This article is a revised version of a lecture given in

Amsterdam in June 1999 at the International Tax Academy

of the International Bureau of Fiscal Documentation.
Contents
1. INTRODUCTION
2. THE FOREIGN TAX CREDIT A SUPERIOR POLICY?
2.1. Superiority of the tax credit method?
2.2. Recent critics of mainstream theories
2.2.1. The original intent of the foreign tax credit
2.2.2. The credit method as a competitive
disadvantage
2.2.3. The credit method as an expensive
complication of tax law
2.2.4. No inter-nations equity
2.2.5. Source state taxation as a requirement of
international fairness
3. AVOIDANCE OF DOUBLE TAXATION AND MARKET
FREEDOMS
1. INTRODUCTION
As all adherents of international tax law know, there are
two ways of avoiding double taxation: exempting foreign
income from domestic taxation and granting a credit for
foreign taxes. When the first conventions for the avoid-
ance of double taxation were concluded 100 years ago in
fact, the very first treaty of that kind, between states not
united in a federation, Austria and Prussia, dates from 21
June 1899
1
it was logical for the two states to distribute
taxable goods and events between themselves so as to
make each good or event taxable only in one state; thus,
each good or event became exempt from taxation in the
other contracting state. Until World War II, this was the
method unanimously applied by all double taxation con-
ventions between continental European states.
The credit method, in contrast, was originally invented
if I may say so by the United Kingdom, but until the
1940s it was restricted to the taxes levied by states of the
British Empire, in particular, by India. A credit for foreign
taxes was first introduced in 1918 by the United States. At
that time, however, it was a unilateral measure in favour of
US citizens and, subject to reciprocity, to resident aliens.
As a treaty provision, the credit method was considered by
the League of Nations drafts of 1928 as an alternative to
the exemption method (as it was subsequently adopted) by
the OECD Model Convention. Yet during the 1920s and
1930s, both credit states, the United States and the United
Kingdom, were reluctant to conclude double taxation con-
ventions. Therefore, tax treaties used the exemption
method almost exclusively until, after VE day, the United
States and the states of the British Commonwealth set
about to build up treaty networks of their own. Since that
time, the credit method has gradually also become popular
with some states of the European continent, which adopted
it either as a unilateral method, as Germany, or for their
treaties, as the Scandinavian states and, more recently,
France.
Whether the Member States of the European Union should
choose one of these two methods as their uniform standard
method, as long as income taxes are not harmonized in
Europe, may be asked as a question of policy or as a ques-
tion of European Community law. I will first discuss the
policy question and then talk about the legal aspects.
2. THE FOREIGN TAX CREDIT A SUPERIOR
POLICY?
2.1. Superiority of the tax credit method?
As a matter of policy, the only reason for adopting a uni-
form method is that one of the two methods proves, with-
out doubt, to be superior to the other method. This has
been held to be the case with the credit method.
It is common knowledge that, during the last decades, pol-
icy questions of international taxation have been discussed
almost exclusively by economists and pre-eminently by
economists from the United States. Among them, Har-
vards Richard Musgrave and his wife Peggy Musgrave
had particular influence. Richard Musgrave was the first to
distinguish between the economic and equity aspects of
international taxation and, as regarded the economic
aspects, between capital-export and capital-import
neutrality.
2
Peggy Musgrave worked out the details on
the basis of his ideas
3
and deserves credit for observing
that, in discussions on equity, an additional distinction is
necessary: we may talk about equity in taxing the individ-
ual taxpayer (individual equity) and about equity in dis-
tributing the tax revenue among the states involved
(inter-nation(s) equity).
4
4 BULLETIN - TAX TREATY MONITOR JANUARY 2002
2002 International Bureau of Fiscal Documentation
1. See Hemetsberger-Koller, Der wirtschaftspolitische Hintergrund des
Doppelbesteuerungsabkommens zwischen sterreich und Preuen 1899, in
Gassner et al., Die Zukunft des Internationalen Steuerrechts, Schriftenreihe zum
Internationalen Steuerrecht, Vol. 10, 1999, at 13.
2. Musgrave, Richard, Criteria for Foreign Tax Credit, in Taxation and
Operations Abroad, Symposium, 1960, at 83.
3. Richman (now Musgrave), Peggy, Taxation of Foreign Investment Income.
An Economic Analysis, 1963.
4. Id. at 5. Nations consist of individuals, of course; thus, an injustice done to
a nation is an injustice to a group of individuals.
Which Method Should the European Community
Adopt for the Avoidance of Double Taxation?
Prof. Dr Dr h.c. Klaus Vogel
On the economic side, there is agreement that a system of
international taxation should promote worldwide pro-
ductivity, which, according to modern economic theory,
will be highest when income-producing factors are dis-
tributed by market mechanisms with as little public inter-
ference as possible. A tax system of that character is called
an efficient one. To achieve this, taxes should be neutral
(to the extent possible); in other words, they should not
influence international investment in whatever direction.
Richard Musgrave, as mentioned, distinguished between
two types of tax neutrality, which he called capital-
export and capital-import neutrality. According to his
definition, export neutrality means that the investor
should pay the same total (domestic plus foreign) tax
whether he receives a given investment income from for-
eign or from domestic sources, whereas import neutral-
ity means that capital funds originating in various coun-
tries should compete at equal terms in the capital market of
any country.
5
The Musgraves further assumed that only
capital-export neutrality comports with the goal of eco-
nomic efficiency and that the way to achieve this was to
tax the worldwide income of residents in combination
with granting them a credit for foreign taxes. In addition,
they tried to show that this method alone was in accord-
ance with both inter-individual and inter-nations equity.
6
Surprisingly, therefore or was it not so surprising? their
theories justified the United States system of international
taxation as it exists.
On earlier occasions, I have stated that distinguishing
between two types of neutrality which are opposed to each
other is, in my view, a self-contradiction. If neutrality
means the absence of all (or nearly all) external influences,
the absence of certain influences only, while other influ-
ences are upheld, is no neutrality. If a glass contains
whisky, but not water, it is not empty, and the same is true
if the glass contains water, but not whisky. Similarly, a tax
system that does not influence capital-import, but export,
cannot be called neutral. I further tried to criticize the
assumption that capital-export neutrality promotes eco-
nomic efficiency. Rather, it discriminates against invest-
ment in low-tax states, in particular developing countries,
and was therefore accurately called fiscal imperialism.
7
Efficiency, in contrast, requires that the total burden of
taxes levied on taxpayers investing in foreign countries
not be higher than the taxes imposed on domestic enter-
prises in those countries. In this assumption, I recently
found some support in three monographs by Ramon Jef-
fery, Adolfo Martn Jimnez and, even more thoroughly,
Eric Kemmeren.
8
But I do not want to repeat myself.
9
Instead, I intend to point out that, even in the birth coun-
try of the foreign tax credit method, the United States,
this method and its underlying principle, worldwide tax-
ation of residents, are increasingly subject to criticism.
2.2. Recent critics of mainstream theories
2.2.1. The original intent of the foreign tax credit
Two scholars of Yale University, Michael J. Graetz and
Michael M. OHear, in an article on tax history based on
careful investigation, recently demonstrated convincingly
that the original intent of the present United States system
of taxing international income was by no means to give
primacy to residence state taxation, nor was it a deliberate
policy to achieve worldwide efficiency or capital-
export neutrality.
10
The authors explain that the introduc-
tion of the foreign tax credit by the United States was the
work of Thomas Sewall Adams, who became Professor of
Economics at Yale in 1916, who was the co-author of a
widely used economics textbook and much respected by
his colleagues,
11
and who, in 1917, was appointed tax
adviser to the Treasury Department by President Wilson.
12
Until 1923, Adams was the Treasurys principal adviser on
issues of tax policy and tax administration and, at the same
time, its spokesman before the House Ways and Means
Committee and the Senate Finance Committee whenever
tax legislation was being formulated. When, in 1918, the
US income tax which had been low before was raised
as a consequence of the war and double taxation became a
serious burden on Americans doing business or investing
abroad, it was Adams who suggested that Americans
should be entitled to claim a credit against their US taxes
for taxes paid to other countries, and he was successful
with this suggestion.
13
During the brief discussion of the proposal in Congress,
speakers focused on the great burden caused by double
taxation, but also depicted the foreign tax credit as a
method to encourage foreign trade and to prevent revenue
loss through incorporation of foreign subsidiaries or ex-
patriation.
14
The Revenue Act 1921 then, again instigated
by Adams, limited the foreign tax credit to a proportion of
the taxpayers overall US tax liability equal to the propor-
tion of his global income derived from foreign sources,
and the Act also introduced certain source rules.
15
Thus,
the basic structure of the foreign tax credit, still valid
today, was established.
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2002 International Bureau of Fiscal Documentation
5. Musgrave, supra note 2, at 84 ,85.
6. For references from the various publications of Richard and Peggy Mus-
grave on international taxation, see Kaufman, Fairness and the Taxation of
International Income, 29 Law and Policy in International Business (1998), at
145, 153-154, note 48, et seq.; and Vogel, Worldwide vs. source taxation of
income A review and re-evaluation of arguments, Intertax 1988 (in three
parts), at 216, note 5; republished in McLure/Sinn/Musgrave, et al., Influence of
Tax Differentials on International Competitiveness, 1990, at 117, 118, and again
in Vogel, Der offene Finanz- und Steuerstaat, 1991, at 77, 78.
7. Bracewell-Milnes, The Economics of International Tax Avoidance, 1980,
at 30, 35. See also Lehner, Wettbewerb der Steuersysteme im Spiegel europ-
ischer und US-amerikanischer Steuerpolitik, Steuer und Wirtschaft 1998, at
159, 173: the protectionist tendency of the tax credit method.
8. Jeffery, The Impact of State Sovereignty on Global Trade and International
Taxation (Studies in International Taxation, No. 22), 1999; Martn Jimnez,
Towards Corporate Tax Harmonization in the European Community (Studies in
International Taxation, No. 23), 1999; Kemmeren, Principle of Origin in Tax
Conventions, 2001.
9. For a detailed argument, see Vogel, supra note 6, and as a supplement and,
in part, revision, Vogel, Taxation of Cross-Border Income, Harmonization and
Tax Neutrality under European Community Law (Foundation for European Fis-
cal Studies, Erasmus University Rotterdam, No. 2), 1994.
10. Graetz and OHear, The Original Intent of U.S. International Taxation,
46 Duke Law Journal 1021 (1997).
11. Mr Adams was president of the National Tax Association in 1923 and of
the American Economic Association in 1927.
12. For details, see Graetz and OHear, supra note 10, at 1027 et seq.
13. Id. at 1045 et seq.
14. Id. at 1047, note 106, citing Magill/Schaab, American Taxation of Income
Earned Abroad, 13 Tax Law Review 115 (1958), at 118.
15. Graetz and OHear, supra note 10, at 1054 et seq.
In all his legislation, Adamss basic goal was to achieve
equity for both the taxpayer, who should not suffer the
double burden of taxes, and the state of source (today, in
the terminology of Peggy Musgrave, we would speak of
inter-individual and inter-nations equity
16
). From
Adamss printed publications and speeches and, in add-
ition, from numerous unpublished sources, in particular
letters and protocols, Graetz and OHear demonstrate that,
according to Adamss firm conviction, the state of source
should have primacy in taxing the profits produced on its
territory: [B]usiness ought to be taxed because it costs
money to maintain a market and those costs should in
some way be distributed over all the beneficiaries of that
market.
17
And: Income must to some extent be taxed
where it is earned, at rates and by methods determined by
the conditions under which it is earned not by the condi-
tions under which it is spent.
18
Notwithstanding, Adams chose a credit, not an exemption
of foreign income, for avoiding double taxation because
he considered residence an important backstop to source-
based taxation: Residence, according to Graetz and
OHear, only deferred to source if the source in fact exer-
cised its jurisdiction.
19
The taxpayer should be taxed at
least once. This goal, however, can be guaranteed just as
well by exemption in combination with a subject-to-tax
clause, as it is found in many double taxation conventions
today and, in some states, such as the Netherlands and
Switzerland, in their domestic law as a unilateral meas-
ure.
20
Exemption with a subject-to-tax proviso avoids a
serious drawback of the foreign tax credit, which is that a
low rate of tax adopted by the source state or a reduction
of the tax base will be sucked away by a higher tax of
the state of residence. But subject-to-tax clauses were not
yet known at that time, and we may assume that Adams
had not yet perceived these disadvantages caused by the
credit method.
All in all, the foreign tax credit was not introduced to pre-
serve residence state taxation, nor was it introduced to
attain capital-export neutrality. Rather, its idea was to give
primacy to taxation by the state of source and to prevent
double non-taxation. These objectives, though, would
today be better achieved by exemption in combination
with a subject-to-tax clause. It is only a slight overstate-
ment to say: the foreign tax credit is an imperfect prede-
cessor of that clause. At any rate, the foreign tax credit is
not, and never was, a method superior to exemption.
2.2.2. The credit method as a competitive disadvantage
Nor is it true that the credit method promotes economic
efficiency. A recent American monograph by Gary Clyde
Hufbauer, assisted by Joanna M. van Rooij,
21
demon-
strates to what extent the present US system of taxing for-
eign income impairs the competitive position of American
enterprises in foreign markets.
22
After examining the dif-
ferent theories on how corporate income taxation should
be structured in the international sphere, in particular the
theories on capital-export and import neutrality, Hufbauer
finishes by suggesting what he just before called the Ger-
man version of a territorial system (he evidently does not
know about the Dutch):
23
Under a territorial system the
United States would tax business income earned in US ter-
ritory, but not business income earned by US firms in for-
eign territory. Even dividends and interest paid by a for-
eign subsidiary to its US parent should remain tax free.
This one step would put US multinationals on a competi-
tive tax footing with their European and Asian counter-
parts in terms of foreign production activity.
24
Thus, an
American wants to adopt European legal traditions at the
same time that American international tax law is so popu-
lar in Europe.
It is true, though, that Hufbauer intends to treat two types
of foreign income in a different manner: income from
portfolio investment and from headquarters activities. In
other words, he suggests that the exemption be restricted
to active foreign income. This is logical in view of his
being interested only in improving the competitive situ-
ation of American enterprises.
25
A system which in prin-
ciple stays with the foreign tax credit method and provides
exemption merely for active foreign income, however,
would be in danger of colliding with the General Agree-
ment on Tariffs and Trade (GATT) and with the General
Agreement on Trade in Services (GATS). Both agree-
ments prohibit, inter alia, export subsidies, seeing that they
interfere with free competition. As early as the 1970s, a
GATT panel, at the instigation of the United States, had
voiced the opinion that the exemption method in inter-
national income taxation was such an illicit subsidy.
26
The
GATT Council, in contrast, reversed this decision, reason-
ing that exemption is a traditional method based on a phil-
osophy different from what was then considered the phil-
osophy on which the credit method was based.
27
This
argument, however, would fail if exemption is not granted
in general, but only to the advantage of certain activities. It
would then become difficult to maintain that exemption is
not a subsidy. Such limited exemption might turn out to be
a violation of GATT and GATS (should not the latters tax
reservation apply).
2.2.3. The credit method as an expensive complication
of tax law
The same objection, however, cannot be raised against a
plan developed in 1996 by a committee of the Republican
Party called not without pretention the National Com-
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2002 International Bureau of Fiscal Documentation
16. See note 4, supra.
17. Graetz and OHear, supra note 10, at 1036, citing Adams, The Taxation of
Business, 11 National Tax Association Proceedings 185 (1917), at 187.
18. Graetz and OHear, supra note 10, at 1037, citing Adams, Fundamental
Problems of Federal Income Taxation, 35 Q.J. Econ. 527 (1921), at 542-543.
19. Graetz and OHear, supra note 10, at 1038-1039.
20. Klaus Vogel on Double Taxation Conventions (London, The Hague,
Boston: Kluwer Law International, 3rd ed., 1997), Introduction, marginal note
16, and Preface to Articles 6 to 22, marginal note 10.
21. Hufbauer, assisted by van Rooij, U.S. Taxation of International Income:
Blueprint for Reform, 1992.
22. Id. at 29-30.
23. Id. at 59.
24. Id. at 135-136.
25. Moris Lehner reminds me that the same rationale is behind the activity
provisos in CFC legislation and behind the activity clauses (as well as
switch-over clauses) in tax treaties.
26. See GATT Documents L/4423, 4424 and 4425, Intertax 1977, at 68, 103
and 111.
27. See Harwood, The GATT/DISC Dispute, Taxes International 1981/25,
at 3.
mittee in Economic Growth and Tax Reform. This com-
mittee, chaired by Jack Kemp, the former Secretary of the
US Department of Housing and Urban Development, was
charged with developing a new tax system for the United
States that should be radically new and, at the same time,
radically simple.
28
Its suggestions were made popular in
the United States by the slogan that, by adopting the new
tax system, the majority of Americans would be able to
send in their tax return on a postcard. With respect to inter-
national taxation, the Kemp Commission proposed that
Congress might consider a territorial system of income tax
for business income as well as for individual income.
29
That is, the U.S. tax should be imposed on all income
generated within the borders of the United States, whether
by U.S. residents or foreigners. Conversely, income
earned outside the United States by U.S. businesses and
individuals should not be subject to U.S. taxes.
30
This
would indeed be a radical departure from the United
States legal traditions!
Among its reasons for this proposition, the Kemp Com-
missions report argues that:
The foreign tax provisions of the internal revenue code put
U.S. businesses and individuals at a considerable competi-
tive disadvantage in global markets, and generally reduce
total world-wide investment by, and income of, U.S. resi-
dents. ... Similarly, American workers abroad in low tax
countries, and the companies that employ them, are at a dis-
advantage relative to foreign workers and firms in such
locations.
The global tax system of the United States discourages U.S.
firms from engaging in production or other activities
abroad, or pressures U.S. businesses to structure foreign
business operations in particular forms purely for tax
reasons. This should not be a goal of tax policy. Imposing
higher taxes on foreign operations of U.S. businesses does
not improve the U.S. investment climate, and does not add
to domestic investment. Insofar as it discourages investment
abroad, however, it costs domestic U.S. operations billions
of dollars in sales to potential foreign subsidiaries and part-
nerships that were never formed. ...
31
The report goes on:
In recent years, the United States has imported capital
because investment has far exceeded domestic saving. The
new tax system will undoubtedly encourage domestic sav-
ing, but it will probably attract foreign capital too by mak-
ing the United States a particularly attractive place in which
to invest. A capital importing country may raise more rev-
enue from a simple territorial tax system than from a system
based on the residence of the investor.
32
As I said before, this report is a document of a political
party intended to attract voters support. Notwithstanding,
I consider many of its reflections on international tax law
and, in particular, on the demerits of worldwide taxation in
combination with a foreign tax credit worth thinking
about.
2.2.4. No inter-nations equity
While this is economic reasoning, another recent United
States publication by Nancy H. Kaufman, a professor at
St. Louis University Law School, pleads for source state
taxation from an equity point of view.
33
Kaufman criticizes
the traditional discourse on equity in international tax-
ation, pointing out that arguments which may be valid in
discussing inter-individual equity may not at all be helpful
when inter-nations equity is concerned. Much of the
existing literature about equity in international taxation
defends the prevailing framework of source, residence,
and citizenship taxation by reference to the interindividual
equity theories from which the income tax flows, which
are, above all, the ability-to-pay theory and the benefit the-
ory.
34
These theories, however, were developed for a uni-
tary fiscal setting; they do not consider a world where a
multiplicity of tax jurisdictions exists. In particular, she
shows that inter-individual equity does not require the
taxation of worldwide income, as was held by many
authors from Seligman to the Musgraves.
35
Moreover, she
proves that taxation by the source state alone is not in con-
tradiction to inter-individual equity.
36
She even contends
that extending or not extending domestic tax law to for-
eign income is not at all a question of inter-individual
equity.
37
As a way of finding her own solution, she tries to rely on
the concept of economic allegiance, coined by Georg
von Schanz
38
and adopted by the four professors of public
finance whom the League of Nations appointed in the
early 1920s to draw up a report on how best to avoid
double taxation.
39
Contrary to the experts who promoted
residence-based taxation, she finds in the criterion of eco-
nomic allegiance a justification for source state tax-
ation.
40
Yet she is very careful in making her conclusions.
She just observes that it would be a mistake to think of
international equity in taxation only in terms of the entitle-
ment theory (by which she means the theory of the Mus-
graves) and that a conception of internation equity
founded on [economic allegiance] theory deserves greater
attention than it has received.
41
She reserves her final
answer, however.
One might argue that economic allegiance is a very
vague concept and that no precise answer can be derived
from it. But, from this, it does not follow that the concept
might not be useful as a starting point. Let us remember
that the modern law of the conflicts of (private) law or pri-
vate international law started from Savignys assumption
that the question of which states private law was to be
applied should be determined by the centre of gravity of
the legal relation (der Schwerpunkt des Rechtsverhlt-
nisses). From this starting point, a very complex and
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2002 International Bureau of Fiscal Documentation
28. The National Commission on Economic Growth and Tax Reform,
Unleashing Americas Potential A pro-growth, pro-family tax system for the
21st century, Tax Notes, 22 January 1996, at 413, 414.
29. Id. at 426.
30. Id. at 449.
31. Id. at 450.
32. Id.
33. Kaufman, supra note 6.
34. Id. at 153.
35. Id. at 173 et seq.
36. Id. at 183 et seq.
37. Id. at 182.
38. Von Schanz, Zur Frage der Steuerpflicht, Finanzarchiv 9 II (1892)
at 1, 4.
39. Kaufman, supra note 6, at 194 et seq.
40. Id. at 202.
41. Id. at 203.
sophisticated system of private international law was
developed. In the same way, economic allegiance may
one day be the nucleus of a sophisticated international tax
law.
2.2.5. Source state taxation as a requirement of
international fairness
In the same vein, in The David R. Tillinghast Lecture in
October 2000,
42
Michael Graetz, co-author of the excellent
historical article on Thomas Sewall Adams referred to
above (see 2.2.1.), brushes aside all over-sophisticated
economic considerations and simply relies on fairness as
the decisive criterion for shaping international income tax
policy. Whereas I, in my criticism of the prevailing eco-
nomic view,
43
attempted to criticize this view immanently,
i.e. based on its own premises, Graetz flatly denies that
those premises are or should be of political relevance:
There are three major problems with relying on worldwide
economic efficiency ... as the foundation for international
income tax policy. First, it seeks to improve worldwide
rather than national well-being. Second, the idea of eco-
nomic efficiency is too limited. Third, focusing on eco-
nomic efficiency as the guiding light excludes other impor-
tant values.
44
It is natural, Graetz argues, that tax policy gives primacy
to a countrys own citizens. Historical experience, how-
ever, shows that a country can considerably improve the
lot of its citizens through multilateral cooperation and
agreement.
45
The United States decided to make income taxes a central
feature of the U.S. tax system because the American people
were convinced that fairness demanded it. ... Having
decided to impose an income tax, it is mysterious why con-
cern for fairness should disappear simply because goods or
services or labor or capital have crossed national bound-
aries.
46
Graetz refers to Adams for support of his view, which
Graetz holds with even more conviction than Kaufman,
that fairness (i.e. equity) in international income taxation
means
that each nation has the right to tax income produced
domestically .... The claim of source countries to tax income
produced within their borders is analogous to a nations
long-recognized claim of sovereignty over national re-
sources within their boundaries.
... [It] is also grounded in the view that foreigners, whose
activities reach some minimum threshold, should contribute
to the costs of services provided by the host government ....
The services a nation provides may contribute substantially
to the ability of both residents and foreigners to earn income
there. Taxing that income is one way for the source country
to be compensated for its expenditures on the services it
provides.
47
I have nothing to add to this.
3. AVOIDANCE OF DOUBLE TAXATION AND
MARKET FREEDOMS
The foregoing observations, which reported just a few
arguments from the birth country of the foreign tax
credit in favour of taxation by the source state and of
exemption by the residence state, by no means exhausted
the policy discussion of which of the two methods is bet-
ter economically and which one may be more equitable.
There are, of course, defenders of the traditional main-
stream arguments as well. Instead of pursuing that dis-
cussion further, however, I should like to inquire whether
the law of the European Community requires us to choose
a certain method in treaties between the EU Member
States and, if so, which method this might be.
As the European Court of Justice held in Gilly,
48
the aboli-
tion of double taxation among the Member States is one of
the objectives of the Treaty of Rome.
49
But Art. 293 (ex
220), which mentions this objective (among others), is not
self-executing. It confers no right on individuals on
which they may be able to rely before their national
courts. This does not, however, exclude individual provi-
sions of a double taxation treaty from coming into conflict
with European Community law, in particular with the fun-
damental market liberties of the EC Treaty. Under this
aspect, the Court in Gilly examined a number of provi-
sions of the GermanyFrance double taxation treaty,
though in the end the Court concluded that there was no
violation.
It is common knowledge that the EC Treaty guarantees
five basic freedoms: free exchange of goods, free move-
ment of workers, free establishment of enterprises, free
provision of services and free movement of capital. Of
these, the free movement of capital was not originally a
self-executing freedom: according to the case law of the
European Court of Justice, former Art. 67 constituted
nothing more than an obligation of the Member States
gradually to eliminate obstacles to the free flow of capital.
The Treaty of Maastricht, however, replaced Arts. 67 to 73
by new Arts. 73 b to 73 g (now Arts. 56 to 60), which now
absolutely prohibit any obstacles to the free flow of capital
within the Community.
50
We have to consider, therefore,
whether the two traditional methods are compatible with
all five liberties guaranteed by the Treaty of Rome in its
actual version.
In its early decisions in the field of direct taxation, the
European Court of Justice viewed these liberties primarily
as rules prohibiting discrimination against citizens of other
EC Member States. Such was the ruling in Werner,
51
where a citizen of Germany residing in the Netherlands
was denied deductions reserved to German residents
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2002 International Bureau of Fiscal Documentation
42. Graetz, Taxing International Income: Inadequate Principles, Outdated
Concepts, and Unsatisfactory Policies, 54 Tax Law Review 261 (2001).
43. See text accompanying note 7, supra.
44. Graetz, supra note 42, at 276-277.
45. Id. at 293-294.
46. Id. at 295-296.
47. Id. at 298.
48. Case C-336/96.
49. See in detail Lehner, The Influence of EU Law on Tax Treaties from a
German Perspective, 54 Bulletin for International Fiscal Documentation 8/9
(2000), at 461; and Lehner, Der Einflu des Europarechts auf die Doppel-
besteuerungsabkommen, Internationales Steuerrecht 2001, at 329.
50. Regarding the conflict between the uncompromising guarantee of free
movement of capital in new Art. 73 b and the reservation in Art. 73 d upholding
tax discrimination dependent on residence or place of investment, see Mssner
and Kellersmann, Freiheit des Kapitalverkehrs in der EU und das deutsche Kr-
perschaftsteueranrechnungsverfahren, Deutsche Steuerzeitung 1999, at 505.
51. Case C-112/91.
which the Court at that time, because Werner was a Ger-
man national, considered to be an internal German affair.
Meanwhile, however, the Court seems to have changed its
position. In a few decisions, it interpreted the treaty provi-
sions in question not only as prohibiting discrimination of
non-resident EU citizens, but also as forbidding to the
advantage of both residents and non-residents all other
restrictions that interfere with free trade within the Com-
munity.
52
This is important for our question, for neither
exemption nor credit discriminates among non-residents
on whichever basis. But the credit method is recom-
mended by its supporters on the ground that it provides
capital-export neutrality, and this is another way of stating
that it counteracts and eliminates any attractiveness of
investment which originates from (or is intensified by) a
certain tax environment in another state. The same applies
to the attractiveness of work in the other state or the provi-
sion of services there.
As long as direct taxes are not harmonized in the European
Community, the Member States are free to choose their
own system and rates of direct taxation (to the extent they
do not grant non-residents exceptionally low rates of tax or
similar favourable conditions which would constitute an
illicit subsidy or at least violate their duty of cooperation
under Art. 10 (ex 5) of the EC Treaty). Residents of the
Member States are at liberty to exploit the differences
resulting from this diversity of tax systems. Striving for
capital-export neutrality by applying the tax credit
method interferes with their freedom to do so and is, there-
fore, an intrusion into their free choice of the places where
they would otherwise establish enterprises, invest capital,
provide services or take up employment.
53
To be precise, it
is an indirect interference, not a strict prohibition. But it is
common ground that the market liberties guaranteed by
the Treaty of Rome protect against indirect interference in
the same way that they protect against direct obstruction.
Establishing that there is a discrimination of or a restric-
tion on market liberties does not automatically mean, it is
true, that the EC Treaty is violated. According to the case
law of the European Court of Justice, the discrimination or
restriction may be justified for particular reasons. In Gilly,
for example, the Court relied on the fact that no unifying
or harmonizing measure for the elimination of double
taxation has yet been adopted at Community level, nor
have the Member States yet concluded any multilateral
convention to that effect under Article 220 [now 293,
K.V.] of the Treaty and that, therefore, [t]he Member
States are competent to determine the criteria for taxation
on income and wealth with a view to eliminating double
taxation by means, inter alia, of international agree-
ments. From this, the Court concluded that the choice of
connecting factors for the allocation of taxation between
the contracting states in Arts. 13, 14 and 16 of the
FranceGermany treaty could not be regarded as a dis-
crimination which is unjustified, therefore violating the
EC Treaty. But we have to distinguish: what we discuss
here is not the allocation of taxable goods or events
between the contracting states by distributive rules, but the
method by which the state of residence avoids double tax-
ation in cases where the treaty accords priority of taxation
to the state of non-residence. That the contracting states
are competent to define the criteria for distributive rules is
undisputable, but it does not follow from this that they are
competent to choose a method for the avoidance of double
taxation which impairs the goal of creating a common
market by establishing tax barriers to work, trade or
investment.
The same applies to the Courts observation in Gilly
regarding the OECD Model Convention, according to
which the FranceGermany treaty is drafted to a consider-
able extent. The decision states that it is not unreasonable
for the Member States to base their agreements on inter-
national practice and the model convention drawn up by
the OECD. From this, it might be inferred that, because
the OECD Model treats the exemption and credit methods
as equivalent, both methods must also be admissible under
EC law. Such reasoning, however, overlooks that the
OECD Model is drawn up for independent states, regard-
less of whether they are members of a common market or
not. Moreover, the reason that the OECD Model presents
two methods alternatively is that no agreement could be
reached between the states traditionally adhering to
exemption and those adhering to the foreign tax credit
method. I do not know, whether the Fiscal Affairs Com-
mittee of the OECD ever discussed, even realized, that the
credit method favours investment in the state of residence
by making investments in certain other states less attrac-
tive at least the Committee did not publish anything of
that kind. Therefore, no justification under EC law can be
gleaned from the fact that the credit method is an alterna-
tive in the OECD Model.
Nevertheless, we should not expect too rashly a decision
by the European Court of Justice declaring that exemption
is the only method admissible under EC law. It may not be
conclusive that the Parent-Subsidiary Directive gives a
choice of either method: this directive is secondary law
and subordinate to the EC Treaty. But as Moris Lehner
correctly pointed out on several occasions, discrimination
and restrictions (and, in particular, the distortion of com-
petition brought about by the tax credit method) very often
are the result of the combined action of both contracting
states.
54
Moreover, the fact that both methods have been
used for many decades will not be neglected by the
JANUARY 2002 BULLETIN - TAX TREATY MONITOR 9
2002 International Bureau of Fiscal Documentation
52. Cases Asscher, C-107/94, Futura, C-250/95, Gilly, supra note 42, Jessica
Safir, C-118/96, and AMID, C-141/99. See, in particular, Lehner, Limitation of
the national power of taxation by the fundamental freedoms and non-discrim-
ination clauses of the EC treaty, EC Tax Review 2000-1, at 5, 7 et seq. For fur-
ther details, see Lehner, Begrenzung der nationalen Besteuerungsgewalt durch
die Grundfreiheiten und Diskriminierungsverbote des EG-Vertrages, in Pelka
(ed.), Europa- und verfassungsrechtliche Grenzen der Unternemensbesteuerung
(Verffentlichungen der Deutschen Steuerjuristischen Gesellschaft, 23), 2000,
at 263, 271; and Reimer, Die Auswirkungen der Grundfreiheiten auf das
Ertragssteuerrecht der Bundesrepublik Deutschland Eine Bestandsaufnahme,
in Lehner (ed.), Grundfreiheiten im Steuerrecht der EU-Staaten (Mnchener
Schriften zum Internationalen Steuerrecht, 23), 2000, at 39.
53. Same result: Lehner, Limitation of the national power of taxation by the
fundamental freedoms and non-discrimination clauses of the EC treaty, supra
note 52, at 14; Lehner, The Influence of EU Law on Tax Treaties from a Ger-
man Perspective, supra note 49, at 470; Lehner, Begrenzung der nationalen
Besteuerungsgewalt durch die Grundfreiheiten und Diskriminierungsverbote
des EG-Vertrages, supra note 52, at 283; and Reimer, supra note 52, at 89.
Regarding the impact of EC market liberties on tax conventions, the excellent
dissertation by Kemmeren, supra note 8, argues similarly.
54. Lehner, Limitation of the national power of taxation by the fundamental
freedoms and non-discrimination clauses of the EC treaty, supra note 52, at 10;
Court.
55
This was the argument of Professor Juliane
Kokott from Dusseldorf, a specialist of European and
international law, at a symposium held in Munich two
years ago.
56
She held the credit method to be admissible,
but as she said, she was pained (geqult)
57
by this con-
clusion.
Yet again we have to distinguish. We have to consider:
court rulings striking down provisions which apply to the
Member States residents, even if based on the EC
Treatys fundamental freedoms, intervene far more seri-
ously into the Member States domestic law than rulings
prohibiting a (marginal) discrimination of foreigners.
58
As
Adolfo Martn Jimnez in his politico-legal treatise on the
long way to corporate tax harmonization in Europe rightly
observes, the Court may be in a very good position to
ensure that capital import neutrality is achieved within the
EC. But, on the other hand, too daring Court decisions
may undermine the Courts legitimacy, because [t]oo
much activism may lead the Member States to neglect the
Court decisions.
59
Political considerations in solving such
conflicts are not illegitimate for a constitutional court,
which the European Court of Justice in fact is. Such courts
always have to find a balance between applying the law as
they see it and finding political acceptance of their deci-
sions by their constituents. Therefore, there is little chance
that the European Court of Justice will in the near future
declare the credit method a violation of the rights of EU
citizens.
This does not necessarily mean that the credit method does
not violate EC law. As was shown before, the credit
method hampers investment, the provision of services and
the taking up of employment in the other EU Member
States, and there is no legal justification recognizable for
these impediments. But if the Court should choose to
adopt a reserved attitude in this matter, that could very
well be explained by the assumption that fundamental
rights, to the extent they restrict the Member States
domestic law, are not self-executing which they are
when preventing the discrimination of non-residents but
require legislative action.
60
Thus, the ECs legislative
organs, the Commission, Council and Parliament, would
be called upon to create a system of avoiding double tax-
ation which is in accordance with the EC Treatys basic
freedoms.
If these organs fail do so, it is very well possible that the
conflict between the credit method and the ECs market
freedoms will one day lead to a verdict of the Court against
the credit method as a method to avoid double taxation
among the EU Member States. But this is a perspective in
the long run; as I said before, I do not expect that it will
happen so quickly.
10 BULLETIN - TAX TREATY MONITOR JANUARY 2002
2002 International Bureau of Fiscal Documentation
Lehner, Begrenzung der nationalen Besteuerungsgewalt durch die Grundfrei-
heiten und Diskriminierungsverbote des EG-Vertrages, supra note 52, at 274-
275; Lehner, Der Einflu des Europarechts auf die Doppelbesteuerungsabkom-
men, supra note 49, at 332.
55. According to Lehner, The Influence of EU Law on Tax Treaties from a
German Perspective, supra note 49, at 465, there is a rebuttable presumption
that treaties which meet the OECD standards are also compatible with EC law.
56. Kokott, Die Bedeutung der europarechtlichen Diskriminierungsverbote
und Grundfreiheiten fr das Steuerrecht der EU-Mitgliedsstaaten, in Lehner
(ed.), Grundfreiheiten im Steuerrecht der EU-Staaten, supra note 52, at 1.
57. Id. at 135.
58. Lehner, Limitation of the national power of taxation by the fundamental
freedoms and non-discrimination clauses of the EC treaty, supra note 52, at 7;
Lehner, Begrenzung der nationalen Besteuerungsgewalt durch die Grundfrei-
heiten und Diskriminierungsverbote des EG-Vertrages, supra note 52, at
266-267.
59. Martn Jimnez, supra note 8, at 285 and, in particular, at 327.
60. To the same effect: Lehner, Limitation of the national power of taxation
by the fundamental freedoms and non-discrimination clauses of the EC treaty,
supra note 52, at 7; and Lehner, Begrenzung der nationalen Besteuerungs-
gewalt durch die Grundfreiheiten und Diskriminierungsverbote des EG-Ver-
trages, supra note 52, at 267, 280.