Monthly Archives: August 2016

Running thoughts on EU Apple-Ireland state aid decision

While the storm is raging in wake of the European Commission’s decision in its state aid investigation of Apple’s Irish tax structure, and while we wait for the 130 page decision documentation, here is a log of my thoughts on the issues:

1) This is historic

Before any more analytical thoughts, I must remark that this is absolutely historic. The significance is not to be understated. Although the €13bn is not formally a fine imposed on Apple, the payback order will feel like one to everyone involved. And the amount would be the largest EU fine ever.

But it’s not just the numbers. With this decision, the international tax landscape will fundamentally change. States would certainly become more cautious about granting Advance Pricing Agreements (APAs) for companies, and the normative environment for corporate tax structures would definitely change. Regulatory traction is up, tax risks are up for companies, disputes will be up. A new world indeed.

Apple’s response, as expected, is skeptical, and outlines what it thinks would be the implications:

The European Commission has launched an effort to rewrite Apple’s history in Europe, ignore Ireland’s tax laws and upend the international tax system in the process.

(…)

The Commission’s move is unprecedented and it has serious, wide-reaching implications. It is effectively proposing to replace Irish tax laws with a view of what the Commission thinks the law should have been. This would strike a devastating blow to the sovereignty of EU member states over their own tax matters, and to the principle of certainty of law in Europe.

2) The EU-US tax war is set to reach lava-like heat levels

The European Commission is doubling down on its pursuit of fair tax competition via state aid. The EU-US tax war should be extreeemely interesting after the EC decision.

When the US Treasury last week released a White Paper on state aid, it was clearly a last-gasp attempt to persuade the EC to change its stance on Apple’s Irish tax structure – or else. Repercussions were threatened, in a diplomatic manner of course.

After rumors of a payback order in the range of €0.5 to €1bn, the €13bn finding indicates that the EC in no way sought a compromise solution on their analysis – something which I had certainly expected. They are standing firm on their findings.

Although Competition Commissioner Margrethe Vestager reiterated in her press conference the strong cooperation between the EU and the US in the G20 and OECD forums on tax issues, she also remarked very clearly that, “this is an EU tax issue”, and that she was not positioned to “discuss the US tax code”.

Even so, the EC press release included a snappy retort to the US White Paper, suggesting that the US should not be complaining about the EU state aid investigation, when it could just go ahead and tax the profits themselves! A clear reference to the deferral rules that allow Apple to pile up its.

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3) The EC doesn’t want Apple to pay €13bn to Ireland.

Huh? Yes, that’s correct. Sure, the EC wants €13bn paid, because its analysis finds that is the correct amount of tax outstanding. But it does not want Ireland to collect it all (which Ireland doesn’t want either).

In fact, the EC wants the €13bn distributed among the EU Member States, where Apple’s sales have been located. Also of interest is that the EC opens the door for the outstanding tax to be paid in the US (as noted above).

Both the EC press release and Vestager in her conference emphasised repeatedly – they practically pressed for it – that other EU Member States may seek for Apple’s profits to be allocated to their states, rather than to Ireland:

Furthermore, Apple’s tax structure in Europe as such, and whether profits could have been recorded in the countries where the sales effectively took place, are not issues covered by EU state aid rules. If profits were recorded in other countries this could, however, affect the amount of recovery by Ireland (see more details below).

The EC has not looked into this issue – Vestager was also clear on this. But she was also clear the the analysis provided by the Commission could be beneficial for those ends. In other words, “EU Member States – go ahead and pursue Apple profits using our findings”. As France and others have sought for Google’s European taxes, we might soon see a surge of EU Member States pursuing a share of Apple’s European profits over the past ten years.

Update 1 (31 Aug):

4) Of course Ireland doesn’t want the €13bn

We should not be surprised that the Irish government has immediately appealed the decision. Still, many are. As one Twitter user remarked (sorry, couldn’t find the tweet again), the heavily indebted Irish government will now spend millions on lawyers and years of time to argue that the world’s deepest private pockets should not pay them €13bn.

Why? Because it would ruin the Irish economy. Or so the thinking goes. Ireland has spent years building its reputation as a highly tax competitive investment environment. And whatever you might think of the strategy, it has succeeded in some sense. Apple, Google, Facebook and a host of major global corporations have chosen to invest in Ireland – and it’s not just virtual relocation; the influx has come with plenty of local jobs as well.

If suddenly now the carpet is pulled from under a key component of this strategy (favourable tax rules), the hit to Ireland’s investment attractiveness could be considerable. The added uncertainty and the potentially negative outlook for other companies with special tax deals could mean a serious chill in foreign investment inflows. It might also speed up outright withdrawals of investment. Which in turn could hurt the real economy by making workers less productive, etc. etc.

All of this, of course, is arguable. Does the Irish economy really benefit from foreign relocations when you consider the price paid elsewhere? And is it even fair for Ireland to engage in this kind of tax competition to the detriment of other countries? But from the Irish government perspective, it is clear that maintaining the status quo is the best possible outcome.

Update 2: 3 Sep

5) Does the decision harm state sovereignty?

One of the more prevalent criticisms of the Apple state aid decision is that it harms Ireland’s sovereignty. And that the continued use of state aid rules to clamp down on national tax rulings threatens to harm sovereignty more broadly in the EU. What right does the EU have to reverse an independent, authoritative decision made by a sovereign government to agree on a certain profit allocation for a multinational company? In particular as the EU does not have competence over national direct taxes.

The sovereignty criticism activates a profound concern held by many Europeans that the EU has gone too far, has too much power, meddles too much in national affair (witness Brexit). So it’s no wonder that the state aid decision will be queried in this light.

The criticism rests on a central point: The EC has re-interpreted state aid and international tax law in order to pursue the case. If it hadn’t, it would not be able to leverage state aid rules to prosecute Apple and others. This is the central tenet of critics’ claims, even if it isn’t always recognised outright.

In response, the EC has been clear: We are not infringing national sovereignty, and we have not reinterpreted state aid or international tax law. The EC outlined its approach to tax rulings and state aid in a White Paper, arguing that state aid rules have applied to tax and transfer pricing issues for decades. No new practice, they are saying, just new cases.

In fact, the EC has been hinting that it is enforcing state sovereignty with its Apple pursuits, rather than harming it. The EC has been vocal about the fact that these are not Irish profits to tax; rather other Member States, where the products are sold, and the US, where the IP is held, are entitled to (some of) it. So Ireland has perhaps infringed the sovereignty of those countries.

Which side is right remains to be seen, as the Irish government has now appealed the state aid decision to the European Court of Justice (ECJ) General Court of the EU (thanks hselftax). There are a few possible outcomes:

If, as also the US has argued in the Treasury White Paper, the EC has extended beyond its mandate on state aid, then yes, there is clearly an infringement on sovereignty. I personally think it is unlikely that the Court(s) will find the EC guilty of outright trespassing, as there seems to be a solid basis for undertaking the investigations in the first place – but anything can happen.

Second, if the Courts rule in favour of Ireland on the basis of the substance of the case, rather than the scope of EC’s activities, it will reaffirm that EC has not infringed national sovereignty de jure, even if it may have hurt public trust in the EU institution and its acceptance of sovereignty de facto.

Finally, the Courts could rule in favour of EC, thereby confirming that EC is not infringing sovereignty and has correctly analysed the situation. I note that such an outcome would probably not defuse but spur on criticism of ‘the sovereignty-defying EU’, but in a legal sense that argument would now be wrong.

The Commission has indicated that the Apple state aid decision will be released within the new few months. Once we know more, the real scrutiny will set in…

More to come..
Relevant links:

Discussing discussions around the corporate income tax

The corporate income tax is under pressure. A host of factors have contributed to economic, normative and political discussions on the need for corporate income taxation and its role in the architecture of national and international tax systems.

Among the most persistent calls today is the lowering or scrapping of corporate income tax (CIT) altogether. And that’s not surprising, given that statutory CIT rates around the world have been in free fall for decades:

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Although arguments to support this call are in the media weekly, two recent posts brought them very clearly to my attention. First, Diego Zuluaga, of The Institute of Economic Affairs (a UK free-market think tank), wrote this post in City A.M., the City of London newspaper, arguing that the CIT should be abolished because it discourages investment and incentivises tax avoidance. Second, Scott A. Hodge of TaxFoundation (a US tax policy research organisation) re-iterated arguments that the CIT is harmful to economic growth.

These and other positions are heard often in the debate on corporate income taxation, so it’s fair to examine the arguments and the science behind, which is the aim of this post. I want to break down some of the most prevalent discussions:

Corporate income tax, investment and wages

One central discussion around the CIT concerns its impact on investment and wages. A particularly popular argument comes straight from the neoclassical econ textbook, and is well-established: The CIT discourages investments, harming wages. Capital and investments will flow where the costs are lowest and the returns are highest, relatively speaking. Thus, the higher the CIT, the lower the returns, and thus the less desirable investment climate. If your country has a high corporate tax burden, investors will find it less attractive to invest there. In turn, fewer investments lead to a greater labour to capital share (K/L), meaning workers have relatively less machinery, technology, etc. at their disposal, making them less productive. And since each production factor is rewarded according to their marginal productivity, labour’s wage compensation decreases as a result.

And it’s not just theory. A well-known empirical meta study on these behavioural effects (tax elasticities) tells us that in the average situation, a 1%-point decrease in the effective marginal corporate tax rate will increase the corporate tax base by 0.4% due to intensive investment decisions (e.g. increasing production), and a 1%-point decrease in the effective average corporate tax rate will increase the tax base by 0,65% due to extensive investment decisions (e.g. buying a new plant).

Udklip

On the other hand, there are a few criticisms of the argument. First, tax is only one side of the fiscal coin – expenditure is the other. Wherever there’s a tax, there’s a corresponding expenditure (or saving for future expenditure). So if the corporate income tax is raised, current or future government expenditure increases consequently, or the tax burden is shifted somewhere else, and vice-versa if the corporate income tax is lowered. The actual or potential government expenditure and the structure of the tax burden could raise the investment incentive by increasing returns or lowering risk, for instance via spending on education, infrastructure, technology – and thus if it is de-financed, the effect might be a net deterioration in the investment climate. But that would require detailed contextual analysis. Some studies confirm that CIT rates are relatively unimportant factors in business investment decisions – trumped by market size, human capital, infrastructure, etc. Some studies on the investment effect of CIT deal with the ‘fiscal coin’ issue by investigating long time series (usually 10-20 years) across many countries. Yet, even 20-year timelines may not necessarily be sufficient to reflect public spending or tax burden shift impacts, as it may take several decades for investment benefits, economic growth harms (e.g. from increase inequality) or structural tax shifts to kick in. Still, in the current research, the results are often, but not always, a negative semi-elasticity of investment to corporate income tax:

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Second, even if investment is harmed by the CIT – what kind of investment is it? If it is real, productive investment that is discouraged, it is obviously harmful. If it is virtual ‘on paper’ investment is that is discouraged, it does not hurt the real economy. The latter could be profit shifting, round-tripping investment, or white-washing of black/grey investments. Evidence on the tax elasticity split of these two is naturally extremely sparse, given the difficult task of assessing the ‘real’ or ‘virtual’ nature of investments. Some studies have found that corporate tax incentives are poor at attracting real investments, whilst others argue that there is no relationship at all between low CIT rates and increased foreign investment. Well-known tax economist Kimberly Clausing has also argued that virtual investment re-allocations are far more tax sensitive than real economic activities.

The CIT and economic growth

A related argument, that CIT harms economic growth, is probably the most prevalent and well-analysed position against corporate income taxation. The intensely cited OECD ‘Tax and Economic Growth‘ piece from 2008, also referred to by Hodge, found corporate taxation to be the most harmful tax to economic growth. The conclusion was partly based on a statistical analysis of OECD firm investment levels and corporate taxes 1996-2004. In another study, the OECD compared tax levels with growth rates for 21 countries over 35 years and found that “corporate income taxes appear to have the most negative effect on GDP per capita”. Theoretically, the backdrop is familiar: the CIT causes behavioural distortions (fewer investments, more tax avoidance, etc.), which are harmful to overall output.

As noted above, there may be reasonable questions of the universal “CIT is harmful” thesis in relation to the timeline and the strength of conclusion. Are economic and statistical models sufficiently robust and sensitive to long-term structural evolutions caused by CIT changes, such as the impact of changed public spending levels, inequality (which may also harm growth), to provide clear evidence that the CIT is generally, or even in the average situation, harmful to economic growth? Much of the underlying economic science, based on statistical modelling and econometrics, is taken as evidence of universal laws or generalisable cause-effect relationships, but there are fair questions whether causality is really evidenced. Rather than asking or answering whether the CIT is generally harmful, you might say the more apt question concerns the specific circumstances under which a certain CIT raise or reduction might contribute to economic growth. We know, for instance, that because the CIT acts as a backstop for personal income taxation, at a certain low point, the CIT will facilitate significant tax avoidance as individuals disguise personal income as corporate income. In recent years, even the OECD itself has distanced its 2008 analysis with a more balanced view. Still, we must recognise that a sizable economic literature today holds that the CIT is, generally, harmful to economic growth.

Second, again parallel to above, even if the CIT harms economic growth – what kind of growth is it? If national output growth is based on proceeds from paper shifted assets, the real economy impact might be negligible. If it’s based on actual economic activity shifts, then the story is different. There are reasons to believe real economic activity is less sensitive to tax than virtual capital re-allocation, as noted above. And if that is the case, then lowering the CIT rate merely facilitates an international negative-sum tax competition game, based on virtual capital reallocation, harmful to overall world welfare.

Moreover, it is well-established that CIT rate cuts harm national inequality, as tax burdens are shifted from capital onto labour and consumption, which is usually less progressive, and as public spending (where less wealthy citizens are often the target) is cut. Thus, economic growth from CIT cuts might come at the cost of inequality, less social cohesion and democratic harm.

The question of incidence

A third common discussion on the corporate income tax is its incidence. Who bears the burden of the corporate income tax? Some might find that a strange question, but in economic theory, the corporation is merely an intermediate vehicle. In the end, all flows move through the corporation and end up elsewhere, as dividends to shareholders, as products and services to customers, as wages to employees, etc. When speaking of the CIT incidence, the debate is usually whether it is labour (in the form of lower wages) or the shareholders (in the form of lower dividends or retained earnings) that bear the brunt of the burden. The answer to that question is instrumental to both economic, normative and political assessments of the corporate income tax. If, for instance, it falls primarily on labour, a CIT reduction could well be quite progressive; if it falls mainly on capital (shareholders), it is more likely to be regressive (depending on who those shareholders are).

Hodge’s post and the WSJ essay cited both argue that “workers bear the true economic burden of the corporate income tax through reduced wages.” This is a popular sentiment, and is usually employed in arguments for reducing the CIT. And certainly, scientific support is abundantly available. Theoretically, the incidence depends on the elasticities (yes, that word again) and mobilities of the production factors. In a modern open economy, capital is said to be more able than labour to ‘escape’ the tax incidence, by shifting investments abroad, thus reducing the marginal productivity of labour and incidentally leaving them to bear the burden. Empirically, you can pick any of a long list of studies that find labour’s share of the burden in an open economy to be significant (e.g. 1, 2, 3)

Both the theory and the empirics here are simplified, of course. Corporate tax incidence is highly complex and context-dependent, with differences in the short-, medium, and long-term, but there is no doubt that a large literature supports the notion that labour bears the main burden of corporate taxation.

On the other hand, you can find an equally large literature to support the notion that capital bears the main burden of corporate taxation. Yes, that is correct. Again, there are variations in the way incidence is studied and theorised, but there is a similarly long list of studies available (e.g. 12, 3). In short, the argument here is that capital is not always more mobile and flexible than labour, partly because the ability of capital to ‘escape’ may have been decreased over time due to more sophisticated regulation.

In other words, there is a fundamental lack of consensus in the economics literature on the incidence of corporate taxation. There is no reasonable argument that the burden “clearly falls on labour”, nor that it “clearly falls on capital”. The only likely agreement is that there is some split, which is difficult to define and is context-dependent.

Corporate taxation and profit shifting

A final discussion, invoked by Zuluaga amongst others, is the extent to which the corporate tax burden incentivises tax avoidance. The argument that it does so significantly is, again, based in economic theory, as well as empirics. The CIT lowers the rate of return, and thus capital will flow elsewhere – a part of which will be virtual financial re-allocation (profit shifting). As De Mooij and Ederveen’s table 4 shows above, they empirically estimate that a 1% increase in the statutory CIT rate will decrease the corporate tax base by 1.2% due to profit shifting. The 1.2% estimate is based on a number of longitudinal and cross-sectional studies, mainly from the OECD countries or North America in the 1980s and 1990s. Whether one can generalise based on such evidence is, as discussed above, probably questionable. Still, there are many studies with similar findings. And the effect of profit shifting is obviously less corporate tax revenue, and thus public spending cuts or the shift of the tax burden to other areas.

On the other hand, and as noted elsewhere, over the past decades regulatory tightening of corporate profit shifting may have contributed to a notable reduction in the profit shifting elasticity. Subsequent international reforms have contributed to the lessened ‘virtual mobility of corporate profits. The OECD certainly seem to think so, at least. Furthermore, even if the elasticity is still substantial, ongoing reform attempts will likely squeeze the slipperiness more and more, so that in the future we might expect the effect on tax avoidance of corporate income taxation to become less and less important. So while lowering or abolishing the CIT might be advocated as one way to reduce tax avoidance, there are clearly regulatory alternatives, which may be more prudent.

To sum up: the impact of corporate income taxation on investments, wages, growth and profit shifting are hot, important and contested, and for each debate there are clear arguments for and against. Again and again, we see these arguments being used selectively by different discussants in debates. But it is important to maintain some balance. Ultimate claims on the “truth” about corporate income tax and the science behind it are simply untrue – there is no one answer. The state of our knowledge on these topics are not so that we can conclude decisively on cause and effect, unfortunately. Still, science can bring us far, and we should employ the best research available. But we should employ it with caution. I think we would all do well to keep that in mind.

September 2017 update: To all of the above, I think it is worth adding a recent discussion in economics on the nature of the contemporary economy, in particular economic concentration, and its impact on the investment, wages, growth and incidence. A number of economic researchers and commentators (1, 2, 3) have noted recently that the contemporary economy is marked by significant and increasing economic concentration and monopoly power. This has important implications for economic theory and reality on corporate taxation. In particular, monopoly power indicates that capital forces are able to extract significant rents from the economy. In turn, this might indicate that the incidence of corporate taxation falls more heavily on capital (shareholders), and less heavily on labour, which may also require a re-thinking of the economic effects on wages, investment and wages.

The quiet BEPS revolution: Moving away from the separate entity principle

For the longest time, international law has treated multinational enterprises (MNEs) as consisting of separate, independent units, rooted in separate national jurisdictions. Apple’s US corporate headquarters is distinct from its Irish holding company, which is distinct from its local national subsidiaries – even though they are all part of the same multinational group. Their reporting compliance and tax liabilities are, to a large extent, manifested separately at the country-level.

This ‘separate entity’ principle resonates throughout international taxation. It is, in particular, the basis of the entrenched arm’s length standard (ALS), the notion that related-party trade should accord to market terms.

The OECD/G2o BEPS (Base Erosion and Profit Shifting) project is, however, fundamentally challenging the separate entity principle. Stronger CFC (controlled foreign corporation) rules (Action 3) will manufacture formal links between group entities located in high-tax and low-tax jurisdictions. Tightened interest deduction rules (Action 4) will mandate group-wide formulas for thin capitalisation. Expanded use of the profit split method in transfer pricing (Actions 8-10) will put pressure on the ALS. And new transfer pricing documentation and country-by-country reporting (CBCR) obligations (Action 13) will provide tax authorities with more and better information on corporate group structures and value chains.

This trend is not a BEPS noveltyz Rather, the BEPS project underscores and accelerates a trend that has been emerging and increasing over the past 10-20 years in particular. There has been, and continues to be, a gradual move towards treating MNEs as unitary structures, rather than distinct fragments.

Interestingly, it is one of the more inauspicious regulatory innovations that provides the best illustration of the BEPS challenge to the separate entity principle: reporting mechanisms.

How can something so trivial be so crucial? Let’s take a step back first. Back in 2015, when the OECD, the G20 and a host of other stakeholders were discussing country-by-country reporting, one contested question was: How and where are companies going to submit their reports to tax authorities? Civil society groups wanted companies to file locally in all jurisdictions where they operate (e.g. to accommodate developing countries), while business lobbies advocated headquarter filing in the parent country of residence (to ensure more ‘trustworthy’ tax administrations would gatekeep the data). The eventual outcome was somewhat of a compromise. Parent-HQ filing was chosen as the primary filing mechanism, but the agreement also built in a secondary mechanism, a ‘safety valve’ of sorts. Thus, in the February 2015 recommendations on BEPS Action 13, the OECD introduced this:

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And in the June 2015 Implementation Package, the secondary mechanism was detailed further. Here, we learnt that a subsidiary may be required to file the CBCR if:

a) the parent is not required to file in his home country, or
b) international information exchange or treaty sharing agreements are insufficient for the report to be exchanged from the parent company home country, or
c) there has been a “systemic failure” by the home country as regards the report.

In other words, if, for one of the stipulated reasons, a tax administration is not able to obtain the CBCR of an MNE with a subsidiary in its jurisdiction from another country’s tax administration, the tax administration in question can request the CBCR to be filed locally, by the subsidiary.

Make no mistake: This is groundbreaking. The UK HMRC and the Danish Skat can now force Apple’s local subsidiaries to obtain and provide extensive information on its global taxation and economic activity, in case they cannot procure that information from the US IRS due to a failure on the part of the US legislature, Apple, the IRS or the treaty system. And the same goes for developing country tax administrations.

But this is extraterritorial jurisdiction, surely? An espoused phenomenon in international law and international relations, a threat to the SOVEREIGNTY of nations. We are, after all, requiring purely local managers to provide information beyond the geographic boundaries of their authority, no? How would they even have access to that information?

Except, remember, we are moving towards treating MNEs as unified entities, not as disjointed networks. Therein consists the BEPS challenge to existing international law.

And this challenge is clearly on display. I want to highlight two ways in particular we can observe this:

Firstly, national law-makers are questioning whether it is even constitutional for them to enact or enforce this legislation. As EY note, in the context of the EU implementation of the BEPS agreement:

Certain Member States had expressed concerns that they may not be in position under their legal systems to require the full information of a given group from a subsidiary that cannot obtain or acquire all the information required for fulfilling the reporting requirement.

In the EU context, the proposed solution is to allow subsidiaries to file partial information (what they have available), while countries maintain the right to penalise non-compliance in such instances. But other countries have already implemented the BEPS regulation, which they may or may not be able to actually enforce, both practically and legally.

Secondly, and perhaps most blatantly, the secondary mechanism has led to panic among US multinationals. Why? While other countries have implemented the BEPS Action 13 requirements for financial years starting 1 Jan 2016, as agreed, the US has only required its companies to file for financial years starting 1 Jan 2017, to give an extended adjustment timeline. So there is a very real possibility that US multinationals, many of which have a lot of foreign subsidiaries, will be required to file locally for FY2016.

In response, the US has sought to allow voluntary filing of CBCR reports by US MNEs for FY2016. The proposed US regulations specify:

The Treasury Department and the IRS intend to allow ultimate parent entities of U.S. MNE groups and U.S. business entities designated by a U.S. territory ultimate parent entity to file CbCRs for reporting periods that begin on or after January 1, 2016, but before the applicability date of the final regulations, under a procedure to be provided in separate, forthcoming guidance.

The US is not alone, though. Recent OECD guidance on voluntary filing notes that also Japan and Singapore face similar issues.

The fact that OECD felt the need to issue guidance on such an otherwise trivial topic, and that American, Japanese and Singaporean MNEs are pushing for voluntary filing, underlines the dilemma created by secondary filing. There would be no push for voluntary filing if the secondary mechanism wasn’t seriously threatening existing standards within international law. Increased compliance burdens from expanded reporting requirements was the main criticism of multinationals in response to BEPS Action 13. So it should make us pause that they are now mobilising to voluntarily report to the IRS above and beyond their legal obligations.

But the secondary filing mechanism is just one or many streams pushing for a change in the perception and legal treatment of MNE groups. The ultimate push in this direction is, of course, unitary taxation, which would allocate tax based on the total consolidated worldwide income of MNEs.

What all these developments have in common is that they point in one direction: Increasingly, we will likely see legislation adjust to the new “reality”, that multinationals are not loosely connected collectives but rather more closely integrated enterprises.