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March 12, 2007
Cooperation in European Tax Reform: Why Can't We Be Friends?
by Joann M. Weiner

Full Text Published by Tax Analysts®

Document originally published in Tax Notes International
on March 12, 2007.

As the European Union prepares to celebrate its 50th anniversary on March 25, László Kovács, the EU commissioner for taxation and customs, chose to make his first keynote address in the United States to highlight the importance of cooperation on tax policy and trade. The speech allowed Kovács to illustrate to a U.S. audience how cooperation among the initial six member states was indispensable in expanding the European Economic Community to a European Union of 27 member states with nearly 500 million citizens. Trans-European cooperation works to eliminate the internal barriers to the free movement of goods, labor, capital, and services and to promote freedom of establishment. The commission's new focus on cooperation bodes well for further economic growth in Europe.

Kovács hails from Hungary, a country that last year recognized the 50th anniversary of its revolt against Soviet rule. The revolt failed to topple the regime, and Hungary then suffered under communist rule for another quarter century before regaining its freedom in 1989. Just 15 years later, Hungary and other countries that had been under Soviet domination joined the democracies in the European Union.

The economic prosperity and freedom within the European Union act as a powerful magnet to Hungary and the 11 other countries that have joined the EU since 2004 and to those that hope to join in the near future. The cooperative actions of the EU's members have helped create an unprecedented period of peace for most of Europe. Perhaps given his background, Kovács feels particularly keen to spur greater economic prosperity in the EU.

Cooperation lies at the foundation of the European Union, and the idea permeates many of the European Commission's policies. As established in the Treaty of Rome, six European countries committed to "lay the foundations of an ever closer union among the peoples of Europe." The now 27 member states work tirelessly to create an economic community free of internal trade and tax barriers. The EU has been largely successful in eliminating internal trade barriers, and it continues to work toward eliminating, or at least reducing, external trade barriers.

In the tax area, progress has not been as dramatic or as complete. More than a decade after achieving the single market in 1992, many EU member states continue to erect tax barriers to protect their tax bases at the expense of preventing EU businesses from operating in the most competitive manner possible. Kovács sees one of his primary tasks as dismantling those barriers.

Unlike in the trade area, where the member states have ceded negotiating authority to the European Commission, member states have retained near sovereignty over their national tax policies. Since the commission does not have the authority to set member state tax policy, it must adopt an alternative approach in this area.

Cooperation is the approach the commission has chosen.

Coordinating Reform

In December 2006 the European Commission adopted a communication (COM (2006) 823 final) that proposes coordinating the member states' direct tax systems in the internal market. The overall goal is to ensure that member states coordinate their tax systems to comply with Community law and interact with one another in a coherent manner.

Chart 1. Number of ECJ Cases Involving Direct Taxation,

European Commission, Taxation and Customs Union.

This coordination becomes increasingly important as the member states take steps to adapt their tax policies to decisions from the European Court of Justice, whose decisions leave the member states substantial leeway to transform their EU-incompatible tax laws into EU-compatible tax laws. Unilateral steps, whether through tax or treaty policies, however, cannot eliminate the tax obstacles that exist through the EU.

The commission believes that cooperation is the only way to eliminate these obstacles. The main objectives of the Commission's "coherent and coordinated" tax approach are to:

      1) remove discrimination and double taxation;

      2) prevent unintended nontaxation and abuse; and

      3) reduce the compliance costs associated with being subject to more than one tax system.

As the commission frequently notes, with 27 different company tax systems, the European Union is far from being a properly functioning single market in the field of corporate taxation. Among the many adverse consequences of this incoherent state are that EU enterprises are not as competitive globally as they could be and they are discouraged from investing and operating across internal borders.

The ultimate result from this situation is that employment and economic growth in the European Union are both lower than they might otherwise be. As Kovács indicated, the EU has a long way to go to meet the Lisbon goals of greater economic growth, increased employment, and improved competitiveness. Allowing companies to use a single set of tax rules for their EU operations is one measure the commission views as essential to allowing the internal market to work for the benefit of its businesses.

A Revised Strategy

Since releasing its comprehensive company tax study in 2001, the European Commission has focused its energies in the direct tax area on removing the obstacles that hinder the creation of a true internal market. (The full text of the company tax study is available at This strategy involves short-term and medium-term objectives.

In terms of short-term objectives, the commission released in December two specific communications, one on cross-border loss relief for companies and groups (COM/2006/824) and one on exit taxes (COM/2006/825), along with the broad communication on coordination. The cross-border loss relief measure encourages member states to explore ways to allow companies to offset losses incurred in one member state against profits earned in another member state. At present, only a handful of member states allow cross-border loss offsetting and a few member states do not even allow domestic loss offsetting.

A chief reason for the loss-offset communication is to help member states coordinate their policies in reaction to the ECJ's decision in Marks & Spencer (Case C-446/03), which dealt with cross-border loss relief between companies. The ECJ found that the U.K.'s law that did not allow a U.K. parent to set off the losses of its foreign EU subsidiaries against the U.K. parent's profits infringed the freedom of establishment. Without its guidance, the commission fears that the member states will take an uncoordinated approach to providing cross-border loss offsetting so that the ultimate outcome would be worse than the current situation.

The communication on exit taxes addresses issues raised in de Lasteyrie (Case C-9/02). In that case, the ECJ held that the French tax on the unrealized income of an individual who moved outside of France created an impermissible obstacle to the freedom of establishment. The commission's goal is to coordinate the exit taxes in member states to avoid cases of double taxation and double nontaxation. Coordination is important as the de Lasteyrie decision may also have direct implications for exit taxes levied on companies.

These communications establish short-term measures that member states can take to eliminate some of the tax obstacles in the internal market. The commission's top priority, however, is creating a common consolidated corporate tax base (CCCTB), which it sees as a comprehensive way to eliminate most remaining tax obstacles in the EU. The commission has been working toward this goal for years, beginning with its company tax study in 2001 and continuing since 2004 through the CCCTB working group and subgroups. These study groups involve representatives from all the member states and, when conducted in extended format, academic and business representatives.

The commission has great ambitions for this project. It intends to present a comprehensive legislative proposal for a common consolidated corporate tax base in 2008 and, perhaps, to see it implemented two years later.

Broadly speaking, the CCCTB will allow companies to apply one set of rules for calculating their profits within the 27 EU member states. The CCCTB will be optional for EU companies. However, if they adopt the CCCTB, they will benefit from having a single tax base covering all of their EU operations. Companies that do not adopt the CCCTB will continue to operate with the national tax systems in the member states. Member states will be required to make the CCCTB available to their companies that wish to use it and will have a choice as to whether to continue with their existing tax system in parallel with the new system.

To allow the member states to set their own tax rates, the commission will devise a mechanism to distribute the EU tax base. These mechanisms include using a formula based on macroeconomic factors, such as national product, and the traditional formulary apportionment method based on firm-specific activity. The commission has released two working papers discussing various options for distributing the EU tax base.

ECJ Pressure

The commission has not taken all of these steps voluntarily. The European Union has seen a dramatic increase in taxpayer litigation in national courts and at the European Court of Justice involving situations in which a member state's national tax system violates the EC Treaty. Although EU businesses have not achieved perfect success in these cases, the overriding outcome from the ECJ's decisions in the direct tax area has been to strike down tax measures that inhibit cross-border investment and potentially lead to double taxation. Many have therefore concluded that the ECJ, not the commission, is now the driving force in determining EU company tax policy. Chart 1 shows the dramatic increase in cases involving direct taxation at the ECJ since 1992.

Table 1 lists some relevant cases in recent years dealing with direct taxation.

                Table 1. Selected ECJ Direct Tax Cases

 Year      Case            Name                     Issue

 1986    C-270/83  
Commission v. France       Imputation tax credit
(Avoir Fiscal)

 2000    C-35/98  
Verkooijen                 Dividend exemption

 2000    C-141/99  
AMID                       Cross-border losses

 2001    C-397/98  
Metallgesellschaft.        Taxation of group income;
Hoechst                    advance corporation tax

 2002    C-324/00  
Lankhorst-Hohorst          Thin capitalization

 2003    C-168/01  
Bosal Holding BV           Participation exemption;
                                              parent-subsidiary directive

 2004    C-315/02  
Lenz                       Foreign dividends

 2004    C-9/02    
Hughes de Lasteyrie        Exit tax
du Saillant

 2004    C-319/02  
Manninen                   Cross-border dividend
                                              imputation credit

 2005    C-446/03  
Marks & Spencer            Group relief; cross-
                                              border loss compensation

 2006    C-196/04  
Cadbury Schweppes          Antideferral and
                                              controlled foreign
                                              corporation regimes

 2006    C-170/05  
Denkavit                   Withholding tax on
                                              outbound dividends

 2007    C-29204  
Meilicke                   Tax credits for

 Pending C-492/04  
Lasertec                   Thin capitalization and
                                              non-EU countries

Three cases highlight the ECJ's growing influence: Lankhorst-Hohorst (2002), Marks & Spencer (2005), and Cadbury Schweppes (2006). In each case, the ECJ found a particular feature of member state tax law incompatible with the EC Treaty. In Lankhorst-Hohorst, for example, the court ruled against Germany's thin capitalization regime. In Marks & Spencer, the court ruled against the U.K.'s group loss relief system, and in Cadbury Schweppes, the court ruled against the U.K.'s controlled foreign corporation regime.

The pending decision in the Lasertec case (C-492/04) may present the most important issues for non-EU companies, since this is the first case to address relations in the direct tax area between EU and non-EU countries. Lasertec involves the application of Germany's thin capitalization rules to a German corporation that borrowed funds from a shareholder resident in Switzerland. The company argues that Germany's rules inhibit the free movement of capital provision in the EC Treaty. Unlike the provision concerning freedom of establishment, the free movement of capital provision applies to non-EU nationals and companies. Thus, it is applicable to the capital transfers between the German company and its Swiss shareholders.

Although the logical step from the ECJ's point of view may be to extend the favorable tax rules throughout the EU, the potential revenue consequences of taking such a step may lead member states to react in a defensive manner. The tax authority's primary concern is often to protect the home tax base. The European Court, however, has not been overly sympathetic to that argument and has rejected "protecting revenue" as a justification for a tax law that violates the EC Treaty. To illustrate, the ECJ ruled in the Meilicke case (C-292/04) not only that protecting the national tax system does not justify Germany's legislation, but also that Germany may be liable to taxpayers for refunds of inappropriately collected amounts (see reference to Verkooijen (C-35/98) from 2000).

While each of these cases represents a victory of sorts for the taxpayer, the reactions by the member states have not been so benign. Rather than cooperate and find a coherent solution, each member state has chosen to follow its own path to make its tax rules treaty-compatible. For example, in response to the ruling on thin capitalization, Germany decided to apply its thin capitalization rules to all companies, while Spain took the opposite approach and essentially indicated that it will no longer apply its thin capitalization rules.

Chart 2. Corporate Income Tax Rates in the EU and the
U.S., 2006

To help guide member states through the policy muddle created by the ECJ decisions, the commission takes a new approach in its recent communication. Rather than warning of the dangers of allowing the ECJ to set member state tax policy, the commission addresses matters dear to member state governments. Failure to coordinate responses to the ECJ decisions, the commission warns, could erode member state tax revenues, interfere with their ability to operate efficient and balanced tax systems, and "impact the sustainable financing of member states' social models."

Healthy Dissent

Some observers have expressed concern that it is necessary to guard against tax rate harmonization through tax base harmonization. Once a common tax base is in place, some argue, imposing a common tax rate becomes the inevitable next step. For example, Charlie McCreevy, the European commissioner for internal market and services, has long railed against the commission's tax coordination strategy. Speaking before the Irish Taxation Institute in February 2007, McCreevy argued, "Higher taxes feed fatter government." Although taxation is not his portfolio, Commissioner McCreevy, Ireland's former finance minister, feels comfortable addressing tax issues that affect Ireland and other small, low-tax countries in the European Union.

McCreevy cites Ireland's success in introducing low tax rates that have stimulated economic growth while, somewhat paradoxically, not weakening the tax base. He argues that the commission's plans to create a common tax base will inevitably lead to common tax rates, warning, "Let nobody fool you: Consolidating the tax base is a condition precedent to consolidating the rate." McCreevy apparently does not believe commission officials who stress in every speech concerning company tax policy that tax rate harmonization is not on their agenda. Many appear to view the commission's CCCTB proposals as a Trojan horse for harmonizing tax rates.

Across the Pond

At this point, U.S. businesses are essentially mere observers in the EU's company tax reform project. One area of interest for U.S. businesses may arise in tax rates. As the EU countries have reduced their tax rates to historic lows, U.S. companies may put pressure on Congress to keep U.S. corporate tax rates competitive. For example, as shown in Chart 2, one year ago the U.S. rate was already higher than the rate in every other EU country, a difference that will grow substantially if proposed cuts in the German rate take place.

The two new member states, Bulgaria and Romania, tax corporate income at 10 percent and 16 percent, respectively. The addition of these new member states has appeared to spur rate reductions in the EU-15 member states, with Greece, the Netherlands, and Spain reducing their corporate tax rates in 2007. Perhaps these rate reductions in the EU may end up benefiting U.S. companies in the long run.

As shown in Chart 2, many EU countries have sharply cut their tax rates in recent years. Whereas the U.S. was a relatively low-tax-rate country 20 years ago, it is now a relatively high-tax-rate country.

Breaking Through the Impasse

For an American audience, the internal divisions among European countries presents a curious drama. On the one hand, since the member states must approve all direct tax policies unanimously, smaller countries can effectively oppose actions pursued by the larger countries. On the other hand, the larger member states still effectively control the agenda. Nevertheless, a group of like-minded small countries can effectively block passage of any measures in company tax reform. There is a way to get around this impasse, although the commission is not yet ready to turn to this measure.

The EU Constitution contains a measure known as "enhanced cooperation" that allows a group of roughly one-third of the member states to work together to pursue common interests, subject to certain conditions. Enhanced cooperation loosens the constraint imposed by the unanimity requirement in the company tax area. By recent reports, 20 of the member states either explicitly support the commission's plans or are open to evaluation following release of a specific proposal. Based on these numbers, the commission would seem safe in considering enhanced cooperation a viable option.

At this point, however, the European Commission is sticking to the path of "cooperation and cohesion" by encouraging all 27 member states to work together to implement the measures that will eliminate the discrimination and double taxation that undermine the competitiveness of EU businesses. The commission's view is that any proposal addressed to fewer than all member states would occur only after the commission had made a proposal for all member states to the European Council and a group of member states had explicitly requested action under enhanced cooperation.

Given the well-known Irish objection to the commission's plans, it would appear that the commission is fighting a losing battle. However, the possibility of enhanced cooperation remains open. Should the commission fail to gain unanimous approval of its proposal, it is possible that a subset of member states will move forward and adopt a common consolidated tax base.

After all, if EU companies doing business in these countries truly view Europe as their market, then it is sensible for EU governments to cooperate and offer them a single set of European tax rules. With the compelling arguments in favor of a common consolidated corporate tax base, it is hard to see why the governments in so many EU member states continue to remain opposed to the idea. Rather than seeing a Trojan horse, perhaps these member states are seeing a mirage.

Joann M. Weiner is a contributing editor to Tax Notes International. E-mail:

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