IFS
Corporate Income Taxes in the EU:
An Economic Assessment of the Role of
the ECJ
Steve Bond (Nuffield College, Oxford and IFS)
Malcolm Gammie (TLRC, IFS)
Socrates Mokkas (University of Oxford)
ETPF/IFS Conference
The Impact of Corporation Tax Across Borders
London, 24 April 2006
IFS
Goals
• To review implications for EU corporate
income taxes of case law at the ECJ
• To provide an economic assessment of the
changes to EU corporate income taxes
resulting from these ECJ rulings
IFS
Background
• “The ECJ has no rival as the most effective
supranational judicial body in the history of
the world” (Alec Stone Sweet)
• The ECJ has decided over 100 cases
involving income taxation
• Mostly ruling against tax provisions of
member states
IFS
Legal Background
• Four freedoms – free movement of goods,
persons, services and capital – and freedom
of establishment enshrined in EC/EU treaties
• Member states retain competence in direct
taxation (and veto over direct tax proposals),
subject to EU law
• Commission and national courts can refer
cases to the ECJ
IFS
ECJ Case Law
• Non-discrimination – tax measures of one EU
country should not discriminate against
nationals of another member state
• Market access – tax measures of one EU
country should not act as barriers to the
exercise of Treaty freedoms
• Justifications
– Cohesion/proportionality
– Prevention of tax evasion/avoidance
IFS
Economic Background
• Capital Export Neutrality (CEN) – requires
same tax treatment for domestic investment
and outbound foreign investment
• Capital Import Neutrality (CIN) – requires
same tax treatment for domestic investment
and inbound foreign investment
• Taxes will distort international investment
decisions (location or ownership) unless both
CEN and CIN hold
IFS
Economic Background
• With different tax rates, CEN would require all
countries to adopt pure residence-based
taxation
• And CIN would require all countries to adopt
pure source-based taxation
• Neither can be achieved unilaterally
• Achieving both (no tax distortions) would
require a common tax base and common tax
rates
IFS
Small Open Economy Results
• Small open economy (SOE) –
production/consumption of goods and
services have no effect on world prices
• Perfect capital mobility – investment/saving
have no effect on world interest rate
• Source-based taxation of capital income can
be inefficient in a small open economy with
perfect capital mobility
IFS
Small Open Economy Results
• Source-based taxation of capital income deters
investment in the source country
• In a small open economy, incidence is shifted
fully onto (relatively immobile) domestic workers
– post-tax return to owners of capital unaffected
– less capital per worker implies lower wages
• More efficient to tax labour income directly
– avoiding distortion to capital-labour ratio
IFS
The Big Picture
How would economists with a blank sheet of
paper design a corporate income tax system
for the EU?
IFS
Two Extreme Views
• Assuming
– No obstacles to coordination
– EU large enough for SOE results not to apply
• Single EU corporate income tax
– Consolidated tax base
– Single tax rate
• Caveat
– Some economists would advocate no taxation of
income from capital even in a closed economy
context
IFS
Two Extreme Views
• Assuming
– No chance of coordination
– Individual EU countries small enough for SOE
results to apply
• No (source-based) corporate income taxes
• Caveats
– Location-specific rents
– Backstop to personal income tax
IFS
The Big Picture
• We do not endorse either of these extreme
positions
• We assess the impact of the ECJ on
corporate income taxes in the EU both from
the perspective of an observer who favours
harmonization; and from the perspective of
an observer who favours abolition
IFS
Requirements of EU law
• No reason to believe that full compliance with
EU law will produce effective harmonization
of corporate tax treatments
– i.e. single level playing field across all 25 EU
countries
• Nor make it impossible or prohibitively
expensive for national governments to raise
significant revenues from corporate taxes
IFS
A compliant system
• Consider a territorial system, with all member
states exempting foreign-source income
• No discrimination within national markets
then implies a level playing field within each
country
IFS
A compliant system
• But member states determine own tax rules
and own tax rates, subject to EU law
• Effect would be not a single level playing
field, but a patchwork of 25 level playing
fields
– different heights primarily reflecting different tax
rates applied within national markets
IFS
A compliant system
• This would satisfy capital import neutrality but
not capital export neutrality
• Firms investing in member states with low tax
rates treated more favorably than firms
investing in member states with high tax rates
• Effective harmonization not required for EU
corporate taxes to comply with EU law
• Likely that significant tax revenues could be
raised in a compliant system of this kind
IFS
Requirements of EU law
• EU law does not even require that two
participants in a domestic market face equal
tax burdens
• Provided differences result only from
interactions between different national taxes,
not from discrimination within tax rules of a
single member state
IFS
Requirements of EU law
• Parent-Subsidiary Directive allows credit
method as well as exemption method for
relieving double taxation of foreign-source
income
• UK firm investing in Ireland may face higher
overall tax rate than German firm investing in
Ireland, or domestic Irish firm
• Some departures from capital import neutrality
are permitted, if they result from interactions
between tax rules in different countries
IFS
The Influence of the ECJ
• 10 years ago, the impact of the ECJ on UK
corporation tax had been minimal
• Since then:
– Abolition of ACT
– Effective abolition of imputation
– Changes to transfer pricing and thin capitalisation
rules
– Changes to treatment of finance leases
– Cross-border losses
– Concern over future of CFC rules and credit system
IFS
The Influence of the ECJ
• EU member states are now in responsive
mode
• Revising national corporate income taxes in
response to actual or prospective ECJ rulings
• At least in the UK, the government’s agenda
for corporate tax reform has been replaced by
firefighting legislation – patching up
corporation tax to make it comply with EU law
IFS
The Big Picture
• EU corporate taxes are very different now
than they were 10 years ago
• But there is no clear trend, or obvious
pressure, towards either harmonization or
abolition
• Viewed from either extreme position, neither
the corporate taxes we have now nor those
we could be heading towards are clearly
superior to the corporate taxes we had before
IFS
The Big Picture
• More generally, full compliance with EU law is
likely to leave intact some of the most significant
distortions to efficient allocation of business
activity within the EU
– Investment attracted to countries with low CT rates
– Cross-border business structured in tax-efficient ways
– Shifting of profits into countries with low CT rates
– Location of headquarters and R&D also affected
IFS
The Big Picture
• Mainly due to differences in corporate tax
rates, substantial departures from capital
export neutrality persist within the EU
• At this macro level, hard to discern any great
improvement stemming from the volume of
litigation at the ECJ
• Not the role of the ECJ to produce an efficient
corporate tax system for the EU
IFS
Specific Changes
We focus on four areas where the ECJ has
been, or is likely to be, influential:
• Integration of personal and corporate income
taxes
• Transfer pricing and thin capitalisation
• Source or residence-based corporate taxation
• Credit or exemption systems of double tax
relief
IFS
Integration
• Imputation systems used historically by many
EU member states were discriminatory
– Dividend tax credits not given for foreign corporate
income taxes
– Dividend tax credits not given to foreign
shareholders
– Additional tax imposed on firms with insufficient
domestic taxable income (e.g. surplus ACT)
IFS
ECJ Influence
• Key cases
–
–
–
–
–
–
Metallgesellschaft (1998)
Verkooijen (2000)
Lenz (2004)
Manninen (2004)
ACT GLO (pending)
Meilicke (pending)
IFS
Recent Changes
• Imputation system replaced by classical
system in Ireland, and by forms of (partial)
exclusion (from personal income tax) in (e.g.)
Germany, France, Italy and the UK
• In (e.g.) Ireland, Germany and the UK, higher
personal taxation of dividend income was
explicitly linked to reductions in corporate
income tax rates
IFS
Economic Assessment
• In closed economies, dividend taxation raises
cost of capital for investment financed by new
equity
– Already relatively unimportant for investment
decisions of mature firms
– But more important for investment decisions of
high growth firms and start-ups
– Favours retained earnings over new equity finance
IFS
Economic Assessment
• In small open economies with perfect capital
mobility, link between dividend taxation and
investment and financial decisions is weaker
– Stock market valuation of corporate dividends
insensitive to dividend taxes paid by domestic
shareholders
IFS
Economic Assessment
• As economies become more open and more
integrated, case for relieving double taxation of
dividend income (e.g. by imputation) becomes
weaker (Boadway-Bruce, 1992; DevereuxFreeman, 1995; Fuest-Huber, 2000)
• Switch from (source-based) corporate income
tax towards (residence-based) dividend
taxation has some advantages
IFS
Transfer Pricing and Thin Capitalisation
• Opportunities to shift taxable profits from high
tax rate to low tax rate jurisdictions using
transfer pricing or thin capitalisation are
relevant only in cross-border context
• Traditional anti-avoidance rules therefore
applied only to cross-border transactions
• Thus discriminating between domestic and
international transactions
IFS
ECJ Influence
• Key cases
– Lankhorst-Hohorst (2000)
– Thin Capitalisation GLO (pending)
• Response (e.g.) in Germany and UK has
been to extend the scope of these antiavoidance rules to also cover domestic
transactions
IFS
Economic Assessment
• This outcome raises administrative and
compliance costs, without any substantive
effect on the application of these rules
• Open question as to whether the new rules
are fully compliant with EU law
• If not, there could be significant erosion of
corporate income tax bases, and (hence)
more incentive for EU countries to coordinate
(e.g. on some form of formula apportionment)
IFS
Source or Residence Taxation
• Within corporate income taxes, pending
cases at the ECJ may favour a shift towards
source-based taxation
• Two areas where existing departures from
pure source-based taxation are at risk:
– Controlled foreign corporation (CFC) rules
– Credit system for relief of international double
taxation
CFC Rules
IFS
• Key cases
– Cadbury Schweppes (pending)
– CFC and Dividend GLO (pending)
• Like imputation systems, CFC rules tend to
discriminate between domestic and foreign
investments, and between different foreign
investments
• (Without harmonization of CFC rules),
restrictions on application of CFC rules within
EU would significantly weaken effectiveness
of CFC rules against non-EU tax havens
IFS
Credit Systems
• Standard operation of credit systems appears
to be discriminatory
– Dividends from foreign subsidiaries are liable to
tax, while dividends from domestic subsidiaries
are not
• Key case
– Franked Investment Income GLO (pending)
– AG Opinion (6 April) supports principle of credit
method, but not its operation in the UK
IFS
Possible Responses
• Replacement of credit method by exemption
method
• Extension of credit method to dividends
received from domestic subsidiaries
• Open question as to whether an extended
credit system would be fully compliant with
EU law
• Less doubt about compliance of exemption
system
IFS
Economic Assessment
• Economic analyses do not decisively favour the
credit method over the exemption method, or
vice versa (Horst, 1980; Janeba, 1995; MintzTulkens, 1996; Devereux-Hubbard, 2003;
Davies, 2003)
• And some favour deduction over credit or
exemption (Feldstein-Hartman, 1979)
• Simplicity of exemption system may be a major
advantage (Federal Tax Commission, 2005)
IFS
Conclusions
• The ECJ is now a major influence on the
direction of corporate income taxes within the
EU
• Compliance with EU law is unlikely to
produce either effective harmonization of
corporate tax treatments within the EU
• Or the abandonment of corporate income
taxes
Conclusions
IFS
• A plausible outcome is a territorial system, with
exemption of foreign-source income, no
discrimination on the basis of nationality, but
different tax rates in different EU countries
• A patchwork of 25 level playing fields, each at
different heights, not a single level playing field
• Question as to whether playing fields are even
required to be level within countries, if
differences reflect interactions between two tax
systems (e.g. credit rather than exemption)
IFS
Conclusions
• The areas of corporate taxation that have been
the focus of ECJ cases (imputation systems,
anti-avoidance rules, systems of double tax
relief) are not the chief suspect for significant
economic distortions (which remains differences
in corporate tax rates)
• The legal pressure that is currently driving
changes to corporate income taxes within the
EU is a poor substitute for serious political
debate on corporate tax reform
IFS
Conclusions
• It is not the role of the ECJ to produce a more
efficient corporate income tax system for the EU
• There are powerful long term pressures toward
either more uniform corporate tax treatments
within the EU, or lower corporate tax rates
• But these stem from increased mobility of capital
and business activities, not from the ECJ