In Europe’s tax race, it’s the base, not the rate, that counts
In late November, members of the American Chamber of Commerce gathered at the Four Seasons hotel in Dublin for a Thanksgiving lunch of roast turkey and pumpkin pie and a declaration of hospitality from Ireland’s finance minister.
“We’re a friendly country for investors and one of the key elements of the friendliness of the package is the 12.5 per cent tax rate,” Michael Noonan said. “I want to tell you once more, that’s not negotiable.”
Noonan’s comment alluded to attempts by some fellow European Union countries to persuade Ireland to increase its official corporation tax rate, one of the lowest in the developed world. The 12.5 per cent rate, Irish politicians often say, is core to Ireland’s ‘brand’ as an investment location.
But low headline taxes are just one reason companies like to base themselves in Ireland, and not even the most important. Many of the multinationals gathered at the Four Seasons that day pay far less than 12.5 per cent tax, their accounts show. Ireland helps them do this by generously defining what profit it will tax, and what it will leave untouched.
And it’s not just Ireland. The amount of profit a country taxes - commonly known as the tax base - has been shrinking for multinationals in many European countries over the past decade or so, experts say, a fact easily lost in talk about headline rates. Countries have found that reducing the base - agreeing to not tax some profits that a company makes - helps attract firms and, they hope, jobs. But as recent protests against corporate tax avoidance in Britain highlight, voters are beginning to question that tactic. If taxpayers see governments helping companies to avoid taxes, it could hurt their ability to tax everyone else.
That is a point made by the Organisation for Economic Cooperation and Development, a Paris-based club of rich economies, which last week called for an overhaul of the entire international corporate tax system.
Most national tax rules pre-date the widespread rise of multinationals, it said, and desperately need to be updated. Perhaps the most pressing concern is the tax base.
“The problem of the tax base is clearly more important than the tax rate,” says Sven Giegold, a German Member of the European Parliament (MEP) for the Green Party and a member of the EU parliament’s Committee on Economic and Monetary Affairs. “And that’s, interestingly, exactly the opposite of the public debate.”
The situation is particularly severe in Europe, a single market of more than 500 million people. Tax competition is a global phenomenon but European countries are especially vulnerable, because EU rules bar members from hindering capital flows.
Multinationals which set themselves up in smaller countries such as Ireland, Luxembourg or the Netherlands can pay low taxes, not just on profit earned in those places, but also on that earned in much bigger markets such as the UK or Germany. And sometimes, they may not have to pay any tax at all on profits earned in those bigger markets. Their host countries allow them to send it offshore to tax havens.
“This is a huge problem in the EU because you have a common market but you have 27 different corporate tax systems,” said Kimberly Clausing, a Professor of Economics at Oregon’s Reed College who specialises in corporate tax avoidance.
If you look at headline tax rates alone, you might think tax competition in Europe had ended. Between 1980 and 2007, average EU corporate income tax rates fell from more than 45 per cent to almost 25 per cent, according to data from the OECD and the EU. Since then, though, they have shed just one percentage point.
But the more stable headline rates say nothing about how countries define a company’s tax base. Take, for example, the Netherlands, which has a history of tax leniency dating back 120 years. Today, its headline corporation tax rate of 25 per cent is actually above the EU average. But by being selective about how it defines taxable profit, it offers many firms a much lower effective tax rate, tax advisers and executives say.
The country allows foreign companies to reduce their taxable profit by making payments to affiliates for loans, the use of brands and other services, said Kees van Raad, Professor of International Tax Law at the University of Leiden. And while many other countries charge withholding taxes on such payments, the Dutch usually do not.
Tax deals are often agreed in advance with companies that are considering basing themselves in the Netherlands, so they know where they stand.
That was the experience of coffee chain Starbucks, which established its European headquarters in Amsterdam in 2002. The company received a ruling which gave it a “very low” tax rate, Troy Alstead, the company’s Chief Financial Officer, told a UK parliamentary committee in November, although the firm declined to provide further details. In 2011, Starbucks’ European headquarters declared a pre-tax profit of just 500,000 euros (HK$5.2 million) on sales of 73 million euros (HK$755.5 million). Starbucks says it follows the tax rules of all the countries where it operates. The Dutch tax authority declined to comment.
Some tech firms shift much bigger amounts. Amazon.com’s main operating unit, based in Luxembourg, faced a headline tax rate of 30 per cent. But for 2011 it managed to report a taxable profit of just 29 million euros (HK$300.1 million) on 9.1 billion euros (HK$94.2 billion) of sales at its Luxembourg-based EU headquarters by paying hundreds of millions to a tax-exempt affiliate, which is also based in Luxembourg.
Such policies mean firms like Amazon - which employs many thousands of people in France, Germany and the UK, and has billions of dollars of sales in these countries - don’t have to declare any profits there. Instead, it can apportion almost all its European profits to an office of 200 people in Luxembourg City.
The Luxembourg tax office declined comment. Amazon said it abides by the tax rules in every country where it operates.
Similarly, Google’s international headquarters in Dublin made tax-deductible payments to a Bermudan subsidiary via a Dutch affiliate. The arrangement is known as a “Double Irish Dutch sandwich”: the Irish-registered entity cuts its taxable profit by paying a Dutch affiliate, which pays a subsidiary in a tax haven. Using a Dutch affiliate means withholding taxes don’t have to be paid.
In 2011, Google Ireland reported taxable profit of 24 million euros (HK$248.4 million) on turnover of 12.5 billion (HK$129.4 billion). Its Bermudan unit was responsible for “substantially all” of the group’s US$8 billion (HK$62.1 million) in overseas pre-tax profit, according to regulatory filings.
Google said it abides by the tax rules in every country where it operates. The Irish tax authority and department of finance declined to comment on Google or other companies, although Irish officials said the approach is to simply agree a level of profit that could be reasonably attributed to the number of employees in the country. In Google’s case, this was 2,000 people at the end of 2011, most of those in telesales. One senior tax official said: “We charge tax on the profits that arise from the activities carried out here.”
There is no evidence that countries like Ireland or the Netherlands are breaking international tax rules, says Professor Michael Devereux, Director, Centre for Business Taxation & Professor of Business Taxation at Oxford University, adding that countries are free to design their tax systems as they see fit.
Larger countries have joined the competition. One way to compete is by introducing a ‘patent box’, also known as an ‘innovation box’. In recent years, France and Spain as well as the Netherlands and Belgium have all adopted such a system, offering tax rates as low as 5 per cent. Britain is due to introduce its version in April.
Patent boxes allow companies to pay a lower tax rate on profits linked to patented innovations. Governments say it’s a way to encourage innovation and high-value jobs in research and development. But critics see it as tax avoidance, albeit government-sanctioned and in palatable form.
Typically, a patent box tax system will ignore a large chunk of earnings made on a product which contains a patented item. “Even if the patented element of a product is minor, 100 per cent of income arising from the product falls into the regime,” accountants KPMG wrote of the UK patent box in a brochure.
The mechanism rewards commercialisation of existing patents, rather than the development of new ones, said Helen Miller, senior research economist at the Institute for Fiscal Studies, an independent think tank.
The European Commission estimated in December that around 1 trillion euros (HK$12.0 ttrillion) is lost to tax evasion and avoidance every year, and called on member states to cooperate better.
One radical solution - approved in a vote last September in the European Parliament - is for the EU to adopt a totally new approach to taxing companies, known as the Common Consolidated Corporate Tax Base (CCCTB). This would see countries apportioned a share of a company’s profits based on sales and staffing; each could then tax that profit how they saw fit.
Such a move would make it much harder, if not impossible, for companies to shift profits.
However, the European parliament only has advisory powers in relation to tax.
A European Commission spokeswoman said the Commission backed the idea, but that every member state must agree before a directive becomes binding. Ireland, the Netherlands and the UK have either opposed the CCCTB or withheld support.
“This is a race to the bottom,” said Giegold, the Green politician. “Each country which applies these low rates, and the more countries there are that use these special regimes, the harder it is to get rid of them.”