Principles of Economics and

Business 2
Economics of Taxation

Klaus Fonseca Hoeltgebaum

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 Overview

• Week 1 Recap
 Theory
 Exercises
• Week 2 Recap
 Theory
 Exercises
• Week 3 Recap
 Papers review
 Exercises
• Exam Questions
• Essay Papers Review
• Essay Tips
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Week 1

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 Tax Basics

• Definition of Taxes: Compulsory payments to government

which are then used to provide something back to each agent.
Collected through a tax system
 Compulsory payments → Avoid free-riding on services provided

• Purposes:
 Government Budget: financing public services (roads, public healthcare, salaries)
 Policy:
 Behavior nudges (Speeding fines, littering fines, etc…)
 Income Redistribution (UBI, grants, subsidies, social welfare programs)
 Increase total welfare (Infrastructure, public health, public education)
 Supportive (Tax compliance, auditing, etc...)
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 Principles of Tax Policy (Big 4)

• NEUTRALITY: Business activities are all equally favorable →

taxes will not distort business activity preferences for different
business structures and methods

• EFFICIENCY: Low compliance costs for business &

administrative purposes

• CERTAINTY AND SIMPLICITY: Optimal decision making

not distorted by taxation

• EFFECTIVENESS AND FAIRNESS:

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 Corporate Income Tax (CIT)

CIT: Tax on corporate income, taxed at a certain tax rate (%)

• Taxpayers are companies / firms / enterprises / multinationals /

juridical agents
• Tax Base: Profits made by the company
 Normal return of capital + excess profits (value creation).

• Levy system (collection method): Assessment or self-

declaration
 Outsider evaluation vs. self-reported

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 ‘Profits’ → Financial Accounts vs.
Tax Accounts

Relationship between profits declared on commercial accounts,

versus what can be taxed?

1. Formal dependence → Taxable Profits == Commercial Profits.

2. Practically Formal dependence → Formally TA = CA.
Legislation may determine differences
3. Material dependence → Not formally written down, but practice
TA = CA.
4. Material independence → Commercial accounts are starting
account, but not necessarilyAthenaStudies
equivalent to the tax account. 7
 Why difference of FA vs. TA?

• Continental Approach:
 Everyone is responsible for a company’s fiscal decision. (Creditors, stakeholders, employees)
 Profit must be clearly stated → Creditor must be able to determine and collect their earnings
== Creditor Protection
 ‘Prudence Principle’ -- Profits only declared when fully realized, losses must be stated
before incurred. CA == FA because profits are realized

• Anglo-Saxon Approach:
 Only shareholders are responsible to company’s fiscal decision
 Profits can be showed immediately and declared by their ‘fair value’.
 Eg. Land asset value increased by $100000 → profit of $100000
 CA =/= FA because profits are not yet realized

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 Exercise

• The prudence principle is defined as:

a. Only shareholders are responsible for a company’s decision making
b. If an asset price raises, profits can be immediately declared according to their ‘fair value’
c. Profits are only declared once fully realized and losses must be declared before incurred
d. Commercial accounts are not the same as Taxable accounts

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 Standard Economic Theory for
CIT design

• Assumptions
 Small open economy
 Capital mobility & labour immobility

• Source-based CIT: Countries have different investment

profitability based on taxation.
 CIT → Investments → Capital / worker → Output per worker → Wages

• *** CIT is a tax on labour! → Theoretically efficient CIT ==

0

• However in reality: Economic rents (excess profits) + immobile

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capital AthenaStudies
 Standard Economic Theory for
CIT design

+++ Reasons to keep CIT:

• If economic rents go to tax havens → increase tax on normal

profits to capture escaping economic rents
• Market failures:
 CIT serves as supply side entry barrier → more efficient markets
 Avoids moral hazard problems → reduces excess profits that can be exploited by board vs.
shareholders (Principal-Agent problem)

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 Tax Competition

• Aggressive tax planning (companies) → Shifting profits to

lower tax countries.
 Tax competition lowered CIT drastically

• ‘Cartel’ by countries → framework for international tax system

to avoid CIT race to bottom
 Also makes tax-treaties easier = linking (of tax systems)
 Hybrid Entities → Subsidiaries or foreign branches with two different taxation statuses in
two different countries
 Companies exploited treaties to deduct interest taxation multiple times.
 Reverse Hybrid Entities  Exploit treaties for tax benefit collection

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 Transfer Pricing

• Pricing of intermediate good sales between related groups.

 Arm's length price → Intermediate good priced at unrelated groups.
 In reality → Company & Country negotiate good price

• Issues:
 Market price may not exist
 Double taxation
 Aggressive Tax Planning

• Routine vs. Residual profits (IMF):

 Routine: profits from normal sale difference from sale price - cost price.
 Residual: profits above routine profits

• OECD Guidelines: Taxation guidelines -- sometimes differ from

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arm’s length
 Transfer Pricing Reports

• In the OECD guideline reading:

• Transfer pricing reports:
 Country-by-Country reports: global income information
 Master file: TP policy of the company
 Local file: Subsidiary transactions

• CbCR: Countries formally not allowed to use TP to adjust prices

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 Exercise

• There is a company group located in three different

countries. The parent-company X is in Country A, the
subsidiary Y is in Country B and the subsidiary Z is in
country C. Subsidiary ‘Y’ sells an intermediate good at
a transfer price of $100 to subsidiary ‘Z’. The actual
arms length price is $300.
a. If Country B asks subsidiary Y to adjust its transfer price to the arms length
price then there is a international double taxation of $200.
b. If Country C asks subsidiary Z to adjust its transfer price to the arms length
price then there is a international double taxation of $200.
c. If Country B asks subsidiary Y to adjust its transfer price to the arms length
price then there is a international double taxation of $100.
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d. If Country B asks subsidiary Y AthenaStudies
to adjust its transfer price to the arms length
 Corporate Taxation at an
International Context
Mirrless Review

• Bilateral tax treaties → Avoid double taxation of income from

the same company in 2 different countries (reduce compliance
costs)
• How & where to tax profits? → Currently source-based taxation 
 Why → easiest

• Implementation costs: Complicated tax regulation results in high

compliance costs for Multinational firms (MNEs)
 Transfer pricing → at which price goods are valued in related-parties trade
 Arm's length pricing → transfer price should be the same as an ‘unrelated’ - parties trade
 Issue: Assets that have no unrelated parties trades?
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 Corporate Taxation at an
International Context

• Thin capitalization rules: cap interest deductible against

taxable profits (usually for interest paid between related parties) 

• Interest allocation rules: restrict interest deductibility from

borrowing to finance operations in the same jurisdiction
 Which one to use? → a bit arbitrary & various disputes. High compliance costs

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 Corporate Taxation at an
International Context
• Who pays the tax? → incidence (see slide 8)
• Economic rents: surplus or excess profits above minimum
returns on investments.
 Argues that in theory, CIT = 0 but economic rents should be taxed the maximum amount
possible. Closed economy → Economic Rent Tax = 100%

• Double tax relief → Dividends to foreign subsidiaries & how to

avoid double taxation
 Exemption method: dividends are exempt from taxation -- taxes were already paid in source
country
 Credit method: dividends taxed at home rate but credit the rate already taxed at another
country.

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 Executive Summaries Final
Reports
OECD 2015 Paper
• Main goal: determine how to avoid tax base erosion and profit
shifting (BEPS)
• Article 2: Controlled Foreign Companies (CFC).
 Defines CFCs, CFC income, how the income is distributed & calculated, and how to avoid
double taxation

• Article 4: Limit BEPS from interest deductions & other financial

payments
 Rules which determine if the net-interest and expenses are calculated not just for the
subsidiary, but also for the entire MNE group. Thin capitalization & interest allocation rules
 Recognize special cases of high leverage where capping or restricting interest deductibles
could be harmful

• Article 5: Transparency on taxations if MNEs operate in

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different tax jurisdictions AthenaStudies
 Executive Summaries Final
Reports

• Articles 8-10: Changes in nexus & allocation rules to better align

Transfer Pricing Outcomes with Value Creation
 Essentially update arm’s length principle so that intangible assets and economic activities of
companies are taxed in a more relevant manner →better aligned to where the actual
transactions occur

• Article 13: Cross-country documentation of Transfer Pricing

(Country-by-Country Reporting)
 Requires large MNEs to report pricing used in each country if they transaction materials
between different jurisdictions

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 Corporate Taxation in the
Global Economy

IMF Report

• BEPS project: eliminate most notorious tax evasion and profit

shifting schemes.
 Overviews current agreements and how there are still substantial profit shifting
opportunities. 

 Tax competition remains + high amounts of profit shifting in developing countries still
present

 Digitalization → rights to tax even if company has no physical presence (transaction taxes)

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 Proposal regarding the disclosure of
income tax information…

EU Proposal:

• Increase MNE transparency on total amount of taxes paid. 

• Public scrutiny → evaluate if aggressive tax planning is being

used across jurisdictions

• Defines which tax information must be made publicly available

for income evaluation.

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Week 2

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 Digitized Business Models

• Large operation scale but no physical presence (in

taxable jurisdictions)

• Intangible Assets → Tax haven valuation issues

• User Content and Data gathered from users → Taxable

presences?

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How to combat these? →  Nexus & allocation rule
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 OECD Two Pillars

• Pillar 1: New taxing nexus & profit allocation rules for

market jurisdictions
• Ex. US-based. Revenues in US, NL, FR, IT. CBCR →
verify excess profit attributable to which market
jurisdictions. 

Formulaic Approach (FA) applied:

Revenues earned in country 
_________________________ XExcess taxable profit. 
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Total Revenues of firm AthenaStudies
 Exercise:

• A USA-based MNE earns $1000 in revenues in the

USA. They also earn $100 revenue in Spain, 500$ in
Germany, and $400 in Poland. Their excess worldwide
profits are determined to be $800. They are subject to
taxation from OECD Pillar 1.
 What is the tax portion of revenues that can be collected in Germany?

• What are the goals of these new OECD taxes?

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 OECD Two Pillars

• Pillar 2: Tax-back approach → Worldwide minimal tax.

So extra tax at parent company up to some minimum.

• Elaborated in papers:
 Essentially to guarantee some tax neutrality at a global level for domestic,
foreign and inward capital movements.

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 EU-Digital Service Tax (DST)

• Digital Service Tax = Firm pays 3% of the sales revenue

tax to the country where user base is located

• Short term fix for profit taxation of value creation by

digital firms

• Charges revenues from digital sales (intermediate

marketplaces & data sale) ~ Similar to a turnover tax. 

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 EU-Digital Service Tax (DST)

• Only companies (consolidated groups) worth more than

750 million euros or have a tax base of 50 million euros
in the EU
 Must sell user data or user generated content. (European IP address used)

 Sell and earn revenue with advertisement spaces

 Have a platform that creates and links supply and demand

• The DST is applied where the value is created

 Usually the end-user

• Proposal has not been implemented

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 Exercise

• Facebook sells $1000 worth of data collected from

German Instagram users to Ford Company, based in the
USA. Suppose the digital service tax applies. Which
statement is true?

a. Facebook has to pay a tax of $30 in Germany.

b. Facebook has to pay a tax of $30 in Germany and the

$USA.

c. Facebook has to pay a tax of $15 in Germany and $15 30

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 Floris de Wilde, Comparing
Tax Policy Responses ...

• Defends an all-in approach → Tax reforms should hit

all MNE’s as they are increasingly relying on digital
services 

• Distinguishing digital firms from non-digital ones will

only complicate and make tax-systems more inefficient.

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 Addressing Tax Challenges of
Digitalized Economy

OECD BEPS Interim report → Some reallocation and

reconsideration of pricing models from MNE’s. New
considerations for nexus & allocation rules.

• Changes in allocation rules → better align value

creating activities from user base
 Allow taxation based on user-base location economic activity

• Changes in nexus rules → allows tax jurisdictions

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 Addressing Tax Challenges of
Digitalized Economy

• These changes target:

 Market intangible assets → residual income taxation in market jurisdictions

 Economic presence → Divide tax base, allocation of profits with weightings to

each tax base.

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 Addressing Tax Challenges of
Digitalized Economy

• Issues: 
 Double taxation when multiple market jurisdictions involved

 Profit determination & Allocation

 Administrative costs→ legal incidence 

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 Addressing Tax Challenges of
Digitalized Economy

• Other BEPS challenges:

 Income inclusion rule: Allows for additional taxation of foreign branches if
their effective tax rate was low

 Tax on base of eroding payments: Allows to deny deduction for payments or

treaty relief unless shown that it was subject to an effective tax rate above some
minimum global rate. 

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 Secretariat Proposal for
‘Unified Approach’ ...

• Proposal to unify current approaches:

 New Nexus → based on sales in jurisdiction
 New profit allocation rules →
 New residual profit calculated for market jurisdictions given a formulaic
approach, taxable to each jurisdiction.

•
Implementation issues:
 Definitions of profit & quantity
 Double taxation

• Profit allocation → Pillar one system described in

lecture & here. 36
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 Secretariat Proposal for
‘Unified Approach’ ...

Summary of the proposal:

• Scope: Covers consumer facing businesses. Extractive
industries are out of scope
• New Nexus: Creates a new nexus that does not rely on
physical presence, but on sales.
• New Profit Allocation rule (beyond arm’s length
principle): A new profit allocation rule that does not rely
on the company having a permanent establishment or
separate subsidiary within the tax jurisdiction that they
operate.
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 Keep arm’s length rule for mostAthenaStudies
cases. New complementary cases solved by
 Secretariat Proposal for
‘Unified Approach’ ...

Summary of the proposal:

• Increased Tax Certainty – Three Tier Mechanism:
 Amount A: a new taxing right given to jurisdictions on the residual profit,
allocated by the formulaic apportionment approach (FA, see slide 25 it’s similar
to that one)
 Amount B: A fixed taxable right for the baseline marketing and distribution
functions that occur in the market jurisdiction (so some compensation is paid to
countries where these business are located and operate)
 Dispute prevention mechanism: in case there is a dispute, this amount is the
effective binding amount that is charged.
 In particular, if the company makes excess profits that are not captured by
Amount B, then amount C can be enforced.

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 Proposal for a common system
of a digital services...

• Similar to Secretariat proposal ‘Unified Approach’ 

• Aims to end misallocation of tax profits based on old

CIT definitions and new digital goods economy.
 Tries to tackle double taxation issues within EU

 Define fair value creation principle based on arm's length rule and transfer
pricing for members within EU to be able to tax fairly within their jurisdictions.

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Week 3

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 Legal Structures

• Sole Proprietorship:
 Taxed under personal income tax systems

• Partnerships:
 Taxed under personal income profit sharing

• Business activities: Organizations of labour and capital

with economic activities and the goal of making profits
– broad definition (not very specific)
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 Consumer to Consumer (C2C) [Sharing economy falls here]
 Legal Structures

• Sole Proprietorship:
 Taxed under personal income tax systems

• Partnerships:
 Taxed under personal income profit sharing

• Business activities
 Organizations of labour and capital with economic activities and the goal of
making profits – broad definition (not very specific)

 E.g. AirBnB – should a renter in the website be considered a business? 42

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 Enforcement issues of C2C
Platforms

• Ease of making business: higher amounts of profits

being made now
 Higher enforcement costs for authorities

• Distinction between business and side-activity unclear

• Tax Regulations:
 Apply current tax system

 New sharing economy taxation

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 Combination of both AthenaStudies
 Small Business Taxation

Article

• Small businesses → different tax treatments from large

shareholder corporations
 Recently Income taxation > Capital taxation → Tax neutrality violation

• Structure: legal business form in practice have tax

treatment differences.
 Sole proprietor: no distinction between personal & business liabilities
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 Partnership: no distinction between personal & business liabilities
 Small Business Taxation

• Small businesses → Can exploit taxation difference for

higher growth -- distorts commercial decisions to
incorporate
 Tax distortions: From dividends vs. income tax differences and capital gain
accumulation

 Employed vs. Self-Employed

 Incorporated vs. Unincorporated

• Reforms: 45
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 Taxations of Individuals in the
Sharing Economy

• Sharing transactions →  Peer-to-peer transaction types

 Cash

 Barter

 Cost-sharing

 Gifts/Donations -- usually not relevant for income tax purposes

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 Taxations of Individuals in the
Sharing Economy

• Regulatory challenges: when do these microtransactions

become large enough to be taxed?
 New Regulations

 Consider sharing economy transactions with existing regulations

 Both

• Author: Should not create separate tax regulations only

for sharing economy → neutrality distortions.
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Recognize challenges ofAthenaStudies
new economic model.
 Does company size matter in
defining the scope of a CIT

• How to measure company size -- a bit arbitrary

 Shareholders / Employees / Profit / Sales / Balance Sheet

• Smaller companies usually given more favorable tax

treatment:
 Stimulates competition and job creation→ generates wealth

• Circumstances which advantage should exist (Crawford

& Freedman)
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 Repair market failures – under investment of small firms
 Does company size matter in
defining the scope of a CIT

• Repairing market failures

 Not favoured by Crawford/Freedman

• Reducing compliance cost

 Widely accepted Crawford/Freedman

• More possibilities for loss compensation

 Arguable according to Crawford/Freedman

• Preventing bankruptcies
 No clear economic reason according to Crawford/Freedman

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 THINGS TO NOTE

• Lots of focus on IMF and OECD proposals

• Most theoretical questions are in the Mirrless Review
Chapters
 Transfer pricing
 Tax principles

• Some EU regulation questions (Digital Service Tax

WILL come up)
• MC Questions  Many times there is only one answer
which is plausible. So even if you don’t understand or
remember what is being asked, focus on what you’re
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sure came up in class orAthenaStudies
you’ve heard before
Mock Exam Questions

or

Essay?

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Old Exam (no solutions)

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Old Exam (no solutions)

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Old Exam (no solutions)

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