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By David Ernick, Esq.
PricewaterhouseCoopers LLP, Washington, DC
Pacta sunt servanda ("Agreements must be kept")
The question has often arisen whether "international law" is an oxymoron – whether "obligations" in income tax treaties and other international agreements are really binding upon the parties, when they are not buttressed by some sort of enforcement mechanism. That question has never been more relevant in the tax world than it is today, where the OECD's Base Erosion and Profit Shifting (BEPS) project has revealed stark fault lines in the putative agreements on international tax norms and OECD member country commitment to achieving consensus seems to be fraying. This commentary compares the approaches of the OECD and the WTO to dispute settlement and suggests that it may be time for the OECD to adopt dispute settlement mechanisms similar to those used by the WTO in order to avoid the adverse consequences of unresolved international tax disputes.
As the BEPS project unfolds and the direction of the changes to be recommended by the OECD becomes clearer, several commentators have predicted a coming "tsunami" of international tax disputes.1 Indeed, the proposals from the OECD to date offer many potential sources of increased disputes, including, for example, inconsistent reasoning between proposals to address the tax challenges of the digital economy and those addressing the transfer pricing aspects of intangibles,2 achieving "consensus" on reforms by adopting an "all of the above" approach,3the enormously complicated proposals to address hybrid mismatch arrangements,4and the tensions surrounding the balance between source and residence taxation and the desire of some to use the BEPS project as the vehicle to change that balance.5 And the common bonds among countries that have traditionally animated the cooperation that takes place at the OECD and lead to mutual gains through the achievement of more uniform tax rules may be breaking down, as revenue pressures lead countries to focus on their own interests.6 This commentary will focus only on one likely driver of increased controversy, the new country-by-country (CBC) reporting template, and then examine possible new mechanisms for resolving those disputes, borrowing heavily from approaches taken by the WTO and in free trade agreements.
In brief, the essential concern with CBC reporting is that it enables a significant movement away from the arm's-length principle as the basis for transfer pricing rules, but without explicitly repudiating it. The template is proposed to be used only as a risk assessment tool and not as a substitute for a detailed transfer pricing analysis for purposes of the imposition of substantive transfer pricing adjustments by tax authorities. However, the risk assessment contemplated by the CBC template includes comparing whether the taxpayer's reported allocation of profits among countries is consistent with the location of its employees, tangible assets, and sales – the same three factors commonly used in formulary apportionment systems. The potential for increased controversy is thus obvious, as some tax authorities may continue to hew to the arm's-length principle, while others may use the CBC template to assert transfer pricing adjustments consistent with a formulary apportionment system.
The U.S. Treasury Department has already indicated that it is seeking "guarantees" that other countries will not use the template in practice to make transfer pricing adjustments consistent with formulary apportionment.7To prevent such inappropriate use, the U.S. proposal is apparently to include "cautionary language" in the final version of the OECD's recommended CBC template and to refuse to share templates filed by taxpayers with the IRS with other countries. (The United States favors an implementation approach whereby the CBC template is only filed with the parent company of the multinational enterprise (MNE) group and shared with other jurisdictions only under treaty Exchange of Information provisions.)
That approach will likely be unavailing, however, as the OECD has no power whatsoever to compel member countries to follow its recommendations.8The OECD is merely a standard-setting institution and its guidance is never self-executing. Consequently, OECD member countries and G20 countries (and others) are completely free to adopt CBC reporting regimes that are substantively different from the OECD-recommended template and to require that their version of the template be filed directly with their tax administration, regardless of the jurisdiction of the parent company of the MNE group. Once actual reporting has begun, they are also free to use the information provided by the template as they so choose. Taxpayers seem destined to be caught in the middle, with instances of double taxation rising.
The need for improved dispute resolution procedures is therefore obvious. But what mechanisms might be available? Several commentators recommended that the CBC template be paired with binding "baseball-style" arbitration as a required dispute resolution mechanism. The salutary effects of binding baseball-style arbitration are well known, as it incentivizes Competent Authorities to work cooperatively (and reasonably) to obtain a prompt resolution of a dispute9 and, failing that, allows the taxpayer to have the dispute settled by a neutral arbitrator, with the decision binding on the tax authorities. Work toward that solution could be covered under Item 14 of the BEPS Action Plan, which promises to make dispute resolution mechanisms more effective and Item 15 of the Action Plan which offers work to develop a multilateral instrument, which could potentially be the vehicle to quickly implement the binding baseball-style arbitration which could be the output of Item 14. That sequencing would therefore be the ideal solution, but, unfortunately, is unlikely to happen. The suggestion by commentators to pair CBC reporting with binding baseball-style arbitration was apparently met with a tepid reception from OECD and G20 member countries, which is not surprising -- those jurisdictions where such a mechanism would be most useful are where it is least likely to be adopted.
In the long run, therefore, the OECD may need to become more like the WTO with respect to dispute resolution procedures. Traditionally, countries have zealously guarded their sovereignty with respect to tax matters and been reluctant to cede the design and operation of their tax systems to other countries or organizations. Only limited concessions have been tolerated, such as through bilateral tax treaties (with only rudimentary enforcement mechanisms) and very limited coverage of tax matters in trade agreements. With respect to trade rules, however, almost the exact opposite approach has been taken. The WTO is a multilateral organization whose goal is to liberalize trade between member countries by establishing a framework for negotiating and implementing trade agreements backed up by a strong dispute resolution process designed to enforce adherence to the underlying agreements. At the WTO, "agreements must be kept" is not just an aspirational goal, it is an ironclad rule.10
The primary goal of the WTO dispute settlement system is to provide both security and predictability to the international trade system, and it does so by providing procedures through which members can ensure their rights under the agreements can be enforced.11 A "Dispute Settlement Body" (which is comprised of all WTO members) has the responsibility for settling disputes, which is exercised through authorization of "panels" of experts to hear and decide disputes.
When a member believes another member has established rules that are inconsistent with the WTO Agreement, the complaining member first must call for "consultations" with the other member – the parties must first "talk to each other to see if they can settle their differences by themselves."12 The parties have 60 days to try to work it out, failing which the complaining party may request the establishment of a panel to resolve the dispute. And, importantly, the respondent country can block the creation of a panel once, but generally, when the Dispute Settlement Body meets for a second time, the appointment of the panel can no longer be blocked – meaning that one side of the controversy generally has the right to bring it in to the dispute settlement process, unlike the process under our income tax treaties, where one side of the controversy can generally keep it out of the Competent Authority process by alleging that it is not within the scope of the Mutual Agreement Procedure article.13
Up to 45 days are allotted for a panel to be appointed, which then has six months to give its final report on the dispute to the parties. Three weeks afterward, the panel's final report is distributed to all WTO members. The report will then be adopted by the Dispute Settlement Body within 60 days unless a consensus (i.e., all members) rejects it. Note the speed with which the process occurs; from initial consultations of the parties to the final adoption of the panel's report by the Dispute Settlement Body, only one year has elapsed. Appeals are of course allowed, but take place at what can only be characterized as lightning-fast pace (at least compared to the typical resolution of income tax disputes) – appeals are heard and decided within 90 days.
Perhaps most importantly, procedures are available to ensure compliance with the Dispute Settlement Body's ruling. When the ruling is that a country has violated a trade obligation, it is expected to correct its noncompliance. It is given a "reasonable period of time" to do so; failing that, it will be ordered into negotiations with the country bringing the complaint to try to determine compensation that is acceptable to both sides. And finally, if an agreement on satisfactory compensation cannot be reached, the party bringing the case may request permission to "retaliate" (e.g., by banning imports, raising import duties, etc.) against the other party from the Dispute Settlement Body. The preferred solution throughout the process is for the parties to consult together and resolve the dispute by themselves, but if that cannot be accomplished, a speedy, efficient settlement process is provided where the dispute can be resolved according to internationally agreed rules, backed up with strong enforcement mechanisms. It is a far cry from the current procedures for resolving disputes concerning income tax measures.
It would appear to be the ideal type of dispute resolution system for income tax measures but it would obviously take time to reach that state, although we may be nearing a tipping point, where so many disputes arise that the current system becomes overwhelmed and provides the impetus for countries to work together to establish new processes. If a WTO-like dispute settlement process cannot be achieved in the short-term and the OECD is unlikely to get consensus among all its members and the G20 countries to agree to mandatory binding baseball-style arbitration, are there any short-term solutions available?
For starters, complete consensus at the OECD on BEPS Action 15 is not necessary to achieve some success, and instead of a multilateral instrument implementing binding baseball-style arbitration among all countries participating in the BEPS project, a plurilateral14 instrument signed by some subset of those countries would achieve some significant measure of progress. A similar situation is currently in progress at the WTO, where a small group of countries has blocked implementation of the Trade Facilitation Agreement (TFA), which is an agreement that would increase efficiency and uniformity in customs and other border procedures and is estimated to create up to $1 trillion in benefits and 21 million new jobs worldwide. Recognizing that benefits of that magnitude cannot simply be left on the table, countries are already thinking about the "next best" alternative and turning the TFA into a plurilateral agreement (binding only those countries that sign) if the multilateral agreement cannot be salvaged at the WTO.15 A similar plurilateral agreement under BEPS Action 15 would still be a significant positive achievement. In this instance, it would actually complement the OECD's traditional consensus-based approach rather than threaten it, it would lead to regional benefits and closer economic integration for those countries that become signatories, and could actually provide the impetus leading to a consensus agreement at some later date.16
If even that level of cooperation fails, the United States might take the lead by developing a uniform, single-issue protocol covering only binding baseball-style arbitration and offering to sign with any of its current treaty partners. Such a protocol could significantly improve upon the current U.S. approach to this issue by providing that either Competent Authority can bring a case in to the Mutual Agreement Procedure, rather than allowing either Competent Authority to keep it out.17 Once several treaty partners signed such a protocol and a critical mass has been established, pressure might quickly build for other countries to sign.
As globalization accelerates, multinationals evaluate the desirability of any particular country as a potential investment location on various bases, with tax considerations becoming increasingly important. Knowing that an efficient, timely, mandatory system of dispute resolution is available to resolve tax controversies would be a significant boost to investor confidence. Conversely, foreign direct investment in countries that are unwilling to subject their tax rulings to evaluation by a neutral arbitrator would likely be affected. Enough pressure might build over time so that binding baseball-style arbitration eventually becomes the norm rather than the exception.
It is clear that an inflection point has been reached, as a significant and growing backlog of tax controversies highlights the need for action.18 To prevent unresolved international tax disputes from threatening cross-border trade countries must explore alternatives like baseball-style arbitration, accompanied by the ability of a complaining country to invoke arbitration even without agreement of the respondent country and backed up by a strong compliance mechanism. Concerns about sovereignty with respect to tax matters should not be a barrier, as agreeing to such a process has appropriately been characterized as an exercise of sovereignty rather than a relinquishment of it.19 The WTO model for settling disputes has much to offer and can assure countries (and investors) that they will actually realize the benefits of the agreements they have negotiated – that the other party to an agreement will not "break its promise."20 Innovative solutions must be found to forestall the growing number of international tax disputes, recognizing, as the WTO does, that "[t]he best international agreement is not worth very much if its obligations cannot be enforced when one of the signatories fails to comply with such obligations."21
This commentary also will appear in the October 2014 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Gleicher, 892 T.M., Transfer Pricing: Competent Authority Consideration, Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties -- U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶3600, Section 482 -- Allocations of Income and Deductions Between Related Taxpayers, ¶7160, U.S. Income Tax Treaties.
1See, e.g., Swenson, Global tax audits and disputes: New forces are converging to form second wave, available at http://www.pwc.com/gx/en/tax/publications/transfer-pricing/perspectives/assets/tpp-globaltaxauditsanddisputes.pdf (discussing predictions of a growing "perfect storm" in the global tax controversy arena, driven by acute need of countries to raise large amounts of revenue, increasing willingness of countries to adopt positions diverging from historic international tax norms, political pressure on tax planning of multinational corporations based on populist rhetoric, growing differences in tax norms between source and residence countries, and use of the BEPS project by many countries to justify taking extreme positions in tax audits and disputes).
2See, e.g., comments from the United States Council for International Business on the the OECD's Discussion Draft on the Tax Challenges of the Digital Economy, available at http://www.oecd.org/ctp/comments-action-1-tax-challenges-digital-economy.pdf (noting that the draft revisions to Chapter VI of the Transfer Pricing
Guidelines specify that the returns to intangibles should be allocated by reference to the location of personnel who perform or control the development, enhancement, maintenance, and protection of the intangible, and not by reference solely to ownership, funding and bearing risk; in contrast, the digital economy Discussion Draft expresses concern that taxpayers control the location of functions and assets, and thereby suggests that the
location of the actual business activities giving rise to the development, delivery and support of digital products and services may not be the determinants of the jurisdiction to tax income arising from those activities but, rather, the location of customers is key).
3See, e.g., Morrison, BEPS Action 6 — Treaty Shopping Double Whammy, Tax Mgmt. Int'l J. (June 13, 2014) (criticizing proposed recommendation under BEPS Action 6 to address treaty shopping concerns by adopting both a Limitation on Benefits provision and a main purpose test, instead of simply choosing one or the other, and noting that the consequent combination of considerable complexity with considerable uncertainty will likely be unworkable in practice).
4See, e.g., Schler, BEPS Action 2: Ending Mismatches on Hybrid Instruments, Part 2, Tax Notes Today: Special Reports (Aug. 19, 2014) (noting that "the complexity of the proposed regime makes worldwide information sharing under the Foreign Account Tax Compliance Act model seem like child's play," and the danger that as countries have already begun to take unilateral action to address concerns regarding hybrid mismatch arrangements they may not subsequently change their rules to conform to the final OECD recommendations).
5See, e.g., Collins, Calleja, and Bersten, The Forces and Tensions Shaping BEPS, Transfer Pricing Int'l J. (May 30, 2014) (noting how differences in opinion regarding the balance between source and residence taxation lead to problems reaching consensus on many issues, including the determination of the existence of a permanent establishment, the allocation of profits from intercompany transactions according to the arm's-length principle or global formulary apportionment, the role and operation of controlled foreign company rules and other anti-deferral regimes, and the taxation of the digital economy).
6See, e.g., Bell, U.K. Official Says Countries `Naturally' Will Advocate Own Interests in BEPS Talks, 106 Daily Tax Rep. I-2 (June 2, 2014) (noting comments of U.K. official regarding strong degree of "self-interest" currently existing among countries participating in the BEPS project and summarizing the atmosphere within the OECD at the moment by stating that "there are no self-denying saints at the BEPS negotiating table.").
7See Gregory, U.S. Seeks Ban Against Formulary Use of Data in Country-by-Country Template, 69 Daily Tax Rep. G-6 (Apr. 10, 2014).
8See, e.g., Bell, OECD Official Questions Business Concerns About Filing of Country-by-Country Template, 97 Daily Tax Rep. I-1 (May 20, 2014), quoting comments by Joe Andrus, former head of the OECD's transfer pricing unit, at the public consultation on transfer pricing documentation and country-by-country reporting, explicitly highlighting the lack of power the OECD has to compel members to follow its recommendations. In response to comments from business representatives that the OECD should force countries to accept that the template would only be filed with the parent company tax return, Andrus responded, "There seems to be a suggestion…that someone would prohibit sovereign countries from requiring this information to be filed locally. Who exactly is going to prohibit those countries from doing that? You ascribe a little more authority to the OECD than it has."
9See, e.g., Opening Statement of Robert B. Stack, Treasury Deputy Assistant Secretary (International Tax Affairs), Senate Committee on Foreign Relations (Feb. 26, 2014), available at http://www.foreign.senate.gov/imo/media/doc/022614AM_Hearing_Testimony%20-%20Bob%20Stack.pdf ("[T]he prospect of impending mandatory arbitration creates a significant incentive to compromise before commencement of the arbitration process.").
10See "Introduction to the WTO dispute settlement system," available at http://www.wto.org/english/tratop_e/dispu_e/disp_settlement_cbt_e/c1s3p1_e.htm ("[M]arket participants need stability and predictability in the government laws, rules and regulations applying to their commercial activity, especially when they conduct trade on the basis of long-term transactions. In light of this, the [WTO dispute settlement system] aims to provide a fast, efficient, dependable and rule-oriented system to resolve disputes about the application of the provisions of the WTO Agreement. By reinforcing the rule of law, the dispute settlement system makes the trading system more secure and predictable. Where non-compliance with the WTO Agreement has been alleged by a WTO Member, the dispute settlement system provides for a relatively rapid resolution of the matter through an independent ruling that must be implemented promptly, or the non-implementing Member will face possible trade sanctions.")
11 This (very) brief summary of the WTO dispute settlement procedures is taken from the description available at http://www.wto.org/english/thewto_e/whatis_e/tif_e/disp1_e.htm.
13See "Introduction to the WTO dispute settlement system," available at http://www.wto.org/english/tratop_e/dispu_e/disp_settlement_cbt_e/c1s3p3_e.htm ("The detailed procedures are designed to achieve efficiency, including the right of a complainant to move forward with a complaint even in the absence of agreement by the respondent.").
14 "Plurilateral" is used here in the WTO sense of the word. The WTO refers to "multilateral" agreements as those binding all WTO members and "plurilateral" agreements as those binding only a narrower group of signatories. See Plurilaterals: of minority interest, available at http://www.wto.org/english/thewto_e/whatis_e/tif_e/agrm10_e.htm.
15SeeQ&A: Last-ditch efforts to save WTO deal, Financial Times (July 31, 2014).
16SeeUnderstanding the WTO – Regionalism: friends or rivals?, available at http://www.wto.org/english/thewto_e/whatis_e/tif_e/bey1_e.htm ("They seem to be contradictory, but often regional trade agreements can actually support the WTO's multilateral trading system. Regional agreements have allowed groups of countries to negotiate rules and commitments that go beyond what was possible at the time multilaterally. In turn, some of these rules have paved the way for agreement in the WTO. Services, intellectual property, environmental standards, investment and competition policies are all issues that were raised in regional negotiations and later developed into agreements or topics of discussion in the WTO.").
17 This approach to ensuring access to dispute settlement mechanisms has been agreed to by the United States in other contexts. See, e.g., n. 11, above, describing how one country can invoke WTO dispute settlement procedures without the consent of the other country. The United States also takes a similar approach in its bilateral free trade agreements. Briefly, these agreements generally provide binding dispute resolution procedures to prevent expropriations by one party, and include therein coverage of tax measures, since in extreme cases tax measures can be confiscatory. The relevant provision provides for a "filter" mechanism which protects against investors bringing meritless claims by allowing the tax authorities to stop a claim if they both agree that it is without merit. So if both Competent Authorities agree that a tax measure is not an expropriation, the claim stops. But if either party thinks it may be an expropriation, the claim proceeds to arbitration. For an example of such a provision, see Article 23.3.6(b) of the United States-Korea Free Trade Agreement, available at http://tcc.export.gov/Trade_Agreements/All_Trade_Agreements/korusfta/Exceptions.pdf.
18See Swenson, above at n. 1, citing OECD statistics on open MAP cases reported by OECD member countries as evidence of a recent surge in tax audits and controversies.
19See Groen, Arbitration in Bilateral Tax Treaties, Intertax, Vol. 30, No. 1 (2002), pp. 3-27.
20See Understanding the WTO: Settling Disputes, available at http://www.wto.org/english/thewto_e/whatis_e/tif_e/disp1_e.htm ("Disputes in the WTO are essentially about broken promises. WTO members have agreed that if they believe fellow-members are violating trade rules, they will use the multilateral system of settling disputes instead of taking action unilaterally. That means abiding by the agreed procedures, and respecting judgements [sic].").
21 "Introduction to the WTO dispute settlement system," available at http://www.wto.org/english/tratop_e/dispu_e/disp_settlement_cbt_e/c1s1p1_e.htm.
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