What Corporate Tax for Europe? [Archives:2006/917/Business & Economy]

By: Stephano Micossi
The European Commission is considering a common model of corporate taxation for the European Union that cannot possibly work. Instead, it should consider a simpler, and more viable, alternative that already exists.

Corporate income in the EU is currently taxed under widely divergent national rules, based on separate accounting (SA) of income earned in each country. Cross-border intra-company transactions are accounted for according to market prices for similar transactions – the so-called “arm's-length principle” (ALP).

The system is complex, expensive to administer, and can result in double taxation because members usually do not allow full write-offs for losses and tax liabilities incurred abroad. It is also prone to tax evasion, owing to different definitions of corporate income in the member states and the vast opportunities for cheating offered by ALP (since reference market prices often do not exist), not to mention profit-shifting to low-tax jurisdictions.

The Commission is now proposing that EU companies operating in more than one member state be taxed on a common definition of earned income – the Common Consolidated Base Taxation (CCBT). Earned income would be calculated on a consolidated basis for the group and then “apportioned” among the member states according to a formula reflecting each business unit's contribution to overall group income. The formula could include such factors as sales, payroll, and tangible assets, as in Canada and the United States, or value-added, adjusted to exclude imports in order to measure the value-added “produced” in each country. Each member state would remain free to decide the tax rate applicable to its portion of group income.

Under this approach, taxable income would be determined from the consolidated accounts based on international accounting standards (IAS), which since 2005 have become legally binding for EU-listed companies' financial reports. This offers full tax write-offs for losses within company groups, and transfer prices would no longer matter.

Even so, the Commission's proposal has fatal shortcomings. For one thing, the factors included in the apportionment formula would in practice be taxed at the national rates, creating fresh incentives for factor- and profit-shifting.

But it is two other obstacles that render CCBT hopeless. First, the IAS responds to the information needs of financial investors, but it does not provide a reliable definition of income for tax purposes. The accrual principle typical of financial accounting is incompatible with tax systems' realization principle. Moreover, the IAS leaves the allocation of profit and losses to different fiscal years largely undetermined, with each member state choosing different solutions.

Second, common legal rules on group consolidation do not exist; indeed, many EU countries' commercial law contains no legal definition of a group. The attribution of companies to a common group would need to be based on legal control, that is, ownership of some defined threshold of equity – 51% or higher. But a much lower share of equity often is sufficient to secure de facto control, thus encouraging groups to adapt their capital structure – moving firms in and out of the group's boundaries – to minimize tax liabilities.

Clearly, CCBT is a non-starter. But this doesn't mean that EU companies are condemned to live with 25 different national tax systems. The idea of a common tax base must be preserved in order to simplify the system and narrow the scope for profit-shifting. However, a radical change in approach is required: the notion of income as a basis for corporate taxation should be scrapped altogether.

Referring to corporate income made sense when company taxation was seen as a “back stop” within a system of progressive taxation of personal incomes. But most countries have now adopted “dual” income taxation that treat the fruits of capital more leniently than other personal income. More importantly, the notion of corporate income is inherently arbitrary, for it is based on correct measurement of capital consumption in each tax period, which has become less and less reliable owing to the increased importance of intangibles in the value of companies.

Moreover, any tax whose proceeds increase in line with company returns is bound to discourage investment. This disincentive disappears if the corporate tax base is decoupled from current profits and linked to some broad measure of activity. Indeed, this would create an incentive for each company to outperform the average, since above-average profits would go untaxed.

Another reason to scrap income and move to presumptive taxation of corporate activities stems from the EU's decentralized nature. While taxing the return on capital at the national level could discourage investment, taxing companies in exchange for location advantages might not. Countries that offer world-class infrastructure, high-skill staff, and simple business rules may be well entitled to ask companies to pay a commensurate tax in return.

In sum, the EU “federal” corporate tax should be thought of as a benefit tax, based on a broad measure of activity, applied at a moderate rate, and unrelated to current returns; nor should it be deductible from other taxes. Among the various options under consideration, the value-added tax base – perhaps averaged over a number of years – looks best, since the accounting and tax-assessment infrastructures already exist.

Of course, value-added includes profits, and to this extent the incentive for companies to manipulate transfer prices may reappear. But the incentive would be much weakened, because gross returns typically represent a fairly small share of total value-added.

This model leaves the assessment and administration of corporate taxes entirely in the hands of member states, and would not require harmonization of legal and accounting rules. It would be transparent, simple, and easy to administer. The gigantic apparatus for managing transfer prices and tax credit claims with foreign tax authorities could be dismantled.

Indeed, the only losers would be Europe's outsized army of tax lawyers and accountants.

Stefano Micossi, a former Director General of Industry at the European Commission, is Managing Director of Assonime, a business association and think tank in Rome.

Copyright: Project Syndicate, 2006.

www.project-syndicate.org
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