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By David Ernick, Esq. PricewaterhouseCoopers LLP Washington, D.C.
On July 1, 2016, Latvia deposited its instrument of accession to the OECD Convention, thereby becoming the 35th member of the Organization for Economic Cooperation and Development. That modest expansion of membership, however, is dwarfed by the number of countries now participating in the OECD's tax work “on an equal footing,” thereby being treated as full members with the right to veto any proposals or reports with which they disagree. More than 60 countries were directly involved in the formulation of the final Base Erosion and Profit Shifting reports which received approval from the G20 leaders in November 2015. But the BEPS project did not end with the publication of those reports; soon thereafter, the OECD established an “inclusive framework” on implementation and monitoring of the BEPS measures. Details on what that involves are scarce, although the OECD has promised some form of monitoring of compliance with the four BEPS “minimum standards,” as well as a peer review of implementation of the BEPS measures around the world to ensure that no country gains an “unfair competitive advantage.”
Ninety countries are now participating in this “inclusive framework” and all of the OECD's tax work, which raises important questions about whether the OECD can remain an international tax standard-setting organization. The BEPS project highlighted the struggles the OECD went through in achieving consensus with non-OECD member countries, and where such consensus could not be achieved, the final BEPS reports resorted to a “menu of options” approach, which simply memorialized divergent country views. Those struggles will only be magnified in coming years by the vast expansion of participation in the OECD's tax work, as an inverse relationship likely exists between the number of countries gathered together in an OECD conference room and their ability to achieve true consensus around a single recommended approach.
The fact that the consensus on international tax norms is rapidly dissolving has important consequences for economic growth. From the very beginning of the BEPS project, questions regarding the ability of the OECD to achieve consensus around rules based objective standards have animated concerns from global businesses that they will need to apply inconstant rules to calculate their taxable income in all countries in which they operate, with the inherent risk of double (or multiple) taxation of the same dollar of income with no timely and effective mechanism to resolve such disputes. Those concerns are only heightened with each passing year, as the OECD's annual statistics on the Mutual Agreement Procedures (“MAP”) caseloads of all its member countries and of “partner economies” reflect an inventory of cases rising inexorably.
Not surprisingly, the most recent statistics reflect cross-border controversies at record-breaking levels, showing 2,509 MAP cases initiated in 2015, as compared to 2,259 in 2014. The number of disputes awaiting resolution swelled to 6,176 at the end of 2015, compared with 5,429 at the end of 2014. (Note though that there is some over-reporting, as the figures reflect all the cases reported by each country, which means cases are likely to be reported twice, once by each country involved in the dispute.) A top IRS official from the Advance Pricing and Mutual Agreement program recently reacted to those numbers with pessimism, and noted it is likely to get worse in future years, as he expects a “tsunami” of MAP cases soon.
The ability of such controversies to act as sand in the gears of international commerce was recognized early on, and Action 14 of the BEPS Action Plan promised significant improvements in dispute resolution, including through mandatory binding arbitration. On November 24, 2016, the OECD published the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”), which does include optional provisions for mandatory binding arbitration. (The MLI is truly both “multilateral” and “inclusive,” as more than 100 countries and jurisdictions participated in its development.)
Unfortunately, mandatory binding arbitration is not “mandatory” in the sense that countries are expected to implement it as a mandatory BEPS minimum standard. It will apply only if both contracting jurisdictions choose to apply it, and reportedly there are only approximately 27 jurisdictions that have expressed an interest in doing so. Moreover, although so-called “baseball arbitration” is the default for those countries agreeing to arbitration, countries may reserve the right to adopt “independent opinion” arbitration (or, of course, not to agree to arbitration at all).
Baseball arbitration encourages the competent authorities to set forth reasonable positions and settle cases without going to arbitration, because a party who fails to compromise during negotiations risks a complete loss at arbitration. Independent opinion arbitration is comparatively sub-optimal because it does not promote such settlements, as the competent authorities are much more likely to rely on the arbitrator to resolve disputed issues by finding a “reasonable,” middle-ground solution. Independent opinion arbitration has no disincentives for extreme positions unsupported by the tax treaty. Given the existing inventory of MAP cases and the great increase in disputes expected as a result of implementation of the OECD's BEPS recommendations, the administrative difficulties arising from a solution resulting in many cases which must be decided by an arbitrator should not be underestimated.
Moreover, the length of time for the arbitrator to reach a decision and the costs of doing so are both minimized in baseball arbitration. The arbitrator's responsibility consists only of choosing one of the proposed resolutions submitted by the competent authorities. The time and expense of writing a reasoned, “independent opinion” is eliminated (as are questions about whether such an opinion should be precedential).
For similar reasons, baseball arbitration should result in less objections to mandatory binding arbitration based on purported sovereignty concerns. Some countries appear to object to arbitration because of the concern that an independent opinion from an arbitrator may have, or be incorrectly interpreted to have, precedential value and thereby limit a tax authority's ability to interpret treaty provisions under their own views. Those concerns disappear with baseball arbitration, as no opinion is provided. Consequently, sovereignty concerns to arbitration as a general matter are likely to be significantly reduced where baseball arbitration is chosen.
In addition to Action 14 on dispute resolution, the MLI is the vehicle to transpose other tax treaty measures from the BEPS project into existing bilateral and multilateral tax agreements. Unfortunately, doing so will likely be the catalyst for even more cross-border tax controversies — making it even more imperative that widespread implementation of mandatory binding arbitration occur quickly.
Action 6 on treaty abuse recommended that countries choose from three alternative approaches to prevent treaty shopping — a principal purpose test (PPT), a simplified limitation on benefits (LOB) article combined with a PPT, or a more complex LOB accompanied by either an anti-conduit rule or a PPT. It is always difficult to predict what options countries will select, but it seems likely that most non-U.S. jurisdictions will opt for the PPT when signing on to the MLI. The rapid inclusion of a PPT in a great number of treaties introduces a great deal of uncertainty and unpredictability in establishing a person's entitlement to treaty benefits, and seriously erodes the important role of tax treaties in promoting bilateral trade and investment.
The implementation through the MLI of the recommendations under Action 7 on preventing the “artificial avoidance” of permanent establishment (PE) status will significantly lower the PE threshold as compared to the current rules. That will occur through an expansion of the dependent agent test, a narrowing of the independent agent exemption, a tightening of the specific activity exemptions from PE status for facilities used for storage, display or delivery of goods, etc. (including an anti-fragmentation test to prevent activities being split across separate legal entities), and certain measures to prevent abuse of the 12-month building site PE rule.
The breadth and subjectiveness of the new rules, combined with the expected intensified focus on PE issues by tax authorities, will likely result in more controversies (especially as revenue-hungry tax authorities increasingly look to PE rules as an alternative to transfer pricing rules). Moreover, as the comment letters received on the recent discussion draft on attribution of profits to PEs make clear, there is a lack of common understanding and agreement in practice on how to attribute profits to PEs. It is disappointing that the MLI will significantly lower the PE threshold in a great many treaties, while the OECD was unable to simultaneously achieve agreement on the rules for determining the amount of profits attributable to a PE. More controversy seems inevitable.
Although intended to build agreement around uniform rules for the taxation of cross-border income, the OECD's BEPS project failed to achieve meaningful consensus, due in part to the reliance on subjective and ambiguous anti-abuse rules. That subjectiveness results in a system where countries can pursue claims for a higher share of taxes on cross-border income by interpreting the rules provided by the BEPS recommendations differently, while simultaneously claiming consistency with a mandate to combat “base erosion and profit shifting.”
That dissolution of the historical consensus on international tax norms will lead to greater risks of double taxation of U.S. companies operating internationally. Already, the OECD MAP statistics reflect the fact that the existing platform for resolving treaty-related tax disputes is severely stressed and urgent measures are required to improve the resolution of cross-border tax controversies in order to avoid significant negative impacts on economic growth.
In that regard, it will be imperative for the OECD to redouble its efforts to ensure more widespread implementation of mandatory binding arbitration. The increased uncertainty and level of disputes as a result of the BEPS recommendation can be mitigated somewhat if tax authorities agree to resolve their disputes through mandatory binding arbitration. Doing so through so-called “baseball arbitration” is the optimal solution, as it incentivizes the competent authorities to take reasonable positions during the MAP (and thereby encourages resolution before arbitration), reduces the time and costs to reach a decision, and minimizes concerns regarding sovereignty issues (meaning more countries are likely to agree to arbitration).
Copyright © 2017 Tax Management Inc. All Rights Reserved.
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