Corporate Tax Harmonization for the Single Market: What the European Union Is Thinking; Bottom-Line Issues for American Business
McLure, Charles E., Jr., Business Economics
When corporations operate in several jurisdictions that impose income taxes, it is necessary to divide taxable income among them. The Commission of the European Communities proposes that the European Union shift from individual national accounting to dividing the income of groups of corporations operating in multiple EU Member States according to an agreed formula. Adoption of the Commission's proposals, politically difficult because EU tax rules require unanimous approval, would have important implications for American corporations operating in the EU. These could include simplification, the ability to offset losses incurred in one Member State against profits earned in another, greater neutrality toward corporate form and cross-border reorganizations, reduced double taxation, perhaps lower tax liabilities, and greater opportunities for expansion into and within the EU. The proposals, however, would also entail transition costs, reduced opportunities for tax planning, and greater uncertainty regarding tax treaty issues.
This paper describes and appraises the Commission's proposals and their implications for U.S. firms. (1)
When a group of affiliated corporations operates in more than one nation or state that imposes an income tax, it is necessary to divide the taxable income of the group among the taxing jurisdictions. The American states employ formulas to "apportion" the income of multi-state corporations among the states where they do business. By comparison, the Member States of the European Union (EU), like other nations, currently employ separate accounting to determine the income of each member of a corporate group and "source rules" to attribute that income to the Member States where the income is deemed to originate. Inherent in that approach is reliance on arm's length prices--prices that would prevail in transactions with unrelated parties--to value transactions between members of the corporate group. But using separate accounting and the arm's length standard (hereinafter SA/ALS) in the context of an integrated market such as the U.S. or the EU is complex and impedes efforts to create a single market. The Commission of the European Communities (hereinafter the Commission), the executive body of the EU, has recently proposed that the Member States of the EU consider shifting to formula apportionment (FA) to divide the consolidated income of groups of EU corporations operating in more than one Member State among those Member States. See Commission of the European Communities (2001, 2002) and Diemer and Neale (2004).
If adopted, the Commission's proposals would have important implications, both positive and negative, for American corporations doing business in the EU. On the positive side, tax compliance would be vastly simpler, losses incurred in one Member State could be offset against profits earned in another, taxation would no longer dictate organizational form or discourage economically rational reorganizations, there would be less double taxation, increased tax competition among Member States might result in lower taxes, and there would be increased opportunities for American firms to expand into or within the EU. On the other hand, there would be transition costs, reduced opportunities for tax-motivated income shifting between Member States, and uncertainty regarding treaty issues.
Problems of SA/ALS
The economic integration of the EU will make the continued use of SA/ALS to divide the EU-source income of corporate groups increasingly problematical: (2)
* The need to comply with 25 national tax systems creates overwhelming complexity and excessive compliance costs;
* The need to distinguish between types of income and determine the geographic source of each is an important source of compliance costs;
* The growing number of transactions between affiliated corporations increases costs of compliance and administration of transactions-based transfer pricing rules;
* Arm's length prices may not exist for some of the most important transactions between affiliated corporations, including those involving intangible assets such as intellectual property;
* There are both incentives and opportunities to manipulate transfer prices to shift income to low-tax jurisdictions;
* Economic interdependence between operations occurring in various Member States may make it conceptually impossible to arrive at a scientifically defensible division of income resulting from the joint operations;
* When Member States do not agree on the transfer prices a corporation should use, double taxation may result;
* The European Court of Justice (ECJ) may find that thin capitalization rules, intended to prevent excessive use of debt to shift profits to low-tax Member States, contravene the EU Treaty; (3)
* The inability to offset losses incurred in one Member State against profits earned in another discourages cross-border expansion and favors locating economic activities in the larger Member States, since this maximizes the likelihood of being able to offset losses;
* Using SA/ALS can have tax consequences that distort choices of organizational form (e. …