5

New Equity 30.2 34.7 30.7 35.2 34.5 33.1

Debt 20.0 23.8 20.7 23.6 23.5 22.3

Mean 26.8 31.1 27.4 31.4 30.9 29.5

In this case, it is important to remember that, as explained in Box 3, the EATR varies according to the expected level of profitability of the investments. In particular, in the absence of personal taxes, the EATR is identical to the EMTR for marginal investments, and it rises when the profitability rises because allowances against the cost of the investment become relatively less important when the cost of the investment becomes smaller relative to the returns.

Since the assumed real rate of return of 20% is not high enough to mean that allowances and deductions are too small to have much impact, the pattern of the EATR in Table 2 bears some resemblance to that of the EMTR in Table 1.

Some differences may however be underlined. Concerning the source of finance, it is now worth noting that the relative advantage of debt is lower than in the case of marginal investment, reflecting the lower value of the interest deductibility relative to the return generated. Therefore, this advantage tends to diminish when the profitability of the investment rises.

The relative ranking of the treatment of the 5 assets is also the same as in Table 1, but the introduction of extra-profits results in a narrowing of the differences between them. Once again, however, these averages hide a considerable dispersion between countries. This is explored in sections 4.2 and 4.3.

The introduction of personal taxation

In principle, if companies act in the interest of their shareholders and the international capital market is not perfectly mobile, they should take account of their tax liabilities. If a different choice of source of finance, for example, results in a higher post-tax income for the shareholders, then this is advantageous. As discussed in Box 5, this situation is more likely to be relevant when the shareholders are domestic residents, and hence face the domestic tax system. Of course, even in this case there may be considerable variation in the tax position of different shareholders, which may make it impossible for a company to maximise the post-tax earnings of all shareholders. Table 3 presents the cost of capital and the effective marginal tax rates, averaged across the 15 EU Member States, for the 15 hypothetical investments in the case where companies aim to maximise the wealth of top-rated qualified shareholders, taking into account their personal tax liabilities on the hypothesis that these are known by the company

39 . A qualified shareholder is a shareholder who holds a substantial part of the shares of the company. Three personal taxes are introduced in this section: on interest received, on dividend income and on capital gains.

This table, therefore, captures the extent to which corporate taxation and these three forms of personal taxation affect the incentives to undertake the particular forms of investment considered in this study, assuming that the investments will not raise extra-profits.

For the theoretical reasons explained in Box 5 the analysis of the impact of personal taxation is restricted here to the case of a marginal investment.

Table 3 Cost of Capital and Effective Marginal Tax Rate - average across all 15 EU Member States

- top personal tax rate, qualified shareholder

Cost of capital Intangibles Industrial Machinery Financial Inventories Mean (upper line) Buildings Assets

EMTR (lower line)

Retained 4.1 5.2 4.3 5.6 4.9 4.8

Earnings 51.0 61.4 53.3 63.4 60.3 59.3

New Equity 4.7 5.9 4.9 6.3 5.6 5.5 56.7 64.5 58.8 68.1 65.5 64.0

Debt 3.5 4.6 3.8 4.9 4.3 4.2 30.9 44.6 34.9 52.4 47.5 44.7

Mean 3.9 5.1 4.2 5.4 4.8 4.7 48.0 58.2 50.5 61.8 58.4 56.9

Note. In the case of Spain, the cost of capital for several types of investment is close to zero. This implies that the EMTR can reach extremely large values. This table therefore presents an average of the costs of capital across all 15 EU Member States. However, the results for the EMTR are an average only over the 14 EU Member States excluding Spain.

39 Companies should aim to maximise the wealth of other kind of shareholders. If they would act in the interest of the

zero-rated shareholders, then in most countries there will be no effect on the cost of capital and the EMTR compared with the case of only considering taxes on corporations. This is obviously because considering such shareholders does not introduce any new form of taxation. However, in certain countries this is not the case. Instead, Finland, France, Germany and Spain all permit a zero-rated shareholder to claim a rebate equal to the tax credit associated with the payment of a dividend. This has a significant impact on the cost of capital and hence the EMTR in the case of new equity finance, where the return subsequently distributed as a dividend. In this case the effective tax burden is considerably lower. If the shareholder taken into consideration would be a top-rate, non-qualified shareholder, then the only countries presenting significantly different situations compared to the case of a qualified shareholder will be Italy and the Netherlands. This is due to the different tax rates on dividend applied to non-qualified shareholders. In Italy the tax rate is higher for qualified participation and in the Netherlands it is lower. The other countries apply the same rates to both kinds of shareholders.

Table 3, shows, that when personal taxation is taken into account, the differences observed in Table 1 still exist, even if a different treatment of the sources of finance can be observed. But the most striking feature of this table is that the taxation of the investment backflows in the hand of the shareholders considerably reduces the EU average cost of capital and increases by more than twice the effective marginal tax rates.

The most important reason for the decrease of the cost of capital is the impact of the personal tax on interest. In fact, the post-tax rate of return required by the shareholder depends on the post-tax rate of return of an alternative financial investment. Assuming the alternative to be lending, then any tax on interest -the return on lending- reduces the post-tax return to lending. Consequently a lower post-tax rate of return is required from equity investment. In fact, on average, investment financed by retained earnings and debt have a cost of capital less than the real interest rate of 5%. Of the five assets, only industrial buildings and financial assets have an average cost of capital above 5%.

Personal taxes do not generally affect the cost of capital for investments financed by retained earnings. This is because they affect the net cost of the investment in the exactly same way as the net return to the investment. Suppose, for example, that the tax rate on a dividend payment is 30%. And suppose that a company finances the purchase of an asset costing 100 euros by reducing dividends. The net cost to the shareholder is therefore 70 euros. Suppose also that the investment generates a gross rate of return of 10%, being worth 110 euros after one period (ignoring taxes). When this amount is distributed as a dividend, it generates post-tax income of 77 for the shareholder. But this represents a post-tax rate of return to the shareholder of 10% -the same as the pre-tax rate of return. The impact of the dividend tax is negated by the fact that it affects both the net cost of the investment and the net return. There are much smaller effects on the cost of capital for investment financed by debt.

The underlying reason why the average EMTRs in Table 3 are considerably higher than those in table 1 is that the alternative opportunity open to each individual is to lend an equivalent sum. Therefore the EMTR compares the cost of capital with the post-tax rate of return on lending rather than to the real interest rate. Since this post-tax rate of return is lower as a result of taxes on interest received, the effective marginal tax rates are higher.

Differences across the EU

This section begins to address the question of the differences between Member States in their treatment of the specific forms of investment considered in this analysis.

It is useful to remember that in this section only domestic investment is considered, and therefore the analysis of the differences in Member States' tax treatment relates to the case of a domestic company resident in the same Member State.

Within such a framework, differences between Member States may affect the international competitiveness of resident companies and, under certain assumptions, the location choice of multinationals.

In fact, first, when companies operate mainly in their domestic country, but export their output to other countries, where they compete with each other, a lower tax burden in one country may generate a competitive advantage for companies resident in that country.

Second, in certain specific cases, differences in the effective tax burden between countries could also affect the location choice of individual companies. This would be the case for multinational companies that ignore personal taxes (perhaps because they do not know the identity of their marginal investor) and that are able to leave effective tax rates close to those of the host country, due to the provisions of international tax codes or to the tax planning activity of the company.

This section considers these questions by looking at the EU range of values for the 15 types of hypothetical investment considered earlier.

With regard to the location of investment, it should be noted again that the data arising from the application of the theories underlying this analysis give summary measures of the incentives (or disincentives) to undertake different types of investments and do not provide evidence of the impact of taxation on actual economic decisions. Box 6 presents a short survey of the empirical studies which have attempted to measure the impact of tax differentials on actual location choice in recent years.

Box 6: Links between business taxation and companies' location decisions

The mandate given to the Commission by Member States requests an assessment of the effects of differences in the EU Member States' effective tax burdens on the location of economic activity and investments. The methodologies applied in the current study assess the relative incentives (or disincentives) provided by each country's tax law to undertake various types of investment at home or in the other EU countries. To what extent taxation has an impact on actual investment decisions depends, however on the extent to which tax incentives lead to changes in actual behaviour.

If taxation were the only element influencing location decisions, that is, ceteris paribus, differences in the effective tax burdens between countries would be the only factor determining location decisions, investment should be located in countries where taxation is lower. But taxation is only one of the elements affecting location decisions. Several differences arising from the macro and micro economic framework of each country contribute to determine the actual behaviour of companies.

The fact that differences in the effective tax burdens between countries persist, shows that the arbitrages are not perfect and that taxation is not the only element affecting location decisions.

Therefore, when assessing the impact of taxation on location decisions it is necessary to isolate the effects of taxation among the other factors in order to study the correlation between taxation and location decisions.

While there has been a fair amount of empirical studies of this issue in the US, the empirical literature in Europe is rather scant. Three major issues have been explored:

(A) The convergence of tax rates

(B) The incidence of international tax differentials on the flows of foreign direct investment

(C)The relationship between taxation and location in the context of tax competition amongst local governments,

.

(A) According to many authors, one implication of the hypothesis of tax competition amongst governments to attract business should logically be the convergence of the observed tax rates. Empirical evidence of such convergence is, however, not very strong.

Moreover, the relative convergence of statutory tax rates on companies' profit and on individual investors' income and capital gains that has been observed in the European Union does not, in itself, give much indication of the extent to which tax competition and effective differences amongst Member States in the treatment of such income remain.

In fact, the effect of differences in taxation on economic decisions depends on their marginal impact on the rates of return to investment, which, in turn, depends not only on apparent tax rates, but also on rules determining the tax base. So, the convergence of effective marginal tax rates should be evident over a period of time.

Unfortunately, it is not possible to study this possible convergence due to the lack of appropriate data based on forward-looking methods covering a long enough period of time.

(B) One obvious direction for testing the consequences of differentials in national business taxation on location decisions is foreign direct investment, where, by definition, capital is internationally mobile.

The empirical relevance of tax considerations in investment decisions has been mostly studied by looking at the investment location decisions in multinational corporations. A number of empirical studies show that tax considerations are relevant in investment decisions. Nevertheless, the size of the correlations varies according to the specific methodology applied.

Devereux and Griffith (1998), using individual firm activity data of US multinationals investing in Europe (restricted to the UK, France and Germany) show that the choice of the location, conditional on the decision to produce abroad rather then to export, is driven by taxation and other cost-related factors.

Friedman, Gerlowsky and Silberman (1992) consider the establishment of new manufacturing plants of European and Japanese firms at the state level in the USA. They find that per capita state and local taxes are strong determinants for location.

Hines (1996), on the basis of models of the investment process, reported positive correlation between investment levels and after-tax returns to foreign direct investment.

A recently published study - Fontagné, Benassy-Quéré and Larèche-Révil (2000)- has attempted to implement a direct econometric test of the hypothesis by confronting net bilateral foreign direct investment flows with indicators of business tax differentials; their results support the hypothesis.

Most of these studies investigating the empirical relations between tax differentials and investment location suffer from particular difficulties. A difficulty encountered by all empirical investigations looking at international investment flows is the potential interference of many other elements of national tax and social protection systems in the decision of a multinational corporation to locate investment in one country rather than another. This points to the need for further research on the interaction between several tax instruments with different bases.

The studies using foreign direct investment data all have to face the weaknesses of existing data, with, in particular, the difficulty of distinguishing between financial transactions and "real" foreign direct investment. Certain studies use inappropriate indicators of tax pressure based on apparent average tax rates on corporate profits, which can widely differ from the relevant indicators as expressed by effective tax rates.

Therefore, the fact that the existing literature has been rather deceptive in furnishing coherent results on the size of the impact of taxation on capital flows or location decisions seems mainly due to sample biases or data shortcomings. A way to properly deal with the difficult issue of the interaction between taxes on various factors would be to use a general-equilibrium framework allowing for imperfect competition on some markets. An alternative way of proceeding would be to confront net bilateral foreign direct investment flows with series indicators of average effective tax burden.

(C) A number of studies based on European data have focused on the hypothesis of tax competition amongst local governments within national economies. This restricted field has the advantage of more closely resembling the US context in which the original empirical work was initiated. In addition it also restricts the number of differences potentially interfering with business tax differentials in the firms' location decisions: for instance, within the national economy, social contributions are uniform. However, even in this environment of restricted differentiation amongst jurisdictions, they are potentially many factors influencing the location of firms, and taxation is only one of these.

Conventional wisdom currently rests on the apparently sound hypothesis that firms' location decisions, be it when a firm relocates or when it decides to open a new plant or office, are made according to many factors, that are treated in a hierarchical way. A firm first chooses the region -the so-called "macro location" decision- based on such factors as market for product, labour market conditions and labour costs, etc. Only then, in the so-called "micro- location" decision - i.e. when choosing the precise locality in which to settle- will local tax differentials influence the firm's choice (Jayet, 1993; Jayet and Wins, 1993; Conseil national des impôts (F), 1997, Madiès, 1997a and b; Houdebine and Schneider, 1997; Paty, 2000).

To conclude, the empirical studies show, to different degrees, that there is a negative correlation between the size of taxation and location decisions. Nevertheless, most of the empirical studies suffer methodological weaknesses or are tailored to study just the effect of local business taxation. It is therefore difficult to have "the" quantitative measure of this impact even if the existence of such a relation is generally undisputed.

Because of the weaknesses of the existing methodologies and the severe limitation due to lack of available data, it is considered that none of the existing approach could be usefully adopted in the current analysis, without considerably extending the range of the work. Taxation has certainly an influence on the location of economic activity but it is very difficult to correctly isolate this influence.

Relevant economic measures: range of the cost of capital and EATR values across the EU

As in the previous analysis on the influence of domestic tax regimes on the organisation of companies' investments, the first case analysed in this section is the simplest case in which there are no personal taxes. The calculations are made for the same 15 different types of investment.

Tables 4 and 5 capture the range of values across EU Member States and therefore present the highest and lowest values observed when analysing separately individual EU Member States, respectively in the case of marginal investments and in the case of investments whose assumed rate of return is 20%. These ranges give some indication of the differences between EU Member States in their treatment of specific forms of investment. The individual situation of each EU Member State is presented in section 4.3 40 .

  • A) 
    The case of a marginal investment

TABLE 4 Cost of Capital -

- maximum and minimum across the EU

- only corporation taxes

Maximum

Minimum Intangibles Industrial Buildings Machinery Financial Assets Inventories

Retained 8.4 10.1 9.8 12.6 10.5

Earnings 3.4 5.1 4.3 5.8 5.5

New Equity 8.4 10.1 9.8 10.4 9.0

3.4 5.1 4.3 5.8 5.5

Debt 4.8 6.3 5.7 5.7 5.0

1.6 2.2 2.2 3.0 3.6

This table provides evidence of considerable variation across Member States in the cost of capital for each investment. A range of 5 percentage points or more is common. For example, the cost of capital on investment in machines financed by retained earnings and new equity ranges from 4.3% to 9.8%. This would suggest that companies located in the lowest value country have a significant advantage over firms located in the highest value country in selling their output in the European, and possibly world, markets. Moreover, this would imply that, under the conditions mentioned above, multinational companies resident in the EU have a significant incentive to locate investments in the lowest value country.

40 The lowest and highest values presented in Tables 4,5 and 6 cannot be compared with the lowest and highest values of

country data presented in section 3.3. In this section the hypothesis is that each asset is entirely financed by each source

of finance. Appendix C (country tables) gives detailed results for each EU Member State. In section 3.3, where the

situation for each country is presented, data related to each asset are averaged across the sources of finance.

  • B) 
    The case of a highly profitable (infra-marginal) investment

    TABLE 5 Effective Average Tax Rate - maximum and minimum across the EU - only corporation taxes

    Maximum Intangibles Industrial Machinery Financial Inventories

    Minimum Buildings Assets

Retained 40.6 46.3 44.3 54.3 48.2

Earnings 10.1 17.0 9.4 11.0 11.0

New Equity 40.2 45.4 44.3 47.9 42.0

10.1 17.0 9.4 11.0 11.0

Debt 26.9 31.5 32.2 34.8 28.8

6.6 13.5 6.0 2.5 7.5

This table shows that there is even greater variation in the effective average tax rates across Member States than there is in the cost of capital. To take one example, the EATR on investment in machines financed by retained earnings and new equity ranges from 9.4 to 44.3%.

In contrast to the case of a marginal investment, differences in the EATR are less likely to generate a competitive advantage (or disadvantage). In fact, the EATR is based on the assumption that the investment will generate a rate of return in excess of the minimum required. If a company in this situation (resident in one country) finds itself undercut by its competitors, then there is nothing to prevent it from responding by reducing its prices, and lowering its pre-tax rate of return.

As far as location is concerned, the difference with the marginal case is that an infra-marginal project which is not located in more than one place is now analysed. The large variation in the EATR between possible sites for location of investment may therefore indicate considerable distortions to location choices.

The introduction of personal taxation

When personal taxation is introduced into the analysis of tax differentials in the domestic case, it is worth noting that differentials in Member States' effective tax burden are still relevant in affecting the relative competitiveness of domestic operators, as was the case for the analysis of the cost of capital, but they are no longer relevant for the choice of location. In fact, in this case the objective of companies is to maximise the wealth of their domestic shareholders. This could be incompatible with the hypothesis that the company aims at leaving effective tax rates close to those of the host country by means of tax planning

Table 6 shows the range of values of the cost of capital across the 15 EU Member States, using as an example a qualified shareholder taxed at the highest personal tax rate. Once again, the impact of personal taxation is restricted to the case of a marginal investment.

Table 6 Cost of Capital - - maximum and minimum across the EU

- Top personal tax rate, qualified shareholder

Maximum Intangibles Industrial Machinery Financial Inventories

Minimum Buildings Assets

Retained 6.5 7.1 6.4 9.6 7.1

Earnings 0.0 0.1 -0.3 0.2 -0.8

New Equity 8.9 8.9 8.8 10.0 8.8

0.2 0.4 0.0 0.5 -0.5

Debt 4.8 6.4 6.2 5.7 5.0

2.0 2.5 2.6 3.0 3.6

The differences shown in this table are even more striking than in the case of Table 4. These results imply that the differences in the tax systems may give some companies a considerable competitive advantage over others.

Summing up the results of Tables 4,5 and 6 it is possible to assert that, in the EU, the competitiveness of domestic companies and, under the conditions described above, the location choice of multinationals can be affected in a significant way by differences in the effective domestic tax burden.

The next section examines the dispersion of the effective tax burden across the EU more closely by presenting the situation of each Member State.

The position of the EU Member States

One of the main purposes of this section is to analyse the differences in the effective tax burden borne by EU companies located in different Member States and thus appreciate the possible effects of such differentials on competitiveness and investment decisions. Under the hypothesis and assumptions already mentioned, Tables 7 and 8 present country data where only corporate taxation is taken into account : this includes the statutory tax rates, the surcharges and the local taxes. (The list of such taxes for each Member State is given in Annex B). Section 4.3.2 will present data including the forms of personal taxation already considered above.

Relevant economic measures: cost of capital, EMTR and EATR by Member States

  • A) 
    The case of a marginal investment

Table 7 shows the cost of capital and the EMTR for the level of corporation and examines more closely the dispersion across the EU and the relation between the effective tax burden and the national tax rate on profits.

Debt

-25.0 -42.9 -13.6 -11.1 -8.7 -56.2 -47.1 3.8 -38.9 -35.1 -21.9 -28.2 -21.9 -39.5 -25.0

TR quity New e

E M 33.3 37.5 33.3 30.5 44.4 35.5 34.2 15.2 10.0 35.1 35.1 36.7 35.1 25.4 35.1

earnings

Retained 33.3 37.5 33.3 30.5 44.4 48.4 34.2 15.2 10.0 35.1 35.1 36.7 35.1 25.4 35.1

Debt 4.0 3.5 4.4 4.5 4.6 3.2 3.4 5.2 3.6 3.7 4.1 3.9 4.1 4.3 4.8

quity New e 7.5 8.0 7.5 7.2 9.0 7.6 7.6 5.9 5.5 7.7 7.7 7.9 7.7 6.7 7.7

earnings

Retained 7.5 8.0 7.5 7.2 9.0 9.7 7.6 5.9 5.5 7.7 7.7 7.9 7.7 6.7 7.7

AL IT

C AP Inventories 6.3 6.7 7.1 6.8 7.4 7.9 7.4 5.5 5.0 6.5 6.9 6.5 6.4 6.6 6.9

T OF Assets

C OS Financial 7.3 8.0 7.1 6.8 8.0 10.0 5.1 5.5 7.7 7.7 7.4 7.7 7.4 6.6 6.9

Machinery 5.9 5.3 5.4 5.6 8.4 5.8 6.1 5.2 3.8 5.3 5.9 5.2 5.4 5.0 5.6

l

ry Buildings

ount Industrial d overal 6.1 7.0 8.1 6.1 8.5 7.2 5.1 6.8 4.6 6.8 6.9 6.2 6.7 6.0 8.2

by c

TR ce an Intangibles 5.9 5.2 4.2 6.1 5.2 5.4 6.8 5.3 2.9 5.2 5.1 6.7 6.5 5.0 5.5

f in

an

L EMTR

al and EM rce of N 20.9 22.4 21.9 19.9 33.2 31.0 18.2 11.7 -4.1 20.7 22.6 22.5 22.8 14.3 24.7 R A L Capital

apit O VE MEA Cost of

6.3 6.4 6.4 6.2 7.5 7.3 6.1 5.7 4.8 6.3 6.5 6.5 6.5 5.8 6.6

of C y asset, sou

C ost - b - only corporation taxes tax rates (1)

Corporate 34.00 40.17 32.00 28.00 40.00 52.35 40.00 10.00 41.25 37.45 35.00 37.40 35.00 28.00 30.00

ry

7 ium al

Count ance embourg

Table Austria B elg Denmark Fi nland Fr Germany Greece Ir eland It aly L ux Netherlands Portug Spain Sweden UK

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Note. Each un (1) in

Table 7 shows that there is considerable dispersion across the EU. Focussing first on the overall average, it is notable that 7 Member States have an average cost of capital between 6.3% and 6.5%. Three others (Greece and Finland and the UK) are very close to this range, leaving five significantly outside: France and Germany have an average of 7.5% and 7.3% respectively, and Sweden, Ireland and Italy have an average of 5.8%, 5.7% and 4.8% respectively.

This EU wide spread cannot be explained by one feature of the national tax systems alone, but it can be observed that Germany had in 1999 the highest statutory tax rate on profit, and France by far the highest non-profit taxes (local taxes on corporations). On the other hand, statutory tax rates in Sweden, in Ireland and for certain categories of income (see below) in Italy, are by comparison the lowest. Even Finland, which has one of the lowest statutory tax rates, shows a relatively low cost of capital.

All the EU Member States, except Ireland, have an EMTR lower than the overall corporate tax rate.

The fact that Ireland has an EMTR higher than the corporate tax rate is fundamentally due to the relatively high (relative to the corporate tax rate of 10% applying to the manufacturing sector) real estate tax rate (1.58%) applicable to industrial buildings (see Table 3 of Appendix B). The influence of the real estate tax in the EMTR for Ireland is shown in Table 7, where the cost of capital for industrial buildings is 6.8 and therefore the related EMTR is 26.8%. This influences the overall mean.

In order to appreciate the dispersion across Member States and the relation between overall nominal profit rates and EMTR it is useful to look at the situation of the specific types of investment both by type of assets and by source of finance.

Table 7 clearly confirms that, from the point of view of the corporation, the most tax-efficient way of financing is debt. The major reason is that deduction of nominal interest payments from the corporation tax base significantly reduces the effective tax burden on investments financed by debt. The effect of interest deduction is high in countries where the corporation tax rates are higher. Furthermore, in certain countries, debt-financed investments are subsidised if, relative to other countries, assets receive "accelerated" depreciation as is the case for example in Belgium, Greece, Italy and Sweden.

Financing through new equity and retained earnings is disadvantageous, as no deduction from the taxable base for the corresponding payments (dividends) is allowed. The national effective tax burden for both forms of financing almost equal the tax rate on profit. Given the close relation of the effective tax burden on new equity and retained earnings to the tax rates on profits in most of the EU Member States, it can be inferred that "normal" accounting rules for profit computation, in so far as they are considered in the model, in general do not have a great impact on the effective tax burden and on the ranking of the countries, as they only result in "timing differences". Rather, it is likely that the different tax rates on profit explain most of the differences in EMTR between countries.

The Italian case is worth noting. Table 7 shows an advantage of the Italian tax regime. This advantage can be largely traced to the Italian "dual income" tax system, which splits the tax base for profits into two components, taxed at different rates. Very broadly, the "ordinary return", calculated as the interest rate multiplied by equity invested into the company, is taxed at 19%, while the residual profit is taxed at 37%. In this way, the system "encourages" self-financing through retention of profits and the issue of new share capital. This results in a more homogeneous treatment between debt and equity financing. Since in this section only marginal investments are considered, which, by definition do not earn any residual profit, then the return on such investment is essentially taxed at the lower rate.

The French case is also worth noting. Table 7 shows that France has marginal effective tax rates for retained earnings and new equity far above the overall nominal tax rate on profit. This is due to the fact that France imposes high non-profit taxes.

With regard to assets, in general, intangibles and machinery are taxed quite generously. The only exception is Greece, where buildings are depreciated for tax purposes over a period of ten years and where financial assets benefit from a very favourable tax rate. Reasons for the general disadvantageous treatment of buildings include the comparatively long lifetimes for tax purposes and the obligation to use straight line depreciation (except in Finland and Sweden).

As far as non depreciable assets are concerned, inventories are, in general, more heavily taxed. It is very difficult to draw general conclusions concerning the relative treatment of depreciable and non depreciable assets. In fact, as already pointed out when analysing Table 1, estimates of the effective tax burden could be sensitive to the assumptions made for true economic depreciation. Section 5 of this section examines the sensitivity of the results commented on in this section to the assumptions made.

  • B) 
    The case of a profitable (infra-marginal) investment

Table 8 presents a summary of the effective average tax rates for each Member States for investments whose pre-tax real rate of return is 20%

Table 8 Effective Average Tax Rate by country

-by asset, source of finance and overall -only corporation taxes

EFFECTIVE AVERAGE TAX RATES

ty qui bt

verall Mean ssets

Country Corporate O earnings

w e De

 tax rates (1) Industrial B

uildings

Intangibles Machinery

Financial A Inventories R etained Ne

Austria 34.00 29.8 28.6 29.2 28.4 33.2 29.9 33.9 33.9 22.3

Belgium 40.17 34.5 30.7 36.1 31.0 39.2 35.3 39.1 39.1 25.8

Denmark 32.00 28.8 21.3 34.7 25.3 31.2 31.2 32.3 32.3 22.1

Finland 28.00 25.5 24.8 24.8 23.1 27.3 27.3 28.8 28.8 19.3

France 40.00 37.5 30.6 40.6 40.1 39.0 37.1 42.1 42.1 28.8

Germany 52.35 39.1 33.9 39.0 34.9 46.8 40.8 46.1 40.1 27.7

Greece 40.00 29.6 35.5 30.4 33.4 11.6 37.1 34.4 34.4 20.8

Ireland 10.00 10.5 8.9 15.8 8.2 9.8 9.8 11.7 11.7 8.2

Italy 41.25 29.8 24.9 29.8 27.4 36.1 31.1 31.8 31.8 26.1

Luxembourg 37.45 32.2 28.6 33.7 29.2 36.6 32.9 36.6 36.6 24.0

Netherlands 35.00 31.0 26.7 32.4 29.2 34.2 32.5 35.1 35.1 23.3

Portugal 37.40 32.6 33.2 31.8 28.6 36.5 32.8 37.0 37.0 24.5

Spain 35.00 31.0 31.1 31.8 27.4 34.2 30.7 35.2 35.2 23.3

Sweden 28.00 22.9 19.6 23.4 19.7 25.7 25.7 26.0 26.0 17.1

UK 30.00 28.2 24.2 33.7 24.7 29.3 29.3 31.8 31.8 21.6

Note. Each asset column represents an average across all three types of finance, with weights of 55% retained earnings, 10% new equity and 35% debt. Each finance column represents an unweighted average across all 5 assets. The overall average is an average across all 15 types of investment, with the same weights. (1) Including surcharges and local taxes

For all countries bar one (see below), the EATRs are higher than the effective marginal tax rates but still lower than the overall nominal profit tax rate. The effective tax burden rises when the profitability rises because allowances against the cost of the investments become relatively less important when the cost of the investment becomes smaller relative to the returns.

It is worth noting that the only country which has an EATR lower than the EMTR is Ireland. For this country the average tax burden of the investment decreases when profitability rises and marginal investments are relatively more highly taxed than profitable investments. In fact, as was shown when analysing Table 7, for Ireland the marginal tax rate is higher than the national profit tax rate because of the relatively high real estate tax rate applicable to industrial buildings. When profit rises, the weight of this tax becomes relatively less important because the tax is levied not on profit but on the value of the industrial buildings. As a result, when profit rises, the effective tax burden for industrial building diminishes.

Table 8 shows that, when profitability is set at 20% the EATR for industrial buildings is 15.8%. This is lower than the EMTR for industrial buildings (26.8%) but still higher than the corporate profit tax rate. This influences the overall mean.

There appears to be rather more dispersion in the overall average EATR for each Member State than there is in the equivalent EMTR. The Irish average rate is only 10.5%. Other rates range from 22.9% in Sweden to 39.1% in Germany.

The other main conclusions of the previous section are equally applicable in the case of a profitable investment. The link between effective tax burden and national profit tax rate is now even stronger and it is noteworthy that the ranking of Member States is almost the same when considering the EATR and national profit rates. The only exceptions are Italy and Greece. For Italy, again, the existence of "dual income" tax system tends to reduce its EATR in comparison to the national profit rate when the profitability is set at 20%. At the same time, this system plays now a less important role than in the case of a marginal investment. Italy has the lowest average cost of capital, but only the seventh lowest EATR. For Greece, the higher difference between its national corporate rate and average effective tax burden seems to depend on the generous capital allowances granted for depreciable assets and on the very favourable treatment of financial assets, which benefit from reduced rates.

Box 1 Tax Analyser: Effective Average Tax Rates (corporation level) across 5 EU Member States and the USA.

This box gives measures of the effective tax burden of companies as computed by the application of the model "Tax Analyser", which was described in section 3. (The hypothesis and restrictions of this model are given in Annex H).

For the sake of international comparability and in order to isolate the effects of taxation, the comparisons of the effective average tax rates are made under the assumption that the weights of assets and liabilities of the model firms are identical in all countries. The Tax Analyser model refers, as a base case, to a typical medium-sized German manufacturing company with data taken from published German statistics. (Annex H explains the structure of the balance sheet of the model firm).

The effective average tax rates for the scenario in which only taxes at the level of the corporation are taken into account, over a calculation period of ten years, are shown in the following table.

TABLE A Effective Average Tax Rate across 5 EU Member States and the USA

- Only corporation taxes

F D IRL NL UK EU-5 USA Average

EATR - (corporation) 39.7 32.8 8.3 24.0 21.0 25.2 29.7

relative in % 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Corporation tax and 54.3 77.0 77.2 98.5 88.6 79.1 80.1 surcharges

Trade tax / franchise tax on - 22.3 - - - 4.5 12.7 income

Trade tax on capital / taxe 32.4 - - - - 6.5 - professionnelle

Employer´s contribution 10.7 - - - - 2.1 -

Property tax - - - - - - 7.2

Real property tax 2.6 0.7 22.8 1.5 11.4 7.8 -

As was the case for the analysis of a hypothetical investment, this table shows that there is considerable variation in the EATR, with a range of 31.4 percentage points between the highest and lowest rate. In the case of a hypothetical investment the range was 28.6 percentage point. Therefore, the application of the Tax Analyser model confirms the magnitude of the variation inside the EU.

If we compare the results of Table 8 with the results of Table A, the most striking result is that, with the exception of France and Germany, the ranking of the countries from the highest to the lowest EATR is the same for each model and this ranking closely follows the country ranking according to statutory tax rates. The difference in the relative position of France, which is the highest EATR country here and the second in the ranking in Table 8 can be explained by the fact that, in contrast to the hypothetical investment case, a higher portion of non-profit taxes is included in the Tax Analyser model. That is, the three "employer taxes" and the personal expenses forming part of the base of the "taxe professionnelle" are included in the Tax Analyser model.

The differences between EU countries' EATR are self-evidently due to different national tax systems, tax bases and tax rates. But, it is important to stress that the Tax Analyser model takes into account almost all the elements that affect the tax base. Only special incentives are excluded.

The results of Table A reveal that there is considerable variation in the structure of the national tax systems. In all countries, profit taxes have the highest impact on the EATR. By contrast, the impact of non-profit taxes on the EATR is low on average. The only exception is France where the weight of nonprofit taxes is 45.7%.

When the corporation tax bases are compared for a typical medium sized company, Figure A below reveals a large variation between the countries. This considerable range is mainly caused by the low tax base in France, as notably a consequence of the relatively high social contributions, and, to a lesser extent in Germany. These differences are, however, smaller than would be expected from the findings in many qualitative analyses of these tax bases.

FIGURE A Comparison of overall corporation tax bases of 5 EU Member States and the USA

(Typical medium-sized company)

2 . 5 0 0

2 . 0 0 0

1 . 5 0 0 T h o u s a n d s o f E u r o

1 . 0 0 0

5 0 0

0

F D U S A U K N L I R L

The analysis of the tax bases shows that all tax regimes are designed as more or less integrated systems. This means that there is a particular relationship between the tax rate and the tax base. High rate countries tend to compensate it through a reduced tax base and vice versa. Nevertheless, the cases of France and Germany, which have the highest EATR, and the highest overall corporation rates, clearly illustrate that higher tax rates more than compensate for reduced tax bases. On the other hand, despite having the highest corporation tax base, Ireland benefits greatly from its comparatively very low rate, which results in by far the lowest effective corporation tax burden. In general, tax rate differentials more than compensate for differences in the tax base.

Therefore, the effects of the different tax bases, even if these differences partly compensate tax rate differential, have therefore only a comparatively minor impact on EATR.

The introduction of personal taxation

The introduction of personal taxation in the case of a marginal investment increases the effective tax burden significantly. This is caused by the taxation of the investment backflows in the hand of the shareholders. But personal taxes do more than simply increase the wedge driven between the initial return on the investment and the return finally received by the financier. They alter the whole structure of incentives to use one form of finance rather than another.

Table 9 shows the range of values of the cost of capital and the EMTR in each Member State for a qualified shareholder taxed at the highest personal tax rate.

Table 9 Cost of Capital and EMTR by country - by asset, source of finance and overall - top personal tax rate, qualified shareholder

Overall Cost of Capital Mean

ty qui bt

w e De

Country Cost of C

apital EMTR

Industrial B uildings A

ssets

Intangibles Machinery

Financial Inventories R etained earnings Ne

Austria 5.8 43.5 5.4 5.6 5.4 6.7 5.7 6.5 7.6 4.1

Belgium 5.7 30.2 4.6 6.3 4.7 7.1 5.8 6.5 8.1 3.7

Denmark 4.1 78.4 2.4 5.9 3.3 4.5 4.5 3.8 4.6 4.6

Finland 5.4 60.2 5.2 5.3 4.8 5.9 5.9 6.1 4.6 4.6

France 5.3 72.5 3.5 6.4 6.6 5.4 4.7 5.1 7.8 4.9

Germany 5.4 79.5 4.0 5.3 4.3 7.7 5.6 6.8 4.1 3.5

Greece 5.0 27.8 5.6 4.1 5.0 4.1 6.0 5.9 5.6 3.5

Ireland 4.1 56.4 3.8 5.3 3.7 3.9 3.9 3.1 6.0 5.2

Italy 5.1 18.8 3.1 4.9 4.0 8.0 5.4 6.0 5.6 3.5

Luxembourg 4.1 70.3 3.4 4.5 3.5 5.1 4.0 4.1 4.7 4.0

Netherlands 2.8 95.7 2.3 3.1 2.6 3.4 2.9 2.0 2.2 4.4

Portugal 5.4 33.8 5.6 5.3 4.4 6.6 5.4 5.8 8.7 3.9

Spain 1.5 156.3 1.6 1.8 1.3 1.9 0.9 -0.2 0.1 4.5

Sweden 5.3 73.2 4.5 5.4 4.5 6.0 6.0 5.6 6.7 4.3

UK 5.1 56.9 4.1 6.7 4.3 5.3 5.3 5.2 5.8 4.8

Note. Each asset column represents an average across all three types of finance, with weights of 55% retained earnings, 10% new equity and 35% debt. Each finance column represents an unweighted average across all 5 assets. The overall average is an average across all 15 types of investment, with the same weights.

As explained in section 4.1.2 the introduction of personal taxation implies a decrease in the cost of capital and a considerable rise in the effective marginal tax rates.

As in Table 7, over half the countries have an average cost of capital within a very narrow range: in this case between 5.0% and 5.4%. The only two significant outliers are the Netherlands with an average cost of capital of 2.8% and Spain with only 1.5%. Neither of these countries had a low cost of capital when personal taxes were not taken into account. In both cases the low cost of capital can be traced to the difference in the tax treatment between dividends and interest received by the shareholders. In the Netherlands, for example, qualified shareholders can pay tax on interest at a rate of 60% on nominal interest receipts, but pay tax on dividend income at a rate of only 25%. The high tax rate on interest income means that the shareholder demands a much lower rate of return on their investment in equity, which is reflected in the cost of capital.

However, the ranking of countries by the EMTR is very different. This is because the EMTR is defined as the percentage difference between the pre-tax rate of return earned on the investment and the post tax rate of return earned by the shareholder- that is, the difference expressed as a proportion of the cost of capital. Given a very low cost of capital in Spain, it is quite likely that the EMTR will appear very high. This is compounded in the case of Spain by the fact that the high tax rate on interest income implies that the shareholder is willing to accept a very low post tax rate of return on equity investment; in this case actually less than zero. This results in an EMTR over 100%. The fact that countries with the same cost of capital nevertheless have a different EMTR is because the post-tax rate of return differs between countries.

As far as the whole structure of incentives to use one form of finance over another is concerned, it is no longer true that debt is always the form of finance which minimises the effective tax rate. For a majority of Member States debt is still the most favoured form of finance and new equity the less efficient form, with retained earnings in between. The reasons for the different relative treatment of finance are the different corporation tax systems, the taxation of capital gains from the disposal of shares from the shareholders and, in certain relatively generous cases, final withholding taxes on interest income. These three tax-drivers have an interactive impact on the relative position of the forms of finance.

For example, the reason for the lower tax burden on retained earnings when personal taxation is considered, is simply that capital gains are either not taxed at the personal level, (whereas debt or dividends are) or else that capital gains are not taxed on accrual but only on realisation, whereas with dividends and debt any tax due cannot be postponed in this way.

Box 2 Tax Analyser:

Effective Average Tax Rates (overall level: corporation and shareholders) across 5 EU Member States and the USA

Compared to the tax burden at the level of the corporation (see Box 1 Tax Analyser), the overall tax burden including personal taxes is higher, with no changes in the country ranking.

TABLE B Effective Average Tax Rate across 5 EU Member States and the USA

- Corporate and personal taxes

F D IRL NL UK EU-5 Average USA

EATR - (corporation and

shareholder) 48.8 37.4 17.2 32.0 25.6 32.2 32.0

The range of the EATR is also higher. This suggests that there is even more variation in personal taxes than in corporate taxes.

Besides corporate taxes, these differences at the overall level come from the interaction of corporate and personal income taxes, the individual income tax rates including surcharges and capital taxes at the shareholder level.

The impact of the German tax reform

The analysis so far has been based on the tax regimes which were in place in 1999. For the purpose of comparison across countries it is important to choose a particular time at which to make a comparison. Clearly, tax reforms in the EU can and do occur almost continuously, and so it is impossible for any set of results to reflect the long-term position. However, the German tax reform, which came into effect on January 1, 2001, is such a substantial and important reform affecting at the same time the system, the taxable base and the rate, that it is useful to investigate how the main conclusions of the analysis are affected by it. Therefore, this section investigates the impact of the German tax reform on the main results of the previous analysis.

Box 7: Description of the major tax changes in Germany

With effect from January 1, 2001, the German tax reform has changed the corporation tax system, reduced corporation and

personal income tax rates and broadened the tax base.

Corporation tax system : The full imputation system that has been in force since 1977 has been abolished and instead a

shareholder relief system has been introduced. Under the new system (which is similar to the system in Luxembourg), only

one half of the dividends received by a private shareholder are subject to personal income tax. At the same time, all

deductions connected with dividend income from the income tax base are halved. However, other elements of private

capital income such as interest receipts are still taxed at the full rate. The abolition of the (full) imputation system follows

an international trend. After the German tax reform only five EU Member States remain that apply an imputation system:

Finland, France, Italy, Portugal and Spain. The vast majority of the Member States now utilise shareholder relief systems.

Corporation tax rates : The changes in the corporation tax rate cover both the structure and the level of the tax rate. The

split-rate that distinguished between retained (40%) and distributed profits (30%) has been abolished and a single uniform

tax rate of 25% has been introduced. Although the 25% corporation tax rate is the second lowest of the countries

considered in this report (and within the EU), the solidarity levy of 5.5% and the trade tax with an average rate of 17.56%

remain. This has reduced the national tax rate on retained earnings from 52.35% to 39.3%. Although this is a significant

reduction, the statutory tax rate is still high by EU standards. Only France, at 40%, has a higher tax rate.

Income tax rates : The top marginal personal income tax rate is being lowered from 53% (55.92% including the solidarity

levy of 5.5%) in three successive steps leading to a rate of 42% (44.31% including the solidarity levy) in 2005. The top

marginal tax rate begins at a taxable income of Euro 52.152. For the year 2001 the top marginal rate has been set at

48.5%, and it will be 47% in 2003. For the purposes of the following calculations only the situation applying from the year

2005 is considered.

Corporation tax base : There has been a broadening of the tax base by cutting back the depreciation rules both for tangible

fixed assets and for buildings. The maximum declining balance rate for tangible fixed assets has been reduced from 30%

to 20%. For buildings, the straight-line depreciation has been reduced from 4% to 3%.

Relevant economic measures: cost of capital and EATR before and after the reform

The effects of the reform both on the cost of capital and the EATR for domestic investments in the case in which there are no personal taxes are summarised in Tables 10 and 11.

  • A) 
    The case of a marginal investment

Table 10 presents the cost of capital for domestic investment in Germany both before the reform (based on the 1999 tax regime) and after the reform has been implemented. For each of the 15 types of investment, the upper number represents the case before the reform, and the number below represents the cost of capital after the reform.

Table 10 Germany Cost of Capital before and after reform - only domestic investment

- only corporation taxes

Before reform Intangibles Industrial Financial

(upper line) Buildings Machinery Assets Inventories Mean

After reform

(lower line)

%

Retained 7.8 9.8 8.0 12.6 10.5 9.7

Earnings

6.6 8.4 7.4 9.5 8.2 8.0

New Equity 5.8 7.6 6.1 10.4 8.2 7.6

6.6 8.4 7.4 9.5 8.2 8.0

Debt 1.6 3.0 2.2 5.7 3.6 3.2

3.2 4.7 3.9 5.7 4.5 4.4

5.4 7.2 5.8 10.0 7.9 7.3 Mean

5.4 7.1 6.1 8.2 6.9 6.8

The lower rate on retained earnings reduces the cost of capital for investment financed by retained earnings. Further, since the split rate system is abolished, and in the absence of personal taxes, the cost of capital for retained earnings equals that of new equity. The cost of capital for new equity rises, partly because of the broadening of the tax base, and partly because the effective subsidy to paying dividends is removed. The cost of capital for debt finance also rises -and rather more substantially. This is due to the fall in the tax rate, which means the value of interest deductibility will fall.

With respect to the taxation of different types of assets, investment in all types of assets benefits from the tax rate reduction. However, only investment in buildings and in machinery suffers from the reduction in depreciation allowances. Overall, given the assumptions made here, the average cost of capital across assets is generally reduced; however, it rises for investment in machinery.

It is worth comparing the relative position of Germany after the tax reform with its position before the tax reform. The overall average cost of capital for Germany before the reform was 7.3% . This is the second highest in the EU after France. After the reform the overall average cost of capital for Germany falls to 6.8%. Given the economic assumptions used in the computation, then, the average cost of capital for domestic investment in Germany does fall, but not by enough to change its ranking in the EU. The reason could be the overall national tax rate, which at 39.3% is still the second highest in the EU.

  • B) 
    The case of a highly profitable (infra marginal) investment

Table 11 presents the impact of the tax reform on the EATR for domestic investment in the absence of personal taxes. As noted elsewhere, the EATR depends more closely on the statutory tax rate than does the cost of capital. As a result, the EATR on retained earnings falls substantially - on average across the 5 assets from 46.1% to 38.7%. The EATR on investment financed by new equity also falls - unlike the cost of capital for such investment- reflecting the lower statutory corporation taxation tax rate for distributions. Finally, on average the EATR for investment financed by debt is almost unaffected, although there are differences across assets.

Table 11 Germany EATR before and after reform - only domestic investment

- only corporation taxes

Before reform Industrial

(upper line) Intangibles Buildings Machinery

Financial

Assets Inventories Mean

After reform (lower line) %

Retained 40.6 46.3 41.2 54.3 48.2 46.1

Earnings

34.4 39.9 36.6 43.2 39.3 38.7

New Equity 34.9 40.1 35.8 47.9 41.9 40.1

34.4 39.9 36.6 43.2 39.3 38.7

Debt 23.1 27.2 24.8 34.8 28.8 27.7

23.9 28.6 26.1 31.7 27.9 27.6

33.9 39.0 34.9 46.8 40.8 39.1 Mean

30.8 35.9 32.9 39.2 35.3 34.8

The overall average impact of the German tax reform on EATR is to reduce it from 39.1% to 34.8%. Comparing Germany to other Member States (shown in Table 8), pre-reform, Germany had the highest EATR, ahead of France, (37.5%) and Belgium (34.5%). The effect of the reform is to shift Germany's ranking in terms of the EATR from the highest to the second. As with the cost of capital, the reform appears to have some impact on the effective tax rates faced by domestic German companies, but it has little effect on Germany's overall position relative to other EU Member States.

The introduction of personal taxation

Table 12 presents the cost of capital when the firm is owned by a qualified shareholder taxed at the highest personal tax rate. The addition of personal taxes has several effects. First, the reduction in the tax rate on interest income raises the post-tax return available on lending by the shareholder, which in turn raises the post-tax required return on equity. This tends to raise the cost of capital. Second, the abolition of the imputation system tends to raise the cost of capital for investment financed by new equity. However, this is offset by the reduction in the personal tax rate on dividend income. Third, the reduction in the effective capital gains tax rate tends to reduce the cost of capital, especially for equity financed investment. These effects are reflected in the results in Table 12.

Table 12 Germany Cost of Capital before and after reform - only domestic investment

- top personal tax rate, qualified shareholder

Before reform Intangibles Industrial Financial

(upper line) Buildings Machinery Assets Inventories Mean

After reform

(lower line)

%

Retained 5.4 6.8 5.6 9.3 7.1 6.8

Earnings

3.6 4.7 4.1 5.6 4.4 4.5

New Equity 2.8 3.9 3.2 6.4 4.2 4.1

4.2 5.3 4.7 6.2 5.0 5.1

Debt 2.3 3.3 2.6 5.7 3.6 3.5

3.7 4.8 4.2 5.7 4.5 4.6

4.0 5.3 4.3 7.7 5.6 5.4 Mean

3.7 4.8 4.2 5.7 4.5 4.6

The changes in the cost of capital are similar to those in Table 10 - on average the cost of capital rises for investment financed by new equity and debt, and falls for investment for investment financed by retained earnings. However, the rise in the cost of capital for investment financed by new equity is more substantial than in Table 10 reflecting the replacement of the imputation system.

Box 3 Tax Analyser: The effects of the German tax reform

This Box highlights the impact of the German tax reform on the EATR both at the level of the corporation and overall (corporation and shareholder) based on the behaviour of a typical medium-sized German corporation in the manufacturing sector over the calculation period of ten years.

  • A) 
    Corporation level

The following table compares the tax burdens for the base case corporation in the manufacturing sector in 1999 and after the tax reform (denoted as 2001).

TABLE C Effective Average Tax Rate in Germany before and after the reform

- only corporation taxes

GER GER

1999 2001

EATR (corporation)

  • effective in % 32.8 30.1

Relative in % 100 100

Corporation tax incl. Surcharges 77.0 65.6

Trade tax 22.3 33.4

Real property tax 0.7 1.0

The tax reform reduces the EATR of the typical German corporation from the manufacturing sector over the calculation period of 10 years by 2.7 points. Regarding the weight of the different taxes in the EATR, the results from Table C show that a decrease in the corporation tax is mechanically associated with an increase of the shares of the trade tax and of the real property tax in the total EATR. Since both local taxes are deductible as business expenses from the base of the corporation tax, and the corporation tax rate is reduced, the (corporation) tax savings due to the deduction of these taxes will also be lower. Moreover, the change in the depreciation rules immediately affects the trade tax since it is based on the same taxable profits as the corporation tax.

An analysis of the impact of the different elements of the reform (see Table D) reveals that the decrease in the effective tax burden that can be attributed to the reduction of the corporation tax rate is outweighed (by more than 50%) by the changes in the depreciation rules and the corporation tax system. The reduction in the effective tax burden which is solely attributable to the lower corporation tax rate is 23.4%. The new depreciation rules for buildings and tangible fixed assets increase the effective tax burden by 5.5% (buildings 1.3% and tangible fixed assets 4.2%). The EATR increase due to the change in the corporation tax system is 11%. This requires some explanation. It is assumed here that the amount of dividends distributed to the shareholders after the reform is the same as before the reform. Since the dividends are no longer accompanied by a tax credit, the corporation must increase its cash distribution in order to pay the same amount of dividends to the shareholders as before the reform.

TABLE D German Tax Reform - increases and decreases attributed to different changes in taxation - only corporation taxes

in % of 1999

EATR

Reduction of corporation tax rate to 25% -23.4

Reduction of straight-line depreciation for buildings 1.3

Reduction of declining balance depreciation 4.2

Abolition of full imputation system 11.0

Altogether, the EATR reduction is too low to improve the relative position of Germany in the country ranking. Before the reform, German corporations’ EATR (32.8%) was the second highest after France (39.7%). After the reform, Germany is still second highest (30.1%) now closely followed by the USA (29.7%). There is still a considerable gap to the Netherlands (24%) in fourth position.

  • B) 
    Overall (corporation and shareholder) level

If we consider the overall level including personal taxes of the shareholders, the German tax reform reduces the effective tax burden significantly. In addition to the reduction of the marginal (and average) income tax rate, which affects both the dividend and interest income, this result can be attributed to the introduction of the new corporation tax system. According to the German method of shareholder relief only one half of the dividends is subject to personal income tax. The results in Table E, which combine corporate and personal taxes, show that the overall EATR falls from 37.4% in 1999 to 30.1% in 2005. As a result Germany improves two positions in the country ranking to third lowest place behind Ireland (17.2%) and the UK (25.6%).

TABLE E Effective Average Tax Rate in Germany before and after the reform - Corporate and personal taxes

GER GER

1999 2001 / 2005

EATR (corporation)

  • effective in % 32.8 30.1

EATR (corporation and shareholder)

  • effective in %(1) 37.4 30.1

(1) The fact that the effective tax rates at the corporation and shareholder level are identical is only valid for the individual case. It cannot be concluded that the effect of the German tax reform is to equate these rates. It will depend on the income of the shareholder whether the rates are higher, lower or by chance the same.

As a result, overall it seems reasonable to conclude that a typical medium-sized corporation with a low number of shareholders benefits from the German tax reform.

The results presented in this box are in line with the results presented in section 4.4. Despite the considerable reduction of the EATR, the German tax reform has only minor effects on the relative position of Germany in the country ranking.

Neutrality and distortion effects: concluding remarks from the domestic analysis

The analysis of the domestic case shows that European tax codes have an influence on the incentives to investment and the choice of the way of financing the investment. The analysis suggests that, in practically every situation analysed, on the one hand, tax systems tend to favour investment in intangibles and machinery and, on the other, debt is, by far, the most convenient source of financing. Moreover, the data tend to show that financing by retained earnings implies a lower cost than financing by new equity when personal taxation is taken into account. Thus, tax regimes as such are clearly not neutral to the extent that they tend to distort investment and financing decisions compared to a situation without taxation. From a purely economic point of view this has an impact on the efficiency of the allocation of resources within Member States and within the EU as a whole.

The previous analysis also suggests that there is considerable variation in the effective tax burden faced by investors resident in the different EU Member States. However, the Member States' tax codes tend to favour the same forms of investment by assets and sources of finance. Differences between the effective tax burden in the EU Member States can affect the competitiveness of companies competing in the same external markets and may affect, under certain conditions, the location choice of multinationals.

The wide spread within the EU cannot be explained by one feature of the national tax systems alone. However, the analysis presented above tends to show that the different overall nominal tax rates on profits (statutory tax rates, surcharges and local rates) can explain most of the differences of EMTR between countries. Therefore, although tax regimes are designed as more or less integrated systems (in general high tax rates on profit correlate with lower taxable bases and vice versa) tax rate differentials more than compensate for differences in the tax base. These conclusions are to be considered when discussing the compensatory effects of a broad tax base compared to a relatively low tax rate on the effective tax burden. The relative weight of rates in determining the effective tax burden of companies rises when the profitability of the investment rises. The policy simulations presented in section 7 will allow a better appreciation of the influence of particular features of taxation on the effective tax burden differentials between Member States.

When considering the effect of the German reform the analysis suggests that, although this reform appears to have some impact on the effective tax rates faced by domestic German companies, the reform has little effect on Germany's position relative to other EU Member States. This is because the overall national corporate tax rate in Germany remains high by the standards of the EU.

How far governments should be concerned about non-neutralities and differentials depends on the different legitimate goals of tax policy. For instance, a desire to "fine tune" depreciation allowances in order to approximate true economic depreciation would have to be traded off against the desire for administrative simplicity. Also, when personal taxation is taken into account, solutions which would ensure that one form of financing is not favoured over another, could be incompatible with the traditional goal of progressive taxation of comprehensive income. With a progressive personal income tax, it is more difficult to achieve a neutral corporate tax system. More generally, a non-neutral tax regime may be justified from the point of view of economic efficiency in order to encourage or discourage certain activities insofar the activities in question render positive or negative side-effects.

On the other hand, concerns related to the non-neutrality of tax systems derive from the fact that taxation is one instrument for the creation of an appropriate business environment, and that its various other goals can often be furthered more effectively by other policy means. In this case the taxation system must not act as an obstacle to market efficiency. Moreover, a system characterised by large differences may often offer unintended opportunities for tax avoidance.

T ESTING THE ASSUMPTIONS OF THE MODEL

Various assumptions have been made to generate the results given so far. This section examines the effects of altering these assumptions, thereby illustrating the sensitivity of the results to the assumptions made. In fact, the previous analysis is based on a set of very specific hypothetical investments under specific economic conditions. Therefore, the data presented in the previous sections should not be regarded as the universally valid values for the effective tax burden in different countries. It is therefore legitimate to ask to what extent the general results shown above depend on the assumptions and, in particular if changes in the parameters defining the investments or in the economic variables alter the general conclusions of the previous sections. In fact, even if there are no universally valid values, it is important to check whether it is possible to make generally valid statements regarding differences in the effective tax burden. In order to answer this question, this section conducts a sensitivity analysis which recalculates the cost of capital and each effective tax rate several times, each time varying the main parameters of the model. This is done for the average values across the EU and for the different countries separately. For the purposes of this exercise, only corporate taxes are considered.

Sensitivity of the average EU cost of capital and EATR to the changes in the economic model or level of taxes

Tables 13 and 14 present an average across all Member States of the cost of capital and EATR for the different forms of investment, corresponding to the tables in the previous sections. The first row in each of these tables summarises the position in the base case, that is the averages shown respectively in Tables 1 and 2. The other rows consider separately the effects on the overall average of changing one parameter or set of parameters at a time. These changes involve the economic variables (real interest rate, rate of inflation and level of profitability of the investment), the weights assigned to the assets and the impact of local taxes and special investment incentives. There is no row numbered 4 in Table 13 (cost of capital), since that would refer to the change in profitability which is relevant only for the EATR.

Table 13 Cost of Capital - average across all the 15 EU Member States - only corporation taxes

ty

Cost of capital (%) qui bt

O verall mean A

ssets etained w e De

Intangibles Industrial B

uildings

Machinery Financial Inventories R earnings Ne

1 Base case 6.3 5.4 6.7 5.6 7.3 6.7 7.6 7.4 4.1

2 Real interest rate: 10% 12.5 11.0 13.1 11.2 13.9 13.4 14.6 14.4 8.6

3 Rate of inflation: 10% 6.7 5.4 6.1 5.7 9.6 6.5 9.2 8.9 2.1

5 OECD/Ruding weighs 6.1 - 6.7 5.6 - 6.7 7.3 7.2 3.9

6 BACH average weights 6.0 4.7 6.0 4.9 6.5 5.9 8.0 7.8 4.4

7 Service sector weights 6.1 4.6 5.8 4.8 6.4 5.8 8.3 8.1 4.6

8 Equal weights 6.4 5.4 6.7 5.6 7.3 6.7 7.6 7.4 4.1

9 High level of local taxes 6.5 5.4 7.3 5.7 7.4 6.7 7.8 7.6 4.2

10 Low level of local taxes 6.2 5.4 6.2 5.5 7.2 6.6 7.4 7.2 4.0

11 Tax incentives for 5.1 4.1 5.7 2.2 7.1 6.5 6.3 6.1 3.0

new investments

Note. Each asset column represents an average across all three types of finance, with weights of 55% retained earnings, 10% new equity and 35% debt. Each finance column represents an unweighted average across all 5 assets. The overall average is an average across all 15 types of investment, with the same weights. Note also that the OECD report and the Ruding report considered only three assets: industrial buildings, machinery and inventories.

Table 14 Effective Average Tax Rates

- average across all the 15 EU Member States - only corporation taxes

ty qui bt

EATR (%) earnings

w e De

O verall mean Industrial B

uildings A ssets

Intangibles Machinery

Financial Inventories R etained Ne

1 Base case 29.5 26.8 31.1 27.4 31.4 30.9 33.5 33.1 22.3

2 Real interest rate: 10% 24.9 20.3 27.0 20.7 28.6 28.0 31.7 31.0 12.5

3 Rate of inflation: 10% 30.7 27.0 29.4 27.6 38.9 30.6 38.7 37.9 16.1

4 Level of Profitability: 40% 31.6 30.4 32.6 30.7 31.7 32.5 33.5 33.3 28.0

5 OECD/Ruding weights 29.2 - 31.1 27.4 - 30.9 33.0 32.7 22.2

6 BACH average weights 28.0 24.7 28.9 25.3 29.0 28.6 34.4 34.0 23.0

7 Service sector weights 28.9 25.3 29.2 25.8 29.5 29.2 36.1 35.7 24.0

8 Equal weights 29.6 26.9 31.2 27.5 31.5 31.0 33.5 33.1 22.3

9 High level of local taxes 30.5 27.3 33.6 28.2 31.9 31.4 34.4 34.0 23.3

10 Low level of local taxes 28.6 26.3 28.9 26.5 30.8 30.3 32.5 32.1 21.4

11 Tax incentives for new 25.7 22.8 28.0 17.0 30.5 30.3 29.4 29.0 19.0

investments

As far as the economic parameters are concerned the tables show that, when the real interest rate is doubled from 5% to 10%, ceteris paribus, the cost of capital roughly doubles in all cases and the EATR tends to fall. This reflects the fact that, in the case of the cost of capital, taxes tend to have a multiplier effect: very roughly, the cost of capital is the real post-tax required rate of return multiplied by a factor reflecting the tax system. The EATR falls because the pre-tax rate of return is still fixed at 20% and so investments are rather less profitable. Given the relationship between the EATR and profitability demonstrated in Figure 1, one would expect the EATR to be lower. Although the values of the cost of capital are higher and those of the EATR slightly lower, the relative pattern across types of investments

is not affected.

By contrast, introducing a higher rate of inflation, from 2% to 10% exacerbates the differences between debt and equity finance. This is due to the fact that nominal interest rates are assumed to rise in line with inflation; since these are deductible in the case of debt financing, both the average cost of capital and the

average EATR fall for debt finance.

The rise of the profitability of the investment from 20% to 40% increases the value of the EATR. This is in line with the analysis in Box 1. The higher the profitability of the investment, the closer is the EATR to the statutory profit tax rates. In general, this tends to reduce differences both between types of investments and types of financing and between countries. Figure 2 illustrates that for a level of profitability of 40% the individual countries EATR have already moved much closer to the national nominal profit tax rates. Italy and Greece show wider differences for the reasons explained in section 4.3 (commentary on Table 8). Annex D shows the distribution of the EATR in each EU Member State. It therefore presents the range of values of the EATR for all possible levels of profitability.

at e

a t 20% a t 40% or y R

TR TR

EA EA St at

ut

y an rm Ge

ly

y Ita

ut or tat m lgiu

Be

a nd S

ce ee

& 40% Gr

f 20% e nc

Fra

ns o

ber States et ur rg ou

ax r mb xe

e t Lu

pr al rtug

Po

age at

ver ain Sp iv e A

ect ds

E ff an erl th

Ne

fective Average Tax Rates by Mem ia str

at es 1999 - Au

ax R k ar m

at e T Den

UK

it Tax Rates and Ef C or

por

rof n

de

Swe

S tatutory P nd nla Fi

d lan

F igure 2 Ire

00% 00% 00% 00% 00% 00% 00% 00% 00%

50, 45, 40, 35, 30, 25, 20, 5,

00%

15, 10, 0,

00%

Changing the weights of assets (rows 5 to 8) has almost no effect on the average cost of capital or the average EATR. This suggests that the weights of the assets are not likely to be very sensitive for the purpose of the overall analysis.

Row 5 considers only the 3 assets and the respective weights considered by the OECD/Ruding studies: industrial buildings: 28%, machinery: 50% and inventories: 22%. The weight of the sources of finance is held constant at the levels of the base case scenario. These weights are taken from the OECD (1991) and Ruding (1992): retained earnings: 55%, new equity: 10% and debt: 35%.

Rows 6 and 7 use weights generated from accounting data (the BACH database). This approach uses accounting data for a large number of companies from different Member States. The numbers in the table below reflect the relative importance of each of the 5 assets, and each of the 3 sources of finance.

BACH weight

(%) d nery

ta ine Debt

Intangibles Industrial Buildings Machi Financial

assets

Inventories Re Earnings New Equity

Manufacturing 2.9 14.3 19.3 45.6 17.9 24.7 20.5 54.8

Services 3.2 12.3 11.9 54.2 8.4 21.6 19.4 59.0

The high weight in the BACH database attached to debt for both the manufacturing and services sector implies that the average cost of capital and EATR is lower for the 5 assets. The overall averages are lower mainly as a result of the high weight for debt.

Considering that the purpose of the quantitative analysis in this study is to "isolate" the impact of taxation on the same identical investment in each EU country, indicators based on the weight of each individual Member State have not been computed.

Rows 9 and 10 in each of the Tables relate to local taxes. In the analysis in the base case, "typical" values of local taxes were used: these are detailed in Appendix B. However, by their very nature, local taxes vary within a country. Hence two more extreme cases are considered - where local taxes are 50% higher than those in the base case and where they are half those in the base case 41 - to discover whether these taxes play an important role in determining the cost of capital and the EATR. In fact, local taxes seem to play a relatively small role in determining these measures. The results are very close to the base case, with the exception of investments in industrial buildings. This reflects the fact that most real estate taxes are local taxes, which apply to buildings but not to other assets.

The final row considers the impact of special investment incentives There are a large number of such incentives within the EU, which takes a variety of forms. The exercise here is intended only as a part of a sensitivity exercise, to get an impression of the likely effect of such incentives, rather than to document them fully. Specifically, the last row of each Table gives the average cost of capital and average EATR where each country operates a single investment incentive. The incentives considered represent countrytypical incentives extracted from a questionnaire. They reflect significant or common incentives.

41 Note that this is simply intended to investigate the relative importance of local taxes. In practice, under existing law,

local governments may not have the right to vary local taxes by these amounts. This is the case in France and Italy for example.

Depending on the country, the incentives considered might be extraordinary depreciation, special tax credits or special tax incentives. The precise incentive for each country is given in TABLE 12 of Appendix B.

Not surprisingly, such incentives do reduce the average cost of capital and the average tax burden without altering the relative position of the source of finance.

All in all, the previous analysis demonstrates that in most cases the parameters used in the model tend to have a little effect on the overall EU values of the cost of capital and the EATR. More importantly, changing the parameters does not alter the nature and the broad size of differences observed in section 4 as far as the overall EU values are concerned.

Impact of the sensitivity analysis on the relative position of Member States

The exact values of the effective tax burden of each Member State can, however, vary according to the definition of the investment and, as mentioned above, there is no universally valid value in one country. The purpose of this section is therefore to test if the ranking of Member States according to their average cost of capital and the average EATR arising from Tables 7 and 8, would be affected by changes in the assumptions used in the base case. The analysis is made for the 1999 situation.

Tables 15 and 16 show the ranking of Member States from 1 to 15, with the country with the highest cost of capital or EATR having the rank 1, and the lowest having the rank 15. Each of the cases presented in Tables 13 and 14 are presented; these are numbered 1 to 11 with 1 corresponding to the ranking relative to the base scenario. The column numbered 4 is blank in Table 15 (cost of capital), since that refers to the change in profitability which is relevant only for the EATR. The first column presents the average ranking over columns 1 to 11 and therefore gives the position of each Member State when all the different sensitivity analyses are taken into account.

Table 15 Ranking of Member States by Average Cost of Capital - highest=1, lowest=15

  • only corporation taxes

Country Sensitivity Analysis No.

1 2 3 4 5 6 7 8 9 10 11 nk

Ra (Average)

Austria 9 9 8 9 ./. 8 10 10 9 10 7 6

Belgium 5 7 5 10 ./. 7 6 3 5 5 8 4

Denmark 4 8 11 4 ./. 4 4 4 8 4 10 1

Finland 11 11 12 6 ./. 10 11 12 11 11 9 3

France 2 1 2 1 ./. 1 1 2 1 1 1 13

Germany 1 2 1 2 ./. 3 2 1 2 2 2 5

Greece 12 12 10 12 ./. 6 15 15 12 12 11 14

Ireland 14 14 14 14 ./. 13 13 11 14 13 14 10

Italy 15 15 15 15 ./. 15 14 14 15 15 15 15

Luxembourg 10 10 9 11 ./. 9 7 7 10 6 12 12

Netherlands 6 5 6 5 ./. 5 5 6 7 9 4 9

Portugal 7 6 3 8 ./. 12 9 8 6 8 5 2

Spain 8 4 4 7 ./. 11 8 9 4 7 3 11

Sweden 13 13 13 13 ./. 14 12 13 13 14 13 8

UK 3 3 7 3 ./. 2 3 5 3 3 6 7

Looking across the columns in Table 15, many of the rankings are largely unaffected by the sensitivity analysis. For example, apart from the last column (investigating special investment incentives), France has always the highest cost of capital, and is never lower than second. Italy usually has the lowest, and is

never higher than 14 th . However, while these more extreme cases tend to be fairly stable, there is rather

more movement in the rankings for countries in the middle of the distribution. This is not surprising: as noted in the discussion above, a number of countries have average costs of capital very similar to each other. The ranking of these countries is likely to change more easily than the rankings of the countries outside the band. Despite this, the most notable feature of the Table is the consistency of the ranking of each country across the different elements of the sensitivity analysis. Comparing, for example the ranking based on the base case (column 1) with the average rank in the first column, most of the countries have the same rank in the two columns. This suggests that the base case does give a reasonable indication of the relative positions of each Member State.

Table 16 Ranking of Member States by Average EATR - highest=1, lowest=15

- only corporation taxes

Sensitivity Analysis No.

Country

nk

Ra 1 2 3 4 5 6 7 8 9 10 11

(Average)

Austria 8 8 10 8 10 10 9 9 8 9 7 7

Belgium 3 3 3 3 3 4 3 3 3 3 3 2

Denmark 10 11 11 11 8 9 10 10 11 10 11 6

Finland 13 13 13 12 12 13 12 13 13 13 13 11

France 2 2 2 2 2 1 2 2 2 2 1 8

Germany 1 1 1 1 1 2 1 1 1 1 2 1

Greece 11 10 9 9 11 3 14 15 10 11 8 13

Ireland 15 15 15 15 15 15 15 12 15 15 15 15

Italy 9 9 4 13 13 11 6 6 9 8 10 14

Luxembourg 5 5 6 5 6 5 4 4 5 4 9 4

Netherlands 6 7 8 7 5 6 7 7 7 7 6 5

Portugal 4 4 5 4 4 7 5 5 4 5 4 3

Spain 7 6 7 6 7 8 8 8 6 6 5 9

Sweden 14 14 14 14 14 14 13 14 14 14 14 12

UK 12 12 12 10 9 12 11 11 12 12 12 10

Table 16 repeats the exercise for the EATR. Once again, there is considerable stability in the rankings of countries across the different elements of the sensitivity analysis. Thus, for example, Germany has the

highest ranking in the base case (column 1). Only in two cases does the ranking fall, and then only to 2 nd . Ireland has the lowest ranking on all but one case -for the service sector- where it rises to 12 th . This rise

in the Irish case is because the 10% corporation tax rate applies only to manufacturing and some other special sectors of industry, and the rate applied in general for the service sector is 28%. In the absence of personal taxes, the ranking of countries according to the EATR is broadly similar to that of the cost of capital. As was the case for the cost of capital, this table suggests that the base case does give a reasonable indication of the relative position of each Member State.

Box 4 Tax Analyser: Testing the importance of the assumptions

In order to test the robustness of the results presented in the previous boxes "Tax Analyser" the effects of alternative assumptions of the input data on the EATR are tested by means of sensitivity analysis covering data both at the level of the corporation and the level of the shareholder.

  • 1) 
    Level of the corporation

The impact of changing assumptions is investigated by varying on the one hand the tangible fixed assets to total balance sheet ratio of the model firm and on the other, the weighting of the sources of finance.

  • a) 
    Investment policy

This variation takes into account a change in the model firm's capital intensity. The quantity of tangible assets as a percentage of total assets is raised or reduced first by 10% and then by 20% in comparison with the base case. The ratio in the base case is 22.9%.

The results in figure B show that, with the exception of Germany and the Netherlands, the EATR increases with the capital intensity.

FIGURE B Effective Average Tax Rate across 5 EU Member States and the USA

- variation of tangible fixed assets to total balance sheet ratio - only corporation taxes

F D IRL NL UK USA

40

35

30

25 R

20 EAT

15

10

5

0

18,3 19,5 20,6 21,8 22,9 24,0 25,2 26,3 27,5

Tangible fixed assets to total balance sheet-ratio (per cent)

In Germany and the Netherlands the EATR decreases due to a shift from less generous rules for nondepreciable assets (i.e. financial assets) to a more generous capital allowances practice for depreciable assets. In the case of Ireland, the UK and the USA, it is above all the higher level of real property tax in the overall tax burden that overcompensates for the effects of the capital allowances and is therefore decisive in causing the increase. The EATR increase in France is noticeable. This can attributed to the structure of the French "taxe professionnelle". In fact, the basis of this tax includes tangible fixed assets but exempts intangibles and financial assets.

Although there is no change in the country ranking, it is worth noting that France and Germany have very similar EATR in the case of low capital intensity.

  • b) 
    Structure of finance

In order to investigate the impact of changing assumptions regarding corporate financing on the EATR, the weighting of the sources of financing is gradually changed by increasing the equity to total capital ratio from 25% to 100%. This increase is accompanied by a reduction of the interest expenses for long term debt.

FIGURE C Effective Average Tax Rate across 5 EU Member States and the USA

-variation of equity to total capital ratio

- only corporation taxes

F D IRL NL UK USA

50

45

40

35

30

25

EATR 20

15

10

5

0

25 50 75 100

Equity to total capital ratio (per cent)

Figure C shows that the EATR increases with the equity to total capital ratio in all countries. Therefore, as already underlined for the analysis of a hypothetical investment, national tax systems are not neutral towards the source of company finance.

This discrimination against equity financing at the level of the corporation is more evident in Germany and in the USA. Besides the high level of the corporation tax rate, this result is caused by the levying of other taxes that do not treat the payments for debt and equity capital equally. By contrast, the increase in the EATR is lower by far in Ireland and the UK. Since both countries apply the lowest corporation tax rate and levy no other taxes that discriminate against a particular source of finance, the reduction or saving of taxes due to the deductibility of interest is also the lowest.

Since the discrimination against equity financing in contrast to debt financing is common in all the tax systems that are under review, the EATRs neither cross nor converge. Therefore, differing assumptions about the debt to equity ratio do not change the country ranking of the base case. The level of variation within the sources of finance depends to a great extent on the level of the statutory corporation tax rate. Low tax rates tend to reduce such variations.

  • 2) 
    Overall level (corporation and domestic shareholder)

Just as at the corporation level, the tax burden at the overall level, that is including personal taxation, is influenced by the assumptions about the economic data. Among the variables which have a large impact on the overall EATR, the distribution policy of the company and the sources of company financing provided by the shareholders are the most relevant.

  • a) 
    Dividend policy

In order to work out the impact of changing distribution policy assumptions on the overall EATR, the corporation's distribution rate is gradually increased from zero (full retention of profits) to 100% (full distribution of profits).

Figure D below shows that if the profits are fully retained in the corporation the overall EATR is above all influenced by taxes at the level of the corporation. Due to the differences in the tax burden of the corporation, already explained in previous sections, the overall EATR is the highest in France and the lowest in Ireland.

FIGURE D Effective Average Tax Rate across 5 EU Member States and the USA - variation of rate of distribution

- corporate and personal taxes

F D IRL NL UK USA

60

50

40

EATR

30

20

10

0 25 50 75 100

Rate of profit distribution (per cent)

The overall EATR increases with the rate of distribution in all countries. However Germany improves its relative position while the position of France, Ireland and the USA deteriorate. Ireland and the USA even lose one place in the ranking. This result can be attributed to a great extent to the different corporation tax systems and the degree of progression of income tax rates.

It is interesting to note that the EATRs converge with an increased rate of distribution. The combination of different levels of corporate and personal taxes and the interactions of these taxes with the different corporate tax systems thus reduces the dispersion of the EATR at the level of the shareholders to a great extent.

  • b) 
    Equity to total capital ratio

In order to investigate the impact of changing assumptions about the financing of the corporation on the EATR at the shareholder level, it is assumed that the corporation is entirely financed by its shareholders with debt or equity capital (i.e. the corporation does not raise any funds from third parties). In the case of debt financing, the shareholders receive interest income from the loan granted to the corporation at a fixed rate. Whereas, in the case of equity financing, the profits are fully distributed to the shareholders. The weighting of the sources of finance are gradually changed by increasing the equity to total capital ratio from 25% to 100%. Figure E shows the results.

FIGURE E Effective Average Tax Rate across 5 EU Member States and the USA

- variation of equity to total capital ratio

- corporate and personal taxes

Altogether, the results show that taxation is not entirely neutral towards the financing of a corporation in

F D IRL NL UK USA

75

70

65

60

EATR 55

50

45

40

25 50 75 100

Equity to total capital ratio (per cent)

any of the countries covered by the computation. Moreover, no common pattern exists as to a preferential taxation of debt or equity financing. Since there are countries that either favour debt financing (Germany and, in particular, the UK and the USA) or equity financing (France and the Netherlands) or that tax the source of finance almost equally, both the level of the EATR and the ranking of the countries at the overall level depends on the assumptions regarding the equity to total capital ratio. In general, such dispersions are lowest in countries that either apply a full imputation system (e.g. Germany in 1999) or-irrespective of the corporation tax system-apply a low corporation tax rate (e.g. Ireland). In addition another prerequisite for neutrality towards company financing is an equal treatment of the dividends and interest payments with respect to income tax (and of shares and loans with respect to private property tax).

T HE TAXATION OF TRANSNATIONAL INVESTMENTS

Section 4 examined the impact of taxation on the incentives to invest domestically. This section uses the same approach to consider the impact of taxation on the incentives to undertake transnational investments, i.e. to invest across country borders.

It describes how the framework used to analyse the domestic corporate tax systems of the EU Member States can be extended to cover investments located in one country by companies residents in another. The purpose of this section is to analyse whether there is an incentive for EU companies to choose specific forms of investment and the tax-favoured locations for their investments (which may not be the most favourable locations in the absence of taxes). To the extent that companies respond to such incentives, the tax system may create a global misallocation of resources as activities may be financed or undertaken in high cost locations because they are tax-favoured.

In order to understand the effects of the different Member States' tax systems on investment coming from two of the main EU economic partners in the transnational case, the analysis also considers inward investment into each Member State from the USA and from Canada, which respectively have a credit system and an exemption system.

As was the case for the analysis of domestic investments, this section gives summary measures of the potential distortions by tax systems of transnational investments and does not provide a measurement of the impact of these potential distortions on international investment patterns. (Box 6 in section 4 presented a short survey of the empirical studies which have attempted to measure this impact). The fact that companies may use more complex financial arrangements and group structures in order to minimise tax burdens indicates that the potential distortions reported in this section can be sufficiently large to alter company behaviour from that which would otherwise prevail. It should also be recalled that there are costs associated with these complex financial arrangements. Moreover, to the extent that these arrangements can imply tax evasion, this may create new distortions.

The tax treatment of transnational investments

Investing across borders results in a substantially more complex tax position than investment in one country. Purely domestic investment is determined by one tax system. Transnational investment involves not only dealing with two (or more) tax systems, but also dealing with the interactions of these systems.

Throughout section 6, attention is focused on a parent company that invests in a foreign country by means of a wholly-owned subsidiary. As well as taking account of the domestic tax system, charges on the payments of interest between the subsidiary and the parent and any further taxes levied by the country of residence of the parent company are also incorporated. (The details of the tax regimes modelled are given in Annex B). The other assumptions are the same as those made in the domestic case. With these assumptions, the effects of the tax systems on transnational investments can be isolated from the effects of prevailing economic conditions.

The position of the subsidiary is essentially the same as the independent firm analysed in the domestic case. It may invest in one of the five assets, and it is financed in one of the three ways: retained earnings, new equity and debt. The parent company also raises finance in one of these three ways.

As in the analysis of domestic investments, primarily corporate taxes are considered. Given that it is assumed here that cross border flows of capital are possible, it seems reasonable also to suppose that parent companies can be financed on the international market. But in this case, for the reasons explained in Box 5, it is less plausible that personal taxation affects investment decisions and that the identity of the shareholder is known. Most of the analysis in this section is therefore based on the comparison of taxes paid by the corporation only.

Nevertheless, section 6.5 discusses the role of personal taxes, especially in the context of whether tax credits associated with a dividend payment by the parent to the domestic shareholder are available if the underlying source of income is from abroad.

It is worth noting that the introduction of transnational investments considerably increases the number of cases to be dealt with 42 . Therefore, this section summarises these cases (by calculating simple averages) and highlights only the main issues arising from the transnational investment additional to those already discussed in the context of the domestic investment.

Transnational effective tax rates: detailed positions (cost of capital and EATR) of the EU Member States

The tables in this section summarise the effective tax burden of each possible transnational investment, averaged across the five different assets and the three sources of finance of the parent company. A separate table is used for each of the three different ways in which the subsidiary can be financed.

These tables address the question of differences in the effective tax burdens across possible locations of the investment for a given State of residence of the parent company or, alternatively across possible States of residence of the parent, for an investment in a given location. Moreover, they identify differences in taxation which arise solely because of the way the investment is financed.

  • A) 
    The case of a marginal investment

Three fundamental matrices of transnational rates are given in Tables 17, 18 and 19. These give the required pre-tax rates of return, - the cost of capital - necessary when there is a 5% post-tax rate of return from investing cross-border. The parent country (home country) is given down the side of each matrix and the subsidiary country (host country) is given along the top of the matrix. Table 17 gives the cost of capital when the subsidiary is financed by retained earnings, table 18 when the finance is through new equity from the parent, and table 19 when the parent lends funds to the subsidiary. In all three cases the reported figures represent the averages of the five types of assets and the weighted averages of the three sources of finance of the parent, using the weights of the domestic case.

The results can be interpreted in the following ways. When an Austrian parent company decides to expand the operations of its Belgium subsidiary by retaining funds in the subsidiary then, on average, it must earn a pre-tax rate of return in Belgium of 8.0% in order to be able to give its investors a post-tax

42 In the previous section attention was focussed on 15 possible investments in a domestic context, although considered

in several different scenarios. Transnational investments from each of the 15 Member States to the other 14, plus inward investment to each Member State from 2 further countries creates 240 (15x14 + 2x15) different cross border flows. For each of these there are 9 possible sources of finance and 5 possible assets.

rate of return of 5% (see Table 17); whereas if the Belgium subsidiary were financed by funds lent by the parent, the subsidiary would need to earn 6.0% (see Table 19).

Table 17 presents the cost of capital for investment financed by retained earnings in the subsidiary. As was the case for a domestic investment discussed in section 4.1, the cost of capital in this case is not influenced by the taxation of dividends paid by the subsidiary to the parent. In fact, since the parent forgoes dividends to finance the investments and receives higher dividends as the return from the investment, the tax rate on such dividend flows nets out of the analysis.

Given the assumption of no personal taxes, there is in general also no differences between investments financed by the parent from retained earnings and new equity. Within the different sources of finance used by the parent, then, only debt financing introduces any element of the parent (home) country tax regime.

This implies that within each column in Table 17 - i.e. considering a single subsidiary (host) country - differences in the cost of capital across different home countries arise only in the different treatment of debt in the parent company. Some countries, Austria, Denmark, Netherlands, Spain and Canada do not permit interest paid on loans used for outbound investments to be deductible; these countries have a higher cost of capital. Other countries do permit this. In their case the tax rate determines how valuable this deduction is, and hence how low the average cost of capital is. It is worth noting that the higher the tax rate, the more valuable the deduction.

By contrast, the differences within each row reflect primarily the host country tax system. These differences are likely to affect the location choice of the parent companies. The relative ranking of host countries in Table 17 is very close to that shown in the case of domestic investments. Thus, on average, Italy is the most attractive host location and France and Germany are the least attractive host locations.

Summing up the results of table 17, it can be observed that when the subsidiary is financed by retained earnings, the differences in the cost of capital of subsidiaries located in the same country largely depend on the treatment of debt financing of the parent and on the tax rates applied in the home countries. On the other hand, the incentives to locate faced by the parent company largely depend on the domestic tax systems of the possible host countries.

These results are therefore largely in line with the results obtained in the case of domestic investments, notably the considerable variation in the effective tax burdens and the inherent misallocation problems.

Mean 7.6 6.1 6.4 6.6 6.0 5.5 6.0 7.3 6.4 6.2 7.5 6.2 6.3 6.7 6.4 7.6

Kingdom

United 7.7 6.3 6.6 6.7 6.3 5.9 6.1 7.3 6.4 6.4 7.7 6.4 6.5 6.8 ./. 7.7

eden Sw

6.7 5.4 5.7 5.8 5.4 5.0 5.1 6.4 5.5 5.5 6.7 5.5 5.6 ./. 5.7 6.7

Spain

7.7 6.3 6.6 6.7 6.3 5.8 6.2 7.4 6.4 6.4 7.7 6.4 ./. 6.8 6.7 7.7

Portugal

7.9 6.3 6.7 6.8 6.3 5.9 6.3 7.5 6.5 6.5 7.9 ./. 6.5 6.9 6.7 7.9

nds rla Nethe

7.7 6.2 6.6 6.7 6.3 5.8 6.2 7.4 6.4 6.4 ./. 6.3 6.5 6.8 6.6 7.7

Luxembourg

7.7 6.2 6.5 6.7 6.2 5.7 6.1 7.3 6.3 ./. 7.7 6.3 6.4 6.7 6.6 7.7

in gs. y Ital

earn 5.5 3.9 4.2 4.4 3.9 3.4 3.9 5.1

./. 4.0 5.5 4.0 4.1 4.4 4.3 5.5

n ed Ireland

inance 5.9 4.8 5.1 5.2 4.8 4.5 4.3 ./. 4.9 4.9 5.9 4.9 5.0 5.2 4.9 5.9

retai ith

w Greece 7.6 6.1 6.4 6.6 6.1 5.5 ./. 7.2 6.2 6.2 7.6 6.2 6.3 6.6 6.5 7.6

ced parent f

an

in Germany 8.1 9.3 8.2 8.2 9.7 8.2 s f 9.7 8.1

8.4 8.6 8.1 ./. 8.3 8.7 8.5 9.7

ry i France

9.0 7.5 7.8 8.0 ./. 7.0 7.5 8.7 7.6 7.6 9.0 7.6 7.7 8.0 7.9 9.0

b si d ia

eighted average of

e su Finland 7.2 5.8 6.1 ./. 5.8 5.4 5.6 6.8 5.9 5.9 7.2 5.9 6.0 6.3 6.2 7.2

th

h en Denmark

w 7.5 6.1 ./. 6.5 6.1 5.7 6.0 7.1 6.2 6.2 7.5 6.2 6.3 6.6 6.5 7.5

ital

Belgium

Cap 8.0 ./. 6.8 6.9 6.4 6.0 6.5 7.6 6.5 6.6 8.0 6.5 6.6 7.0 6.8 8.0

Cost of - only corporation taxes; w Austria ./. 6.1 6.4 6.5 6.0 5.6 6.0 7.2 6.2 6.2 7.5 6.2 6.3 6.6 6.5 7.5

to

le 17 % al

T ab ium ance

Cost of ital fr

om

Austria B elg Ir eland It

aly embourg UK

Portug Spain Sweden Canada

Cap Denmark

Fi nland Fr Germany Greece

L ux Netherlands

Mean 6.3 6.5 7.4 6.1 6.3 6.4 6.0 5.8 6.9 7.2 6.4 7.4 7.4 6.2 6.1 6.5 6.5 8.6

Kingdom

6.4 6.6 United 7.7 6.5 6.6 6.7 6.4 6.1 7.7 7.3 6.6 7.7 7.7 6.5 6.5 6.8 ./. 7.7

eden Sw

5.4 5.7 6.7 5.6 5.7 5.8 5.5 5.2 7.2 6.4 5.7 6.7 6.7 5.6 5.6 ./. 6.1 7.2

Spain

6.3 6.7 7.7 6.5 6.6 6.7 6.4 6.0 7.0 7.4 6.6 7.7 7.7 6.6 ./. 6.8 6.7 9.6

Portugal

6.3 6.8 7.9 6.5 6.7 6.8 6.4 6.1 6.8 7.5 6.6 7.9 7.9 ./. 6.5 6.9 6.7 12.4

nds rla Nethe

6.4 6.6 7.7 6.5 6.6 6.7 6.4 6.0 7.0 7.4 6.6 7.7 ./. 6.5 6.5 6.8 6.6 8.3

Luxembourg

6.3 6.6 7.7 6.4 6.5 6.7 6.3 6.0 6.6 7.3 6.5 ./. 7.7 6.5 6.4 6.7 6.6 8.3

y Ital

4.0 4.3 5.5 4.1 4.2 4.4 4.0 3.6 4.0 5.1 ./. 5.5 5.5 4.2 4.1 4.4 4.3 7.4

4.6 5.0 y.

Ireland

5.9 5.0 5.1 5.2 4.9 4.7 8.2 ./. 5.1 5.9 5.9 5.0 5.0 5.2 7.1 5.9

6.2 6.5 w e inance

Greece

7.6 6.3 6.4 6.6 6.2 6.6 ./. 7.2 6.4 7.6 7.6 6.4 6.3 6.6 6.8 7.6

h ne

8.2 8.6 wit

Germany

ed parent f 7.6 6.2 6.3 6.5 6.1 ./. 6.0 7.2 6.3 7.6 7.6 6.3 6.2 6.5 6.4 9.7

France

7.6 7.9 9.0 7.7 7.8 8.0 ./. 7.2 7.5 8.7 7.8 9.0 9.0 7.8 7.7 8.0 7.9 9.6

y is financ Finland

5.9 6.2 eighted average of 7.2 6.0 6.1 ./. 5.9 5.6 7.5 6.8 6.1 7.2 7.2 6.1 6.0 6.3 6.4 8.2

Denmark

6.2 6.5 7.5 6.3 ./. 6.5 6.2 5.9 7.2 7.1 6.4 7.5 7.5 6.4 6.3 6.6 6.5 7.5

n t h e subsidiar

Belgium

6.6 6.9 al whe 8.0 ./. 6.8 6.9 6.6 6.2 6.5 7.6 6.8 8.0 8.0 6.7 6.6 7.0 6.8 10.0

apit Austria

6.2 6.4 ./. of C 6.3 6.4 6.5 6.2 5.9 7.0 7.2 6.4 7.5 7.5 6.4 6.3 6.6 6.5 9.4

to

C ost - only corporation taxes; w

ital ium al

USA Mean 18 % ance Cost of Cap fr om Austria B elg Denmark Fi nland Fr Germany Greece Ir eland It aly embourg UK Portug Spain Sweden Canada

Table L

ux Netherlands

Mean

7.0 6.6 6.3 6.8 6.2 5.9 6.7 7.7 7.1 4.8 6.6 6.5 6.4 6.6 6.4 5.8 6.1 7.4

Kingdom United

7.1 6.9 6.9 7.3 6.8 6.5 7.3 8.1 7.7 5.4 7.1 7.1 7.0 7.1 7.0 6.4 ./. 7.6

eden Sw

6.6 6.0 6.3 6.7 6.2 5.9 6.7 7.5 7.2 4.9 6.5 6.5 6.3 6.5 6.3 ./. 6.1 7.1

Spain

7.5 6.9 6.4 6.9 6.3 6.0 6.8 7.7 7.0 4.8 6.7 6.6 6.5 6.7 ./. 5.9 6.1 7.7

Portugal

8.2 6.9 6.2 6.7 6.1 5.8 6.7 7.6 6.8 5.1 6.5 6.5 6.3 ./. 6.3 5.7 5.9 8.3

nds rla Nethe

6.9 6.8 6.4 6.9 6.3 6.0 6.8 7.7 7.0 4.8 6.6 6.6 ./. 6.7 6.5 5.9 6.1 7.3

Luxembourg

6.9 6.7 6.1 6.6 5.9 5.7 6.5 7.4 6.6 4.4 6.3 ./. 6.1 6.4 6.1 5.5 5.8 7.0

y Ital

4.6 4.5 6.1 6.6 5.9 5.6 6.5 7.5 6.5 4.3 ./. 6.3 6.1 6.4 6.1 5.5 5.8 7.4

Ireland

7.6 5.6 6.9 7.2 6.8 6.6 7.2 7.9 7.4 ./. 7.0 7.0 6.9 7.1 6.9 6.5 7.1 7.4

6.7 6.8 bt inance 5.7 6.2 5.6 5.3 6.2 8.2 ./. 5.1 6.0 5.9 5.8 6.0 5.8 5.2 5.5 6.4 h de

6.7 6.6 wit parent f

Germany

ed 5.8 6.3 5.7 5.3 6.3

./. 6.3 4.0 6.1 6.1 5.9 6.1 5.9 5.2 5.5 7.2

France

8.2 8.1 7.1 7.6 6.9 6.6 ./. 8.5 7.5 5.3 7.3 7.3 7.1 7.4 7.1 6.5 6.8 8.0

y is financ Finland

6.9 6.5 eighted average of 6.6 7.0 6.5 ./. 7.0 7.8 7.5 5.1 6.8 6.8 6.7 6.9 6.7 6.1 6.4 7.6

Denmark

6.7 6.7 6.5 6.9 ./. 6.2 6.9 7.7 7.2 5.1 6.7 6.7 6.6 6.8 6.6 6.1 6.3 7.2

n t h e subsidiar

Belgium

7.2 7.0 al whe 6.0 ./. 5.9 5.6 6.5 7.4 6.4 4.8 6.3 6.3 6.1 6.3 6.1 5.5 5.7 7.3

apit Austria

6.8 6.6 ./. of C 6.8 6.2 5.9 6.7 7.6 7.0 4.7 6.6 6.5 6.4 6.6 6.4 5.8 6.0 7.6

to

C ost - only corporation taxes; w

ital ium al

USA Mean 19 % ance Cost of Cap fr om Austria B elg Denmark Fi nland Fr Germany Greece Ir eland It aly embourg UK Portug Spain Sweden Canada

Table L

ux Netherlands

6.6 6.4

7.1 7.0

6.6 6.4

6.7 6.4

6.7 6.3

6.6 6.4

6.3 6.1

6.3 6.1

7.1 7.1

5.9 5.8

6.0 5.7

7.3 7.1

6.9 6.7

6.7 6.6

6.2 6.1

6.5 6.4

USA Mean

Table 18 considers the case in which the subsidiary is financed by new equity from the parent. Since the return from this investment is assumed to be paid to the parent as a dividend, this adds another ingredient to the cost of capital calculation: the taxation of such dividend flows 43 . The differences between Tables 17 and 18 therefore reflect the taxation of the dividend receipts in the hand of the parent (and the German split rate system when Germany is the host country).

A number of (home) countries exempt such income in the hands of the parent: Austria, Belgium, Denmark, Finland, Luxembourg, the Netherlands, Sweden and Canada. For parent companies in these countries, in the absence of personal taxes the cost of capital when funding the foreign subsidiary through new equity is the same as when the subsidiary retain earnings.

Other countries operate a limited credit system: essentially credit is given for the foreign tax paid (in the host country); the home country levies further tax only if the home country tax exceeds that of the host country. In many cases, then, financing the foreign subsidiary by new equity and paying tax on the dividend receipts generates a higher cost of capital of the transnational investments. As a result the average cost of capital for inward investments (the average of each column) is higher in Table 18 than in Table 17.

Table 19 presents the case in which the parent lends to the subsidiary and subsequently receives an interest payment (and the return of capital). All the host countries permit the interest paid to be deductible from corporation tax, although some charge a withholding tax as interest is paid; all home countries tax the interest income, with a credit for any foreign tax levied.

Relative to the case of financing by retained earnings, there are two main differences. First, the income of a marginal investment is primarily taxed in the home country rather than the host country; this can increase or reduce the cost of capital depending on which country has the higher rate. Second, however, it is generally the case that the parent is able to claim interest deductibility on its own borrowing if that borrowing is used to finance lending to the subsidiary; this gives an advantage over providing equity finance to the subsidiary for those countries where interest deductibility is not permitted if the loan is used to support equity investment in the subsidiary. In general these factors tend to reduce the dispersion of costs of capital across different possible locations of investments.

The figures shown in Tables 17, 18 and 19 illustrate a large variation in the way that each country treats other countries. Thus the return required by a subsidiary of a parent country in one country depends crucially on where that subsidiary is located. This suggests that there are considerable incentives for companies to choose tax-favoured locations for their investments which may not otherwise be the most favourable location. Similarly, subsidiaries operating in a given country face different required rates of return depending on where their parent company is located. Moreover, these figures show that, in line with the analysis of domestic investments, there are differences in taxation which arise solely because of the way which the investment is financed.

  • B) 
    The case of a highly profitable (infra-marginal) investment

The three following tables present EATR for transnational investments as defined above, whose profitability is now fixed at 20%. Table 20 shows the EATR when the investment is financed by retained earnings, Table 21 in the case of financing by new equity and Table 22 when the subsidiary is financed by borrowing from the parent.

43 The taxation of dividends may in principle also reflect the withholding taxes charged by the host country; however,

these have now been eliminated within the EU by the parent subsidiary directive, (COM(90)/435/EEC).

Mean

33.4 29.2 29.8 30.5 28.6 19.0 33.2 33.8 30.0 28.8 33.3 29.6 29.2 30.9 31.5 37.0 33.2 30.1

Kingdom

United 31.8 27.9 28.0 28.5 27.5 17.7 33.2 30.6 28.2 27.3 31.8 28.2 27.6 28.7 ./. 31.8 30.7 28.4

eden Sw

26.0 22.2 22.2 22.7 21.7 11.0 30.3 24.8 22.5 21.6 26.0 22.5 21.8 ./. 24.8 28.4 27.6 22.9

Spain

35.2 31.2 31.4 31.9 30.8 21.7 33.5 34.0 31.5 30.7 35.2 31.5 ./. 32.1 31.6 41.2 35.0 31.6

Portugal

37.0 33.0 33.2 33.7 32.7 23.8 33.9 35.8 33.3 32.6 37.0 ./. 32.9 33.9 33.5 48.4 38.6 33.3

nds rla Nethe

35.1 31.2 31.3 31.8 30.8 21.6 33.5 34.0 31.5 30.7 ./. 31.4 31.0 32.0 31.6 37.1 33.0 31.2

Luxembourg

36.6 32.6 32.8 33.3 32.3 23.4 33.4 35.4 32.9 ./. 36.6 32.9 32.5 33.5 33.1 38.5 34.4 32.9

y Ital

31.8 28.0 28.1 28.6 27.6 17.9 27.5 30.7 ./. 27.5 31.8 28.3 27.8 28.8 28.3 38.3 29.9 28.0

Ireland

11.7 8.1 7.8 8.3 7.5 -5.7 27.9 ./. 8.4 7.1 11.7 8.3 7.4 8.5 22.1 11.7 25.0 9.9

in gs.

inance Greece

earn 34.4 30.4 30.6 31.0 30.0 25.4

./. 33.2 30.7 29.9 34.4 30.7 30.2 31.2 32.9 34.4 33.0 31.1

n ed

parent f Germany 46.1 42.1 42.4 42.9 41.8 ./. 41.5 45.0 42.4 41.8 46.1 42.3 42.1 43.1 42.7 50.4 43.5 43.0

retai ith France

w 42.1 38.1 38.4 38.9 ./. 29.8 37.5 41.0 38.4 37.8 42.1 38.4 38.1 39.1 38.6 43.8 39.7 38.4

ced

in an Finland

s f eighted average of 28.8 25.0 25.0

./. 24.5 14.3 31.8 27.6 25.3 24.4 28.8 25.2 24.6 25.7 26.5 33.4 29.1 25.5

Denmark

d ia

ry i

32.3 28.7 ./. 29.2 28.3 18.8 32.9 31.2 29.0 28.2 32.3 29.0 28.4 29.4 29.0 32.3 30.3 29.0

b si

e su Belgium

th 39.1

./. 35.4 35.9 34.8 26.4 34.5 38.0 35.5 34.8 39.1 35.5 35.1 36.1 35.6 44.5 36.9 35.4

h en Austria ./.

29.9 30.1 30.6 29.5 20.1 32.9 32.7 30.3 29.4 33.9 30.2 29.7 30.8 30.3 40.1 31.8 30.0

T R

w

to

E A - only corporation taxes; w

al

TR ium ance

le 20 % EA fr

om

Austria B elg It

aly embourg

Denmark Fi

nland Fr

Germany Greece Ir

eland Spain UK Sweden Canada USA Mean

T ab L ux Netherlands Portug

Mean

33.0 29.4 29.3 30.1 28.5 20.1 35.8 33.4 30.2 32.8 32.9 29.8 28.8 30.5 31.9 39.6

Kingdom

United 31.8 28.6 28.0 28.5 27.8 18.6 38.0 30.6 28.8 31.8 31.8 28.8 27.6 28.7 ./. 31.8

eden Sw

26.0 22.9 22.2 22.7 22.1 11.9 36.6 24.8 23.1 26.0 26.0 23.1 21.8 ./. 26.5 30.1

Spain

35.2 31.9 31.4 31.9 31.2 22.5 36.1 34.0 32.2 35.2 35.2 32.1 ./. 32.1 31.6 46.2

Portugal

37.0 33.7 33.2 33.7 33.0 24.7 35.3 35.8 34.0 37.0 37.0 ./. 32.9 33.9 33.5 58.4

nds rla Nethe

35.1 31.9 31.3 31.8 31.1 22.4 36.1 34.0 32.1 35.1 ./. 32.1 31.0 32.0 31.6 38.8

Luxembourg

36.6 33.3 32.8 33.3 32.6 24.2 34.8 35.4 33.6 ./. 36.6 33.5 32.5 33.5 33.1 40.2

y Ital

31.8 28.7 28.1 28.6 27.9 18.7 27.8 30.7 ./. 31.8 31.8 28.9 27.8 28.8 28.3 43.3

Ireland

inance 11.7 8.8 7.8 8.3 7.8 -4.8 39.5 ./. 9.0 11.7 11.7 9.0 7.4 8.5 29.8 11.7

y parent f 34.4 31.1 30.6 31.0 30.4 29.2 ./. 33.2 31.4 34.4 34.4 31.3 30.2 31.2 34.1 34.4

quit Germany w e 40.1 36.9 36.4 36.9 36.2 ./. 35.5 39.0 37.1 40.1 40.1 37.1 36.1 37.1 36.7 50.3

h ne France

wit

ed 42.1 38.8 38.4 38.9

./. 30.7 37.5 41.0 39.0 42.1 42.1 39.0 38.1 39.1 38.6 45.4

eighted average of Finland

28.8 25.6 25.0 ./. 24.9 15.1 37.4 27.6 25.9 28.8 28.8 25.9 24.6 25.7 27.5 36.8

y is financ Denmark

32.3 29.3 ./. 29.2 28.6 19.6 36.6 31.2 29.6 32.3 32.3 29.6 28.4 29.4 29.0 32.3

Belgium

h e subsidiar 39.1 ./. 35.4 35.9 35.2 27.2 34.5 38.0 36.1 39.1 39.1 36.1 35.1 36.1 35.6 49.5 n t

Austria

whe - only corporation taxes; w ./. 30.6 30.1 30.6 29.9 21.0 36.0 32.7 30.9 33.9 33.9 30.8 29.7 30.8 30.3 45.2

TR to

EA

al

21 TR % ium ance EA fr om Austria

B elg Denmark Fi

nland Fr

Germany Greece Ir

eland It aly embourg Spain UK Sweden Canada

Table L

ux Netherlands Portug

Mean

35.7 30.4 29.7 31.9 29.4 28.7 31.1 27.6 36.4 26.0 31.1 30.4 29.9 31.3 29.9 28.5 30.5

Kingdom

33.1 29.2 United 29.1 31.5 28.7 27.8 31.0 26.9 38.0 23.8 30.8 29.9 29.3 30.9 29.3 27.4 ./.

eden Sw

31.5 24.0 24.5 27.0 24.1 23.2 26.4 21.6 36.6 19.3 26.3 25.3 24.7 26.4 24.7 ./. 26.5

Spain

38.4 32.3 30.8 33.2 30.4 29.5 32.7 28.9 36.1 25.5 32.4 31.6 31.0 32.5 ./. 29.1 29.9

Portugal

43.6 33.9 31.9 34.2 31.4 30.6 33.7 30.1 35.3 28.3 33.4 32.6 32.1 ./. 32.1 30.2 31.0

nds rla Nethe

34.7 32.0 30.8 33.2 30.3 29.4 32.6 28.9 36.1 25.5 32.4 31.5 ./. 32.5 31.0 29.1 29.9

Luxembourg

36.1 33.3 31.4 33.8 31.0 30.1 33.2 29.6 34.8 26.2 33.0 ./. 31.6 33.1 31.6 29.8 30.6

y Ital

31.6 28.6 33.5 35.8 33.1 32.2 35.3 31.9 35.2 28.3 ./. 34.2 33.7 35.1 33.7 31.8 32.6

inance Ireland

34.7 11.9 bt 15.9 18.6 15.4 14.5 17.9 11.7 39.5 ./. 17.8 16.7 16.1 17.9 16.1 14.2 29.8

h

34.6 31.9 wit 28.3 30.7 27.9 27.0 30.2 31.9 ./. 26.4 30.0 29.1 28.5 30.1 28.5 26.6 30.0

ed Germany

39.5 37.5 35.0 37.3 34.6 33.7 36.8 ./. 36.3 29.9 36.5 35.7 35.2 36.6 35.2 33.4 34.1

y is financ eighted average of France

41.4 39.0 36.2 38.4 35.7 34.9 ./. 35.0 37.5 31.0 37.7 36.9 36.4 37.8 36.4 34.5 35.3

Finland

32.4 26.5 e subsidiar 26.8 29.3 26.4 ./. 28.7 24.3 37.4 21.5 28.5 27.6 27.0 28.6 27.0 25.1 27.5

n t

h

Denmark

31.7 29.8 whe 29.2 31.5 ./. 27.9 31.0 26.7 36.6 24.2 30.8 29.9 29.4 30.9 29.4 27.6 28.3

TR Belgium

38.5 35.9 EA - only corporation taxes; w 33.1 ./. 32.7 31.8 34.9 31.5 34.4 29.6 34.7 33.9 33.3 34.8 33.3 31.5 32.3

Austria

33.5 30.8 22 ./. 32.3 29.4 28.5 31.7 27.8 36.0 24.5 31.5 30.6 30.1 31.6 30.1 28.2 29.0

to

Table

al

TR ium

USA Mean % ance EA fr om Austria B elg Denmark Fi nland Fr Germany Greece Ir eland It aly embourg Spain UK

L ux Netherlands

Portug Sweden

36.6 34.7 30.2

31.4 33.1 29.6

29.7 31.5 25.5

40.9 36.2 31.0

49.3 39.7 31.9

35.7 33.6 30.9

36.3 34.2 31.4

43.1 36.2 33.3

18.3 34.7 18.7

30.6 31.9 28.9

44.4 37.6 35.0

40.8 38.7 36.0

34.7 32.4 27.5

31.4 31.7 29.5

42.8 35.8 33.0

40.1 32.7 30.1

Canada USA Mean

Much of the discussion above regarding the cost of capital remains relevant for the case of the EATR. However, some additional factors are also now present.

In measuring the EATR it is assumed the investment is more profitable that is, extra-profit is generated by the subsidiary. This is paid to the parent in the form of dividend. Any tax liability associated with such a payment reduces its value to the parent and hence increases the EATR. In this case, the taxation of the dividend payments from the subsidiary to the parent does affect the EATR even when the subsidiary is financed by retained earnings. Further, since this tax rate varies according to the home country, the EATR on an investment in a specific host country may vary according to the home country of the parent, even when the subsidiary is financed by retained earnings. Of course, this is also true when the subsidiary is financed by new equity and debt.

Consequently, there is even more variation within each column in Table 20 than there is in the comparable Table 17 showing the cost of capital. When personal taxes are excluded, the main effect of the home country tax is through the tax rate; where the home country has a limited credit system, there is a positive tax on the dividend payment to the parent only if the home country tax exceeds the host country tax.

The variation within the rows of Table 20 also reflects home and host country taxation. Yet, the same host countries turn out to have high EATR as had high cost of capital: Germany has an average EATR of 43.0%, and France has an average EATR of 38.4%. At the other extreme, Sweden has an average of 22.9% and Italy an average of 28.0%. These would appear to be significant differences in the EATR facing companies in other countries choosing where to locate.

A similar pattern arises in Table 21, where the subsidiary is financed by new equity.

When the subsidiary is financed by debt, these differences are still considerable even if they are smaller. EATR ranges from 25.5% for Sweden as a host country to 36.0% for France as host country.

If the position of USA and Canadian investors is taken into account, the data tend to show that investments from these two countries - and from Canada in particular - into the EU are relatively more highly taxed than intra-EU investments. The worst situation for Canadian inbound investments is largely due to the weight of withholding taxes on dividends. Moreover, since the USA applies a foreign tax credit system, and Canada an exemption system, investments from the latter country retain the benefit of lower than Canadian rates in the host country. In general investments from countries which operate an exemption system benefit from a lower tax rate in the host country. Data (EMTR and EATR) related to foreign investment in Ireland from the USA and Canada clearly illustrates this.

In order to draw more general conclusions and notably to identify the impact of international tax regimes on the incentive to undertake transnational, as opposed to domestic, investments, it is useful to summarise the data and compare it with the data for domestic investments. This is done in the next section.

Allocation effects of international taxation

As shown in the previous section, issues of international taxation are very complex to deal with since they involve the interaction between national tax systems. One commonly used criteria to assess the allocation effects of international taxation is to capture the extent to which the tax treatment of transnational investments gives an incentive to undertake transnational, as opposed to domestic, investments. This is done by evaluating the tax treatment of cross-border investment flows against the criteria of capital import and capital export neutrality.

Capital export and capital import neutrality

Capital export neutrality (CEN) occurs when the tax system is neutral towards the export of capital since the investors face the same effective tax burden on income from similar investments, whether they invest in the domestic economy or abroad. In such situations the tax systems provide no incentives to invest at home rather than abroad, and vice versa. A regime of capital export neutrality therefore tends to ensure an efficient allocation of resources across countries.

CEN is achieved when investors are taxed on accrued worldwide income and receive full credit against domestic tax liabilities for all taxes paid abroad. A pure credit system with no limitation on the foreign tax credit and no deferral of domestic taxes on profits retained abroad would ensure capital export neutrality. Under such a regime, the free mobility of capital would tend to equate the effective tax burden across borders, because each investor would then also obtain the same after-tax rate of return on domestic and foreign investments. A cross-country equalisation of the rates of return before tax implies that no output gain can be made by reallocating capital from one country to another. It is worth noting that a pure credit system does not exist in any EU tax regime.

The importance of attaining capital export neutrality is well assessed in terms of economic welfare. It seems clear that if taxation distorts the location of productive activity, then goods may be produced at higher cost, which is likely ultimately to be borne by the consumer in terms of higher price. Thus the absence of capital export neutrality creates an economic loss to the extent that differences in the cost of capital and effective tax rates result in changes in behaviour. Moreover, capital export neutrality maximises the volume of output obtainable from any given global stock of capital.

Capital import neutrality (CIN) prevails when domestic and foreign suppliers of capital to any given national market obtain the same after-tax rate of return on similar investments in that market. A regime of capital import neutrality ensures that imported and domestic capital in each jurisdiction will compete on equal terms. Therefore, a regime of capital import neutrality would tend to guarantee an efficient international allocation of savings flows.

Provided that source countries do not practice tax discrimination between domestic and foreign investors operating in their jurisdiction, capital import neutrality will be attained if residence countries exempt all income from foreign source from domestic tax.

The importance of capital import neutrality has to be underlined in the context of the EU Internal Market. In fact, this concept is important when analysing the competition conditions faced by economic agents. CIN (as reflected in the exemption method) can ensure a level playing field for non resident companies and local companies operating in the same market. Moreover, an exemption system is simpler to administrate and implies less compliance costs than a pure credit system.

When capital income tax rates differ across countries, achievement of CEN implies different net returns to saving in different countries and will therefore tend to distort the international allocation of savings. By contrast, achievement of CIN would guarantee roughly identical after-tax rates of return to savings for savers in different countries, but would distort the pattern of international investment by causing the cost of capital to deviate from one country to another. Consequently the effect on welfare of attaining one neutrality or the other, depends on the relative sensitivity of investment demand to the cost of capital and of savings to the after-tax rate of return.

It is worth noting that capital export and import neutrality could be achieved simultaneously only in the hypothesis that the effective tax burden on profit is identical across all countries, that is in presence of a far-reaching tax harmonisation. This is clearly not the case today.

These concepts are both useful benchmarks by which to judge the efficiency effects of international tax arrangements and a useful starting point to analyse international tax arrangements. The use of these criteria may encourage policy makers to take a more global view of the benefits and costs of existing international tax arrangements and proposed changes thereto.

Relevant economic measures: average cost of capital and EATR by country

  • A) 
    The case of a marginal investment

Tables 23 summarises the cost of capital shown in Tables 17 to 19 and compares these costs with those for domestic investments, in order to identify the impact of international tax regime on the incentive to undertake transnational, as opposed to domestic, investments.

Table 23 Average Cost of Capital by Country

- domestic, average inbound and outbound - only corporation taxes -average over sources of finance of subsidiary

EU Average EU Standard

Cost of Capital Deviation

%

D omestic Inbound Outbound Inbound Outbound

Austria 6.3 6.5 7.1 0.2 0.6 Belgium 6.4 6.7 6.3 0.3 0.6 Denmark 6.4 6.6 6.3 0.3 0.6 Finland 6.2 6.4 6.3 0.3 0.6 France 7.5 7.7 6.2 0.3 0.5

Germany 7.3 7.0 6.3 0.3 0.6 Greece 6.1 6.4 6.6 0.3 0.6 Ireland 5.7 5.9 6.4 0.4 0.6 Italy 4.8 5.0 6.5 0.3 0.4 Luxembourg 6.3 6.5 6.7 0.3 0.6

Netherlands 6.5 6.6 7.1 0.2 0.6 Portugal 6.5 6.7 6.3 0.3 0.6 Spain 6.5 6.7 6.3 0.3 0.6 Sweden 5.8 6.0 6.3 0.3 0.6 United Kingdom 6.6 6.8 6.4 0.3 0.5

EU Mean 6.3 6.5 6.5 0.3 0.6

EU Standard Deviation 0.6 0.6 0.3

Canada ./. ./. 7.8 ./. 0.8 USA ./. ./. 6.6 ./. 0.6

Note. These are averages across either host (for outbound) or home (for inbound) countries of an overall average cost of capital for each pair of home and host countries. This overall cost of capital is found by taking an unweighted average of each element of Tables 17, 18 and 19.

The first column presents the average cost of capital for domestic investments in each Member State, averaged over the 15 types of investments, using the base case weights. The second column presents the average cost of capital for inbound investments and the third column the average cost of capital for outbound investments. The fourth and fifth columns present the dispersions respectively for inbound and outbound investment 44 .

A comparison of the figures in the first three columns gives some indication of the effects of the tax systems on investment flows. Many factors will, of course, determine investment flows. Insofar as tax is of any importance, then if the required cost of capital when investing domestically is lower than when investing abroad, companies will prefer domestic operations (assuming, of course, that there are equal investment possibilities in each country). Whether this results in a net inflow of capital, depends on whether investment in that country is more attractive to foreign owned companies than investment in their own domestic economies or into other countries.

By computing the average required rate of return when investing in or from each country a lot of the information contained in Tables 17 to 19 is lost, in particular the variation between countries and source of finance. (Annex C presents detailed country tables showing the outbound and inbound cost of capital and EATR for the 15 investments analysed in this study). To compensate, the standard deviations (fourth and fifth columns) give some indication of the degree to which the international tax regime results in subsidiaries which operate in the same country face different effective tax rates according to the residence of the their parent company and the source of finance, and the extent to which the location of a subsidiary for a parent company and the source of finance may affect the effective tax rate. A low figure in the last column, for example, suggests that there is only a small dispersion across countries in the effective tax rate faced by a company when considering in which country to undertake an investment.

If the third column (outbound) were identical to the first column (domestic) and the fifth column (standard deviation of outbound) were full of zeros, this would imply that any company resident in a EU Member State would face (on average) the same cost of capital whether it invested at home or in any other Member State. If that applied generally in the EU, then location decisions of companies would not be affected by taxation. This situation represents capital export neutrality.

If the second column (inbound) were identical to the first column (domestic) and the fourth column (standard deviation of inbound) were full of zeros, this would imply that any company resident in a EU Member State or Canada or the USA would face (on average) the same cost of capital if it invested in a specific EU host country. This implies that companies choosing to locate in a specific location all face the same cost of capital, and hence, none has the benefit of a tax-induced competitive advantage over others. This situation represents capital import neutrality.

Table 23 clearly shows that neither capital export neutrality nor capital import neutrality are respected in the EU. On average outbound and inbound investments are somewhat more heavily taxed than domestic investments and, therefore, the additional components of the transnational system add somewhat to the marginal effective tax rate on investment.

However, these averages hide significant variations between Member States.The tables presented in section 6.2 showed ranges of variation of more than 30 percentage points. Moreover, the fact that the standard deviations are not zero indicates variations across potential host/home countries.

44 The average cost of capital for inbound investments is formed by first taking an unweighted overall average cost of

capital for each pair of countries (home/host) in Tables 17, 18 and 19. That is, each type of finance of the subsidiary is given an equal weight. An unweighted average is then taken across the 14 (EU Member States only, i.e. excluding Canada and the USA) potential home countries for each host country. The standard deviation of this distribution of 14 elements is presented in the fourth column. The third and fifth column are equivalent, but treating each country listed as a home country rather than a host country.

As far as the case of outbound investments is concerned, the companies located in countries that have the highest domestic cost of capital and apply an exemption system are less heavily taxed when investing abroad and, in particular can benefit from a lower effective tax burden if they invest in a foreign subsidiary either through new equity or profit retention (see Tables 17 to 19). Thus, from the point of view of high tax countries, investments in low tax countries are more advantageous than domestic investment, and debt financing is the least attractive way to finance the subsidiary.

On the other hand, if the investor is located in countries which have the lowest costs of capital, on average, domestic investment is more attractive than transnational investment. It is worth noting that, when different sources of finance are considered, it is not always true that high tax countries are always unattractive and that it depends on the source of finance of the subsidiary. If the subsidiary is financed by debt, as a consequence of interest deductions the foreign profits are taxed at the lower domestic and not the foreign corporate profit rate (see Tables 20 to 22). This could imply a lower effective tax burden.

When inbound investments are taken into account, all countries, except Germany, have average cost of capital for inbound investments higher than that of domestic investment. Therefore, domestic companies have on average a competitive advantage over subsidiaries located in their country.

  • B) 
    The case of a highly profitable (infra-marginal) investment

As with the cost of capital, it is useful to summarise the information in Tables 20 to 22 in order to assess how far away the EU tax regimes are from either capital export neutrality or capital import neutrality. Table 24 presents results for the EATR comparable to that in Table 23 for the cost of capital.

Table 24 Effective Average Tax Rate by Country

- domestic, average inbound and outbound - only corporation taxes

EU Average EU Standard

EATR Deviation

D omestic Inbound Outbound Inbound Outbound

Austria 29.8 30.3 32.1 2.5 6.6 Belgium 34.5 34.8 30.2 2.0 6.3 Denmark 28.8 29.5 29.5 2.7 6.6 Finland 25.5 26.5 29.7 3.4 6.5 France 37.5 37.8 29.4 1.9 6.2

Germany 39.1 38.5 22.2 0.9 7.4 Greece 29.6 30.6 35.1 1.1 1.7 Ireland 10.5 13.5 31.1 8.1 4.0 Italy 29.8 30.0 30.4 2.2 6.5 Luxembourg 32.2 32.5 30.7 2.1 6.5

Netherlands 31.0 31.4 32.1 2.3 6.6 Portugal 32.6 33.0 30.2 2.1 6.4 Spain 31.0 31.6 29.3 2.4 6.6 Sweden 22.9 24.1 29.9 3.9 6.3 United Kingdom 28.2 29.1 31.3 3.0 3.5

EU Mean 29.5 30.2 30.2 2.7 5.8

EU Standard Deviation 6.5 5.7 2.6

Canada ./. ./. 37.7 ./. 9.0 USA ./. ./. 34.5 ./. 3.4

Note. These are averages across either host (for outbound) or home (for inbound) countries of an overall average cost of capital. This overall cost of capital is found by taking an unweighted average of each element of Tables 20,21 and 22.

This Table confirms the result of the previous section and in particular indicates that, on average, outbound investment is more heavily taxed than domestic investment. For Germany and France (and to a lesser extent Belgium), the EATR for outbound investment is substantially lower than for domestic investments. The standard deviation indicates that there are variations in potential host countries for each home country. As with the cost of capital, this indicates that the EU tax regime is some way from capital export neutrality.

The same is true for inbound investment, although in this case for every host country, except Germany, EATR on inbound investment is higher than that for domestic investments. Clearly, on average, on this measure the net impact of the taxation on international flows is to increase tax liabilities. There are again variations within each host country for the average EATR faced by companies resident in different home countries.

It is worth noting that the countries which show the highest differences between average domestic EATR and average outbound EATR are the countries which have the highest EATR and the highest profit tax rates on domestic investment (Germany, France, Belgium) and the countries which have the lowest EATR and the lowest profit tax rates on domestic investment (Ireland, Sweden and Finland). This seems to confirm that, even when the interactions of different tax regimes are taken into account, differences in national profit tax rates are of the utmost importance in determining the role of taxation in resource allocation.

The tax minimisation approach: "tax efficient" average cost of capital and EATR by country

The previous section showed that, on average, the interaction of the EU Member States taxation systems implies differences in the tax treatment of domestic investment compared with outbound or inbound investment and, therefore, that capital export or capital import neutrality is never attained. But, as already explained, a lot of specific information for each Member State is lost when computing overall averages.

In particular, considering the different treatment across Member States of different sources of finance, it is realistic to suppose that parent companies would try to minimise their tax burden by choosing the most convenient source of finance of the subsidiary. If one particular source of finance is tax disadvantaged, then it would not be used.

This section considers how the international tax regime affects the effective tax burden faced by a company willing to invest abroad when it chooses the most tax-efficient means of financing the subsidiary 45 .

  • A) 
    The case of a marginal investment

Table 25 shows the averages of the cost of capital across host countries and across home countries, based on the most efficient way to finance the subsidiary and it is comparable to Table 23.

45 The analysis does not take into account the “tax efficient” means of financing the parent company. This is partly to

provide measures which are comparable to the analysis of domestic investments. But it is further based on the notion that there exist constraints on the use of different forms of finance by a parent firm. However, in financing a whollyowned subsidiary, the position is quite different. The financing of a parent company is subject to the constraints imposed by third party financiers- both equity and debt providers. It is reasonable to suppose that the parent firm has considerably more discretion concerning the financing of a subsidiary because it can provide either equity or debt itself.Where debt financing is provided by third parties it is reasonable to assume that they also take into account the standing of the parent company. Accordingly a parent company is more able to take advantage of tax advantages associated with specific forms of finance. It has to be considered, however, that the use of specific forms of finance may be restricted by Member States' legislation, such as thin-capitalisation rules for debt financing and CFC legislation for the use of equity financing. These restrictions are not taken into account here.

Table 25 "Tax Efficient" Average Cost of Capital by Country

- domestic, average inbound and outbound - only corporation taxes - only most favoured source of finance for the subsidiary

EU Average EU Standard

Cost of Capital Deviation

%

D omestic Inbound Outbound Inbound Outbound

Austria 6.3 6.0 6.2 0.6 0.4 Belgium 6.4 5.9 5.9 0.4 0.8 Denmark 6.4 6.1 5.9 0.4 0.6 Finland 6.2 5.9 5.7 0.4 0.6 France 7.5 7.0 5.9 0.5 0.7

Germany 7.3 5.7 5.5 0.6 0.8 Greece 6.1 5.7 5.8 0.3 0.9 Ireland 5.7 5.0 4.8 0.4 0.4 Italy 4.8 4.3 6.2 0.6 0.5 Luxembourg 6.3 5.9 6.0 0.5 0.8

Netherlands 6.5 6.1 6.3 0.4 0.4 Portugal 6.5 6.1 6.0 0.4 0.8 Spain 6.5 6.1 6.0 0.4 0.7 Sweden 5.8 5.5 5.7 0.4 0.5 United Kingdom 6.6 6.3 5.8 0.4 0.6

EU Mean 6.3 5.8 5.8 0.4 0.6

EU Standard Deviation 0.6 0.6 0.3

Canada ./. ./. 7.1 ./. 0.7

USA ./. ./. 6.1 ./. 0.8

Note. These figures are based on the most tax-efficient means of financing the subsidiary - that is retained earnings, new equity or debt. This is found by taking the minimum cost of capital for each element in Tables 17, 18 and 19. Averages are then constructed across either host (for outbound) or home (for inbound) countries.

This approach generates a rather different picture, even if CEN and CIN are still not respected, compared to the situation illustrated in Table 23.

In general, domestic investments are more heavily taxed than outbound and inbound investments. This suggests that, to the extent that companies are free to choose the most tax-favoured form of investment, then - other things being equal- the international tax system works such that foreign multinationals operating in a host country are likely to face a lower cost of capital than domestic companies.

This suggests also that, as already commented on in section 6.2, from the point of view of a foreign investor, so-called high tax countries are not always unattractive as a business location and that companies resident in low tax countries may take advantage to invest abroad instead of at home.

It is worth noting that it has been assumed here that the company is able to use the most "tax efficient" way of financing only in the case of transnational investment. This hypothesis is realistic considering that a multinational company has, in general, greater flexibility when financing its subsidiary than a domestic company (see footnote 44).

The relevant component that results in distortions with respect to cross border location and financing decisions is, above all, the profit tax rate. In fact, if there were only minor differences between the tax rates, there would be less incentives to use either debt (e.g. for investors located in low tax countries) or equity (investors located in high tax countries) for the financing of foreign investment. However, the tax base can have a greater impact on the cost of capital in particular situations (e.g. favourable depreciation regimes) as is the case, for example, in Belgium, Greece, Italy and Sweden.

It should be noted that Table 25 shows "extreme" situations and that national tax regimes may impose restrictions on the use of particular sources of finance.

Moreover, Table 25 shows higher dispersions than Table 23. This means that the averages shown in Tables 25 hide even greater variations across countries.

  • B) 
    The case of a highly profitable (infra-marginal) investment

Table 26 shows the averages of the EATR across host countries and across home countries based on the most efficient way to finance the subsidiary, and is thus comparable to Table 24.

Table 26 "Tax Efficient" Effective Average Tax Rate by Country - domestic, average inbound and outbound

- only corporation taxes - only most favoured source of finance for the subsidiary

EU Average EU Standard

EATR Deviation

D omestic Inbound Outbound Inbound Outbound

Austria 29.8 28.7 29.3 3.0 5.7 Belgium 34.5 32.6 28.8 2.2 7.0 Denmark 28.8 27.8 28.2 3.0 6.6 Finland 25.5 24.8 27.9 3.6 6.1 France 37.5 35.6 28.2 2.4 6.8

Germany 39.1 34.9 19.0 1.7 8.3 Greece 29.6 28.4 32.7 1.5 2.6 Ireland 10.5 9.9 26.0 7.4 3.2 Italy 29.8 27.9 29.4 3.1 7.0 Luxembourg 32.2 30.7 28.2 2.7 7.1

Netherlands 31.0 29.8 29.5 2.8 5.7 Portugal 32.6 31.2 29.1 2.5 7.0 Spain 31.0 29.8 28.3 2.8 6.9 Sweden 22.9 22.3 27.8 4.0 5.9 United Kingdom 28.2 27.4 29.4 3.3 3.3

EU Mean 29.5 28.1 28.1 3.1 6.0

EU Standard Deviation 6.5 5.9 2.8

Canada ./. ./. 35.6 ./. 8.4 USA ./. ./. 32.6 ./. 3.9

Note. These figures are based on the most tax-efficient means of financing the subsidiary - that is retained earnings, new equity or debt. This is found by taking the minimum cost of capital for each element in Tables 20, 21 and 22. Averages are then constructed across either host (for outbound) or home (for inbound) countries.

This Table indicates that, if the source of finance is chosen so as to minimise the EATR, then, on average in the EU the domestic EATR is very close to the outbound and inbound EATR. However, the fact that the standard deviations are not zero, and are even relatively high, indicates that international regimes are far from neutral and that CEN and CIN are not respected.

While a number of countries have EATRs broadly similar for domestic, outbound and inbound investments, for some other countries they are markedly different for domestic and outbound investments. This is the case in high profit rate countries and low profit rate countries (as was also the case in Table 24).

Restrictions on imputation systems for transnational investments

The previous analysis was based on the assumption that the parent company has sufficient undistributed domestic profit that any additional dividend which it wishes to pay as a result of the additional investment in the subsidiary can, for tax purposes, be deemed to be a payment from domestic income. In this section the situation is considered in which dividend payments are paid from the foreign source of income (the subsidiary) to the shareholders. In this way another element is introduced: the domestic treatment of foreign source income.

In Finland and France, dividend payments deemed to be paid from foreign source income are subject to an equalisation tax. In 1999 in Germany, such dividend payments did not qualify for the imputation tax credit. In all three cases, then, there can be in effect an additional tax on outbound investments. In fact, compared to the situation shown in Table 23, in Finland and France, the average cost of capital for outbound investment increases substantially - from 6.3% to 7.8% for Finland and from 6.2% to 8% for France. There is a smaller rise for Germany: from 6.3% to 7%.

As far as the EATR is concerned, the rise is even more spectacular. Compared with the situation shown in Table 24, there is a substantial rise in the average EATR for outbound investment from Finland and France - from 29.7% to 46.7% in Finland and from 29.4% to 48.9% in France. Again, the rise for outbound investments from Germany is smaller - from 22.2% to 33.2%. In the case of Finland, this exacerbates the average discrimination against outbound investments. In Germany it reduces the average discrimination in favour of outbound investment. And in France it turns the discrimination from being in favour of outbound investment to being in favour of domestic investment.

Effects of the German tax reform on international investments

The purpose of this section is to examine the impact of the German tax reform on international investment. First, the case of inbound investment to Germany and outbound investment from Germany are considered. Then, the impact of the German tax reform on the overall means and standard deviations in the EU is analysed.

  • A) 
    The case of a marginal investment

Table 27 presents estimates of the average cost of capital for domestic investment, inbound investment to, and outbound investment from, Germany. It also presents the standard deviations for both inbound investment and outbound investment and the average position for the EU as a whole. It does so for the two cases in which the subsidiary is financed by an average of retained earnings, new equity and debt, and for the case in which the most tax efficient form of financing is chosen. The top half of the Table summarises the position before the reform. These are taken from Tables 23 and 25 above. The bottom half of the table summarises the position after the reform.

The domestic position is the same as shown in more detail in Section 4. The position for inbound investment into Germany is fairly similar to the position for domestic investment. That is investment financed by retained earnings in the subsidiary will tend to face a lower cost of capital due to the lower tax rate. But where the subsidiary is financed by debt the cost of capital tends to increase slightly, and when it is financed by debt, it tends to increase rather more substantially, due to the lower tax rate and hence higher cost of paying interest. The net impact is a very small reduction in the average cost of capital for inbound investment averaged across the three types of finance. However, the average cost of capital for domestic investment falls rather more, and so post-reform inbound investment will have a very slightly higher cost of capital than domestic investment (instead of a slightly lower cost of capital).

The average cost of capital for outbound investment, again averaged over the three sources of finance of the subsidiary, is virtually unchanged by the tax reform. This is partly because Germany largely exempts foreign source dividends. The lower tax rate on the receipt of interest from subsidiaries tends to reduce the cost of capital. However, this is offset by the reduction in the value of the deductibility of interest paid by the parent, and the abolition of the split rate system, which pre-reform gave an advantage to new equity financing of the parent.

However, this is only true on the assumption that all distributions are financed from the domestic income of the corporation. If we assume instead that distributions are financed from foreign source income, then the discrimination of foreign investment which was analysed in the section 6.3 above no longer exists - because under the reformed system, distributions are treated in the same way irrespective whether they are financed from domestic or foreign profits.

Table 27 Average Cost of Capital for Germany and EU average

- domestic, average inbound and outbound - only corporation taxes

EU Average EU Standard Deviation

Cost of Capital

estic

% m bound bound Do Inbound

O ut Inbound O ut

BEFORE REFORM

Average over sources of finance of subsidiary

Germany 7.3 7.0 6.3 0.3 0.6

EU Mean 6.3 6.5 6.5 0.3 0.6

EU Standard 0.6 0.6 0.3 Deviation

Tax Efficient source of finance of subsidiary

Germany 7.3 5.7 5.5 0.6 0.8

EU Mean 6.3 5.8 5.8 0.4 0.6

EU Standard 0.6 0.6 0.3 Deviation

AFTER REFORM

Average over sources of finance of subsidiary

Germany 6.8 6.9 6.3 0.3 0.6

EU Mean 6.3 6.5 6.5 0.3 0.6

EU Standard 0.6 0.6 0.3 Deviation

Tax Efficient source of finance of subsidiary

Germany 6.8 6.5 6.0 0.4 0.8

EU Mean 6.3 5.9 5.9 0.4 0.6

EU Standard 0.6 0.6 0.3 Deviation

Note. These are averages across either host (for outbound) or home (for inbound) countries of an overall average cost of capital for each pair of home and host countries. This overall cost of capital is found by taking an unweighted average of each element of Tables 17, 18 and 19.

There is a greater effect on the tax efficient form of financing of the subsidiary. This is because of the reduction in the value of interest deductibility. Pre-reform, the most tax advantageous form of finance for a German subsidiary was debt. Reducing the tax rate reduces this advantage, so that the tax efficient cost of capital rises, and the tax efficient form of finance may in any case also change. The average cost of capital for the tax efficient form of the outbound investment also rises.

However, these changes in Germany are not large on average. In no case does the average cost of capital change by more than one half of one percent. As a result, the position for the EU as a whole is virtually unchanged.

  • B) 
    The case of a profitable (infra-marginal) investment

    Table 28 Average EATR for Germany and EU average - domestic, average inbound and outbound

    - only corporation taxes

    EU Average EU Standard Deviation

    EATR

    estic

    % m Do Inbound O ut bound Inbound O ut bound

    BEFORE REFORM

    Average over sources of finance of subsidiary

Germany 39.1 38.5 22.2 0.9 7.4

EU Mean 29.5 30.2 30.2 2.7 5.8

EU Standard Deviation 6.5 5.7 2.6

Tax Efficient source of finance of subsidiary

Germany 39.1 34.9 19.0 1.7 8.3

EU Mean 29.5 28.1 28.1 3.1 6.0

EU Standard Deviation 6.5 5.9 2.8

AFTER REFORM

Average over sources of finance of subsidiary

Germany 34.8 35.6 30.2 0.9 6.1

EU Mean 29.2 30.6 30.6 1.8 5.5

EU Standard Deviation 6.1 5.4 1.4

Tax Efficient source of finance of subsidiary

Germany 34.8 34.2 28.9 1.3 7.0

EU Mean 29.2 28.7 28.7 2.0 5.8

EU Standard Deviation 6.1 5.7 1.4

Note. These are averages across either host (for outbound) or home (for inbound) countries of an overall average cost of capital for each pair of home and host countries. This overall cost of capital is found by taking an unweighted average of each element of Tables17, 18 and 19.

Table 28 presents a similar analysis to the one in Table 27, this time for the EATR. For inbound investment the EATR tends to fall for investment financed by retained earnings and new equity, and to rise for investment financed by debt. Overall, the reduction in the tax rate causes the average EATR for inbound investment financed by an average of the three types of finance to fall, although by less than the fall in the average domestic cost of capital.

However, there is a significant rise in the EATR on outbound investment. Pre-reform the EATR on outbound investment was considerably lower than the EATR on domestic investment, thereby inducing German firms to invest abroad. This rise can be traced largely to the reduction in the value of the deductibility of interest paid by the parent and the abolition of the split rate system. However, as with the cost of capital, this is only true for the case in which dividends are paid from domestic source income.

A similar pattern is found for the tax efficient financing of the subsidiary, both for inbound and outbound investment. The larger changes in the EATR as a result of the reform create some impact on the overall EU averages, as shown in the Table.

Neutralities and distortions in transnational investments: concluding remarks from the international analysis

The results for the international case, show that the co-existence of the Member States tax regimes may have an influence on transnational investment patterns and financing decisions.

The data arising from the quantitative analysis, and notably from Tables 17 to 22, illustrate a variation in the way in which each country treats other countries. Thus, the effective tax burden of subsidiaries of a parent company in one country depends crucially on where that subsidiary is located. The range of variation in the effective tax burdens of subsidiaries located in different host countries can rise above 30 points regardless of the method of financing of the subsidiary. This provides an incentive for companies to choose the most tax-favoured location for their investment, which may not be the most favourable location in absence of taxes. Similarly, subsidiaries operating in a given country face different effective tax burdens depending on where their parent company is located. Even in this case the range of variation can reach more than 30 points.

As a result, capital export neutrality and capital import neutrality are never respected and the EU averages hide considerable variations across potential host/home countries. This implies that tax arbitrage may have an important impact for companies considering in which country to undertake an investment and that subsidiaries which operate in the same country face different effective tax rates according to the residence of their parent.

Moreover, to the extent that companies are free to choose the most tax-favoured form of investment, then the international tax system works such that foreign multinationals operating in a host country are likely to face a lower cost of capital than domestic companies.

The spread observed between domestic, outbound and inbound investments is the result of complex interactions between different national tax regimes and cannot be explained by just one feature of taxation. However, as was the case for domestic investment, the analysis presented above tends to show that the relevant component that is most likely to be responsible for distortions with respect to incentives for cross-border location and financing decisions is the national profit tax rate, although the tax base may have a greater impact in particular, specific situations.

As said already in commenting on the results of the domestic analysis, neutrality of taxation systems is one of the goals of taxation policy and this has to be balanced against other legitimate goals. However, to the extent that the absence of neutrality determines movements of capital which are not justified by economic efficiency and that involve welfare losses, the picture presented in this section deserves attention. To what extent differences of the considerable size observed in this quantitative analysis and the consequent possible losses in welfare can be justified by the need to maintain national autonomy in view of national goals attached to taxation policy is, ultimately, a matter of political choice.

T HE IMPACT OF HYPOTHETICAL POLICY SCENARIOS IN THE EU

Purpose of the simulations

The previous sections have clearly shown that the actual tax treatment of investment strongly differs across countries in the EU. In particular, the effective tax burden for cross-border investments in the EU considerably differs according to the home country of the parent companies and the location of their foreign subsidiaries.

This situation is not optimal with regard to the proper functioning of the Internal Market. Indeed, the absence of capital export neutrality may lead to distortions in the international allocation of investment as, ceteris paribus, investments may take place not in the lowest cost locations but in the lowest tax locations. This in turn potentially limits growth in productivity and employment in the EU.

It is therefore particularly useful to consider how the measures of the cost of capital and effective tax rates presented above would be different in the event of various hypothetical tax policy scenarios.

In what follows, 15 hypothetical policy scenarios are considered. Each of the simulations is based on a particular element of the tax regimes being harmonised across the EU. This helps to identify the importance of specific features of tax regimes, notably for capital export and capital import neutrality. The simulations are divided into three groups (see Box 8). The first group of simulations examines the impact of elements of the "domestic" corporation tax regime, that is the statutory tax rate and the value of capital allowances. The second group turns to elements of the "international" corporation tax regime, such as the treatment of interest payments from one Member State to another, and the taxation of income received in the home country. The third group examines the relationship between corporation tax and personal taxes.

The impact of the hypothetical policy scenarios considered here of course depends on the tax treatment of domestic, inward and outward investment, and on the specific features of each of the tax systems that have been presented above. In this respect, it should be noted that, as before, the simulations are based on the tax regimes as they existed in 1999 and which generally are quite similar to the situation in 2001. However, for Germany, simulations explicitly take into account the situation for 2001, in order to fully incorporate the recent tax reform. Contrary to the limited changes in other EU countries, reforms in Germany are such that basing simulations on the pre-reform situation could modify somewhat the global results of hypothetical reforms.

An exhaustive analysis of every possible case is not provided here for the sake of conciseness. Instead, only the most striking results are presented in order to highlight some of the pros and cons of the various tax reforms envisaged in part IV. More detailed results can be found in Annex F.

Box 8 Definition of simulations

A. Domestic Elements of Corporation Tax

  • 1. 
    Common corporation tax rate, incl. surcharges. Rate is EU average of 32.28%.
  • 2. 
    Common corporation tax rate, incl. surcharges and local taxes. Rate is EU average of 33.84%.
  • 3. 
    Common corporation tax rate, incl. surcharges and local taxes. Rate is 25%.
  • 4. 
    Band of corporation tax rates, incl. surcharges and local taxes. Rates permitted between 25% and 35%. Countries outside this band move to nearest limit.
  • 5. 
    Harmonisation of capital allowances. Common rules for depreciation, inventories and investment incentives.
  • 6. 
    Common tax base. Depreciation based on true economic depreciation.

B. International Elements of Corporation Tax

  • 7. 
    Abolition of withholding taxes on interest paid by subsidiary to parent within EU.
  • 8. 
    Limited credit system for foreign source dividends received by parent from EU subsidiary. No discrimination in imputation systems against foreign source income originating in the EU.
  • 9. 
    Full credit system for foreign source dividends and interest received by parent from EU subsidiary. No discrimination in imputation systems against foreign source income originating in the EU.
  • 10. 
    Exemption for foreign source dividends received by parent from EU subsidiary. No discrimination in imputation systems against foreign source income originating in the EU.
  • 11. 
    Taxation according to parent country rules. Subsidiary taxed using the tax base of the home country of the parent but the tax rate of the host country. No interest deductibility by the subsidiary. No taxation of foreign source income received by parent. No discrimination in imputation systems against foreign source income originating in the EU

C. Relationship of Personal and Corporate Taxes

  • 12. 
    Classical system. Double taxation of dividends. Personal tax rates for taxpayers (not including zero-rated shareholders) set to highest income tax rate on labour income. Equalisation taxes abolished. Capital gains taxes and personal property tax rates unchanged from base case.
  • 13. 
    Full imputation system for dividends paid out of domestic and EU foreign source income. Tax credit set to parent’s corporation tax rate. Otherwise as 12.
  • 14. 
    Shareholder relief system. Personal tax rates for taxpayers (not including zero-rated shareholders) set to 50% of highest income tax rate on labour income. Otherwise as simulation 12.
  • 15. 
    Comprehensive Business Income Tax. Interest deductibility abolished. All personal tax rates set to zero. Exemption for dividends and interest paid by subsidiary to parent within EU.

    Scenarios involving domestic elements of corporation tax

    The Base Case

A number of simulations based on harmonization or approximation of the statutory corporate tax rate and the definition of the tax base are considered first. In the hypothetical policy scenarios listed in Part A of Box 6, the international elements of tax regimes - such as withholding taxes and the taxation of foreign source income - and the personal tax regimes are left unchanged.

The first row of Table 29 reproduces the average across the 15 EU Member States for the EATRs and the cost of capital as well as the standard deviation of the distribution across the 15 EU Member States in the current situation (including the German reform). The subsequent rows in the Table show how these summary measures change in the presence of various hypothetical policy scenarios.

As shown in section 6 above, the existing system (the “Base Case”) clearly does not exhibit either capital export neutrality or capital import neutrality. For the measures based on the average source of financing of the subsidiary for outbound and inbound investments, the average cost of capital is only slightly higher than the average domestic cost of capital. The same is true of the average EATR. However, these averages hide considerable variations across countries, which are summarised in the figures for the standard deviations for both inbound and outbound investment. As explained in more detail in section 6.3, the figure for standard deviation for outbound investment expresses the average deviation in the cost of capital or EATR for an investment made in 14 potential host countries by a parent company based on their territory. The standard deviation summarises the variability in the tax treatment of foreign investments across the EU. It is therefore the focus of the analysis of the impact of hypothetical reforms presented below.

Comparing inbound and outbound investment, it is clear that there is significantly more variation across potential host countries for a company based in a specific home country compared to the variation across potential home countries of an investment taking place in a specific host country, i.e. standard deviation for outbound investment is higher than that for inbound investment. The Base Case therefore suggests that the EU tax regime is closer to exhibiting capital import neutrality than capital export neutrality. As underlined in section 6.3, the absence of capital export neutrality can give rise to economic inefficiencies.

The following sections discuss in turn the hypothetical tax policy scenarios.

 a t 7

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TAB 1. T 2. T ye

Approximation or harmonisation of tax rates

The first four simulations consider cases of approximation or harmonisation of the statutory tax rates. At one extreme, a full harmonisation of the rates is considered (scenarios 2 and 3). This implies setting a common statutory rate, including surcharges and local taxes, at the same level in all the Member States. However, an approximation of tax rates could exclude local taxes. This case of partial harmonisation is considered in scenario 1. At the other extreme, a limited approximation of the rates via the setting of a band of permitted tax rates is considered (scenario 4).

Three main conclusions can be drawn from this set of simulations :

• First, unsurprisingly, an approximation of the statutory rates leads to a reduction in the dispersion of

EATRs and the cost of capital across the Member States for all the types of investment considered in the four simulations. This result is mostly due to the fact that those countries with the more extreme average costs of capital move towards the middle of the distribution, with a consequent reduction in

the standard deviation.

As the various simulations show, the changes in the EATR dispersion tend to be greater than changes in the dispersion of the cost of capital. The scale of the differences in the impact on the cost of capital and the EATR reflect the differences in these two measures, discussed above. In particular, since the EATR measures the effect of tax on a more profitable investment, the importance of allowances is rather less than it is for the cost of capital, and so the impact of the statutory tax rate is

correspondingly greater.

This result is fundamental. Indeed, concretely it implies that a consequence of the approximation of the statutory rates in the EU is an increased capital import neutrality. In other words, there is less variation in the costs of capital and the EATRs faced by parents from alternative home countries choosing to locate a subsidiary in the same host country. Moreover, the differences between the potential locations faced by a parent in a specific country in simulations 1 to 4 are lower than under

the current system, implying also a movement towards capital export neutrality.

To illustrate why this happens suppose there is complete harmonisation of the tax rate in the EU. If all countries have the same statutory tax rate, then the distinction between, say, taxing foreign source dividend income with a limited credit system as opposed to an exemption system would disappear. In the absence of personal taxes, equalising statutory corporate tax rates is therefore close to introducing source country taxation for equity financed investment - with each source (ie. host) country having the same rate of tax. This clearly corresponds to a move towards capital import neutrality. It is worth noting, however, that home country taxation still matters in some cases. For example, several countries disallow interest payments made by the parent if the loan is used to finance outbound investment. Also, some countries impose local taxes on interest receipts from the subsidiary. Finally,

some countries do not operate a pure exemption system.

The above analysis is also true for debt financed investment: the rate at which the subsidiary receives relief for the payment of interest to the parent is the same as the rate at which the parent pays tax on the interest receipt. In this case, however, there may also be withholding taxes on interest, which may

differ according to the home country.

• Second, the reduction in the dispersion of EATRs and the cost of capital is a function of the degree

of approximation of the statutory tax rates across the Member States. A full harmonisation of the tax rates leads to a lower dispersion of EATRs and costs of capital than a partial harmonisation, and the

latter has a larger impact than the setting of a tax rates band.

The comparison of scenario 1 with scenario 2 easily illustrates that result. Indeed, one can see that imposing identical local taxes in addition to a basic common corporate tax rate, moves the overall position within the EU still closer to source-based taxation, as there is then no difference in statutory tax rates between countries. As would be expected, the results are broadly similar in the two cases. However, the most striking difference between simulations 1 and 2 is that the standard deviation of EATRs across host countries for outbound investment falls further. This again reflects the greater dependence of the EATR on the statutory tax rate. While significant differences in the cost of capital across potential host locations is still strongly influenced by the definition of allowances (which are

still allowed to differ between countries), allowances are rather less important for the EATR.

• Third, in the partial analytical framework of this study, driving down an already common tax rate

would have little impact on economic efficiency. It is mostly by reducing the dispersion of effective tax rates that gains in economic efficiency can be realised.

This is illustrated by a comparison of scenarios 2 and 3. The only difference between the two simulations lies in the statutory rate which is imposed to Member States (25% instead of 33,84%). Unsurprisingly, choosing a lower rate reduces the average cost of capital and the average EATR for all forms of investment: domestic, inbound and outbound. For example, the average domestic cost of capital across all countries falls from 6.4 to 6.0, and the average domestic EATR falls from 30.0% to 22.4%. Similar falls occur for inbound and outbound investment. However, the dispersions of both measures is virtually unchanged from the previous case of a higher statutory tax rate. This is true of the dispersion of domestic measures across each countries, the dispersion across possible locations for outbound investment and the dispersion across possible home countries for inbound investment (although in this case there is a small reduction in the dispersion of the average EATR for the case of

the average source of subsidiary financing).

Comparing simulation 3 with simulation 2 is nevertheless illuminating. Indeed, a large part of the discussion in this study is concerned with economic inefficiencies arising as a result of differences in taxation between types of investment, or between countries. A process of tax competition which simply drove down an already common tax rate (for example, comparing this simulation with the previous one) would have little impact on economic efficiency: it is only by reducing the dispersion

of effective tax rates that gains in economic efficiency can be realised.

Box 9:

The impact of the equalisation tax in Finland and France

Finland and France impose an equalisation tax on distributions from foreign source income, to ensure that any tax credit available to the shareholder is matched by a tax payment to the home government. In the simulations it is generally assumed that parent companies resident in these countries can distribute dividends from domestic source income, in which case these special rules do not apply. Here we investigate what happens to the results in the case in which parent companies in Finland and France are required to make distributions from foreign source income. That is, we assume that the marginal dividend in each period is financed from foreign source earnings, and is therefore subject to the equalisation tax.

In examining the impact of the hypothetical policy scenarios under this alternative assumption, most of the preview conclusions continue to hold. The only significant difference in the pattern of results is that the average standard deviation of costs of capital and EATRs for inbound investment is higher both in the Base Case and in each of the simulations. Although the cost of capital and EATR on inbound investment from other countries may fall as a results of some of the reforms, it does not fall so sharply for investment from Finland and France. These features of the tax systems therefore move the overall EU tax regime further away from both capital export neutrality and capital import neutrality.

Harmonisation of capital allowances

A number of the remedies to tax obstacles suggest an approximation or even a harmonization of the tax bases across the Member States. This is in particular so in the case of comprehensive options, such as those presented in Part IV. It is therefore interesting to examine the impact of harmonising the main elements of the tax base taken into account in the model, namely the rules for depreciation of assets and for inventories (see Box 4 in section 3.2).

Simulation 5 presents the impact of a harmonization of capital allowances. Allowances are assumed to take the following values in every EU Member State :

• machinery - declining balance at 2 times straight line over 7 years

• buildings - straight line at 4%

• intangibles – straight line at 7 years life

• inventories – LIFO valuation allowed

• financial assets - zero.

All other aspects of EU tax regimes - including the statutory rate and other aspects of the tax base - are as in the existing systems discussed above. This falls well short of proposals to create a consolidated tax base throughout the EU, where any individual company would need to calculate its taxable profits only

according to one set of rules.

The results of this simulation show that harmonising the capital allowances has almost no impact on the average cost of capital or the average EATR. The averages and standard deviations shown in Table 29 are almost identical to the Base Case. If anything there is a slightly greater dispersion of EATRs across both host and home countries. This may reflect that tax regimes are designed as a whole - a high tax rate tends to go with a more generous structure of allowances and vice versa, a conclusion already made in section 4. Harmonising only allowances may increase differences in effective tax rates between countries, unless such a reform is accompanied by an approximation in the tax rates. Furthermore, this reform has only small effects in any Member State. Part of the reason for this result is that allowance

rates are already broadly similar throughout the EU.

Going one step further, simulation 6 also examines the impact of a partial harmonization of the base including, this time, depreciation rates set at the assumed rate of true economic depreciation. Such a simulation is interesting for two reasons. First, it enables a comparison of the depreciation assumptions underlying the tax systems with the assumed true economic depreciation. It then gives an indication of the tax incentives linked to depreciation for different types of assets. Second, it gives useful indications of the possibly distortive impact on the allocation of investments of the deprecation rules in the Member States.

Setting values for allowances in line with what is assumed to be true economic depreciation rates 46 gives almost the same basic results as in simulation 5. However, a slight increase in the average costs of capital and EATRs compared to this simulation and to the Base Case can be observed. To the extent that the estimates of depreciation used for the allowances are closer to true values, this would suggest that, on

46 In common with the rest of the report, the allowances are assumed to take the following values: machinery - declining

balance at 17.5%; buildings - declining balance at 3.1%; intangibles - declining balance at 15.35%; inventories - LIFO valuation allowed; financial assets - zero.

average, EU tax regimes are relatively generous in their choice of capital allowances. The standard deviations also tend to be slightly higher. The conclusion from the previous simulation - no discernible gain in economic efficiency from harmonising the tax base - therefore would also apply even if capital allowances were set closer to true economic depreciation.

Box 10: Domestic reforms with personal taxes

Simulations 1 to 6 have also been considered in the presence of personal taxes (see appendix F). As earlier in the report, it has been assumed that the company maximises the wealth of a resident, possibly tax-paying, shareholder, taking into account personal taxes on dividends, interest and capital gains.

The actual results presented below are based on an unweighted average over three types of shareholder (a zero-rated shareholder, a non-qualified top-rate shareholder, and a qualified top-rate shareholder) for the two following cases: (a) the parent distributes all dividend payments out of domestic source income, and (b) at the margin the parent distributes dividend payments from foreign source income.

As explained in section 4, compared to the Base Case, the costs of capital are lower on average, and the EATRs slightly higher, when personal taxes are taken into account. There also tend to be higher standard deviations especially for inbound investment. This is true for both cases (a) and (b). In fact, for case (a), unlike the case in Table 29, the standard deviation across potential home countries for inbound investment is now generally higher than that across potential host countries for outbound investment.

In general though, personal taxes have little effect on the impact of hypothetical policy scenarios to corporation tax. The most striking difference from Table 29 when personal taxes are introduced is that the standard deviation for inbound investment does not generally fall when corporation tax rates are harmonised within the EU. The reason for this result is clear: there is still substantial variation due to personal taxes being different across home countries. In other words, tax systems have to be considered as a whole. Simply harmonising one element of the tax system, without taking into account its relationship with the other elements thereof, notably personal taxes, could lead to inconsistencies.

Scenarios involving international elements of corporation tax

Table 30 considers the international elements of corporation tax regimes. The abolition of withholding taxes on interest is examined first (simulation 7). Next, it examines three possible ways in which the treatment of foreign source dividend income (from an EU subsidiary) could in principle be harmonised within the EU: a limited credit system in all countries, a full credit system in all countries, and exemption in all countries (simulations 8-10). Lastly, simulation 11 assumes the application of parent country tax rules to the taxation of subsidiaries (see also part IV).

As with the investigation of hypothetical policy scenarios involving domestic elements of corporation tax, the main analysis here is presented in the absence of personal taxes. Again, this is consistent with the existence of an international capital market in which there is no reason to suppose that the shareholders of a parent company are domestic residents. If they are not, then the prospect of the parent company being able to identify - and act upon - their personal tax rates is remote. .

Outbound

Dev. 5.8 5.8 2.7 2.7 6.3 7.5

d. Inbound

ary S tan 2.0 2.1 2.1 7.1 1.4 2.7

si di Outbound

ub

e S e 28.7 28.7 30.9 27.3 28.3 30.5

th Inbound

ci ng E ATR Averag 28.7 28.7 30.9 27.3 28.3 30.5

an in Outbound

of F 0.6 0.6 0.7 0.8 0.6 0.9

ay Dev. d. Inbound

t W S tan 0.4 0.4 0.4 0.5 0.4 0.8 ci en

ital Outbound

Effi

e 5.9 5.9 5.9 5.7 5.9 6.7

Inbound

tax ost Tax on M C

ost of Cap Averag 5.9 5.9 5.9 5.7 5.9 6.7

Outbound orati

Dev. 5.5 5.5 2.2 1.9 6.1 7.5

d. Inbound

ts of corp

en S

tan 1.8 1.8 2.0 6.5 0.9 2.6

em e Outbound el nc

on s si

ati Inbound ng ni ia

ry ub

id 30.6 30.5 33.2 29.7 30.0 31.1

ntern ar bs

e S e

s of i ti

c e t su Domestic

es

on tates ci en ce of th E

ATR Averag 29.2 29.2 29.2 29.2 29.2 29.2

an ati

ul dom effi

in Outbound

m ber S of em 0.6 0.6 0.5 0.6 0.6 0.9

t out d tax

Dev.

d. Inbound

en

lts for si e an

rces of F ou

5 EU M S tan 0.3 0.3 0.3 0.4 0.3 0.8

par

c resu by Outbound

asi ns e over S 6.5 6.5 6.6 6.4 6.5 6.9 across 1 io nce; averag lt s: b on but na ital Inbound ati

st ri t fi Averag 6.5 6.5 6.6 6.4 6.5 6.9

Resu evi ted

e

on A

T R d ; di aren rd es ei gh Domestic

ati

ul da ax e of p W Cost of Cap Averag 6.3 6.3 6.3 6.3 6.3 6.3

im l and E io

n t the

ta d stan at s

of S por averag xe m e e g to s

ary c api e an

or ted g ta yste om m m ome om in rd ule

m t of y c io

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yste nc yste y r

os ei

gh at

S um - c - averag - onl - w e

re dit s nd inc n i nd inc

as re st d c ide re dit s

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ig ption s ide n acco ountr io

nt c

r div r fo em r div re

B as N o w on inte L im fo F ull c fo Ex fo T axat pa

0 an

Me S tandard Devi 7 8 9 10 11

LE 3

TAB

Abolition of withholding taxes on interest

Abolishing withholding taxes on the payment of interest from a subsidiary to its EU parent has almost no effect on any of the measures presented in this report. As can be seen from Table 30 (simulation 7), there is virtually no change in any of the averages or standard deviations in this simulation.

The reason for this lies in the tax treatment of the parent in the home country. All EU Member States tax interest receipts from EU subsidiaries in the hands of the parent. All Member States use a limited credit system, so that taxes paid in the host country are credited against home country taxation. However, all Member States also permit interest payments to be deductible from corporation tax. So the only tax which the interest payments may face in the host country is a withholding tax when the interest is paid to the parent. In Germany, however, half of interest payments are subject to trade tax. This clearly limits the advantages of debt financing of a German subsidiary. But in virtually all cases, the rate of withholding tax is lower than the home country tax rate. As a result, the withholding tax does not increase the overall tax liability; it merely shifts revenue from the home country to the host country. But the measures presented here are not affected by which revenue authority receives the tax payment. As such, they are almost completely unaffected by the abolition of withholding taxes on interest payments from subsidiaries to parents.

There is one exception to this within the EU. Ireland has a 10% corporation tax rate, and three countries levy a withholding tax on payments to an Irish parent at a higher rate than this: Belgium (15%), Greece (20%) and Portugal (15%). In these cases, Ireland does not offer a full credit for the withholding taxes paid, and so these withholding taxes do affect the overall tax liability of the Irish parent. Analysis of the impact of this scenario on individual countries confirms that only these four countries are affected by the reform. An implication is that the same effect on effective tax rates in the EU could be generated by simply reducing these three withholding tax rates to 10% or less.

Harmonising the treatment of foreign dividends

Currently, only 3 Member States tax dividends received by a parent from an EU subsidiary on the basis of a limited credit system (Greece, Ireland and the UK). The other 12 Member States all use some form of an exemption system. Simulations 8 to 10 show the impact of an identical system for the 15 Member States, that is, either a credit system or an exemption system.

Consider first a full credit system applied to the 15 Member States (simulation 9). Instead of limiting the credit given for foreign taxes to no greater than the underlying home country tax liability, a full credit system would reimburse any additional tax paid. This is automatically the case for interest income in all countries except Ireland, where the corporation tax rate may be lower than the withholding tax rate charged by the host country. If this system were introduced on an accruals basis, that is, if it applied to profits at the point at which they were earned, rather than when repatriated to the parent, then this system would effectively be taxation in the home country. As such there would be full capital export neutrality at the level of the parent firm, i.e. the parent firm would simply pay the home country tax wherever it chose to locate its investment.

However, consistent with the operation of most international taxation, dividends and interest are taxed only when repatriated to the parent. In this case, taxation in the host country is still important. Consider, for example, the cost of capital for an investment financed by retained earnings in the subsidiary. To finance such an investment, the shareholder gives up the post-tax value of the dividend which would otherwise have been paid by the subsidiary to the parent. When the eventual return on the investment is distributed by the subsidiary, the shareholder only receives the post-tax value. In this case, the cost of capital is independent of the taxation of the dividend paid by the subsidiary – since the same tax rate is applied both to the cost and the return, it nets out of calculation.

This suggests that, for a marginal investment, reflected in the cost of capital, the international tax regime becomes a mixture of a residence-base and a source-base. Take the example of Ireland as a home country, for the average of possible sources of finance of the subsidiary. Where the subsidiary of an Irish parent is financed with retained earnings, the Irish tax rate is irrelevant, and so the cost of capital reflects only the host country tax system (which has not changed). But where the investment is financed by new equity provided by the parent, for example, the fact that there is a full credit system - and that the Irish tax rate is only 10% - implies that there is a significant reduction in the cost of capital.

These effects are partly reflected in results presented in Table 30. For outbound investment, there is a fall in the overall average cost of capital and of the average EATR across Member States in simulation 9 compared to the Base Case. At the same time a substantial fall in the standard deviation can be observed for the EATR. This is consistent with a move towards capital export neutrality. For inbound investment, the average cost of capital and EATR also diminish, but the standard deviation increases. Therefore, introducing a full credit system leads to less capital import neutrality.

Box 11: Impact of a limited credit system (simulation 8)

Where the home country tax rate is lower (higher) than the host country tax rate, a limited credit system will not result in any further tax (reimbursement) in the home country. In this case, it therefore has the same impact as an exemption system. The main effects of the introduction of a limited credit system for the 15 Member States is therefore to increase the tax liability on the receipt of dividends from EU subsidiaries of parents in home countries with high statutory tax rates.

This scenario therefore pushes the overall system towards capital export neutrality, in that the gap in the impact of tax between domestic and outbound investment is narrowed. This does not show up clearly in the average results of Table 30, however. This is because cross-border investment (based on the average of the subsidiary sources of finance) already has, on average, a higher cost of capital and a higher EATR than domestic investment. Any increase in the average effective tax rate for cross border investment therefore increases this disparity.

Consider now a full exemption system for all the EU Member States (simulation 10). At first sight, this may seem to imply that, for equity-financed investments, the EU tax system should become entirely source-based, especially in the absence of home country personal taxes. However, some countries do not permit the deductibility of costs borne by the parent against the parent's tax liability where the cost supports outbound investment (see Annex B, table 13).

Overall, this policy scenario does move the EU tax system in the direction of capital import neutrality, especially as measured by the EATR - for which the average standard deviation for inbound investment for the average source of finance of the subsidiary falls from 1.8 to 0.9. There is a corresponding slight move away from capital export neutrality.

Taxation according to the parent country rules

This simulation is in many respects close to the concept of "Home State Taxation" explained in Part IV. Any parent company within the EU has to compute its EU taxable profit once only, applying the definition of the home country tax base to its EU-wide profits. The tax base for each company would be allocated between different countries, which would apply their own tax rates to their allocated tax base.

In order to do this, it is necessary to make some assumptions about how the subsidiary is taxed. The first stage is that the profits of each subsidiary are consolidated in the whole groups' EU-wide profits. For this purpose, the relevant tax base rules are treated as those of the parent's home country. However, a further assumption is that there is no difficulty in allocating the EU-wide profit to individual countries. That is, it is assumed that the whole of the taxable profit earned by the subsidiary is allocated back to the host country, to be taxed at the host country corporation tax rate. There is then no further tax on repatriation of dividends or interest from subsidiary to parent; nor is there any further tax on the corporation on payment of dividends to the shareholders. Essentially, then, the host country tax rate is applied to the tax base as defined by the home country. Moreover, due to the consolidation process, interest payments from the subsidiary to the parent company are not deductible in the host country. This tends to increase the host country’s tax base.

It is worth noting that two advantages of Home State Taxation are that it permits loss consolidation and that any parent would have to calculate its EU-wide profits according to only one set of rules. However, these advantages are not captured by the model used in this report, since it makes no allowance for the compliance and administrative costs of implementing taxes and considers only profitable situations.

To understand the impact of Home State Taxation, it is useful to consider the position if the proposal were taken one step further. Suppose instead that the home country tax rate was applied to the EU-wide profit, rather than the host country tax rate. In this case, the tax regime in the host country would be irrelevant; in effect there would be residence taxation at the corporate level; hence there would be capital export neutrality.

As Table 30 (simulation 11) makes clear, however, applying the tax rate of the host country makes a substantial difference. Instead of achieving capital export neutrality, the resulting tax regime is actually further from capital export neutrality than the existing regime. That is, the average dispersion of effective tax rates facing parent companies on outbound investment within the EU is higher than in the Base Case. This is true on every measure. Thus, the standard deviation of the costs of capital is higher - both for the tax efficient and average form of financing of the subsidiary. And the average dispersion of the EATR is also higher in both cases.

This again suggests a connection between the tax base and tax rates in individual countries: if a high tax rate is applied to a low tax base, then the average cost of capital may not appear to be particularly high. For example, a parent company in a home country with, say, a low tax base may invest in another country which has a high tax base but a low tax rate. But, under the Home State Taxation proposal, the parent would apply the low tax rate in the host country to the low tax base in the home country. Overall, on outbound investment, the results suggest that differences in tax rates alone may create substantial differences across potential locations for investment in both the cost of capital and the EATR. As would be expected, taxation according to parent country rules also moves the EU tax regime further away from source-base taxation, and hence further away from capital import neutrality.

Scenarios involving the relationship between corporate and personal taxes

Much of the debate on the co-ordination of taxes on capital in the EU in the past has been concerned with the relationship between personal and corporate taxes. In a closed economy, this is a vital ingredient of the overall effective tax rate, since the overall level of saving and investment should depend on both forms of taxation.

But, as argued elsewhere in this study, the role of personal taxes for cross-border flows of capital is much less clear. Indeed personal taxes levied on domestic shareholders may well affect the cost of capital and the EATR on domestic and outbound investment. But with an open capital market, there is no particular reason why the company may not be owned by foreign shareholders. Further, as already noted in Box 8, personal taxes in the home country do not play a very significant role in affecting the main conclusions of the analysis. This is mainly because personal taxes typically apply to all forms of profit, and hence do not discriminate between domestic and outbound investment.

This section nevertheless briefly reviews the impact on the measures described above of harmonising the relationship between corporate and personal taxes. Table 31 presents results for four hypothetical policy scenarios. It should be noted that the Base Case includes personal taxes, contrary to the Base Case in Tables 29 and 30.

The first hypothetical scenario is to introduce a classical relationship between the corporate and personal taxes (simulation 12). Under a pure classical system, company profits are taxed twice - once at the level of the firm, and once when distributed as dividends. Top-rated shareholders would pay the full top rate of income tax on dividend income. This is higher than the rate actually levied in several countries, since such countries reduce the double taxation of dividends by reducing the rate of personal income tax. However, it is assumed that zero-rated shareholders continue to pay no tax.

Given that many EU countries either allow a tax credit associated with a dividend payment, or levy a lower rate of income tax on dividends, harmonisation based on a classical system generally increases the size of the tax burden, unless tax rates are adjusted. This is reflected in the impact on the average EATRs shown in Table 31. Such a harmonisation tends to reduce the dispersion of the average EATRs across countries, and to reduce the average standard deviations for outbound and inbound investment. Thus, to the extent to which the overall tax systems become more similar to each other, there is a movement towards both capital import neutrality and capital export neutrality. Again, however, it should be noted that the importance of this result depends on the extent to which such personal tax rates are relevant in an international context.

However, it should be noted that with a classical system, the average costs of capital tend to be lower than in the Base Case. This is because it is assumed within the simulation that interest receipts are also taxed at the top personal tax rate. Where this raises the existing personal tax rate on interest income, then because the post-tax return to lending, i.e. the alternative use of funds, falls, the required post-tax return to investment in equity also falls, and hence the cost of capital tends to fall.

The next hypothetical scenario is to introduce a full imputation system in every country (simulation 13). This would offer a tax credit to all shareholders equal to the underlying rate of corporation tax in the home country. For domestic source income distributed to shareholders, the overall tax rate would then be simply the shareholder's personal tax rate. However, when the tax credit is also available for foreign source income distributed to shareholders, the overall tax rate on such income will also reflect the tax rate in the host country.

Outbound

Dev. 5.1 3.9 6.0 6.1 6.9

d. Inbound

ary S tan 5.4 2.9 6.8 2.9 0.0

si di Outbound

ub

e S e 32.5 41.9 23.3 21.3 33.0

th Inbound

ci ng E ATR Averag 32.5 41.9 23.3 21.3 33.0

an in Outbound

of F 0.6 0.6 0.6 0.6 0.8

ay Dev. d. Inbound

t W S tan 0.7 0.5 0.5 0.5 0.0 ci en

ital Outbound

Effi

e 4.8 4.4 4.0 4.0 7.4

ost Tax Inbound M C ost of Cap Averag 4.8 4.4 4.0 4.0 7.4

Outbound

4.9 3.7 5.7 5.9 6.9

d. Dev. Inbound

S tan 5.6 2.7 7.1 2.8 0.0

e

nc Outbound

T ng si Inbound

ni ia

ry ub

id 34.0 43.1 25.0 23.1 33.1

ersonal ar bs

e S e

ti c e Domestic

es t su 33.0 42.2 24.2 21.8 33.1

e and P ci

en ce of th E ATR Averag dom an Outbound ber states of effi

in

0.5 0.5 0.5 0.5 0.7

Corporat em t out d tax en d.

Dev. Inbound

e an rces of F ou

io n of 5 EU m par S

tan 0.6 0.5 0.5 0.5 0.0

by Outbound

eract io ns e over S

5.4 4.9 4.6 4.6 7.5

Int across 1 nce; averag ts: on na ital Inbound

ati st

ri but t fi Averag

R evi ; di 5.4 4.9 4.6 4.6 7.5 aren ted e

ion Resul A

T d

rd t ax ei gh Domestic

at

ul da onal e of p W Cost of Cap Averag 5.2 4.7 4.4 4.4 7.5 im l and E rs ss S ta d stan pe st

em te m of averag sy ys

ine us

s f s

ary c api e an e of

n xe

m t of at

ted

io te

m tion elie

os op r ei

gh at

S um - c - averag - t - w e g ta r r iv

e B

ns ax

as s ys puta

ehe

e C ic

al

re holde pr m

e T

ithholdin co

an B

as C la ss Full im w Sha C om In

1 Me S tandard Devi 12 13 14 15

e 3 bl

Ta

This scenario involves a reduction of the overall tax liabilities, as measured by the EATR. The cost of capital is also reduced, even though this reform only affects the cost of capital when the parent finances the investment by new equity. However, the dispersion in either measure in the standard deviations on inbound and outbound investment, is generally at least as high as in the Base Case. This should not be surprising. Consider, for example, the variation in the EATR faced on inbound investment into the same host country by different parents. With a full imputation system in the home country, the effective tax rate in the home country more closely reflects the personal tax rate than the corporate tax rate. Since these tend to vary more between countries, so the average standard deviation of the EATR on inbound investment tends to increase relative to the Base Case.

A similar position is true of the next hypothetical scenario: a classical relationship between the corporate tax and the personal tax, but a personal tax rate on dividend income set at only 50% of the shareholder's normal income tax rate (simulation 14). Following OECD (1991), this is known as a shareholder relief system. On average, this generates similar costs of capital and EATRs as the full imputation system. However, compared to the full imputation system the overall effective tax rate depends less on the personal tax rate of the shareholder and more on the corporation tax rate. As a result, the dispersion of the EATR for inbound investment into a particular host country by different parents is lower than in the case of the full imputation system.

The final hypothetical policy scenario is based on a proposal considered by the US Treasury in 1992. This proposal - the comprehensive business income tax - was to abolish interest deductibility, and hence put equity and debt finance on the same footing (simulation 15). The reform analysed here extends this basic version to eliminate personal taxes entirely. In effect there is therefore only corporate level taxation, levied on profit before interest payments. Further, source country taxation is imposed by making each country exempt dividends and interest receipts from a subsidiary in the EU. Hence the single level of tax applies essentially in the host country.

As might be expected in such a scenario, capital import neutrality is completely achieved. All subsidiaries in a given host country face the same tax regime, irrespective of the nationality of the parent companies. Further, on average, the cost of capital for domestic investment is the same as the cost of capital for cross-border investment, and the same is true for the EATR. However, the reform also moves the EU tax regime away from capital export neutrality. That is, the dispersion in effective tax rates across possible locations for investment available to a parent company is greater than in the Base Case.

Conclusions

This section of the report has examined the role of specific features of the tax regimes in the EU. It has done this by simulating the impact of hypothetical policy scenarios on the measure of effective tax rates set out earlier in the report. Of course, a vast range of different investments has been considered in this report; only a summary picture can be provided of the effect of any hypothetical scenario (more details are given in Annex F).

Nonetheless, the results of considering hypothetical policy scenarios are striking.

• Introducing a common statutory tax rate in the EU would have a significant impact by decreasing the

dispersion of effective tax rates across Member States. There is a significant fall in the average dispersion of both the cost of capital and the EATR facing parent companies between alternative Member States. There is also a fall in the dispersion between subsidiaries located in a given Member State which are owned by parents located in other Member States. To the extent that taxation matters, such scenario would be likely to go some way in reducing locational inefficiencies within

the EU.

• By contrast, no other scenario would have such a significant effect. For example, introducing a

common tax base while leaving tax rates unchanged tends, if anything, to increase the dispersion in

effective tax rates.

• Since withholding taxes on dividends between subsidiaries and their parents have been abolished

within the EU, the international features of corporation taxes do not play a significant role in increasing distortions. Introducing a common means of taxing foreign source income, for example,

has little impact on the dispersion of effective tax rates.

• Similarly, introducing a common form of integration of corporate and personal taxes in each

Member State does not tend to reduce the dispersion of effective tax rates between Member States.

Box 5 Tax Analyser: Impact of hypothetical tax policy scenarios in the EU

As in the case of the hypothetical investment approach, the purpose of simulations is to identify the weight of the different tax drivers in the effective average tax burden, i.e. to compute the relative weight of the tax bases, the tax rates, the different types of taxes and the corporation tax system in the EATR separately. Therefore, the scenarios are divided into three categories: elements of the tax base, the corporation tax rate including local taxes and the corporation tax system. By setting just one element of the different tax regimes equal across countries, it is possible to identify the effect of this particular element on the level and also on the variation of the effective tax burdens and, hence on the possible distortion of competition within the countries under consideration.

Each simulation considers only the medium-sized company in the base case using typical data for the manufacturing sector. Except for Germany, the scenarios are based-as in the previous boxes Tax Analyser- on the tax regimes which were effective in the fiscal year 1999.

Classification of simulations

A. Corporation tax base

  • 1. 
    Common depreciation on intangibles. Straight-line over 5 years (20%).
  • 2. 
    Common depreciation on buildings. Straight-line over 25 years (4%).
  • 3. 
    Common straight-line depreciation on tangible fixed assets. Straight-line over the estimated periods of economic use (5 to 10 years depending on type of asset).
  • 4. 
    Common declining balance depreciation on tangible fixed assets. Declining balance at 3 times straight-line over the estimated periods of economic use, at a maximum of 30%.
  • 5. 
    Common valuation of inventories. Full costs and LIFO allocation.
  • 6. 
    Common allocation of pension costs (book reserve German type). Allowing to build up a book reserve for

    pensions as in Germany.

  • 7. 
    Common allocation of pension costs (pension fund US type). Allowing funded schemes as in the Anglo-Saxon

    countries (UK and Ireland).

  • 8. 
    Common book reserves for bad debts. Future guarantee payments within next 2 years, 2% of annual turnover.
  • 9. 
    Common overall tax base (IAS). Depreciation methods according to (1)-(3) above, depreciation periods are 5

    years for intangibles, 40 and 50 years for buildings, 5 to 10 years for tangible fixed assets, valuation of

inventories according to (5), allocation of pension costs according to (7), no provisions for bad debts.

B. Corporation tax rate and local taxes

  • 10. 
    Common corporation tax rate, including surcharges but excluding local taxes, at EU average of 32.28%.
  • 11. 
    Common corporation tax rate, including surcharges and local profit taxes, at EU average of 33.84%.
  • 12. 
    Common corporation tax rate of 25%, including surcharges and local profit taxes.
  • 13. 
    Common corporation tax rate of 25%, including surcharges and all (profit and non-profit) local taxes.

    C. Corporation tax system

  • 14. 
    Common corporation tax system. Classical system (only corporate taxes).
  • 15. 
    Common corporation tax system. Classical system (corporate and personal taxes).
  • A) 
    Scenario involving the corporation tax base

The following table presents simulations referring to the corporation tax base. The first 8 of these simulations consider only a single element of the tax base. By contrast simulation 9 analyses the effects of a uniform tax base based on the "International Accounting Standards". All other elements of the tax regimes are unchanged.

TABLE F Results for simulations involving elements of the corporation tax base

-effective average tax rates - only corporation taxes

EU-5

F D IRL NL UK EU-5 USA

Average Stand. Dev.

Base case 39.7 30.1 8.3 24.0 21.0 24.6 10.4 29.7

  • 1. 
    Common depreciation on

intangibles 39.7 30.1 8.3 24.0 21.0 24.6 10.4 29.7

  • 2. 
    Common depreciation on

buildings 40.2 29.3 8.3 23.6 21.0 24.5 10.4 28.8

  • 3. 
    Common straight-line

depreciation on tangible 44.1 30.6 8.4 24.5 21.4 25.8 11.7 32.3

fixed assets

  • 4. 
    Common declining

balance depreciation on 41.0 28.4 7.9 22.3 19.7 23.9 10.9 29.8

tangible fixed assets

  • 5. 
    Common valuation of

inventories 38.0 29.7 7.9 21.8 19.2 23.3 10.1 27.5

  • 6. 
    Common pension scheme

(book reserve) 44.5 30.1 9.2 27.1 24.0 27.0 11.3 34.1

  • 7. 
    Common pension scheme

(pension fund) 39.7 26.2 8.3 24.0 21.0 23.8 10.1 29.7

  • 8. 
    Common book reserves

for bad debts 36.2 26.6 7.9 21.4 18.8 22.2 9.3 26.6

  • 9. 
    Common overall tax base

(IAS) 46.7 29.7 8.7 24.5 21.4 26.2 12.4 32.3

As far as the depreciation rules are considered, several conclusions can be drawn from the results. First, with respect to the changes in the national EATR, it is evident that depreciation practices on tangible fixed assets are still quite different throughout the EU-5 Member States. France seems to be in a relatively favourable position and Ireland in a relatively disadvantageous position. Second, with respect to the level of change in both the national EATR and the EU5 average EATR, the different depreciation rules on tangible fixed assets have a noticeable impact on the effective tax burdens. This can also be explained by the high weights of tangible fixed assets as a proportion of the total investment of the model firm. Third, with respect to the increases in the standard deviations, it is evident that common methods and allowance rates for tangible fixed assets would increase differences in the EATR between countries if all other elements of the tax regimes remained unchanged.

With respect to the valuation of inventories, it is assumed that production costs are valued at full cost and that LIFO is allowed as an allocation method in each country. This harmonisation scenario tends to decrease all national EATRs and the EU-5 average EATR (by 1.3 percentage points) as well as the standard deviation (by 0.3). Full cost tends to increase the tax burden and LIFO tends to decrease the tax burden. Obviously, for the base case model firm, the increasing effect of applying full cost is more than compensated for by the decreasing effect of applying LIFO allocation. Moreover, the calculation of production costs on a full cost basis tends to smooth the differences between different capital allowances and other elements of the production costs (such as pension costs) if the finished goods are stored for a certain period of time. This explains the decrease in the standard deviation.

The harmonisation of occupational pension schemes’ allocation of pension costs considers two different scenarios: (6) a common regime for building up a pension reserve (book reserve) as in Germany and (7) a common regime for a funded system that allows the deduction of annual (periodical) payments to a pension fund as prevails in the Anglo-Saxon countries . In the case of book reserves , the national EATR, except in Germany, the EU-5 average EATR (by 2.4 percentage points) and the standard deviation (by 0.9) increase. The reason for this considerable increase is a broader tax base in each country except Germany and the high portion of pension costs in the total costs of the model firm. A common system for pension funds would only affect the position of Germany since it is already applied in the other countries. Therefore, the impact on both the EU-5 average EATR and the standard deviation is only minor.

It is always very arbitrary to specify conditions under which bad debts occur. Therefore, bad debts were not considered in the base case at all. The European Tax Analyzer model, however, can account for bad debts. To analyse the effect of such provisions on the tax burden, the build-up of a book reserve for bad debts is now allowed in all countries. In doing so it is assumed future warranties which amount to 2% of the annual turnover of the model firm have to be fulfilled within two years. Accounting for a book reserve for bad debts under these conditions decreases both the national EATR and the EU-5 average EATR (by 2.4 percentage points). The decrease is highest in France and Germany (3.5 percentage points) and lowest in Ireland (0.4 percentage points). This result clearly reflects the (corporation) tax savings due to the deduction of the annual contributions to the book reserve from the tax base. The amount of tax saving increases with the statutory tax rate on profits, which is highest in France (40%) and Germany (39.3%) and lowest in Ireland (10%). The asymmetric decrease of the national EATR is also reflected by the lower standard deviation (9.3 compared to 10.4 in the base case). As a general conclusion from this example, it seems likely that both the national EATR level as well as the dispersion of the EATR across countries are lower compared to the base case if book reserves for bad debts are taken into account. However, with respect to the extreme assumptions in our example – the bad debts amount to 2% of the annual turnover –a considerable variation of the EATR still remains.

In order to get a better idea about the impact of the corporation tax base on the EATR compared to other elements of a corporate tax regime that constitute the effective tax burden (i.e. tax rates, local taxes, corporation tax system), finally a harmonisation scenario with a uniform tax base in all countries is considered. In doing so, it is assumed that the provisions of the International Accounting Standards (IAS) form, without exception, the basis for the determination of taxable profits in the six countries. In particular, the following rules are considered simultaneously relevant:

− Depreciation of intangibles, buildings and tangible fixed assets only on a straight-line basis over the

estimated periods of economic use – 5 years for intangibles, 40 and 50 years for buildings and 5 to 10 years for tangible fixed assets.

− Valuation of inventories is based on the full costs with FIFO as the allocation method.

− Costs for occupational pension schemes are deducted from the annual taxable profits according to a

funded scheme as prevails in the Anglo-Saxon countries

− Provisions for bad debts are not permitted.

The results presented in Table F indicate that, with the exception of Germany, the national EATR would rise if the IAS were relevant for the determination of taxable profits. As a consequence, the EU-5 average EATR increases by 1.6 percentage points. Thus, by taking the IAS as a benchmark, we can conclude that the national accounting provisions are currently more generous. However, since the changes in the EATR in Germany, Ireland, the Netherlands and the UK are only minor, it is only France that seems to be in a relatively favourable position with respect to the tax base. Therefore, the change in the EU-5 average EATR can be above all attributed to the large change in France. As far as the Anglo Saxon countries and the Netherlands are concerned, the minor changes of the EATR can be attributed to the fact that the tax bases in these countries already correspond to the IAS to a greater extent than the tax bases in European continental states (e.g. France), except in the USA. Germany’s result also suggests that the tax base corresponds with the IAS. Since the German EATR decreases, the national tax accounting rules are even a bit less generous. Although the broadening of the tax base according to international standards was one of the aims of the German tax reform, a lot of differences, which would compensate for each other considerably if the IAS became relevant still exist. However, with respect to these compensating effects, it is also clear that it is not sufficient just to compare the individual elements of the tax base (e.g. depreciation rules or provisions) when analysing the impact of the tax base on the effective tax burden.

The most striking result of this harmonisation scenario is, however, the increasing standard deviation (by 2.0) which is greater than in all previous simulations. This indicates that with a harmonised overall corporation tax base the differences between the national EATR would, ceteris paribus, not only remain, but that these differences would even increase since the variation in the EATR across countries increases. The remaining variations in the EATR can be attributed to the different statutory tax rates, local taxes and the corporation tax systems. In the case of a uniform tax base, the real effects resulting solely from these differences are clearly demonstrated. As pointed out earlier, higher tax rates tend to be combined with lower tax bases and vice versa (see the first box Tax Analyser). This correlation might explain the increasing dispersion of the EATR when tax bases are harmonised: in such instances the compensating element (i.e. a more generous tax base) disappears.

  • B) 
    Scenarios involving the corporation tax rates and local taxes

 In order to separately identify the impact of the relevant provisions on the EATR, single elements of the tax rates as well as combinations of the corporation tax rate and local taxes are considered. The results of each simulation are listed in Table G and compared with the results obtained from the existing tax regimes (base case).

TABLE G Results for simulations involving tax rates and local taxes

  • effective average tax rates - only corporation taxes

    EU-5

    F D IRL NL UK EU-5 USA

    Average Stand. Dev.

Base case 39.7 30.1 8.3 24.0 21.0 24.6 10.4 29.7

  • 10. 
    Common CT rate, at EU

mean 36.7 34.1 23.6 21.8 22.7 27.8 6,3 28.4

  • 11. 
    Common CT rate incl. local profit taxes, at EU 37.1 24.0 24.5 23.1 24.0 26.5 5.3 25.3 mean
  • 12. 
    Common CT rate of 25%

incl. local profit taxes 33.6 17.0 18.3 16.6 17.5 20.6 6.5 19.7

  • 13. 
    Common CT rate of 25%

incl. all local taxes 9.6 17.0 16.2 16.2 14.8 14.8 2.7 16.2

Simulation 10 introduces a common corporation tax rate of 32.28% including all surcharges levied in France and Germany. The rate of 32.28% is the average rate across all 15 EU Member States for the fiscal year 1999 - except for Germany where the rates applying after the tax reform in 2001 have been used. However, this simulation does not imply that in all Member States all profits will be taxed at the same rates. Since local profit taxes are still levied, differences will remain.

Introducing such a common corporation tax rate increases the EU-5 average EATR significantly, by 3.2 percentage points. At the same time, however, there is also a considerable reduction of the standard deviation from 10.4 to 6.3 indicating less variation of the EATR across EU Member States. In fact, since the EATR does not change significantly in France, the Netherlands and the UK, these changes are mainly caused by Germany and Ireland. The EATR in Germany increases by 4.0 percentage points. Since there is an extra burden imposed by the trade tax on income in Germany, the statutory tax rate on profits would rise from 39.3% to 44.2%. However, the most significant change is in Ireland with an increase of the EATR by 15.3 percentage points from 8.3% to 23.6%. This is because the advantage of the 10% corporation tax rate would now disappear.

It should be noted that – in contrast to all simulations considering the tax base – the ranking of the countries would be different from the base case. Ireland would drop back from first to third place whereas the Netherlands would improve from third to first place. The other countries would keep their positions. Since only the corporation tax rate is harmonised, this country ranking reflects the remaining differences between the effects of the tax base, the local profit and non-profit taxes and the corporation tax systems.

Simulation 11 is based on the previous one, but now local profit taxes are included in the common statutory tax rate. For the countries considered here, this implies that the trade tax in Germany and the franchise tax on income in the USA are assumed to be abolished, or alternatively, credited against corporation tax. The uniform tax rate chosen is 33.84%, which represents the average statutory tax rate across the 15 EU Member States.

Since only Germany levies a local profit tax within the EU-5 Member States, this harmonisation scenario would significantly reduce the EATR in Germany. By contrast, there would only be moderate increases of the EATR in the other countries. Germany would improve two positions to second place, bringing it to a level equal to that of the UK. Altogether, the EU-5 average EATR would be reduced moderately and the standard deviation of the EATR across countries would fall further. The new value of 5.3 is almost 50% lower than the standard deviation of the EATR for the existing tax regimes (base case). Compared to the existing tax regimes, introducing a harmonised statutory tax rate on profits would therefore substantially reduce distortions resulting from differences between the EATR for domestic investment in Europe.

However, not all distortions would disappear. The remaining differences can be attributed to the tax bases, the local non-profit taxes and the corporation tax systems. France in particular, would still be in a very disadvantageous position with respect to the levy of non-profit taxes.

Compared to the previous case, simulation 12 simply reduces the common statutory tax rate on profits from the EU average rate of 33.84% to 25%. As a consequence of the lower tax rate all of the national EATRs as well as the EU-5 average EATR would be further reduced. However, with respect to the increasing standard deviation, the more striking result of this simulation is that the dispersion of the EATR rises. This happens because the tax saving due to the deductibility of local non-profit taxes becomes smaller as the statutory tax rate on profit decreases. In other words, the effects of the different non-profit tax levels emerge more obviously if the statutory tax rate on profits is reduced.

The result of this simulation is also important since it reveals the effects of the tax rate on the variation in the effective tax burdens. The comparison with the previous simulation makes clear that a further reduction of a statutory tax rate on profits, which is already harmonised, to a level significantly lower than the average across countries, will only reduce the average effective tax burden. However, the economic distortion will increase, since the standard deviation rises.

In addition to measures considered in the previous case, simulation number 13 abolishes non-profit taxes (e.g. real property tax). This implies that the only tax that exists in each country is a tax on profits which is levied at a uniform rate of 25%. Since there are no other taxes, the remaining differences between the EATR are the result of the different tax bases and the corporation tax systems. As a result of this simulation, all of the national EATRs and the EU-5 average EATR would be further reduced. Moreover, the standard deviation of the EATR falls to 2.7, by far the lowest value obtained in any of the 15 simulations.

This scenario illuminates the remaining dispersions of the effective tax burdens across countries which can be attributed to the tax bases and the corporation tax systems.

In the country ranking France moves from last to first position. But this result is not surprising, since France has the lowest tax base and is the only country that uses an imputation system.

  • C) 
    Scenarios involving the corporation tax systems

The following table presents the impact of a common classical tax system on the level and dispersion of companies' effective tax burden. All the other elements of the tax regimes remained the same. Since the corporation tax system is the linkage between corporate and personal income taxes, personal taxes have been introduced in a separate step. In the case of personal taxes, the amount of dividends is the same as in the base case and there is no “shareholder relief” on dividend income.

TABLE H Results for corporation tax system scenarios

- effective average tax rates - corporate and personal taxes

F D IRL NL UK EU-5

EU-5 USA

Average Stand. Dev.

Base case (only corporate

taxes) 39.7 30.1 8.3 24.0 21.0 24.6 10.4 29.7

Base case (corporate and

personal taxes) 48.8 31.0 17.2 32.0 25.6 30.9 10.4 32.0

  • 14. 
    Common CT system, classical system (only 48.0 30.1 8.3 24.0 21.0 26.3 13.0 29.7 corporate taxes)
  • 15. 
    Common CT system, classical system (corpo 55.7 32.0 17.2 37.4 26.6 33.8 12.8 32.0 rate and personal taxes)

At the corporate level the introduction of a common classical system would only affect the EATR in France. This is because all of the countries considered here except France already apply a kind of classical system at the corporate level. The abolition of the imputation system, in general, would increase the EATR. The reason is that if the tax credit is denied, a relatively higher cash distribution will be required to pay the same amount of dividends as before. As a result of the increasing French EATR, both the average EU-5 EATR and the standard deviation of the EATR across countries rises.

Introducing an EU-wide classical system and including personal taxes would leave only the effective tax burden in Ireland (and in the USA) unaffected. By contrast, since none of these countries operates a pure classical system, the EATR in all other countries would rise. The EATR increase would be most significant in France (from 48.8% to 55.7%) due to its high average income tax rate. There would be only minor increases in the EATR in Germany and the UK. Altogether, the EU-5 average EATR at the overall level would rise. The same is true for the standard deviation, which increases from 10.4 to 12.8.

To summarise, it seems reasonable to conclude that the introduction of a common corporation tax system without modifying other elements of the tax regimes at the same time would increase distortions, resulting from different levels of company taxation, within the EU. There are different reasons for this result. At the corporate level the effects resulting from the different tax rates, tax bases and local taxes would emerge if there were a common corporation tax system. At the overall level it is the different structure of the income tax rates that increases the variation of the EATR.

  • D) 
    Concluding remarks

A major finding of the analysis of the effective tax burdens by means of the Tax Analyser model is that all tax regimes seem to be designed as more or less integrated systems. This means that there is a particular relationship between the tax rate, the tax base and the corporation tax system. As a broad conclusion, it is possible to say that, in general, a higher statutory tax rate on profits correlates with a lower taxable base and vice versa.

The simulations presented in this box help to understand the weights of each of the most important elements of a tax regime in the effective tax burden.

Introducing a common corporate tax base (simulation 9) clearly helps to achieve more transparency in the calculation of effective tax burdens. However, the outcome of this simulation indicates that such a change would result in increasing values both for the average effective tax burden and – what seems more important – the dispersion of the EATR across EU Member States.

Similarly, a common classical corporation tax system (simulation 14) tends to increase both the average effective tax burden in Europe and the dispersion of the EATR across EU Member States.

By contrast, the introduction of a common statutory tax rate on profits (simulation 11) would significantly reduce the dispersion of the EATR across the EU Member States. None of the other hypothetical scenarios considered here reduced the variation of the effective tax burdens in a comparable way. The effects on the EATR of a common statutory tax rate on profits depends on level of the tax rate. In our example, the average EATR increases. Although a lower common tax rate would reduce the average EATR, the dispersion of the EATR across countries tends to rise again. Therefore, reducing statutory tax rates on profits significantly does not simultaneously ensure greater neutrality towards taxation.

S OME EFFECTS OF TAX OPTIMISATION BY MEANS OF FINANCIAL INTERMEDIARIES ON THE EFFECTIVE TAX RATES ON TRANSNATIONAL INVESTMENTS BY G ERMAN AND UK COMPANIES

Introductory remarks

The potential distortions highlighted in the analysis of cross-border investments indicate that there can be considerable incentive for companies to alter their behaviour in order to minimise their global tax burden.

Section 6.3.3 showed that companies can considerably minimise their effective tax burden if they choose selected forms of finance for the subsidiaries, the most tax convenient form of finance depending on the result of the interaction of the taxation regimes of the home/host countries. The results of the analysis indicate that this situation corresponds to a degradation of capital export and capital import neutralities.

Companies may also use more complex financial arrangements and group structures in order to minimise their effective tax burdens. The area of financing offers many possibilities, in particular for multinational companies. In general, the implementation of an intermediary financial company is advantageous if the relevant income bears a lower tax burden compared with the direct financing of a foreign subsidiary by the parent company.

Therefore, the purpose of this section is to understand to what extent the tax optimisation strategy of companies -by means of an intermediary financial company- affects their effective tax burden and, in general, the results arising from section 6, in terms of tax induced distortions in the allocation of resources.

The most tax efficient strategy for cross border financial arrangements through financial intermediaries depends on the tax burden in all countries involved and on the provision of the tax treaties between these countries. It is therefore obvious that there is no universally valid tax optimisation strategy for international financing (see Box 10).

In order to work out the most relevant tax driven factors influencing this strategy and keeping the analysis still manageable, Germany and the UK only are taken as examples for the location of the parent company (the subsidiary being located in all Member States). For the intermediary financial companies, the case of a Belgian co-ordination centre and a Dutch finance company are considered.

As is the case for the main body of the quantitative analysis, the tax regimes considered here are those in operation in 1999. Thus, the two countries differ with respect to the national profit tax rate (30% in the UK and 52.35% in Germany), the method for eliminating the international double taxation of dividends (exemption in Germany and credit with limitation in the UK) and the provisions for withholding taxes on interest payments in their tax treaties concluded with the other Member States. All this will clearly have an impact on both the choice of location of the financial intermediary and the use of the source of finance.

It is worth noting that the situation has dramatically changed since 1999. The German tax regime has been subject to a fundamental reform and the UK has reviewed its legislation in the area of tax planning. Moreover, there have been developments in tax co-ordination at the EU level, involving, among other things, the scheduled rollback of the Belgium co-ordination centre and of the Dutch finance companies.

It is however still very useful to consider the results of the analysis of the cases presented in this section. They can illustrate whether, and to what extent, the strategies considered here have an impact on the analysis above which showed that countries are competing mostly with their tax rates for attractive conditions as a place of location for foreign investors. It can, therefore help to understand whether removing these forms of financial intermediaries, for example in the context of the Code of Conduct for business taxation, helps to solve the problem of tax-induced resources misallocation.

Box 12: Possible financial arrangements

Transfer of money from parent to financial intermediary / from financial intermediary to subsidiary Taxation at the level of the

Subsidiary Financial intermediary Parent

Symmetric financing

New equity / Taxation of profits Taxation of dividends, Taxation of dividends, international double international double

New equity taxation is avoided by taxation is avoided by exemption or credit with exemption or credit with limitation limitation

Debt / No taxation of profits as In principle no taxable Taxation of interest interest on loan is income as the interest received from the financial

Debt deductible received from the intermediary subsidiary is decreased by

the interest paid to the parent

Asymmetric financing

New equity / Taxation of profits Taxation of dividends, Taxation of interest international double received from the financial

Debt taxation is avoided by intermediary exemption or credit with

limitation

Deduction interest paid to the parent

Debt / No taxation of profits as Taxation of interest Taxation of dividends, interest on loan is received from the international double

New equity deductible subsidiary taxation is avoided by exemption or credit with limitation

  • New equity / New equity: The transfer of new equity capital via a financial intermediary could be more tax efficient if the tax treaty between the country of the subsidiary and the parent eliminates the double taxation of dividends by granting a limited tax credit, whereas the tax treaty between the country of the subsidiary and the country of the intermediary company as well as between the country of the intermediary company and the parent provide the exemption method. Moreover, the financial intermediary could be used as a “mixer company” in order to avoid excess foreign tax credits. If the dividends from different subsidiaries are pooled at the level of the financial intermediary the parent company benefits from the averaging of foreign tax credits when double taxation of dividends is avoided by the credit with limitation on a per-country basis. Finally the above strategy is advantageous when the country of the subsidiary uses a split-rate corporation tax system.
  • Debt / Debt: A financial intermediary that is used as a conduit company for interest payments typically gains an advantage from the reduction of withholding taxes on interest (treaty shopping). This can be achieved if the tax treaty between the state of residence of the subsidiary and the intermediary company allows to collect lower or even no withholding taxes on interest compared to the tax treaty between the state of residence of the subsidiary an the parent company.
  • New equity / Debt: Where debt capital is transformed into new equity capital there is an advantage to an intermediary company if the tax saving from the interest deduction at the level of the intermediary is higher than the tax burden on the interest receipts at the level of the parent.
  • Debt / New equity: The transformation of equity into debt financing offers advantages if the financial intermediary pays taxes at a lower rate than the subsidiary would have to pay on its profits and the parent company would have to pay on receipt of the interest. Moreover, the ultimate repatriation of the equity funds to the parent should bear no further tax liability (e.g. dividends are exempt from tax at the level of the parent).

    The German parent's approach for optimising international financial arrangements (1999)

    The legal framework of the analysis

In 1999 Germany has a comparably high national tax rate on profits. International double taxation of dividends is eliminated by the exemption method. One might reasonably argue therefore that the principle aim of German multinationals is to establish financial intermediaries as base companies (asymmetric financing) in order to shelter the low taxed income from taxation in Germany. The predominant way of financing is that the German parent contributes new equity funds to the intermediary company and the intermediary company transforms these equity funds into debt financing of the subsidiary (i.e. new equity / debt from box 12). Figure 3 summarises the sources of finance and the resulting cash flows.

From the perspective of a German parent company Belgium, Ireland and the Netherlands are the most important countries for the location of financial intermediaries. The following analysis concentrates on Belgium and the Netherlands which allows the fundamental principles of the German taxation of foreign financial intermediaries in 1999 to be highlighted.

Figure 3: German perspective of international financial arrangements

EU Subsidiary (M em ber States)

Debt

Interest

Financial Interm ediary

(Belgium C o-ordination Centre BCC Dutch Financing Com pany DFC)

Dividends

Equity

EU Parent Com pany (G erm any)

R etained S ales D ebt I

nterest E quity D iv. E arnings of shares

Individual Shareholder (G erm any)

  • A) 
    The case of a Belgian co-ordination centre

Subject to certain prerequisites a Belgian Co-ordination Centre (BCC) can be formed by a foreign (i.e. non-Belgian) parent company either as a Belgian corporation or a branch. The BCC must be a member of a multinational group and carry on only the development and centralisation of certain activities including financial operations for the sole benefit of the group (so-called “intra-muros” requirement). Limits are imposed as a BCC may not own shares of other (Belgian or foreign) corporations. Therefore, the BCC can only act as a financial intermediary but not as an intermediary holding company.

Although, like every Belgian corporation or branch, a BCC is liable to corporation tax at an effective statutory rate of 40.17% (corporation tax of 39% plus surcharge of 3%), there is a special tax benefit resulting from the definition of the tax base. The tax base is computed on a cost-plus basis rather than on realised profits. The costs that are taken into account is the sum of the BCC’s operational expenses excluding personnel or financial charges. Due to this definition of the tax base interest payments received by the BCC from other group members are in principle not taxable in Belgium. Moreover, distributed dividends are not subject to Belgian withholding tax which results in a quasi-exemption from any Belgian taxes for the financing activities. On the other hand, withholding taxes on interest payments from the subsidiaries to the BCC deducted in the state of residence of the subsidiaries become final and cannot be credited against Belgian corporation tax.

As a general rule, retained profits of the BCC are only taxable in Belgium (deferral principle) and, according to the Belgian-German tax treaty, distributed profits are exempt from corporation tax and trade tax at the level of the German parent.

The deferral principle is violated to a certain extent by the German Controlled Foreign Companies (CFC) legislation including Passive Foreign Investment Company (PFIC) rules. Accordingly, following the German “deemed dividend approach”, retained profits of a foreign company resulting from passive income are attributed to the German parent company and are subject to corporation tax and trade tax if the shareholding in the financial intermediary is at least 50% (controlled foreign company) and the total (effective) tax burden on the profits is less than 30% (low tax jurisdiction).

As passive income is defined, inter alia, as income realised by the foreign financial intermediary from holding of liquid funds or the lending of equity capital received by a parent company, a BCC earns passive investment income. The German legislation explicitly provides, however, that the tax treaty provisions applicable to distributed dividends also apply to deemed dividends under CFC legislation. As the Belgian-German tax treaty does not contain an “activity proviso” the passive income of a BCC would be – as a first step – exempt from German taxation.

With regard to capital investment income, however, the German PFIC rules set out of force treaty provisions which provide the exemption method. To the extent that the capital investment income is stemming from the financing of a foreign based company which is engaged in active business, 60% of the investment income is treated as passive income and attributed to the German shareholder (i.e. the parent company). Although the amount of 60% is entirely subject to corporation tax it is exempt from trade tax. To mitigate double taxation an indirect foreign tax credit is granted to taxes paid by the BCC and to taxes withheld on investment income received by the BCC. The remaining 40% of the capital investment income are treated as ordinary passive income so that the participation exemption according to the Belgium-German tax treaty applies. Moreover, a genuine distribution of the profits (part of the 60% profits) of the financial intermediary company which have been already attributed to the German shareholder according to the PFIC rules are explicitly exempt from corporation tax.

Depending on the location of the subsidiary that is financed by the BCC the financial operation bears different tax burdens: The (minimum) statutory corporation tax rate including the solidarity levy is 42.2% (40% * 1.055) plus trade tax in the case of a German subsidiary and 25.32% (60% * 40% * 1.055) in the case of a foreign based subsidiary. Therefore a German parent does not benefit from a BCC with regard to the financing of its domestic subsidiaries. The tax burden will be the same. With regard to the financing of foreign subsidiary, however, the tax burden is significantly lower compared to both domestic subsidiaries and direct financing by the German parent. In the latter case the interest receipts from the foreign subsidiaries would also be subject to the statutory tax rate of 42.2% plus trade tax.

  • B) 
    The case of a Dutch finance company

The Netherlands are the most common place for the location of financial intermediaries of German multinationals. A Dutch Finance Company (DFC) like every other company is subject to corporation tax with its profits at a nominal rate of 35%. As this tax rate is very close to the EU-average, the main tax advantages are therefore an extensive network of tax treaties and the possibility of informal advance rulings with the Dutch tax authorities with respect to the taxation of profits. A special tax incentive for a DFC, however, is the creation of a so-called financial risk reserve which enables a DFC to put up to 80% of the taxable income from annual group financing into a book reserve and to deduct the annual contribution from taxable income. Depending on the contribution to a risk reserve a DFC is able to arrive at an effective statutory corporation tax rate between 35% and 7%. This is also the final tax liability in the Netherlands. Withholding taxes on interest receipts are creditable against Dutch corporation tax and distributed dividends to a German parent company are not subject to withholding tax in the Netherlands.

With regard to the taxation of profits of a DFC the general rule is that they are not taxable in the hands of the German shareholder as long as they are retained (deferral principle). In case of a distribution the dividends of a DFC are exempt form corporation tax and trade tax according to the Dutch-German tax treaty.

As the DFC in principle is always resident in the Netherlands and the effective tax burden usually is above 30%, there is no taxation in Germany either due to a German place of residence or according to the German PFIC rules. The latter rules are likely to apply, however, if the DFC makes contributions to a risk reserve resulting in an effective statutory corporation tax rate below 30%. The critical contribution is around 14.3% (35% * 85.7% = 29.995%). As any contribution above this amount would result in an even higher tax burden due to the PFIC rules compared to the situation in which no contributions to the risk reserve are made at all, the most tax efficient strategy would be to contribute such an amount so that the effective corporation tax rate is just above 30%.

Although this strategy bears certain risks as the total profits of the DFC could be treated as capital investment income it is assumed to prevail in the case where the DFC is granting loans to its subsidiaries. Moreover, it is assumed that the reserve can be released tax free (e.g. a purchase of participation is assumed) so that the Dutch corporation tax rate will be fixed at 30%.

Relevant economic measures: cost of capital and EATR of a German parent and its EU subsidiaries

Tables 32, 33 and 34 compare the cost of capital and the EATR of a German parent and its EU subsidiaries both for the most tax efficient way of financing the subsidiaries by the parent and for the case of a financial intermediary. The financial intermediary can be either a BCC or a DFC, financed by the German parent with equity capital, and which transfer the money as debt capital to other group members located in the Member States 47 . For each way of financing averages and standard deviations are calculated.

As a consequence of the high German statutory tax rate the most tax efficient direct way of financing an EU subsidiary from the perspective of a German parent is always profit retention of the subsidiary (see section 6).

Compared to this, the use of a financial intermediary results in a lower cost of capital/EATR in 10 out of 14 cases if it is assumed that distributions are financed out of domestic earnings (see table 32). Only for subsidiaries located in Ireland, Italy, Sweden and the UK is direct financing by the German parent still more favourable. On average, the use of a BCC is more tax efficient than direct financing. A DFC only offers very minor advantages. However, with regard to the standard deviations the dispersion is reduced significantly if a financial intermediary is used. This is due to the fact that for the marginal return (cost of capital) or interest payments (EATR) a uniform statutory tax rate of 25.32% (in case of a BCC) or 30% (in case of a DFC) applies.

The most important reason for the advantage in using a financial intermediary compared to direct financing is a reduction of the statutory tax rate on company profits where they are channelled through an intermediary. Debt financing by a BCC turns out to be more advantageous than profit retention in the subsidiary if the statutory tax rate in the host country of the subsidiary is higher than the effective statutory tax rate on interest after the German Passive Foreign Investment Company (PFIC) rules are

47 Although a DFC may also hold participation in other companies and therefore provide a subsidiary with new equity

capital, this way of (equity financing) is not considered here. The reason is that there are no additional tax advantages compared to the direct supply of new equity capital by the German parent as Germany exempts the resulting dividends

applied (as shown above the effective tax rate is around 25%). All Member States except Ireland and Italy impose corporation tax rates above 25%.

Compared to a BCC a DFC might be expected to offer a less favourable tax effect as the relevant tax rate on the interest income is higher (as shown above, the effective tax rate is around 30%). For four Member States, however, the opposite turns out to be true. This result is explained by the levy of withholding taxes on interest payments in the host country of the subsidiary to the financial intermediary. In case of a DFC these withholding taxes are not relevant as they can be credited against Dutch corporation tax on the interest income. In case of a BCC, however, the withholding tax becomes relevant for that part of the underlying income that is not covered by the PFIC rules (i.e. 40%).

As only 60% of the income attributed to a BCC is taxable and 40% exempt, in Germany 40% of the withholding tax deducted cannot be credited against German corporation tax and thus becomes final. In the case of France, Greece, Portugal and Spain the 15% withholding tax on interest payments to a BCC overcompensates for the advantage of a lower effective statutory tax rate on profits as compared with a DFC.

The ranking of the host countries for the subsidiaries from the perspective of a German parent company differs between the cost of capital and the EATR.

In the case of a financial intermediary the cost of capital of a cross-border investment is determined by the (individual) tax base in the host country of the subsidiary and the (uniform) effective tax rate imposed on profits of the financial intermediary. Therefore, in the case of a marginal investment, Member States only compete as places of location in their rules for determine corporate profits (i.e. their tax bases). This is demonstrated by the BCC case where Belgium (4.5%) has a lower cost of capital than Luxembourg (4.6%) and Denmark (5.2%).

For a more profitable investment the EATR is relevant. Although with respect to the EATR the changes in the country ranking are only minor, one important aspect has to be considered. As the economic rent cannot be shifted from the subsidiary to the financial intermediary by means of financial arrangements based on the arm’s-length-principle (the possible shifting by transfer prices is not considered here), the economic rent is always taxed at the statutory rate in the host country of the subsidiary. As the national tax rates on profits are lower in Denmark (EATR of 16.8%) and Luxembourg (EATR of 19.2%) both countries can improve their position in the ranking compared with Belgium (EATR of 21.2%).

Therefore, as has already been demonstrated in the base case and for several of the simulations attempted in section 7 above, countries are competing with their tax rates for attractive conditions as a place of location for foreign investors. The use of a financial intermediary cannot change the country ranking. It only reduces the EATR by a certain amount as the profits that are transferred by the financial arrangement are subject to a lower tax rate. The predominant role of the tax rate in comparison with the tax base is also demonstrated by the significant reduction of the standard deviations of the cost of capital. All in all this reveals a greater disparity of the tax rates than of the tax bases among Member States.

The introduction of personal taxes has no effect on the country ranking and the relative advantages of the different ways of financing if it is assumed that all distributions to the ultimate shareholder of the German parent are financed from domestic earnings.

ev. Stand. D 0.8 8.3 0.5 5.7 0.4 5.4 0.6 7.2 0.7 7.9 0.6 5.5 0.5 5.2 0.6 6.7

Mean

5.5 19.0 5.3 18.4 5.5 18.9 5.1 16.7 3.9 19.0 3.7 18.2 3.9 18.7 3.4 16.7

Kingdom

United 5.9

17.7 6.1 18.8 6.1 18.6 5.9 17.7 4.3 17.7 4.5 18.5 4.5 18.3 4.3 17.7

Sweden

5.0 11.0 5.0 11.2 5.5 13.3 5.0 11.0 3.6 11.6 3.5 11.5 4.0 13.5 3.5 11.5

Spain

5.8 21.7 5.6 20.8 5.5 20.6 5.5 20.6 4.2 21.3 3.9 20.3 3.8 20.1 3.8 20.1

ugal Port

5.9 23.8 5.4 22.0 5.3 21.8 5.3 21.8 4.2 23.4 3.6 21.6 3.6 21.4 3.6 21.4

ds Netherlan

estic earnings 5.8 21.6 4.9 18.4 5.5 20.5 4.9 18.4 4.2 21.3 3.2 18.1 3.8 20.1 3.2 18.1

dom Luxembourg

5.7 23.4 4.6 19.2 5.2 21.3 4.6 19.2 4.1 23.1 2.9 19.1 3.5 21.0 2.9 19.1

Italy

3.4 17.9 5.2 23.9 5.1 23.7 3.4 17.9 1.8 18.3 3.5 23.7 3.4 23.5 1.8 18.3

Ireland

Greece

5.5 25.4 5.0 23.7 4.8 17.6 4.8 17.6 3.9 25.4 3.3 23.2 3.1 17.6 3.1 17.6

Germany ./. ./. ./. ./. ./. ./.

./. ./. ./. ./. ./. ./. ./. ./. ./. ./.

any: distributions by parent out of C France

erm 7.0 29.8 6.2 27.0 6.1 26.8 6.1 26.8 5.3 29.2 4.5 26.4 4.4 26.2 4.4 26.2

G

d Finlan

5.5 14.3 5.3 13.8 5.8 15.9 5.3 13.8 3.9 14.4 3.7 13.7 4.2 15.7 3.7 13.7

ay, BCC and DF ark Denm 5.7 18.8 5.2 16.8 5.7 18.8 5.2 16.8 4.2 18.9 3.7 16.9 4.2 18.8 3.7 16.9

m Belgiu

isation in the case of fi cient w 6.0 26.4 4.5 21.2 5.1 23.3 4.5 21.2 4.3 26.1 2.8 21.1 3.4 23.1 2.8 21.1

capital and EATR Austria

5.6 4.9

ost tax ef 20.1 17.3

5.4 19.4 4.9 17.3 4.0 19.9 3.2 17.1 3.8 19.1 3.2 17.1

to

Tax Optim - cost of - m - corporate and personal taxes l es ) )

nes ost ay npita

ax

ost ay m p. ) m p. )

n m t w gi um ds ds

um ax n m t w

f Ca (%) orp. T ing i in

atio

fi cien rd (

B el ing Co erlan im al T el

gi um um

ing i in

atio

rd ( B ing Co erlan im

st o and EATR ly C nc -o nc na ef Min rs on nc

fi cien

 ef -o re nc

Table 32 Co On Fi tax Co

nt re na

Ce Fi

(Neth Pe na na Min

Fi tax Co

nt Ce Fi (Neth

ev. Stand. D 0.8 7.0 0.6 5.0 0.4 4.6 0.6 5.9 0.4 3.9 0.9 3.5 0.4 3.1 0.9 3.8

Mean

6.0 28.9 5.3 26.7 6.0 28.9 5.1 25.8 4.6 42.6 3.4 40.0 5.5 44.5 3.4 39.8

Kingdom

United 6.3

27.9 6.2 27.5 6.5 28.6 6.2 27.5 5.0 42.0 4.7 41.2 6.0 44.3 4.7 41.2

Sweden

5.4 22.2 4.9 20.3 6.0 24.1 4.9 20.3 4.6 39.1 2.9 35.1 5.5 41.4 2.9 35.1

Spain

6.3 31.3 5.7 29.2 6.0 30.3 5.7 29.2 5.0 44.4 4.0 42.3 5.5 45.4 4.0 42.3

ugal Port

6.4 33.1 5.5 30.2 5.8 31.4 5.5 30.2 5.2 45.9 3.8 43.1 5.3 46.1 3.8 43.1

ds Netherlan

6.3 31.2 4.8 26.4 6.0 30.3 4.8 26.4 4.4 43.1 2.5 39.1 5.5 45.4 2.5 39.1

f oreign earnings Luxembourg

6.3 32.7 4.4 27.1 5.7 30.9 4.4 27.1 4.1 43.6 2.2 39.7 5.2 45.9 2.2 39.7

Italy

3.9 28.0 5.3 31.9 5.7 33.0 3.9 28.0 3.6 44.2 3.7 44.3 5.2 47.4 3.6 44.2

Ireland

Greece

5.9 33.0 5.2 30.9 5.3 27.8 5.2 27.8 4.7 44.1 3.7 41.9 4.9 43.9 3.7 41.9

Germany ./. ./. ./. ./.

./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./.

any: distributions by parent out of C France

erm 7.5 38.2 6.3 34.5 6.7 35.6 6.3 34.5 5.0 46.7 4.6 46.0 6.2 49.0 4.6 46.0

G

d Finlan

5.9 25.0 5.2 22.5 6.3 26.4 5.2 22.5 4.8 40.4 3.1 36.5 5.8 42.8 3.1 36.5

ay, BCC and DF ark Denm 6.2 28.7 5.1 25.1 6.2 28.8 5.1 25.1 4.7 42.2 3.0 38.5 5.7 44.4 3.0 38.5

m Belgiu

isation in the case of fi cient w 6.5 35.2 4.3 28.8 5.6 32.6 4.3 28.8 5.1 46.9 2.0 41.0 5.2 47.1 2.0 41.0

capital and EATR Austria

6.1 4.7

ost tax ef 30.0 25.4

5.9 29.4 4.7 25.4 4.3 42.5 2.5 38.5 5.4 44.8 2.5 38.5

to

Tax Optim - cost of - m - corporate and personal taxes l es ) )

nes ost ay npita

ax

ost ay m p. ) m p. )

n m t w gi um ds ds

um ax n m t w

f Ca (%) orp. T ing i in

atio

fi cien rd (

B el ing Co erlan im al T el

gi um um

ing i in

atio

rd ( B ing Co erlan im

st o and EATR ly C nc -o nc na ef Min rs on nc

fi cien

 ef -o re nc

Table 33 Co On Fi tax Co

nt re na

Ce Fi

(Neth Pe na na Min

Fi tax Co

nt Ce Fi (Neth

If we now consider that distributions to the ultimate shareholder are also financed from foreign profits and ignore personal taxes for the moment, we can see from the results shown in Table 33 that a BCC does improve its relative position in comparison with both the most tax efficient direct way of financing and the use of a DFC. This can be explained by the German PFIC rules that add 60% of the profits of a BCC to the German corporation tax base. As these profits are subject to corporation tax they qualify for the reduction of the corporation tax rate for distributed profits. On the other hand, both profits resulting from the most tax efficient direct way of financing and distributed dividends from a DFC are exempt from corporation tax in Germany and therefore cannot take advantage from the split-rate corporation tax system. As a consequence, only in the case of Greece, Ireland and Italy will a BCC offer fewer advantages. (Compared with the other scenario that assumes that distributions are taken from domestic earnings, a BCC now is also more attractive for subsidiaries in France, Portugal, Spain, Sweden and the United Kingdom).

Moreover, if we take personal taxes into account, a BCC would even become more attractive as only certain dividends taken from profits of a BCC (i.e. those 60% of the profits covered by the PFIC rules) qualify for the domestic German corporation tax credit.

Finally, Table 34 compares the cost of capital and the EATR on domestic investment and on outbound investment depending on the assumptions of the financing of profit distributions. The results are overall averages taken from the section on domestic investment and the previous Tables in this section.

Table 34 Tax Optimisation in the case of Germany: comparison of domestic and outbound investment

- cost of capital and EATR - most tax efficient way, BCC and DFC - corporate and personal taxes

Corporate taxes Personal taxes Distributions by

Cost of Capital/ parent out of Distributions by

Distributions by

parent out of Distributions by

EATR domestic parent out of domestic parent out of

earnings foreign earnings earnings foreign earnings

Domestic 7.3 6.0 5.2 2.8 investment 39.1 35.6 37.7 30.8

Outbound investment

  • Financing in most 5.5 6.0 3.9 4.6 tax efficient way 19.0 28.9 19.0 42.6
  • Co-ordination 5.3 5.3 3.7 3.4 Centre (Belgium) 18.4 26.7 18.2 40.0
  • Financing Comp. 5.5 6.0 3.9 5.5 (Netherlands) 18.9 28.9 18.7 44.5
  • Minimum (1) 5.0 5.1 3.4 3.4 16.7 25.8 16.7 39.8

(1) Member States' mean of the most tax-efficient way out of the three possibilities

Compared with domestic investment in Germany, tax optimisation reduces the cost of capital and the EATR on outbound investment. The advantage for foreign investment increases significantly if it is assumed that in the case of outbound investment the distributions are taken from domestic profits. If instead the distributions have to be taken from foreign profits, outbound investment is still more tax efficient than domestic investment if the focus is on corporate taxes only. Tax optimisation again increases the advantage of outbound investment. In addition, if personal taxes become relevant, outbound investment can now be in a better position with respect to the cost of capital if a BCC is used. Tax optimisation can therefore overcompensates for the disadvantages of foreign source income that does not carry a tax credit within the imputation system. However, with respect to the EATR, domestic investment remains in a better tax situation. The reason is that the economic rent distributed from the subsidiary to the parent does not allow for a tax credit at all.

The UK parent's approach for optimising international financial arrangements (1999)

The legal framework of the analysis

In contrast to Germany the effective statutory tax rate on profits in the UK (currently 30%) is below the EU-average. Another important difference that has an impact on any tax planning strategy is the method for eliminating international double taxation of foreign dividends. Instead of the exemption method the limited foreign tax credit method applies. Having regard to the comparably low corporate tax rate in the UK it is therefore less attractive to establish a foreign intermediary as a base company. Sometimes, however, an intermediary is used as a group financing company following in principle the same structure as was suggested for a German multinational (i.e. asymmetric financing of new equity / debt - see figure 3). Having regard to the application of the tax credit method the principle aim of a UK multinational ought to be to optimise its position towards foreign tax credits. This can be achieved by an intermediary holding company that serves as a so-called “Mixer Company”. Recalling the principle forms of financial arrangements set out in box 10 this structure belongs in the category of symmetric financing (new equity / new equity). Figure 4 summarises the sources of finance and the resulting cash flows.

Figure 4: UK perspective of international financial arrangements

EU Subsidiary (Member States)

Debt Equity (DFC) (Mixer)

Interest Dividends (DFC) (Mixer)

Intermediary

(Dutch Mixer Company Dutch Financing Company DFC)

Dividends

Equity

EU Parent Company (United Kingdom)

Sales

Debt I Retained nterest Equity Div. Earnings of shares

Individual Shareholder (United Kingdom)

From the perspective of a British parent company the Netherlands, Ireland or Jersey are important countries for the location of intermediary companies. The following analysis concentrates on the Netherlands as this example illustrates the fundamental principles and effects of these tax planning strategies.

  • A) 
    The case of a Dutch Finance Companies (DFC)

The interposition of a Dutch Finance Company (DFC) between a UK parent and another EU subsidiary follows the same structure as set out in section 8.2 on Germany. Moreover, the Dutch taxation of UK owned Dutch finance companies is exactly the same. Contributions to a risk reserve are also the same and it is assumed that the risk reserve can be released tax free so that the effective corporation tax rate of the DFC is 30%.

Under the UK controlled foreign companies legislation, the profits of the DFC would not be imputed back to the UK if it was a “holding company” within the meaning of the relevant provisions. This could normally be achieved relatively easily. If and when the finance company declares a dividend to the UK parent, that dividend will be subject to UK corporation tax at 30% less a credit for the underlying tax borne by the finance company. Assuming a fixed Dutch corporation tax rate of 30% there will be no further UK tax liability.

  • B) 
    The case of a Dutch Mixer Company

Against the background of tax optimisation for foreign tax credits under the UK method for eliminating double taxation of foreign dividends, the use of an overseas holding company was a relatively common tax planning strategy for UK multinationals. Although this structure has been legislated against in the UK Finance Act 2000, it was the standard tax planning for UK based multinationals up to 1999 and is therefore considered here.

When a UK company receives a dividend from an overseas subsidiary, that dividend is subject to UK corporation tax at 30%. The UK eliminates double taxation of foreign dividends by granting a tax credit for the underlying foreign tax. However, this credit is calculated on a per-source basis and limited to the UK corporation tax on the grossed-up amount (i.e. dividend plus underlying tax). Therefore, optimum efficiency arises where the overseas subsidiary’s underlying rate of tax is equal to the UK tax rate of 30%. To the extent that the underlying rate is greater than 30%, some of the credit is effectively wasted since the first 30% of the underlying tax is sufficient to prevent any further UK tax liability on the dividend arising. Correspondingly, to the extent that the underlying tax rate is less than 30%, UK tax is payable. UK law did not permit the averaging out of underlying tax rates at the UK company level.

If a “mixer” company was incorporated in the Netherlands, these inefficiencies could be minimised and the effective rate of tax on overseas dividends reduced to 30%, thus ensuring that no further UK tax was payable, and that no overseas tax was ‘wasted’.

The Dutch mixer would receive dividends from high-tax (e.g. EU) subsidiaries and also hold shares in companies in low-tax jurisdictions. Due to the Dutch participation exemption there was no Dutch tax payment on the dividends. At the level of the Dutch holding company dividends from the low-tax companies (with low foreign tax applied to them) could be mixed with dividends from the high-tax EU subsidiaries. The mixer company would then pay a single dividend to the UK parent.

The dividends from the Dutch mixer company is the total amount of dividends that was received by the UK parent from the various overseas subsidiaries At the level of the UK parent, in calculating the underlying tax borne by the Dutch mixer company, the average rate of tax on the dividends determines the amount of foreign tax credit available. Judicious adjustment of the timing and amount of dividends would ensure that the overall rate was 30%. This was extremely advantageous for UK parents of groups with subsidiary companies in jurisdictions with varied local tax rates, since the effect of this is to average out the level of underlying tax, so a well-structured group could ensure that profits were only repatriated which were subject to an underlying rate of approximately 30%.

The use of mixers to smooth the rate of tax on overseas subsidiaries could be extended by the introduction of subsidiaries with artificially low rates of tax, effectively money-box companies, where an appropriate amount of zero-taxed income could be mixed with ‘real’ foreign income to achieve a 30% rate.

Although in an optimum situation there is an effective tax rate of 30% on all overseas subsidiaries it is not clear to which subsidiaries the benefits should be attributed. They could be attributed to those subsidiaries located in high tax jurisdictions (i.e. with statutory tax rates above the UK rate of 30%) as their tax burden is effectively reduced to 30%. However, the benefits could also be attributed to subsidiaries in low tax jurisdictions (i.e. with statutory tax rates below the UK rate of 30%) as a further UK tax on their dividends is avoided due to mixing. Economically, the latter dividends are thus exempt from UK tax. In the following, however, the first interpretation is used.

8.3.2 Relevant economic measures: cost of capital and EATR of a UK parent and its EU

subsidiaries

Tables 35 and 36 compare the cost of capital and the EATR of a UK parent and its EU subsidiaries both for the most tax efficient way of financing the subsidiaries by the parent and for the case of a financial intermediary. The financial intermediary can be either a DFC or a Dutch mixer company that are both financed by the UK parent with equity capital. However, different forms of finance are used by the intermediaries: whereas the DFC transfers the money as debt capital to other group members the mixer company injects new equity capital into the subsidiaries. In case of a mixer company the subsidiaries can also retain their earnings. In addition to the country results, averages and standard deviations for each way of financing are calculated.

Table 35 shows that, as a consequence of the comparably low UK statutory tax rate and the limited tax credit on foreign source dividends the most tax efficient way of directly financing an EU subsidiary from the perspective of an UK parent is, on average, debt financing. Only in source countries with an even lower statutory tax rate does profit retention in the subsidiary turn out to be more tax efficient. This is the case for Finland, Ireland, Italy and Sweden. The advantage of profit retention over new equity financing and debt financing can be attributed to the fact that the foreign subsidiaries do not pay the higher UK tax rate on profits.

Compared to the most tax efficient way of direct financing, the interposition of a mixer company is more advantageous in 11 out of 14 cases. Only for subsidiaries in the countries imposing lower tax rates than the UK (Finland, Ireland and Sweden) will tax optimising strategies offer no further advantages. Unlike the German situation, the interposition of a DFC has no tax benefit. This is explained by the UK tax credit system. The profits of a DFC cannot be effectively deferred from UK taxation because they are distributed to the UK parent and therefore always liable to the UK corporation tax.

The reason for the advantage of a mixer company compared to direct financing is the limited UK tax credit on dividends in the case of direct financing. As the statutory tax rates in those foreign countries where the interposition of a mixer company offers advantages are higher than the UK tax rate, there will always be excess foreign tax credits in the UK. This is also true in case of debt financing of a foreign subsidiary (which is the most tax efficient way of direct financing in most cases), as the foreign profits above the interest rate are distributed as dividends which only carry a limited tax credit. Mixing dividends reduces the tax rate attributed to foreign dividends to the UK rate of 30% and thus avoids any excess tax credits.

The total avoidance of excess tax credits explains the reduction of the cost of capital in case of a mixer company. In general this reduction compared with the most tax efficient way of direct financing increases with an increase in the statutory tax rate of the foreign subsidiary (i.e. the reduction is higher in the case of a Belgian subsidiary (corporation tax rate of 40.17%) compared with an Danish subsidiary (corporation tax rate of 32%)).

Looking at the results for a German and Italian subsidiary, specific features of these two tax systems come up. In the case of Germany the cost of capital for the most efficient way of direct financing (i.e. debt financing) are increased by 50% of the local trade tax (because 50% of the interest payments have to be added back to the base of the trade tax). With the interposition of a mixer company, however, new equity financing becomes advantageous as all German taxes including trade tax can be credited against UK corporation tax. In the case of Italy the result can be attributed to the dual income tax (DIT) which lowers the cost of capital of an Italian subsidiary. In case of a mixer company it is assumed that Italian corporation tax can be credited against UK corporation tax at the statutory rate leaving the DIT advantage unaffected.

In contrast to the tax optimising strategy of a German parent company (where debt it used as the only source of finance of a foreign subsidiary), the interposition of a mixer company also reduces the effective average tax rate by a considerable amount. This can be attributed to the fact that not only the foreign corporation tax on the marginal return but also the foreign corporation tax on the economic rent can be credited against UK corporation tax. The ranking of the host countries for the subsidiaries from the perspective of a UK parent company, do not differ between the cost of capital and the EATR. With respect to the cost of capital and the EATR among Member States, however, differences remain. These are explained by the differing domestic tax bases (rules for computing taxable income) which are still relevant. This also explains the greater standard deviation.

The introduction of personal taxes has no effect on the country ranking and the relative advantages of different ways of financing. This is because the shareholder relief system means all distributions are treated in the same way in the hands of UK shareholders.

ev. Stand. D 0.6 3.3 0.9 3.2 0.4 2.4 0.9 3.2 0.6 2.7 0.9 2.6 0.4 2.1 0.9 2.6

Mean

5.8 29.4 5.5 24.1 6.1 30.5 5.5 24.1 4.8 34.4 4.6 29.9 5.1 35.2 4.6 29.9

Kingdom

United ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./. ./.

Sweden

5.7 24.8 5.7 24.8 6.1 26.5 5.7 24.8 4.9 30.6 4.9 30.6 5.2 31.8 4.9 30.6

Spain

6.1 29.9 6.0 26.0 6.1 29.9 6.0 26.0 5.1 34.6 5.1 31.3 5.1 34.6 5.1 31.3

ugal Port

5.9 31.0 5.7 25.0 5.9 31.0 5.7 25.0 4.9 35.6 4.8 30.6 4.9 35.6 4.8 30.6

ds Netherlan

6.1 29.9 6.0 25.9 6.1 29.9 6.0 25.9 5.1 34.6 5.1 31.3 5.1 34.6 5.1 31.3

Luxembourg

5.8 30.6 5.6 24.5 5.8 30.6 5.6 24.5 4.8 35.3 4.7 30.2 4.8 35.3 4.7 30.2

Italy

4.3 28.3 2.8 14.8 5.8 32.6 2.8 14.8 3.3 33.6 2.0 22.2 4.8 37.2 2.0 22.2

Ireland

Greece

5.5 30.0 5.2 23.4 5.5 30.0 5.2 23.4 4.5 34.8 4.4 29.2 4.5 34.8 4.4 29.2

p any and DF Germany 5.5 34.1 4.4 20.3 5.5 34.1 4.4 20.3 4.5 38.5 3.6 27.0 4.5 38.5 3.6 27.0

France

6.8 35.3 6.5 27.6 6.8 35.3 6.5 27.6 5.8 39.4 5.6 32.9 5.8 39.4 5.6 32.9

UK ixer com

d Finlan

6.2 26.5 6.2 26.5 6.4 27.5 6.2 26.5 5.3 31.9 5.3 31.9 5.5 32.5 5.3 31.9

ay, Dutch m ark Denm 6.3 28.3 6.2 26.8 6.3 28.3 6.2 26.8 5.4 33.4 5.4 32.1 5.4 33.4 5.4 32.1

m Belgiu

isation in the case of fi cient w 5.7 32.3 5.4 23.9 5.7 32.3 5.4 23.9 4.8 36.8 4.6 29.9 4.8 36.8 4.6 29.9

capital and EATR Austria

6.0 5.9

ost tax ef 29.0 25.8

6.0 29.0 5.9 25.8 5.1 33.8 5.0 31.2 5.1 33.8 5.0 31.2

to

Tax Optim - cost of - m - corporate and personal taxes l es y

) es ost ay y ) pita ax

ost ay

n m t w pan ds

m p. ) ds ds m p. ) ds

um ax n m t w pan um

f Ca om (%) orp. T ing i fi cien erlan ing Co erlan im al

 T om

ing i erlan ing Co erlan im

st o and EATR ly C nc er C nc na ef Min rs on nc

fi cien ef er C nc

Table 35 Co On Fi tax Mix

(Neth na Fi (Neth Pe na na Min

Fi tax Mix

(Neth Fi (Neth

Table 36 compares the cost of capital and the EATR on domestic investment and on outbound investment

Table 36 Tax Optimisation in the case of UK: comparison of domestic and outbound investment

- cost of capital and EATR - most tax efficient way, Dutch mixer company and DFC - corporate and personal taxes

Cost of Capital/

EATR Corporate taxes Personal taxes

Domestic 6.6 5.7 investment 28.2 33.2

Outbound investment

  • Financing in

most tax efficient 5.8 4.8

way 29.4 34.4

  • Mixer Company 5.5 4.6 (Netherlands) 24.1 29.9
  • Financing Comp. 6.1 5.1 (Netherlands) 30.5 35.2
  • Minimum(1) 5.5 4.6 24.1 29.9

(1) Member States' mean of the most tax efficient way out of the three possibilities

Compared with a domestic investment in the UK, the cost of capital on foreign investment is lower if the most tax efficient way of financing or tax optimisation are considered. However, the EATR on outbound investment is always higher except in case of a mixer company. This is simply explained by the mechanism of the limited UK tax credit for foreign income which now becomes relevant.

Final remarks

The strategy of tax optimisation depends on the tax system in the home country (in particular on the method for eliminating international double taxation) and the relative ranking vis-à-vis the statutory tax rate. For German and UK parents is has been shown that tax optimisation in the field of financing does reduce both the cost of capital and the effective average tax rate on outbound investment. However, there are still differences between the host countries, which can be attributed to the domestic tax bases in these countries and their statutory tax rates. The tax base always has an impact. However, this impact is only minor. The tax rate becomes important for profitable investments, as pure profits cannot be shifted from one country to another by simple financial arrangements. Therefore, tax optimisation cannot remove all tax obstacles for cross-border investment caused by different tax rates and different tax bases. Moreover, under specific circumstances there is a significant impact from withholding taxes on interest payments.

Compared to domestic investments the cost of capital and the EATR on outbound investments can be significantly reduced by the use of financial intermediaries. The advantage is more substantial in the case of a German parent which is explained by the higher tax burden on domestic investments. Given the fact that mixer companies will not be allowed in the UK in the future, only minor advantages from the use of financial intermediaries will remain. It seems likely that a UK multinational bears the same cost of capital and effective average tax rate on investment whether these investment are financed directly (by a loan) or a financial intermediary is interposed.

The effects of abolishing tax-reducing financing structures in Europe and elsewhere will depend on the location of the parent company. From the above results it seems reasonable to conclude that the tax burden for multinationals will be increased in those countries imposing high taxes on domestic investment. In contrast, there will be only minor effects for multinationals resident in low tax countries.

Therefore, removing these financial intermediaries will not contribute, per se, to solve the problem of tax-induced resources misallocation. Taking into account that the main tax driver for effective tax rates differentials is the overall tax rate, companies located in "high tax" countries will have the possibility to compensate for the removal of financial intermediaries by exploiting the possibility of tax arbitrage arising from those differentials.

EFFECTIVE TAX RATES FOR SMALL AND MEDIUM-SIZED ENTERPRISES IN GERMANY, ITALY AND THE UK IN 1999

This section presents estimates of the costs of capital and effective average tax rates which apply to small and medium sized enterprises in Germany, Italy and the UK. First the tax regimes which apply in each country is outlined. Then the position of small and medium sized enterprises is compared with that of large corporations.

Tax Regimes in Germany, Italy and the UK

  • a) 
    Germany

Entrepreneurs in Germany may set up the legal form of their firm as a corporation or partnership (or as a sole trader). For the purposes of the analysis it is assumed that there are restrictions on the sale of the shares and participations. Hence the entrepreneur is assumed not to sell the firm, with the consequence that the effective capital gains tax rate is zero.

Small and medium-sized corporations are taxed in the same way as large corporations. However, depending on the book value of their assets, small corporations are permitted a 20% accelerated capital allowance for machinery. In addition, they can establish a tax-free reserve of 50% of the initial cost two years in advance of the purchase of the asset. This reserve is reversed when the first depreciation allowance is granted.

Partnerships are not subject to an income tax directly; instead the income is imputed to the partners. However, for the purposes of the trade tax and the real estate tax, the partnership itself effectively is subject to tax. Both taxes are deductible from the income tax base of the partners. The income tax base of the partners is determined in the same way as the corporate profit tax for a corporation. The accelerated capital allowance also applies. The tax base of the trade tax and the real estate tax are also determined in the same way as they are for corporations. However, the trade tax has a tax exempt amount, which means that for small partnerships the marginal rate can be zero. To allow for this, results below are presented for both a zero-rate and top-rate trade tax.

As the personal income tax follows a progressive schedule from 0% to 53% (in 1999), the marginal statutory tax rate depends on the overall personal income. A 5.5% solidarity surcharge on the income tax is also levied. However, for most partnerships the marginal tax rate on trade profits is limited to 45% plus the solidarity surcharge.

The analysis below is presented for shareholders with the following tax rates: (a) zero (b) 35.1% (the marginal rate on taxable income of 30.000 Euro) and (c) 45% (the top rate). Allowing for local taxes, this results in the following overall tax rates:

overall CT rate on overall CT rate on overall income tax overall income tax retained earnings distributed profits rates rates on interest

corporation 52.35 43.7 0 ; 35.4 ; 54.3 0 ; 35.4 ; 54.3

partnerships:

no trade tax - - 0 ; 37 ; 47.5 0 ; 37 ; 55.9

with trade tax - - 17.6 ; 48.1 ; 56.7 0 ; 37 ; 55.9

The income tax rates shown correspond to each of three cases (a), (b) and (c) described above.

  • b) 
    Italy

As in Germany, small and medium sized enterprises can take the form of a corporation or a partnership/sole trader. The tax regime for corporations is the same as for larger corporations.

Also as in Germany, the profits of a partnership are imputed to the partner and taxed according to the personal progressive income tax with rates ranging from 19% to 46%. Partnerships pay the regional tax (IRAP) and the tax on immovable properties (ICI). Neither is deductible from the personal income tax.

To be eligible for the Italian DIT (dual income tax) relief, partnerships must comply with two rules. First, partnerships must use ordinary (not simplified) accounting. Second, the “ordinary return” must be within the first bracket of tax - and hence taxed at 19%. It is assumed that, in the case of debt finance, partnerships borrow from banks, implying that the tax rate charged is 12.5%, as for corporations.

As with the German case, we analyse shareholders with three different personal income tax rates (zero; marginal rate on taxable income of 30,000 Euro; top rate). The results are as follows:

overall CT rate overall income tax imputation rate overall income tax rates on profits rates on interest

corporation 41.3 0 ; 34.0 ; 46.0 0 ; 37 ; 37 12.5

partnerships 4.3 ; 38.3 ; 50.3 0 12.5

  • c) 
    The United Kingdom

In the UK, most small and medium sized enterprises take the legal form of a corporation. Corporation tax differs in two respects from that levied on larger companies. First, the tax rate applied is lower: here it is assumed to be 20%. Second, plant and machinery receives capital allowances at the rate of 40%, rather than 25%.

The personal tax rates for the three types of shareholders (zero; marginal rate on taxable income of 30,000 Euro; top rate). Considered here are:

overall CT rate on personal income tax imputation rate overall income tax retained earnings rates on distributions rates on interest

corporation 20 0 ; 10 ; 32.5 0 ; 10 ; 10 0 ; 20 ; 40

Cost of Capital and Effective Average Tax Rate

This section presents measures of the cost of capital and the effective average tax rate for each of the three countries considered. There are three tables, corresponding to three possible income tax positions of the owner of the firm: a zero rate, a top rate, or a medium rate. In the first two cases, the results for small and medium sized enterprises can be compared with the results for large companies. The types of assets and sources of finance as well as their weights are the same as for the base case. This results in 15 types of investment.

Given the different legal forms available to small enterprises and the differences in the tax treatment described above, tax measures for a number of cases are presented. Thus, in Germany, a company is considered, and the company may or may not benefit from the accelerated depreciation allowances and the tax-free reserve. Both positions for a partnership are also considered. In addition, partnerships which are liable, and those which are not liable, to trade tax are considered. This gives six separate categories for German enterprises.

For Italy, there are three categories. An enterprise may be a company. Alternatively, it may be a partnership, in which case it may or may not receive the benefit of the DIT regime. For the UK, only a company is considered.

Zero rate shareholder

Table 37 analyses the situation of a zero-rated entrepreneur. It gives measures for each of the categories described above, as well as, for comparison, the case of a large company undertaking domestic investment in the same country.

Beginning with Germany, the cost of capital for a small or medium sized company which receives no incentives is equal to that for a similar large company. The same is true of the EATR. However, if the small company does receive these incentives, it faces a lower cost of capital, and a slightly lower EATR. However, both the cost of capital and the EATR are much lower for partnerships. In the absence of trade tax and personal income tax, essentially only the real estate tax is paid, which has only very small effects relative to no tax at all. If the partnership has a liability to trade tax as well, the cost of capital and the EATR are correspondingly higher, although still lower than those facing a company.

Table 37 Cost of Capital and Effective Average Tax Rate

- zero-rate personal taxpayer - average over 15 types of investment

Large Small and Medium-sized Enterprise Cost of Capital Corporation

(upper line)

EATR

(lower line)

Base Case corporation partnership

no trade tax with trade tax

incentive no incentive no incentive no

incentive incentive incentive

Germany 6.9 6.4 6.9 5.1 5.1 5.6 5.7

22.3 20.4 22.3 0.4 0.4 15.7 16.1

Italy 4.0 4.0 - 4.6 4.6 - -

27.1 27.1 0.0 0.0

UK 6.6 6.1 - - - - -

28.2 19.3

Note. Only Germany levies a trade tax. The "incentives" are as follows.

Germany: 20% accelerated capital allowance for machinery; tax-free reserve of 50% of investment two years in advance of the purchase of the asset, which is reversed when the first capital depreciation allowance is granted. Italy: the "incentive" refers to when the DIT relief is available.

UK: corporation tax rate of 20% and 40% capital allowances for plant and machinery.

In Italy, the tax system has the same impact on small and medium-sized companies as on larger companies. Note here that in the table, both types are assumed to benefit from the DIT relief. This implies that the tax system provides an incentive to invest in Italy relative to the case of no tax (where the cost of capital would be 5%). In turn, this implies that the cost of capital is actually higher for partnerships with zero-rated shareholders than it is for small companies. However, by contrast, since the income tax rate is zero, then the EATR on such partnerships is also zero. The comparison between large companies and small and medium sized partnerships (with zero personal income tax rates) in Italy is therefore subtle. At the margin, the Italian corporation tax regime effectively subsidises investments, and so treats marginal investments more generously than the regimes for partnerships. However, for more profitable firms and investments, the lack of income tax on the partnerships implies that they are more favourably treated than larger companies.

In the UK, the comparison is straightforward. Small and medium-sized companies receive the benefit of a lower statutory tax rate and higher allowances. Both the cost of capital and the EATR are therefore lower than for larger companies.

Top rate personal shareholder

Table 38 analyses the situation of entrepreneurs who pay income tax at the highest rate. In general, the costs of capital are lower in Table 38 than in Table 37 while the EATRs are higher. This reflects the discussion in Section 4. The shareholder is assumed to compare the return which can be earned on the hypothetical investment analysed here, with some other financial investment, such as a bank account which pays interest. Introducing tax on the interest receipt from the bank implies that the post-tax rate of return from the alternative asset is now much lower. Other things being equal, this reduces the required return - ie. the cost of capital - from the hypothetical investment. On the other hand, an extra layer of tax

must raise the EATR.

The relative position of large companies, small companies and small partnerships in Germany and in the UK is similar to that shown in Table 37. The small company is assumed to have non-qualified shareholders, and so the cost of capital and the EATR in the absence of the incentives are the same as for the large company. The incentives marginally reduce the cost of capital and the EATR. The figures for the partnership are lower than those for the companies. Similarly, in the UK, the small company again

benefits from the lower corporation tax rate and the higher allowance.

Table 38 Cost of Capital and Effective Average Tax Rate - top-rate personal taxpayer

- average over 15 types of investment

Cost of Capital Large Corporation Small and Medium-sized Enterprise

(upper line)

EATR

(lower line)

Base Case corporation partnership

qualified nonno trade tax with trade tax qualified

incentive no incentive no incentive no

incentive incentive incentive

Germany 5.4 3.4 3.2 3.4 2.7 2.9 3.1 3.3

47.7 43.3 42.9 43.3 27.9 28.4 37.0 37.5

Italy 5.1 4.8 4.2 - 3.4 5.9 - -

37.1 35.5 34.4 32.7 39.2

UK 5.1 5.4 3.4 - - - - -

35.3 36.1 26.1

Note. See notes to Table 37. In this table, the results for the large company are split into those for qualified shareholders and

non-qualified shareholders .

However, in Italy, the position is a little different. The DIT relief still has the effect of reducing the cost of capital for companies to be below 5%. However, this is now also the case for partnerships (which receive the DIT relief). In fact the net impact of the differences in rates faced by companies and partnerships is that the cost of capital is lower for the partnerships. The same is true of the EATR. Part of

the difference between large and small companies is that the owners of the latter are assumed not be liable for capital gains tax.

"Medium" rate shareholder

Table 39 presents the results for "medium" rate (the average of the zero and top rate) entrepreneurs. The position is similar to that discussed above.

Table 39 Cost of Capital and Effective Average Tax Rate - medium-rate personal taxpayer

- average over 15 types of investment

Cost of Capital Small and Medium-sized Enterprise

(upper line)

EATR

(lower line) corporation partnership

no trade tax with trade tax

incentive no incentive no incentive no

incentive incentive incentive

Germany 4.3 4.5 3.7 3.9 4.2 4.5

33.0 33.8 22.5 23.1 33.0 33.6

Italy 4.0 - 4.2 5.4 - -

24.7 25.2 28.9

UK 5.0 - - - - -

14.3

Note. See notes to Table 37. In this table, there are no results for large companies, as the analyses of shareholders in such companies elsewhere in this study are limited to zero-rate and top-rate shareholders

Concluding remarks

To conclude, the results of this section show that the specific tax rules applied to SMEs in the countries analysed have the effect of lowering the effective tax burden. In Germany (1999) and in Italy the parternships bear a lower tax burden in comparison to companies whatever the position of the shareholders.

But, when comparing the results of this section with those shown in section 6.3.3, which examined the tax minimisation approach, it is worth noting that small and medium sized enterprises in Germany, Italy and the UK bear a higher tax burden than multinationals investing abroad.

MEMBER STATES’ EFFECTIVE TAX RATES IN 2001

This section presents estimates of the cost of capital and of the marginal and average effective tax rates for the EU Member States in 2001. The purpose of this section is to give a summary update of the 1999 picture in order to highlight the principal changes in individual positions and of the overall picture during the last two years. The case presented is that of a domestic investment taking into account corporate taxes but not personal taxes. In fact, the detailed analysis presented for 1999 has shown that the general conclusions arising from the domestic and international analysis are broadly similar in terms of the range of variation, the ranking of Member States and the principal tax driver.

The hypotheses underlying the definition of the investment and of the economic framework in which the investment takes place are the same as in the 1999 analysis. The same tax parameters are also applied, updated to take into account the 2001 tax regimes. Annex B details the tax parameters applied in the present computation.

Tables 40 and 41 present 2001 country data and correspond to Tables 7 and 8 shown in section 4.3.

Table 40 shows the cost of capital and the EMTR for the level of corporation and compares these data with the overall country data presented in Table 7.

Table 40 Cost of Capital and EMTR by Country -2001 - by asset, source of finance and overall

- only taxes on corporations Overall Mean Overall Mean Cost of Capital 1999 2001 2001

Country

l l d y

pita pita ta ine

Cost of Ca EMTR Cost of Ca EMTR Intangibles Industrial Buildings Machinery Financial Assets Inventories Re Earnings

New E quit Debt

Austria 6.3 20.9 5.7 12.6 5.3 5.8 5.2 6.6 5.6 6.6 6.6 4.1 Belgium 6.4 22.4 6.4 22.4 5.2 7.0 5.3 8.0 6.7 8.0 8.0 3.5 Denmark 6.4 21.9 6.4 21.6 4.3 8.1 5.6 6.9 6.9 7.3 7.3 4.6

Finland 6.2 19.9 6.4 21.3 6.1 6.4 5.6 6.8 6.8 7.3 7.3 4.6 France 7.5 33.2 7.3 31.8 5.2 8.4 8.5 7.6 7.0 8.7 8.7 4.8

Germany 7.3 31.0 6.8 26.1 5.4 7.1 6.1 8.2 6.9 8.0 8.0 4.4 Greece 6.1 18.2 6.0 16.9 6.7 5.1 6.0 5.2 7.1 7.4 7.4 3.5 Ireland 5.7 11.7 5.7 11.7 5.3 6.8 5.2 5.5 5.5 5.9 5.9 5.2 Italy 4.8 - 4.1 4.3 -15.9 2.4 4.0 3.2 7.5 4.4 4.7 4.7 3.6

Luxembourg 6.3 20.7 6.3 20.7 5.2 6.8 5.3 7.7 6.5 7.7 7.7 3.7 Netherlands 6.5 22.6 6.5 22.7 5.1 7.0 5.9 7.4 6.9 7.8 7.8 4.1 Portugal 6.5 22.5 6.3 21.0 6.5 6.1 5.1 7.5 6.4 7.6 7.6 4.0 Spain 6.5 22.8 6.5 22.8 6.5 6.7 5.4 7.4 6.4 7.7 7.7 4.1

Sweden 5.8 14.3 5.8 14.3 5.0 6.0 5.0 6.6 6.6 6.7 6.7 4.3 UK 6.6 24.7 6.7 24.8 5.5 8.3 5.6 6.9 6.9 7.7 7.7 4.8

Table 40 shows that 7 Member States (Belgium, Denmark, Ireland, Luxembourg, Netherlands, Spain and Sweden) have the same cost of capital in 2001 as in 1999. Five Member States have minor changes. Finland and the UK show a slight increase in the cost of capital and in the EMTR due to an increase in the corporation tax rate from 28% to 29% and a minor increase in real estate tax (Finland) and a minor increase in real estate tax (UK). France, Greece and Portugal have a slight decrease in the cost of capital and in the EMTR. In the case of France this is due to a reduction in the corporation tax rate from 40% to 36.43% which is compensated to a small extent by a reduction in the coefficient of declining-balance depreciation by 0.25%. The reduction for Greece and Portugal is due to a reduction in the corporation tax rate from 40% to 37.5% and from 34% to 32% respectively. It is worth noting that Denmark has the same cost of capital in 2001 as in 1999 and a very minor reduction in the EMTR, which is almost unchanged. This is due to the combination of a reduction of the corporation tax rate from 32% to 30% almost entirely compensated for by lower allowances for machinery.

For Germany, Austria and Italy there are some substantial difference between 2001 and 1999.

The reasons for the reduction of the cost of capital and of the EMTR for Germany have been widely commented on when presenting the effects of the German tax reform in section 4. As already underlined, this reform seems to have only limited effects on the ranking of Germany.

In 2000 Austria introduced a reform of the corporate tax in the form of a dual income tax. This reform included a reduction of corporation tax rate from 34% to 25% on deemed profits that can be attributed to the increase of equity capital. Moreover, a reduction in straight-line depreciation on buildings from 4% to 3% was approved in 2001. As a result, the Austrian cost of capital and EMTR have substantially decreased. The aim of the introduction of a dual system was to ensure a more homogenous treatment between debt and equity financing as is the case for the Italian dual income system. When comparing the EMTR for the different forms of finance in 1999 (see Table 7) and in 2001 it can be observed that the reduction in the Austrian EMTR is the result of the reduction of the EMTR on retained earnings and new equity whereas the EMTR on debt financing is practically unchanged. Therefore, the reform does seem to result in a more homogeneous treatment of the different sources of finance.

The reduction in the Italian cost of capital and EMTR in 2001 is the result of a reduction of the corporation tax rate from 37% to 36% and, more substantially, of an increase in the equity base concerning the calculation of the allowance for the dual income tax from 100% to 120% in 2000 and 140% in 2001. It is worth noting that, following the 2001 spring elections, the new Italian government has "frozen" the dual system as of the 30 June 2001 and has introduced other forms of tax incentives. It is therefore rather difficult, at this stage, to define precisely the tax code applied to Italian investments in 2001.

Overall, the picture for 2001 shows that a number of Member States have a lower cost of capital and EMTR as a result of changes in the tax codes aimed at reducing the corporate tax rate or introducing or modifying the dual income system. These changes have not fundamentally affected the ranking of Member States nor reduced the dispersions of the EMTRs inside the EU. The most evident change is the remarkable reduction in the Austrian effective tax burden, which now places Austria at the lower end of the ranking together with Italy, Ireland and Sweden.

As far as the situation of the different taxation of specific forms of investment by assets and sources of finance is concerned, the picture is not very different from that of 1999. Only Austria and Italy, due to the implementation or modification of the dual system, seem to have in 2001 a considerably more balanced taxation of the different sources of finance. However, due to the reduction of the statutory tax rates in a number of Member States, the benefit of debt finance on equity finance decrease as the value of the tax deductions decrease.

Table 41 presents a summary of the effective average tax rate for each Member State in 2001 for investment where the pre-tax real rate of return is 20% and compares these data with the overall country data presented in Table 8.

Considering that the EATR is more closely tied to the statutory tax rate than is the cost of capital or the EMTR, the large reduction in the statutory tax rate in Germany generates the largest fall in the average EATR, despite the decrease in allowances. In terms of reduction in the average EATR, this is followed by France because of the reduction in its statutory rate of just over 3.5 percentage points.

In contrast, it is the EMTR that is more affected under the dual income system in Italy and Austria than the EATR. Therefore, although the modification (Italy) and the introduction (Austria) of the dual income system lowers their respective EATRs, the effect is not so great as the effect on their EMTRs and the Irish and Swedish EATRs (unchanged in comparison to 1999) remain the lowest.

As a result, when the pre-tax real rate of return is fixed at 20%, the EU 2001 differential is reduced mainly due to the effect of the reduction of the German and French effective tax burden, whereas the lowest effective average tax rate remains the Irish rate. Apart from this reduction in the range of rates of about 4 percentage points, the global picture arising from 2001 in terms of countries at the highest or lowest range of the ranking and principal tax drivers is fundamentally unchanged in comparison to the 1999 picture.

Table 41 Effective Average Tax Rate by Country - 2001

- by asset, source of finance and overall - only taxes on corporations

ll ll d ra ra nery

Country Ove 1999 Ove 2001 ta

ine

Intangibles Industrial Buildings Machi Financial

Assets

Inventories Re Earnings

New Equity Debt

Austria 29.8 27.9 26.4 28.2 26.2 30.9 27.6 30.7 30.7 22.6 Belgium 34.5 34.5 30.7 36.1 31.0 39.2 35.3 39.1 39.1 25.8 Denmark 28.8 27.3 19.9 33.3 24.7 29.3 29.3 30.7 30.7 21.0 Finland 25.5 26.6 25.7 26.6 23.9 28.3 28.3 30.0 30.0 20.2 France 37.5 34.7 27.8 38.2 38.4 35.6 33.8 39.0 39.0 26.8 Germany 39.1 34.9 30.8 36.0 33.0 39.2 35.4 38.7 38.7 27.7

Greece 29.6 28.0 33.3 28.5 31.3 11.9 34.8 32.4 32.4 19.7 Ireland 10.5 10.5 8.9 15.8 8.2 9.8 9.8 11.7 11.7 8.2 Italy 29.8 27.6 22.5 27.1 24.9 35.1 28.4 28.7 28.7 25.5

Luxembourg 32.2 32.2 28.6 33.7 29.2 36.6 32.9 36.6 36.6 24.0 Netherlands 31.0 31.0 26.7 32.6 29.2 34.2 32.5 35.2 35.2 23.3 Portugal 32.6 30.7 31.3 30.1 26.9 34.4 30.9 34.8 34.8 23.0 Spain 31.0 31.0 31.1 31.8 27.4 34.2 30.7 35.2 35.2 23.3

Sweden 22.9 22.9 19.6 23.4 19.7 25.7 25.7 26.0 26.0 17.1 UK 28.2 28.3 24.2 34.0 24.7 29.3 29.3 31.8 31.8 21.7

Almost all the changes to corporation taxes in the EU between 1999 and 2001 have resulted in a reduction of tax liabilities. In two of these cases, Austria and Italy, reforms have been directed towards reducing the tax burden on marginal investments. Consequently, the reforms in these two countries have

a greater effect on the EMTR than the EATR.

However, six other countries have reduced their statutory tax rates, albeit with relatively small reductions (the main exception being Germany which reduced its rate from 40% to 25%). In some of these countries, governments have offset the reductions by also reducing allowances (again to the greatest extent in Germany). In general, this has resulted in relatively small reductions in the EMTR, but rather

larger reduction in the EATR.

The trend analysed here is consistent with a pattern of generally declining statutory tax rates and hence generally declining EATRs, notably for high tax rates countries. It is possible that this decline in the effective tax burdens is a result of tax competition between the Member States as they attempt to attract

investments.

COMPARISON OF THE RESULTS WITH THOSE OF THE RUDING AND BAKER &M C KENZIE REPORTS

During the last decade a number of studies have presented international comparisons of effective corporate tax burdens. For the reasons outlined in Section 3, the most commonly used approaches for international comparisons have been based on general forward-looking frameworks partly similar to the approach taken in this study. At the European level, the most well-known studies are the Report of the Ruding Committee of 1992 (to which the mandate given to the Commission from the Council for the current study explicitly refers) and the Baker & McKenzie study commissioned by the Dutch Ministry of Finance in 1999.

The purpose of this section is to compare the principal results arising from these two studies with those presented in the above analysis.

As already explained in Section 3, the application of the forward-looking approach, common to all these studies, gives synthetic measures of the effective tax burdens based on hypothetical situations. In practice, it consists in defining a hypothetical investment identical in all countries and then applying to this identical hypothetical investment the different national tax codes. This "isolates" the taxation elements among all the other factors influencing the effective tax burdens and can thus help identify the most important tax drivers influencing the effective tax burdens and their differences.

The results obtained by the application of this approach depend, therefore, on the hypotheses and assumptions underlying the definition of the hypothetical investment considered and the economic framework.

Consequently, when comparing different studies using this methodology, it should always be borne in mind that the aim of these approaches is not to give universally valid values of the effective tax burden for each country considered, but to allow comparisons between countries on the basis of the same investment. In fact, the individual measures of effective tax burdens rely on the specific assumptions used when applying the model. Therefore, when comparing the results of these different studies, the differences in the underlying hypothesis and assumptions must always be borne in mind.

Comparison of the methodology and the assumptions with those of the Ruding and Baker and McKenzie reports

  • A) 
    Ruding report

The scope of the mandate received by the Ruding Committee in 1990 covered some of the aspects that this study is addressing: in particular, the effects of differences in business taxation on incentives to invest and the way to alleviate distortions deriving from business taxation differentials.

In order to investigate the overall effect of taxation on the incentive in each country to undertake new investment, either at home at abroad, the Ruding report presented an analysis based on forward-looking indicators related to the taxation of a hypothetical investment. Only the case of a marginal investment was covered and, thus, the computation presented evidence of the cost of capital and marginal effective tax rates for the 12 Member States of the 1992 European Community and some selected main economic partners, on the basis of the theoretical background presented above. The Report assessed also the contributions of particular features of taxation to the lack of neutrality of taxation systems on capital flows by means of simulations.

The present report has gone beyond this approach to also consider effective average tax rates both on hypothetical investments and hypothetical model firm behaviour.

As far as the hypotheses and assumptions are concerned, the Ruding report presented results related to a simple investment in the manufacturing sector taking into account the effects of corporate taxes and ignoring all personal taxes, but considering the effects of imputation credits. The Ruding report considered three forms of assets (machinery, buildings and inventories) whereas the present study takes into account two more forms of assets: intangible and financial assets. For the simulations, the personal taxation of the suppliers of fund was included. The present report has considered the effects of overall corporate taxation (statutory tax rates, surcharges and local taxes) on a simple investment in the manufacturing sector and has also included, separately, the effects of personal income taxation of dividends, interest and capital gains.

Concerning the other tax parameters used in the calculation, the Ruding report and the present report rely on the same framework.

  • B) 
    Baker and McKenzie study

As with the current study, the purpose of the Baker & McKenzie study was to compute the differences of the EU countries corporate effective tax burden in order to underline the principal tax drivers for these differences.

The Baker & McKenzie study presented an analysis based on the King and Fullerton methodology related to the taxation of a hypothetical investment. Only the case of a marginal investment was covered and, thus the study presented evidence of effective marginal tax rates for the 15 EU countries using the tax codes in force in 1998. Effective marginal tax rates were computed for all the 15 countries in the domestic case. For the transnational investment only the cases of Germany, the United Kingdom and the Netherlands were analysed. The report did not assess the contributions of specific features of taxation to the lack of neutrality by means of simulations.

As far as the hypothesis and assumptions are concerned, the hypotheses related to the hypothetical investment considered are very similar to those used in the present study. The main difference is that the Baker & McKenzie study considered a pre-tax real rate of return of 10% against the 5% post-tax rate of return considered in this study and in the Ruding report and an inflation rate of 1.1% against the 2% used here.

The Baker & McKenzie report considered a simple investment in the manufacturing sector composed of 5 assets taking into account the effects of corporate taxes and, separately, of personal taxes.

The following box summarises the main differences of the hypothesis and assumptions used in the three studies compared in this section.

Box 13 Comparisons of the hypothesis and assumptions between the Commission study (2001) and the Ruding

(1992) and the Baker & McKenzie (1999) reports

Commission study(2001) Ruding report (1992) Baker & McKenzie study (1999) Methodology Devereux & Griffith: King and Fullerton: King and Fullerton:

Marginal and average indicators Marginal indicators Marginal indicators

Type of analysis Domestic analysis Domestic analysis Domestic analysis

Cross-border analysis (all EU Cross-border analysis (all Cross border analysis countries) 1992 Community countries (only UK, D and NL) plus selected partners)

Year (tax code) 1999 and 2001 1990 1998 and 2001

Simulations of yes yes No hypothetical reforms

Sector Manufacturing Manufacturing Manufacturing

Sensitivity analysis for services Sensitivity analysis for services Types of assets Intangibles, machinery, buildings, Machinery, buildings, Intangibles, machinery, buildings,

financial assets, inventories inventories financial assets, inventories Weight of assets 1/5 each Machinery: 50%, Machinery: 70.49%

Buildings: 28% Buildings: 12.99% Inventories: 22% Inventories: 29.84% Intangibles: 1.43% Financial assets: 38.25%

Source of finance New equity, retained earnings, debt New equity, retained New equity, retained earnings, debt earnings, debt

Weight of sources of New Equity: 10% New Equity: 10% New Equity: 10% finance Retained earnings 55% Retained earnings 55% Retained earnings 55%

Debt: 35% Debt: 35% Debt: 35%

Inflation rate 2% for all countries 3.1% for all countries 1.1% for all countries

Rate of return Post-tax rate:5% Post-tax rate:5% Pre-tax rate:10%

Tax parameters Overall corporation tax rates Statutory corporation tax; Overall corporation tax rates including surcharges and local including surcharges and local taxes; taxes;

Corporate real estate taxes, net Corporate real estate taxes, net wealth taxes and other non-profit wealth taxes and other non-profit

taxes on wealth; taxes on wealth; Tax credit associated with dividend Tax credit associated with dividend and equalisation tax; and equalisation tax; Personal income tax rates, including Personal income tax rates, including withholding taxes on dividend, withholding taxes on dividend, interest and capital gain; interest and capital gain; Individual net wealth taxes on Individual net wealth taxes on shareholdings and lending shareholdings and lending Withholding taxes on dividends and Withholding taxes on Withholding taxes on dividends and interest dividends and interest interest Treatment of foreign source Treatment of foreign Treatment of foreign source dividends and interest received by source dividends and dividends and interest received by parent companies interest received by parent parent companies Capital allowances for industrial companies. (only in the Capital allowances for industrial buildings, machinery and simulations) buildings, machinery and intangibles. Tax treatment of Capital allowances for intangibles. Tax treatment of financial assets and inventories industrial buildings, financial assets and inventories machinery and intangibles.

Comparisons of the results in the domestic case

Tables 42 and 43 present a comparison of effective tax burdens across the three studies considered. The Ruding report presented only cost of capital indicators. Therefore Table 42 compares the cost of capital presented in Section 4 of this study with those computed in the framework of the Ruding report. The Baker & McKenzie study presented only effective marginal tax rates. Table 43 thus compares the EMTR presented in Section 4 of this report with those published in the Baker & McKenzie study.

Debt 2.6 2.8 3.2 - 3.5 1.4 2.7 4.6 2.6 3.4 3.2 2.9 3.5 3.1 3.7

quity New e 6.8 6.9 7.2 - 3.5 2.2 2.7 5.0 2.6 7.8 7.0 7.3 7.5 4.3 4.7

earnings

Retained 6.8 6.9 7.2 - 7.0 8.8 7.1 5.4 8.8 7.8 7.0 7.3 7.5 6.4 7.4

(1992) AL IT

C AP Inventories 8.3 8.3 6.8 - 7.3 6.9 5.9 5.5 6.3 8.4 6.2 6.4 7.9 6.3 7.4

R EPORT T OF

C OS Machinery 4.0 4.2 5.3 - 4.6 5.2 4.8 5.0 5.5 4.9 5.2 5.2 5.5 4.5 5.2

R UDING

Buildings 5.4 5.4 6.0 - 5.4 5.1 5.0 4.9 6.7 6.9 6.0 6.1 5.7 5.1 5.8

Overall average 5.3 5.4 5.8 - 5.4 5.6 5.1 5.1 6.0 6.2 5.7 5.7 6.1 5.0 5.9

Debt 4.0 3.5 4.4 4.5 4.6 3.2 3.4 5.2 3.6 3.7 4.1 3.9 4.1 4.3 4.8

quity New e 7.5 8.0 7.5 7.2 9.0 7.6 7.6 5.9 5.5 7.7 7.7 7.9 7.7 6.7 7.7

Retained 7.5 8.0 7.5 7.2 9.0 9.7 7.6 5.9 5.5 7.7 7.7 7.9 7.7 6.7 7.7

st m

ent

m ission study (2001)

Inventories

ic Inve (2001) AL 6.3 6.7 7.1 6.8 7.4 7.9 7.4 5.5 5.0 6.5 6.9 6.5 6.4 6.6 6.9 est IT T UDY

om C

AP

ssets Financial A

D 7.3 8.0 7.1 6.8 8.0 10.0 5.1 5.5 7.7 7.7 7.4 7.7 7.4 6.6 6.9 S ION S T OF

IS

al for M C

OS

Machinery 5.9 5.3 5.4 5.6 8.4 5.8 6.1 5.2 3.8 5.3 5.9 5.2 5.4 5.0 5.6

apit C OM

Buildings

of C Industrial 6.1 7.0 8.1 6.1 8.5 7.2 5.1 6.8 4.6 6.8 6.9 6.2 6.7 6.0 8.2

C ost - Ruding report (1992) and Com - only corporation taxes

Intangibles 5.9 5.2 4.2 6.1 5.2 5.4 6.8 5.3 2.9 5.2 5.1 6.7 6.5 5.0 5.5

BLE 42 Overall average 6.3 6.4 6.4 6.2 7.5 7.3 6.1 5.7 4.8 6.3 6.5 6.5 6.5 5.8 6.6

TA

al

UNTRY ium embourg

C O ance Austria B elg Denmark Fi nland Fr Germany Greece Ir eland It aly L ux Netherlands Portug Spain Sweden UK

Table 42 shows a rather different picture across the two studies. In general, the cost of capital is lower in the figures arising from the Ruding report and the ranking of the Member States is different in the two computations. The differences in the tax parameters considered may have a great influence on these results, notably on the observed levels of the cost of capital. As was shown in Box 11 the present study considers a broad range of taxes levied on companies, whereas the Ruding report considered just the statutory corporate tax rate. Section 4 of this study underlined the weight that taxes other than the corporate tax may have on the level of the effective tax burden, in certain countries in particular. Therefore, it cannot be concluded, simply by comparing the results of Table 42, that the cost of capital is generally higher now than ten years ago.

It is interesting to observe that differences due to different assets and weight of assets seem to play a lesser role in determining differences in the results. In fact, Section 5 (sensitivity analysis) showed that the results of the present study would not be fundamentally affected by using the same weights as those used in the Ruding report. By contrast, when using the "Ruding report" weights for the sources of finance the cost of capital of the present study would be slightly lower. (See sensitivity analysis number 5 in section 5.1).

The fact that the ranking of the Member States is also different may be due, on the one hand, to the differences on the tax parameters used and, on the other hand, to the number of tax reforms undertaken by Member States this last decade. It is difficult, just on the basis of the results shown in Table 42, to infer which is the relative weight of these two factors in determining differences in the picture presented now and the situation of ten years ago. It is evident that national tax reforms may have had a considerable effect in determining ranking differences.

One useful way to compare the results presented in Table 42 is to analyse whether the global picture in terms of influence of the tax systems on the incentives to invest and financing decisions has evolved since early 1990s.

The analysis of Section 4 suggested that the tax systems tend to create a misallocation of resources by favouring certain forms of assets and certain sources of finance. The same patterns are observable in the figures of 1992. Today, however, the differences in the effective tax burdens held by different forms of investment or financing are smaller then ten years ago, although still considerable. This seems to suggest that the tax reforms undertaken during the last decade may have in part contributed to make more neutral the influence of taxation on the organisation of domestic investments. Nevertheless, the persistence of high differences reopens the debate on the possible distortive effects of taxation on the allocation of resources within the EU and on the possible frustration of equity goals of policymakers by tax arbitrage arrangements.

When comparing the size of the Member States' differentials, it is worth noting that the magnitude of the variation of the cost of capital between countries has not diminished. On the contrary the range between the lowest and highest value is wider. At the corporate level, the Ruding report presented a range of the average countries' cost of capital between 5% and 6.2%. The present report shows a range between 4.8% and 7.5%. Once again, it has to be underlined that the current study takes into account a broader range of taxes levied on companies and that the Member States with the highest cost of capital are countries which levy high non-corporate profit taxes. The difference with the situation ten years ago is that now it seems to be a group of "core countries" which have very similar costs of capital.

Table 43 compares the effective marginal tax rates computed in the Baker & McKenzie study with those arising from the current study.

Here again the differences in the assumptions determine differences in the country data.

m ission study (2001)

ent:

estic Investm enzie report (1999) and Com

or Dom

EMTR f Baker & McK - only corporation taxes

43

T ABLE

Debt 6.1 -3.9 0.7 -0.3 18.4 4.4

-11.9 1.7 -0.5 -4.2 0.3 -2.6 12.8 -1.4 2.5

quity New e 38.1 37.9 34.5 27.8 52.4 54.2 27.3 33.1 27.3 38.1 35.2 35.8 43.3 27.0 32.8

earnings

Retained 38.1 37.9 34.5 27.8 52.4 54.2 27.3 33.1 27.3 38.1 35.2 35.8 43.3 27.0 32.8

(1999)

Inventories 28.2 26.3 24.5 21.8 42.3 40.4 25.2 25.1 22.8 26.6 25.2 24.5 34.5 21.7 24.3

R EPORT

IE year 1998) R

ssets Financial A

EMT 28.2 26.3 22.3 18.4 39.4 40.4 5.2 21.0 17.7 26.6 22.9 24.5 34.5 18.4 20.3

C K

ENZ

code of Machinery

  • M (Tax 23.7 8.4 14.9 12.0 37.3 26.7 18.0 15.5 4.9 16.1 18.0 16.5 23.7 7.6 14.6

ER Buildings

B AK Industrial 25.4 30.2 35.9 17.3 47.2 34.7 5.9 29.1 24.5 18.3 26.0 19.9 35.6 17.5 35.2

Intangibles 28.4 10.9

-17.8 18.4 25.9 20.8 23.1 21.1 8.9 12.5 23.1 24.8 35.0 6.2 14.5

Overall average

27.0 23.5 22.8 18.1 40.7 37.0 13.7 22.3 17.7 23.5 23.2 22.5 32.8 17.2 22.3

Debt -25.0 -42.9 -13.6 -11.1 -08.7 -56.2 -47.1 3.8 -38.9 -35.1 -21.9 -28.2 -21.9 -39.5 -25.0

quity New e 33.3 37.5 33.3 30.5 44.4 35.5 34.2 15.2 10.0 35.1 35.1 36.7 35.1 25.4 35.1

earnings

Retained 33.3 37.5 33.3 30.5 44.4 48.4 34.2 15.2 10.0 35.1 35.1 36.7 35.1 25.4 35.1

(2001) Inventories 20.6 25.4 29.6 26.5 32.4 36.7 32.4 9.1 0.0 23.1 27.5 23.1 21.9 24.2 27.5

T UDY year 1999) R

ssets Financial A

EMT 31.5 37.5 29.6 26.5 37.5 50.0 2.0 9.1 35.1 35.1 32.4 35.1 32.4 24.2 27.5

S ION S

IS

M code of Machinery

15.2 5.7 7.4 10.7 40.5 13.8 18.0 3.8 -31.6 5.7 15.2 3.8 7.4 0.0 10.7

C OM (Tax Buildings

Industrial 18.0 28.6 38.3 18.0 41.2 30.6 02.0 26.5

-08.7 26.5 27.5 19.3 25.4 16.7 39.0

Intangibles 15.2 3.8

-19.0 18.0 3.8 7.4 26.5 5.7 -72.4 3.8 2.0 25.4 23.1 0.0 9.1

Overall average 20.9 22.4 21.9 19.9 33.2 31.0 18.2 11.7 -4.1 20.7 22.6 22.5 22.8 14.3 24.7

ium al embourg

C O

UNTRY

ance

Austria B elg Denmark Fi nland Fr Germany Greece Ir eland It aly L ux Netherlands Portug Spain Sweden UK

The main difference between the Commission report and the Baker and McKenzie report is that the first considers a fixed post-tax return (the real interest rate) and the second a fixed pre-tax rate of return. It is noteworthy that the results of the quantitative approaches depend on the interest rate assumption adopted as the real interest rate corresponding to the post-tax rate of return. This study uses a post-tax rate of return of 5% as the base reference case for real investment decisions and computes the range of effective tax rates applicable at the fixed post-tax rate of return. The Baker and McKenzie study, contrary to the prevailing practice, use a fixed pre-tax rate of return typically set at the higher rate of 10% and compute the range of effective tax rates applicable at the fixed pre-tax rate of return. This explain to a large extent the different numerical results of the two studies.

The differences of the values arising from the two computations are also partly due to the different hypothesis in terms of the considered investment and tax parameters.

Notwithstanding these differences, there is a remarkable similarity in the general conclusions arising from the two pictures.

First of all, the ranking of countries is consistent in the sense that, even if the individual country positions can vary (for instance France has the highest EMTR in the Baker & McKenzie study and the second highest EMTR in the present study), we find the same group of countries at the top and at the bottom of the scale (apart from Ireland). It should be underlined that when countries have a very similar cost of capital (see previous Table) even a small change in the assumptions and parameters is likely to affect the ranking of these countries.

Notwithstanding the difference in the relative position of Ireland due to the important difference in the tax rate considered, the lowest EMTR countries in both studies are Italy, Sweden, Greece and Finland and the highest EMTR countries are France, Germany and Spain. The results of both studies reveal a considerable range of around 30 points between the highest and lowest values. Moreover, the Baker & McKenzie study stressed that the principal tax driver for these differences is, above all, the overall corporate tax rate and that differences in the tax base can play an important role in specific individual situation. The present study comes to at the same conclusions.

The two studies also show similar results for the differences in the effective tax burden on different assets and sources of finance, and therefore similar conclusions can be drawn from the two studies. It is worth noting that the Baker and McKenzie study considered an inflation rate of 1.1%, against 2% in the present study. A higher rate of inflation exacerbates the differences between debt and equity finance. This is due to the fact that nominal interest rates are assumed to rise in line with inflation; since these are deductible in the case of debt financing, the EMTR falls for debt financing.

In general, the two studies make similar statements on the ranges of tax differentials, the country ranking and the reasons for these differentials.

Baker and McKenzie has recently published an updated version of its study, taking into account the Member States' tax codes for the year 2001. This updated version also applies some different economic and tax parameters. In contrast to the 1999 study the updated version considers a broader range of nonprofit taxes including the payroll taxes. Moreover, for Ireland the rate of 12.5% (rate which will be in force in 2003) is taken into account in the 2001 version, as against 28% in the 1999 version. The inflation rate is now fixed at 2% (as against 1.1% in the 1999 version).

As was the case for the 1999 study, the computation is based on a fixed pre-tax rate of return of 10%. It includes sensitivity analysis for different levels of the pre-tax rates of return. As mentioned above this study uses a fixed post-tax rate of return of 5% as the base reference case.

The following table shows the Member States' effective marginal tax rates computed by Baker and McKenzie for 2001 where the pre-tax rate of return is fixed at 10% and 6% respectively. These data are compared with the effective marginal tax rates computed in this study where the post-tax rate of return is fixed at 5%.

Table 44 EMTR for domestic investment:

Baker and McKenzie report (2001) and Commission Study (2001) - only corporation taxes

BAKER and McKENZIE report (2001) COMMISSION Study (2001) Tax code of year 2001 Tax code of year 2001

PRE-TAX RATE OF RETURN (p) POST-TAX RATE OF RETURN (r)

10% 6% 5% (base case)

COUNTRY

Austria 18.25 20.42 12.6

Belgium 18.89 17.22 22.4

Denmark 18.81 19.79 21.6

Finland 18.09 18.58 21.3

France 30.11 36.84 31.8

Germany 25.20 23.80 26.1

Greece 6.76 4.89 16.9

Ireland 9.43 10.64 11.7

Italy 13.74 11.54 - 15.9

Luxembourg 18.98 17.12 20.7

Netherlands 20.67 19.94 22.7

Portugal 18.15 16.55 21.0

Spain 18.30 16.56 22.8

Sweden 15.73 15.53 14.3

United 20.83 23.40 24.8 Kingdom

Due to the differences in the hypothesis (fixed pre-tax rate of return as against fixed post-tax rate of return) the results of the Baker and McKenzie and of the current study are not directly comparable. The case in which the pre-tax rate of return is fixed at 6% is the closest to the case considered in this study where the post-tax of return is fixed at 5%, accordingly these two situations forms the basis of the present comparison.

The differences in individual results of the two studies are due not only to the different fixed pretax/fixed post-tax assumptions but also due to differences in a range of other assumptions.

The Baker and McKenzie study for 2001 considers a broader range of non-profit taxes including the payroll taxes and the rate applied to Ireland is 12,5% as against 10% rate in force in 2001 for the manufacturing sector. Moreover, the "dual income" system in force in Italy has been applied in a different way in the two studies. The Italian "dual income" tax systems splits the tax base for profits into two components, taxed at different tax rates. Very broadly, the ordinary return, calculated as the interest rate multiplied by equity invested into the company, is taxed at 19%, while the residual profit is taxed at 37%. However a rule applied in the past and abolished in 2000, stated also that, whatever the result of the application of the dual system, at the end the average rate applied (resulting in the application of these two different rates according to the method of financing and the amount of residual profit) should not be less than 27%. This study has not taken into consideration this "minimum" global corporate rate of 27% and in the marginal case (no extra-profits) the rate of 19% has been applied. Instead, the Baker and McKenzie study applies this "minimum" rate of 27%. As a result the EMTR in this study is lower than the EMTR in the Baker and McKenzie study. And, finally, the weights of the five assets composing the hypothetical investment considered is different in the two studies.

Notwithstanding these differences, there is a remarkable similarity in the general conclusions arising from the two pictures for 2001, as it was the case for 1999. The same conclusions drawn from the comparison with the 1999 results remain valid for the 2001 results.

Comparisons of the results in the transnational case

As, in the transnational case, the Baker & McKenzie report computed effective marginal tax rates only for three countries (D, NL and UK), this section does not make a comparison between the results of the present study and those arising from the Baker & McKenzie study. The comparison is thus limited to the results of the Ruding report.

The present study showed, in section 6 (Tables 17 to 19), that there is a large variation in the way each Member State treats other Member States. Each Table presented the cost of capital for each country averaged across the five different assets and the three sources of finance of the parent and showed separately the three different ways in which the subsidiary is financed.

Table 45 shows the cost of capital for transnational investment presented in the Ruding report. This table shows average cost of capital for each Member State across the sources of finance and the assets considered making also an average of the three different ways in which the subsidiary can be financed.

 debt,

UK n a

6.4 5.9 6.9 7.0 6.7 6.4 7.3 9.0 6.2 t i e of en

erag

st m

ve

Portugal

7.2 5.7 8.1 8.4 6.0 6.5 14.0 7.6 7.7 t;

 in ht

ed av

eig w

e paren

lands th

ce in an

Nether 6.1 5.9 7.4 6.4 6.3 6.2 6.8 8.3 6.3 f rom f

in

es

d debt t rais

bourg th ir en

Luxem 6.5 6.4 6.9 6.5 6.7 6.5 7.0 8.0 6.2 ned

o

t an

y Ital are zero; par es

7.2 6.7 9.5 7.4 7.0 6.7 6. 6.0 7.1 aren e p

) al tax m th on

48 f ro

ents ent to Ireland 5.6 5.3 6.1 9.1 6.7 5.4 5.1 9.6 5.5 uity re; pers

 eq w he

(investm n

ew ery

France

rce 7.0 6.5 7.7 10.3 7.2 5.4 7.3 9.5 7.0 th

ird

ne 5% ev

S ou , o

Spain iary id t rate of

7.5 5.6 7.2 8.8 6.1 7.2 14.2 8.5 7.0 bs teres

or Transnational Investm e su y th

Greece b re; real in

5.4 6.5 4.9 5.1 6.5 6.0 11.7 7.2 6.5 ns tio w he

Capital f ery reten

Germany ird

6.2 6.1 5.5 6.5 6.4 5.2 6.4 5.4 6.4 th ne 3.1% ev of

 b y o

Denmark ced fl

ation

6.7 5.8 7.5 9.3 6.7 6.0 6.7 7.7 6.5 an gs in ts ; in in

is f se as

Belgium iary

ed earn

id et of

5.4 6.6 7.7 6.7 6.6 6.2 6.6 7.2 6.4 bs e s

R uding Report (1992) : Cost of - only corporation taxes e su erag

d retain an

t g th m in ht ed av

45 : e nc en w s

hares

)

vestm ium ance embourg

A ssu w eig ne

T ABLE R eside (i n fr om B elg Denmark Germany Greece Spain Fr Ir eland It aly L ux 48

6.2 7.0 5.9

8.4 5.7 6.6

5.7 11.1 6.2

6.7 9.5 6.5

6.3 7.1 6.1

5.5 8.4 7.0

7.0 7.0 6.9

5.7 10.9 5.9

6.4 6.4 5.9

6.2 6.7 6.0

6.1 6.6 5.9

al

Netherlands Portug UK

Tables 17 to 19 and Table 45 are not directly comparable, for three main reasons. First, as was the case for a domestic investment, differences in the parameters used, and notably the number of taxes levied on companies, can explain some differences in the results between the two studies.

Second, the tax reforms of the last decade and notably the reforms related to the tax regimes can explain the different results in individual Member States in 1999 compared with those of ten years ago.

Third, the fact that these matrices summarise all the domestic and international features of taxation makes it very difficult, when comparing the figures from the two studies, to attribute to one factor or another the origin of differences in the results.

All that said, two observations can be made. Tables 17 to 19 show that subsidiaries located in some host countries, and notably Ireland and Italy, always have a lower cost of capital than subsidiary located in other host countries. On the other side, subsidiaries located in Germany and France always have a higher cost of capital. Table 45 presents a more mixed picture and it is impossible to say that some host countries are generally more or less attractive.

As far as the size of variation is concerned, the picture arising from Tables 17 to 19 shows considerable variations within columns and rows. Therefore, on the one hand, there is considerable incentive for companies to choose tax favoured locations and, on the other, the effective tax burden of a subsidiary depends heavily on the home country of the parent company. When looking at Table 42, it does not seem that such incentives have diminished compared to the situation of ten years ago.

Table 46 compares the figures in the Ruding report and the present study which assess the extent to which the tax treatment of transnational investments gives incentives to undertake transnational, as opposed to domestic investments.

Outbound

0.5 0.7 0.4 - 0.5 1.1 1.3 2.9 1.1 0.5 0.8 1.6 0.3 0.5 0.4

Inbound

EU Standard Deviation 1.1 0.5 0.9 - 1.1 0.4 2.1 1.5 0.8 0.9 1.5 2.1 2.1 1.5 0.8

Outbound

6.7 6.5 6.1 - 6.2 7.3 7.9 8.6 8.0 6.6 6.5 8.0 6.6 6.5 6.4

Ruding Report (1992) Inbound 6.7 6.6 6.9 - 7.6 6.1 7.0 6.7 7.1 7.0 7.0 7.9 8.0 6.4 6.8

EU Average

Domestic

5.3 5.4 5.8 - 5.4 5.6 5.1 5.1 6.0 6.2 5.7 5.7 6.1 5.0 5.9

Outbound

0.6 0.6 0.6 0.6 0.5 0.6 0.6 0.6 0.4 0.6 0.6 0.6 0.6 0.6 0.5

ia ry Inbound EU Standard Deviation 0.2 0.3 0.3 0.3 0.3 0.3 0.3 0.4 0.3 0.3 0.2 0.3 0.3 0.3 0.3

b si

d

udy su

Outbound

ce of 7.1 6.3 6.3 6.3 6.2 6.3 6.6 6.4 6.5 6.7 7.1 6.3 6.3 6.3 6.4

an

m ission st f in

om Inbound 6.5 6.7 6.6 6.4 7.7 7.0 6.4 5.9 5.0 6.5 6.6 6.7 6.7 6.0 6.8

rces of

Capital by Country EU Average t and C

or Domestic

ep 6.3 6.4 6.4 6.2 7.5 7.3 6.1 5.7 4.8 6.3 6.5 6.5 6.5 5.8 6.6 Commission Study (2001)

estic, average inbound and outbond uding r

Average Cost of - R - dom - only corporation taxes - average over sou

Capital dom %

46 y ing bourg al

Cost of tr

ia ium ark an

rm tug n eden

T ABLE Aus B elg Denm Finland France Ge G reece Ir eland It al

y

Luxem N etherlands Por Spai Sw United K

As is the case now, both capital export and capital import neutrality were absent ten years ago. The Ruding report showed differences between domestic, outbound and inbound cost of capital that were larger than the differences found in the present study. Moreover, the standard deviations for inbound and outbound costs of capital were also higher. It seems, therefore, that the reforms undertaken during the last decade had a positive influence in reducing, on average, the incentives to undertake domestic investments as opposed to transnational investments.

But, as pointed out above, the averages presented in the current study mask large differences across the possible home/host countries. A lot of information is lost, in particular the variation between countries and sources of finance. There is, in fact, a remarkable range of variation in the effective tax burden of subsidiaries located in different host countries or for subsidiaries operating in a given country.

Moreover, it has to be stressed, once again, that the different picture arising from the two studies is at the same time the result of evolving tax systems and of different economic assumptions and parameters underlying the computations.

One important difference in the results of the two studies is that, while ten years ago all Member States had a cost of capital for domestic investment lower than the outbound cost of capital, now, there are some Member States for which outbound investment is less heavily taxed than domestic investment. These are the Member States with the highest national profit rate. On the other side, Member States with the lowest national profit tax give a marked advantage to domestic investment.

Comparison of the results of the simulations of hypothetical tax reforms

The results of the simulation presented in section 7 of this study are generally in line with the impact of hypothetical reforms simulated in the Ruding report.

In particular, the importance of the harmonisation of statutory corporate tax rates to increase the degree of locational tax neutrality is one of the main conclusions of the Ruding report. In addition, that report similarly demonstrated that "harmonisation of certain aspects of the tax base in isolation does not always increase neutrality".

The limited impact of the abolition of withholding taxes on cross-border interest payments is underlined in the Ruding report, as is the potentially large positive impact of the abolition of withholding taxes on dividend payments between related companies. It is likely that further progress in this respect, beyond that currently provided for in the Parents-Subsidiaries directive could still bring some benefit as far as locational neutrality is concerned.

As to the possible adoption by all EU Member States of a common exemption system for foreign source income, the Ruding report noticed that this would have improved capital export neutrality and capital import neutrality. The current study (see simulation 10 in section 7) however produces the opposite result for capital export neutrality. Similarly, for a common credit method, the Ruding report presented unambiguously positive results, both for capital export and import neutrality, while simulation 9 in section 7 shows a move away from capital import neutrality.

Lastly, the conclusion, made in the Ruding report, that the adoption of a common classical corporation tax or a common imputation system would not improve the overall degree of locational tax neutrality slightly differs from the results presented in the current study. Indeed, simulation 12 in section 7 suggests that a common classical system could improve the overall allocational neutrality in the EU.

Results from other studies

Measuring the effects of corporate income taxes on the cost of capital is a standard way of assessing the potential impact of corporate taxation on investments.

During the last few years a number of studies have presented estimates of effective corporate tax burdens at national and international level by means of the application of approaches similar to that used in the present report.

In particular, the French Sénat (1999) published a report on tax competition in Europe which includes a comparison of domestic and international effective corporate tax burdens for the EU Member States in 1998. More recently Bond and Chennels (2000) published a comparative study of effective corporate tax burdens for seven selected world economies (five EU Member States plus USA and Japan) with the purpose of studying the trends in effective corporate taxation over the last thirty years.

As already underlined above, the numerical results arising from the application of forward-looking methodologies and therefore also the country ranking can differ due to different hypotheses concerning the economic environment in which the investment takes places and the specific investment considered.

A detailed analysis of the different numerical results of studies published over the last few years would demand a detailed assessment of the different hypotheses and goes beyond the scope and purpose of the present report. It is nevertheless useful to compare the general statements arising from these different studies in order to understand whether the different applications give coherent answers to the question of the potential role of taxation on investments.

The quantitative results presented in the French Sénat report showed tax differentials as high as the differentials arising from the computation in the present study. They confirmed that capital export and import neutrality are never attained and that the average values for each country in the international case hide considerable bilateral variations. Moreover, they pointed out that the present tax regimes give a strong advantage to debt financing and tend to favour investment in machinery (intangibles have not been included in the considered investment).

The Bond and Chennels comparisons, which also confirm the size of tax differentials and the nature of imbalances, goes a step further in showing a decline and a marked convergence in the cost of capital measures over the last ten years in particular.

C ONCLUSIONS

This is the first time a comprehensive study has analysed such a broad range of indicators of the effective company tax burden, both marginal and average, for the Member States of the European Union. These different indicators reflect different hypotheses related to the underlying methodology, as well as to the domestic or international localisation of the investment, the profitability of the investment or of the firm considered, and the size and behaviour of the companies. The computations have been supplemented by "sensitivity analysis" which tests the impact of different hypotheses on the results.

The broad range of data computed is not intended to give "universally valid values" for the effective tax burden in different countries, but rather to give indicators, or illustrate interrelations, in a series of relevant situations. In fact, effective tax rates may vary depending on the characteristics of the specific investment project concerned.

A number of general conclusions regarding both the differences in the effective tax burdens and the identification of the most relevant tax drivers which influence these tax burdens, can nevertheless be formulated on the basis of the results. Therefore, coherent explanations can be given of how Member States' tax regimes create incentives to allocate resources. The most striking feature of the quantitative analysis in this study is that, across the range of different situations, the relevant conclusions and interpretations remain relatively constant.

This study does not aim to estimate quantitatively the impact of differences in effective tax rates on the actual location of investments. The data arising from the application of the principles and assumptions underlying this study give summary measures of the incentives (or disincentives) to undertake different investments but do not provide empirical evidence of the impact of taxation on actual economic decisions. The empirical studies which have attempted to study the relevance of tax considerations in investment decisions show that there is, to differing degrees, a negative correlation between the size of taxation and location decisions. Nevertheless, certain methodological weaknesses and data shortages which affect these studies make it difficult to define "the" quantitative indicator which summarises this relation.

When domestic investments are considered, (see section 4) the analysis for 1999 suggests that there is a variation in the effective tax burden faced by investors resident in the different EU Member States, depending on the type of investment and its financing. However, the Member States tax codes tend to favour the same forms of investment by assets and sources of finance.

The range of the differences in national effective corporate taxation rates, when personal taxation is not taken into account, is around 37 points in the case of a marginal investment (between -4.1% for Italy and 33.2% for France) and around 30 points in the case of more profitable investments (between 10.5% for Ireland and 39.1% for Germany when the hypothetical investment methodology is applied and between 8.3% for Ireland and 39.7% for France when the "Tax Analyser" model is applied). In the "Tax Analyser" model France shows a higher effective tax burden than Germany (which is second in the ranking) because this model takes into account a high number of non-profit taxes which are particularly relevant in France.

Germany and France are always at the upper range of rankings of the Member States and Ireland is, in general, at the lower range of these rankings, apart for the case of a marginal investment where Italy shows a considerably lower effective marginal tax rate. The advantage of the Italian tax regime for marginal investments can be largely traced to the Italian "dual income" tax system. At the margin the Italian corporation tax regime effectively subsidises investment. But, when the profitability of the investment rises the effective tax burden rises and for an intra-marginal investment the Italian effective tax burden is in the middle of the EU range. In general, there are not substantial differences in the ranking of the Member States when comparing marginal and infra-marginal indicators.

The analysis suggests also that, in practically every situation analysed, on the one hand, the tax systems tend to favour investment in intangibles and machinery and, on the other hand, debt is, by far, the most tax-efficient source of finance for all Member States.

The introduction of personal taxation substantially increases the effective tax burdens and the observed differences. In this situation the ranking of Member States by effective tax burden is very different from the case in which only corporate taxation is considered. Moreover, it is no longer true that debt is always the form of finance which minimise the effective tax rate, even if for a majority of Member States debt is still the most favoured form of finance.

It is worth noting that the values of the effective tax burden for each Member State can vary according to the definition of the economic variables and parameters underlying the application of the methodology and, as mentioned above, there is no universally valid value in one country. However, the sensitivity analysis in section 5, suggests that the ranking of Member States is largely unaffected by changes in the assumptions used in the base scenario.

Differences between the effective tax burden in the EU Member States may be important for two reasons. First, differences in effective tax rates faced by companies located in different Member States, but competing in the same market, may affect their international competitiveness: two different companies, competing in the same market, may face two different tax rates. Second, when multinational companies face only the tax rate of the country where the activity takes place then differences in the effective tax rates between countries could also affect the location choice of individual activities. This can occur either as a result of the provisions of international tax codes, for example when the repatriation of profits by way of dividend from a subsidiary to a parent results in no further taxation because the dividend is exempt, or as a result of tax planning. A multinational company may therefore face different tax rates, depending on where its activities are located.

The EU wide spread cannot be explained by one single feature of the national tax system. However, the analysis tends to show that the different national tax rates on profits (statutory tax rates, surcharges and local taxes) can explain most of the differences in effective corporate tax rates between Member States.

Therefore, although tax regimes are designed as more or less integrated systems (in general high tax rates on profits seem to correlate with a narrower taxable base and vice versa), tax rate differentials more than compensate for differences in the tax base. This is particular relevant when discussing the compensatory effects of a generous tax base compared to a relatively low tax rate on the effective tax burden.

The quantitative analysis also shows that the relative weight of rates in determining the effective tax burden of companies rises when the profitability of the investment rises and that, consequently, the compensatory effects of a lower tax base in countries with high tax rates on effective tax rates tend to disappear when the profitability rises.

When transnational investments are considered, (see section 6) the data for 1999 arising from the quantitative analysis illustrates a variation in the way each Member State treats investments in or from other countries. Thus, the effective tax burden of a subsidiary of a parent company in one country depends crucially on where that subsidiary is located. The range of variations of the effective tax burdens of subsidiaries located in different host countries can reach even more than 30 points regardless of the method of financing of the subsidiary. This suggests that there is considerable incentive for companies to choose the most tax-favoured locations for their investment, which may not be the most favourable location in the absence of taxes. Similarly, subsidiaries operating in a given country face different effective tax burdens depending on where their parent company is located. Even in this case the range of variation can reach more than 30 points.

The analysis of the effective tax burden of transnational investment also allows an assessment of the allocation effects of international taxation by capturing the extent to which the tax treatment of transnational investments gives incentives to undertake transnational, as opposed to domestic, investment. The data show that, on average in the EU, outbound and inbound investments are more heavily taxed than otherwise identical domestic investments and, therefore, the additional components of the transnational system add somewhat to the effective tax rates on investment.

But, to the extent that companies are free to choose the most tax-favoured form of finance, then the international tax system works such that foreign multinationals operating in a host country are likely to face a lower effective tax burden than domestic companies. This is true even when the treatment of multinationals is compared with the more favourable domestic treatment allowed for small and medium sized companies (see sections 6 and 9).

The spreads observed between the effective rates of taxation in the international analysis are the result of complex interactions between different tax regimes and cannot be explained by just one feature of taxation. However, as was the case for the domestic investment, the analysis tends to show that the relevant component that results in distortions with respect to cross border location and financing decisions is, above all, the overall national tax rate. This is, in general, the most important tax driver when the incentives of taxation to use particular sources of finance and specific locations are considered. The tax base does however have a greater impact in specific situations - for example when a Member State applies a particularly favourable depreciation regime as is the case in Greece, and to a lesser extent in Finland and Sweden.

It is worth noting that across the range of domestic and cross-border indicators presenting the effective tax burden at the corporate level, there is a remarkable consistency as far as the relative position of Member States is concerned, notably at the upper and the lower ranges of the ranking. In general, Germany, and France tend to show the highest tax burdens while Ireland, Sweden and Finland tend to be at the lower range of the ranking. (The particular situation of Italy in the marginal case has been commented on above).

When the domestic analysis is updated to take into account the 2001 tax regimes (section 10), the overall picture shows that a number of Member States have a lower cost of capital and effective marginal tax rate as a result of changes in the tax codes aimed at reducing the corporate tax rate or introducing of modifying the dual income system. These changes have not fundamentally affected the ranking of Member States nor reduced the dispertion inside the EU. The most evident change is the remarkable reduction in the Austrian effective tax burden, due to the introduction of the dual income system, which now places Austria at the lower end of the ranking together with Italy, Ireland and Sweden.

In the case of a more profitable investment, the EU differential is reduced mainly due to the effect of the reduction of the German and French effective tax burden, whereas the lowest effective average tax rate remains the Irish rate. Apart from this reduction in the range of rates of about 4 percentage points, the global picture arising from 2001 in terms of countries at the highest or lowest range of the ranking and principal tax drivers is fundamentally unchanged in comparison to the 1999 picture.

The German tax reform that entered into force on 1.1.2001 is undoubtedly a significant reform which implies a substantial cut in the corporation tax rate and in income tax rates, partly financed by the broadening of the tax base, including the abolition of the split rate system and the imputation system. However, despite these changes and the considerable reduction of the average effective tax burden at the corporate level, the German tax reform has only minor effects on the relative position of Germany in the EU country ranking. In fact, the overall national corporate rate in Germany remains high by the standards of the EU. Consequently, the effective tax burden remains among the highest in the EU.

When the role of specific features of the tax regimes is examined by simulating the impact of hypothetical policy scenarios on the measure of effective tax rates by means of harmonisation of particular features of taxation in isolation (see section 7), the results of the application of the two methodologies underlying this study show that:

• Introducing a common statutory tax rate in the EU would have a significant impact

by decreasing the dispersion - both between parent companies and between subsidiaries - of effective tax rates across the Member States. To the extent that taxation matters, such reform would be likely to go some way in reducing locational

inefficiencies within the EU.

• By comparison, no other scenario would have such a

significant impact. For example, introducing a common tax base or applying the definition of the home country tax base to the EU-wide profits of a multinational would tend to increase the dispersion in effective tax rates if tax rates were kept constant. Two remarks have to be made concerning these results. First, the methodologies applied do not take into consideration all the elements of the tax base. However, the "Tax Analyzer model", the results from which are similar to those arising from the simulations of hypothetical investment, does consider a significant number of elements of the tax base. Second, benefits which would arise under either a common consolidated tax base or a home country tax base approach such as loss consolidation and simplified transfer pricing cannot be

modelled using the methodologies used in this report.

• Introducing a common form of integration of corporate and personal taxes, other

than a pure classical system, would not tend to reduce the dispersions of effective

tax rates between Member States.

It should be noted that these conclusions are the result of a static analysis. They therefore do not assess the dynamic effects and possible reactions induced by the harmonisation of particular features of taxation in isolation.

The potential distortions in the allocation of resources found in the analysis of transnational investments indicate that there can be a considerable incentive for companies to alter their behaviour in order to minimise their global tax burden. Therefore this study considered some stylised examples of tax optimisation strategies of companies by means of an intermediary financial company, focusing on the likely effects of an abolition of these tax reducing financing structures (see section 8). The study shows that preventing such tax optimisation strategies will not contribute, per se, to solving the problem of tax-induced resources misallocations. Taking into account that the main tax driver for effective tax rates differentials is the overall tax rate, companies located in "high tax" countries will have the possibility to compensate the removal of financial intermediaries by exploiting the possibility of tax arbitrages arising from those differentials.

The size of tax differentials and dispersions in the EU measured in this study deserves attention. The principal tax driver for these differences is, above all, the overall national corporation tax rate. Although the existence of market failures can justify a certain degree of tax differentials in order to offset these externalities, the size of the differences observed in this study is likely to impact on economic efficiency. This study has not attempted to quantify the size of any efficiency loss that might be associated to existing differences in effective corporation tax rates in the European Union.

But taxation ultimately involves a political choice and may entail a trade-off between pure economic efficiency and other legitimate national policy goals and preferences. The objective of neutrality of taxation systems within the Internal Market has therefore to be seen in the context of national autonomy in the field of taxation..

PART III:

COMPANY TAX OBSTACLES TO CROSS-BORDER

ECONOMIC ACTIVITY IN THE INTERNAL MARKET

2. I NTRODUCTION

The Council mandate given to the Commission defines "the remaining tax obstacles to cross-border economic activity in the Internal Market" as "tax provisions that may hamper cross-border economic activity in the Internal Market". This description of tax obstacles is rather broad. Hence, the present study focuses on additional tax or compliance burdens which companies incur as a result of doing business in more than one Member State and which therefore represent a barrier to cross-border trade, establishment and investment.

The underlying cause of those additional tax and compliance burdens is the existence within the Internal Market of 15 separate tax systems. First, the fact that each Member State is a separate tax jurisdiction has a number of consequences. In particular:

• companies are obliged to allocate profits to each jurisdiction on an arm’s length

basis by separate accounting, i.e. on a transaction by transaction basis;

• Member States are reluctant to allow relief for losses incurred by associated

companies whose profits fall outside the scope of their taxing rights;

• cross-border reorganisations entailing a loss of taxing rights for a Member State are

liable to give rise to capital gains taxation and other charges;

• double taxation may occur as a result of conflicting taxing rights.

Moreover, each Member State has its own sets of rules, in particular laws and conventions on financial accounting, rules for determining taxable profit, arrangements for collection and administration of tax and its own network of tax treaties. The imminent enlargement of the EU makes it all the more urgent to address the underlying problems.

The need to comply with a multiplicity of different rules entails a considerable compliance cost. To face this multiplicity of approaches at all levels is an important obstacle to cross-border economic activity, involving not only financial costs, internal and external, but also significant frictional losses and braking effects. The costs and risks associated with complying with more than one system may even discourage small and medium-sized enterprises from engaging in cross-border activity.

These fundamental problems mean European multinational companies are in a more difficult competitive situation in comparison to third country businesses, especially when the latter enter the European market for the first time, as they are free in their location decisions and can develop a tax-optimal structure. Interestingly enough, once established in the EU, the US business community is often complaining about having to cope with 15 different tax systems in the EU as well and pleads, for instance in the Trans-Atlantic Business Dialogue, for a simpler EU system. 49

In a broader perspective, the tax obstacles to the Internal Market may also result in economic terms in a loss of potential EU welfare. In setting a tax incentive towards domestic economic activity the obstacles violate the basic neutrality criterion explained in Part I of this study. Moreover, they may result in an overall economic situation of the EU and its citizens that is less efficient, equitable and effective than it could be and thus reduces the general well-being. However, in order to determine the size of these welfare effects, it would in particular be necessary to quantify the compliance cost inherent in the existence of 15 different tax systems within the Internal Market or, in other words, the fiscal surcharge for international activities.

Currently, such calculations are not available for the EU and there is certainly scope for future economic research in this area. The present study could not embark on such a demanding exercise. The available studies

50 on compliance cost mostly concern the USA, Canada and Australia, i.e. countries which are economically broadly comparable to the EU economies. It is difficult to draw firm detailed conclusions from these studies. Nevertheless, they show that tax compliance costs for international and cross-border activities are substantial. Moreover, such costs are regressive to size, which means that ceteris paribus they hit small and medium-sized enterprises relatively harder than bigger companies.

Against this background, the following analysis of company tax obstacles in the Internal Market focuses on the company tax issues encountered by groups of companies active in the Internal Market. This includes the tax rules governing mergers and acquisitions, capital gains taxation, transfer pricing, the cross-border off-setting of losses as well as the taxation of all forms of cross-border flows of income, notably dividends. Company tax obstacles in the Internal Market also concern possible hindrances to cross-border economic activity resulting from the taxation of specific forms of remuneration (notably stock options, etc.) and of posted and migrant workers in the EU (notably concerning supplementary pensions). Finally, the specific situation of small and medium-sized enterprises and partnerships is considered and a section on value-added tax completes the overall picture of tax obstacles hampering cross-border economic activity. It is not attempted to provide a detailed classification of any of