Arbitration in International Tax Dispute Resolution

Tax Dispute Resolution:
Arbitration in International Tax Dispute Resolution
2001 Dr Jean-Philippe Chetcuti. All Rights Reserved.

1. The mutual agreement procedure

1.1. The rise of the mutual agreement procedure

1.1.1. League of Nations Model DTC

Between the First and the Second World Wars, a number of countries displayed an inclination towards the signing of bilateral double taxation agreements.  Although the necessity for rules governing the resolution of international tax conflicts was not felt immediately at the outset of the rapid developments in the international tax scene, nonetheless, the very first DTCs ever to be concluded still contained rules for final decisions to be made by bodies beyond the control of the competent authorities.  The 1924 Model Double Taxation Agreement of the League of Nations provided for the setting up of a technical committee to decide double taxation disputes.

1.1.2. The UK-Ireland 1926 DTC

The UK-Ireland agreement of 14 April 1926 concerning income taxes provided for the delivery of binding judgments by a tribunal:

Any question that may arise between the parties of this Agreement as to the interpretation of this Agreement or as to any matter arising out of or incidental to the Agreement shall be determined by such tribunal as may be agreed between them and the determination of such tribunal shall, as between them, be final.

In 1927, the League of Nations published a model treaty for mutual assistance in tax matters.  In 1928, it published a model DTC which not only provided for a mutual agreement procedure but also envisaged the creation of a commission to settle disputes among the taxing jurisdictions regarding the interpretation or application of the convention.  If no solution could be reached by mutual agreement, then each of the contracting states was entitled to submit the matter for resolution to the then Permanent International Court.

1.1.3. Czechoslovakia-Rumania 1934 DTC

Even the DTC of 20 June 1934, in connection with succession duties, entered into by Czechoslovakia and Rumania, contemplated a similar mode of dispute resolution; a board was formed by the Fiscal Committee within the League of Nations to hear both parties, jointly if deemed necessary or advisable, and to bind the parties with its opinion.

1.1.4. Mutual agreement

However, the passage of time proved that it was necessary to find solutions for problems arising in other different areas relating to a DTC.  Not only could the aim of the DTC be frustrated by cases of taxation of a taxpayer in both countries, but also, for instance, by difficulties in the interpretation of the provisions of the convention, by cases of double taxation not covered by the convention, or by changes in the internal regulations of the Contracting States in the area covered by the convention.  If the importance of such convention was not to be undermined, such matters had to be promptly resolved by efficient methods of co-operation, this necessitating close co-operation between the Contracting States to achieve mutual agreement.  The practice developed for the finance ministries of the Contracting States to engage in negotiations with the aim of securing agreement and solving disputes on the interpretation of the convention.  This method was also adopted concretely when a taxpayer called for negotiations on the interpretation of the convention.

1.1.5. OECD 1963 Draft DTC

Thus, rules for a mutual agreement procedure started appearing in DTCs, authorising the competent authorities to enter negotiations with the aim of obtaining agreement to solve individual cases in which the intentions of the convention had not been fulfilled.  As this method developed further, conventions started laying down special rules governing the conduct of the negotiations between the competent authorities and before long, the mutual agreement procedure had crystallised in the foremost method of solving disputes arising from the implementation and interpretation of the DTCs, so much so that it was adopted by the OECD Draft DTC on Income and on Capital adopted by the Council in 1963.  Nonetheless the mandates of the convention were limited as they only contemplated the appointment of commissions to serve as consultative bodies for each particular dispute and stopped short of providing them with any adjudicative authority.

1.1.6. A European DTC

In 1968, the EC Commission suggested conducting negotiations to work out an arrangement for actual disputes to be submitted to a standing committee of the national tax authorities.  Unfortunately, due to insurmountable political obstacles, discussions on a Pre-Draft for a European DTC had to be abandoned.

1.1.7. Revision of the Mutual Agreement Procedure

Criticism levelled at the 1963 OECD Draft Model Convention regarding the role of the taxpayer in the mutual agreement procedure, and the marked lack of a procedure which would lead up to a mutual agreement, led the working groups of the Committee on Fiscal Affairs in 1971 to commence work to revise and develop the said Draft DTC in the light of the experience of the existing conventions.  This escalated in the proposal and adoption by the Council, in 1977, of amendments to Article 25 containing the existing provisions of the mutual agreement procedure.  The competent authorities would be authorised to resolve by mutual agreement difficulties or doubts regarding the interpretation or application of the convention and also to eliminate cases of double taxation which are not covered by the convention.  According to the Commentary on Article 25 of the 1977 Model DTC, Article 25 represents the maximum that Contracting States are prepared to accept.  They agreed to seek a solution but did not want to commit themselves to find a joint solution to eliminate the double taxation.

The basis of the original procedures was left intact; however, a new paragraph (4) was added to it.  The provisions envisage the possibility of the formation of a joint commission for an oral exchange of views; when it seems advisable in order to reach agreement to have an exchange of opinions, this exchange may be conducted via the commission consisting of representatives of the competent authorities of the Contracting States.  The OECD Model Convention leaves it to the competent authorities to determine the composition of and the procedural rules to regulate this joint commission.  In the event that a commission is actually formed, then the Contracting States are duty bound to give taxpayers promoting the case before the joint commission the following rights:

1.          the right to make representations in writing or orally, either in person or through a representative;

2.          the right to be assisted by counsel

Moreover, to facilitate the reaching of an agreement, the Contracting States are bound to entrust the chairmanship of each delegation to a judge or high official chosen first and foremost on the basis of his special experience.  Possibly, also, the Contracting States may be ready to subject themselves to an obligation to reach an agreement at the end of the procedure.  Furthermore, the competent authorities may agree to seek the opinion of an impartial third party, or an advisory opinion from independent arbitrators, but the final decision still remains with the contracting states.   It appears, though, that such possibilities have not been used so far.

1.2. The weaknesses of the competent authority procedure

The mutual agreement procedure, also known as the competent authority procedure can boast of having benefited international business and has earned a reputation as the best method of resolving instances of double taxation. Nonetheless, it presents certain undeniable defects:

1.       Though DTCs generally encourage the competent tax authorities to reach an agreement which eliminates double taxation, this is in no way imposed on them compulsorily and therefore there still remains the possibility that double taxation will persist after the application of the mutual agreement procedure.

2.       DTCs fail to lay down time limits or procedural rules for the mutual agreement procedure, and specify no method for their implementation (even though many conventions stipulate that competent authority agreements will be implemented notwithstanding national time limits).

3.       The affected taxpayers are normally excluded from the competent authority deliberations or, in any event, have no official or guaranteed status in such deliberations.

4.       Procedural rules followed by the competent authorities differ significantly from those applicable to domestic examination and appeals.

5.       Procrastination in reaching a conclusion of competent authority proceedings can be very long, and is of concern to businesses.

6.       Even if the competent authorities agree to eliminate double taxation, the taxpayer may not be neutral as to how this is achieved. The competent authority decision may not conform to national or treaty law, and may be influenced by extraneous factors such as other pending competent authority cases.

For these reasons, an international movement gained momentum with the view that binding and compulsory arbitration could tackle the weaknesses of the competent authority procedure. An arbitral award fixing the applicable transfer price is infallibly reached, adopting an impartial, predictable and transparent process which specifically includes proper taxpayer involvement, and which applies law rather than compromise.

2. Proposals for arbitration

2.1. Lindencrona and Mattssons proposal for an arbitral procedure

At the Ninth Conference of the Law of the World, Lindencrona and Mattsson suggested compulsory arbitration in front of an international institute for arbitration in tax disputes in Stockholm as a logical step following the failure by the parties of a DTC to settle an international tax dispute.  The justification given for this curtailment of States tax jurisdiction is that the parties to a DTC would have already consented to particular limitations of their taxing jurisdiction and should therefore not object of a further limitation intended to ensure that a solution is found to disputes on the interpretation of the DTC.

Lindencrona and Mattsson, together with Francke, also featured at the 1981 Berlin Annual Congress of the IFA dealing with the mutual agreement procedure in tax treaties.  They presented a Cahiers proposing an arbitral procedure for the settlement of all international tax disputes and not restricted to those arising from transfer pricing.  They proposed a model clause to be included in future tax treaties, worded as follows:

If one of the Contracting States is of the opinion that one of its residents has, due to a difference of opinion between the Contracting States as to the interpretation of application of this Convention, not been taxed according to this Convention it shall, if a solution has not been found by other means, call for arbitration for settlement of this dispute.

The arbitration procedure is initiated by a request for arbitration to the International Institute for Arbitration in Tax Disputes in Stockholm and shall follow the rules of that institute.

The award shall be binding on the Contracting States.

With the further development of the mutual agreement procedure in mind, the authors of this proposal advocated arbitration as a remedy to be resorted to only after all other measures have been exhausted without success.  Besides the principle of the exhaustion of domestic remedies, a prerequisite for the commencement of the arbitration would be that, in the opinion of the arbitration institute, the arbitral award would be capable of implementation.  If not, the application for arbitration would be rejected.

Lindencrona and Mattsson believed that an International Institute for Arbitration in Tax Disputes would be necessary to solve administrative and technical problems arising from and after the appointment of an arbitration commission.  An arbitration institute would ideally be founded by the United Nations to give it supranational status and would be responsible for the laying down of a uniform procedure, a system which would treat different cases uniformly.  The Institute would draw up a list of suitable arbitrators from different countries and assume the role of a forum open for all interested countries, thus imparting stability to the arbitral procedure and saving the individual Contracting States the trouble of devising rules for particular arbitral procedures.  The suggested rules regulated the appointment and the composition of the arbitral commission and the manner of initiation of the arbitral procedure, thus doing away with the problem of determining the applicable law.

The taxpayer would have no independent right of initiation, as this, they argued, would undermine the mutual agreement procedure currently practiced between states and would also require the present rules to be extensively amended.  Nonetheless, taxpayers should be given the opportunity to be heard in person and to present to the arbitral commission any supporting documentation relevant to their cause.  It was proposed that the direct expenses of the arbitral procedure should be borne equally by the states involved irrespective of the outcome.  Awards should generally be published and final.

As the Swedish national reporters for the first topic, Lindencrona and Mattsson were the only national reporters who advocated without reservation in favour of mandatory arbitration of tax disputes if the contracting states could not reach a solution in their dispute themselves.

On the other hand, in its Report on Transfer Pricing, Corresponding Adjustments and the Mutual Agreement Procedure, the OECD Committee on Fiscal Affairs reviewed the Draft Directive and concluded that it could not, for the time being at least, recommend the adoption of a compulsory arbitration procedure to supersede or supplement the mutual agreement procedure.

2.2. Carl S. Shoups proposal

Shoups opinion on arbitration of transfer pricing disputes involving multinational enterprises was that it should be voluntary but binding.  Thus any country or any taxpayer choosing to employ this arbitral remedy should commit itself to its continued use for a term of three to five years and would have to bind itself to abide by the boards award and waive any right of appeal therefrom.

The right of initiative before the proposed permanent board of arbitration would lie with either one of the tax administrations concerned or with one of the associated companies.  Arguing in favour of the right of initiative of the taxpaying company, Shoup acknowledged that a taxpayer might not be happy with the transfer price agreed upon between the two countries tax authorities.  Such an agreement might still affect the companys legal position as it is in the fiscal interest of the taxpayer for a lower transfer price to be established if the importing company operates in a lower tax jurisdiction and for a higher transfer price to be agreed if it is the exporting company that operates in the lower tax jurisdiction.  Therefore if the arbitration board was to command respect, it should not seek to compromise; rather, its awards should  be based on strict principles.

Shoup was contrary to the rule of the exhaustion of domestic remedies and all in favour of allowing taxpayers to appeal at once to the arbitration board the decision of which would overrule any interim or eventual decision of the domestic courts.  Otherwise, by the time the taxpayer has exhausted his rights of domestic appeal, the dispute would have dragged on for so many years that an agreement with the other country could become significantly difficult.

Unlike Lindencrona and Mattsson, Shoup overlooks the possibility of taxpayers using the two systems and opting for the most favourable result.  To prevent abuse of the arbitral system, the former make it a precondition for the commencement of the arbitral procedure that all domestic legal remedies available in either state have been resorted to.  Otherwise, the procedure would only be initiated if the taxpayer declared in writing that he would accept the arbitral award.

2.3. The ICC all for arbitration

Since 1959, the International Chamber of Commerce (ICC) has played an important role in the promotion of arbitration as an appropriate and efficient method for the resolution of taxation disputes, culminating in the publication of a position paper in 1984 describing the shortcomings of the mutual agreement procedure and calling both for reforms of the mutual agreement procedure and for the introduction of an arbitration procedure.  However, since then, little significant progress has been registered in this regard and the acceptance of proper arbitration provisions is still not as widespread as is desirable.

As regards the mutual agreement procedure, the ICC, representing taxpaying companies, has called for the better protection of the rights of the taxpayer.  Thus the taxpayer should have the right to demand the initiation of the mutual agreement procedure, to submit any materials to the competent authority and also the right to be heard and to reject any unsatisfactory mutual agreement.  A mutual agreement should be implemented in all cases, even if taxation incompatible with the treaty has been confirmed by a judicial decision.

In the event that no satisfactory agreement is reached by the competent authorities which is compatible with the treaty or if the problem is not resolved within one year, the taxpayer should be able to compel the said authorities to submit the case to an arbitral commission.  This should be composed by one member chosen by each state, who in turn chooses an independent chairman.  The arbitral award should always be based on the treaty and not on a compromise reached by the parties.  The taxpayer should have the right to present his views to the arbitration commission and put forward his arguments before meetings of the commission.  The award should be implemented in all cases.  The costs of the procedure should be borne by the states.

In its 1999 action programme, the ICC reiterated its commitment to encourage governments to accept compulsory arbitration in international tax conflicts.  The ICC recommends the negotiation and adoption by all governments of bilateral or multilateral tax conventions for the compulsory and binding arbitration of tax controversies, using the OECD as the most appropriate forum for the purpose.  Its recommendation is based on its broad experience in commercial arbitration as a cost-effective and equitable form of dispute resolution with significant advantages to businesses and government and with a significant chance of enhancing global economic growth and development through elimination of unintended instances of double taxation.

2.4. The OECD an unacceptable surrender of fiscal sovereignty

A number of members composing the BIAC, the Business and Industry Advisory Committee to the OECD, are also members of the tax commission of the ICC and have actively pursued the idea of an arbitral procedure. However, as reflected in the 1984 OECD report entitled Transfer Pricing and Multinational Enterprises Three Taxation Issues, the government representatives were, for the time being, unwilling to recommend the adoption of a compulsory arbitration procedure to supersede the mutual agreement procedure.  They were of the opinion that the need for such compulsory arbitration has not been demonstrated by evidence available and the adoption of such procedure would represent an unacceptable surrender of fiscal sovereignty.

Over the years, the views of the Committee on Fiscal Affairs of the OECD regarding international tax arbitration have evolved.  Arbitration is not expressly contemplated in the OECD Model Convention but the 1995 Transfer Pricing Guidelines note that developments since 1984 call for the reconsideration of the matter.  The Committee on Fiscal Affairs has committed itself to the further analysis of the topic in view of incorporating the conclusions thereof in the said guidelines.

In favour of arbitration we have the Commentary to the OECD Model Convention which depicts arbitration as the answer to the significant problem of the failure of the competent authorities to eliminate double taxation.

3. Current use of arbitration

3.1. The draft German-Swedish Income Tax Treaty

In 1985, amidst opposition from other states to an arbitration procedure, Germany and Sweden drafted an income tax treaty which included an arbitration clause.  Thus, in addition to the mechanism contemplated in the European Convention for the Peaceful Settlement of Disputes, the Contracting States have the option to agree to refer the dispute to a Court of Arbitration, whose decision will be binding between the Contracting States.

The contemplated Court of Arbitration is composed of judges of the courts of the Contracting States or of third countries or of international organizations and follows internationally recognised arbitral procedures.  Awards have to be based upon the treaties of the Contracting States and on general international law so that a decision ex aequo et bono is inadmissible.  The parties have the right to completely present their case and to propose their own motions.

Unfortunately, the use of the drafted arbitration clause is completely voluntary.  Much more would be achieved if the use of an arbitral procedure had been mandatory.   Moreover, the imposition of a time-limit within which the competent authorities have to reach a mutual agreement was desirable; their failure to agree within, say, a year, would have triggered an arbitration procedure.  Another perceived fault is the composition of the arbitral court of judges who do not have a reputation for international tax expertise.

3.2. The USA-Germany Treaty

The 1979 OECD Report on Transfer Pricing failed to persuade either the OECD Members or the MSs of the EC to set up a unitary institution entrusted with the tasks of settling double taxation disputes.  Rather, some OECD Members set out to publish their own unilateral transfer pricing rules.  Others worked on finding solutions on a bilateral level; the United States drafted the first model convention which contemplated the possible triggering of an arbitral procedure  in the event that mutual agreement negotiations between tax authorities fail to secure relief from double taxation.  Apart from the use of an arbitration panel, the solution offered by the United States resembled the OECD Model Convention.

The procedure was implemented in the DTC between Germany and the United States. Furthermore, the USA-Germany Treaty, unlike other treaties such as the USA-Luxembourg DTC, also included an arbitration clause.  The arbitration procedures are to be agreed [upon] by the two Contracting States, and established by exchanges of notes through diplomatic channels. Notes were exchanged at the time of the signing of the Convention which specify a set of procedures to be used in the implementation of paragraph 5. Changes in these procedures may be made through future exchanges of diplomatic notes. The agreed rules of the procedure are as follows:

3.2.1. Exhaustion of the mutual agreement procedure

The diplomatic notes, which marked the conclusion of the treaty, detailed the rules for the arbitral procedure, laying down that arbitration cannot be used from the outset.  Before, every effort must be done to secure a solution by mutual agreement.  This does not means that a Contracting State is obliged to compromise if it feels strongly about its legal position.  In the event that the Contracting States fail to find a solution they may then revert to the arbitral procedure.

3.2.2. Abuse of arbitration provision

On the matter of the relation between national procedure and the arbitral procedure, the USA-Germany DTC makes it impossible for a taxpayer to use both the national courts and the mutual agreement procedure and then choose the best outcome.  Before the opening of the arbitral procedure, the taxpayer has to bind himself in writing to be bound by the arbitrators award.  If the taxpayer denies his consent to the procedure, no arbitration will take place and the taxpayer thus bears the risk of a negative outcome.

3.2.3. The position of the taxpayer – confidentiality

Another meaningful feature of modern doctrine on arbitration which applies to this procedure is confidentiality which is highly beneficial to the taxpayers.  The arbitral board is bound by the confidentiality and disclosure provisions applicable in both Contracting States and the convention. Should problems of conflict arise, the most restrictive condition prevails.

As regards the publication of the awards, despite the silence of the notes on the matter, it is hoped that such publication will be carried out in the light of the principles of confidentiality.

3.2.4. Locus standi of the taxpayer

The taxpayers are afforded the opportunity to present their views to the arbitration board.  The same provision applies to the mutual agreement procedure.

Being international public arbitration, arbitration of tax disputes is a procedure to which the parties are the Contracting States, unlike the state-taxpayer relationship typical of domestic tax disputes.  However, the very purpose of the arbitration is to prevent the arbitrary taxation of taxpayers and to give effect to the relative law and the treaty.  Thus the notes give taxpayers some rights such as the right to be heard and to confidentiality.

3.2.5. Law not compromise

An award is based, rather than on the tax policy or domestic tax law of either Contracting State, on the convention, on the domestic laws of both Contracting States and on the principles of international law.

3.2.6. Costs

The costs of arbitration are to be borne by the Contracting States which may, however, require that a taxpayer agrees to bear the states share of the costs.  However, this can only take place in exceptional cases.   Competent authorities who believe that they have a weak case are not compelled to resort to arbitration under the USA-Germany DTC, despite any insistence to that effect by the taxpayer.  Some argue, however, for allowing taxpayer to risk arbitration and assume the responsibility for the resultant costs thereof.

As the counter-argument goes, the possibility of burdening the taxpayer with the costs brings with it the risk that the competent authority will expect the taxpayer to meet the costs.  As far as the taxpayer is concerned, if no mutual agreement is reached within a specified time limit, the competent authorities should be compelled to invoke the arbitration procedure and bear the costs therefor.

3.2.7. Binding force and the law of precedent

Under the USA-German DTC, the awards of the arbitral board are binding on both Contracting States with respect to that case and also upon the taxpayer.  Awards have no precedential effect as this, coupled with the absence of the possibility to appeal, would mean that an award which tackles a particular legal question will have closed any possible discussion on the issue forever.  This does not mean that such decisions will not ordinarily be taken into account in subsequent competent authority cases involving the same taxpayer(s), the same issue(s), substantially similar facts, and also in other cases where appropriate.

Ultimately, while it is encouraging that an arbitration clause has been included in certain US DTCs, the fact that arbitration is not compulsory is a major drawback.

3.3. The Arbitration Convention

In 1990, the states of the then European Community concluded a multilateral convention providing for the use of compulsory arbitration in international taxation disputes concerning transfer pricing.  The Arbitration Convention represents a valuable precedent which merits consideration in framing the appropriate terms for international arbitration provisions in general.  For this reason, the next chapter is dedicated solely to the Convention.