(Ed. Note: The “Innovation Fact of the Week” appears as a regular feature in each edition of ITIF’s weekly email newsletter. Sign up today.)
The European Commission is set to release a report this week on corporate tax reform. According to news reports, it will recommend that the European Union make unilateral changes to the way its members tax large international companies. If these reports are accurate, European leaders should reject the report’s proposals. Unilateral action would shackle Internet companies in particular and jeopardize several years of progress toward negotiating important reforms to international tax law.
Corporate tax law is extremely complex, and it gets even harder when considering the interrelationships between the tax laws of different nations. This complexity is particularly true for Internet companies. If a sales person in Ireland talks to a company in the United Kingdom about running Internet ads in Germany, which country should get to tax the profits? Although each country is free to set its own tax laws, these laws have been supplemented by myriad treaties to minimize double-taxation and simplify international transactions. Most experts think these laws need updating to reflect increased globalization, the growing role of services and information goods, and the threat of low-tax jurisdictions. That is largely why the international community is currently engaged in the Base Erosion and Profit Shifting (BEPS) project, led by the Organization for Economic Cooperation and Development (OECD). Although it is less than three years old, this process has resulted in several detailed reports and recommendations for future action.
But many European countries are anxious to pass their own laws quickly. This stems from a general feeling that Internet companies are not paying their fair share of taxes. According to Reuters, the report contends that these companies pay a tax rate of only 10.1 percent on their profits, compared to 23.2 for traditional companies. However, these figures do not include all of the taxes that Internet companies must pay. Most of these companies are American, and the United States imposes a tax rate of 35 percent on all income earned abroad. Because this tax is deferred until the companies repatriate the earnings, many Europeans pretend that it does not exist. But it does.
Many countries are upset that American companies make profits through transactions with their nationals but pay very few taxes as a result. There are two reasons for this. One is that the companies use so-called “transfer pricing” rules to shift income to countries with lower taxes. These rules are set by governments and accounting professionals. The BEPS project is currently looking at tightening the rules but, until it does, companies have the right to use them.
Second, to reduce double taxation, current treaties require that companies have permanent establishments in a country before that country is allowed to tax their profits. Many Internet companies lack this presence. Again, the permanent establishment rule exists for a good reason: to prevent companies from having to pay tax to two countries on the same income. In the United States, a similar rule holds for states. As a result, states often use an apportionment rule based on some combination of property, sales, and payroll located in the state. The EC lately has been promoting a similar policy to distribute corporate profits among EU members. An apportionment rule for countries would be a significant departure from current practice and would require negotiation with other countries, including the United States. In the meantime, the EC wants members to consider interim steps such as taxing revenues rather than profits.
Should the EU go ahead and unilaterally change these tax rules, it would almost certainly violate the terms of international treaties. The other provisions of these treaties would then be in question, because partner countries would surely want compensation. The United States would be especially harmed because U.S. companies could immediately deduct any increase in European taxes from their U.S. tax liability.
The controversy also demonstrates the continued need for corporate tax reform in the United States. The high U.S. tax rate on foreign profits protects other countries from having to worry about the economic consequences of imposing their own higher taxes. Because companies can deduct foreign taxes from their U.S. liability, any increase in foreign taxes would reduce tax revenues in the United States. Rather than fearing tax competition, countries should welcome it. Taxing corporate income, and especially corporate investment, harms economic growth much more than does taxing individual income or consumption.
The OECD BEPS project began as a good faith effort to tackle an international problem on which governments have different perspectives. It has made a good amount of progress. For European governments to unilaterally change the rules because they want a larger cut of the total taxes that U.S. companies pay would be acting in bad faith and would bolster recent attempts to weaken the Western alliance.