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

04.2013

In 1996, Mario Monti, during a press conference presenting a new report from his department, which later became known as the "Monti Report", made a notable remark: "The climate is changing". This statement signified that, for the European Commissioner for Taxation, new regulations were required to address the taxation issues faced by EU member states. His report proposed a series of measures to address a problem that had long concerned national tax authorities in the EU: tax fraud.

In the late 1980s, the freedom of capital movement within the EU was introduced. Governments were now required to operate under new conditions, as capital, companies, and individuals could freely move within the EU and globally. From a taxation perspective, the situation could be summarised as follows: "Let each ship set its sails", meaning that every state had to do what it could to finance its own budget.

"Tax competition" was seen as a legitimate option, allowing each state to spontaneously adjust its tax system in relation to others, without the need for tax harmonisation. The term "tax harmonisation" was considered taboo; instead, the focus was on competition between tax systems.

This created a situation where states engaged in open competition to attract capital. Countries offered significant tax advantages, such as taxing interest income at a proportional rather than progressive rate for unlimited taxpayers, and eliminating withholding tax on this income for limited taxpayers (see Article 14.1.f of the Spanish Personal Income Tax Law for non-residents). The consequence was a decline in tax revenue in many states over the years.

By the end of the 1990s, the problem was no longer that certain types of income were being taxed too lightly, but that they were not being taxed at all. For example, interest income was regulated by the Double Taxation Agreements (DTAs), specifically Article 11 of the OECD Model Convention, which provided for taxation of interest in the country of residence, even though the source country could impose a withholding tax, which was deductible in the country of residence to avoid double taxation. However, under the tax competition model, source countries refrained from taxation, leaving the residence country to tax the income exclusively. Unfortunately, only a small number of taxpayers declared such income, knowing that their national tax authorities had no knowledge of their foreign investments.

This led to a substantial economic tax fraud problem, as the income was neither taxed in the source country (legally) nor in the country of residence (illegally). As a result, it became essential for the residence country to receive information from the source country. However, the source country had little incentive to provide such information, often due to negligence or the use of bank secrecy laws, which were seen by some countries as a tool of economic policy. While legal instruments existed that allowed for the receipt of tax information from other countries (upon request), these were rarely used, and when they were, they were often ineffective, as the flow of information was too slow.

Until the 1990s, the exchange of information was not a priority for national tax authorities. However, Mario Monti's statement marked a turning point, and many (European) countries recognised the necessity for change. The long-term viability of tax competition was questionable, and it was increasingly seen as leading to a "race to the bottom" with associated issues of tax fraud.

In 2003, a directive was passed, introducing the first automatic exchange of information between EU member states, albeit limited to one type of income: interest income derived from bank deposits by non-residents. This directive marked a radical change: the exchange of information was no longer taboo. Following this, the OECD created a "blacklist" of countries that refused to participate in the exchange of information, generally those with higher tax burdens to fund the welfare state. After extensive negotiations, almost all previously labelled tax havens have committed to information exchange. In fact, since 2011, a DTA between Germany and Liechtenstein has been in place to regulate the exchange of tax-relevant information.

In recent years, changes have occurred even more swiftly: the United States is set to sign an agreement ("FATCA") with several European countries, including Spain and Germany, under which banks must automatically send tax-relevant information to foreign authorities. In February 2011, a new European directive was issued, stipulating that the regular exchange of information would no longer be upon request, but would occur automatically. This also facilitates concurrent audits by different national tax authorities concerning a specific taxpayer, standardises administrative deliveries abroad, and even allows the transfer of information to third countries.

Articles 25 and 26 of the new DTA between Spain and Germany not only regulate the exchange of information in great detail, but also the mutual assistance regarding the collection of taxes when the taxpayer resides in another country. It is no longer possible to assume that "the Spanish tax authority won't catch me because I live in Germany" (and vice versa). The EU is a single market, which now means that national tax authorities handle foreign cases with the same diligence as they do their domestic ones.

As this is a new process, it is expected that it will take several more years before the information exchange system functions flawlessly. The 2003 directive took more than five years to become operational.

To combat tax fraud, the Spanish tax administration has additionally introduced a declaration requirement for taxpayers (Form 720); all taxpayers in Spain must report their assets held in other countries. In this case, the Spanish state receives information not through communication from foreign tax authorities, but directly from the taxpayers themselves. The penalties for failing to submit this declaration are extraordinarily high; for example, no statute of limitations applies to undeclared assets or income in Spain.

Despite these developments, mistrust remains concerning so-called tax havens. Recently signed DTAs with some tax havens include anti-abuse measures, and may even exclude the application of the DTA in certain cases.

The benefits of the DTA between Spain and Germany can even be nullified by either the Spanish or German tax authorities if abuse situations are detected (as regulated in Article 28 of the agreement under the title "Limitation of Benefits"). Anti-avoidance measures now take precedence over tax benefits in the new DTA.

In summary, the new DTAs place greater emphasis on ensuring that taxpayers engage in proper tax planning for their investments, reinforcing the fight against tax evasion in the international context.

++ Article originally published in German in the magazine “Economía” in 2013, issued by the German Chamber of Commerce in Spain ++