The European Commission´s Idea of Small Business Tax Neutrality

Bret N. Bogenschneider*

Abstract

The European Commission recentlyannounced a competition policy of what might be called “small business tax neutrality” in several of itsstate aid rulings. Simply put, states may not grant tax benefits that create a tax advantage to multinational firmsin comparison to SME´s. As explained in detail here, the United States is engaged in tax competition yielding a structural advantage in favor of U.S. multinationals against European SME’s including by facilitating the avoidance of European tax, which also notably reduces the foreign tax credit offset upon repatriation of earnings to the United States. Also,U.S. tax laws grant U.S. multinationals tax incentives on U.S. earnings including special incentives for R&D and domestic manufacturing which areincremental to the lax enforcement of U.S. tax lawson corporate audits especially with respect to transfer pricing. The anti-competitive effect is that U.S. multinationals enjoy a significanttrade advantage against their competitors of all stripes and are able to seize market share from European SME’s(just as also occurred in U.S. domestic markets where SME’swere eliminated as competition in the U.S. domestic markets over the past decade). Several policy options are providedherein to reduce the competitive advantage of U.S. multinationals in the respective European markets and particularly with respect to European SME´s.

Keywords: tax competition; strategic trade policy; common market; tax policy.

1Introduction

In several of its recent tax rulings the European Commissioner in charge of competition policy, Margrethe Vestager, repeatedly stated that one purpose of the state aid rules is to limit tax advantages to multinational firms not otherwise available to small and medium enterprises (“SME´s”).[1] Although neoclassical economic theory generally does not take into account disparate treatment of small versus large firms as a matter of internationaltax policy,[2] Vestager´s approach reflectswhat has recently been referred to in the international context as “Small Business Tax Neutrality”.[3] In rulings related to Starbucks, the Belgian “excess profit”tax scheme, and McDonalds, respectively, the European Commissionindicated as follows:

  1. Starbucks. “Tax rulings that artificially reduce a company´s tax burden are not in line with EU state aid rules. They are illegal. I hope that, with today´s decisions, this message will be heard by Member State governments and companies alike. All companies, big or small, multinational or not, should pay their fair share of tax.” (Starbucks, IP/15/5880).
  2. Starbucks. “Tax rulings cannot use methodologies, no matter how complex, to establish transfer prices with no economic justification and which unduly shift profits to reduce the taxes paid by the company. It would give that company an unfair competitive advantage over other companies (typically SMEs) that are taxed on their actual profits because they pay market prices for the goods and services they use.” (Starbucks, IP/15/5880).
  3. Belgian “Excess Profit” Tax Scheme. “Belgium has given a select number of multinationals substantial tax advantages that break EU state aid rules. It distorts competition on the merits by putting smaller competitors who are not multinational on an unequal footing.” (Belgium, IP/16/42).
  4. McDonald’s. “In particular, the Commission will assess whether Luxembourg authorities selectively derogated from the provisions of their national tax law and the Luxembourg-US Double Taxation Treaty and whether thereby the Luxembourg authorities gave McDonald’s an advantage not available to other companies in a comparable factual and legal situation.” (McDonald’s, IP/15/6221).

Based on these comments it seems clear that Commissioner Vestager has correctly identified that multinational firms often enjoy a significant tax advantage against domestic European firms. This tax advantage is not “neutral” in economic terms. In particular, U.S. multinationals are often able to avoid European level taxes on European profits whereas SME´s are not able to avoid European taxes on profits. The U.S. taxing authority is well-aware of this feature of the international tax system. Of course, the less tax paid to Eurozone nations by U.S. multinationals the less of an offsetting foreign tax credit the U.S. fisc is required to grant upon repatriation of any foreign earnings.[4] Accordingly, both the U.S. taxing authority, and also European nations, who believe that attracting “mobile” capital from multinational firms benefits the local economy (even if it does not entail significant tax collections), have perceived incentives to facilitate tax avoidance by multinational firms.[5] And, this is of course a form of tax competition as between Europe and the United States.[6] In technical terms, such “tax competition” between the European Union and United States is one aspect of “Strategic Trade Policy”.[7] Both the U.S. Congress and the Internal Revenue Service do not consider tax competition to be a secret,[8] and as such, openly foster trade benefits to U.S. firms that create a competitive tax advantage against European SME´s in particular. This aspect of tax competition by U.S. multinationals against European SME´s as Strategic Trade Policy is discussed in detail in this article. Tax incentives reduce the tax base irrespective of the applicable tax rate. So, discussions of the corporate tax rate without reference to the tax base are in many cases a red-herring. Notably, the U.S. Congress carefully pushes the envelope of allowable trade incentives to benefit its multinational firms under applicable World Trade Organization (“WTO”) guidance. Occasionally, the U.S. gets too aggressive with granting tax incentives to domestic firms as famously occurred in the year 2004 with the repeal of Extraterritorial Income regime (aka “ETI”) after the WTO ruled it an illegal trade subsidy,[9] and again in the year 2007 with the voluntary repeal of special tax credits for the production of pulp and paper products.[10]

In economic terms, Strategic Trade Policy refers to any trade policy which could affect interactions between firms in an international oligopoly setting.[11] Prior research in economic theoryfocused on the use of tariffs and quotas as the predominant means of trade policy as opposed to corporate tax incentives.[12] This is ostensibly strange since the seminal work in the field of Strategic Trade Policy first introduced the subject by modeling research and development (“R&D”) incentives as government trade policy.[13] R&D incentives arenow amajortax subsidy in the corporate tax code particularly of the United States and the United Kingdom, but also in a growing number of other EU countries, such as the Netherlands, which have also recently implemented various “patent box” regimes.[14] Meanwhile, prior research in the field of international tax law has focused on the policy implications for the selection of an overall system of corporate taxation, particularly that of a tax credit versus tax exemption method, also referred to as a “worldwide” versus “territorial” systemof international taxation.[15] Priorlegal research generally ignores the implications ofindustrywide oligopoly to tax policy. Legal research more typically seeksto identify optimal tax policy under a system of positive “neutrality” under various scenarios.[16] Of course, merely the title Strategic Trade Policy implies that the desired policy outcome from a particular tax system is not “competitive neutrality”.[17] A game theoretical element ispresupposedwhere “winning” means improving domestic affairs at the expense of a foreign rival or vice-versa.[18] Perhaps the most well-known application of this approach to trade policy is the preeminent work of Paul Krugman who showed that a trade policy of import protection can function as export promotion.[19]

The terminology of “corporate tax competition” as trade policy between the European Union and the United States given by Genschel, Kemmerling & Seils distinguished as between “general” versus “targeted” tax competition.[20] Although tax competition in Europe usually calls to mind historical Gibraltarian or Luxembourgish schemes to act as an offshore corporate tax haven for multinational firms, tax competition is taken more broadly hereas corporate tax subsidies for multinational firms which function as systemic tax competition in accordance with WTO standards.[21] Primary examples are R&D tax credits (IRC §41), incentives for domestic manufacturing (IRC §199) and variations of selective tax enforcement to either aggressively enforce tax rules by audit particularly against foreign firms, or, not to enforce tax rules for transfer pricing against domestic firms.[22] As such, the tax outcomes for large corporations are not taken as separate and distinct from general economic policy; tax policy actually is one aspect of economic policy. Notably, James Branderat one point mentioned tax policy as one potential mechanism of Strategic Trade Policy, but does not list taxation as an area for further research in the field.[23] As such, an inquiry into tax policy for the European common market from the perspective of Strategic Trade Policy is long-overdue.[24]

2Background on the EU US Tax Policy Dynamic.

Immediately after the announcement of the ruling against Starbucks, Robert Stack announced on behalf of the U.S. Treasury department that it considered the recent State Aid rulings of the European Commission to be ex-post tax enforcement given the Commission´s rulings entailed reversal of the benefit of the APA´s for all prior periods. This action would be presumptively un-Constitutional as a matter of U.S. tax laws and is therefore objectionable to a U.S. legal audience.[25] Since the European Commission´s State Aid enforcement actions are taken essentially in slow motion over a period of months or years, various U.S. regulatory agencies have ample time to retaliate against European firms by issuing much larger sanctions for unrelated reasons as deemed appropriate to effectuate a strategic quid-pro-quo.[26] The U.S. Treasury department, on the other hand, may act on most matters of international tax law by its rule-making and regulatory authority without major Constitutional objections. In terms of Strategic Tax Policy, the U.S. Treasury department is thus practically unfettered in setting international tax policy. It follows then that if the U.S. Treasury thought it was losing on corporate tax matters it could seek to immediately reform the international tax system to the extent of its rulemaking authority. However, the U.S. Treasury is perhaps best described as recalcitrant on corporate tax reform and has only begrudgingly participated in the OECD Base Erosion and Profit Shifting (“BEPS”) initiative.[27] Accordingly, the view that the U.S. Treasury department will voluntarily cooperative to reduce tax competition and help European states collect tax revenue from U.S. multinationals is unrealistic.

The classical terminology of international tax policy centered on “neutrality” is based in part on various articles of the Treaty on the Functioning of the European Union (“TFEU”), and also, the seminal dissertation of Peggy Musgrave who introduced the concepts of “capital export”- versus “capital import”- neutrality to international tax policy.[28] The concept of neutrality has been expanded to other economic contexts including recently the idea of “capital ownership neutrality”,[29] and also, “small business tax neutrality”.[30] The proposal for “small business tax neutrality” may be of particular importance to the European common market given the ongoing decline in small business activity reported by the European SME Observatory.[31] Small business tax “neutrality” in this context means reducing the structural tax advantage enjoyed by multinational firms by equalizing effective tax rates to small business with targeted tax incentives to the lower effective rate paid by multinational firms. The effect as a matter of Strategic Trade Policy is that tax neutrality to small business may reduce in part “crowding out” of domestic capital with foreign direct investment from multinational firms in an oligopoly setting. This represents a new concept in tax policy as prior research envisioned tax “neutrality” as not artificially distorting the choice of legal entity form by reducing small business taxation from the statutory rate with tax incentives.[32]

The U.S. Treasury Department fostersboth “general” and “targeted” tax competition using tax policy. Tax competition is not viewed as a dirty secret in the United States as it may be in the European Union.[33] Indeed, the Internal Revenue Service openly claims to be enforcing a system of tax competition in favor of U.S. multinationals, and also, not enforcing the existing U.S. tax laws against U.S. multinationals in many cases as a matter of U.S. corporate tax law. A specific example of non-enforcement of tax law in the United States is the Accumulated Earnings Tax which would function as a back-up CFC rule against U.S. multinationals and result in a tax assessment against the unrepatriated cash accumulations in Ireland, for example.[34] Another example is the lax audit practice of the IRS against domestic U.S. firms where it applies a “policy of restraint” to not request FIN48 audit records from large corporations that specifically detail the aggressive tax positions of U.S. publicly traded firms.[35] To emphasize the point, the tax audit for U.S. firms does not include any investigation or review of the FIN 48 records of aggressive tax positions which are required to be created for accounting purposes.[36] Accordingly, fostering the international competiveness of U.S. firms actually is the tax policy of the U.S. taxing authority. This implies that European tax policymakers may not simply ignore the game theory analytic of Strategic Tax Policy interactions between the European Union and the United States as this might represent a radical failure to understand one´s adversary.

Meanwhile, the brightest minds in the field of taxation (on both sides of the Atlantic) are essentially unable to identify a determinative method to the direct tax jurisprudence of the ECJ.[37] This should hardly be surprising given the “neutrality” idea in the EU Constitution taken as relevant to direct taxation was not given with any context, so under the best of circumstances the ECJ would be forced to work out the meaning of that term in the case law. Furthermore, nearly all member states are potentially out of compliance with existing ECJ rules on direct taxes in some manner or another. Under such circumstances, any enforcement at all is selective tax enforcement. The ECJ at times takesas its mantra in tax policy an idealized version of “freetrade”(often referred to “competition”) between the Member States as a form of economic “neutrality” under the TFEU.[38] However, if there is any truth to Strategic Trade Policy at all, “freetrade” is subject to manipulation by trade policyas Krugman illustrated. As such, a constitutional principle(or “norm”) of “neutrality” will need to take into account the Strategic Tax Policy of other states when interpreting the constitutionality of tax laws of Member States. A failure to consider the limits of “free trade” is to lose the tax policy gameby forfeit.

3U.S. Multinationals versus European Small Businesses.

At the very minimum, Strategic Tax Policy requires looking at the strategic perspective relevant to the US and the EU and their respective trade policy goals. Further, it isimportant to note the possibility of what might be called tax policy-“own goals”. Perhaps the quintessentialexample of a tax policy “own goal” is to intentionally set up a tax system witha high effective rate of small business taxationin the Eurozone in combination with negligible (or very low)effective rate of large business taxation,thus intending to attract U.S. multinationals (ie, “mobile capital”) as competitors into the domestic European market even if it means putting European small business out of business.[39] The first observation ought to be that U.S. multinationals are fresh off a crushing victory over U.S. small businesses in the domestic U.S. market. Notably, U.S. multinationals benefit from reduced tax assessments[40]and small businessesoften fail for lack of capital particularly with respect to some industries.[41] The various tax incentives for small business are insufficient to offset the structural tax advantages available to large corporations in both the United States and Europe including a lower statutory rate, transfer pricing, and the lack of tax enforcement.

Thus, by disproportionately taxing small business in comparison to large business this resulted in the elimination of the greatest form ofcompetitionfor U.S. multinationalsin the U.S. domestic market and will ultimately have the same result in European markets. U.S. multinationals are exceptionally well-positioned to use corporate tax competition to gain market share in European markets with the tacit encouragement of the U.S. Treasury department. In the meantime, U.S. multinationals have continued to consolidate capital even further into various industrial sector behemoths, of which the recent Dow Chemical - DuPont merger is illustrative. The leading economists on the subject of Strategic Tax Policy report that trade policies are not sensitive to model specifics indicating tax policy proposals may be derived from existing theory so it is appropriate to draw tax policy conclusions such as those given in this article.[42] And, tellingly, small business activity is now declining rapidly in the Eurozone, just as it did in the United States over the past decade.[43]

4U.S. Tax Competition as Mercantilism.

Tax competition by the United States is a modern-day form of mercantilist trade policy where the goal is to grab market share from foreign competitors using tax policy as a mechanism.[44] Many U.S. firms accordinglyintend to exploit a lack of capital in the small business sector in the European Union to take market share from these firms in local European markets. As such, “free trade” does not mean equal gains from trade; the opening domestic European market to foreign corporations does not guarantee a net gain from trade. The tax differential between U.S. multinationals and small businesses (ie, the lower effective tax rate paid by multinational firms) is very high with a double small-business effective tax rate in the United States. However, the differential is potentiallyeven higher in Europe given the effects of VAT on small business resulting ina substantial effective tax rate differential in favor of multinationals (depending on the incidence analysis for VAT to be applied) in most countries of the EU. The details of Starbucks’ APA with the Netherlands further suggest the effective tax rate of Starbucks in Europe is set by Starbucks itself with its contrived residual profit level.[45]