The corporate tax systems in place today were conceived to a large extent in the aftermath of World War I. At that time, multinational enterprises were mostly industrial companies, selling tangible products. Business models were largely decentralised, with production processes clearly divided between parent and subsidiary companies. This made source taxation, whereby profits are taxed where they arise, relatively simple to apply. To ensure the fair distribution of tax revenues between countries, while avoiding double taxation, transfer pricing based on the arm's length principle (ALP) was devised. The ALP ensured that the price of intra-group transactions matched comparable market prices, thereby providing a clear means of allocating profits within a multinational enterprise. To resolve cross-border disputes on corporate taxation, bilateral treaties were chosen as the preferred tool, rather than a multilateral approach.
Overall, this international framework for corporate taxation worked well in an era of more limited cross-border activity and traditional business models. It was only as the economy evolved and trade became more globalised that cracks in the system started to appear.
In the EU, the debate around corporate taxation began to emerge as early as the 1960s, as economic and political integration led to more cross-border activity. Problems which could hamper the development of the Single Market, such as double taxation, became more important. From the early 1990s, the focus was on preventing such tax obstacles, and the Parent-Subsidiary Directive 1 and Interest and Royalties Directive 2 were adopted for this purpose.
For many years, the non-binding Code of Conduct for Business Taxation has been considered an effective tool for addressing tax competition in the Single Market. However, as corporate tax planning has become more sophisticated and competitive forces between Member States have increased, the tools for ensuring fair tax competition within the EU have reached their limits.
