The harmonisation of the European Union's (EU's) tax systems was never going to be easy.

In fact, many view the European Commission's vision for a single European market with a single tax rate as nothing more than a pipe dream. But with the commission soon to publish its progress report on member states' recent agreement to establish a consolidated corporate tax base, and with the push towards tax harmonisation progressing on other fronts as well, the dream appears to be getting steadily closer to reality.

"The movement towards tax harmonisation is there," says Patrick Mears, head of Allen & Overy's tax practice. "Tax incentives are being eaten into, state aid is being hit and nearly all of the decisions coming out of the European Court of Justice (ECJ) accord with EU principles on the freedom of establishment. In a creeping way, we are getting closer to a level playing field for taxation."

Spearheading the push is the EU's combined tax package, which comprises a draft directive on the Tax Treatment of Savings Income and a Code of Conduct on Business Taxation. Since the European Council (Ecofin) agreed the package back in 1997, at around the same time the Organisation for Economic Co-operation and Development's (OECD) project on harmful tax competition was being developed, the savings tax directive has been making all of the headlines.

Things are set to hot up even further, with the OECD's end-of-year deadline fast approaching and Switzerland and the US remaining intransigent in their standpoints. By contrast, the Code of Conduct has been chugging along quite smoothly.
"There has been a lot less squabbling about the Code of Conduct than the savings tax directive and there are reasons for that," says Edward Troup, tax partner at Simmons & Simmons and former special adviser to HM Treasury.

"The Code of Conduct is an inter-governmental code and not an EU directive which has to be implemented through the European Commission. Also, the Code of Conduct group meets in closed sessions so there is a lot less publicity."
The Code of Conduct seeks commitments from member states for the 'standstill' and 'rollback' of 'harmful tax measures'. Sixty-six such measures were identified in the 1999 report of the Code of Conduct group, under the chair of the UK's paymaster general, Dawn Primarolo.

These included Belgian coordination centres, which enabled a company with part of its business based in Belgium to be taxed on a percentage of its running costs regardless of actual profits or losses; and Dutch ruling practices, which made it possible to cut a deal with a Dutch tax inspector and get a favourable tax ruling that did not necessarily relate to the company's balance sheet. Both of these measures have since been eliminated despite the absence of any formal sanctions under the Code – its enforcement is solely dependent on peer group pressure.

"The Code of Conduct has already had a chilling political effect," says Guy Brannon, head of Linklaters' tax practice.

"Its 'name and shame' approach has seen certain countries' tax regimes held up as undesirable. Whether or not the Code will ever be enshrined in anything more solid, I am not sure, but, so far, political pressure has worked very effectively."
Indeed, national tax sovereignty is steadily being eroded as member states increasingly defer to the EU. The UK is no exception, as evidenced in ICI v Colmer (1998), which involved a dispute over whether or not losses made by a group of companies not resident in the UK in which ICI had a consortium interest were disallowable for UK tax purposes, without prejudicing the general EU right to freedom of establishment.

The ECJ found that the UK measures offended EU principles and held that despite the fact that direct taxation did not fall within the purview of EU law, the powers retained by member states must nevertheless be exercised consistently with its principles. In effect, the ICI decision made it clear that the ECJ has become a UK tax court and that the Inland Revenue must now undertake a full review of legislation so that it can be amended to comply with EU law.

"The ECJ is pushing towards harmonisation and almost every one of its decisions is in favour of the tax payer and freedom of establishment," says Brannon.

"The ICI case shows how EU member states' legislatures are now very careful in framing new legislation to make sure everything complies with the commission's law."

Legislative changes and specific instances of rollback are not the only measures of the Code of Conduct's impact. The way in which the Code has encouraged talks and negotiations between member states has also had a significant bearing on changing the political climate of the EU.
"The acceptance nowadays that EU countries are no longer able to use their tax systems to attract business in, to the detriment of others, was not around 10 years ago," says Troup.

"The spirit of the Code of Conduct is that we are all part of one club. If that is all it achieves then that is an achievement in itself."

As with the savings tax directive, membership to the Code of Conduct club is not only limited to the EU's 15 member states. Ecofin advises that the Code's principles be adopted on as broad a geographic basis as possible, including in member states' dependent or associated territories as well as third countries.

In practice, however, the Code's focus is less on third countries and more on territories, which means that the UK's clean bill of health was blemished by the four harmful tax practices identified by the OECD in Jersey, Guernsey and the Isle of Man. These are exempt companies, captive insurance and treasury operations, but it is the ring-fencing of tax advantages for non-resident companies that tops the list.

The timetable to dismantle all four harmful tax measures lays down a date of 1 January, 2003 and allows a further period until 2005 for benefits from existing measures to run out. The Isle of Man has already met with the timetable through its strategy to implement a zero rate of tax for resident and non-resident companies alike, announced in summer this year. Jersey and Guernsey, however, are still weighing up their options.

"The Channel Islands are under some pressure from the UK to come to an agreement on the Code of Conduct, and the UK, in turn, is under pressure from the EU to deliver on this," says Edward Devenport, a partner in Jersey law firm Mourant.
"The Channel Island authorities are in regular discussions with UK Treasury and the Inland Revenue and a range of options is being reviewed. The finance and economic committee has strongly hinted that a zero rate of corporate tax would be the most likely outcome."

A fiscal review has been underway in the Channel Islands for the past 18 months, but no
significant report is expected for release until later this year. The timing of this review has as much to do with accommodating the principles of the
EU's Code of Conduct and placating the UK as it does with maintaining the islands' financial competitiveness.

"Once key competitors such as the Isle of Man, Gibraltar and the Republic of Ireland start moving towards reducing their tax rates, the Channel Islands will be forced to move from a competitive position anyway, regardless of the Code's principles," says Phil Austin, chief executive of Jersey Finance.

"Whatever the outcome of the fiscal review, the Channel Islands will not be allowed to become financially uncompetitive."

This realisation tempers any knee-jerk reaction the Channel Islands might have in asserting their constitutional right to set their own taxes and lends a more conciliatory tone to negotiations over the second part of the EU's tax package.

But just in case the UK ends up having to play hardball with the Channel Islands – like it did over the savings tax directive earlier in the year – it has kept something up its sleeve. Recently enacted in the Finance Act 2002 was a measure that enables the UK to remove the Controlled Foreign Corporation Exemption by reference to jurisdiction. In basic terms, this allows the Treasury to tax the profits of a foreign subsidiary incorporated in, say, the Channel Islands.

"This is one of the weapons in the UK Treasury's armoury that might be used to attack Jersey," says Devenport.

Slaughter and May's tax partner Graham Airs puts it rather more bluntly: "The UK is trying to beat the Channel Islands up. It is thought that this measure in the Finance Act was enacted with them specifically in mind."
The agenda behind the Code of Conduct is not tax harmonisation as such. It is a much more limited exercise than that – exposing a neighbouring member state's tax abuses is much easier than telling them they have got to change their entire tax system, after all.

But it is undoubtedly part of the movement in that direction and even if tax harmonisation across the EU remains a bridge too far for the time being, then a level playing field certainly is not.