6.2 Current Situation of Corporate Taxation in the EU
6.2.1 Separate Entity Approach Versus Single Entity
The current situation in the area of corporate taxation in the European Union, where companies are facing 28 different corporate taxation systems, has two very impor- tant impacts. First, the loopholes between the national corporate taxation systems are often used by multinational groups for aggressive tax planning, resulting base erosion and profit shifting in the European Union. Second, they are increasing the compliance costs of taxation for both tax administration and companies themselves.
The complexity of current taxation systems hinders the expansion of SMEs on foreign markets as mentioned by Chen et al. (2002) and Solilova´ and Nerudova´
(2016). Taking into account the fact that SMEs represent over 99% of all companies and two-thirds of total employment in the Internal Market (European Commission 2016e),32 the European Commission has always aimed to structurally harmonize the area of corporate taxation, though with only very limited success.
With respect to the determination of corporate tax base of the group of multi- national companies, there are two basic approaches: theseparate entity approach andsingle entity approach with an allocation mechanism. The majority of Member States in the European Union tax the members of the group as separate entities, even though from an economic perspective, they are members of one group (Kumpf
30Communication from the Commission to the European Parliament and the Council: Building a fair, competitive and stable corporate tax system for the EU, COM(2016) 682 final, 25 October, 2016.
31For more details see EP Legislative Observatory, Procedure file on the common consolidated corporate tax base (CCCTB), 2016/0337(CNS). Available at:http://www.europarl.europa.eu/oeil/
popups/ficheprocedure.do?referenceẳ2016/0336(CNS)&lẳen
32European Commission. (2016). Annual Report on European SMEs 2015/2016, SME recovery continues.https://www.isme.ie/assets/Annual-Report-on-European-SMEs-2015-2016.pdf
1976). Moreover, each entity has to create an appropriate tax base in line with the arm’s length principle33—i.e., group entities must be taxed as if they were dealing with independent parties, free from the conditions arising from their special rela- tionship that may lead to a distortion of prices. In other words, the price has to be set as if the transaction were to be carried out between the independent companies.
However, Jacobs (2011) underlines that the allocation of profits in line with this standard to the branch of the entity or associated entity, which is an independent company from a legal point of view, is sometimes complicated. Moreover, Solilova´
and Nerudova´ (2013) add that the changes in economic environment have forced governments and multinational entities (MNEs) to define the transfer prices more precisely; otherwise, the tax administration can adjust the tax base of the entity to better reflect the open market conditions (Picciotto1992), with an impact on taxable profits, tax revenues of Member States and compliance costs of taxation overall.
Further, during the last decade and mainly in connection with the BEPS project, the question whether the allocation of tax revenues between Member States on the basis of the arm’s length principle and separate accounting (separate entity approach) can be still considered to be the most appropriate method within the EU arose. The current implementation of the arm’s length standard, which was first introduced during the 1930s,34 does not reflect the current economic realities of integrated multinational enterprises and markets, the digital environment and an environment dependent on intangibles. In this respect, Gammie (2003) underlines that a higher degree of integration for businesses makes the arm’s length fiction appear increas- ingly artificial. Hence, the arm’s length standard is not sufficient to prevent profit shifting through the manipulation of transfer prices, which is now resolved through the BEPS recommendation. Sullivan (2002,2004) adds that a large part of oppor- tunities for tax avoidance exist under the current international separate entity approach and arm’s length standard.
A second approach to the calculation of the tax base of the groups is a single entity approach with an allocation mechanism. Under this principle, all group members are treated as one single entity, i.e., all operations except those involved in the intra-group transactions of the individual members of the group are integrated into the single unit. Further, this approach is usually related to the minimal threshold of common stock ownership. Another element connected to the single entity approach is the allocation mechanism. As mentioned by Weiner (1999) and Weiner and Mintz (2002), the application of such a system requires the establish- ment of mechanisms for sharing the tax base between jurisdictions in which the members of the group are residents. The taxation theory offers several mechanisms for the sharing of the tax base. Some have already been implemented, e.g., in the
33The arm’s length standard is mentioned in Article 9 of the OECD Model Convention, and its practical application is followed by OECD TP Guidelines published in 1995, last update 2017. For more details about the arm’s length principle, OECD TP Guidelines and transfer pricing rules, see Chap.2.
34The arm’s length principle was implemented in the U.S.-France treaty in 1932 for the first time.
6.2 Current Situation of Corporate Taxation in the EU 139
USA and Canada. Generally, allocation mechanisms can be distinguished into two groups: the first group is based on macrofactors (usually aggregated at the national level—i.e., GDP or national VAT tax base), and the second group is based on microfactors (i.e., Value Added or selected indicators from the financial statements of the entities). Lodin and Gammie (2001) add that the selection of the individual method of formulary apportionment, as well as the selection of factors, significantly influences the size of the allocated group tax base. McDaniel (1994) underlines that the allocation mechanism is based on different assumptions from those of the separate entity approach; therefore, it has different economic impacts and generates different technical problems. Moreover, the OECD TP Guidelines35clearly reject the application of global formulary apportionment as a method for allocating profits between associated entities and consider it to be a non-arm’s length approach. In contrast, some authors prefer and support the introduction of formulary apportion- ment, as it takes into account the economic reality of integrated entities and markets; it is not such a compliance burden, and it is more stable against interna- tional tax avoidance (Miller1995; McIntyre2003; Harvard1976; Mintz and Smart 2004; Obermair and Weninger2008, and others). Contrary to the separate entity approach, formulary apportionment is able to eliminate some of the most common methods of profit shifting.
Formulary apportionment represents the tool traditionally used for tax base sharing in the USA and Canada. The history of formulary apportionment in the USA dates back to the 1870s, where it had been first applied in the area of property taxation. As mentioned in the literature (Weiner 2005), instead of measuring a company’s property in an individual state, companies measured their property, and the tax base was distributed to individual states based on the share in railways in each individual state. For income taxation purposes, the formulary apportionment was first applied in Wisconsin. At the end of the 1930s, nearly all states in the USA had already applied the three-factor formula with equally weighted factors. This formula is known as the Massachusetts Formula in taxation theory, and it can be expressed as Eq. (6.1).
PiẳPt
1 3
Ci
Ctþ1 3 Li
Ltþ1 3 Si
St
ð6:1ị
wherePirepresents the profit allocated to statei,Ptis the profit of the companies, Cstands for capital andS represent sales. As mentioned in the literature (Mayer 2009), since the 1980s, states have moved from equally weighted factors to the allocation formulae, where higher weight is put on the sales factor, while the weight in the case of payroll and capital has been decreased.
The development of allocation mechanisms in Canada has been slightly different from its development in the USA. As mentioned by Weiner (2005), originally, the allocation rules allocated income to the state where the permanent establishment of
35OECD TP Guidelines, part C, notably para 1.32, 2017.
the company was situated. If the company possessed a permanent establishment in more provinces, income was allocated based on the company’s accounting or according to the share of the permanent establishment in the total income of the company. As mentioned in the literature (Mintz 2004), while this system was widely criticized, the discussion of the possible implementation of the US model raised fears that it could allocate too much income to exporting provinces. There- fore, the formulary apportionment was modified to a two-factor formula with equally weighted factors. The Canadian formula can be expressed as Eq. (6.2).
PiẳPt
1 2
GIi
GIt
þ1 2 Li
Lt
ð6:2ị
wherePirepresents the profit allocated to provincei,Ptis the profit of the compa- nies,GItrepresents the gross income of the company, andLis labour. The main difference between the US formulary apportionment and the Canadian formulary apportionment lies in the fact that federal allocation rules comprise specific rules for specific industry sectors—e.g., the insurance industry or road transportation.
According to Petutschnig (2010), the most-used factors represent payroll, capital and sales. These factors are used in the allocation formulae in different combina- tions and with different weights. The key element of the CCCTB proposal36 is formulary apportionment based on the microfactors that comprise three equally weighted factors—sales, labour and assets—as can be seen in Eq. (6.3).
ShareXẳ 1 3
SX Sgroupþ1
3 1 2
PX PGroupþ1
2 EX EGroup
þ1 3
AX AGroup
CCCTB ð6:3ị
whereSrepresents the sales of goods and services,Pis payroll (comprising wages and salaries, bonuses and other compensation), E represents the number of employees (employed for the period of 3 months at least) and A denotes assets (including fixed assets, buildings, aircraft, boats and machines).
The tax sharing mechanism in the conditions of the EU based on the CCCTB proposal has been extensively discussed in literature. McLure (1997), Hellerstein and McLure (2004) recommend learning from the US and Canadian experience with formulary apportionment. Weiner (2005) and Mintz (2004) also stipulate several problems from the US and Canadian experience that may be useful for EU corporate taxation. The problem with the sharing mechanism within the EU and possible proposals has been also discussed by Sorensen (2004), Devereux (2004) and Agu´ndez-Garcı´a (2006). Other authors, such as Lodin and Gammie (2001), have focused on value added-based apportionment.
36Proposal for Council Directive on a Common Consolidated Corporate Tax Base, COM(2016) 683 final, at 25 October 2016.
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