Changes in international taxation at the end of the 1990s to combat tax evasion in a new international context

01.2011

In 1996, Mario Monti, then European Commissioner for Taxation, made a succinct statement during a press conference while presenting a report on direct taxation in the EU: “The climate is changing.” This report (known as the Monti Report) briefly and simply, yet with an unprecedented level of firmness, outlined the main challenges faced by the tax administrations of EU member states. For several years, there had been considerable dissatisfaction among various national administrations regarding the rise in tax evasion amid the increasing free movement of capital.

The 1990s were a complex decade: the completion of the internal market by 1 January 1993; the Maastricht criteria to join the monetary union leading to the Euro; the economic crisis in Spain following the 1992 Olympic Games; the collapse of the ERM when Germany unilaterally raised the interest rate of the Deutschmark to cool its overheated economy post-reunification; and the subsequent economic collapse in the new eastern German states.

The fiscal coordinates of each country at that time could be summed up as follows: "each boat must manage its own sail" – or in other words, it was a period when tax competition between states was considered a legitimate option, allowing countries to naturally align their tax systems without intervention from EU bodies. The word harmonisation was a taboo, and only tax competition was openly discussed. The solution provided by states was to create two taxable bases for income: one for less mobile factors (such as labour and real estate income), subject to a progressive tax rate, and another for mobile factors (capital income), subject to a proportional rate, much lower than the progressive one. States competed openly to attract capital, offering significant tax advantages. It was tax competition with the effects of a race to the bottom.

However, the problem identified in the late 1990s was not that certain incomes were subject to low tax rates. The issue was that, in some cases, no tax was being paid at all. In the case of interest income, the system of Double Taxation Agreements (Article 11 OECD Model) stipulated that interest should be taxed in the country of residence of the investor, with the possibility of withholding tax at source, which could be credited against the tax due in the country of residence to avoid double taxation. However, in a context of tax competition, the country of residence would forgo taxing the income. This meant that the country of residence was expected to tax that income exclusively, but few taxpayers were forthcoming about their overseas investments if they knew that their national tax authorities had no knowledge of them. In other words, I would not declare income earned abroad if I knew that my national tax authority had no information about it. And this is the problem that all national tax administrations face today. Taxation in the country of residence (in line with the principle of worldwide income taxation) is not possible if the source country of the income does not provide information to the residence country about the income generated within its jurisdiction. The backbone of maintaining the welfare state, which is a fiscal state, can only be achieved if residents are aware that their country of residence has access to information on their international investments.

Until the 1990s, this need was not considered a priority by national tax administrations. But Mario Monti’s statement changed the situation, and many European countries realised that change was inevitable. With tax competition, not everyone was winning; it was leading to a race to the bottom, with the added issue of tax fraud due to the lack of information available to the country of residence.

In 2003, a directive was passed that established, for the first time, an automatic and spontaneous information exchange system between EU member states, but only in relation to a very specific type of income: interest income from bank deposits held by non-residents. This directive represented a revolutionary change. The Info-Austausch (information exchange) was no longer taboo, and even states could now benefit (up until then, source states had little incentive to cooperate with residence states).

The European Commission exerted political pressure (and other forms of leverage) on non-EU states close to the EU (such as Switzerland, Andorra, Gibraltar, etc.) to sign equivalent measures to prevent capital from flowing out of Europe to these jurisdictions. Meanwhile, the OECD also took action and compiled a blacklist of states that refused to provide information to requesting states (usually those with higher tax pressure to finance their welfare states). As a result of numerous negotiations, almost all jurisdictions once considered tax havens now provide fiscal information.

In recent years, changes have accelerated even further: the USA is about to sign an agreement called FATCA, under which banks will transmit fiscal information directly to national authorities, spontaneously, without prior request. In February 2011, a new EU directive (2001/16) was approved, establishing that the standard method of information exchange would be spontaneous (each national administration would transmit information to the other administration to verify the honesty of non-residents). Additionally, the new Double Taxation Agreement between Spain and Germany now meticulously regulates not only the exchange of information but also assistance in the collection of taxes.

In summary, the goal is to replicate the systems already in place in domestic markets, where tax administrations oversee income earned and ensure that tax returns align with the actual income reported, but to implement this system on an international level.