Resolution of International Transfer-Pricing Disputes

Transcription

Resolution of International
Transfer-Pricing Disputes
Yitzhak Hadari*
PRÉCIS
La question de l’heure en fiscalité internationale vise les différends entre
les autorités fiscales et les multinationales en matière de prix de transfert.
Leur résolution exige la mise en équilibre des intérêts respectifs des deux
parties. D’une part, les autorités fiscales tentent d’assujettir le revenu
mondial des multinationales à un niveau d’imposition approprié et
d’atteindre une répartition appropriée de ce revenu entre les
administrations visées. D’autre part, les multinationales souhaitent mener
leurs activités et préserver leur rôle de principal moteur de l’économie
mondiale, sans être assujetties à une double imposition. Elles s’attendent
à pouvoir fonctionner dans le cadre d’une structure fiscale mondiale leur
offrant un degré raisonnable de certitude, alliée à des résultats uniformes
et équitables.
Les principaux régimes fiscaux du monde, qui s’appliquent aux
multinationales, ont en général adopté le principe de la pleine
concurrence comme principale norme en matière de prix de transfert.
Toutefois, il existe des différences marquées entre les administrations
quant aux méthodes précises devant servir à déterminer les prix de
transfert acceptables pour les opérations au sein de multinationales.
Dans cet article, l’auteur suggère de ne plus mettre l’accent sur les
méthodes appropriées, mais plutôt sur les mécanismes appropriés pour
régler les différends entre les contribuables et les administrations fiscales
intérieures, et entre les administrations fiscales nationales et les
multinationales à l’échelle internationale. L’auteur traite de plusieurs
mécanismes qui ont évolué sur ces deux plans, notamment les ententes
anticipées en matière de prix de transfert (EAPT), la procédure d’examen
simultané (PES), les règles d’exonération et l’arbitrage.
De l’avis de l’auteur, ces mécanismes de résolution des différends sur
la scène internationale devraient être intégrés aux conventions fiscales,
en vertu de l’article 25 du traité type de l’OCDE. Il propose que les
procédures de consentement mutuel comprennent au moins l’une des
techniques suivantes, selon les préférences des parties au traité. D’abord,
* Of the Faculty of Law, Tel Aviv University. I wish to thank John Tiley for his valuable comments. Responsibility for the article is, however, entirely mine.
(1998), Vol. 46, No. 1 / no 1
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CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE
les autorités compétentes et les autorités fiscales internes inciteraient les
contribuables à conclure des EAPT pour régler les questions de prix de
transfert à l’avance et au cas par cas. Deuxièmement, la PES devrait être
expressément intégrée aux traités en vue de faciliter les échanges
d’information entre les autorités fiscales qui travaillent en collaboration,
plus précisément les échanges de renseignements reliés à la vérification
des multinationales. Troisièmement, il serait souhaitable d’arriver à une
forme d’entente limitée sur les règles d’exclusion dans le cadre de la
norme de la pleine concurrence. Quatrièmement, tous les traités
devraient comprendre le recours à l’arbitrage obligatoire et exécutoire,
sous réserve du consentement du contribuable, pour supprimer la double
imposition lorsque les autorités compétentes n’arrivent pas à s’entendre
relativement à un cas donné. Ce recours ne devrait être utilisé qu’après
un délai déterminé à partir du moment de la soumission du cas aux
autorités compétentes.
En outre, l’auteur propose que le modèle de OCDE pour les
conventions fiscales soit modifié en vue d’y inclure un mécanisme
d’arbitrage obligatoire et exécutoire. Les autres mécanismes mentionnés
pourraient être recommandés ou mentionnés dans le commentaire sur le
modèle de l’OCDE.
Comme mesure provisoire, pour faciliter l’acceptation de la procédure
arbitrale, l’OCDE pourrait recommander expressément l’adoption du
mécanisme d’arbitrage dans le cadre de son étude actuelle sur les prix de
transfert.
ABSTRACT
Transfer-pricing disputes between tax authorities and multinational
enterprises (MNEs) are the most important issue in international taxation
today. Their resolution requires a balancing of the respective interests of
both parties. On the one hand, tax authorities seek to subject MNEs to an
appropriate level of taxation on their global income and to achieve an
appropriate allocation of that income among the jurisdictions involved.
On the other hand, MNEs wish to conduct their activities and preserve
their role as the major driving force in the world economy without being
subjected to double taxation. They expect to be able to operate within a
world tax structure that offers them a reasonable degree of certainty
coupled with uniform and equitable results.
The world’s major tax systems, which apply to MNEs, have generally
united under the umbrella of the arm’s-length principle as the main
substantive standard applicable to transfer pricing. However, important
differences exist between jurisdictions regarding the specific methods
that should be used to determine acceptable transfer prices for
transactions within MNE groups.
In this article, the author suggests that the focus should be shifted
from the appropriate substantive methods to the appropriate
mechanisms for resolving conflicts between taxpayers and domestic tax
administrations at the national level, and between national tax
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RESOLUTION OF INTERNATIONAL TRANSFER-PRICING DISPUTES
31
administrations and MNEs at the international level. The author discusses
several mechanisms that have evolved at both levels—specifically,
advance pricing agreements (APAs), the simultaneous examination
procedure (SEP), safe harbours, and arbitration.
In the author’s view, these mechanisms for dispute resolution in the
international arena should be incorporated into binational tax treaties,
pursuant to the mutual agreement procedure of article 25 of the OECD
model treaty. The author proposes that the mutual agreement procedure
should include one or more of the following techniques, according to the
preferences of the treaty parties. At the first level, the competent
authorities and domestic tax administrations would encourage taxpayers
to conclude APAs in order to resolve transfer-pricing issues in advance
and on a case-by-case basis. At the second level, the SEP should be
specifically included in treaties in order to facilitate information sharing
between collaborating tax authorities, and specifically the exchange of
audit information pertaining to MNEs. At the third level, agreement on
some limited safe harbours within the arm’s-length norm is desirable. At
the fourth level, all treaties should include recourse to compulsory and
binding arbitration, subject to the taxpayer’s consent, to eliminate double
taxation when the competent authorities cannot reach agreement in a
given case. Such recourse should be used after a defined period from the
time the case was referred to the competent authorities.
It is further proposed that the OECD model for binational tax treaties
should be amended to include a compulsory and binding arbitration
mechanism. The other noted mechanisms could be recommended or
mentioned in the commentary on the OECD model.
As an interim step, to assist acceptance of the arbitration procedure,
the OECD could specifically recommend adoption of this mechanism in its
ongoing study of transfer pricing.
OBJECTIVES AND NEEDS
The phenomenon of the multinational enterprise (MNE) is by no means
new to international lawyers and tax specialists. Pioneering studies of
MNEs by legal scholars began to appear some 25 years ago. My own work
in this area at that time focused on the structure and control of MNEs,
particularly those enterprises with closely integrated operations.1 In a subsequent study, I recommended that this aspect of control should be taken
into account by national policy makers, legislatures, and courts in the
policy, law-making, and interpretation processes.2 The courts also have
1 Yitzhak Hadari, “The Structure of the Private Multinational Enterprise” (March 1973),
71 Michigan Law Review 729-806.
2 Yitzhak Hadari, “The Choice of National Law Applicable to the Multinational Enterprise and the Nationality of Such Enterprises” [1974], no. 1 Duke Law Journal 1-57.
(1998), Vol. 46, No. 1 / no 1
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addressed the MNE phenomenon in applying domestic laws3 to the MNE
or its associated enterprises, which are part of the global MNE group. 4
The main issues in the international tax area have been, in my view,
• how the global income of MNE groups should be allocated;
• what is the proper standard (norm) to be applied; and
• how this allocation process can be coordinated within the frameworks of national policies and domestic laws of the various participating
countries to the satisfaction of all concerned.
The overriding concern is how to protect national revenues and at the
same time accommodate the needs of MNEs themselves, so that they can
continue to operate at optimal capability without being subjected to double, or even multiple, taxation on their global income. It follows that, in
order to meet these objectives, there is a need for a worldwide consensus
as to the proper yardstick or standard of allocation to be applied on the
national level, and for an agreement among world tax authorities to resolve problems according to international tax law norms, while tendering
simultaneous protection to the needs of national tax administrations and
MNE groups.
It is admitted at the outset that the issues in this area are among the
most complex in the taxation field, primarily because of the wide range
of subjects involved. Of particular difficulty is the issue of transfer pricing—how to determine a fair price, for tax purposes, for transactions
between associated (or related) enterprises located in different tax jurisdictions. 5 Analysis of this issue and the development of appropriate
solutions call for special economic, tax, and legal expertise. It is necessary, for example, to collect a large body of reliable data, which indeed
may not be readily available; to bring to the analysis a deep understanding of the economic factors associated with intercompany transactions;
and to possess a similar understanding of MNEs generally and of the
particular industry under consideration. Added to these requirements is
the need for detailed knowledge of the tax legislation of the various countries in which the particular MNE group operates.
3 For example, First Nat. City Bank v. Banco Para El Comercio, 462 US 611 (1983),
wherein the US Supreme Court applied theory in the international banking area to the
local entity of the MNE, citing, at 629, several legal studies of the MNE, including Hadari,
supra footnote 1.
4 The latest nomenclature of the OECD (which generally conforms to the theories and
terminology I used in the articles cited previously, supra footnotes 1 and 2) explains the
differences between the legal entities and the economic entities of the MNE: Organisation
for Economic Co-operation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Paris: OECD) (looseleaf ) (herein referred to
as “the OECD report”).
5 The OECD report observes that “one of the most difficult issues that has arisen is the
establishment for tax purposes of appropriate transfer prices. Transfer prices are the prices
at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises.” Ibid., preface, at paragraph 11.
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The need for a better solution to transfer-pricing disputes between
MNEs and national tax authorities is manifest. The significance of MNE
intragroup transactions in the world economy today is suggested by the
fact that 33 percent of the world trade of goods is within MNE groups, 6
and such trade has been growing at a relatively rapid pace in recent
decades. 7 It is clear that substantial tax revenues are at stake in the absence of adequate transfer-pricing controls.
The US Internal Revenue Service ( IRS) and the US courts have more
experience in this area than their counterparts in any other country. US
judges have attested that their files in a typical MNE case are of a magnitude unmatched in most other legal areas, including antitrust, and that
MNE cases account for some of the biggest tax deficiencies. 8
It is acknowledged that, at least until recently, the US tax authorities
have generally failed to cope adequately with MNEs, and particularly with
foreign-based MNE groups, which are considered by US tax authorities to
have drastically underpaid their fair share of US taxes owed. 9 Subsequent
to the IRS’s efforts to collect its fair share of the taxes imposed on MNEs’
taxable income, there were reports of US litigation exceeding $32 billion
in tax deficiencies in 1992.10
6 United States, General Accounting Office, “International Taxation: Problems Persist
in Determining Tax Effects of Intercompany Prices” (1992). According to another study,
intercompany transactions accounted for 43 percent of reported (book) worldwide income
of US MNEs, originating from their foreign affiliates: “U.S. International Tax Policy for a
Global Economy,” prepared for National Chamber Foundation by Price Waterhouse, April
15, 1991, reported in Jamie Elliott, “Developments in Transfer Pricing” [1995], no. 4
British Tax Review 348-57, at 348, footnote 5.
7 For earlier figures, see Hadari, supra footnote 1, at 739-40.
8 For example, one famous case resulted in a 196-page decision of the US Tax Court:
Eli Lilly and Co. and Subsidiaries, 84 TC 996 (1985), aff ’d. in part, rev’d. in part and
remanded, 856 F2d 855 (7th Cir. 1988). Another decision of the same court produced a
190-page opinion: Sunstrand Corporation, 96 TC 226 (1991). For the magnitude of the
testimony and litigation, see Philip J. Bergquist and Kenneth A. Clark, “Arbitration of
Transfer Pricing Disputes,” in Robert Feinschreiber, ed., Transfer Pricing Handbook (New
York: Wiley, 1993), 549ff., at 551-52. As of May 1992, section 482 cases amounted to over
42 percent of the total number of cases of more than $10 million dollars, and the total
amount of tax involved in section 482 cases exceeded $4 billion: See “Report of the Office
of Special Counsel,” in Reports of the United States Judicial Conference (November 1992),
exhibit 10. See also supra footnote 6 and infra footnote 9 and accompanying text.
9 See Francis M. Allegra, “Section 482: Mapping the Contours of the Abuse of Discretion
Standard of Judicial Review” (Winter 1994), 13 Virginia Tax Review 423-515, at 426-27,
citing statistics for several years ago. For example, in 1986, 45,000 US foreign affiliates
reported $543 billion in sales and $1.5 billion in net losses. In 1987, such sales resulted in
$687 billion of taxable income, but only $4.6 billion in income tax paid—that is, the effective rate of tax was 0.66 percent, about half the rate paid by US-controlled MNE groups.
Later reports continue to support those statistics with respect to all MNE groups: see Report
by the Controller General to the Congress, “International Taxation: Transfer Pricing and
Information on Nonpayment of Tax,” GAO-GGD 95-101 (1995). See also supra footnote 8.
10 See articles and notes cited by Allegra, supra footnote 9, at 432, and a list of the then
pending cases at the Tax Court involving many of the gigantic MNEs with headquarters all
(The footnote is continued on the next page.)
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THE INTERNATIONAL NORM
There are two basic approaches for resolving such questions as proper
transfer pricing or division of MNE group income among the participating
tax jurisdictions. One is the direct or formulary apportionment approach,
which attempts to define and determine the global income of the MNE
group and then adopts the proper formula based on economic parameters
for the just division of its income among the participating jurisdictions.11
This approach ignores the distinct economic or legal entities that constitute the MNE group, instead treating the group as one economic entity.
The second approach is the indirect or transactional approach. Under
this approach, each national MNE is recognized as an independent economic entity, but not necessarily a distinct legal entity, which is a part of
the global MNE group. The MNE could therefore be an independent and
distinct legal entity under domestic law (for example, a corporate body
such as a corporation under US corporation law or a company under UK
company law), or it could be a local branch of a foreign corporation,
which, for tax purposes, is regarded as a separate entity. A local branch of
a foreign corporation with substantial domestic activities is usually considered a permanent establishment (PE) under the bilateral tax treaties
and is taxed locally as if it were an independent legal entity. Under the
transactional approach, a price must be attached to every transaction between
MNEs located in different tax jurisdictions. Therefore, each transaction
within the MNE group across national borders is usually subject to domestic
taxation.
From a theoretical point of view, there is a very strong preference for
the direct formulary apportionment approach. No one could forcefully
argue against an internationally agreed upon formula, including all its
components and measurements, along the lines of the US unitary state
systems regarding states’ franchise tax. 12 Of course, the optimal solution
would be an international organization such as the International Court of
10
Continued . . .
over the globe—for example, Exxon, Texaco, Mobil, Apple Computer, Nestle, Chevron,
Hitachi, Converse, Yamaha Motor, and National Semiconductor.
11 For discussion of the formulary apportionment approach in the MNE context, see
generally, and the references there cited, Reuven S. Avi-Yonah, “The Rise and Fall of
Arm’s Length: A Study in the Evolution of U.S. International Taxation” (Summer 1995),
14 Virginia Tax Review 89-159, at 92; and Monica Brown Gianni, “Transfer Pricing and
Formulary Apportionment” (March 1996), 74 Taxes: The Tax Magazine 169-82, at 170.
See also Asim Bhansali, “Note: Globalizing Consolidated Taxation of United States Multinationals” (May 1996), 74 Texas Law Review 1401-38, in which the author argues for a US
unilateral repeal of the arm’s-length norm, ending the tax deferral of US-based MNEs, and
the adoption of consolidated income tax returns for MNE groups with an apportionment
formula for determining source of income for purposes of the US foreign tax credit, and
thus avoiding double taxation.
12 Barclays Bank v. Franchise Tax Bd. of California, 114 S. Ct. 2268 (1994); Exxon
Corp. v. Wisconsin Dept. of Revenue, 447 US 207 (1980); and Mobil Oil Corp. v. Commissioner of Taxes, 445 US 425 (1980). Compare F.W. Woolworth Co. v. Taxation & Revenue
Dept., 458 US 354 (1982).
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Justice, designed to apply the formula to any given case in line with the
recent World Trade Organization, 13 and an international court to adjudicate taxation disputes between countries, or between countries and MNE
groups. Although such proposals have been suggested repeatedly during a
great part of the 20th century, no progress has yet been reported. Not only
was the formulary apportionment approach rejected by the OECD; but even
the regional markets, including the former European Communities or the
European Union with their supranational laws and institutions, have not
achieved such an objective. As a result, the international transfer-pricing
norm has developed along the lines of the indirect, transactional method.
Major progress in the area of international taxation has been made by
the OECD and its predecessor, the OEEC.14 Both organizations promoted the
concept of bilateral tax treaties, negotiated between two countries, for the
purpose of avoiding international double taxation and preventing international tax avoidance. Many countries now have in place tax treaties that
generally follow the OECD model.
With respect to the taxation of MNE s, the OECD has subscribed to the
transactional separate-entity approach, respecting the independence of each
MNE whether it is incorporated as an independent legal entity or not. This
position is reflected in article 9 of the OECD model, which sets out the
arm’s-length standard, and in article 7, which addresses the taxation of
PEs such as branches, although the latter article also permits the use of a
formulary apportionment approach in certain circumstances.
Under article 7, if an MNE did not establish itself in a host country as
a separate legal entity and operated as a PE under the OECD model, it
would deal with its foreign-based headquarters, pursuant to article 7(2),
as though two independent entities were involved. The PE would then be
entitled, under article 7(3), to deduct its business expenses as though it
were a separate legal entity.
The OECD model recognizes that many countries treat the foreign branch
and its headquarters as a single entity, which they legally are. Accordingly, article 7(4) provides that the income of the PE may be attributed on
the basis of a formulary apportionment method where it is customary for
the two countries involved to apply such a method. This exception is not
allowed when the entities are related, under article 9, which is the general
article that applies to most intercorporate transactions of MNE groups.
Even in the exception for PE s, the OECD model emphasizes that final
13
OECD report, supra footnote 4, at paragraph 4.168.
The Organisation for European Economic Co-operation (OEEC) made its first recommendation concerning double taxation on February 25, 1955, on the basis of the work
commenced in 1921 by the League of Nations, with the first model treaty in 1928. This is
the historical origin of the model tax treaty developed by the OECD, initially published in
1963 and now in its 1992 version with current updates: Organisation for Economic Cooperation and Development, Model Tax Convention on Income and on Capital (Paris:
OECD) (looseleaf ) (herein referred to as “the OECD model”), I-1 et seq.
14
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results must conform to the separate-entity test and provides that “the
results shall be in accordance with the principles contained in the Article.”
What are the standards or criteria to be applied under the separateentity approach? It has been well established by international agreements
that it is the so-called arm’s-length standard that should apply; namely,
each transaction between the associated enterprises of the MNE or the
MNE group should be priced as it would be if it were carried out by
unrelated entities.
The arm’s-length standard was adopted in the first major study of transfer prices and MNE s by the OECD in 197915 and is acknowledged by
paragraph 3 of the OECD commentary on article 9(1) of the OECD model.
Article 9(1) prescribes:
Where
a) an enterprise of a Contracting State participates directly or indirectly
in the management, control or capital of an enterprise of the other Contracting State, or
b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an
enterprise of the other Contracting State,
and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those
which would be made between independent enterprises, then any profits
which would, but for those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
The arm’s-length standard has also been endorsed by the UN model treaty
between developed and developing countries.16
The United States has varied its position on the arm’s-length standard.
Initially, it endorsed the standard and incorporated it into domestic tax
legislation—specifically, section 482 of the Internal Revenue Code and
the detailed 1968 regulations promulgated under that section.17 The United
States also tried to apply the arm’s-length standard through attempts to
obtain or establish data for comparable unrelated transactions. In addition, the United States convinced most of its trading partners to adopt
similar specific arm’s-length rules and generally to adhere to the main
15 Organisation for Economic Co-operation and Development, Transfer Pricing and
Multinational Enterprises (Paris: OECD, 1979).
16 United Nations, Model Double Taxation Convention Between Developed and Developing Countries, UN publication ST/ESA/102 (New York: UN, 1980).
17 Internal Revenue Code of 1954, as amended. The current version of the Code, the
Internal Revenue Code of 1986, as amended, resulted from the Tax Reform Act of 1986,
Pub. L. no. 99-514, enacted on October 22, 1986.
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transfer-pricing methods. Germany was one of the first countries to follow, 18 then Canada,19 Australia, 20 France, 21 and others.22
The United Kingdom has traditionally preferred to resolve its transferpricing disputes by settlement. 23 This approach, set out in an Inland
Revenue memorandum (made public in a 1981 press release), is based on
the arm’s-length standard and has been upheld by the courts. 24 Although
the United Kingdom has enacted general statutory provisions that address the taxation of MNEs, the absence of detailed rules leaves ample
room for flexible solutions. This flexibility has been preferred by the UK
Inland Revenue.25 Recently, however, the United Kingdom released draft
legislation, in a consultative document, announcing a new transfer-pricing
18 In addition to the statutory provisions of 1972, the German tax authorities published
a handbook of detailed guidelines in 1973, similar to the US 1968 regulations. For a brief
survey, see Alan Stroad and Colin Masters, Transfer Pricing (London: Butterworths, 1991),
113-15.
19 Canada generally followed the US example, with variations, and the OECD recommendations. In September 1997, draft transfer-pricing legislation was tabled, adopting the
arm’s-length standard on the basis of comparable independent transactions, while also
permitting the use of a profit-based method in certain circumstances, and requiring taxpayers to maintain contemporaneous transfer-pricing documentation and records. See Allan
Lanthier and Diane Bale, “Transfer-Pricing Proposals” (October 21, 1997), 5 Canadian
Tax Highlights 73; and Nathan Boidman, “Canada To Revamp Regime To Set Things Right”
[December 1997], International Tax Report 1-5. For a brief description of the existing law,
see Stroad and Masters, supra footnote 18, at 120-26.
20 Australia entered into an advance pricing agreement with the United States in 1990,
and even extended it to a bilateral agreement based generally on the arm’s-length norm
and the OECD guidelines: see infra footnotes 89-92 and accompanying text.
21 France has adopted a more flexible approach. For a brief survey, see Stroad and
Masters, supra footnote 18, at 115-19.
22 For example, see New Zealand’s recent revised guidelines in (November 17, 1997),
vol. 31, no. 46 Tax News Service 456. There are several tax services on the transfer-pricing
laws of most countries and even a recent periodical entitled International Transfer Pricing.
See, for example, Bruno Gouthière et al., Transfer Pricing: European Rules and Practice,
Tax Management Foreign Income Portfolio no. 895, and Nathan Boidman et al., Transfer
Pricing: Foreign Rules and Practice Outside of Europe, Tax Management Foreign Income
Portfolio no. 897 (Washington, DC: Bureau of National Affairs, 1995).
23 Stroad and Masters, supra footnote 18, and Tax Management Foreign Income Portfolio nos. 895 and 897, supra footnote 22.
24 The memorandum, entitled “The Transfer Pricing of Multinational Enterprises,” is a
useful announcement of conformity with the OECD report of 1979, supra footnote 15, but
falls short of announcing specific transfer-pricing methods. See Tolley’s Accounting Principles for Tax Purposes, 2d ed. (Croydon, Eng.: Tolley, 1996), 351, appendix 11. See also
Stroad and Masters, supra footnote 18, at 38-39; Gouthière et al., supra footnote 22, at
A-121 et seq.; Glaxo Group v. IRC, [1995] STC 1075 (Ch. D.) and [1995] STI 2055 (CA);
Simon’s Weekly Tax Intelligence, February 8, 1996; [January 1996], International Tax
Report; [August 1997], International Tax Report; Maurice H. Collins, “Transfer Pricing in
the United Kingdom,” in The Tax Treatment of Transfer Pricing (Amsterdam: International
Bureau of Fiscal Documentation) (looseleaf ); Ametalco UK v. IRC, [1996] STC 399 (SCD);
and Roger Emerson, “International Transfer Pricing in Questions of Procedure and SelfAssessment” [1997], no. 5 British Tax Review 325-36.
25 Stroad and Masters, supra footnote 18, at 38-39.
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regime along the lines of the recommendations in the OECD report, with
an emphasis on detailed documentation requirements.26
Japan was among the later countries to follow the world trend, enacting specific rules in 1986.27 The approach adopted in the Netherlands
generally resembles the past UK position. 28 Most of the above-mentioned
countries also have introduced advance pricing agreement (APA) programs.29
In the mid-1980s, the United States began to reconsider its adherence
to the arm’s-length standard, following reports that it did not receive its
fair share of taxes on income attributed to MNEs. 30 Although the IRS had
experienced success in the late 1960s and early 1970s in transfer-pricing
litigation involving US and foreign-based MNEs, in many subsequent cases
it suffered major setbacks. 31 The reports that MNEs underpaid US taxes
led the United States to introduce unilateral measures to amend its transferpricing legislation.
The first move was to add section 367(d) to the Internal Revenue Code.
Section 367(d) was intended to deal with a specific abuse of the transferpricing regime whereby US MNEs developed local patents and other
intangible property, transferred them in tax-free transactions to no-tax or
low-tax jurisdictions such as Puerto Rico, where those assets were exploited, and sold their production back to the US MNE or to other members
of the MNE group, for worldwide distribution. This “round trip” resulted
in major US tax losses, which the IRS attempted to recover—as noted
above, with variable success—through the courts.32
Generally, under section 367(d), a transfer of intangibles to a foreign
entity subjects the US person to tax on additional ordinary income during
the useful life of the transferred intangible in an amount “commensurate”
with the income from the intangible, instead of the possible tax-free
26 Chris Adams, “Practical Effects of UK Draft Legislation,” [November 1997], International Tax Report 1-4.
27 For the development of the Japanese rules, practice, and policy, especially vis-à-vis
the United States, see Joseph H. Guttentag and Toshio Miyatake, “Transfer Pricing: US
and Japanese Views,” in Herbert H. Alpert and Kees van Raad, eds., Essays on International Taxation (Deventer, the Netherlands: Kluwer, 1993), 165-200. For an up-to-date
experience, see Dean A. Yoost and Daisuke Miyajima, “Japan Pursues Foreign Multinationals” (September 1997), no. 8 International Tax Review 49-56.
28 Stroad and Masters, supra footnote 18, at 119-20.
29 See below under the heading “Advance Pricing Agreement.”
30 See supra footnotes 9 and 10 and accompanying text.
31 See the cases surveyed in Avi-Yonah, supra footnote 11, at 123-29; and Allegra,
supra footnote 9, at 433-35 and 493 et seq.
32 See Michael Abrutyn and Jon E. Bischel, “United States,” in International Fiscal
Association, Cahiers de droit fiscal international, vol. 77a, Transfer Pricing in the Absence of Comparable Market Prices (Deventer, the Netherlands: Kluwer, 1992), 657-84, at
674, referring to Eli Lilly, supra footnote 8; Bausch and Lomb Inc., 92 TC 529 (1989),
aff ’d. 933 F.2d 1084 (2d Cir. 1991); and Sunstrand Corporation, supra footnote 8.
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exchange available under the old rules. The regulations under section
367(d) generally apply the section 482 regulatory standards for determining the amount of attributed income.33
The second reform undertaken by the US tax administration was the
introduction of revised regulations under section 482. The 1992 proposed
regulations were based on a 1988 US Treasury white paper,34 but they
adopted an approach different from that of the white paper on several
issues. Specifically, they introduced new standards for the taxation of
MNEs, which involved new profit-based transfer-pricing concepts that
departed from the arm’s-length standard.35 The proposed regulations created
uncertainty and the potential for double taxation of MNE s.36 For example,
the proposals allowed the IRS to infer an ambiguous “prudent business
standard” in lieu of a comparable based on uncontrolled enterprises.
These US transfer-pricing initiatives caused concern in the international tax community, leading to the major OECD study on transfer pricing
and the issuance of detailed guidelines, published in draft form in 199437
and formally adopted in 1995.38 The OECD study, although based on the
international arm’s-length standard, was strongly influenced by the US
reform initiatives.
33 See John P. Warner and Harrison B. McCawley, Transfer Pricing: The Code and the
Regulations, Tax Management Foreign Income Portfolio no. 887 (Washington, DC: Bureau
of National Affairs, 1995), A-139. See generally the OECD report, supra footnote 4, at
chapter VI, “Special Considerations for Intangible Property.”
34 “A Study of Intercompany Pricing Under Section 482 of the Code,” IRS Notice 88123, 1988-2 CB 458 (herein referred to as “the white paper”).
35 See generally, for example, Alan Winston Gramwell and Kenneth Klein, “ ‘Objective’ Tests of Transfer Pricing Prop. Regs. Require Subjective Determinations” (May 1992),
76 The Journal of Taxation 308-15; Marc M. Levy, R. Russ O’Harver, and James P.
Clancy, “Application of Section 482 Prop. Regs. to Transfers of Intangibles Is Likely To
Create Problems” (November 1992), 77 The Journal of Taxation 308-15; James P. Fuller,
“The Treatment of Intangible Property Rights in International Tax Planning” (December
1992), 70 Taxes: The Tax Magazine 982-97; and Elizabeth King, Transfer Pricing and
Valuation in Corporate Taxation (Deventer, the Netherlands: Kluwer, 1994), 38.
36 For criticism, see, for example, Sven-Olof Lodin, “Is the American Approach Fair?
Some Critical Views on the Transfer Pricing Issues,” in Essays on International Taxation,
supra footnote 27, 265-74 and articles cited therein. The white paper, supra footnote 34, at
475, surveyed the foreign objections and recommended continued application of the arm’slength standard. See also Avi-Yonah, supra footnote 11, at 139, for criticism by the trading
partners.
37 Organisation for Economic Co-operation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations: Part I: Principles and Methods,
Discussion Draft (Paris: OECD, 1994) (herein referred to as “the 1994 OECD draft report”).
38 Supra footnote 4. These guidelines superseded the 1979 OECD report, supra footnote 15. Criticism was raised by the UN working group at the Annual Meeting of
Intergovernmental Standards of Experts in Geneva in July 1996. See Richard Casna, ed.,
“UN Working Group Report Sparks Controversy with OECD” [July 1996], International
Tax Report 6-9.
(1998), Vol. 46, No. 1 / no 1
40
The OECD report followed the new US temporary regulations of 199339
and the final regulations of 1994, 40 which changed or relaxed some of the
controversial new standards while preserving some of the new methods,
adding flexibility and attempting to evaluate the transfer prices on
comparables in keeping with international tax norms. Yet another international agreement strongly supports the arm’s-length norm: the European
Community arbitration convention 41 has adopted the arbitration mechanism as a solution for transfer-pricing double taxation conflicts within the
European Union. The EC convention procedure is grounded entirely on
the arm’s-length standard as stated in the OECD model.42 Thus, out of
various studies and regulations on both sides of the Atlantic, there have
emerged—albeit with some differences—generally uniform norms for determining the transfer prices of MNE s, basically along the lines of the
arm’s-length standard, and in general conformity with the OECD model
and most existing bilateral tax treaties.
I am not suggesting that the new international tax regime fully meets
the objectives set forth earlier.43 However, the revised standards, elaborated below, together with new dispute-resolution mechanisms introduced
by the United States and the European Union open the door to the adoption
of changes in bilateral tax treaties, which would achieve further improvement of the world’s tax systems for mitigating conflicts with MNEs.
Before I outline these proposed changes, it is important to summarize
the revised transfer-pricing standards contained in the OECD report and
the US final regulations.
THE REVISED STANDARDS FOR SETTING
TRANSFER PRICES
The US deviation from the accepted arm’s-length standard originated in
the Tax Reform Act of 1986, when Congress, worried by the evidence
that MNE s were underpaying US taxes, mandated that the Treasury should
39 See generally Peter A. Glicklich and Seth B. Goldstein, “New Transfer Pricing Regs.
Adhere More Closely to an Arm’s-Length Standard” (May 1993), 78 The Journal of Taxation 306-14.
40 See generally, for example, “Final Section 482 Regs. Add Flexibility in Transfer
Pricing” (September 1994), 5 The Journal of International Taxation 383ff.; and Marc M.
Levey, Gregg A. Grauer, and James P. Clancy, “Final Section 482 Regs. Aim at More
Flexibility but Retain I.R.S. Audit Focus” (October 1994), 5 The Journal of International
Taxation 456ff.
41 The Convention on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises, 90/436/EEC, July 23, 1990, effective January
1, 1995 (herein referred to as “the EC convention”).
42 Perhaps the North American Free Trade Agreement (NAFTA) will change the trend:
compare Robert S. McIntyre, “Using NAFTA To Introduce Formulary Apportionment”
(April 5, 1993), 6 Tax Notes International 851-56.
43 See above under the heading “Objectives and Needs.”
(1998), Vol. 46, No. 1 / no 1
41
reconsider the continued use of the arm’s-length criterion.44 As a result,
the Treasury published its study of intercompany pricing (the white paper).45
The three traditional transfer-pricing methods—comparable uncontrolled
price, resale price, and cost plus—are all based on comparable arm’slength transactions. Since uncontrolled comparables are often difficult, if
not impossible, to find, the 1968 US regulations provided for a “fourth
method”—a method of last resort—which might be used in lieu of the
first three approved methods where no comparables are available for determining a fair transfer price.46
Two of the innovations of the 1994 US regulations are
1) their greater flexibility, resulting from the repeal of the priority of
the above long-established methods and the recognized superiority of the
“comparable uncontrolled price method”; and
2) the recognition of the “best method rule,” which requires the taxpayer to select the method that produces the “most accurate determination”
of the arm’s-length price. 47
In fact, some old US cases adopted the noted “fourth method”—a profitbased approach to transfer pricing—emphasizing the profitability of the
MNE’s associates 48 on the basis of a return of gross income to total operating costs of functionally similar enterprises, or profit split among the
enterprises, and using round figures without specific economic analysis.49
Both the 1988 white paper and the OECD report highlighted profit-based
methods, although the white paper said that the “fourth method” as developed by the courts has been inadequate.50
For example, the white paper described the “profit split method,”51
which now appears in the regulations,52 as first analyzing the functions
performed by each associated enterprise with the proper allocation of
market rate of return to each function on the basis of comparables. Then
44
HR conf. rep. no. 99-841, 99th Cong. 2d. sess. II-638 (1986).
Supra footnote 34.
46 Treas. reg. section 1.482-2A(e)(1)(iii) (1968).
47 Temp. Treas. reg. section 1.482-1T(b)(1) (1993); and Treas. reg. sections 1.482-1(b)(1)
to (2).
48 For example, E.I. DuPont de Nemours & Co. v. United States, 608 F.2d 445 (Ct. Cl.
1979).
49 For example, Cadillac Textiles Inc., 34 TCM 295 (1975); and Eli Lilly, supra footnote 8.
50 Supra footnote 34, at 469-71. For analysis of countries’ various methods for determining transfer prices in the absence of comparable market prices, see Guglielmo Maisto,
“General Report,” in Transfer Pricing in the Absence of Comparable Market Prices, supra
footnote 32, 19-75, and the various national reports.
51 Supra footnote 34, at 490.
52 Treas. reg. section 1.482-6.
45
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42
the residual profit is split between the enterprises, risking the possibility
that the split will be based on a formula without reference to comparables.53
The profit-split method has the advantage of being very flexible; however, although it is different from unitary methods (based on such factors
as assets, payroll, and sales), it deviates from the arm’s-length standard.
One commentator has specifically suggested that the profit-split method
is based on a flexible formulary apportionment approach.54 In part, however, it refers to the arm’s-length standard in that the split of profit is
based upon “an economically valid basis that approximates the division
of profits that would have been anticipated and reflected in an agreement
made at arm’s length.”55
The comparable profits method is expected to play a major role in US
transfer-pricing cases.56 It is expected that disputes between MNEs and
the taxing authorities will continue with resulting litigation. Cases involving
very profitable intangibles might call for use of the profit-split method
under the “best method rule” owing to a lack of comparables.57 One may
refer to this method as “[l]imited formulary apportionment.”58
We have to wait for audits of current tax years based on the new US
regulations. However, US statistics have been continuing to show underpayment of taxes by MNEs, 59 giving support to the demand for application
of the global formulary apportionment approach,60 with its inevitable adverse effect of international double taxation. Double taxation for highly
integrated MNEs is very likely to occur even now under the current US
regulations.
53
Treas. reg. section 1.482-6(c).
Avi-Yonah, supra footnote 11, at 94 and 129 et seq. Avi-Yonah advocates a US
unilateral application of the profit-split method and other formulary apportionment approaches departing from the arm’s-length standard.
55 OECD report, supra footnote 4, glossary definition of “profit split method.”
56 See, for example, Stephen P. Hannes, “IRS 1994 Transfer Pricing Rules Reward
Planning and Documentation, Increase Penalty Risks,” Tax Notes Today, August 1, 1994.
57 See, for example, George N. Carlson et al., “The Final Transfer Pricing Regulations:
The More They Stay the Same,” Tax Notes Today, July 29, 1994.
58 See Gianni, supra footnote 11, at 173; and Avi-Yonah, supra footnote 11, at 94.
59 United States, General Accounting Office, “International Taxation: Transfer Pricing
and Information on Nonpayment of Tax,” April 13, 1995.
60 Gianni, supra footnote 11; and Avi-Yonah, supra footnote 11. See also, for example,
Eric J. Coffill and Prentiss Wilson Jr., “Federal Formulary Apportionment as an Alternative to Arm’s Length Pricing: From the Frying Pan to the Fire?” (May 24, 1993), 59 Tax
Notes 1103-17; Benjamin F. Miller, “A Reply to ‘From the Frying Pan to the Fire’ ”
(October 11, 1993), 61 Tax Notes 241-56; and Louis M. Kauder, “Intercompany Pricing
and Section 482: A Proposal To Shift from Uncontrolled Comparables to Formulary Apportionment Now” (January 25, 1993), 58 Tax Notes 485-93. For modified apportionment
formulas, see Stanley I. Langbein, “A Modified Fractional Apportionment Proposal for Tax
Transfer Pricing” (February 10, 1992), 54 Tax Notes 719-30; and Reuven S. Avi-Yonah,
“Slicing the Shadow: A Proposal for Updating U.S. International Taxation” (March 15,
1993), 58 Tax Notes 1511-15.
54
(1998), Vol. 46, No. 1 / no 1
43
The 1994 OECD draft report endorsed profit-split methods, and notably
the comparable profits method adopted under the 1994 US regulations. 61
The latter was described as
[a] profit method that determines the level of profits that would have resulted from a controlled transaction . . . if the net return on those
transactions, as indicated by various profit measures, such as the return on
assets, operating income to sales, and other suitable financial ratios, were
equal to the return realized by a comparable independent enterprise.62
Outright acceptance of the comparable profits method was, however,
abandoned in the final version of the OECD report. Although a similar
concept, the transactional net margin method, was substituted, the OECD
report tried to limit its application in conformity with the arm’s-length
norm. That position is consistent with the report’s unequivocal rejection
of the global formulary apportionment approach.63 The OECD report expressly states that in the majority of cases, the traditional transactional
methods should apply, and profit-split methods would apply only in cases
of last resort when traditional methods were unsatisfactory. The OECD
report is much more reserved than the 1994 draft, stressing that “even in
a case of last resort, it would be inappropriate to automatically apply a
transactional profit method without first considering the reliability of that
method.”64
The OECD report and the US regulations have narrowed the gap that
previously existed between the OECD and US approaches, 65 but there is
still a risk that final results under the new US system will be incompatible
with the internationally accepted arm’s-length standard. The US Treasury
admitted that
[t]o the extent that they [profit-split methods] do not rely on such results
[of unrelated parties] they may be considered to be inconsistent with the
arm’s length standard. There are, however cases in which it is impossible to
locate adequate data to reliably apply one of the methods. In such a case a
profit split may be the best available method.66
The OECD’s acceptance of profit-split transfer-pricing methods is, as
noted above, somewhat qualified. The OECD report observed:
61
Treas. reg. section 1.482-5.
1994 OECD draft report, supra footnote 37, at 20. For an account of the opposition
raised by the OECD’s acceptance of the comparable profits method, see Jean-Pierre Le
Gall, “ ‘Other Methods’ Under the OECD Discussion Draft on Transfer Pricing” (January
1995), 2 International Transfer Pricing Journal 22-27.
63 Supra footnote 4, at paragraphs 3.58 to 3.74.
64 Ibid., at paragraph 3.50.
65 See, for example, Elliott, supra footnote 6; and Daniel S. Levy and Deloris R. Wright,
“In the OECD and the United States It’s the Arm’s Length Principle That Matters: Comparison of New Transfer Pricing Regulations” (January 1995), 2 International Transfer
Pricing Journal 28-44.
66 “Treasury Press Release on Final Section 482 Regulations,” Tax Notes Today, July 6,
1994.
62
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44
[T]here are substantial concerns regarding the use of the transactional net
margin method, in particular that it may be applied without adequately
taking into account the relevant differences between the associated enterprises and the independent enterprises being compared. Many countries are
concerned that the safeguards established for the traditional transactional
methods may be overlooked in applying the transactional net margin method.
Thus, where differences in the characteristics of the enterprises being compared have a material effect on the net margins being used, it would not be
appropriate to apply the transactional net margin method without making
adjustments for such differences.67
The OECD report therefore stresses that the comparability standard must
be applied to the transactional profit methods and that considerable caution
must be used in attempts to apply such methods. Profit methods should
not be applied if they cannot produce an arm’s-length result,68 and “as a
general matter the use of transactional profit methods is discouraged.”69
Nevertheless, the OECD report accepted the approach adopted in the
US regulations, 70 conceding that when the traditional transactional methods could not supply satisfactory results, they could be supplemented
with transactional profit methods as a last resort.71 Such difficult cases
occur in MNE groups with intercompany transactions in highly integrated
production of highly specialized advanced products, particularly in high
technology or communications, and are typically associated with unique
and very valuable intangibles. Such transactions have characterized MNEs,
and have been dominated by MNEs, for a long time.72
It has already been noted that the OECD flatly rejected any non-arm’slength approach such as global formulary apportionment (probably based
on some combination of costs, assets, payroll, and sales, or a rate of
return ratio of each MNE relative to the MNE group). A formulary approach within the boundaries of the transactional profit method applied
on a case-by-case basis to one or more associated enterprises, and compared with comparable independent enterprises, is therefore theoretically
an internationally accepted variation within the arm’s-length norm. 73 But
there is a great risk that the borderline between the two methods is too
fine and might be nullified by domestic tax administrations, with the
unavoidable result of double taxation.
67
Supra footnote 4, at paragraph 3.53.
Ibid., at paragraphs 3.55 and 3.56. The OECD Fiscal Affairs Committee would follow
closely the use of the profit methods by OECD member countries, including the United
States, of course.
70 Ibid.
71 Supra footnote 4, at paragraph 3.50.
72 See Hadari, supra footnote 1, at 749-52. For cost contribution arrangements of MNEs
endorsed by the OECD, see the OECD report, supra footnote 4, at chapter VII.
73 OECD report, supra footnote 4, at paragraph 3.60.
68
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45
Global formulary appointment is dependent on multilateral agreement,
which is not a reality in the foreseeable future. Even APAs are usually
bilateral. Perhaps if they were to be extended on a multilateral basis—and
there are signs in this direction 74—global formulary apportionment might
be reconsidered.
Acceptance of global formulary apportionment will likely gain momentum only if and when the majority of countries reach the conclusion
that the current international tax regime applicable to MNE groups is not
functioning adequately, and they are ready to replace it with another system. That is not yet the case, and in my opinion, all efforts must be
directed at improving the current regime in accordance with the conclusions of the OECD report. 75
ALTERNATIVE MECHANISMS FOR RESOLVING
INTERNATIONAL PRICING DISPUTES
As has been observed, despite the convergence of accepted transfer-pricing
methods among tax administrations, important differences continue to
exist, and the potential for major disputes with MNEs remains.76 Current
progress in the development of international mechanisms for dispute resolution could help in alleviating conflict and hardship.
Advance Pricing Agreement
In 1991, the IRS introduced the APA procedure. The idea has been welcomed by legal scholars all over the world.77
Pursuant to this program, the MNE sets out in detail the transfer-pricing
methods it proposes to use and negotiates acceptance of those methods,
or substitution of another approach, with the tax administration before the
transactions in question commence.78 If the parties reach agreement, the
MNE gains certainty regarding the domestic tax results, and both parties
can avoid an extremely expensive transfer-pricing dispute. In the international arena, such agreement will contribute significantly to the avoidance
74 See the discussion of APAs below under the heading “Alternative Mechanisms for
Resolving International Pricing Disputes.”
75 Supra footnote 4, at paragraphs 3.58 to 3.74.
76 See supra footnotes 6 to 10 and accompanying text.
77 See, for example, the articles by Fallon, infra footnote 78; Avi-Yonah, supra footnote
11, at 154; and Guttentag and Miyatake, supra footnote 27, at 187 et seq.
78 Rev. proc. 96-53, 1996-2 CB 375, which updates and supersedes Rev. proc. 91-22,
1991-1 CB 526. See generally “International Taxation: Problems Persist in Determining
Tax Effects of Intercompany Prices,” supra footnote 6, at 70; Geralyn M. Fallon, “Advance
Pricing Agreements: Policy and Practice” (September 1995), 73 Taxes: The Tax Magazine
490-513; and Geralyn M. Fallon, “Advance Pricing Agreements” (June 1997), 75 Taxes:
The Tax Magazine 304-28.
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46
of double taxation. Thus, the APA can serve as a flexible solution for
transfer-pricing conflicts and should be further improved and developed.79
At present, the APA procedure is very complex and expensive, requiring extensive discovery and documentation that is almost as comprehensive
as that required in section 482 litigation.80 Nevertheless, it is an excellent
vehicle, which should be simplified and thus opened to medium-sized and
small MNE s, in order to ensure equality and equity. 81 In addition, consideration should be given to the publication of APA s—of course, respecting
taxpayer confidentiality—in order to provide guidance to other taxpayers.
Obviously, if an APA is administered unilaterally, it will suffer from
the single-country process. Therefore, a binational process is much preferred, assuming that a wide multilateral process is not a feasible alternative. In regional markets, it could be further expanded.
An APA is not a “last resort” substitute for traditional administrative,
judicial, and treaty mechanisms for resolving transfer-pricing disputes;
rather, it supplements them.
As discussed below, 82 in order to avoid double taxation, it is recommended that treaty partners be informed of unilateral APA s, so that a
bilateral or multilateral solution may be considered under the mutual agreement procedure.83 Formally, the taxpayer would invoke the other country’s
competent authority under the treaty. 84 In this way, an accord between tax
administrations could be achieved, and the drawback of an unacceptable
unilateral APA based on a unique economic factor or method would be
avoided.85
79 OECD report, supra footnote 4, at paragraph 4.151. For problems with the use of
APAs for interbranch contracts of MNEs, see, for example, Diane M. Ring, “Risk-Shifting
Within a Multinational Corporation: The Incoherence of the U.S. Tax Regime” (July 1997),
38 Boston College Law Review 667-736, at 721-29.
80 John Turo, “IRS Links Two Pricing Agreements in Derivative Products Area” (May
11, 1992), 55 Tax Notes 725, describing the experience of the Barclays and Sumitomo
banks with APA negotiations extending over 18 months. The US recordkeeping requirements under section 482 are very substantial: Stanley G. Sherwood et al., Transfer Pricing:
Records and Information, Tax Management Foreign Income Portfolio no. 891 (Washington, DC: Bureau of National Affairs, 1995), chapter 2.
81 OECD report, supra footnote 4, at paragraph 4.164. For a critical approach, see
Lodin, supra footnote 36, at 270 et seq.
82 Under the heading “Conclusion and a Proposal for Better Treaty Solutions.”
83 OECD report, supra footnote 4, at paragraph 4.130. It has been reported that 50
percent of US APAs involved foreign competent authorities: Fallon, “Advance Pricing
Agreements: Policy and Practice,” supra footnote 78, at 492.
84 Rev. proc. 96-53, supra footnote 78, at section 5.10.
85 Compare the OECD report, supra footnote 4, at paragraph 4.148. Up to 1994, the US
unilateral or bilateral APA process included Australia, Belgium, Brazil, Canada, France,
Germany, Hong Kong, Ireland, Italy, Japan, Korea, Mexico, the Netherlands, Norway,
Puerto Rico, Singapore, Switzerland, the United Kingdom, and Virgin Islands. United
States, Internal Revenue Service, “I.R.S. Fact Sheet on APA,” FS-94-5, 1994.
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47
In a 1996 release, the IRS further developed the APA program, and
specifically the bilateral APA , under which the IRS will commence competent authority treaty negotiations before the conclusion of the APA with
the US taxpayer.86 Thus, the other treaty partner will be a full party to the
process.
It should be noted that an APA differs from domestic advance ruling
procedures in that it involves an extensive factual process. An APA may
also cover a series of transactions over an extended period, as well as
current, past, or prospective tax years.87 An APA involves all the associated enterprises of the MNE group and therefore requires the invocation
of the mutual agreement procedure under relevant tax treaties with other
countries. The US APA program has added guidelines for functionally
fully integrated MNE groups. 88 The APA has been gaining the support of
countries in addition to the United States, including Canada,89 Japan, 90
Australia, Germany, the Netherlands, and, to a lesser extent, France, Italy,
and the United Kingdom.91 This widespread adoption of APAs is in turn
building support for bilateral advance pricing agreements (BAPAs).92 Under
a BAPA , an MNE would supply information simultaneously to the national
tax authorities (competent authorities) involved; the competent authorities would agree on the methods and practical auditing procedures to be
applied, based on the OECD guidelines; and the competent authorities
would coordinate attempts to reach agreement, deferring the conclusion
of any unilateral APA with the MNE. The MNE would not participate in
the process but would be notified of the results by its competent authority. If consent were reached, the MNE would enter into a parallel domestic
86 Rev. proc. 96-53, supra footnote 78. See Henry J. Birnkrant and Robert T. Cole,
“Final Version of IRS Procedure Alters the Advance Pricing Agreement Process” (April
1997), 86 The Journal of Taxation 240-48.
87 Fallon, “Advance Pricing Agreements,” supra footnote 78, at 310.
88 Notice 94-40, 1994-1 CB 351.
89 Revenue Canada, “International Transfer Pricing: Advance Pricing Agreements (APA),”
Information Circular 94-4, December 30, 1994. See Nathan Boidman, “Canada Agrees
Bilateral APAs and Finalizes New Procedures” [March 1995], International Tax Report
1-5, prescribing guidelines and procedures for Canadian APAs and prescribing transferpricing methodology similar to the US APA procedures. The transfer-pricing methods
include the profit methods introduced in the United States.
90 Japan introduced its own APA called a pre-confirmation system (PCS) in 1987:
Fallon, “Advance Pricing Agreements: Policy and Practice,” supra footnote 78, at 492.
91 Ibid., at 504. For a note on the UK approach, see Collins, supra footnote 24. For the
German approach, see Rosemarie Portner, “Advance Pricing Agreements—Domestic Aspects and Treaty Law” (February 1996), European Taxation, International Bureau of Fiscal
Documentation, Transfer Pricing 50-53.
92 Involving Canada, the United States, Japan, and Australia. See Boidman, supra footnote 89.
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48
APA consistent with the BAPA . 93 The MNE could withdraw its request if
the terms of the proposed BAPA were not satisfactory to it.94
Simultaneous Examination Procedure
The simultaneous examination procedure (SEP) is a process of simultaneous auditing of the MNE group by the tax authorities of two or more
countries that are legally authorized to conduct such an examination. Pursuant to the SEP, each national tax authority conducts the auditing of the
MNE independently and separately in its own jurisdiction, and the audit
findings are exchanged between the countries involved. The SEP is not a
substitute for the mutual agreement procedure. Rather, “[a]ny exchange
of information as a result of the [SEP] continues to be exchanged via the
competent authorities, with all the safeguards that are built into such
exchanges.”95 Competent authorities of various countries often conclude
working arrangements that set out the objectives and procedures for simultaneous auditing and the exchange of information.96
The legal basis for the SEP is the exchange-of-information provision,
article 26 of the OECD model adopted in individual binational treaties.
Article 26 and the commentary allow exchanges of information upon request, spontaneous exchanges, and automatic exchanges.97 In addition,
specific multilateral regional treaties authorize such a program. The bestknown examples are articles 2(a) and 8 of the OECD convention on mutual
administrative assistance in tax matters,98 which expressly authorize simultaneous tax examinations. Article 12 of the Nordic convention on mutual
assistance in tax matters is another example.99
All information obtained is treated as confidential under domestic laws
and must be restricted to specific cases covered by the tax treaty or the
mutual assistance agreement. The MNE concerned is normally notified of
the SEP. 100 Under the SEP program, tax officials of the countries concerned meet and coordinate the audit examination of the MNE group.
Often the MNE participates directly in the process in order to clarify
factual issues, as mandated by domestic law. 101
93 For a discussion of taxpayers’ participation in the competent authority process, see
Birnkrant and Cole, supra footnote 86, at 242-43.
94 Ibid.
97 Ibid.
98 OECD/Council of Europe Multi-National Convention on Mutual Administrative Assistance in Tax Matters, open for signature on January 25, 1988.
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49
It is reported that the SEP enables tax administrations and taxpayers to
arrive more effectively, efficiently, and quickly at satisfactory transfer
prices.102 Often it culminates in early agreements and settlements, including any necessary corresponding adjustments, or at least it narrows down
differences and permits early invocation of the mutual agreement procedure under applicable treaties.
Safe Harbours
Under statutory safe harbour (or safe haven) rules, certain intercompany
transactions are excluded from the application of ordinary transfer-pricing
methods (for example, by the setting of thresholds). Similar results could
be achieved by simplified transfer-pricing rules, such as the setting of
ranges of prices or profits for MNEs.
The benefits of safe harbours are self-evident. They significantly ease
compliance, afford a higher degree of flexibility where no comparables
exist, and provide taxpayers with certainty, since transfer pricing in accordance with such rules must be accepted by the tax authorities. As well, tax
administrations enjoy simplification of the auditing process.103
While recognizing these advantages, the OECD report did not recommend replacing the arm’s-length standard with a set of safe harbour rules.
The report identified several drawbacks that outweigh the advantages.104
First, safe harbour rules are inconsistent with the arm’s-length standard, because for most intercompany transactions in MNE groups there are
no readily available open market prices. For this reason, safe harbours
tend to be arbitrary and do not correspond to the relevant facts and circumstances of the particular case.
Second, MNEs would adjust their intercompany prices in order to comply with the rules of the country with the stronger tax administration, at
the expense of other countries with weaker administrations. The result
would be litigation when those countries tried to apply the arm’s-length
standard, the possibility of double taxation for MNE s, and/or erosion of
the domestic tax base. Consequently, to be effective, safe harbour rules
would require high bilateral or multilateral coordination.
Third, the OECD report suggested that safe harbours would naturally
provide MNE s with tax-planning opportunities and might result in international underpayment of taxes by the diversion of a portion of the MNE’s
income to low-tax or no-tax jurisdictions. 105
Fourth, subjecting taxpayers to two different sets of rules—the safe harbour rules and the arm’s-length rules—would be inequitable, and the lack of
uniformity would result in discrimination and competitive distortions.
102
Ibid.,
Ibid.,
104 Ibid.,
105 Ibid.,
103
at
at
at
at
paragraph 4.87.
paragraph 4.100.
paragraphs 4.103 to 4.120.
paragraph 4.118.
(1998), Vol. 46, No. 1 / no 1
50
Nevertheless, in my view, the adoption and acceptance of safe harbours should be seriously considered. Tax administrations of smaller countries or less developed economies cannot afford the allocation of resources
needed in the transfer-pricing area, and even the most powerful country,
the United States, constantly suffers from underpayment of taxes by MNEs
under the current transfer-pricing regime. 106 Despite the clear drawbacks
of safe harbours, they should not be ruled out by domestic legislatures.
Such rules should be coupled with bilateral or multilateral accords in
order to avoid international tax conflicts.
Arbitration
One of the most advanced mechanisms for resolving binational or multinational tax disputes, which also assists in avoiding double taxation, is
arbitration. The concept of arbitration, as it is generally referred to in this
discussion, covers binding arbitration as well as any kind of mediation or
joint appointment of an advisory commission that would render its opinion on the specific solution for the elimination of double taxation in the
given case.
The best example thus far is the tax arbitration procedure embodied in
the EC convention.107 It is instructive that the EC chose the area of transferpricing disputes to be covered by its innovative multilateral treaty (although
in the EC framework). The EC convention introduces an arbitration procedure within the existing mutual agreement procedure of binational tax treaties.
Although, to date, experience of implementing the EC convention has
been negligible, it might increase. In fact, the UK Inland Revenue has
recently published a notice considering the use of the EC convention as
an alternative route to the mutual agreement procedure under UK bilateral
tax treaties.108 The United Kingdom’s views might be shared and further
developed by other members of the European Union as they gain experience in implementing the arbitration mechanism.
Article 7 of the EC convention provides that whenever the competent
authorities concerned fail within two years to reach an agreement that
eliminates double taxation resulting from transfer pricing of intercompany transactions, they will set up an advisory commission that will deliver
its opinion on the elimination of the double taxation concerned. If the
106
Supra footnotes 6 to 10 and accompanying text.
Supra footnote 41.
108 Richard Casna, ed., “UK Guidance on Using Arbitration Convention” [December
1997], International Tax Report 5-7. For full coverage of the treaty, see Luc Hinnekens,
“The European Tax Arbitration Convention and Its Legal Framework—I” [1996], no. 2
British Tax Review 132-54 and “. . . II” [1996], no. 3 British Tax Review 272-311; and JeanMarie Henckaerts, “International Arbitration and Taxation—The EC Arbitration Convention
for Transfer Prices Disputes” (September 1993), 10 Journal of International Arbitration
111-26.
107
(1998), Vol. 46, No. 1 / no 1
51
MNE initiated domestic legal proceedings, the two-year period will com-
mence on the date of final judgment.109 The advisory commission will
consist of a chair, two representatives of each competent authority concerned (or one representative if both competent authorities so agree), and
an even number of independent persons of standing to be mutually appointed, usually from a list prepared in advance.110
The MNE has the right to make any submissions and to appear in the
arbitration process.111 The advisory commission must give its opinion on
the elimination of double taxation within six months of the date of referral by the competent authorities;112 in turn, the competent authorities must
arrive at a decision within an additional six months. The decision may
eliminate the double taxation concerned even if it deviates from the opinion handed down. 113 The proceedings are not subject to a statute of
limitations under domestic laws.
The substantive standards to be applied by both the advisory commission and the competent authorities are those of arm’s length as enunciated
in the OECD model, which are incorporated in the EC convention. 114
The most important feature of the procedure is the binding power of
the decision that resolves the dispute. Although the decision does not
have the precedential value of a court decision, it may be published by
the competent authorities.115
The arbitration procedure is very attractive, even in the binational context, and therefore has already been included in several tax treaties. Some
examples follow.
The Germany-Sweden tax treaty is unique in providing, in article 25A,
that the European convention of 1957 for peaceful settlements of disputes
applies. Alternatively, the parties may agree on arbitration by a council of
arbitration whose decision will be binding on the parties.116 The council
judges will be judges of the two states, or of third countries, or officials
of international organizations. Taxpayers may present their case, and the
substantive rules will be those of the tax treaties of the parties and of
109
Article 7(1) of the EC convention.
Ibid., article 9(1).
111 Ibid., article 10(2).
113 Ibid., article 12(1). The competent authorities have power to deviate from the opinion, but if they fail to reach agreement, the opinion prevails.
114 Ibid., articles 4, 11, and 12.
116 International Fiscal Association, Resolution of Tax Treaty Conflicts by Arbitration,
proceedings of a seminar held in Florence, Italy in 1993 during the 47th Congress of the
International Fiscal Association (Deventer, the Netherlands: Kluwer, 1994), 89.
110
(1998), Vol. 46, No. 1 / no 1
52
general international law.117 It has been observed that such provisions
grant jurisdiction to the International Court of Justice for tax treaty disputes.118
The Germany-France tax treaty of 1959, as amended by the protocol of
1989, provides in article 25A , in reference to the mutual agreement procedure, that the competent authorities may appoint an arbitration
commission if they have not reached agreement within two years.119 Each
country appoints a representative, and both representatives appoint a member of a third state who chairs the commission. The appointment process
should be completed in three months; otherwise, according to this treaty,
appointments will be made by the Permanent Court of Arbitration. Substantive rules are also those of the tax treaty and international law. In this
case also, the taxpayer may present its case, and the decision is binding.
Recent treaties containing an arbitration clause continue the same trend,
providing that upon the taxpayer’s consent, a case may be submitted to
binding arbitration as an alternative or supplement to the mutual agreement procedure. The treaties provide that the taxpayer has right of hearing.
Also, although the decision lacks precedential effect, it may be published
and will be taken into account in future competent authority issues involving the same taxpayer. The US -Mexico treaty of 1992 contains
provisions such as these. 120 It further prescribes that a protocol sets the
procedures to be applied, including the requirement that the dispute will
be submitted for arbitration if the competent authorities have not reached
agreement within two years. Further procedures would be determined by
the competent authorities. The substantive rules would be those of the
treaty, “giving due consideration to domestic law” of the two states and
the “principles of international law.” 121
A similar mechanism is contained in the US-Germany treaty of 1994, 122
which provides for procedures agreed upon through an exchange of notes.
Again, the substantive rules are those of the treaty, giving due consideration to the domestic laws of both parties and the principles of international
law. It is required that the decision be reasoned. Interestingly, the competent authorities may also submit a case to an independent commission in
order to obtain an expert opinion instead of a decision.123
117
Ibid.
Klaus Vogel et al., Klaus Vogel on Double Taxation Conventions: A Commentary to
the OECD-, UN- and US Model Conventions for the Avoidance of Double Taxation of
Income and Capital (Deventer, the Netherlands: Kluwer, 1991), 1199.
119 Supra footnote 116, at 89.
120 Ibid., at 93.
121 Ibid., at 94.
122 Ibid., at 90. For a thorough discussion of the procedure, including its procedural
shortcomings, see Paul D. Tutun, “Arbitration Procedures in the United States-German
Income Tax Treaty: The Need for Procedural Safeguards in International Tax Disputes”
(Spring 1994), 12 Boston University International Law Journal 179-225.
123 Vogel et al., supra footnote 118.
118
(1998), Vol. 46, No. 1 / no 1
53
Other treaties, while including the arbitration alternative, lack express
procedures. Thus, according to the 1992 US-Netherlands treaty, 124 the procedures are provided in a memorandum of understanding; however, these
may be applied only when there is satisfactory experience with arbitration
under the EC convention and the arbitration provision of the US-Germany
treaty. Even then, recourse to arbitration is not compulsory.
The Israel-Ireland treaty of 1995 provides in article 25(5) that if the
competent authorities fail to reach agreement, upon their and the taxpayer’s consent, the case may be submitted to binding arbitration. Procedures
are not specified but are expected to be established between both countries by an exchange of notes.125
The arbitration mechanism has been gaining support.126 In 1992, the
OECD model, in its commentary on article 25, added arbitration as an
alternative solution within the mutual agreement procedure along the lines
of the EC convention,127 under which the competent authorities refer a
dispute to binding arbitration.
The International Chamber of Commerce (ICC) has strongly endorsed
compulsory arbitration since 1984,128 as part of a wider resolution that
envisages improvement of the general mutual agreement procedure. It
supports obligatory referral to arbitration, with the taxpayer’s consent, if
the competent authorities fail to reach agreement after one year. Each
state would appoint a member to the arbitration commission, which in
turn would choose an impartial chair. The decision would be based on the
treaty rules, with right of hearing for the taxpayer, and the decision must
be implemented despite domestic legal obstacles. The arbitration procedure could even be expanded in triangular cases to include a third country.
Obviously, the ICC supports the European Union developments in this area.
Even arbitration has its shortcomings, but these are outweighed by its
advantages. Interestingly, the OECD Fiscal Affairs Committee, which at
first opposed the use of arbitration in the transfer-pricing context, despite
acknowledging its advantages, appears to have had second thoughts.129 In
124 Article 29(5). See Mary C. Bennet, Ton H.M. Daniels, Fred C. de Hosson, and
Phillip D. Morrison, A Commentary to the United States-Netherlands Income Tax Convention (Deventer, the Netherlands: Kluwer) (looseleaf ), article 29. See also the IFA seminar,
supra footnote 116, at 92.
125 Such procedures have not yet been announced. For the Israeli decree that adopts the
treaty, see Israeli Subsidiary Legislation (Kovetz Takanot), no. 5743, 1996, 718.
126 See, for example, Philip Baker, Double Taxation Agreements and International Tax
Law (London: Sweet & Maxwell, 1991), 332.
127 Paragraph 48 of the commentary on article 25 of the OECD model.
128 This ICC resolution of June 16, 1984 is annexed to the IFA seminar, supra footnote
116, at 97.
129 See resolution of the Fiscal Affairs Committee, “Transfer Pricing Corresponding
Adjustments and the Mutual Agreement Procedure,” July 6, 1982, noted in the IFA seminar, supra footnote 116, at 101; and OECD report, supra footnote 4, at paragraph 4.171.
(1998), Vol. 46, No. 1 / no 1
54
the light of recent developments, particularly in the OECD commentary
on the model treaty and in the European Union, the committee has decided to re-evaluate its position following a study to be conducted in the
near future. 130
The binding arbitration mechanism has many advantages: 131
• it enables a definite solution (if so prescribed) to double taxation
following a deadlock in the treaty mutual agreement procedure;
• it is relatively less expensive and more efficient than other techniques;
• it could be fair to MNE s by granting them the right of hearing;
• the arbitrators could be impartial experts who would be qualified to
assess the pricing methodologies and all the economic factors critical to a
satisfactory decision; and
• it is up to the countries involved to decide whether to subject the
procedure only to the arm’s-length norm and methods, or to leave room
for greater flexibility to the arbitrators or the competent authorities on the
basis of the arbitration findings.
An example of resolving an international transfer-pricing dispute involving an MNE that operated in several countries was given domestically
in the United States, when the Tax Court permitted, on the basis of its
rule 124, a factual pricing dispute to be resolved by arbitration.132 The
controversy related to the IRS’s allocation of income from Apple Singapore to Apple US, based on the arm’s-length methods applicable to Apple’s
intercompany sales, services, and the use of intangibles. The case was
decided by a panel of three arbitrators selected by the parties: a retired
judge, a well-known economist, and an industry expert.
CONCLUSION AND A PROPOSAL FOR BETTER
TREATY SOLUTIONS
Disputes over transfer pricing within MNE groups are the most important
issue in international taxation today. On the one hand, tax administrations
are concerned to impose an appropriate level of taxation on the global
income of MNE groups and to achieve a proper division of that combined
income among the participating countries. On the other hand, MNEs expect to be able to conduct their operations in the world economy without
being subjected to double taxation, and with a reasonable degree of certainty and equity.
130 OECD report, supra footnote 4, at paragraph 4.171. The Fiscal Affairs Committee
has undertaken to study the arbitration alternative and supplement the guidelines of the
OECD report. The World Trade Organization has sophisticated procedures for trade disputes, providing for the appointment of an arbitration panel. See also, regarding NAFTA,
McIntyre, supra footnote 42.
131 See generally Stroad and Masters, supra footnote 18, at 81 et seq.
132 See William W. Park, “Control Mechanisms in International Tax Arbitration,” in the
IFA seminar, supra footnote 116, 45-57; and Bergquist and Clark, supra footnote 8.
(1998), Vol. 46, No. 1 / no 1
55
Tax administrations have generally agreed to adopt the arm’s-length
transactional norm as the main substantive standard applicable to transfer
pricing, although differences remain regarding the specific methods to be
applied in determining arm’s-length transfer prices.
In my view, the focus of future developments should be shifted from
the appropriate substantive methods to the appropriate mechanisms for
resolving disputes between taxpayers and domestic tax administrations at
the national level, and between national administrations and MNE groups
at the international level. Such mechanisms have evolved at both the
national and the international levels, as discussed previously.
To my mind, the only practical way to provide such necessary mechanisms in the international arena is via binational tax treaties. In regional
markets, such as the European Union, the Nordic countries, or even NAFTA
countries, dispute resolution mechanisms could be designed to operate on
a multilateral basis.
The main treaty provision that affords the basis for dispute resolution
mechanisms is the mutual agreement procedure of article 25 of the OECD
model, applying the substantive standards of article 9 for associated enterprises and of article 7 for PEs, in conjunction with the exchange-of-information provision in article 26. Most bilateral tax treaties include articles
similar to these provisions.
It is proposed that the mutual agreement procedure should include one
or more of the following mechanisms, according to the preferences of the
treaty parties:
• At the first level, the competent authorities and domestic tax administrations would encourage taxpayers to conclude APAs in order to resolve
transfer-pricing issues in advance and on a case-by-case basis. This mechanism would facilitate attainment of the two objectives referred to above:
the proper allocation of global income, and the accommodation of the
need of MNEs for certainty and equity, without the risk of double taxation.
The US model income tax treaty of 1996 emphasizes in article 25(3)(g)
that the competent authorities may agree to apply the transfer-pricing
methodology adopted in an APA .
Article 25(3) of the OECD model generally covers APA s,133 but it is
recommended that a more express reference be included in bilateral treaties, in conjunction with the exchange-of-information provision of article
26. APAs have been successfully developed domestically, and even BAPA s
at the international level, with initially favourable responses from tax
authorities and MNEs alike. However, they should be negotiated in a more
flexible and simplified manner, thereby enabling the participation of mediumsized and small MNEs. Binational or multinational APA s are considered
133
Compare the OECD report, supra footnote 4, at paragraph 4.140.
(1998), Vol. 46, No. 1 / no 1
56
much more effective than domestic APA s in reducing potential double
taxation.134 The 1996 US APA procedure is a move in that direction.
• At the second level, the SEP should be specifically included in bilateral treaties in order to facilitate information sharing between collaborating
tax authorities and specifically the exchange of audit information pertaining to MNEs. This mechanism would reduce potential double taxation
while enhancing the chances of resolving any remaining issues through
the competent authorities.
• At the third level, agreement on some limited safe harbours within
the arm’s-length norm is desirable. It would ease compliance, afford flexibility, and provide certainty without the drawback of creating potential
areas for double taxation when such rules are not uniform in the two
countries. Safe harbour rules should play only a limited role in the transferpricing area because of their disadvantages, such as clear deviation from
the arm’s-length standard and unjustified national tax losses.
• At the fourth and final level, in my view, all treaties should provide
for recourse to compulsory and binding arbitration, with the taxpayer’s
consent, when the competent authorities cannot reach agreement to eliminate double taxation in a given case. This mechanism is to be used after a
defined period from the time the case was referred to the competent
authorities.
The treaty or regulations thereunder, which would be concluded by an
exchange of notes, should specifically provide rules concerning the substantive law and pricing methods to be selected, all the procedural aspects
of the arbitration, and perhaps rules for limited judicial review in very
rare situations.
The arbitration mechanism set out in the EC convention could be
adopted, 135 or any variation of its provisions in order to avoid some of its
shortcomings. Thus, the competent authorities would create, for example,
an advisory commission composed of the states’ appointees and an independent chair appointed by those state appointees or by the competent
authorities. Within six months, the commission would deliver its reasoned
decision on the exact method to be applied to eliminate double taxation.
That decision would be binding on the states and the MNE. Alternatively,
countries that strongly object to the surrender of national taxing power in
this manner should agree that the competent authorities, within an additional six months, should adopt a decision that eliminates double taxation
on the basis of the commission decision. It is advisable that the arbitration decisions be published, even without precedential effect, so as to
ensure equity and uniformity.
134
135
Ibid., at paragraphs 4.146 and 4.163.
See the text accompanying footnotes 107 to 115.
(1998), Vol. 46, No. 1 / no 1
57
Hearing rights for all parties should be preserved. In addition, rules
should ensure that the process prevails over any domestic procedural barriers and that it ends the dispute, either by a requirement of exhaustion of
domestic remedies before its invocation or by the requirement that it is
binding domestically. (For example, the taxpayer could sign a waiver of
further litigation if the decision is valid under local law.)
Substantive arbitration rules should be provided for, on the basis of the
treaty substantive rules, while giving due consideration to the domestic
laws of the two countries and to international tax law norms.
The main novel feature of the proposed arbitration mechanism, as compared with that in the few tax treaties that have already adopted such a
solution, is not only its specific procedures and its efficiency, but the fact
that it is compulsory. Thus, it would end the dispute at issue and assure
the elimination of any double taxation.
It is contended that the mere fact that rules of compulsory arbitration
are added to tax treaties would strongly encourage the competent authorities of the countries involved to resolve the dispute before the invocation
of this avenue of last resort. Thus, an arbitration mechanism would serve
a useful purpose even if it were not invoked in practice.
It is further proposed that the OECD model be amended to include a
compulsory and binding arbitration mechanism. The other noted mechanisms could be recommended or mentioned in the OECD model commentary.
Indeed, acceptance of the arbitration alternative would gain momentum
if the OECD Fiscal Affairs Committee recommended it in the committee’s
ongoing study of transfer pricing pursuant to the OECD report.136
136
See supra footnote 130 and accompanying text.
(1998), Vol. 46, No. 1 / no 1

Resolution of International Transfer-Pricing Disputes

Transcription

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