THE OECD S REPORT ON HARMFUL TAX COMPETITION JOANN M. WEINER * & HUGH J. AULT **

THE OECD S REPORT ON HARMFUL TAX COMPETITION THE OECD S REPORT ON HARMFUL TAX COMPETITION JOANN M. WEINER * & HUGH J. AULT ** Abstract - In response to pressures created by the increasing globalization of the world economy, the OECD has issued a report titled Harmful Tax Competition: An Emerging Global Issue that provides an analysis of the phenomenon known as harmful tax competition. The Report identifies factors that characterize tax havens and harmful preferential tax regimes and recommends numerous measures in the areas of domestic legislation, tax treaties, and international cooperation, that countries may pursue to counter harmful tax competition. As part of intensifying international cooperation, the Report recommends that Member countries adopt a set of Guidelines endorsing the 3 R s: to refrain, to review, and to remove. By adopting the Report, Members are agreeing to undertake a political commitment to refrain from adopting new measures or strengthening existing measures, to review existing measures that constitute harmful tax practices, and to remove harmful features of preferential tax regimes within a five-year period. In addition, * International Tax Staff of the Office of Tax Analysis, U.S. Department of the Treasury, Washington, D.C. 20220. ** OECD, Paris, France, and Boston College Law School, Newton Centre, MA 02159. the Report establishes a new international body, the Forum on Harmful Tax Practices, to implement the measures outlined in the Report. INTRODUCTION: THE OECD TAX COMPETITION REPORT The globalization of national economies has increased the challenges of harmful tax competition. In this increasingly integrated global economy, one country s tax policies have a greater potential to impose spillover effects on other countries. While tax competition has many positive effects, and the Report stresses the benefits of fair tax competition, the Report also recognizes that tax policies can have harmful external effects on other countries. The recently released OECD Report on Harmful Tax Competition represents a first step in attempting to curb the harmful effects that may occur when one country s tax policies influence either the policy decisions of another country or the location decisions of financial services and other highly mobile activities. The recommendations presented in the Report set out a 601

NATIONAL TAX JOURNAL VOL. LI NO. 3 number of ways that countries can curb the harmful tax practices that distort trade and investment flows, cause undesirable shifts in the tax burden, impose constraints on governments fiscal choices, increase compliance costs to taxpayers, and undermine the fairness and integrity of tax systems. This Report helps obtain international support for strengthening the unilateral, bilateral, and multilateral efforts against harmful tax competition that will result in improved global economic wellbeing. ORIGINS AND SUMMARY OF THE REPORT In the face of the increased globalization of national economies, the OECD Ministers, in May 1996, called upon the organization to develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases, and report back in 1998. In response to this request, the OECD s Committee on Fiscal Affairs launched its project on harmful tax competition. The project was directed by the Special Sessions on Tax Competition, which prepared the Report under the joint chairmanship of France and Japan. The project garnered high-profile support. At their 1996 Summit in Lyon, the G7 Heads of State endorsed this project, noting that, Tax schemes aimed at attracting financial and other geographically mobile activities can create harmful tax competition between States, carrying risks of distorting trade and investment and could lead to the erosion of national tax bases. The Heads of State urged the OECD to vigorously pursue its work in this field, aimed at establishing a multilateral approach under which countries could operate individually and collectively to limit the extent of these practices. The OECD Council of Ministers released the Report Harmful Tax Competition: An Emerging Global Issue, on April 29, 1998. The OECD Council had approved the Report on April 9, with the abstention of Luxembourg and Switzerland. 1 This paper discusses the recommendations made in the Report and the ongoing work that the OECD will be undertaking in the area of attempting to curb harmful tax competition. It also briefly discusses some implications for the United States. SCOPE OF THE REPORT The Report focuses on geographically mobile activities, such as financial and other service activities, including the provision of intangibles. Although tax incentives aimed at attracting real investment in plant and equipment and savings can also have harmful effects, in the interest of creating a manageable work plan, it was decided to focus the first efforts at the most mobile activities. These represent in some ways the most pressing problem given their relatively high sensitivity to tax rate differentials. In terms of the type of taxes covered, the Report addresses the impact of a jurisdiction s income tax policies on financial investment. Thus, it does not examine how variations in taxation of consumption, labor, or property, for example, may lead to harmful tax competition. Furthermore, although many economic and political factors may influence the location of economic activities, these broad issues were not the focus of the Report. The Report makes explicit the fact that countries must remain free to choose 602

THE OECD S REPORT ON HARMFUL TAX COMPETITION their own tax policies, provided that they abide by international standards in so doing. As a result, policies that one country may view as harmful may not necessarily be viewed the same way by another, nor found to be harmful, under the circumstances outlined in the Report. For example, countries may provide investment incentives to stimulate additional investment. This investment may occur internally, or through attracting foreign investment. Whether these incentives are harmful depends on their design, and the determination must be based on an analysis of all the facts and circumstances. Merely offering a relatively low tax rate is not sufficient to be labeled harmful tax competition. Certain practices, however, can appropriately be termed harmful. Policies that deliberately attempt to divert investment or that serve principally to reduce the tax base of other jurisdictions may be considered as harmful and an appropriate target for elimination. These practices do not reflect different judgments about the desired mix of taxes and spending. By contrast, they represent an attempt to attract savings and investment originating elsewhere or to facilitate the avoidance or evasion of other jurisdictions taxes. Since the problems addressed in the Report are inherently global, the OECD attempted to draw as many non- Member countries as possible into the project. Although non-member countries did not participate in the actual drafting of the Report, the OECD held three separate regional seminars during the course of the project that were designed to involve non-member countries in the dialogue. The Report proposes holding a high-level meeting in 1999 for the purpose of associating non-member countries more closely with the aims of the Report. IDENTIFYING TAX HAVENS AND HARMFUL PREFERENTIAL TAX REGIMES Chapter 2 of the Report discusses the factors used to identify tax havens and harmful preferential tax regimes. The Report does not attempt to identify any particular country regimes, as the point of this Report was to provide an analytical framework for identifying such regimes. Future work, discussed below, will create lists naming actual harmful preferential regimes and tax havens. The Report draws an important distinction between jurisdictions that tax income generally at a relatively low rate, but are not engaged in harmful tax competition, and those where the existence of a low rate is coupled with other factors and special features, which in combination constitute harmful tax competition. Jurisdictions in the first case are countries that collect significant revenues from the income tax, but whose generally applicable effective tax rate is lower than that levied in other countries. Jurisdictions in the second situation, however, are either tax havens and generally impose no or only nominal taxation on income, and thus collect little revenue from the income tax, or are countries with preferential regimes that provide favorable tax treatment in the context of a general income tax system. In the latter case, the tax haven or preferential tax regime has significant undesirable spillover effects on other countries and, as a result, may be categorized as harmful. The Report characterizes these latter two situations as harmful tax practices. Identifying factors that may characterize tax havens is one of the primary objectives of the Report. Tax havens can be described as jurisdictions that have 603

NATIONAL TAX JOURNAL VOL. LI NO. 3 no or only nominal taxation and a reduction in regulatory or administrative constraints, and that refuse to share information with tax authorities, all of which reduce the effective taxation of income located in the jurisdiction. While a number of factors must be evaluated, no or nominal taxation is a necessary condition to identify a tax haven. Other key factors include a lack of effective exchange of information; a lack of transparency in the operation of the legislative, legal, or administrative provisions; and an absence of any substantial activities. An unwillingness by the tax haven to share information not only allows investors to avoid their taxes, but also facilitates illegal activities, such as tax evasion and money laundering. For these reasons, the Report identifies a failure to provide for effective exchange of information as particularly troublesome. Identifying factors that characterize harmful preferential tax regimes is another key objective of the Report. As with tax havens, the Report discusses factors that may help identify such harmful regimes without naming any particular regimes. In general, the preferential tax regimes under evaluation have the effect of diverting income from passive, mobile investment rather than from active, relatively immobile investment. Four key factors help identify these regimes. They include a low or zero effective tax rate on the relevant income, the regime being ring fenced, the operation of the regime being nontransparent, and the jurisdiction operating the regime not effectively exchanging information with other countries. As with tax havens, the first factor to examine is the tax rate. In the case of preferential regimes, the relevant issue is the effective tax rate on the item of income. If a regime applies a zero rate, or if it applies a positive rate but has narrowed the base to such an extent that the effective rate is much lower than the statutory rate, then the regime might be classified as harmful. Once the rate of effective taxation has been identified, then an evaluation of all of the other factors takes place. As with tax havens, a low effective rate of taxation is a necessary, but not a sufficient, condition for identifying a harmful preferential tax regime. All of the factors must be evaluated. Again, lack of effective exchange of information is one of the key factors in identifying a harmful tax policy. Countries may be unwilling or unable to exchange information due to administrative policies, limited access to banking information, or other practices that allow an investor to shield the financial account from potential examination by tax authorities interested in preventing fiscal evasion and avoidance. Lack of transparency is also an important factor. In general, a regime is nontransparent when taxpayers may receive special administrative treatment that allows a particular activity to operate with a low effective tax rate or when the details of the low tax regime are not made available to tax authorities of other countries. If a country operates a regime that is nontransparent, then the tax burden on certain income may be artificially reduced, thus leading to harmful tax competition. With tax regimes, ring fencing is a key factor. A regime is said to be ring fenced when residents are prevented from benefiting from the regime or when nonresidents are prevented from accessing the domestic market. In either case, the country offering the regime is 604

THE OECD S REPORT ON HARMFUL TAX COMPETITION able to protect its revenue base by limiting the tax break to certain areas or certain investors. The Report describes additional factors that should be taken into consideration, for both tax havens and harmful preferential regimes. These include, among others, failure to adhere to international transfer pricing principles, negotiable tax rates or tax bases, existence of secrecy provisions, and regimes that are promoted as tax minimization vehicles. The common characteristic of these factors is that they allow the income to bear a lower tax burden than would otherwise be the case. In the case of both tax havens and harmful preferential regimes, there is no single determinative factor, although low effective taxation is necessary, and each case must be evaluated on the basis of a combination of the factors in a particular context. COUNTERACTING HARMFUL TAX COMPETITION Following the background discussion and the identification of factors to identify tax havens and harmful preferential tax regimes, the Report turns to the means available to counteract harmful tax competition. It provides 19 detailed recommendations in three areas domestic legislation, tax treaties, and international cooperation that, if pursued by OECD countries, will help curb harmful tax practices worldwide. In the area of domestic legislation, the Report recommends actions that will strengthen the efforts that countries can take unilaterally. The recommendations concerning domestic legislation have a similar purpose. By scaling back the tax benefits available to income arising in a tax-privileged setting, countries can discourage the shifting of income to locations due primarily for tax minimization purposes. As with all of the recommendations in this area, the effectiveness of such unilateral countermeasures will be strengthened if they are adopted by a wide range of countries. For example, the first recommendation is that countries consider adopting rules equivalent to the Controlled Foreign Corporation (CFC) rules that 16 OECD Member countries have now adopted. The CFC rules are intended to tax currently the income of multinational investors that is most easily moved. The recommendations encourage countries to extend their CFC regimes to income arising in tax havens or harmful preferential regimes and would coordinate the legislation in terms of their effectiveness in counteracting harmful tax practices. The recommendations concerning tax treaties focus on bilateral efforts countries can undertake to curb harmful tax competition. These recommendations build on the bilateral arrangements already in place between countries. They aim at ensuring that tax treaties are not improperly used to facilitate harmful tax practices. Perhaps the most important of these recommendations is the one concerning greater and more efficient use of exchanges of information. One of the most effective ways to curb tax evasion is to make it clear to investors that relevant information about financial accounts will be shared with tax authorities from the residence country. Another important recommendation in the treaty area is to exclude from treaty benefits those entities or income covered by measures identified as constituting harmful tax practices. Thus, for example, the normally reduced rates of withholding would not apply in 605

NATIONAL TAX JOURNAL VOL. LI NO. 3 situations where harmful tax practices were present. While the Report makes a series of practical recommendations in the area of domestic legislation and tax treaties, the innovative recommendations fall in the area of intensifying international cooperation. These recommendations, in particular the Guidelines, focus on encouraging countries to work together to curb the spread of harmful tax practices, among both OECD Members and non-members. The Guidelines promote the 3 R s : Countries will refrain from adopting new, or strengthening existing, measures; will review existing measures; and will remove the harmful features of their preferential tax regimes. The review period covers two years and the removal period covers five years, both from April 9, 1998, the date on which the OECD Council approved the Report. (An additional two years is allowed for removing benefits to taxpayers currently subject to the preferential regime.) The Report also recommends creation of a Forum on Harmful Tax Practices that will coordinate implementation of the recommendations and guidelines. The Forum will be responsible for monitoring implementation of the guidelines, for drawing up a list of countries that fall into the tax haven category, and for taking forward the wider mandate. THE FORUM ON HARMFUL TAX PRACTICES In some ways, the most important achievement of the Report is the establishment of the Forum on Harmful Tax Practices. This Forum is the first broadly mandated international institutional structure directly responsible for the evaluation and coordination of existing and proposed tax measures. The Forum will perform a number of different functions. During the initial two-year period, the Forum will carry on a series of crosscountry reviews that will provide an overview of how different types of preferential regimes operate and help identify those factors that make them harmful. Countries will be asked to provide details of the operation of generic preferential regimes in their jurisdictions and, if the measures are not classified as harmful in the self-review process, the justification for that treatment. This process will allow the Forum to put reviews of specific regimes in a broader context and ensure that uniform standards are being applied. More important, under the structure set up in the Report, after the initial period of self-review, a country that believes a measure in another country may constitute a harmful tax practice may request the Forum to examine the measure in that country. Under procedural rules to be established, the Forum will apply the criteria set out in the Report and make a determination as to whether harmful tax competition is involved, and may release an opinion on the issues. If a harmful tax practice is found to be present, the measure will be subject to the same requirements regarding listing and removal as those measures identified as harmful in the self-review process. The opinions of the Forum would be nonbinding, as indeed are all of the undertakings in the recommendations. Nonetheless, the existence of an opinion by an international body that a domestic measure is in violation of important political commitments undertaken by a Member country should have a strong impact. In particular, since the procedure will apply to proposed as well as existing measures, it may well discourage the 606

THE OECD S REPORT ON HARMFUL TAX COMPETITION enactment of distorting forms of harmful tax practices. In any event, it gives an additional argument to opponents of these sorts of measures. In addition to its quasi-judicial function, the Forum also will play an important role in providing a setting for improving international cooperation in the areas covered by the Report. This work will extend beyond OECD Member countries and it is intended that non-member countries be associated with the recommendations to the extent possible. This dialogue is an extremely important part of the process and is intended to ensure that the application of the Guidelines by Member Countries will not simply result in the displacement of investment to harmful preferential regimes in non-member countries. One of the first tasks of the Forum will be to draw up a (nonexhaustive) list of jurisdictions meeting the definition of tax haven set out in the Report. That list is intended to allow participating countries to coordinate their policies toward jurisdictions identified as havens. For example, one of the recommendations is to consider the termination of tax treaties with jurisdictions found to be tax havens. The tax haven list would allow that action to be taken on a coordinated international basis. THE EUROPEAN UNION REPORT On December 1, 1997, European Union (EU) Finance Ministers, under the presidency of Luxembourg, agreed to a package of measures to tackle harmful tax competition. 2 This package includes a political agreement on a Code of Conduct for business taxation and a commitment to remove harmful tax regimes as soon as possible following a review process, with exceptions granted under special circumstances. The EU Code and the OECD Guidelines have many similarities, and the EU Members of the OECD worked carefully to ensure that the commitments made under the individual Reports remained consistent. Both Reports share the goal of attempting to limit the harmful effects of tax competition, and each Report attempts to do so in a manner consistent with its institutional framework. However, as the non-eu Members of the OECD did not have a role in the EU Report, the scope and objectives of each project are not identical. Moreover, the institutional structure of each organization influenced the type of recommendations that it was possible to make. Thus, EU Member countries have entered into certain obligations through the EU Report that do not bind the non- EU Members of the OECD. In addition, the OECD Report deals specifically with tax havens and stresses the importance of exchange of information. Taken together, the Code and the Guidelines are broadly compatible and mutually reinforcing. IMPLICATIONS FOR THE UNITED STATES The United States strongly supported the OECD Report for several reasons. First, since the United States already has implemented strong antiabuse measures, by encouraging other countries to adopt strong antiabuse rules in their domestic legislation and their tax treaties, it helps preserve the competitive position of U.S. multinational companies as they increasingly expand their investment worldwide. Second, by recommending that countries improve their exchange of information provisions in their treaties and to review their bank secrecy laws, it helps prevent the tax evasion that is made possible by jurisdictions that fail to 607

NATIONAL TAX JOURNAL VOL. LI NO. 3 provide the relevant information to the tax authorities. Moreover, the recommendation to improve the sharing of information leads to a related initiative, proposed by the G7 Heads of State at the Birmingham Summit, to undertake coordinated international action in curbing money laundering and other financial crimes. This initiative will further assist efforts to eliminate tax havens as a place to evade taxes. Finally, the international efforts promoted by the Report help encourage worldwide cooperation in creating an efficient and fair competitive field for investment. In particular, the Guidelines, under which OECD Member countries undertake a political commitment to eliminate their harmful preferential tax regimes, will help eliminate some of the features of countries tax policies that create the greatest distortions. These features cause a misallocation of investment and may lead companies to choose a location primarily for tax purposes. Conclusions The OECD Report represents a first step toward attempting to halt the race to the bottom that can arise when countries engage in tax practices that have negative externalities on other countries. These adverse effects may take the form of altering the location of investment, increasing the tax burden on less-mobile factors, or encouraging tax evasion and facilitating tax avoidance. All of these effects can be termed harmful as they lead to a misallocation of resources that reduces world welfare below its optimum point. As the OECD s efforts unfold in the next few years, countries may very well see a reduction of these harmful effects and an improvement in the global economic environment. ENDNOTES Any views expressed in the paper are those of the authors and do not necessarily reflect the policies of the U.S. Treasury Department, the OECD, or its Member Countries. The authors thank Jeffrey Owens, Lowell Dworin, and Bill Randolph for helpful comments. 1 The Report was published by the OECD on April 28, 1998, under the title Harmful Tax Competition: An Emerging Global Issue. 2 See Conclusions of the ECOFIN Council Meeting on December 1, 1997 concerning taxation policy, Official Journal of the European Communities (98/C 2/01), January 2, 1998. The Report from the Commission is titled A Package to Tackle Harmful Tax Competition in the European Union. REFERENCES Commission of the European Communities. A Package to Tackle Harmful Tax Competition in the European Union. COM(97) 564 Final, Brussels, 1997. Organisation for Economic Co-operation and Development. Harmful Tax Competition: An Emerging Global Issue. Paris: OECD, 1998. 608