The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
How much deference should a tax authority engaged in or considering a Mutual Agreement Procedure (MAP) with respect to one of its residents give to the adjustment asserted by the other Contracting State? This interesting question of international tax policy and practice has been put squarely on the table by the most recent proposed amendments to Article 7 of the OECD Model Tax Convention and its Commentary dealing with the attribution of profits to a permanent establishment (PE).
As discussed in my article in the March 12, 2010 issue of the Tax Management International Journal, the OECD released on November 24, 2009, a second version of proposed new language for Article 7 and the associated Commentary. The purpose of this new language is to implement certain conclusions reached in the Report on Attribution of Profits to Permanent Establishments as adopted by the OECD in 2008 ("Profit Attribution Report"), and referred to as the Authorized OECD Approach (AOA). The prior article noted with approval the improvements made in the second draft toward the goal of ensuring that international double taxation is relieved when either the residence or source state makes an adjustment to the profits reported as subject to tax in a PE.
Towards that goal, the November 24 discussion draft proposed revised language for Article 7(3) of the Model Convention as follows:
Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other State shall, to the extent necessary to eliminate double taxation on these profits, make an appropriate adjustment to the amount of the tax charged on those profits. In determining such adjustment, the competent authorities of the Contracting States shall if necessary consult each other.
The mandate that the other State "shall" make an appropriate adjustment in order to relieve double taxation, in combination with the requirements of Article 23 A or 23 B (Methods for Elimination of Double Taxation), was intended to respond to taxpayer concerns that treaty mechanisms exist to ensure that double taxation is relieved. The new draft Commentary on Article 7(3) in paragraph 42 goes as far as saying that this language "ensures that there is no unrelieved double taxation of the profits that are properly attributable to the permanent establishment." (Emphasis added.)
The new draft Commentary makes it clear that the proposed language imposes on the non-adjusting state an obligation to defer to the state making the initial adjustment, but only if the non-adjusting state considers that the adjustment conforms to the principles of the AOA. The non-adjusting state "is obliged to make an appropriate corresponding adjustment only if it considers that the adjusted profits correctly reflect what the profits would have been if the permanent establishment's dealings had been transactions at arm's length."1
As practitioners know, it is possible that reasonable interpretations of the arm's-length standard can lead to very different views of an arm's-length result, which is the cumulative effect of choices regarding the appropriate comparables, the need for or magnitude of adjustments to those comparables, or any number of other elements of the determination of an arm's-length price. The AOA itself leaves open many interpretative issues that will be debated and disputed for years. The functions that constitute "significant people functions" and the actions necessary to attribute an asset or a risk to a PE are just a couple of these. Many taxpayers are well aware of cases where tax authorities have defended positions that many observers would regard as unreasonable based on a superficially compliant application of the Transfer Pricing Guidelines. There will be many cases where a state may make an adjustment to an extreme point on a range, but which the other state (or the taxpayer for that matter) may not be able to demonstrate was outside the realm of an arguably reasonable application of the AOA. The clear possibility exists, therefore, that a state could initiate an adjustment that may seem to be an extreme application of the AOA, but insist that the other state defer to its adjustment and grant double tax relief on the basis that its position is still a reasonable application of the AOA.
Presumably this deference is not intended to extend to the question of whether a PE exists in the first place, as this provision relates only to the attribution of profits under Article 7 to a PE, the existence of which is determined under Article 5. Extending the principle of deference to the adjusting state in the context of PE determinations undoubtedly would lead to even more mischief.
The possible effect of this grant of some degree of "first mover advantage" was not lost on some states. In paragraph 66, the draft Commentary notes that some states, apparently a minority, would prefer to not give any deference to the adjusting state's preferred position as to the appropriate arm's-length price or method. Those states would prefer to reserve for the state not initiating the adjustment the ability to cause the propriety of the initial adjustment to be reviewed by the Competent Authorities, even if the initial adjustment arguably conformed to Article 7(2). The Commentary presented that position as an alternative to the new Article 7(3), as follows:
Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other Contracting State shall, to the extent necessary to eliminate double taxation, make an appropriate adjustment if it agrees with the adjustment made by the first-mentioned State; if the other Contracting State does not so agree, the Contracting States shall eliminate any double taxation resulting therefrom by mutual agreement.
How much deference is appropriate? The draft Commentary justifies the obligation to give deference to the adjusting state by stating that such obligation supports the objective of relieving double taxation by providing an enforceable mechanism to ensure this result. Decreasing the possibility of unrelieved double taxation certainly is a central objective of tax treaties. Those managing the international tax affairs of multinational organizations are anxious to avoid the prospect of being caught between differing interpretations of the arm's-length standard or the AOA by two tax administrations.
To this observer, however, the mandate to grant deference to the adjusting state opens the door to too much potential mischief. Determinations of the amount of profits attributable to a PE will be intensely factual exercises. Despite the best efforts of the authors of the Profit Attribution Report, the AOA for the most part describes general principles rather than specific rules. Much interpretative work will be left to taxpayers and tax administrators to determine those specific functions, assets, and risks which will be attributed to the PE, and then to articulate the hypothetical dealings between the PE and the rest of the enterprise, all in a context where there are no actual commercial transactions to give a framework to those hypothetical dealings. Once all that is accomplished, then transfer pricing principles need to be applied to those hypothetical dealings in order to determine the arm's-length price or result to arise from the dealings. All of the factual uncertainties that are inherent in the application of transfer pricing principles under Article 9 will exist here: the selection of comparables, the propriety and magnitude of any adjustments, assessment of relative contributions of intangible assets, and more.
Transfer pricing practitioners know that a few small changes in the assumptions here or there can have a large effect on the ultimate result. The culmination of this process – the amount of profits attributable to that particular PE – will be the end result of a large number of legal and factual inputs. The scope for controversy is large. More importantly for this purpose, in many cases it would be possible to support a wide range of results as arguably reasonable applications of the AOA, and the points at the ends of the range would both result from an application of the AOA principles and neither could be demonstrated to be wrong.
In this environment, granting deference to the adjusting state would seem to give the first mover the possibility to hold the other state hostage to an adjustment made to the end of a range. As the vast majority of adjustments will be by states where the PE is located, rather than by the state of residence, the effect of this will be to put a thumb on the scales in favor of allowing source states to make and sustain adjustments that increase profits attributable to PEs.
The concept of incorporating an obligation to grant deference into the Convention itself (or even the Commentary) would be a departure from traditional principles of treaty interpretation. A tax treaty negotiated between two states and ratified by the appropriate bodies in each state is in the nature of a contract between the two states. The OECD term for the two national parties indeed is "the Contracting States." United States internal law regarding the interpretation of tax treaties generally regards a treaty as a contract between the two states, and applies principles of treaty interpretation that are similar to those applicable to the interpretation of commercial contracts. The basic interpretative principle is that the court must determine the intent of the parties as to the meaning or application of a treaty term as of the date the treaty was ratified.2 This principle is tested in interesting ways when it is suggested that interpretative materials issued after the ratification of a treaty could provide guidance for earlier ratified treaties, such as subsequent revisions to the OECD Commentary.3 Even when a U.S. court has considered subsequent materials to be useful guides to interpretation, the purpose still has been to use those subsequent materials to ascertain what the agreement of the parties was at the time of ratification on the particular issue, when the text of the treaty and available contemporaneous interpretative materials were silent or ambiguous on the matter.
Applicable international principles of treaty interpretation are similar. The Vienna Convention on the Law of Treaties also considers treaties essentially to be contracts entered into between the states. The basic rule of interpretation is that the "treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose."4 As is the case with U.S. jurisprudence regarding the interpretation of tax treaties, the point is that the interpretative exercise is framed as an effort to determine the mutual intent of the parties at the time of contracting.
Common law principles of commercial contract interpretation may be a useful reference point. Some common law principles of contract interpretation allow a construction against one party or the other, such as against the party which drafts the contract.5 There is no principle in domestic commercial law jurisprudence that one contracting party must give deference to another party's reasonable interpretation of a term.
All that said, it could be argued that the proposed deference principle to be built into Article 7(3) is fully consistent with these principles of treaty interpretation in that it would constitute a contemporaneous agreement by the parties that a certain degree of authority to resolve ambiguity or exercise flexibility in the application of the AOA will be mutually allowed between the Contracting States. In that light, there is no issue about divining the contemporaneous intent of the parties; they indeed agreed to allow this freedom of action to the first mover state, and to oblige the responding state to accede. What cannot be known at the time of contracting, however, is how the various Contracting States will choose to exercise that freedom of action.
Those who drafted Article 7(3) presumably were very conscious that PE profit attribution issues will generate significant controversies. The AOA analysis is factually intensive. Once the hypothesized dealings are determined, then a second factually intensive analysis to apply the Transfer Pricing Guidelines (TPG) is overlaid on top of the first factual determination of the hypothesized dealings. Some issues (revenue characterization, for example) in principle are binary questions. The question of PE profit attribution is just the opposite. Many cases will present fact patterns that could be susceptible to varying interpretations or applications of the AOA and the TPG. The state proposing the adjustment will always assert that its adjustment is a reasonable interpretation of the AOA and the TPG. That state presumably will argue as a matter of course that the new Article 7(3) requires deference by the other state. The discussion then will be not over whether the AOA and TPG have been applied in the most appropriate way, but whether they have been applied in a sufficiently plausible manner that the adjusting state can demand deference.
Incorporating this obligation to defer to the other state's reasonable interpretation of these principles constitutes an advance consent to grant double tax relief in circumstances that cannot be known at the time of ratification. This does not seem to be a sound approach from the U.S. perspective. The situation might be different if there were less uncertainty as to how these cases will arise and be dealt with in practice. If these cases in fact were to involve a limited number of factual contexts, and the applicable principles to dispose of those cases were clearly known and consistently applied, then perhaps deference could be granted in order to smooth the functioning of the international tax system. That certainly is not the case at the moment with PE profit attribution, however. This sort of deference is not expected in the context of Article 9, which addresses issues that arguably are less daunting than those arising under Article 7, despite similar language in Article 9 that the second state "shall make an appropriate adjustment" when the first state adjusts prices to conform with arm's-length dealings. There is less uncertainty, after all, in determining the nature of documented intercompany transactions compared to the challenges that will be faced by taxpayers and tax administrators to determine the nature of the hypothesized dealings as required by the AOA.
Perhaps the deference principle was regarded as an approach that would reduce controversies by limiting the need for MAP consultations to only those cases where one of the states had taken a clearly unwarranted approach under the AOA. By requiring the second state to give the adjusting state the benefit of the doubt in more routine cases, perhaps the MAP docket could be reduced and Competent Authority resources deployed elsewhere. If this was a consideration, then it would seem to be clearly outweighed by the need for active Competent Authority participation in these cases as they arise to develop an international consensus as to how these novel principles should be applied.
The new draft Commentary describes the deference obligation as directed towards ensuring the elimination of the possibility of double taxation. Indeed, this is a laudable goal. U.S. treaty policy has taken some notable steps toward this goal in recent years, including embracing the concept of mandatory binding arbitration.6 In this author's view, however, the deference proposed in the new Article 7(3) has more potential to cause mischief by empowering the first mover state to demand deference to extreme, but plausible, interpretations of the AOA than it has to streamline the international tax dispute resolution process by expediting the resolution of controversies.
This view apparently was shared by at least some states. As noted above, the draft Commentary proposes an alternative formulation of Article 7(3) that would allow the non-adjusting state to test the appropriateness of the adjustment through the MAP process in any event. The next several years will see a series of treaty renegotiations around the world in which treaty negotiators will need to decide which version of Article 7(3) to include in their treaties. Hopefully, the U.S. Treasury will opt for the alternative version, to help guide the development of international tax practice in these formative years of applying the AOA. This will be in the best interests of U.S. taxpayers, which undoubtedly will be the target of numerous PE profit attribution adjustments by other states.
This commentary also will appear in the May 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and 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 ¶7130, Foreign Persons — Effectively Connected Income, and ¶7160, U.S. Income Tax Treaties.
2 See North W. Life Assurance Co. v. Comr., 107 T.C. 363 (1996); Taisei Fire & Marine Ins. Co. v. Comr., 104 T.C. 535 (1995) (considering OECD Commentary as guidance for determining intent of treaty parties at time of ratification).
3 SeeIntroduction to Model Tax Convention on Income and on Capital, OECD, paragraph 35 ("changes or additions to the Commentaries are normally applicable to the interpretation and application of conventions concluded before their adoption, because they reflect the consensus of the OECD Member countries as to the proper interpretation of existing provisions and their application to specific situations.").
5 See Restatement (Second) of Contracts, §206 (1981) ("In choosing among the reasonable meanings of a promise or agreement or a term thereof, that meaning is generally preferred which operates against the party who supplies the words or from whom a writing otherwise proceeds."); U.S. v. Seckinger, 397 U.S. 203 (1970) ("[A] contract should be construed most strongly against the drafter.").
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