Prof. Lorenz Jarass / Prof. Gustav M. Obermair, October 1998

Connteracting Harmful Tax Competition
through Taxation at Source

Governments around the world have not been able - or may be not even willing - to prevent an evil that has been called, in a rather diplomatic language, erosion of the tax base capital. The term circumscribes the dwindling of the revenue derived from the taxation of large scale business activities. This decrease of revenue which is rather drastic in some countries has been a growing concern of supranational bodies such as the European Commission or the OECD; the latter has recently published several reports on taxation in a global economy and, in 1998, a set of proposals to define the problem and to counteract the detrimental effects.

The problem is made up of three effects that are closely related to each other (cf. section VII of our 1997 report to the EC: More Jobs, Less tax Evasion, Cleaner Environment

  • tax avoidance, often transtormed into tax evasion, made possible through the use of global financial instruments and, in many cases, favoured by the rules of bank secrecy;

  • the growing discrimination, in many countries, of tax residents and domestic business in comparison to tax foreigners and international business, which is due, among other factors, to:

  • the socalled 'tax competition', which, as practiced, should rather be called 'tax dumping' or 'unfair tax practices'.

Historical roots of the Problem

Historical developments going back to the 1920ies have led - more or less in all OECD countries and around the world - to the following system of taxation of income from business activities:

  • Certain parts of operating surplus are taxed according to the principle: 'residence of producer' (e.g. profit),

  • other taxable parts of operating surplus are taxed according to the principle: 'residence of beneficiary' (e.g. interest).

At a time when most investments and returns were domestic, this double system could not give rise to great distortions deriving from tax regimes varying largely from country to country. The globalization of production and trade, the complete liberalization of the international money market and hence the ever growing global flow of financial instruments has led to a completely new situation and created the phenomenon that is precisely described by the term harmLul tax competition:

  • A growing number of countries have established preferential tax regimes for international business (tax havens).

  • A growing share of domestic surplus in the non-tax-havens is legally, e.g. via transfer to international holdings, or illegally, e.g. via untrue transfer pricing, transLormed into non-domestic income and thus shifted to tax havens.

  • The growing sector of financial services and of production of immaterial goods eludes a clearcut definition of the country of production and thus altogether evades taxation according to 'residence of producor'. At the same time payments to the service provider that might be taxable can easily be shifted to a country with a preferential tax regime.

As a consequence we see on the level of countries the increasing erosion of the the base 'business income', on the level of enterprises a gronving tax discrimination of domestic, in particular of small business, that cannot participate in the 'internationalization' of its gross income.

Doubtful Remedies

An ever growing, increasingly diffcult and nontransparent apparatus of national rules and regulations, of bior multinational agreements, supranational directives and international controls may, in our opinion, at best reduce these harmful effects. Certainly the Reconunendations and Guidelines set forth in tlle OECD Report on Harmful Tax Competition will, if enforced, improve the situation; but, as also indicated in this report, new situations may require further and completely new solutions.

One drastic solution could be that govemments relinquish all claims on business income as a tax base and shift taxation entirely towards individual income and property and towards indirect taxes. (De facto even though not yet de jure this is happening in some countries: in Gemmany the contribution of all taxes deriving from both individual and corporate capital to the total tax revenue has been decreased from 17 % to 10 % in the 1980 - 1996 period.)

An Altemative: Taxation at Source

The altemative is a proposal that retains business income and -property as a taxe base by means of a general tax at source, i.e. in the country where a taxable surplus is produced. The proposal which at least in principle is simple, transparent and easily controlled is that the two principles 'residence of producer' and 'residence of beneficiary' are replaced by a single principle 'taxation at the source':

  • All surplus produced (e.g. retained and distributed profit + interest. royalties etc.) is the tax base for an anonymously levied flat rate tax within the enterprise where it is physically produced, irrespective of the nominal tax residence of the corporation or its mother or the beneficiaries of the distribution (similar to 'enterprise tax' or 'business tax', already existing in several countries). No imputation, i.e. the tax paid by the company ca~mot be credited against the shareholder's personal tax liability ('classical system').

  • All surplus distributed (e.g. dividends, interest, royalties etc.) is subject to an additional flat rate withllolding tax at the source ~vhich serves as an individualized prepayment of taxes on personal income. With respect to wages & salaries and some distribution of surplus this fonm of taxation is practiced successtully in most countries anyway.

  • As a result there is at least one party in almost all conceivable economic transactions that has a dominant self-interest to declare fully and correctly in order to avoid an overvaluation and resulting overtaxation of his own income or wealth. Thus also the other party in a given transaction is easily controllable by a comparison of tax records.

Thus any provable result of an economic activity in a given country is subject to taxation in this country. (It is true that the temptation to reduce the provable taxable income within the country by means of untrue transfer pricing may be increased; observation of the OECD's 1995 Guidelines on Transfer Pricing, c.f. Recommendation 6 conceming transfer pricing rules, becomes the more important.)

The Role of Financial Instruments

Payments for financial services, including payments for derivatives and similar financial products which are increasingly used to replace the traditional financing through bank loans, should be treated like interest payments and hence be taxed at source, i.e. at the business entity using the service or instrument, unless the user can prove that the service does not represent a 'synthetic loan'.

Likewise payments for immaterial goods utilized in a given country should also be subject to the source tax in this country, unless the paying party can prove that the receiver of the payment is adequately taxed in his country of residence. Due to the self-interest of the paying party - cf. the section above - to declare these payments and the source tax on them correctly, complicated supranational control systems for the taxation of the trade with financial services and other immaterial goods can thus be avoided.

How to Realize such Tax Policies

In principle the taxation-at-source-measures outlined above could be enacted through national legislation in any country that is suffering from the present unfair tax practices. However, in order to be efficient and to avoid new escapist strategies on the side of global business such legislation ought to be coordinated among a large group of important industrial nations, possibly under the auspices of supranational bodies such as OECD. As far as hannonization Nvithin Europe is concemed, the fact that a large number of European countries are now ruled by a social-democrat majority, detenmined to further the advantages of a global economy and at the same time to counteract its detrimental social effects, may facilitate supranational coordination and collaboration in tax matters.