The suitability of aneconomic substance requirement in
GAARs: an economic perspective
by
Mark Jonker
Prof. dr. I.J.J. Burgers, supervisor
University of Groningen
Faculty of Economics & Business
2 Personal information
Name Mark Jonker
Student number 2068834
E-mail mark.jonker@outlook.com
Phone number +31 (0)6 517 01 500
Study program Economics of Taxation (Fiscale Economie) Supervisor Prof. dr. I.J.J. Burgers
Second assessor drs. D.J.J. Heslinga
Abstract
Tax authorities struggle to collect taxes due to multinationals that avoid taxes. Governments have different instruments to tackle tax avoidance.However, at the same time governments try to attract business with favourable tax regimes.One of the instruments to tackle tax avoidance is the
implementation of an economic substance requirement in GAARs. This thesis gives a qualitative assessment of the suitability of an economic substance requirement in GAARs. The economic effects of a substance requirement are also taken into account. In theory an economic substance
3 Foreword and acknowledgements
This thesis is written as completion of the master Economics of Taxation at the University of Groningen.I was in the comfortable position that I could write the biggest part of my thesis at the office of EY Groningen. During my internship at EY Groningen at the end of 2015 I was able to lay the foundation of this thesis. I am very grateful that I could write my thesis at the EY office as thesis intern after I finished my regular internship. This helped me writing in the biggest part of this thesis in only two months.These two months I was able to solely focus on writing my thesis.
Handing in the final version of a thesis is a big relief for most people. This holds especially for me since I had to finalize this thesis while I relocated to Prague for an internship. The first month in Prague I did not look a single moment at my thesis. Thereafter I had to discipline myself to finalize it after work. If I would have known this in advance I would have worked even harder before I moved to Prague. However, in the end I managed to finalize it.
And last but not least I want to thanks my supervisor from the University, Irene Burgers. Although quite busy on times, she provided constructive feedback on my thesis. While writing this foreword it is hard to value the merits of conducting the research for this thesis and writing this thesis. However, while writing this master thesis I read once more my bachelor thesis. When I compare my bachelor thesis with this thesis it is clear for me that my academic skills have grown significantly. While revising this master thesis I had numerous insights how to construct a better text while avoiding vague language. I hope and believe I can grow during my professional live with an even higher pace. I am looking forward to this next chapter in my life.
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Contents
1 Motivation and introduction ... 5
2 Methodology ... 6
3 Theoretical background of anti-abuse legislation ... 10
4 Economic substance requirements and international governance responses to tax avoidance.. 22
5 The impact of economic substance requirements on tax competition ... 31
6 Impact of economic substance requirements on the behaviour of firms ... 37
7 Conclusion ... 50
8 Limitations and further research ... 53
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1 Motivation and introduction
Taxpayers in every country usually try to minimize taxes on profits. According to the “Financieele Dagblad” (the Dutch Financial Times) of October 29th 2015 multinationals still perceive lowering the tax burden as important1. Compared with five years ago more companies indicate that the core business of their tax departments is lowering the corporate tax bill, despite the rising public interest in tax avoidance of multinationals. Another article of the Financieele Dagblad states that European rules do not end tax avoidance2. According to Paul Tang – Dutch Member of the European Parliament – the new measures proposed by the European Committee will not stop multinationals from avoiding taxes. Tang states that the supply will create its own demand. Savvy tax advisors will create new ways to avoid taxes. The proposed measures will close the biggest loopholes. However, new opportunities will arise.
Complicated structures - within the borders of the law - are made to reduce the tax bill. However, what taxpayers are trying to do might be inconsistent with the concept of fairness in taxation3. From the perspective of John Locke’s social contract theory4, one could perceive complicated structures as an abusive use of tax legislation. One option that countries have to counter such abusive behaviour is to enact in their domestic legislation anti-avoidance rules.
However, abusive behaviour does not only exist on a national level. Globally trading corporations can exploit loopholes that exist in international taxation. Due to differences in legislation of countries for example double non-taxation situations can occur. Therefore, the OECD initiated the Base Erosion Profit Shifting(BEPS)-Action Plan. When the OECD announced roughly two years ago their plans for countering BEPS, the opinions were sceptical to say the least5. It was suspected that the ambitious plans would turn out as a failure. At this point in timeit is hard to oversee what will be the exact outcomes of the BEPS project.However, the BEPS project is making progress and quite possibly turn out a success.
October 5th 2015 the OECD published the fifteen Final Reports regarding BEPS. Countering abusive tax structures is an important pillar. Abuse could be dealt with via tax treaties. However, countries also have domestic general anti-abuse rules as their instrument to counter abusive structures. The former has intrigued me to conduct research in order to assess whether economic substance
1 Financieele Dagblad – Beleggers hameren op lage belastingdruk bij bedrijven – October 29th 2015 2 Financieele Dagblad – Strengere regels maken geen eind aan belastingontwijking – January 26th 2016
3 See for example utilitarian theorists such as Jeremy Bentham and his slogan: ‘No taxation without
representation’
4 Social contract theory is the view that the moral and political obligations of a person are depending on a
contract or agreement among all individuals to form the society in which they live.
6 requirements are suitable for tackling tax avoidance. How could such GAAR be designed and what are the economic consequences. How does it influence corporations and countries?
2 Methodology
The first objective of this research is surveying the different anti-abuse instruments countries have in order to counter tax avoidance. Giving insights in why countries developed these instruments is a goal. Afterwards insights will be given with regard to the relation between domestic GAARs and tax treaties. Thereafter, the characteristics of an economic substance requirement will be outlined. By assessing economic substance requirements the OECD Ottawa taxation framework conditionsof 1998 will be kept in mind. These conditions are: neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility.
When the tax framework is outlined, the economic consequences will be dealt with. Introducing new rules will trigger different behaviours from both companies and governments. Companies can try to avoid the new legislation, or can accept it and pay their fair share. The first is on the basis of neo-classical economic theory, the latter on basis of theories from the corporate social responsibility literature.Countries on the other hand could engage in tax competition. The current literature is primarily focused on competition of corporate tax rates. This research aims at competing on different anti-avoidance instruments.
2.1 Problem definition
In advance I assume that an economic substance requirement in GAARs is a suitable instrument for countering tax avoidance. Compared to more ambiguous instruments it provides more certainty for taxpayers. An economic substance requirement is less vague and ambiguous than for example the intention of taxpayers. However, at the start of this thesis it is not clear whether the substance requirement fits in current tax frameworks, or what the economic consequences will be. Therefore, the following hypothesis will be researched:
“The implementation of an economic substance requirement in GAARs is a suitable instrument for countering tax avoidance.”
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2.2 Sub-questions
In order to be effective it is important that the economic substance requirements fit in the current tax systems of countries. Moreover, it is perhaps even more important how domestic and international tax law interact with regard to economics substance requirements. Also the Ottawa Taxation framework will be used in order to assesseconomic substance requirements. Therefore the following sub-questions are formulated:
(i) How does an economic substance requirement relate to other domestic anti-avoidance instruments?
(ii) How does an economic substance requirement fit in with the international governance responses to tax avoidance?
The introduction of an economic substance requirement could induce different behaviour from both countries and corporations. On the hand countries want to implement strict requirements in order to establish high tax revenues, while on the other hand countries are competing for business. In order to be competitive they lower their tax rate or induce soft or no substance requirements. Companies can change their behaviour as well. With this regard there are two opposites: comply6 and pay the ‘fair-share’7, or avoid as much tax as legal via aggressive tax structures. Therefore the following sub questions are formulated:
(iii) How will countries react on the introduction of substance requirements– will they compete for the lowest economic substance requirements?
(iv) Will companies change their behaviour due to the changed economic substance requirements?
2.3 Research method
This research will be mainly qualitative. The existing literature on different anti-abuse instruments will be assessed. It will be assessed how an economic substance requirement relates to other domestic anti-avoidance instruments. Thereafter will be evaluated how an economic substance requirements fits within the international governance responses to tax avoidance. The Ottawa Taxation Framework will be kept in mind during these assessments.
In order to predict the behaviour of corporations first the literature will be assessed. The standard neo-classical economic theory will be compared with theory from the corporate social responsibility literature. Afterwards I will use case studies from different multinationals and their tax behaviours.
6 By complying I mean not engaging in tax avoidance.
8 To give an answer to the question whether countries would engage in tax competition the literature will be assessed. On the basis of the literature the effects of an economic substance requirement will be described. It is outside the scope of this thesis to give a definite answer to the question whether and how countries compete when implementing an economic substance requirement in their GAARs. This will be a starting point for further research how countries compete on anti-avoidance instruments.
2.4 Research gap
Currently the OECD is investigating how to counter tax avoidance. Action 6 of the OECD Action Plan on Base Erosion and Profit Shifting does not go into depth on economic substance requirements in anti-abuse instruments. This study will provide more insights on this topic and will conclude whether it is feasible given the current tax frameworks of countries.
At this moment in time (June 2016) there is limited literature that connects tax and corporate social responsibility. This study will give an overview of theories from corporate social responsibility and assess how it relates to tax avoidance, in particular how it relates to an economic substance requirement.
The current literature about tax competition is primarily focussed on countries competing by lowering their corporate tax rate. This study will give first insights how companies compete by making use of on anti-avoidance instruments and hopefully spark further research.
2.5 Demarcation
A final clear-cut answer to the question whether an economic substance requirement is a suitable instrument will not be provided in this master thesis. A thorough survey of different anti-abuse instruments in different countries will be provided – with the focus on an economic substance requirement in GAARs. The legal issues will be discussed in detail. However, since this is an Economics of Taxation master thesis legal issues will not be treated exhaustively. Aim is just to provide first insights: A final comprehensive answer on the behaviour of corporations and governments is not feasible within the scoop of a master thesis.
9 Most GAARs have two dimensions to tackle abusive behaviour. The first one is the intention of the taxpayer, which is in practice, hard to ascertain. The second one is a demand of some economic substance, in other words, is not completely artificial. This research will focus mainly on preventing abusive behaviour by an economic substance requirement.
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3 Theoretical background of anti-abuse legislation
The sub-question of this chapter is:
How does an economic substance requirement relate to other domestic anti-avoidance instruments?
A theoretical background of which options governments have to tackle tax avoidance via domestic legislation will be provided in this chapter. First a short introduction will be given on the topic of tax avoidance in subsection 3.1. Then an overview of different domestic anti-abuse measures will be provided in subsection 3.2. International actions for countering tax avoidance are discussed in chapter 4. Economic substance requirements are thereafter discussed into more detail in subsection 3.3.This chapter will also highlight why economic substance is a suitable instrument for countering tax avoidance. The codification of economic substance in the United States will be used as an example. At the end of this chapter the comparison will be made between an economic substance requirement and other domestic anti-avoidance instruments in subsection 3.4.
3.1 The concept of tax avoidance: a short introduction
The concept of tax avoidance has been studied by tax academics and practitioners worldwide. Substantial consensus on the difference between tax avoidance and tax evasion exists. According to Alves Alvarrenga (2013) tax avoidance is a legal arrangement that is intended to reduce tax liabilities. It is within the borders of the law. Therefore, it is not a criminal offence. On the contrary, tax evasion represents an offence against the tax law that is punishable by criminal sanctions.
The difference between tax avoidance and tax minimization is less clear. Generally, tax avoidance is seen as unacceptable or abusive. Tax minimization is seen as acceptable and sometimes encouraged by law, for example the tax deduction of gifts to charity. With the term “abuse” often tax avoidance is meant. Thuronyi (2003) defines tax avoidance as a “behaviour by the taxpayer that is aimed at reducing tax liability, but is found to be legally ineffective (perhaps because of an anti-abuse doctrine or by construction of tax law)…” Tax minimization, on the other hand, is a “behaviour that is legally effective in reducing tax liability”. The OECD makes use of the term harmful tax practises and aggressive tax planning.8
These different concepts yield two questions:
(i) When does a taxpayer’s activity stops to be legitimate tax minimization and becomes tax avoidance, which is against the spirit of the law; and
11 (ii) How should countries deal with transactions that are considered as tax avoidance and at
the same time provide legal certainty for taxpayers?
In the remaining part of this chapter the various options for countries to counter abusive behaviour will be discussed.
3.2 Countries’ responses to tax avoidance: domestic legislation
In order to better understand how countries deal with tax avoidance it is important to note the difference between two groups of countries: common law countries and civil law countries. This division is necessary because both groups enact laws in different ways. Therefore, their imposed anti-avoidance rules are different as well. In civil law countries the primary source of law is statutes. The judiciary has a secondary role of interpreting the statutes. In common law countries case law is considered to be the most important source of law. The judges have the authority to create law in an actual case and this bindsothers in similar cases. Rules do not have an explicit grounding in the specific language of a statute, but have been developed gradually by the courts. In this paragraph the features of common law countries, civil law countries and hybrid solutions are described. In line with the distinction made by the chapter on tax avoidance of Global Perspectives on Income Taxation Law written by Avi-Yonah et al. (2011).
3.2.1 General anti-avoidance rules (GAARs)
The ultimate purpose of a GAAR is stopping unacceptable tax avoidance practices. A GAAR is a provision of last resort and can be invoked by tax authorities to strike down unacceptable tax avoidance practices that would otherwise comply with the terms and statutory interpretation of the ordinary tax law. A GAAR is typically designed to counter practices that are found to be carried out in a manner which undermines the intention of the tax law such as where a taxpayer had misused or abused that law. This is typically achieved by giving the tax authority the power to cancel a particular tax benefit in the situation where the action of the taxpayer is artificial and the only reason is obtaining a relevant tax benefit.
12 the GAAR will always be a delicate matter. According to Waerzeggers and Hillier (2016) the success of the GAAR in achieving its purpose will depend on:
(i) The legal design and drafting of the GAAR; and
(ii) The capacity of the tax authority to appropriately apply the GAAR in a measured and predictable way. The country’s infrastructure to settle tax disputes should also be considered.
The broad powers of a GAAR require adequate safeguards for the taxpayer. Therefore, the implementation of a GAAR in developing countries needs to be more carefully managed.
3.2.2 Common law countries
This sub-paragraph provides examples of common law countries (Li, 2006). The United States and the United Kingdom are the most important examples and will be discussed in-depth.
1) United States
The United States is one of the major common law countries. For actively countering tax avoidance the United States has created a number of anti-avoidance doctrines; ‘business purpose’, ‘economic substance’, ‘step transaction’ and ‘substance-over-form’.
The business purpose doctrine dates back to the landmark case of Gregory v. Helvering (1935)9. In this case the taxpayer, Evelyn Gregory, created and subsequently liquidated a corporation with the sole purpose of avoiding the two levels of tax imposed by corporation tax law. The Supreme Court concluded that the operation had no ‘business or corporate purpose’, but was ‘a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character’.
The economic substance or sham transaction doctrine can be attributed to the Supreme Court case of Knetsch v. United States (1960)10. In this case the taxpayer deducted interest paid with regard to a non-recourse indebtedness incurred to purchase a life insurance annuity policy. The rate of interest payable on the debt was higher than the return under the annuity. Therefore, the taxpayer had no prospect of making money, but only the expectation of being able to take an interest deduction for tax purposes. The Court decided that this scheme was a ‘sham’ in economic terms. No ‘commercial economic substance’ was presented. The parties did not intend that Knetsch would become indebted to the insurance company. No indebtedness was created. The economic substance doctrine also originates from the case Frank Lyon Co. v. United States (1978)11. In this case the Supreme Court held
13 that the title owner that acquired depreciable real estate as if the owner were a mere conduit was indeed the owner for tax purposes. With the result that depreciation on the building was possible. The step transaction doctrine is generally used by the lower courts to disregard interconnected steps that have no significant meaning for tax purposes by consolidating these into a single transaction. The step transaction doctrine also originates from the Gregory v. Helvering Case. It is used to counter tax shelters or bailing assets out of a corporation. Therefore it is part of the routine of the Internal Revenue Service (IRS).
The substance-over-form doctrine is used by the U.S. judiciary to ignore the legal form of a transaction in favour of its underlying economic substance. Commissioner v. Court Holding Co. (1945)12 is a leading case in this matter. In this case a corporation distributed the property to its shareholders in liquidation, with the subsequent sale of the property by the shareholders to the intended purchasers in order to avoid the two levels of tax imposed by corporation tax law. The Supreme Court concluded that the executed sale was in substance the sale of the corporation. On March 30th 2010, the U.S. Congress decided to codify the economic substance doctrine. The two-pronged test was included in the new section 7701(o) of the Internal Revenue Code(IRS) and entitled ‘Clarification of economic substance doctrine’. A transaction has only economic substance when both the following criteria are met:
(i) It changes in a meaningful way the taxpayer’s economic position; and (ii) The taxpayer has a substantial purpose for conducting the transaction.
Both criteria are excluding the tax effects. The first criteria is the objective prong, the second the subjective prong.
The purpose of the codification was clarifying the economic substance doctrine. However, according to Alves Alvarrenga (2013) things remain unclear despite the codification.
2) United Kingdom
In contrast to the U.S. approach, U.K. courts have remained generally reluctant to use broad-based anti-avoidance doctrines. Especially when related to the economic substance of the transactions according to Freedman (2007). Until 1981 the U.K. courts were known for their literal interpretation of tax statues and by an intense formalistic approach. Tiley (2010) states that the courts often insist on treating every transaction having an individual legal identity as having its own separate tax consequences, whatever the terms of the statute.
14 The Duke of Westminster13 is a classic example of this formalistic approach. The House of Lords refused to look at the substance of the transaction in this case and allowed the Duke of Westminster to convert wages paid to his employees into annuity payments that could be deducted from the Duke’s income. This case established that the courts must respect the legal rights that the parties have created, even if those rights were created for a tax-reducing purpose. However, these legal rights should not be respected if the transaction designed to reduce tax liability is a sham.
The Ramsay case (1981)14 went beyond the analysis of “sham versus genuine transactions” established by the Duke of Westminster. In this case the House of Lords refused the taxpayer’s deduction of a capital loss resulting from a series of circular and self-cancelling transactions. However, the House of Lords did not renounce the principle established in Duke of Westminster. The House of Lords concluded that it would be consistent with Duke of Westminster to regard the circular and self-cancelling transaction taken by the taxpayer as one single transaction for tax purposes.
In Furniss v. Dawnson (1984)15 is elaborated on the approach adopted in Ramsey.Furniss v. Dawnson involved a linear transaction in a preordained share-for-share exchange used to achieve tax deferrals. Analysed as a whole, the transaction represented, in fact, a disposition of shares for cash according to the House of Lords.The Ramsay principle or the Ramsay-Furniss principle was applied to circular transactions, transactions where at the end of the series of operations, the taxpayer’s financial position is precisely as it was at the beginning. It is also applied to linear transactions entered for no purpose other than tax avoidance. Thuronyi (2003) concludes that with Ramsay and Furniss v. Dawson the House of Lords adopted a kind of step transaction doctrine.
Her Majesty’s Revenue and Customs (HMRC) consulted in the late 1990s on the possibility of introducing a statutory GAAR. On 21 November 2011, a study group published a proposed bill for a statutory GAAR. The GAAR has effect from July 17th 201316. The legislative response before July 17th 2013 was to increase the number of SAARs. According to Tiley (2010) this might be regarded as a consequence of the failure of U.K. case law to provide certainty for the taxpayer necessary to better deal with tax avoidance.
3.2.3 Civil law countries
Abuse of law is the equivalent of the substance-over-form doctrine and used by civil law countries. The conditions vary from country to country. However, the common denominator is that the tax
13 UK: HL, 1936, IRS v. Duke of Westminster, [1936] A.C. 1; 19 TC 490.
14 UK: HL, 1981, WT Ramsay Ltd. V. Inland Revenue Commissioners, [1982] A.C. 300. 15 UK: HL, 1984, Furniss v. Dawson, A.C., at p. 474
15 authorities are able to disregard tax benefits of a transaction in which the form of the transaction adopted by a taxpayer is not specifically contemplated by law, and the same economic results could have been achieved differently.
1) Germany
Germany is an important example of a country where the abuse of law doctrine can be found in the legal system.17The inappropriate legal structure is ignored for tax purposes and substituted by an appropriate legal form when there is abuse of law. Besides the abuse of law doctrine, Germany has several specific anti-avoidance rules that are meant for combating specific avoidance transactions.
2) France
A specific section of the French tax code contains the abuse of law doctrine in France18. Artificial legal acts can be disregarded by the tax authorities. Art. L 64 du LPF authorizes the tax administration to disregard artificial or fictitious dealings whose sole purpose is to evade or lower the tax liability. This is in essence the substance over form principle.There is also an extraanti-avoidance doctrine under French tax law: the doctrine of abnormal acts of management19. According to this doctrine, tax authorities may disregard management decisions that are contrary to the interest of the business.
3) Brazil
Brazil is another good example. Since January 2001, under Art. 116 of the national tax code, legal transactions performed by a taxpayer that are intended to disguise or change the nature of a taxable event may be disregarded. Some courts have been applying the business purposes and substance-over-form doctrines in tax cases, although is not yet codified.
3.2.4 Hybrid solutions
Some countries have combined the previous and this resulted in a system with common and civil law characteristics(Avi-Yonah, 2011).
1) Italy
Italy is an example of where a hybrid solution has been adopted20. In addition to specific anti-avoidance measures, there is a general anti-anti-avoidance rule. Italian tax authorities may disregard tax advantages if three conditions are met:
(i) The transaction lacks valid economic reasons;
17 Section 42 of the Fiscal Code of Germany (Abgabeordnung) 18Art. L 64 du LPF - Livre des procédures fiscales
16 (ii) The transaction yields a tax benefit; and
(iii) There is a violation of obligations, or a prohibition according to Italian law. 2) Japan
Japan’s jurisdiction developed a limited substance-over-form doctrine in its Income Tax Law21, even though it is a civil law country. This doctrine applies only in a limited number of situations, for example the transaction of family corporations. This is the reason why most of the academics believe that Japanese courts cannot disregards legal acts for tax avoidance purposes without a specific provision.
3) Canada
Canada has a codified general anti-avoidance rule that provides that tax authorities can disregard the tax benefits of an avoidance transaction22. When a transaction has the following characteristics it may be disregarded:
(i) The result is a reduction or deferral of tax (tax benefit);
(ii) It does not have a purpose other than to obtain the tax benefit; and
(iii) The result is a direct or indirect misuse of the statute or a direct or indirect abuse of the statute. In the judiciary a substance-over-form doctrine is developed, which is more traditional for common law countries.
4) Australia
In Australia, there is a general anti-avoidance rule23, in which the tax authorities may disregard the tax benefit of transactions with the primary purpose of obtaining a tax benefit. In order to trigger the anti-avoidance rule three conditions should be fulfilled:
(i) A transaction has to be put in place; (ii) A tax benefit has to be obtained; and
(iii) The primary purpose of the transaction is to reduce taxes.
A general substance-over-form doctrine is not developed by Australian courts. The High Court has rejected the applicability of a judicial substance-over-form doctrine on the ground that it is unnecessary, since a general anti-avoidance rule is already codified. Moreover, Australia has also adopted specific anti-avoidance rules.
21 Income Tax Law of 1965, Law Number 33, 31 March 1964, as amended, art 12; Corporation Tax Law of 1965,
Law Number 34, 31 March 1965, as amended, art. 11
22 Section 245 of the Income Tax Act
17 5) Russia
In Russia tax authorities are allowed to reclassify deals and charge extra taxes based on their anti-avoidance legislation. Special rules could also be applicable in certain situations. The Supreme Arbitration Court of Russia has established a judicial anti-avoidance doctrine in the Plenary Ruling No.53. The term ‘unjustified tax benefit’ was introduced, and can apply to all taxes. It is based on two doctrines: the substance over form and the business purpose.
6) China
Article 47 of the Chinese Corporate Income Tax (CIT) Law contains a general anti-avoidance rule. The Individual Income Tax Law does not contain such anti-avoidance rule. When an enterprise enters into an arrangement ‘not for any reasonable business purposes’ the Chinese tax authorities have the power to make adjustments ‘through a reasonable method.’ ‘Not for any reasonable business purpose’ refers to an arrangement where the ‘main purpose is to reduce, exempt or defer the payment of taxes.’ China does have specific anti-abuse circulars such as Circular 601 regarding treaty application of beneficial ownership.
3.3 Codification of the economic substance doctrine in the United States
Since the United States has codified the economic substance doctrine, its proposal will be used as an example in the following paragraph.As far as I know this is the only codification of an economic substance requirement at the time of writing this thesis (June 2016) and hence an important example.According to Li (2006) the economic substance standard brings certainty and predictability to the GAAR analysis because it is an objective test based on the commercial reality of the business world. Completely artificial structures will be disregarded. Certainty, predictability and fairness for the taxpayer versus protection of the tax base and fairness of the system will always be a trade-off. The economic substance requirement ensures that ordinary business transactions are not affected by the GAAR. However, still an element of uncertainty is expected.
The same line of reasoning will be used, supplemented where needed. The U.S. Courts must simultaneously apply three factors according to the proposal of the codification:
(i) A significant change in the taxpayer’s economic position; (ii) The pursuit of a substantial non-tax purpose; and
18 transaction when it is implemented that demonstrates in a reasonable way that the value of the pre-tax economic benefits from the transaction is both:
(i) Substantial in comparison with the tax benefits; and
(ii) Higher than the return from an entirely risk-free investment.
If the courts determine that the scheme is realized due to a substantial non-tax purpose it should be disregarded.
The courts have to determine whether the transaction represented for the taxpayer a reasonable manner in which to realize a substantial non-tax purpose. However, the tax administration did not adopt this criterion in the two versions submitted in 2007.
The final economic substance doctrine codification of 2010 consists of a two-pronged approach (Lipton, 2010):
(i) The transaction changes the taxpayer’s economic position in a meaningful non-tax way; and
(ii) The taxpayer has a substantial non-tax purpose for entering into the transaction.
To assure that taxpayers state their non-substance transactionspenalties are imposed. The penalty corresponds to 20% of the amount of the tax under-stated. Generally speaking, the U.S. tax authorities attempt to reconcile the following principles in the application of tax penalties: fairness, predictability, efficiency and simplicity.
3.3.1 Impact of the US codification
According to Flesher and Quinn (2014) codification of the US anti-avoidance rule is still too new to draw conclusions. However, some tax commentators have posed questions about the effectiveness of the effort. Lipton (2010) states that it is likely that most traditional tax planning will be unaffected by this new legislation. He claims that the purpose of codification was to raise revenue even though Congress indicated that Section 7701(o) was enacted in order to clarify the law.
3.3.2 Economic impact of the US codification
19 billion, or a quarter of the revenue estimated at its peak. Furthermore, it is likely that much of the revenue will be generated by the strict-liability penalty. However, there is no official breakdown, so this will be hard to check.
Lipton (2010) is especially worried about the strict liability penalty. When should taxpayers disclose that a transaction might be viewed as lacking economic substance? Section 7701(o) simply clarified the pre-existing common law. Therefore, it could be argued that disclosure should only occur in the rare situations that taxpayers entered into transaction which the taxpayer believed could be challenged under the common law. While on the other hand it also could be argued that any time that a taxpayer enters into a transaction in which a significant tax benefit is obtained, the taxpayer might consider making a disclosure. It is possible that the IRS decides to challenge the economic substance of the transaction.
3.3.3 Juridical impact of the US codification
Making a disclosure could be an admission of concern. It is uncertain how judges will impose these new penalties.Notice 2010-62 states that the IRS did not intend to issue general administrative guidance on the types of transactions to which the economic substance doctrine applies. Hence, taxpayers may not want to disclose except in situations where the concern about economic substance is substantial. Lipton (2010) has the opinion that the codification will simply be viewed as a continuation of the status quo. Wells (2010) believes that the codification has strengthened the government’s case and will make it more difficult for the taxpayer to prove economic benefits.Friske et al. (2010) conclude that codification has introduced more convolution, confusion, and uncertainty than clarification due to the ambiguity of undefined terms. They believe the courts may be sympathetic toward taxpayers who have reasonable cause and may be less likely to question economic substance because of the large penalties involved.
According to PwC (2011) the lack of administrative guidance has left taxpayers uncertain as to how the IRS may view specific transactions. On July 15, 2011 a Directive is issued providing guidance to examiners and their managers. However, the Directive does not provide authority upon which can be relied. Therefore, they advise taxpayers to consider disclosing more rather than les.
20 considering ordinary course of business transactions to pay special attention to the codification. The stakes for practitioners and taxpayers have been heightened.
Larin et al. (2009) belief that the introduction of the key principles of the codification of economic substance for the purposes of the application of the GAAR would make it possible to establish a less ambiguous demarcation between abusive tax planning schemes and legitimate transactions. In their view, the numerous attempts to codify the economic substance doctrine illustrate the usefulness in separating routine commercial transactions and transactions carried out for tax avoidance purposes. One stated advantage of codification is the elimination of uncertainty in the application of the doctrine to taxpayer activities. The AICPA wrote a letter in 200724 arguing against the codification of the economic substance doctrine. The main objections were that the codification would introduce statutory complexity, traps for unwary taxpayers, and would deprive the tax law of needed flexibility. Moreover, the rules could be easily avoided by aggressive taxpayers.
3.4 Conclusion
The sub-question of this chapter is:
How doesan economic substance requirement relate to other domestic anti-avoidance instruments?
This chapter provides an overview of the domestic possibilities that countries have in order to tackle tax avoidance. The differencesbetween countries might be partially explained by the differences between common law and civil law countries. For example civil law countries make use of abuse of law legislation. The research shows there are also countries that adopted hybrid solutions, solutions in between common and civil law.
The United States serves as an example of a country that codified the economic substance doctrine. The codification should have brought more certainty for the taxpayer. However, this is not the case, especially not when (severe) penalties are at stake. In the literature the opinions are mixed about effectiveness of economic substance requirements. According to PwC (2011) the application of the economic substance doctrine is uncertain. Other authors feel the result is a less ambiguous demarcation between abusive tax planning and legitimate transactions.These mixed results might be explained by the fact that the codification is relatively new and not much research has been conducted on the topic.The purpose of the codification was clarifying the economic substance doctrine. However, according to Alves Alvarrenga (2013) things remain unclear despite the codification.
24AICPA letter to Congress dated March 26, 2007 – Comments on Codification of the Economic
22
4 Economic substance requirements and international governance
responses to tax avoidance
The sub question of this chapter is:
How does an economic substance requirement fit in with the international governance responses to tax avoidance?
The OECD plays an important role in countering tax avoidance. In subsection 4.1 the OECD’s governance work on tax avoidance will be briefly reviewed. BEPS Action 6 – Tax treaty abuse – will be discussed in more details in paragraph 4.2 followed by different international anti-avoidance instruments. Thereafter the 1998 Ottawa Taxation Framework will be presented in paragraph 4.7 in order to understand what dimensions should be taken into consideration while designing tax legislation.Finally will be assessed how an economic substance requirement fits within these international anti-avoidance instruments.
4.1.1 Brief overview of the OECD’s governance work on tax avoidance
Efforts to have an international fair taxation system started at the beginning of the 20th century. During the International Finance Conference in Brussels in 1920 it was acknowledged that there was a need to study and have a deeper knowledge about double taxation. The first agreements to avoid double taxation were signed from 1923 to 1927. To operate at an international level made the cooperation between countries essential. Therefore, some countries formed an organization that could be able to monitor economic activity and help economic development. As a result the Organization for Economic Co-operation and Development (OECD) was created in 1961.The OECD also thought about facilitating cross border transactions including the corresponding taxation (PwC, 2011).
23 provisions dealing with different aspects of treaty shopping were added to the section “Improper Use of the Convention” in the Commentary on Article 1 in 1992.
In 2003 the OECD delivered the report Restricting the Entitlement to Treaty Benefits, this was a follow-up to the 1998 Report Harmful Tax Competition: an Emerging Global Issue. Moreover, a comprehensive limitation-on-benefits provision was included. This provision is based on the provision found in the 1996 U.S. Model. In 2014 the Model Tax Convention was updated with clarification on the concept of “the beneficial owner”. However, the concept LOB-provision only deals with some forms of avoidance. It should not be considered as restricting the application of other approaches to addressing such cases.
Recently, the OECD reviewed the treaty practices of OECD and non-OECD countries (OECD 2015). The research shows that countries use different approaches to address treaty shopping cases not already dealt with by the provisions of the Model Tax Convention. The OECD recommends a three-pronged approach in order to minimize tax avoidance. Countries should include a clear statement when entering the treaty that they “wish to prevent tax avoidance and – in particular – intend to avoid creating opportunities for treaty shopping.” The OECD recommends that a specific anti-abuse rule – bases on the LOB-provision – will be included in the OECD Model Tax Convention. This rule will address a large number of treaty shopping situations. And thirdly, a more general anti-abuse rule will be introduced in order to tackle treaty shopping and other situations where treaties are abused: the principal purpose test (PPT). This rule reflects the content of the Commentary on Article 1, according to which the benefits of a tax treaty should not be available where one of the principal purposes of arrangements or transactions is to secure a benefit under a tax treaty and obtaining that benefit in these circumstances would be contrary to the object and purpose of the relevant provisions of the tax treaty.
4.2 BEPS Action 6: Tax treaty abuse
Action 6 of the 2015 BEPS Action Plan identifies treaty abuse, and in particular treaty shopping, as one of the most important sources of tax avoidance. The deliverables of Action 6 by the OECD in September 2014 consists of three parts:
(i) Development of model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances; (ii) Clarification that tax treaties are not intended to be used to generate double
non-taxation; and
24 The final BEPS report on Action 6 – Preventing the Granting of Treaty Benefits in Inappropriate Circumstances – of October 5th 2015 (OECD, 2015) distinguishes two types of cases of granting treaty benefits in inappropriate circumstances:
(i) Cases where a person tries to circumvent limitations provided by the treaty itself; and (ii) Cases where a person tries to circumvent the provisions of domestic tax law using treaty
benefits.
The first category of cases involves situations where a person seeks to circumvent rules that are specific to tax treaties. Therefore, it is unlikely that these cases will be addressed by specific anti-abuse rules found in domestic law. A domestic GAAR could prevent the granting of treaty benefits in these cases. However, a more direct approach would be the drafting of anti-abuse rules to be included in treaties. In the second category, the avoidance involves domestic law. Hence, it is impossible to address the avoidance exclusively through treaty provisions and requires domestic anti-abuse rules.
The first requirement that must be met to obtain treaty benefits is that a person must be “a resident of a Contracting State”, as defined in Article 4 of the OECD Model Tax Convention. There are several arrangements through which a person who is not a resident of a Contracting State may attempt to obtain benefits that a tax treaty grants to a resident of that State. These arrangements are generally referred to as treaty shopping. Treaty shopping typically involves persons from third countries trying to invoke the benefits of a treaty between two Contracting States.
4.3 Combination of LOB and the PPT
LOB and the PPT rules both have their advantages and disadvantages. For example, the LOB rule is based on objective criteria, while the PPT requires a case-by-case analysis based on what can reasonably be considered to be one of the principal purposes of transactions or arrangements. This results in more certainty for the taxpayer. The LOB rule is a specific anti-abuse rule aimed at treaty shopping situations. These situations can be identified on the basis of criteria based on the legal nature, ownership in, and general activities of, certain entities. However, the LOB rule only focusses on treaty shopping and does not address other forms of treaty abuses. On top of that it does not address all forms of treaty shopping. An example is conduit financing arrangements, through which a resident of a Contracting State that would otherwise qualify for treaty benefits is used as an intermediary by persons who otherwise were not entitled to these benefits.
25 forms of domestic law and treaty abuses. Therefore these countries might not require the PPT-rule, or prefer a more restricted form. For such countries the LOB rule needs to be adapted to reflect certain constraints or policy choices concerning other aspects of a bilateral tax treating between two countries. Constitutional restrictions are possible or concerns based on EU law.
4.4 Interaction of tax treaties and domestic anti-abuse measures
Domestic anti-abuse measures and anti-abuse measures in tax treaties coexist. Therefore it is essential to acknowledge their interaction. The focus is in particular on how tax treaties preclude or limit the application of domestic anti-avoidance rules. Until 2003 the Commentary on the OECD Model Convention was quite confusing concerning the relationship between tax treaties and domestic anti-abuse rules. However, in January 2003 the OECD issued extensive revisions to the Commentary on Art. 1 of the OECD Model TaxConvention (OECD, 2003). The relationship between tax treaties and domestic anti-avoidance rules was clarified and the problems concerning the improper use of tax treaties were addressed.
Paragraph 23 of the prior Commentary on Art. 1 indicated that domestic anti-avoidance provisions “are part of the basic domestic rules set by national tax law for determining which facts give rise to a tax liability. These rules are not addressed in tax treaties and are therefore not affected by them.” This was regarded as the view of the majority of the OECD member countries.
The OECD’s 1998 Report on Harmful Tax Competition made several recommendations concerning changes to tax treaties in order to counter harmful tax practices. The Report recommended that “the Commentary on the Model Tax Convention be clarified to remove any uncertainty or ambiguity regarding the compatibility of domestic anti-abuse measures with the Model Tax Convention.” The changes in 2003 were a direct result of this recommendation.
4.5 Overview of the 2003 OECD commentary on Art.1
According to the 2003 Commentary on Art. 1 there are two fundamental issues involving tax treaties and tax avoidance:
(i) Whether tax treaties can be interpreted and applied to deny treaty benefits with respect to abusive transactions; and
(ii) Whether domestic anti-avoidance rules conflict with and their application is precluded by, tax treaties.
anti-26 avoidance rules. However, for other countries abuse of a treaty is not necessarily abuse of domestic law. The issue for them is whether tax treaties can be interpreted, independent of domestic law, to deny treaty benefits with respect to abusive transactions.
The Commentary on Art. 1 states about anti-avoidance rules, such as substance-over-form, economic substance or general anti-avoidance rules, the following: “these rules are not addressed in tax treaties and are therefore not affected by them.” Therefore, there is no conflict between domestic anti-avoidance rules and tax treaties rules. Domestic anti-avoidance rules may be applied to determine the character of amounts or transactions for domestic tax purposes. Thereafter the provisions of the tax treaty are applied to the amounts or transactions as characterized by the domestic anti-avoidance rules. The Commentary on Art. 1 OECD model – that there is no conflict between tax treaties and domestic avoidance rules – rests on the proposition that domestic anti-avoidance rules establish the facts to which the treaty applies. However, this basis is subject to scepticism.
The view expressed by the OECD in the Commentary is very clear that there is no conflict between tax treaties and domestic anti-avoidance rules. It states that countries should eliminate double taxation in line with the provisions of their treaties, unless there is clear evidence of abuse.
4.6 Anti-abuse rules and substance within the internal market of the EU
It is generally accepted that under EU law the fundamental freedoms must be reconciled with the legitimate protection of member states’ tax bases. Some member states, for example France, have expressed their desire to prevent ‘the right of cross-border circulation’ from becoming a tool for aggressive tax planning in the hands of multinational enterprises. So far, no country has openly criticized the decisions of the European Court of Justice (ECJ). Besides the case law of the ECJ, some states prefer a more substantial and strengthened regulatory framework at the EU level. In particular with respect to tax avoidance and the allocation of taxing rights.
Since the last two decades there is case law of the ECJ about artificial constructions. In the Imperial Chemical Industries decision25 the first reference to ‘artificiality’ by the ECJ appeared. The ECJ developed in Cadbury Schweppes26 the ‘wholly artificial arrangement’ doctrine27. In Cadbury Schweppes the decision concerned the application of the UK’s CFC legislation to an Irish foreign company. What is remarkable is that the decision started by acknowledging two contradictory rights:
25 ECJ, 16 July 1998, Case C-264/96, Imperial Chemical Industries plc (ICI) v. Kenneth Hall Colmer (Her Majesty’s
Inspector of Taxes)
26ECJ, 12 September 2006, Case C-196/04, Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd v.
Commissioners of Inland Revenue
27 (i) The right of a taxpayer to rely on its EU freedoms for tax avoidance purposes; and (ii) The right of a Member State to use anti-abuse provisions to combat tax avoidance. The main question of this case was: where lies the balance between these two competing objectives. In what circumstances should one of the said rights prevail over the other? The ECJ’s answer is resolute: a taxpayer is free to rely on his EU freedoms for tax avoidance purposes as long as the contractual arrangement underlying the investment structure is not ‘purely artificial.’
4.7 Ottawa Taxation Framework
An OECD ministerial meeting on global e-commerce was held in Ottawa, Canada October 1998. The Committee on Fiscal Affairs endorsed a set of principles - the Ottawa Taxation Framework - that would guide the OECD in its reform efforts with respect to the taxation of international e-commerce (OECD, 1998). The Ottawa Taxation Framework notes that international tax principles should be applied to the new commercial environment. I will use the same principles to assess an economic substance requirement.
In its Ottawa Taxation Framework the OECD formulated the following principles for designing tax policy: neutrality, efficiency, certainty and simplicity, effectiveness and fairness and flexibility. The OECD gave a short explanation of these principles which will be presented in section 4.7.1. In this section I will also assess the relevance of each of the principles for an economic substance requirement. These principles provide a brief understanding how to assess the qualities of tax frameworks. When the tax framework scores high on all principles it is regarded as a proper framework.
4.7.1 Neutrality
The OECD defines the principle of neutrality as: Taxation should be neutral and fair between forms of business activities. A neutral tax will contribute to efficiency by ensuring that optimal allocation of the means of production is achieved. The tax system should not discriminate in favour, or against, any particular economic choice. This implies that the same principles of taxation should apply to all forms of business. Moreover, specific features that may otherwise undermine an equal and neutral application of those principles should be addressed.
28 Therefore, the same taxes should be due. Hence, an economic substance requirement will increase the neutrality of the tax system. A more neutral tax system will benefit society as a whole due to more tax revenues, moreover tax advisors and lawyers could diverge to more productive work. 4.7.2 Efficiency
According to the OECD compliance costs for business should be minimised as far as possible. Moreover, administration costs for governments should also be minimised. When using a purpose test, compliance costs are potentially high. For the tax authorities is hard to determine the intention of the taxpayer. So from the perspective of the taxpayer, the ideas of the tax authorities about their intentions are unknown. Therefore, it could be the case that companies make non-optimal decisions to make sure they end at the safe side. Loopholes in the tax system reduce its efficiency. Many loopholes involve artificial structures without economic substance. Introducing substance requirements therefore will increase efficiency. For the tax authorities economic substance increases efficiency, however, for the taxpayers efficiency is decreased.
4.7.3 Certainty and simplicity
Taxpayers should know where they stand.Therefore according to the OECD, tax rules should be clear and simple. In order to know where they stand, taxpayers should be provided with a certain amount of certainty. Individuals and businesses fulfil their obligations and entitlements better when the tax system is simple. As a result individuals and businesses can make more optimal decisions. A downside of simplicity is that it favours aggressive tax planning, with deadweight losses for the economy as the result.
An economic substance requirement will decrease certainty for taxpayers. When no substance is required it is quite easy to be sure as a taxpayer that you are on the safe side. However, with substance requirements it is uncertain whether the substance is sufficient in the eyes of the tax authorities. Also simplicity decreases, corporations have to keep more legislation in mind.
4.7.4 Effectiveness and fairness
29 4.7.5 Flexibility
Tax systems should be flexible and dynamic enough to keep in pace with recent developments. The OECD underpins it is important that a tax system is dynamic and flexible enough to meet the current revenue needs of governments while adapting to changing needs an ongoing basis. Policymakers have to keep in mind that future developments are often difficult to predict. With an economic substance requirement adjustments could be made about what is regarded as economic substance. Therefore economic substance requirements will increase the flexibility.
4.7.6 Equity
Within a tax policy framework equity is also an important factor. Equity has two dimensions; horizontal equity and vertical equity. Taxpayers in similar circumstances should face a similar tax burden according to taxpayers. However, vertical equity is a normative concept. Definitions can differ from user to user. It could be argued that taxpayers in better circumstances should bear a larger part of the tax burden as a proportion of their income. In practice, the interpretation of vertical equity depends on the extent to which countries want to diminish income variation. Another question one could ask is whether it should be applied to income earned in a specific period or to lifetime income.
4.8 Conclusion
The sub-question of this chapter is:
How does an economic substance requirement fit in with the international governance responses to tax avoidance?
Action 6 of the BEPS Action Plan identifies treaty abuse, and especially treaty shopping, as one of the most important sources of tax avoidance. Both treaty provisions and domestic anti-abuse rules could prevent tax avoidance.
The OECD has attempted to research and counter tax avoidance in several ways. The concept of beneficial owner was introduced in 1977. In 2015 the OECD recommends a three-pronged approach to counter tax avoidance:
(i) A clear statement of wishing to prevent tax avoidance; (ii) A specific anti-abuse rule based on the LOB-provision; and (iii) A principal purpose test.
An economic substance requirement might have the following two-pronged approach:
(i) The transaction changes the taxpayer’s economic position in a meaningful non-tax way; and
31
5 The impact of economic substance requirements on tax
competition
They may like it or not, but national tax policy makers are involved in a game with each other. They are competing for business with their tax systems, while in the same time trying to ensure their tax revenues. Governments want to attract business with low tax rates. However, when corporations engage in tax avoidance they risk being scrutinized by that same government. An example of this is the UK28. In subsections 5.1, 5.2 and 5.3 relevant academic research on the subject of tax competitionwill be mapped. The implications for the introduction of an economic substance requirement will be assessed in subsection 5.4.
The sub-question of this chapter is:
How will countries react on the introduction of substance requirements – will they compete for the lowest economic substance requirements?
5.1 Tax competition studies: early work
One of the early attempts to understand the potential efficiency problems associated with competition for capital by local governments can be found in the work of Oates (1972). He describes the problem as follows:
“The result of tax competition may well be a tendency toward less than efficient levels of output of local services. In an attempt to keep taxes low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal costs, particularly for those programs that do not offer direct benefits to local business.”
Oates concludes that tax competition is inefficient. When all governments behave this way, none gain a competitive advantage, and consequently all communities are worse off. This problem also arises on the level of international tax competition. In order to attract business governments create a favourable tax climate to persuade corporations to conduct business in their countries. If this is beneficial is questionable. Overall, it is a zero-sum game. Therefore corporations win at the expense of governments.
The view that intergovernmental competition is wasteful has raised fundamental questions about the role of governments. This view runs counter to the influential Tiebout Hypothesis. Tiebout (1956) argues that competition for mobile households is welfare enhancing. Subsequent work has applied
32 similar ideas to competition for mobile firms. This hypothesis is in direct conflict with much of the tax competition literature. The Tiebout literature supports policies that allow national governments to function independently in most policy areas. The Treaty on the European Union reflects a presumption in favour of this independence according to Wilson (1999).
Janeba (1997) conducted research on international tax competition. During the nineties many governments lowered the tax rates on capital income. However, at the same time the tax base was broadened. Tax cuts are viewed as means to attract business and hence improve national well-being. Tax reforms took place during the same time period, therefore tax cut policies should not be analysed in isolation. When one country reforms taxes, other countries will follow with reforms. Janeba therefore used a game-theoretic perspective in order to capture the interdependence of decision making. He shows that many elements of a tax code can be viewed as strategic variables of a government. In most research the statutory tax rate is investigated, but also the form of double taxation relief and rules of discrimination are important.
5.2 Tax competition: research during the ninetiesand early two-thousands
By deciding upon their tax rate on the mobile production factor capital a country can extract capital from other countries. Since all countries act the same way the tax rate is driven down to zero, which is referred to as ‘the race to the bottom’. Both Wildasin (1988) and Hoyt (1993) question ‘the race to the bottom’. They describe a model with a restricted number of countries. They show that the tax rate is higher than zero because countries have market power over the firms in their country. Due to the market power the government can set a positive tax rate on capital. This is even the case when there are no restrictions on capital mobility.
Persson and Tabellini (1992) conducted research on the effects of economic integration on tax competition. They found an increase in economic integrations makes mobile capital more responsive to a change in the tax rate. So economic integration opens the door for tax competition since the mobility of capital has increased and its location can be easily altered. In this model the tax rate is set by the median voter. The median voter will shift to the left in case tax rates are lowered by tax competition. Hence, the location of the median voter dampens the effect of tax competition to a certain extent.
33 big stock of capital, so the inflow will be relatively small. Bucovetsky and Wilson (1991) show that small countries should solely tax immobile labour and should not tax capital at all. These findings rest on the assumption that the supply of capital is perfectly elastic. The previous could indicate that small countries compete more on substance requirements than bigger countries.
More recent studies focused on location-specific rents. Baldwin and Krugman (2004) focused on two possible equilibria; there could be an agglomeration of economic activity or not.The existence of agglomerations creates dependency by companies. This results in market power for the countries in setting their tax rate. An economic agglomeration could attract new business and keep existing business although neighbouring countries have a lower tax rate. Baldwin and Krugman conclude that tax rates on capital are higher when an agglomeration is present. Therefore, economic integration does not necessarily have to lead to a ‘race to the bottom’ in tax rates. For example, countries within the European Union with a lot of economic activity are less infected by neighbouring countries lowering tax rates. However, tax competition still leads to inefficiently low corporate income taxes in their model. Economic agglomerations do not have to compete on economic substance requirements to attract and hold business. Countries without an economic agglomeration could decide to compete on lower substance requirements.
5.3 Tax competition: recent academic research from an economic
perspective
Baskaran and Lopes da Fonseca (2014) state that the literature about tax competition has come a long way before it received substantial academic attention. However, there remain unfortunate trade-offs. Countries can compete on taxes on many levels; corporate tax rates, exemptions etcetera. Unfortunately, the requirements of formal modelling and issues of data availability force researchers to limit themselves to only a few key features of a country’s tax system. Moreover, they argue that the empirical literature on international tax competition is in many ways more complex than the literature on local tax competition. One reason for this is that it is difficult to identify an appropriate measure for the tax burden on mobile factors.
34 For example, Swank and Steinmo (2002) and Garrett and Mitchel (2001) use the total tax revenues or tax revenues from the corporate and related taxes as share of GDP to proxy levels of taxation. The idea is that tax competition will increase with economic integration. Therefore, a negative relationship between economic integration and tax revenues may be expected. Swank and Steinmo and Garrett and Mitchel did not find evidence for a decline in tax revenue. Therefore there is no evidence for harmful tax competition. Unfortunately, revenue-based measures for tax competition have a number of shortcomings. This ratio is backwards looking: it is affected by past tax policies, but does not accurately indicate how future policies will evolve. Moreover, total tax revenues reflect the burden not only on mobile factors, but also on immobile factors. Consequently, the tax revenues as share of GDP will proxy the true tax burden on corporations with an error. The former implicates that it is hard to conduct research how exactly countries react to the introduction of economic substance requirements.
Therefore, another strand of literature makes a different compromise. Instead of analysing the full tax burden, these studies focus on a specific mobile factor. The taxation of corporations has received the most attention. Countries are inclined to attract corporations by offering lower tax burdens. Besides a valuable tax base, corporations also offer employment to the voters. The main goal of this strand of literature is to uncover trends and co-movements in tax rates between different countries, and consequently interpret these trends with respect to international tax competition. It could be the case that the business of corporations is affected by the statutory tax rate. They could base their decision where to locate on the effective tax rate of a country. However, it is problematic that the statutory tax rate might not reflect the true tax burden, since tax bases vary between countries. To address this problem, researchers calculate effective tax rates.
According to Baskaran and Lopes da Fonseca (2014) much of the evidence suggests that tax competition does not lead to significant reductions in tax revenues.This might implicate that competing on economic substance requirements could be beneficial for countries. Baskaran and Lopes da Fonseca argue that theoretical predictions are ambiguous. Moreover, the empirical results are neither conclusive. Early contributions point towards a race to the bottom, while more recent ones reach more diffuse conclusions.
