General Directorate Economic and Financial Affairs Workshop on. Corporate Tax Competition and Coordination in Europe

Transcription

1 General Directorate Economic and Financial Affairs Worksop on Corporate Tax Competition and Coordination in Europe Brussels, 25 t September 26 Centre Borscette, 36 rue Froissart, 14 Brussels Room A Reforming te Taxation of Multijurisdictional Enterprises in Europe: a Tentative Appraisal Marcel Gérard European Commission Directorate-General for Economic and Financial Affairs Unit E-3 - Labour markets, taxation and quality of public finances BU-1-2/199 B-149 Brussels - Belgium Fax: copyrigt rests it te autor

2 fucam - FACULTES UNIVERSITAIRES CATHOLIQUES DE MONS ARPEGE Atelier de Recerce sur la Politique Economique et la Gestion de l Entreprise REFORMING THE TAXATION OF MULTIJURISDICTIONAL ENTERPRISES IN EUROPE, A TENTATIVE APPRAISAL Marcel GERARD * ARPEGE / FUCaM Catolic University of Mons, Belgium Ucl, Cesifo and Idep Summary In 21, te European Commission proposed replacing te current system of taxation of multinational companies by te taxation of a consolidated base, computed at te level of all te European entities of a multijurisdictional enterprise, and ten distributed for taxation purposes beteen te various jurisdictions in ic tese entities operate, according to pre-establised criteria. In tis paper, e propose a tentative appraisal of tat reform based on a case study and an analytical exercise. We especially focus on to related issues, te coice of te formula and te composition of te consolidating area eiter te entire EU or some Member States itin an Enanced Cooperation Agreement, and on teir impact on te size and interjurisdictional distribution of tax revenue and social elfare, and on te intensity of tax competition. Our tentative policy conclusion is tat tis paper supports te reform provided tat (1) te formula puts empasis on criteria tat te firm may not too easily manipulate, (2) te activities of te multijurisdictional enterprise are enoug mobile, (3) te consolidation is made compulsory itin te consolidating area, and (4) te consolidating area protects its capacity to actually levy tax by adopting a crediting system vis-à-vis te rest of te orld. JEL: H32, H73, H87 Key ords: multinational enterprises, multinational companies, multijurisdictional enterprises, European taxation, tax consolidation, tax competition. * Pofessor of economics and taxation at Fucam, te Catolic University of Mons, Belgium, and te Louvain Scool of Management, Louvain-la-Neuve, CESifo Fello and member of IDEP. Tis text is based on a researc started in te fall of 24 at te Office of Tax Policy Researc of te University of Micigan and completed during stays at Queen s University, Kingston, Ont., and CESifo, Munic, made possible of a grant from te Belgian Fonds National de la Recerce Scientifique and te generosity of CESifo. Te stimulating ospitality of Robin Boaday as ell as valuable suggestions and comments by Tiess Buettner, Carola Maggiuli, Alexander Klemm, Mattias Mors, Nicole Prieur, Jean-Pierre Vidal and Frans van Istendael are gratefully acknoledged. Address for correspondence: gerard@fucam.ac.be

3 3 1. Introduction In our increasingly global economy, te taxation of multijurisdictional 1 enterprises, in sort MJE s, as become a key callenge for tax designers. Tey are confronted it a tofold reality. On te one and te organisation of te tax system as to secure te capacity for sovereign jurisdictions to levy taxes at rates and on bases determined by tem, toug possibly coordinated troug a netork of bilateral tax treaties or multilateral tax arrangements. On te oter and, more and more mobile firms, illing to settle brances or subsidiaries all over te orld, complain against te complexity and diversity of tax systems, and simultaneously develop a capacity to reduce teir tax liabilities troug te more and more extensive use of sopisticated tax planning strategies. And indeed te present organisation of interjurisdictional taxation, primarily based on a model proposed by te Oecd (see Oecd, 1996) and tereafter called Separate Accounting or SA, provides te various jurisdictions it, apparently, te poer to make sovereign decision on taxation, but oever it as at least to undesirable outcomes: first, it forces te companies illing to operate in many jurisdictions to learn as many tax codes, and second, it allos tose companies to undertake various tax sifting strategies in order to minimise teir tax liabilities. Tose undesirable outcomes are especially present in te European Union. Te first one is even considered as a main tax obstacle to te operation of te Single Market (European Commission, 21). Te second one is, in te EU, often exacerbated by te principle decision tat no EU jurisdiction may be considered as a tax aven by oter European jurisdictions provided its tax system applies in a non discriminatory ay to every EU taxpayer. Te issue for EU tax designers is ten, more tan elseere, to find out a system ic simultaneously removes te tax obstacle mentioned above and is compatible it te principle of subsidiarity leave as muc poer as possible to national autorities and te tax sovereignty of national parliaments. Terefore, in te fall of 21, te European Commission (21, 23) suggested replacing te current system of taxation of MJE s, based on separate taxation of different national entities 1 Trougout tis paper e use te ord multijurisdictional instead of multinational basically because te concept beind te former encompasses tat in te latter, like jurisdiction encompasses nation. Since our main application is to te European Union, e tink tat its appellation makes especially sense: te EU today is more integrated tan just an economic union of sovereign states toug it is not a true Federation ic could justified te use of te term multi-state.

4 4 in a group, by te taxation of a consolidated base calculated at te level of all te European entities in a group, and ten distributed for taxation purposes beteen te different jurisdictions in ic tese entities operate, according to pre-establised criteria. In so doing, it proposed replacing a typical system of tax relations beteen sovereign states it a mecanism tat is more caracteristic of tax relations itin a federation; suc a system is, e.g. applied in te United States to tax companies operating in several States, and in Canada to tax a given company operating in more tan a single province, tus itout consolidation across companies for lessons for Europe from te US and Canadian experiences see Hellerstein and McLure (24), Weiner (25) and Martens-Weiner (26); on te US application of te system, see also Goolsbee and Mayde (2). Tis system, ic as in te meantime been examined and discussed by experts and by te parties concerned, certainly as te great advantage, providing it is sufficiently idespread, of putting an end to a certain number of tax strategies ic MJE s find it in teir interest to practice. As son in te seminal ork of Gordon and Wilson (1986) and te studies motivated by te planned reform in Europe see e.g. Sorensen (24) tat reform could, oever, and under some conditions, increase tax competition beteen States. More specifically, one can so tat te effect of tis cange on tax competition is ambiguous, it te intensification of tax competition being all te less (viz. more) probable if te formula adopted for te distribution of te consolidated taxable base beteen te jurisdictions concerned gives less (viz. more) empasis to a criterion over ic MJE s ave control, suc as te geograpic distribution of investment, production or employment, and mess (viz. more) empasis to a criterion over ic tose firms ave no or little control, suc as te distribution of demand, and tus of sales destinations see e.g. Gérard (25a). Terefore te selection of te formula is a key political decision. Te EU Commission also proposed, as an intermediate step in te ay to consolidation and formulary apportionment, in sort C&FA in te sequel of tis paper, to allo for international compensation of losses beteen companies operating in te EU and belonging to te same MJE for an analysis see Gérard and Weiner (23, 25) and Weiner and Gérard (24). In tis article, e propose a tentative appraisal of te move from separate accounting based taxation, SA, to consolidation and formulary apportionment, C&FA. We especially focus on

5 5 to related issues, te coice of te formula and te composition of te consolidating area eiter te entire EU or some Member States itin an Enanced Cooperation Agreement, and on teir impact on te size and interjurisdictional distribution of tax revenue and social elfare, and on te intensity of tax competition. Our tentative policy conclusion is tat tis paper supports te reform provided tat (1) te formula puts empasis on criteria tat te firm may not too easily manipulates, (2) te activities of te MJE are enoug mobile, (3) te consolidation is made compulsory itin te consolidating area, and (4) te consolidating area protects its capacity to actually levy tax by adopting a crediting system, possibly extended to accrued capital gains troug anti-cfc rules, visà-vis te rest of te orld. For te ease of te exposition, e build up a case study of interjurisdictional investment 2, tat e use in sections 2 to 4. In section 5, e repeat and extend te discussion using an analytical model. 3 We suggest tat te reader suspicious it respect to a presentation based on a case study, reads section 5 first or simultaneously. In bot te case study and te analytical exercise, our approac can be regarded as te use of a multi-step game. In tat game, tere is a single MJE and tree jurisdictions. Te single MJE as to distribute a fixed amount of investment beteen te only to jurisdictions able to ost real activities, in order to satisfy a final demand, exclusively located in tose to jurisdictions and ose size and distribution is fixed. Te tird jurisdiction osts a financial centre and offers a relatively lo tax rate. Te tree jurisdictions are located itin te European Union and none can be considered by anoter as a tax aven. Depending on te economic environment, te MJE may decide to manage various forms of intra-firm trade and to cannel financing and profits troug te tird jurisdiction, possibly using intermodal finance. Steps 1 to 3 caracterize te part of te game played under te SA system, steps 4 and furter te part of te game played under te C&FA ypotesis. Te reader can easily relate tose steps to te istory and development of te European Union. 2 Tis example expands tat in Gérard (25b). 3 A complete version of te model may be found in Gérard (26).

6 6 In step 1, governments observe te initial distribution of te activities of te MJE and tat of te demand for its product, as ell as te economic environment and te institutional arrangements. In step 2 tey play non-cooperatively in order to determine tax rates ic maximise te elfare of teir on jurisdiction, anticipating correctly te beaviour of te MJE. In step 3 te MJE adapts to te ne set of tax rates. Ten, in step 4, all or some jurisdictions may decide for adopting C&FA and tose o adopt tat reform decide cooperatively on te formula to be used to apportion te common tax base in tat respect our ypotesis differs from Wellisc (24); tat difference is justified by te decision process in tax matters itin te EU: unanimity prevails except en an Enanced Cooperation Agreement is set up by some Member States. Next, in step 5, governments revise teir tax rates, again non-cooperatively; e call tat stage maybe improperly tax competition: actually it is a stage ere jurisdictions revise teir tax rates egoistically, in te sole best interest of teir on residents, and for te sake of simplicity e assume tat steps 4 and 5 occur simultaneously. In step 6 te MJE adapts its beaviour to te ne setting. Economic environment is primarily caracterized by te degree of mobility of te MJE. We consider to suc environments. In te first one, te MJE is deemed to be one-degree mobile, by ic is meant tat it only decides on te distribution of its investment, ic implies tat of production and employment tus it takes only a real decision. Ten only to jurisdictions are concerned. In tat setting, if te distribution of investment cosen by te MJE is suc tat production in one jurisdiction exceeds demand in tat jurisdiction, intra-firm trade is conducted using an exogenous at arm s lengt transfer price. In te second environment, te firm becomes to-degree mobile or even n-degree mobile. A to-degree mobile MJE decides on to variables, te distribution of its real activities on te one and, and anoter variable, called a paper variable, on te oter and. Tat oter variable may be e.g. te transfer price or te fraction of te investment and repatriated profit ic is cannelled troug te tird jurisdiction on tat last issue see also Mintz and Smart (24). In any case, tat second variable migt be a source of paper profits. Combining te distribution of real investment it more tan one suc additional variable, e produce an n-degree mobile firm and actually e ill investigate up to a tree-degree mobile MJE.

7 7 Moving to C&FA en te MJE is one-degree mobile enables to find out te best formula for apportioning te common tax base beteen te to concerned jurisdictions. We set fort tat tey ant to maximise te elfare of te residents of teir jurisdiction. Tat elfare depends on bot te consumption of public goods financed troug tax revenue and on tat of private goods made possible by te location of real investment on te territory a question beind is: are te governments primarily interested by attracting tax bases or are tey also by attracting real investments? Hoever, en te MJE is more tan one-degree mobile one can cope it more advanced issues including political economy issues related to decision taking mecanism in Europe. Especially, suc questions like te adoption of te reform at unanimity by all te EU Member States vs its adoption by some itin an Enance Cooperation Agreement, are on te agenda on tat latter topic see also Bordignon and Busco (26). We sould add tat ile C&FA does not make taxation neutral as regards decisions by a MJE (only complete armonisation of effective tax rates could acieve tis), it does, oever, form part of te solution of eliminating tax obstacles to economic activity, notably because of its implications in terms of common rules on constituting te tax base and, upstream, on accounting (see for instance Jacobs et al., 25). Moreover, it can easily be combined it subsidiarity, a principle tat is at te eart of te ole organization of te European Union. Also te introduction of a tird country, possibly remaining outside te consolidation area, paves te ay for tinking about te most efficient geograpic area to consider MJE tax coordination. Te organisation of te paper is as follos. After tis introductory section, e consider an economy ere te MJE is one-degree mobile and tus only alloed to take real decisions, in a SA setting section 2; ten only to jurisdictions are concerned. In section 3, te MJE still operates under SA but it is alloed to make paper profits, being successively to- and ten tree-degree mobile ; in tat latter case, tree jurisdictions are concerned, due to a possible lucrative detour. In section 4 e investigate te move from SA to C&FA in te different settings considered so far. Toug sections 2 to 4 are based on a case study, section 5 proposes a discussion of te reform using an analytical model; tat section first reconsiders

8 8 te case of te one-degree mobile MJE, ten tat of te to-degree mobile MJE. A sort summary of te investigation and policy-oriented conclusions are proposed in section 6. In addition to te contributions already mentioned, interesting papers on related topics are numerous. Let us mention Eggert and Scjelderup (23), Nielsen et al. (23), Petig and Wagener (23), Eicner and Runkel (26) and Riedl and Runkel (26), and in Frenc Gérard (23). 2. Real decisions under separate accounting In tis section e assume tat te MJE is one-degree mobile. It operates in a situation of separate accounting and it adopts real strategies only, by ic is meant strategies tat imply canges in te location of real investment or activities, as opposed to decisions aimed at getting paper profits. Governments ave observed te initial distribution of investment and te distribution of demand all te investment and production is initially located in te ome jurisdiction and demand is equally distributed te to jurisdictions, tey kno te economic environment and te institutional arrangement, SA, and tey ave cosen te tax rates. No te MJE is in searc of te distribution of its investment and production activities tat provides it it te largest possible value. We are tus at step 3 of te game. Folloing a pattern made popular by Devereux and Griffit (1998), en te company realises tat it as a foreign market, to options are open to it: exporting to tis market and establising a local facility tere. Tis facility ill initially be a permanent establisment, and ill ten become a subsidiary. In te latter case, te parent company ill finance it eiter by buying ne sares issued by te subsidiary or making a loan to tat company. In tat subsidiary, te MJE ill first produce for te sole foreign market, ten for bot markets, keeping oever a distribution entity at ome, ten conducting intra-firm trade beteen te production foreign subsidiarity and tat entity, at regular transfer price. We assume tat te to countries only differ in tax rates and initial endoment in production capacity.

9 Producing at ome and exporting Once te company realises tat it can produce not only for its ome market but also for a foreign market, it can decide to produce in its ome country and to export to te foreign country. Let us assume, ten, tat te firm builds to factories side by side, eac one representing an investment I of one million euro, capable of producing eac year 1, boxes at a unitary cost of c = 1 euro, and tat it ill sell tese boxes directly to final consumers at a retail price of to euro, p = 2, on eac one of tese markets. Let us assume tat te corporate tax rate in te ome country is 34 per cent, τ =.34. Bot investment projects are obviously equally profitable. Wit a discount rate r of five per cent, a long time span and te ypotesis of te absence of any inflation and risk, te folloing net present values are obtained 2 1 NPV = NPV* = ( 1.34) 1, 1,, = 32,.5 (1) M p c NPV = 64, = 2 ( 1 τ ) q I r ere te * designates te plant operating for te foreign market, and superscript M refers to te MJE. Te first line of Table 1 belo first reports te discounted flos of before- and after-tax profit for te firm, obtained from summing up te NPV and te amount of investment. Ten it gives te amount of tax revenue for te ome country government, or jurisdiction. Te after-tax discounted flo of profits of te MJE is deemed to measure its Value. Te statistics under te figure of te after-tax profit of te MJE is te standard average effective tax rate, t = M M ( NPVbt + I ) ( NPV + I ) NPV ere subscript bt refers to a situation before taxation and te absence of subscript to a situation after taxation. 4 M bt + I (2) 4 E.g. (4,,-2,64,) divided by 4,, is.34.

10 1 Te figure in te penultimate column of Table 1 gives te tax revenue of te ome country. Suc a figure provides te value of te objective function of te government of tat jurisdiction if it is Leviatan. Unlike tat, if it is committed to maximising te elfare of te residents of its jurisdiction, assumed to depend on te consumption of public goods financed troug te amount of tax revenue, and on te consumption of private goods made possible by te real activities located in te jurisdiction, e need to compute te value of a social elfare function. For tat purposes, suppose tat 6 percent of te production cost consists of age cost and use tat amount as a proxy for te consumption of private goods permitted by te investment. Adding tat latter amount to tat of tax revenue provides us it a measure of te social elfare effect of te investment. 5 Tat value is indicated beteen brackets under te amount of tax revenue ile e figure out in italics te amount of private consumption. Producing at ome and exporting Permanent foreign production est. After-tax profit of te MJE 2,64, t =.34 2,72, t =.32 Table 1 A single legal facility Home country tax revenue (social elfare) priv. cons 1,36, (3,76,) 2,4, 68, (1,88,) 1,2, Foreign country tax revenue (social elfare) priv. cons () 6, (1,8,) 1,2, Aggregate tax revenue (social elfare) priv. cons 1,36, (3,76,) 1,28, (3,68,) 2,4, In tis table, and in te ole exercise conducted in tis paper, e identify te taxable profit and te value of te sales less te costs of production and distribution, tus te before-tax profit. Tat means tat depreciation alloances and oter tax sields are not explicitly introduced. We do not ignore oever tat tey can play a key role in te corporate decision en based on tax comparisons; a simple ay to introduce tem in tis exercise is to reinterpret te tax rates as effective rater tan statutory rates. 5 In te analytical development in section 5, e ill explicitly introduce a cost of public funds and a sado age, on tat matter see Boaday and Bruce, 1984.

11 A permanent establisment abroad No let us add te ypotesis tat te tax rate cosen by te government of te foreign country is loer, say τ f =.3. Tis derives from te fact tat, being initially poorer in investment and employment since all te production of te MJE is concentrated in te oter jurisdiction, tat jurisdiction is more aggressive in te tax competition game tis is in some respect a Ne Economic Geograpy argument. For te MJE, te question of o to benefit from tis rate is raised. A permanent establisment is a dependent facility ic does not ave its on legal status, and ic terefore operates under te legal cover of te company establised in te ome country. Hoever, it does ave a sufficiently stable and permanent activity to be taxed in te country in ic it is establised. 6 If te conditions governing a permanent establisment are satisfied, te profits obtained by it sall be taxed tere, it no possibility of double taxation in te ome country. Te MJE ill transfer to tat foreign country te production of goods destined for tat country no cost is associated to tat operation ere, but suc a cost ill be introduced in te analytic part of te paper. Tat is te case illustrated by te second line in Table 2. Given te difference in tax rates beteen te to countries, te company s value, measured by its aftertax profit, ill improve. Te last column of te Table gives no te aggregate amount of tax revenue over te to jurisdictions and, in parenteses, te total amount of social elfare. Te differences in te company s value observed in te above table may be reflected in differences in te average effective tax rate A foreign subsidiary Te next step is to turn te permanent establisment into a subsidiary. Unlike a permanent establisment, a subsidiary as its on legal status, most often tat of a company resident in 6 Te concept is explained in international tax la, notably in Article 5 of te international model tax convention aimed at preventing double taxation proposed by te OECD (OECD, 1996).

12 12 te country ere it is establised, in tis case te foreign country. It is terefore taxed in tis country. To ays for te parent company financing its subsidiary abroad are considered tereafter, buying ne sares issued by te subsidiary or making a loan to tat company. In te first case dividends are repatriated, in te second one, interests and, possibly, dividends too. We disregard accumulating profits in te affiliate. In case of dividends e need to examine te to mecanisms designed to avoid teir so-called economic double taxation one taxation at te level of te paying affiliate, anoter taxation at tat of te parent company. We ill end up tat sub-section by also locating abroad te production facility tat produces goods for te ome market; in tis case, e suppose tat te MJE maintains a distribution facility at ome to ic te production facility sells its products at an at arm s lengt internal price Repatriating dividends: exemption Te Directive of 23 July 199 governing te circulation of dividends beteen parent companies in te European Union first states tat, under conditions ic e assume to be satisfied, dividends cannot be subjected to a itolding tax in te country in ic tey are paid. Additionally te Directive provides Member States it to options. One is exemption: at most five per cent of te cross border dividends can be taxed in te country of residence of te company receiving tem (te parent company). In tis case, given te ypotesis of maximum distribution of profits as mentioned e intentionally discard te idea of te accumulation of profits in te subsidiary e get, assuming tat te 95 per cent exemption rule applies, 2 1 NPV = ( 1.34) 1, 1,, = 32, NPV* = ( 1.5 (.34))( 1.3) 1, 1,, = 376, 2 (3).5 M NPV = 696, 2 ; t =.326

13 13 As a result of tat limited additional taxation in te country of residence of te parent company, te taxable profit can be sligtly larger tan te before-tax one and te average effective tax rate, sligtly iger. Tis additional tax may be regarded as a tax on te privilege tat consists of te subsidiary being incorporated in its on country, ence reducing te risk for te parent company because of te legal independence of its subsidiary. Tis system as an economic property, knon as capital import neutrality: if te rate of additional taxation is zero, te value of te subsidiary is independent of te origin of te capital financing it. An immediate corollary is tat in suc a system, te location of subsidiaries is at is important, not tat of te parent company. Consequently, tax competition beteen countries ill focus on attracting subsidiaries Repatriating dividends: crediting Te oter option provided by te Directive (and outside te EU tis is te practice in countries suc as te U.S. but also Australia, Canada, U.K., Ne Zealand and many oter) is crediting: te parent company sall be taxed on te group s global profits, but taxes levied outside te borders, itin te European Union, sall be credited to its tax liability up to te amount oed to its country of residence. Consequently, equation (3) is as follos 2 1 NPV = ( 1.34) 1, 1,, = 32, NPV* = ( 1 max (.34,.3)) 1, 1,, = 32, (4).5 M NPV = 64, ; t =.34 and in tis case, since te foreign tax rate is loer tan te national rate, e are back in te initial tax situation. As far as economic properties are concerned, tis system may be capital export neutral: if te foreign tax rate does not exceed te rate in te parent company s country of residence, te group s value does not depend on te geograpical distribution of its subsidiaries. An immediate corollary of tis observation is tat in suc a system, te location of te parent company in te country of loer taxation is, all tings being equal, likely to raise te value of te MJE. Consequently, tax competition ill focus on attracting parent companies or, ere appropriate, intermediate olding companies.

14 14 On te contrary if te tax rate in te subsidiary s country exceeds tat of te parent company tere may be capital import neutrality according to te definition in te preceding point Repatriating interest If te investment in te subsidiary as financed by a loan from te parent company, te latter may receive interest tat, in most tax systems, is deductible by te company tat pays it and taxed in te case of te company receiving it. To comments must be made, oever. First, most countries apply a itolding tax on te payment of interest. As it is generally loer tan te corporate tax rate and tax treaties provisions provide for its crediting, it can be ignored. In fact it ill be ignored all te more readily since European Union legislative developments provide for its disappearance itin multinational groups. Second, financing by loans is limited by measures aimed at averting tin capitalisation of companies e assume tat e are not in tis situation ere (if e introduce tis aspect, e ould ave to resort to mixed financing, and e ould not learn anyting ne from tis) and use of non at arm s lengt interest rate; due to tat latter condition e limit te interest to five per cent of te investment, te excess of profit over tat amount being repatriated as dividends, assuming tat exemption is at ork as it is mostly te case in Europe no. Terefore, 2 1 NPV = ( 1.34) 1, 1,, = 32,.5.5 NPV* = ( 1.34) 1,, ( 1.5 (.34))( 1.3) 1, 1,,.5.5 1,, = 348,1 NPV M = 668,1 ; t =.333 (5)

15 Producing abroad for te ome market Te MJE discovered tat producing goods abroad as fiscally more advantageous tan producing goods on its ome territory. It ill quite naturally consider locating abroad te production facility tat also produces goods for its ome market. In tis case, let us suppose tat it maintains a distribution facility at ome to ic te production facility sells its products at an internal price. In tis case Article 9.1 of te OECD s international model tax convention binding te to countries (tere is also a European treaty along te same lines) obliges it to practise arm s lengt (olesale) prices for intra-group transactions beteen te foreign production facility and te ome country distribution facility. Let us set tis price at p = 1.6 and split te unit costs and te investment beteen.8 for te production and.2 for te distribution. Tis concentration of production abroad improves te company s value and loers te effective tax rate it must pay, as can be seen from te equations belo and te last line in Table 2 furter on, calculated on te basis of a ypotesis of financing by sares in a situation of 95 per cent exemption, NPV = ( 1.34) 1, 2, = 64, NPV* = ( 1.5 (.34))( 1.3) + 1, 1,8, = 677, (6) NPV M = 741,16 ; t =.3147 Te four situations looked at above can be compared by revisiting Table 1; tey replace te second line see Table 2. Tis clearly sos tat (1) te decision regarding te metod of financing, and ence of repatriation of profits, is not independent of te location of te entities concerned and ence of te geograpic distribution of tax rates; (2) tis decision as an impact on te distribution of te tax revenue of te countries concerned; (3) te decision of relocating te entire production abroad also increases te value of te MJE and impacts on te distribution of tax revenues beteen te jurisdictions; and (4) te level of private consumption in te ome jurisdiction te figures in italics amounts to 2,4, in te first line, ten it is equally

16 16 distributed beteen te to jurisdictions, 1,2, in eac, till te last line, but relocating te production in te foreign country limits oever tat component of te social elfare to 24, in te ome country ile it goes up till 2,16, in te foreign country. Producing at ome and exp. For. Subsid. sares/exemption For. Subsid. sares / crediting For. Subsid. Loan Total production abroad After-tax profit of te MJE 2,64, t=.34 2,696,2 t=.326 2,64, t=.34 2,668,1 t=.333 2,741,16 t=.3147 Table 2 A subsidiary abroad Home country tax revenue (social elfare) priv. cons 1,36, (3,76,) 2,4, 73,8 (1,93,8) 1,2, 76, (1,96,) 1,2, 1,31,9 (2,231,9) 1,2, 178,84 (418,84) 24, Foreign country tax revenue (social elfare) priv. cons () 6, (1,8,) 1,2, 6, (1,8,) 1,2, 3, (1,5,) 1,2, 1,8, (3,24,) 2,16, Aggregate tax revenue (social elfare) priv. cons 1,36, (3,76,) 2,4, 1,33,8 (3,73,8) 2,4, 1,36, (3,76,) 2,4, 1,331,9 (3,731,9) 2,4, 1,258,84 (3,658,84) 2,4, Once again, an immediate corollary emerges from te inspection of tat Table: only te equalisation of effective tax rates can ensure neutrality of taxation in terms of te location of subsidiaries and of parent companies, and ence in terms of te distribution of tax revenue beteen te countries concerned. Various combinations of tax parameters may obtain tat equalisation of effective tax rates, but te simplest ay of doing tis is to use identical metods of composing te tax base and to equalise te statutory tax rates. Most studies in literature stop at tis lesson see Bénassy et al. (2, 25), Grubert and Mutti (1991, 2), de Mooij et Ederveen (23), forgetting tat MJE s often pursue more complex strategies and are establised simultaneously in more tan to countries a contrario, Grubert (24) and Gérard and Gillard (24) explicitly consider tax planning strategies. 7 In te next section, e ill try to go beyond tis limit by examining transfer pricing strategies, and ten financial detour strategies. 7 Mintz and Weicenrieder (25) and Weicenrieder (26a, b) propose an empirical investigation of te use of profitable detours by German firms; related studies include Klassen et al. (1993) and Mintz (24).

17 17 At tis stage of te paper, te reader interested by an analytical investigation of te issue examined so far ill no go to section 5.1.1, and ten come back to tis point. 3. From real to paper profits in a system of separate accounting To ays at least are available to add papers profits to te value of te MJE obtained so far. In te first one, te MJE engages in internal transactions involving its entities and implying eiter internal trade at a price cosen by it for strategic reasons, ic must ten be justified, or management fees and related instruments, ic are often easier to use. In terms of te game described in te introduction, e are again in step 3 but it a to-degree mobile firm. In te second situation, te MJE replaces te direct investment and revenue flo circulation it an indirect circulation involving a tird, lo-tax, jurisdiction, but located in te territory of te EU, and intermodal finance, by ic is meant e.g. tat a flo of interests is turned into a flo of dividends itin a passive entity located in te tird jurisdiction. In terms of te game, te MJE is to-degree mobile if e consider cannelling profits troug a tird jurisdiction only, or tree-degree mobile if e combine manipulating te transfer price and cannelling profits troug a tird, lo-tax, jurisdiction Manipulation of transfer prices Te company remember tat it is supposed to produce abroad including for te ome market could ten take te risk of distancing its internal transfer price from te arm s lengt price in order to boost its taxable profit in te jurisdiction it te loest tax rate, in tis case te foreign country. Suppose tat it raises tis price from 1.6 to 1.79, a value ic minimises te overall MJE tax liabilities toug it keeps te tax bases positive in bot jurisdictions e ten speak about optimised transfer price. In tis case, equation (6) becomes

18 NPV = ( 1.34) 1, 2, = 186, NPV* = ( 1.5 (.34))( 1.3) + 1, 1,8, = 938, M NPV = 751,838 ; t =.312 ic is used to produce te figures of te fourt (penultimate) line of Table 3. (7) One important comment is tat te extra profit te MJE obtains in tis ay and tis ill be te case troug all tis section is pure paper profit since it arises from a cange in te sole company s financial strategy itout real investment beind it. Hoever, tis gain is not itout risk. Te country of residence of te distribution unit, in tis case merged it te parent company, could reject tis difference compared it te arm s lengt or full competition price and carry out at is called a primary adjustment, in oter ords re-calculate te taxable base on its fiscal territory using te arm s lengt price as te purcase price for te product. Te foreign jurisdiction, ic te company ill ten ask to carry out a correlative or secondary adjustment re-calculating in turn its taxable base using te arm s lengt price ill eiter agree to tis or refuse depending on eter or not Article 9.2 of te OECD s international model tax convention is included in te convention beteen te to countries. In te event of te application of te European treaty on transfer pricing, a negotiated solution ill ave to be found A lucrative detour We can no suppose tat te MJE discovers tat tere is a jurisdiction itin te EU tat taxes corporate profits at a very modest rate of, say, 14 per cent. Tis country does not constitute a market for te company s product or a place ere it could produce it, but it ill certainly ost a passive facility oned by tis group, say a financial centre. It must be noted tat tis tird country must belong to te European Union, oterise te passage of a financial flo troug its territory could be said to be a detour via a tax aven, depriving te parent company of te benefit of te exemption on te taxation of dividends. 8 8 On te economics of tax avens, interested reader ill see Mongrain, Marceau and Wilson (26) and Slemrod and Wilson (26).

19 19 Te detour ic te MJE ten comes up it is as follos: rater tan subscribe to ne sares in its foreign production subsidiary, it ill subscribe in te same amount to sares in a passive subsidiary in te tird country ic, in turn, ill lend te amount collected to te production subsidiary. As already mentioned, financing by loans is limited by measures aimed at averting tin capitalisation of companies and e assume tat e are not in tis situation ere; oever interest payments are limited to 5 per cent of te investment, since te market rate of interest is deemed to be of 5 per cent. Te profit in excess over interest payment is directly cannelled to te parent company as dividends, again it application of te 95 per cent exemption rule. Tat detour can be named intermodal financing. If tis detour is applied to te previous situation, equations (6) and (7) become, respectively: NPV = ( 1.34) 1, 2, = 64,.5.5 NPV* = ( 1.5 (.34))( 1.14) 1,8, ( 1.5 (.34))( 1.3) + 1, 1,8,.5.5 (8).5 1,8, = 96, 264 NPV M = 1,24,264 ; t =.2439 and NPV = ( 1.34) 1, 2, = 186,8.5.5 NPV* = ( 1.5 (.34))( 1.14) 1,8, ( 1.5 (.34))( 1.3) + 1, 1,8, ,8, = 1, 221, 742 NPV M = 1,34,942 ; t =.2413 (9) We can even apply te detour strategy to te financing of te production investment in te ome jurisdiction. Ten equation (8) becomes

20 2.5 NPV = ( 1.5 (.34))( 1.14) 2, ( 1.34) 1, 2,.5.5 2, = 11, 76.5 NPV* = ( 1.5 (.34))( 1.14) 1,8, ( 1.5 (.34))( 1.3) + 1, 1,8, ,8, = 96, 264 M NPV = 1, 61,34 ; t =.2347 (1) ic is still better for te MJE. In tat case te manipulation of transfer price ill not be used still it generates no furter gain. Only tat last strategy is reported in Table 3, last line. Producing at ome and exp. For. Subsid. sares/exemption Arm s lengt price Optimised transfer price Arm s lengt price and detour Table 3 A MJE engaging in tax strategies After-tax profit of te MJE 2,64, t=.34 2,696,2 t=.326 2,741,16 t= ,751,838 t=.312 3,61,34 t=.2347 Home country tax revenue (soc. elf.) priv. cons 1,36, (3,76,) 2,4, 73,8 (1,93,8) 1,2, 178,84 (418,84) 24, 54,162 (294,162) 24, 68, (38,) 24, Foreign country tax revenue (soc. elf.) priv. cons () 6, (1,8,) 1,2, 1,8, (3,24,) 2,16, 1,194, (3,354,) 2,16, 54, (2,7,) 2,16, Tird country tax revenue (soc. elf.) priv. cons () () () () 28, (28,) Aggregate tax revenue (soc. elf.) priv. cons 1,36, (3,76,) 2,4, 1,33,8 (3,73,8) 2,4, 1,258,84 (3,658,84) 2,4, 1,248,162 (3,648,162) 2,4, 888, (3,288,) 2,4, Tree observations can be made en examining Table 3, ere te first tree lines come from Table 2, te tird one (Arm s lengt price) reproducing te last line of tat Table (Total production abroad), especially en comparing te last line it te tird one. First, itout making any ne real investment, bot te MJE and te passive facility s country obtain a substantial gain (especially te MJE effective tax rate sarply declines). Second, te geograpic (re)distribution of te private and public components of te social elfare is

21 21 canged differently: te country of te foreign active facility is deprived of alf of its tax revenue but not at all of its private consumption. Tird, and tis is a consequence of te second observation, a distinction must be made beteen competition beteen jurisdictions to attract real investments (active facilities) and competition to only attract tax bases, including paper profits. Te latter as a corollary of prime significance: te tax sacrifice to ic a country consents in order to attract a real investment can be infinitely expanded simply by te existence of a jurisdiction tat is attractive for tax bases. In tis case, te foreign country attracted te active facility by offering a tax rate of.3 instead of.34, but te advent of a tird jurisdiction as ad te effect tat te tax rate is effectively muc smaller:.15 instead of.3. Of course, tese tax strategies, te effects of ic are son clearly in Table 3, ould be irrelevant if te effective tax rates ere identical across jurisdictions. Finally, let us still notice tat te MJE could decide not to repatriate its profits to te parent entity in te ome jurisdiction, but instead to use te entity in te tird jurisdiction as a base for accumulating profits and re-investing tem in oter affiliates of te group. In tat latter case, te MJE ill save te.5(.34) taxation of dividends in te ome jurisdictions; ten its value ill gro and te tax revenue and elfare level in te ome jurisdiction decrease accordingly. Wat appens to tese observations if taxation based on a separate accounting mecanism is replaced by tax consolidation accompanied by te distribution of te consolidated tax base beteen te jurisdictions concerned, according to a pre-establised formula, is te topic of te next section. Prior to reading section 4, te model-oriented reader can go to section Moving to Consolidation and Formulary Apportionment As stated in te introduction, in te autumn of 21, te European Commission proposed a substantial modification as regards te manner of taxing MJE s operating on its territory, justifying tis cange by te need to put an end to tax obstacles to economic activity in Europe. Te proposed system, similar to te one practised in te United States and in oter federal countries, for te taxation by te federation members of companies operating on several of te members territories, consists of to stages. First, a consolidated base is calculated using common rules applicable in all te federation members; adapted to te EU,

22 22 tat may mean eiter using te rules applicable in te Member State of te parent jurisdiction or a set of rules specifically determined at EU level for MJE s. 9 Second, tis common base is distributed beteen te members concerned according to a pre-establised formula, it eac member taxing its sare at te rate it intends to practise. In te United States, te distribution formula is based on properties, payroll and gross receipts from sales. In Canada, ic does not apply consolidation, apportionment is based on payroll and gross revenue. It sould be noted tat criteria tat are completely independent of te company migt be cosen, suc as te respective relative area or population of te States, or even teir sare in te common value added. Te cangeover to consolidation and formulary apportionment discussed belo corresponds to step 4 of te game presented in te introduction. Hoever e do not explicitly consider steps 5 and 6 in tis main part of te paper, but ell in te model developed in section 5. Eliminating step 5 turns out to decide at step 4 for a formula, ic rules out any ne race to te bottom for te tax rates, and to assume rate increases politically infeasible. In suc a frameork tere is no reason to reconsider location decisions and disregarding step 6 is te relevant. Again e relax some of tose restrictions in te matematical model in section 5. Tereafter, and more importantly, e first assume tat all te jurisdictions consider entering te consolidation area. Ten e suppose tat te tird jurisdiction remains outside tat area, eiter because it decides not to participate or because te MJE as te option to keep te entity located in tat jurisdiction outside te consolidation perimeter All te jurisdictions enter te consolidation area In te last situation encountered in te previous section, te one combining a manipulated transfer price it a lucrative detour, tere ere tree taxable bases, one in eac jurisdiction, ic e denote respectively as B, tat of te parent company s country of residence, tat of te country of te foreign active unit, and B, tat of te tird country k B f, 9 It seems tat te EU experts ill propose te first solution for small- and mediup-sized enterprises and te te second one for large enterprises.

23 B = 1, +, 5( 1.14) 1,8, , 5( 1.3) + 1, 1,8, B f = + 1, 1,8, (11) B k =.5 1,8,.5 C&FA implies first moving from tree to a single tax base, ten apportioning tat single tax base Consolidation Wen consolidation is conducted, not only tax bases are summed up, but also all intra-firm flos are cancelled out 1. As a consequence neiter te value of te transfer price used for intra-firm trade nor te detour still ave any effect on te consolidated tax base, ic ere amounts to B FA = 2 1, = 4,, (12).5 tus again 4,, if discounted at a 5 per cent rate over te long run. Te property obtained is tat consolidation erases te interest of adopting strategies relating to te manipulation of transfer prices and detours via tird units. One comment must be made, oever: as e ill see later, tis important argument in favour of consolidation does not old unless consolidation is compulsory and adopted by all te Member States of te European Union. If a facility, for instance te tird country facility, remains outside te consolidation perimeter, ten all te strategies remain possible. Tat comment is especially important for te case ere some EU Member States sould ant to adopt Consolidation and Formulary Apportionment itin te frameork of an Enanced Cooperation Agreement tis is not a reason per se to reject suc an Agreement, but it sos te need to be careful about its consequences. 1 Actually it is so only in case of complete or full consolidation, at e assume ere. Diversity oever is observed among EU Member States since some of tem ic already apply interjurisdictional consolidation actually do not cancel e.g. intra-firm flos of dividends.

24 Formulary Apportionment Te criteria of formulary apportionment can generate eigts tat te company ill find more or less difficult to control or manipulate. We ill consider four possibilities ere. First, te investment criterion involving 9 per cent 1,8, out of 2,, in te State of te foreign active facility and te balance in te State of te distribution facility, ic is also tat of te parent company. Since investment decisions are in te company s poer, it can be said tat tis is a criterion controlled by te MJE. If tis criterion prevails, te company ill continue to decide on te location of its investments on te basis of taxation. Not only ill tax competition continue, but also maybe it ill increase since te attraction of investments ill again mean te attraction of a taxable base. Te same occurs if te criterion is payroll, especially ere ere payroll is strictly proportional to investment; terefore e ill disregard tat criterion in tis paper. Next, te criterion of final sales understood as sales to outside te company and in line it te principle of destination involving 5 per cent in te parent company s jurisdiction and 5 per cent in tat of te foreign market. It can be supposed tat since te distribution of sales is partly or totally driven by tat of demand, te company does not control tis criterion or in any case controls it less. Ten, for a jurisdiction, attracting te company to its territory as no implications for tax revenue provided tat sales are not affected of course it is quite a different story if attracting investment stimulates local sales and te effect on tax competition migt be reduced see te analytical section belo for a formal analysis. A tird rule consists of taking an average of investment and sales. Since payroll is strictly proportional to investment ere, tat criterion is equivalent to te average of payroll and sales uses e.g. in Canada on te properties of te Canadian formula, see Weiner (25) and Martens-Weiner (26). Lastly, e ill take a quite arbitrary criterion: since te company is establised in tree jurisdictions, eac one of tem as te rigt to tax one-tird of te consolidated base. Notice tat criteria exogenous to te firm like te distribution of te population or tat of GDP are, in tis discussion, encompassed by tat of final sales assumed to be not controlled by te firm.

25 25 Table 4 illustrates te impact of eac one of tese criteria. To produce tat Table, te after-tax Net Present Value of te MJE is computed according to te equations belo, [ ] [ ] [ ] NPV NPV B M M FA3 = bt.34(.1).3(.9), investment = NPV M bt = NPV M bt FA3.34(.5).3(.5) B, sales FA3.34(.3).3(.7) B, average M = NPVbt ( ) FA3.34(1/ 3).3(1/ 3).14 1/ 3 B, equal (13) Several comments must be made in tis respect in relation it te MJE and from te point of vie of te jurisdictions. In relation to te MJE, it can be seen tat tat (1) regardless of te formulary apportionment criterion used, te MJE is in a more favourable situation in te ne system tan en onedegree mobile and taxation based on separate accounting second line but it is in a less favourable situation tan if en more tan one-degree mobile under cover of separate accounting tird line; 11 (2) te more eigt given by te criterion to a loer rate of taxation, te loer te average effective tax rate to ic te enterprise is subjected. Tus, recourse to te sole criterion of investment, giving precedence to te active country ere te tax rate is lo (te attractive country for real investment), leads to loer effective taxation of te MJE tan te sole criterion of sales, ic gives equal eigt to te to jurisdictions ere active facilities are establised. And te last line loers te effective tax rate by bringing in a jurisdiction it a particularly lo rate. From te point of vie of te jurisdictions, it can be seen tat (1) te tax revenue of te jurisdictions is affected considerably by te formulary apportionment criteria used, ile private consumption is not (as long as distribution of real activity is not revised) generally speaking, looking at te situation it te detour via a tird country, te cangeover to a C&FA system produces to tax revenue inners (except for te last line) and one tax revenue loser among te States concerned ; (2) but oever, global tax revenue is iger so tat it may be supposed tat compensation beteen jurisdictions could be organised and consist of side payments likely to induce te tird country to become involved if unanimity is required. 11 Tat te after-tax profit of te MJE under C&FA, sales antepenultimate line is larger tan its after-tax profit under SA second line is entirely due to te 95 per cent upper limit to te exemption mecanism introduced in te computation; in case of full exemption, te to numbers are equal.