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Sophisticated Financial Engineering and Tax Arbitrage an Assessment of the European Fiscal Regime for Corporate Tax Mitigation

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Sophisticated Financial Engineering and Tax Arbitrage an Assessment of the European Fiscal Regime for Corporate Tax Mitigation 3 Sophisticated Financial Engineering and Tax Arbitrage An Assessment of the European Fiscal Regime for Corporate Tax Mitigation Ronen Palan, Anastasia Nesvetailova, with Hannah Petersen and Richard Phillips The impact of the financial crisis of 2007/8, followed by a series of damaging leaks such as the Panama Papers, Paradise Papers, Lux Leaks and the like, has intensi- fied efforts to reign in the more aggressive forms of tax planning perpetrated by the corporate sector (known as aggressive tax planning, or ATP in short).+ In the past decade, the OECD has launched its Base Erosion and Profit Shifting (BEPS) programme designed to identify and combat gaps and mismatches in tax rules that could be exploited by multinationals to erode the tax base (OECD 2013). In the US, the Tax Cuts and Jobs Act (TCJA) introduced in 2017 is anticipated to have important implications on business taxation worldwide (Avi-Yonah 2019; Dharmapala 2019; Kudrle 2019). A UK Parliamentary Committee on Public Accounts has specifically focused on the professional services enabling ATP practices (House of Commons 2015). Independent researchers have delivered a substantial amount of evidence that massive amounts of profit-shifting are taking place by the corporate sector through so-called conduit low-tax jurisdictions¹ (Cobham and Janský 2018; Dharmapala and Hines 2009; Garcia-Bernardo et al. 2017; Gumpert et al. 2016; Haberly and Wójcik 2015; Hines 1988; Hines and Rice 1994; McGuire et al. 2012; Palan et al. 2013; Phillips et al. 2020; Shaxson 2012). + The authors would like to thank Joras Ferwerda, Andre Guter-Sandu, Yuval Milo, Nikoforos Panougrias, Jean-Phillip Robé, Lucia Rossel Flores, and Brigitte Unger for their help, support, and comments on previous drafts of this chapter. ¹ Certain jurisdictions such as Ireland, the Netherlands or Singapore are increasingly used as regional gateways for foreign investment (Clausing 2016; Cobham and Janský 2019; Haberly and Wójcik 2015). Jack Mintz defined such countries as ‘conduit jurisdictions, having both large capital outflows and inflows (not just one or the other)’—see (Mintz 2004, p. 423; for discussion see Garcia- Bernardo et al. (2017). Ronen Palan, Anastasia Nesvetailova, with Hannah Petersen and Richard Phillips, Sophisticated Financial Engineering and Tax Arbitrage: An Assessment of the European Fiscal Regime for Corporate Tax Mitigation In: Combating Fiscal Fraud and Empowering Regulators: Bringing Tax Money Back into the COFFERS. Edited by: Brigitte Unger, Lucia Rossel, and Joras Ferwerda, Oxford University Press (2021). © Oxford University Press. DOI: 10.1093/oso/9780198854722.003.0003 36 There is no regulatory authority as concerned with ATP as the European Commission. Since 2013, the Competition department of the European Commission launched a number of investigations into the tax affairs of high-profile groups such as Apple Inc. (European Commission 2016), Fiat and Starbucks in the Netherlands (European Commission 2015a), as well as Belgian tax schemes (European Commission 2016), and Amazon. These investigations delivered, without exception, detrimental findings to the multinational enterprises (MNEs) under investigation. To the great consternation of specialist corporate lawyers (Giraud and Petit 2017; Lovdahl Gormsen 2016; Richard 2018; Traversa and Flamini 2015) and the US Department of the Treasury (US Department of the Treasury 2016) fines have been levied (European Commission 2016, 2015a, 2015b).² Away from the headlines, the EU commissioned on Taxation and Customs Union (TAXUD) launched a series of in-depth investigations into ATP practices (TAXUD, 2017). The European Commission introduced two powerful measures, the Common Consolidated Corporate Tax Base (CCCTB) Directive, widely recognized among the strongest measures available for dealing with abusive tax schemes by multi- nationals within the European Union (Dourado 2016; Morgan 2016; Seabrooke and Wigan 2016; Spengel et al. 2018). In addition, the commission launched an Anti-Tax Avoidance Directive (ATAD), a powerful suite of measures that aim to curb aggres- sive tax avoidance and introduce a series of ‘good governance’ principles impacting third country jurisdictions as well (Dourado 2016; Greggi 2019). How successful have these measures been so far? Is the European fiscal regime better as a result of these initiatives? Is it fit for purpose? We consider fiscal regimes as ecosystems (see Chapter 2 for a detailed description of the tax ecosystem) that often respond to regulation by innovation and displacement. Considering that the demand for tax mitigation is unlikely to subside due to new regulations, one of the questions we asked in this project was whether the new rules might result in a so-called squeeze balloon effect. An area or set of practices that are being targeted by regulations would encourage the use of alternatives schemes, so that like a squeezed balloon, shape changes but the overall volume does not. Our concern from the outset had been to identify such potential displacement effects caused by the tightening European fiscal regime. We exam- ined specifically two potential realms of systemic displacement: trade-related and financial oriented set of schemes. Most estimates of corporate tax avoidance focus on trade-related intra-firm transfers. Typically, estimates of rising or declining effective tax rates (ETRs) and profit shifting employ macro-economic financial data on foreign direct investment and portfolio investments, or other similar data ² Unlike other regulatory authorities, in the EU the commission for competitiveness rather than the department of taxation and custom Union (TAXUD) had taken the lead. This has skewed the discussion from tax towards state aid and competition, and left technical legal matters associated with taxation less well developed. .37 (Cobham and Janský 2019; Garcia-Bernardo et al. 2019; Haberly and Wójcik 2015). This important work provides a snapshot of estimates of profit shifting. We sought, in contrast, to delve deeper into the inner sanctum of corporate organization in order to find evidence of marked decline in the use of techniques of tax arbitrage, otherwise known as jurisdictional arbitrage (Nesvetailova and Palan 2014; Palan 2014). These techniques employ structures embedded in the group’s ecology, or group of corporate entities organized in such way that they can exploit gaps, loopholes and blind spots in national regulations with the aim of lowering overall corporate taxation. The assumption is that assessing the intensity in the use of such techniques may provide better indication of the success, or not, of a fiscal regime in curbing trade-related tax mitigation. Our findings suggest that whereas such structures are rarely present in the US market, implying that the US Internal Revenue Service has been successful in curbing technique of tax arbitrage, they are very common throughout the European Union area. We follow then with an analysis of the use of sophisticated financial instru- ments in tax mitigation technique to assess the impact of finance-oriented tax mitigation techniques. Our conclusion is not positive. It appears to us that in comparison with the US (and possibly China), the European fiscal regime failed to address a core political issue. The European market is a unique multi-entry, multi- exit single market fiscal regime. As a result, not only can foreign firms select locations of foreign investments by pitting one country against another, but in the case of the single market, firms can also select their legal entry point into what are still diverging national fiscal regime. These political conditions encourage, as we will see below, the use of those diverging rules and regulations one against the other and affect jurisdictional arbitrage with the overall aim of tax mitigation. 3.1 Corporate Taxation in a Global Economy The standard approach to taxing MNEs is embedded in the broader firm/market dichotomy, which still serves as the building block of an economic analytical thinking (Demsetz 1988; Penrose 2009). The firm is considered ‘a unit of plan- ning’ (Penrose, 2009) and coordinator of factors of production (Coase R. H. 2007), operating within decentralized self-equilibrating economic systems. The preoccu- pation of economists with the price system, notes Harold Demsetz gives ‘serious consideration of the firm as a problem solving institution’(Demsetz 1988, p. 141). As a result, for a long time there was no theory of a firm to speak of. One implication of what became known as ‘the law of diminishing returns to scale’ was that most businesses would remain relatively small (Beck 2004). Firms were not simply neglected; they were not supposed to play an important role in economic life. Clearly, this assumption proved wrong. The history of the twentieth century had been the history of the rise of large multinational corporate organizations. It 38 took decades until economists began to seriously address this purported anomaly (Boudreaux and Holcombe 1989; Coase R. H. 2007; Demsetz 1988). From about the late 1930s on, the very growth of firms, let alone the emergence of powerful multinational enterprises, has attracted growing attention (Buckley and Ghauri 1999; Jones 1988; Penrose 2009). Equally puzzling from the standard economic perspective had been the issue of corporate taxation. The law of supply and demand in self-equilibrating markets was supposed to ensure that profits were paper-thin. Corporate taxation should not have been an issue of public concern because, firms should
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