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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
While there are no official statistics to prove the point, it must certainly be the case that requests for exchanges of information between governments in order to facilitate the enforcement of tax laws are on the rise. Taxpayers may well wonder from time to time what information exchange requests may have been issued with respect to their affairs. Those taxpayers also may be surprised to learn what few opportunities they may have to even learn of the existence of a request, much less to review the request or the information proposed to be exchanged to test whether the exchange request complies with applicable international limitations. While standards do exist under OECD guidance as to what information governments may request and exchange, under the law and practice of the large majority of countries those parameters are left to be enforced by the tax administrations themselves, without any right of the taxpayer to learn of the request or to review the information proposed to be exchanged.
In the case of an audit of a U.S. taxpayer by the IRS, the legal basis for objecting to the production of information requested in an IDR essentially is contained in the law establishing grounds for objecting to the IRS seeking to enforce that information request through an administrative summons in a U.S. district court.1 In general, the most common grounds to object to a summons enforcement action in the corporate income tax context are that the information requested is not relevant or material to the inquiry, or on grounds of privilege, including attorney-client, marital, doctor-patient, and work product protection. While the IRS is prohibited from disclosing a taxpayer's trade secrets to any extent not authorized by law, the fact that the information requested is a trade secret does not allow a taxpayer to refuse to produce it. The taxpayer can test the validity of the information request through defending an enforcement action in district court. The taxpayer therefore has the right to test the legal basis for the IRS request before the fact of producing the information.
The standards governing what information may be requested and exchanged under treaty exchange of information provisions are similar in some respects to U.S. law, but also are very different in other respects. Importantly, the opportunities for taxpayers to enforce the standards in court prior to the fact of the exchange are much more limited, due to the absence of transparency requirements in many countries.
The applicable principles governing the exchange of information in the OECD Model Treaty are contained in Article 26. Article 26(1) provides as follows: The competent authorities of the Contracting States shall exchange such information as is foreseeably relevant for carrying out the provisions of this Convention or to the administration or enforcement of the domestic laws concerning taxes of every kind and description imposed on behalf of the Contracting States, or of their political subdivisions or local authorities, insofar as the taxation thereunder is not contrary to the Convention. ...2
The U.S. Model Treaty contains a similar provision.3
The Commentary to Article 26 provides guidance as to what is and is not contemplated to be covered by the grant of authority under Art. 26(1). The principal interpretative language regarding the scope of Art. 26(1) provides as follows:The main rule concerning the exchange of information is contained in the first sentence of the paragraph. The competent authorities of the Contracting States shall exchange such information as is foreseeably relevant to secure the correct application of the provisions of the Convention or of the domestic laws of the Contracting States concerning taxes of every kind and description imposed in these States even if, in the latter case, a particular Article of the Convention need not be applied. The standard of "foreseeable relevance" is intended to provide for exchange of information in tax matters to the widest possible extent and, at the same time, to clarify that Contracting States are not at liberty to engage in "fishing expeditions" or to request information that is unlikely to be relevant to the tax affairs of a given taxpayer. …4
With respect to trade secrets, Art. 26 expressly provides that there is no obligation on a State to exchange information "which would disclose any trade, business, industrial, commercial or professional secret or trade process, or information the disclosure of which would be contrary to public policy (ordre public)."5
What right, then, does a taxpayer have to be informed as to what information may be exchanged about it, in order to monitor whether the exchange request complies with these limitations, such as the requirement that the information be "foreseeably relevant," that it not contain trade secrets, and that the request not constitute a "fishing expedition"?
The answer is that the view into this process from the taxpayer's side of the lens is opaque indeed. The Commentary does note that the law of some countries provides taxpayer protections which normally require notification to the taxpayer when an information exchange is contemplated, as follows: Some countries' laws include procedures for notifying the person who provided the information and/or the taxpayer that is subject to the enquiry prior to the supply of information. Such notification procedures may be an important aspect of the rights provided under domestic law. They can help prevent mistakes (e.g. in cases of mistaken identity) and facilitate exchange (by allowing taxpayers who are notified to co-operate voluntarily with the tax authorities in the requesting State).6
While that acknowledgement is comforting, the Commentary immediately proceeds to suggest circumstances in which the State from which the information is requested might depart from the otherwise applicable notification requirements:Notification procedures should not, however, be applied in a manner that, in the particular circumstances of the request, would frustrate the efforts of the requesting State. In other words, they should not prevent or unduly delay effective exchange of information. For instance, notification procedures should permit exceptions from prior notification, e.g. in cases in which the information request is of a very urgent nature or the notification is likely to undermine the chance of success of the investigation conducted by the requesting State. A Contracting State that under its domestic law is required to notify the person who provided the information and/or the taxpayer that an exchange of information is proposed should inform its treaty partners in writing that it has this requirement and what the consequences are for its obligations in relation to mutual assistance. Such information should be provided to the other Contracting State when a convention is concluded and thereafter whenever the relevant rules are modified.7
To assess how widespread (or not) such taxpayer notification rights may be, I undertook a small survey of the taxpayer notification requirements in several countries that might be expected to appear in the top 10 list of jurisdictions to which exchange of information requests might be directed: Australia, Canada, France, Germany, Japan, the United Kingdom, and the United States. Of those seven countries, only Germany presently provides domestic law protections to taxpayers, which in the normal case require the tax authorities to inform the taxpayer of the requested exchange.8 Under German law, prior to the release of information to the other tax administration, the German tax authorities must hold a hearing in which the taxpayer is allowed to participate. At the hearing, the tax administration will describe the information requested by the other tax administration, and the taxpayer is given an opportunity to object. German domestic law also provides protections against disclosure of confidential information or of information not relevant to the determination of a tax liability, which could be the basis for an injunction action filed by the taxpayer to prevent the disclosure of such information. These protections are grounded in German constitutionality protected privacy rights.
The domestic law of other countries may contain other types of protections. Under U.K. law, for example, the tax authorities may not disclose information to another tax authority under treaty provisions unless they are satisfied that the other authority is bound by, or will observe, confidentiality rules no less strict than the U.K. rules. Further, one proviso to which exchange of information under the EU Mutual Assistance Directive is subject is that the requesting authority has exhausted the usual sources of information which it could have used to obtain the information. There is no obligation under U.K. law in either case, however, to make the taxpayer aware of the proposed exchange. By way of further example, in Canada, the duty of procedural fairness in administrative law matters could potentially be used to recognize a notification right in the case of treaty information exchange requests. This issue has yet to make its way before a Canadian court, however.
In the absence of actual notice to the taxpayer that the information exchange is happening, the Art. 26 limitations and even domestic administrative guidelines or limits seem hollow indeed. A tax administration which indeed launches a "fishing expedition" involving only countries without notification requirements could proceed to cast its nets across a wide swath of the sea of information, without the taxpayer being able, as a practical matter, to insist that the Art. 26 guidelines be enforced, or to enforce the rights it may have under domestic law to prevent the exchange of information that contains trade secrets, is not relevant to the tax examination, or, if released to a particular country, may not enjoy appropriate protections against public disclosure of taxpayer information. In a situation where the taxpayer has no visibility into what exchange requests are made or fulfilled, the limits imposed in the Art. 26 Commentary would appear to create a rule that as a practical matter aggrieved parties cannot enforce.
Many of the Base Erosion and Profit Shifting (BEPS) elements, as well as other recent initiatives in tax administration, have focused on creating increased "transparency." The country-by-country reporting proposal being developed under the aegis of Action 13 of the BEPS Action Plan is the most high-profile of these initiatives, but the steady pressure by tax authorities for more disclosure by taxpayers also motivates the BEPS Action 12 regarding disclosure of aggressive tax planning arrangements and the discussions of revised transfer pricing documentation requirements under Action 13, which is expressly described as an action intended to "enhance transparency for tax administration."
It seems clear that many tax administrations will be enthusiastically pursuing "transparency" regarding taxpayer activity. Tax administrations recently have been very public in expressing their intention to share information on a multilateral basis with respect to certain targeted taxpayers or industries.9 It is entirely appropriate that the OECD,
through its OECD Model Commentary or otherwise, provides parameters under which such information exchanges should be conducted. For those rules to have practical effect, however, more jurisdictions need to regard transparency as not a one-way mirror. A recommendation from the OECD as part of the BEPS project that other jurisdictions should, in the interests of transparency, adopt taxpayer protections such as the notification and hearing requirements existing under German law would be a good start.
This commentary also will appear in the September 2014 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see , 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7160, U.S. Income Tax Treaties.
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