State of the European Union

As I understand it, both the field of Game Theory and the age-old puzzle of the Prisoner’s Dilemma deal with the dynamic that often individuals will be best off colluding as a group–but one, some or all of them will instead prioritize their relative advantage by acting on their own.

It’s something one thinks of when following the European Union as it tries, in fits and starts, to implement the 15% global minimum tax which each individual EU member agreed to last year at the Group of 20 nations and the Organization for Economic Cooperation and Development.

With unanimity required at the Council of the European Union for most tax matters, Poland was the first to block a directive mandating that EU members enact the new OECD standards into their national laws. (The minimum tax agreement isn’t just an agreement on tax rates–it’s a complex new tax regime that participating nations must apply to the foreign income of corporations headquartered in their jurisdictions.) When Poland finally seemed mollified, Hungary stepped forward to block the process, claiming that the project should be delayed amid inflation and other economic headwinds.

Does this represent a true breakdown in the consensus, or is it simply jockeying and bargaining? I hate to use a hoary journalism cliché, but that remains to be seen. If it is part of the back-and-forth of negotiating, several nations supporting the OECD plan made the most recent move, vowing in a joint statement to implement the tax regardless of what the EU as a whole does.

Most observers take this promise less at face value and more as a tactic, mainly because it’s unclear if these nations can legally follow through. The EU has traditionally required unanimity on taxes, as well as other “sensitive” matters spelled out in treaties. This practice was further reinforced by the the Court of Justice of the European Union’s 2006 “Cadbury Schweppes” decision. While the EU members have debated ending this requirement in recent years, it’s unclear if there’s enough votes for that, either.

I’ll admit, EU politics is something I’ve never totally been able to wrap my head around. Not only because of its almost impossibly baroque leadership structure (two councils, a parliament AND a commission?), but I’ve also never covered it directly in Europe. This latest flareup seems to demonstrate a common theme I’ve noticed in my very limited time following specific EU initiatives (such as its recent state aid investigations)--that it’s an institution unsure of what exactly it is. Or, more specifically, something that its participants have different ideas of what it is and what it should be, without a clear understanding of what all sides have bought into, politically.

This is perhaps most clear in how it deals with income taxes. Which, oddly enough, it’s not supposed to have jurisdiction over at all.

In Cadbury Schweppes Plc et. al. v. Commissioners, the court ruled in favor of the iconic British confectionery company when it challenged the United Kingdom’s controlled foreign corporation tax against Cadbury’s Irish income. CFC rules, used throughout the world including in the United States, normally apply to certain categories of income such as royalties or interest, earned by foreign subsidiaries of companies based in the jurisdiction applying the CFC rule. That income is immediately taxed under the CFC rule as if it were domestic income, at the full national corporate income tax rate.

The CJEU, however, ruled that such a tax violates the principle of freedom of establishment, one of the cornerstones of the EU’s common market. Commerce is supposed to run freely between EU member states, as if there were no borders at all. For one country to tax income earned in another country violates this principle, unless it can show that the structure it’s taxing was created purely for tax reasons, the court said. Since then, EU nations’ use of CFC rules has been much more limited.

To a tax person, the CJEU ruling is fairly baffling. The whole reason that CFC rules exist is because experience has shown us that qualitative determinations of what is or isn’t tax avoidance aren’t enough. Most European countries have general anti-avoidance rules (GAARs) that block tax structures found to be abusive, and the U.S. has a similar rule with the economic substance doctrine. Those can work in limited instances, but judging intent is inherently subjective and difficult. CFC rules are supposed to be broader, blunter tools for capturing the forms of passive income which are most often used in tax avoidance schemes.

Thus, there is a central incompatibility between the OECD’s Pillar Two project and the CJEU Cadbury logic. Pillar Two, which functions similar to a standard CFC rule, uses a formula based on tangible income and payroll to define intangible income, in lieu of a definitional approach. Defining income earned through valuable intangible assets such as intellectual property is hard enough–let alone determining when intangible income is involved in tax avoidance. The appeal of a proxy by formula is that it’s a much simpler, “rough justice” way to deal with avoidance. The whole logic of it falls apart if a qualitative requirement is then laid on top of it.

So, is there any wiggle room for individual EU nations to move forward with Pillar Two, despite the CJEU ruling? Those I talked to differed on the subject.

Dan Neidle, a London-based lawyer formerly with Clifford Chance LLP, now advising through his own entity, Tax Policy Associates Ltd., said it was “pretty clear.”

“The CJEU decision in the Cadbury Schweppes case means that CFC rules are only permissible if they apply to cases where a subsidiary is artificial,” Neidle wrote to me in an online message. “Clearly, Pillar Two applies regardless of purpose. So Pillar Two appears kiboshed by this.”

Joachim Englisch, a professor of public and tax law at the University of Münster, said he saw a lot of “grey area,” however.

The court may not intervene if the countries implementing the Pillar Two rules also implement a “qualifying domestic top-up tax” applying to domestic profits as well, which was their plan. The goal of Pillar Two isn’t necessarily to penalize foreign income, it’s to equalize it with domestic income. The court may be willing to give it a second look.

“It has shown considerable restraint recently with respect to qualifying a mere disparate impact of detrimental rules as an indirect discrimination,” Englisch said in an email.

Regardless, it would certainly make things simpler if everyone just agreed to the EU directive. It’s hard not to suspect that this is the outcome everyone is hoping for, once the politics is finished with.

It’s a bit mystifying that it would be so hard for EU countries to implement an agreement they all signed onto, when the European Union isn’t even supposed to have jurisdiction over direct taxes. But in recent years, the European Commission's competition division, enforcing the common market and anti-discrimination rules, has operated more and more like a de facto tax authority.

The state aid investigations into alleged tax avoidance were also ostensibly an anti-discrimination, not tax, matter. EU member states agreed to avoid using tax incentives or benefits to lure businesses from one country to another–a sweetheart deal promising loose tax enforcement is a violation of that agreement, argued Margrethe Vestager, European Commissioner of Competition.

It makes a certain amount of sense. But it’s hard to see where it stops. Tax authorities make strategic decisions about enforcement (including agreements with taxpayers) every day, due to limited resources as well as legal uncertainty. Couldn’t any of those be challenged as inadequate under the common market rules, and wouldn’t that make the EU the continent-wide tax authority in everything but name?

“The commission has got itself now in a position where it’s a bunch of plumbers doing electrical work,” Robert Stack, then a Treasury deputy assistant secretary, said at the time.

Tax administration is one of the basic functions of state sovereignty, and it’s one of the last things a country would give up before it becomes absorbed into a larger political entity. Has the EU taken the next step to become that entity? If it assumes so without buy-in from all of its members, chaos is bound to ensue. I wouldn’t presume to conclude that Brexit is an example of this chaos, but it’s hard not to take notice.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

New British Prime Minister Liz Truss kicked off her term with a bang, by unveiling an aggressive plan for deep tax cuts, including to the country's planned 25% tax rate. Noticeably absent from the announcement? Any mention of the OECD global minimum tax, pro or con. In a way it makes sense, why tie herself down as the project remains on shaky ground worldwide? On the other hand, it seems significant that she didn't take the opportunity to either re-commit to the project or put another nail in its coffin. Stay tuned.

The OECD released a series of reports on tax administration, to coincide with the 15th Plenary Meeting of its Forum on Tax Administration. The reports included a "manual" on bilateral advance pricing agreements, which tax authorities and taxpayers use to pin down international income allocations for a certain time period, usually 5 years. APAs are increasingly important for the functioning of the global tax system, and have become more controversial as well. (See state aid investigations, above.) This is definitely worth a look.

Speaking of reports, the World Bank also released an overview of the OECD Pillar Two global minimum tax agreement. The Bank notes the complexity of the rules, and commits to assisting low-income countries understand and implement their different options.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Commando Cody, the protagonist from Republic Picture's 1952 serial "Radar Men from the Moon." A civilian researcher who travels to the moon to defeat "Moon Men" threatening Earth, lead by the nefarious Retik.