EU’s State Aid Case: Real Issue is Unfair Competition Between Countries

One of my takeaways from working on the G20/OECD BEPS Project was that it often took two players for base erosion and profit shifting (BEPS) to occur: a tax-planning multinational enterprise and a facilitating country or countries.  BEPS was facilitated by some national governments to increase jobs, investment and revenues in their country.  Thus, competition is not just between companies, but also between countries. 

EU “Competition policy is about applying rules to make sure companies compete fairly with each other.”  The EU State Aid rules do not address the issue of competition between countries. 

There are many affected parties in the EU State Aid case against Ireland and Apple.  Reduced effective tax rates (ETRs) can affect the relative competitiveness of companies.  Interestingly, the EU ruling (currently only a 4 page press release) gave no examples of competitive harm to other companies.  The OECD BEPS Action 11 report notes that the incidence of corporate tax avoidance from BEPS may be more likely to increase rents to shareholders than lower prices to consumers or higher wages to workers.  Without lower consumer prices, the potential harm to other companies is quite limited.

Reduced average ETRs have been shown to affect the location decisions of companies.  A lower average tax rate in Ireland encourages more investment, jobs and tax revenue in Ireland.   The shifting of investment and jobs due to a reduced ETR comes at the expense of jobs and investment in other countries.  BEPS affects the revenue collected by other countries, so other taxpayers, both individuals and companies, have to pay more taxes for a given level of government services.  Thus, it is more likely that any State Aid harmed citizens in other countries, rather than other companies’ shareholders.

The current EU State Aid rules require recovery of the reduced taxes by Ireland.  Ireland could use the additional money to reduce its current 12.5% corporate tax rate, further reduce its Knowledge Development Box 6.25% tax rate, and/or increase its spending on education or infrastructure, further enhancing its competitive position vis-à-vis other countries.  It could be a winner twice with jobs and investment from the initial State Aid, and then with future jobs and investment from spending of the State Aid recovery.  The recommended recovery is equivalent to three years worth of Irish corporate tax collections.  

The EU ruling notes “If other countries were to require Apple to pay more tax on profits of the two companies over the same period under their national taxation rules, this would reduce the amount to be recovered by Ireland.”  This statement likely reflects the EU’s real concern in the Apple case, which is competition between countries and their harmful tax practices.  Distribution of recovered amounts to adversely affected stakeholders would require many assumptions about the incidence of the favorable tax treatment, but clearly the facilitating government is not a negatively impacted stakeholder.  With the current lack of understanding of the effects of corporate tax incidence, such an attempt would be a fool’s errand, and new audits by multiple governments based on then existing transfer pricing guidance for tax years 2003-2013 are neither realistic nor desirable.

In my experience with tax policy issues, it is more important to get the future rules improved rather than attempting to recover past tax benefits.  Fortunately, the G20/OECD BEPS Project and the EU’s Anti-Avoidance Directive are important steps in reducing corporate tax avoidance in the future with improved transfer pricing guidance and improved governmental transparency with spontaneous exchange of information on governmental tax rulings.   Future coordinated multilateral standards to reduce BEPS and reduce personal tax evasion through Automatic Exchange of Information will reduce governments’ use of tax systems to benefit select taxpayers will reduce countries’ harmful tax practices.

Tom Neubig

Tax certainty new focus of G20

Risk is often characterized as the different likelihoods within a known distribution (eg. knowing the rules of the game), while uncertainty is the existence of possible multiple distributions (eg. not knowing which game will be played).

Best available data (BAD) and its use in policy analysis

Policy analysts are continuously striving to find new insights with new sources and types of data.  Analysts are looking for the “best available data”.  This is important for improving policy analysis, but sometimes analysts are more interested in publishing results than understanding exactly what is in the underlying data.  Sages know that databases need to be reviewed carefully before placing great weight on the subsequent analysis.  A database might be the “best available”, but still have significant limitations needed to caveat any analytical results.

Running regressions is fun, but an analyst should know what the underlying data includes.  Interpreting regression results requires a thorough understanding of what the included variables measure and what key observations are missing from the data. 

In the case of Base Erosion and Profit Shifting analyses, the OECD Action 11 report on Measuring and Monitoring BEPS spent the first chapter highlighting the caveats and limitations of current existing databases for analyzing BEPS.  All of the databases have limitations, and company-level data has many advantages for analyzing BEPS issues.  Several empirical studies have used company financial data from Bureau van Dijk’s ORBIS (global) or AMADEUS (European) databases.   Whilst possibly the “best available”, the ORBIS financial report data is not truly global and is incomplete in many respects.

The BEPS Action 13 Country-by-Country reports for the largest MNEs with actual tax, rather than financial, data, will significantly improve the available data for tax agency researchers. Until 2019 at the earliest, ORBIS or AMADEUS databases may remain the “best available.” However, economists from the US Joint Committee on Taxation demonstrated what can be done with comprehensive tax data from MNEs and their subsidiaries available from one country’s tax data. (Dowd, Landesfeld and Moore, 2015, see link).

We would caution analysts to caveat results from the ORBIS database carefully, as the following table from the BEPS Action 11 report shows the ORBIS database is highly skewed to European companies and European headquarters, and a careful look will reveal the absence of many significant tax entities that have been shown to have engaged in BEPS behaviors. 

Because the ORBIS database includes only available financial information, it does not have financial information about most unconsolidated subsidiaries of US-headquartered companies, which file consolidated financial reports.  It includes some entities in tax havens, but generally without any detailed financial information.  Also, when evaluating an available database, it is important to check some of the largest and most important key entities with other available data.  For example, we were not surprised to find that the ORBIS database did not include Apples Sales International for many years, and when a record for the entity was included it included just the name of the entity, not financial information.   Yet it was clear from parliamentary inquiries (and confirmed by the recently released EU illegal state-aid ruling involving Apple’s taxes in Ireland) that Apples Sales International would be a significant MNE observation in estimating the potential tax revenue lost through BEPS. 

The fact there may be several million observations for analysis does not overcome the fundamental data limitation of incomplete, unrepresentative and key missing companies. However, incompleteness and unrepresentativeness does not prevent good analysis from being done when reported with appropriate limitations.  Clearly policy analysts should also follow the Hippocratic oath of Do no harm.  And analysts should be humble with respect to their empirical findings with best available, but compromised, data.

Similarly, suggestions that an empirical finding is “robust” because the underlying data has been tortured in multiple ways and similar results have been found by a number of researchers using the same databases should not be believed if the underlying data is incomplete and unrepresentative.

Working with the best available data is important for continued progress in analyzing BEPS and other issues.  But the old adage of garbage-in, garbage-out still applies.  Another adage could be: cavalier use of “best available data” could be BAD analysis. 

Tom Neubig and Bob Cline

Economic Incidence Analysis of Digital Economy Tax Options

Tax policy analysts may have missed an important incidence analysis in the OECD/G20 BEPS Action 1 Report: Addressing the Tax Challenges of the Digital Economy.  Appendix E.  Economic incidence of the options to address the broader direct tax challenges of the digital economy, p. 275-285. The analysis examines the expected economic incidence of three different taxes designed to impose uniform taxes on both remote and domestic sellers of digital goods and services. The analysis highlights the importance of the market structure of the goods and services in countries in which foreign companies compete without taxable status and the potential response of affected foreign companies to the specific tax policies. 

The Action 1 report concluded that “it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes.” It also noted that key features of the digital economy may exacerbate BEPS risks, many of which could be addressed by proposed BEPS changes in the permanent establishment (PE), transfer pricing, and controlled foreign corporation (CFC) tax rules. The digital economy also raises broader challenges in the areas of nexus, data and characterization for direct taxes (and also challenges for value added tax collections, which will be discussed in a future blog).

The Action 1 report analyzed, but did not recommend, three potential options: (i) a new corporate income tax nexus in the form of a significant economic presence for remote sellers, (ii) a withholding tax on certain types of digital transactions, and (iii) an equalization levy. Countries could introduce any of these three options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties.

In the first half of 2016, Israel and Turkey proposed changes to their permanent establishment rules affecting some companies with "significant digital presence" or with an "electronic place of business", respectively. India enacted a 6% Equalization Levy chargeable on the gross payment for specified digital services and facilities received by a nonresident who does not have a PE in India. (See EY Tax Alert)

Given countries’ consideration of digital economy tax options, the economic incidence analysis of the options is worth highlighting.  The analysis considers the expected economic incidence in open-border economies, but with particular attention paid to the fact that the options represent tax changes only for foreign providers without a permanent establishment (PE) making remote sales of digital goods and services to in-country customers.

“The tax change options are:

·      a corporate income tax on the net income generated from remote sales of digital goods and services to in-country customers by a foreign producer without a PE to which such income is attributed under current law

·      an equalisation levy (“excise tax”) imposed on the remote sales of digital goods and services to in-country customers by the same providers, and

·      a withholding tax on the gross receipts from the remote sale of digital goods and services to in-country customers by the same providers.”

The key policy finding is, given the assumptions, the expected economic incidence of the three tax options for taxing the activities of affected remote sellers related to the sales of digital goods and services by foreign suppliers without a PE would be the same.  In other words, the form of the tax options does not alter the incidence of the new taxes.

·      “In the case of a perfectly competitive market for digital goods and services, the incidence of the corporate income tax increase is likely to be borne by labour in the affected foreign suppliers’ production country and consumers in market countries, depending on the importance of the affected suppliers in the particular market and the availability of replacement suppliers with similar cost structures and the availability of alternative goods and services.

·      If the market is imperfectly competitive, the corporate income tax increase is likely to be borne principally by the equity owners of the affected foreign suppliers.

It should be noted that there will be a difference in the geographic distributions of the tax burdens borne by capital owners, labour and consumers. Any portion of a CIT increase that would be borne by reductions in the income of equity shareholders of foreign suppliers without a PE will occur in countries where the shareholders are located. The distribution of the burden on labour will reflect the geographic distribution of production by the affected suppliers. In contrast, any portion of the tax burden borne by consumers will be spread over market countries where the foreign producers without a PE have market power in setting the domestic price of particular digital goods and services. Therefore, the share of the total worldwide increase in tax burdens borne by consumers, workers and capital owners will vary from country-to-country.

As a final point, further analysis of the economic characteristics of the affected remote producers and the market for particular digital goods and services would need to be analysed to determine whether perfect competition or imperfect competition, in the short and medium term, is the most accurate to use in the incidence analysis. The analysis also does not provide any insights into the distribution of tax burdens by household income levels. In addition, the incidence results for the three tax policy options depend heavily upon the key assumptions about the responsiveness of foreign suppliers of digital goods and services without a PE that will become subject to the alternative tax options.”

Thus, depending on market conditions for the specific services on which the Indian Equalization Levy is imposed, the burden could be borne by Indian consumers in higher prices, IT workers in other countries in lower wages or reduced jobs, and/or global shareholders in lower capital returns.  

Bob Cline and Tom Neubig

Extending OECD's Tax and Growth Analysis to Inclusive Growth

Important new OECD Working Paper (WP), "Tax Design for Inclusive Growth," by four former colleagues at the Centre for Tax Policy and Administration's Tax Policy and Statistics Division. The WP adds critical new dimensions to the prior OECD Tax and Growth work. No longer focused just on economic growth, tax policy and administration designs for both equity and efficiency considerations are discussed.  Many areas for future research are noted.

An important insight highlighted is when tax avoidance and evasion opportunities are closed, the supposed "mobility" of capital is reduced, thus weakening the argument for lower tax rates for "mobile" capital. The OECD/G20 BEPS Project, which will reduce corporate tax avoidance (see OECD BEPS website), and the establishment of a single common global standard on automatic exchange of financial account information  (see OECD AEOI website), while will reduce personal tax evasion, are important tax system changes that will positively affect tax policy for inclusive growth.

Tom Neubig

Future Research Issues for Better Understanding BEPS

Many researchers may have missed a significant contribution of the BEPS Action 11 report identifying important areas for future economic research.  These are some of the questions that arose in the course of the progress made in measuring BEPS.  A good analysis often raises more questions than answers.  Hopefully this report provided both. See the text of the BEPS Action 11 report on pages 122-124 of Chapter 3. 

"Future areas for economic research to better measure the scale and economic impact of BEPS with better data

The mandate for Action 11 included developing an economic analysis of the scale and impact of BEPS (including spillover effects across countries) and actions to address it. This chapter summarises the current understanding of the scale and impact of BEPS based on academic studies, other international organisations’ analyses, as well as some new OECD research. Progress is being made in better understanding BEPS and countermeasures, and the economic analysis show that BEPS is significant and affects many economic decisions of both taxpayers and governments. The issue of BEPS and appropriate geographic allocation of income and expenses relative to measures of value creating activities is important not only to the current corporate income tax, but also would affect other taxes proposed by some academics such as a business cash-flow tax or a comprehensive business income tax.

The current body of empirical research into the fiscal and economic impacts of BEPS demonstrates that the stakes are high, but there is still much further research needed to be undertaken. ... A number of areas for future research beyond the Action 11 mandate but which will add to the understanding of BEPS and MNEs are highlighted, since better data alone will not be sufficient for the best possible analysis of BEPS.

The following are some of the areas where additional analysis is needed:

·      The prevalence and intensity of BEPS. How pervasive are BEPS behaviours? Is BEPS limited to a small number of MNEs or more widespread? Are some MNEs more intensively exploiting BEPS than other MNEs, and if so why (e.g. costs of tax planning, corporate governance, risk profile)? Would largely unrestricted BEPS encourage smaller MNEs to start engaging in BEPS and encourage domestic companies to go global for the BEPS tax benefits?

·      Differences in the profitability of MNEs vs. comparable domestic entities. Are there inherent economic differences between MNEs and domestic entities which make comparisons of ETR difficult? If so, how can competitiveness between MNEs and domestic entities be evaluated?

·      Factors contributing to group profitability. What contributes to the profitability of a global consolidated MNE? How much can be explained by tangible capital, labour and/or sales compared to other factors such as different types of intangible assets, public infrastructure, country risk diversification, etc.

·      Factors contributing to affiliate profitability. What contributes to the profitability of individual MNE entities? How can functions, assets and risks be incorporated in future analyses of BEPS, since they are the basis of arm’s length pricing? How much can be explained simply by tangible capital, labour and/or sales compared to other factors such as the intangible assets of their global MNE, public infrastructure, labour force qualities and stability in a country, etc.? How can these other factors which may change over time be incorporated more fully than just dummy variables?

·      Other tax factors in location decisions. Corporate taxes are only one source- based tax affecting location decisions. How do these other business taxes affect MNEs’ tax decisions? How can measures of profit shifting separate the effects of non-BEPS tax preferences from BEPS?

·      Effects of uncertainty, reputation and compliance costs, and disclosure. Companies face the equivalent of implicit taxes from uncertainty, reputation and compliance costs. Can these be measured and included in the economic analysis of taxes and BEPS? What effects do disclosures to tax administrations have?

·      Mobility of different types of labour and capital. How mobile are different forms of real economic activity, such as top level executives, R&D scientists, production workers, back-office workers, buildings, equipment, different types of intangible assets, etc.?

·      Governments’ strategic behaviours. How do different institutional settings affect countries’ co-operative versus competitive behaviours? How multilateral do agreements need to be to achieve effective co-operative outcomes?

The analysis of BEPS and countermeasures has advanced since 2013, providing more evidence of BEPS and insights into specific BEPS channels and potential effects of BEPS countermeasures. As analysts can only observe the current world with BEPS, any analysis of BEPS and countermeasures must estimate a comparison point, whether it be a world without BEPS, a future world without co-ordinated multilateral action, or a future world with proposed countermeasures. Future analysis of BEPS, MNEs’ BEPS behaviours, and tax competition with improved estimation methodologies are needed to complement improvements in the available data relevant for analysing BEPS and BEPS countermeasures."

Tom Neubig and Bob Cline

How the OECD/G20 Base Erosion and Profit Shifting Project Can Boost US Tax Reform

With the internationally-coordinated OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, as other nations change their tax systems in response to the BEPS Project, the United States can also act to combat base erosion and profit shifting with less concern about loss of competitiveness, jobs and investments.  The additional revenue from stopping income stripping out of the United States, US policymakers make the case for tax reform with a lower corporate tax rate, tough territorial international tax rules, and tax base protection, while leveling the playing field between multinational and Main Street companies, and helping to restore trust in the American tax system’s fairness and effectiveness.  See link to June 8, 2016 op-ed in The Hill by Pascal Saint-Amans and Tom Neubig.

Tom Neubig