The chill winds of tax competition are sweeping across Europe. Spain, which this week confirmed its plan for a sharp cut in corporation tax rates to bring it in line with its competitors, is the latest country to rethink its tax system.

The aspiration of governments to increase growth and to attract investment has already resulted in a wave of corporate tax reductions across the continent during the last eight years. But last year’s accession of 10 new countries to the EU - most of which have very low rates of corporate tax - has intensified competitive pressure on older member states.

The adoption by many former Communist countries of “flat” tax structures has also inspired a wide-ranging debate about tax policy in the rest of Europe.

In Brussels, there is fresh argument about calls to harmonise national tax regimes. Some western European countries have accused their eastern neighbours of “tax dumping”. Low tax countries, including Ireland, argue that it is “healthy” for governments to compete for foreign investment by offering low corporate tax rates.

Tax is usually less important in location decisions than factors such as infrastructure, political stability and cost and availability of labour. But studies have suggested that tax differentials are assuming greater importance in company decision-making, as the other differences between countries within the EU diminish.

Tax competition is most keenly felt near the borders of the low tax countries in central Europe. But more remote countries are also coming under pressure.

Jeffrey Owens, head of tax policy and administration at the Paris-based Organisation for Economic Co-operation and Development, said: “We have moved away from the notion that neighbouring countries are competing. Slovakia competes with China, Portugal and Latin America for car manufacturing. We have moved from the rhetoric of globalisation to the reality of globalisation.”

It is rare that European companies consider moving their domicile or headquarters, although such moves have been mooted by several European groups, including Deutsche Bank of Germany, InBev of Belgium, Total of France and Smith & Nephew of the UK.

The relocation question is usually raised as a result of an acquisition or restructuring. Restructurings often see highly profitable functions, such as intellectual property or treasury operations placed in low-tax countries such as Ireland. “Large multinationals will try to ensure that income is booked in relatively low tax countries and expenses in high tax countries,” says Mr Owens.

Such moves often lead to dissent. An argument as to whether or not Cadbury Schweppes’ treasury operation, which is based in Ireland, should be taxed by the UK government is about to be heard by the European Court of Justice.

More commonly, tax plays an important role in deciding the location of new investment. Inward investment statistics for 2005 show that - although the UK is the leading destination for foreign investment - Switzerland and the Netherlands are disproportionately successful at attracting international headquarters, according to Oxford Intelligence, a research company.

In weighing up location decisions, companies need to look beyond headline rates to assess the total tax burden imposed by a government. Social security contributions are now the largest source of revenue in several member states. There are also significant differences in value added tax, income tax and tax incentives.

European countries have often introduced incentives to attract particular types of business. These are frowned upon by the EU and OECD, which have tried to stamp out “harmful” tax practices.

Belgium was forced to overhaul its tax regime for “co-ordination centres”, which offered favourable tax treatment of financial, accounting and administrative operations. Ireland has phased out its low 10 per cent corporate tax rate for manufacturing, but introduced a general 12.5 per cent corporate rate.

Tensions persist. Deutsche Telekom, Europe’s largest telecoms operator, recently accused Madrid of using its tax rules to unfairly subsidise foreign acquisitions by Spanish companies.

Large companies are increasingly being asked to demonstrate that a change of location is being considered for business, rather than tax, reasons, according to Mr Owens. “If they are too aggressive in tax planning it could have an impact on their reputations. Large companies are becoming more risk averse.”

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