EU tax competition driven by R&D and other incentives, not just rates

By Doug Connolly, MNE Tax

Tax incentives for research and development (R&D) have narrowed corporate tax bases in EU countries and could be considered “a novel corporate tax competition driver,” according to a November 22 EU Tax Observatory report on new forms of tax competition in the EU.

The decline in corporate tax rates in recent years has been well-publicized, fueling the negotiations that led to the October 8 global agreement to set a 15% floor to tax rate competition. In the EU, for instance, average statutory tax rates fell from 35% to 21% between 1995 and 2021, the EU Tax Observatory’s report notes.

The report adds, however, that – while the declines in tax rates have slowed in the past decade – certain tax-base-narrowing measures have become an increasingly important component of tax competition in the EU. Such measures include R&D incentives, patent boxes, capital allowances, tax-deductible interest payments, and corporate equity allowances.

The report cites one study finding that – of the 8.7 percentage point decline in effective tax rates in the EU from 2005 to 2015 – 3.4 percentage points of the decrease, or 39%, resulted from declining statutory tax rates. However, another 2.5 percentage points of the decrease, or 29%, resulted from changes in domestic tax bases. Smaller portions of the decline resulted, the study found, from foreign country tax rate and base changes and from profit shifting.

There has been a “clear upward trend,” the EU Tax Observatory report states, in R&D tax incentives, capital allowances, and other base-narrowing investment incentives. In addition, EU countries have been introducing preferential tax regimes for intellectual property and notional interest deductions.

To illustrate, the report states that R&D tax incentives have gone up 442% in terms of GDP over 18 years. Intellectual property boxes have also become more common, with 14 EU countries now offering intellectual property regimes with tax rates below 15% for certain income related to patents, software, and other intangible assets. Six EU countries have also adopted allowances for corporate equity.

These measures can “substantially drive down the effective tax rates” of multinational enterprises. While the measures are also available to smaller, local companies, multinational entities are more able to take advantage of cross-border differences in tax laws because they can more easily move operations and profits from one country to another.

There are also concerns, as suggested by a study cited in the report, that the increasingly generous R&D incentives are not driving more global R&D activity among multinational entities on the whole, but instead just inducing multinationals to move R&D investments from one country to another.

To address these concerns and issues related to ongoing tax competition via base-narrowing measures, the EU Tax Observatory makes some policy recommendations – while acknowledging the valid policy motivations for R&D and other types of tax incentives.

Among these policy proposals, the group suggests that the 15% global minimum tax rate floor in the OECD-led global tax deal should be coupled with limitations on deductions from the corporate tax base and minimized carve-outs. In this respect, it notes that the October 8 statement left “quite unclear” to what extent the tax base calculation would allow for R&D tax incentives and similar deductions.