Tax harmony in the European Community leaves much to be desired

Until recently, only minimal attention was given to tax harmony in the development of European Community (EC) tax directives. The priority in the EC was originally given to the indirect value-added tax (VAT) over corporate tax harmony, because there was no way that two major tax projects could be conducted at the same time. The need for stability of the member states and their inability to deal with the revenue of two simultaneous programs have been cited as reasons for the emphasis on VAT.

Before looking for the pitfalls in the EC's corporate tax and VAT systems, the VAT and its history must be briefly discussed. In addition, tax planning opportunities or loopholes are highlighted. Much can be gained by interested parties in the United States from focusing on the EC's tax environment.

Value-Added Tax

VAT is a tax levied on the value added to goods and services by each business entity at various levels in the production and distribution chain. It is an indirect tax levied on consumption and borne by the final consumer of goods or services. It is included in the price that the ultimate purchaser pays. Thus, it differs from adirect tax such as income or inheritance tax. In certain respects, a VAT is similar to a retail sales tax. There is a fixed rate of tax and there are exempt products or users. The similarity, however, stops there. Whereas a retail sales tax applies only to the final sale, a VAT applies to each sale in the commercial process: from supplier of raw materials to manufacturer, from manufacturer to wholesaler, from wholesaler to retailer, and from retailer to consumer. In theory, the tax base relates to the increase in value added to the product at each level; in practice, it is measured by the increase in sales price at each level.

Ultimately, the full weight of the tax falls on the final consumer. In the normal situation, each business in the process collects the VAT on its sales, takes a credit for any VAT it has paid on purchases, and remits the net amount to the government. If the business pays more VAT than it collects during the period, it receives a refund or credit. Only the retail consumer is not entitled to a refund or credit for VAT paid.

History of VAT in the U.S. and EC

From time to time during the last 60 years, there have been proposals for a system of taxation bearing a resemblance to VAT. As long ago as 1921, T.S. Adams proposed a form of VAT for the United States. In fact, a bill calling for a federal value-added tax was introduced in Congress in 1940. A variant of the tax was levied by the State of Michigan from 1953 to 1967, and in 1975 Michigan adopted the Single Business Tax, which functions as a VAT. The Michigan Single Business Tax was adopted to replace business income and franchise taxes and certain taxes on inventories. Experience with the Michigan system has been good, and the level of revenues from the tax has been fairly stable, facilitating better planning of state government operations.

In 1970, a Presidential Task Force on Business Valuation examined the concept of VAT in connection with its study of major tax policy issues. The Task Force concluded that a value-added tax system should not be substituted, in whole or in part, for one of the existing federal taxes.

Although a VAT can be found in the tax laws of France from 1954, it was not until the EC approved the system in 1967 that a commonality of taxation began to emerge. France and Germany adopted the system as of January 1, 1968, and other members of the EC adopted it over the next several years. Today, the EC and many countries in South America have adopted the VAT concept.

The Council of the European Community issued two directives on April 1, 1967, requiring member countries to implement the VAT system by January 1, 1971. The purpose was to harmonize the various turnover tax systems then being employed by the members to permit a better flow of imports and exports amogn the members with essentially equal taxation. The VAT was to replace existing taxes imposed by the various EC members. A certain amount of latitude was granted to the member countries in establishing the rates, items to be exempted, businesses that would be exempt, etc. All EC members, however, have hewed to the basic concept that exceptions and reduced rates should be limited.

The EC Value-Added Tax

The VAT system in the EC provides myriad planning opportunities. Tax planners can make use of the differences between the national VAT laws and the manner in which the countries have implemented the VAT directives. To illustrate, consider the case of a Brussels architect providing services for a building in London. Belgium will not impose a VAT on the architect's services because the services are associated with a building that is located outside Belgium. The United Kingdom, however, will also not impose a VAT. The Brussels architect is not considered a taxable person under the U.K. law because the architect is not sufficiently "related" to the United kingdom. It is easy to single out the VAT aspects of a transaction, but a business must consider all aspects in making a location decision.

The VAT directive has not provided sufficient tax harmony within the EC. There are widely diverse tax rates including Luxembourg's 12-percent rate and France's 33-percent rate on luxury items. The VAT continues to be a destination tax imposed on imports, so adjustments are required on border crossings by both countries.

Nevertheless, it is questionable whether there is a clear solution that implements the initial proposal to harmonize tax rates and switch to an origin-based VAT. The VAT is a substantial revenue source and member states worry that an origin tax will prompt people to make purchases elsewhere.

The various VAT rates in the EC member states should not influence a U.S. exporter's selection of location for its European warehouse. The location of a warehouse in a low-VAT jurisdiction will reduce the financing cost associated with the imported goods stored in that warehouse. The same result can be achieved, however, by using bonded warehouses to avoid the VAT on the imported goods.

Parent-Subsidiary Tax Directive

On July 23, 1990, the EC adopted a directive concerning the taxation of dividends paid to a parent company located in one member state by a subsidiary located in another member state. The directive provides that the distribution of such dividends will be exempt form a withholding tax. Furthermore, the member state of the parent company must either refrain from taxing the distributed profits or provide an indirect foreign tax credit.

Several features of the parent-subsidiary directive should be highlighted. A minority shareholder can be a parent company because the directive defines a parent company as a company with a minimum holding of 25 percent of the stock of another company. The United Kingdom will be able to keep its advanced corporation tax so long as a tax credit is given since the directive does not cover an advanced payment of corporation tax by the subsidiary.

Because of Germany's split-rate corporate tax systems, the directive allows Germany to impose a compensatory withholding tax of five percent until mid-1996. To qualify for this exception, Germany must continue to apply a corporate tax rate on distributed profits that is at least 11 points lower than the corporate income tax rate imposed on retained earnings.

Tax Treaty Between the U.S. and EC

There is pressure within the EC to negotiate a tax treaty with the United States that would address issues on which the member states have reached agreement. Everyone concerned expects a U.S.-EC tax treaty in the future. Congress should be aware of the tax environment in the EC to negotiate successfully even a partial treaty with the EC.

Conclusion

Any serious discussion of VAT must begin with the recognition that the adoption of a VAT involves a fundamental change in the philosophy of raising revenue. The addition of VAT to another tax structure involves a shift from near-total reliance on direct taxes on income to a more balanced system that involves indirect taxes on consumption as well as taxes on income. Businesses must take advantage of tax planning opportunities in the EC while other interested observers (e.g., Congress, economists, lawyers, and accountants) must learn from the EC experience to avoid tax disharmony for the future in the United States.

COPYRIGHT 1991 Tax Executives Institute, Inc.
COPYRIGHT 2004 Gale Group