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Belgium tries to woo companies by offering them massive tax breaks to establish their headquarters within the country’s borders. Ireland temporarily lowered its corporate income tax rates to lure foreign manufacturing businesses and banks to its shores. Luxembourg and the Netherlands offer their own unique sweetheart deals to multinationals. So much for a unified Europe. While businesses can benefit from countries’ competing tax rates, there is a catch. Multinationals also must endure the cost and complication of complying with the 15 European Union nations’ very different tax systems. “It makes it more difficult to achieve the proper tax result and avoid double taxation,” explains James Diller, who heads European tax planning for General Motors Corp. You’d think doing business on the Continent would be simpler, considering that Europeans have been working on economic cooperation for almost 50 years. Watching them trade in their liras, francs, and marks for euros earlier this year, Americans might have gotten the impression that the EU finally had adopted something resembling the U.S. federal tax system. But the EU remains a relatively loose alliance of 15 very independent nations. Each is loath to give up its fiscal sovereignty. Nowhere is that more apparent than in how fiercely they protect their tax laws. But all that is changing, albeit slowly. The need to grind down inconsistencies and contradictions among the various tax regimes grows more urgent as globalization spawns more businesses with operations in multiple EU countries. Acutely aware of this, the European Commission (the EU’s executive arm) has gone on the attack. During the last five years, the EC has adopted a three-pronged strategy to make its members’ tax laws more uniform. The EC has asked countries to voluntarily repeal laws that permit unfair tax advantages. The commission has also used its enforcement powers to strike down other tax breaks. And, when necessary, it has brought suit against some countries in the European Court of Justice. “What we are about is making sure there isn’t any unfair competition among member states — that nobody is poaching investment or employment,” says Matthew King, first secretary of the EC’s delegation in Washington, D.C. Why is the EC taking this tack now? Because it has finally learned from past mistakes. Starting in the 1970s, the EC tried to “harmonize” taxes among its member nations by proposing federal tax legislation to the European Council. But the council, a legislative body comprised of a few representatives from each EU nation, invariably defeated these proposals. In the late 1990s, in an effort to meet the growing needs of globalization, the EC changed tactics. Instead of sweeping, tax harmonization laws, it decided on a more indirect route. And that piecemeal approach will eventually succeed, says Peter Nias, a partner in the London office of McDermott, Will & Emery. “There’s momentum building,” he says. “One day, multinational corporations will wake up and say: ‘So, really we’re now all harmonized.’ One day we’ll just realize it’s happened.” RESISTANCE Proposals for federalizing the tax system have been floated for decades, but invariably were stalled or vetoed. The treaties that created the EC give it the right to propose tax legislation. But council members must unanimously support a tax measure in order for it to become law. That means just one country can stop the whole process. And “countries like the United Kingdom jealously guard their right to veto EU tax proposals,” says Jefferson VanderWolk, a London-based partner at Baker & McKenzie. It’s not just the U.K. “It’s a gross generalization,” says J. Edward Troup, a partner with London’s Simmons & Simmons, “but the Germans are the federalizers. The French always look out for themselves, and the Belgians never play by the rules.” Even in Germany, being too strongly in favor of federalization can be fatal. Oskar La Fontaine, Germany’s finance minister in the late 1990s, was a major promoter of EU tax harmonization and was sacked as a result. Italy, after loyally toeing the EU line for years, has recently become more “Euroskeptic” and is now less willing to support federal legislation. SURGICAL STRIKES Instead of mounting full frontal attacks — comprehensive laws to harmonize everything at once — the EC has turned to small, guerrilla assaults. One method: It issued a list, called the “Code of Conduct,” publicizing 60 market-distorting tax breaks in the EU nations. The Dutch, for instance, offer multinationals the chance to use “Dutch ruling procedures,” so that certain financing activities and royalty collections are taxed at a lower rate. Luxembourg encourages foreign corporations to shift income to “Luxembourg finance companies,” which can offer effective tax rates as low as 5 percent. This naming of names seems to have made an impression. Many EU members voluntarily committed themselves to doing away with their offending tax laws. As Michael McGowan, a partner in the London office of Shearman & Sterling, points out: “There’s quite a bit of peer pressure on member states to clean up their acts.” Luxembourg, for one, will be phasing out its special rate for finance companies by the end of 2002. The code also seems to serve as preventive medicine. “Special” tax measures used to get enacted by nations at a “fairly steady” rate, according to Simmons & Simmons’s Troup. Ever since the EU started focusing attention on rogue tax laws, though, none of the member states has introduced such tax breaks, he says. FLEXING ITS MUSCLE When shame doesn’t work, the EC brings in the heavier artillery. The executive body has the right to permit or prohibit “state aids,” special tax breaks countries give to specific sectors to attract foreign investment. While it has had this authority for decades, the EC has deployed it more as globalization has grown. Ireland is a good bellwether of this changing stance. In the 1980s, the country decided to lure foreign manufacturers to its shores — and financial services companies into downtown Dublin — by lowering corporate income tax rates for these types of businesses to 10 percent (versus the country’s overall corporate tax rate of 35 percent). The EC permitted this exceptional tax break because Ireland’s public debt was 70 percent of its GDP, and the country desperately needed help catching up with its EU compatriots. The strategy worked. Manufacturers built factories in Ireland, and, says Shearman & Sterling’s McGowan, “a whole series of foreign banks basically piled into Dublin.” By the 1990s Ireland had the fastest growing economy in the EU So, in 1998, the EC forced Ireland to raise its tax rate for manufacturers and foreign-based Dublin banks to match the country’s overall corporate rate, now 20 percent. The EC’s action was a wake-up call for European nations. “More and more special regimes are likely to come under scrutiny,” predicts McGowan. JUDICIAL ACTIVISM The EC’s “scrutiny” also carries a lot of weight these days because the commission has shown that it is increasingly willing to take member nations to court over tax issues. And the highest court in the EU — the European Court of Justice — has been ruling in its favor. During the past 10 years, the court has ruled that a number of state tax measures are illegal. “The ECJ has become very much more aggressive,” says McGowan. State aid cases, first brought in the mid-1980s, have, in the last five years, he says, “turned from a trickle to a flood.” Taking a page from the EC’s playbook, corporations also are taking countries to court over allegedly unfair tax practices. And, according to Peter Cussons, an international tax partner at PricewaterhouseCoopers, about 90 percent of the time companies prevail. One of the most important ECJ decisions, issued in March 2001, was a joint ruling on cases brought against the U.K. by two German companies: pharmaceutical maker Hoechst AG (now named Aventis) and engineering and chemical company Metallgesellschaft Limited (now named mg technologies ag). These multinationals claimed that British law illegally discriminated against foreign-based companies that had subsidiaries in the U.K. because it gave a certain tax advantage only to British parent companies. The ECJ agreed. The Brits had already done away with the law by the time the decision came down. But the ECJ’s ruling set the stage for some 80 companies to demand a rebate from the U.K. for the unfairly levied tax. Now, corporate heavyweights like Kraft Foods Inc., Xerox Corp., Monsanto Co. and Kellogg Co. are before London’s High Court, demanding hundreds of millions of dollars. No wonder Cussons advises GCs: “Keep your eyes open for ECJ cases that you could benefit from.” But Philip Gillett, group taxation controller at Imperial Chemical Industries PLC, who led his company in challenging a U.K. tax law in the ECJ, is no fan of using courts to change the law. It is an “ad hoc” way of changing the system that, he says, ultimately only “tinkers at the edges” of an ongoing problem. Although dealing with 15 separate tax systems is a burden, Gillett and other company lawyers do not want to see a totally federalized system either. “We want to see competition [among countries] on rates because that’s the way to maintain downward pressure,” he says. What Gillett and others would like, however, is EU agreement on tax base. This would mean each company would have one taxable profit amount for all their EU-based business. Countries then would apply their corporate rates to the portion of taxable income generated within their borders. But, says Gillett, “that’s very, very long term�and politically, I wonder whether it’s feasible.” OUTLOOK No one in international tax circles expects the EC to teach the EU countries to sing in perfect tax harmony any time soon. That’s especially true now that 10 more nations will be joining the EU in 2004. Asked about the likelihood of tax harmonization happening, European lawyers — particularly those who are over 50 — tend to say: “not in my working lifetime.” Nevertheless, change is afoot. Experts foresee tax harmony overtaking the separate tax regimes “by stealth,” as Deloitte & Touche partner Philip Ridgway puts it. “Bits will be stripped away from the current tax regimes until [they get] so close we might as well do it anyway,” predicts Ridgway. The EU will never be one nation, indivisible. But eventually it will have tax laws for all.

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