YITZHAK HADARI 1
COMPULSORY ARBITRATION IN INTERNATIONAL TRANSFER PRICING DISPUTES
1. Introduction:
Substantial portions of international transactions are carried out within
Multinational Enterprises ("MNEs"). The prices determined for such transactions
are referred to as the transfer prices. Because this pricing determination is being
controlled by the MNE itself, it might deviate from the market price ("arm's
length" price) to be determined by uncontrolled entities. And if such pricing
methods are accepted by the countries involved it would cause national tax losses.
As a result, countries have developed laws and rules determining such transfer
prices ("The norms").
The problem is that even though such norms in each country tend to rely on
the arm's length standard, there is great diversity of such national norms and in
their application in reality. Consequently, if two or more countries apply different
rules to the same transaction, it is inevitable that economic double taxation will
occur. It occurs when one country makes adjustment to the transfer prices, while
the other country would not make a corresponding adjustment to such prices. That
is so because a portion of the income arising out of the transaction is being
simultaneously attributed to the enterprise by the two countries involved, and
therefore that portion is being taxed by the two countries, and thus subjecting the
MNE to economic double taxation. Despite the convergence of accepted transfer-
pricing methods among tax administrations, important differences continue to
exist, and the potential for major disputes with MNEs remain. Current progress in
1 Professor of Law, Netanya Academic College; Professor Emeritus & Adjunct Professor, Tel-Aviv University Faculty of Law;
1 the development of international mechanisms for dispute resolution could help in
alleviating conflict and hardship.2
One of the most advanced mechanisms for resolving bi-national or
multinational tax disputes, and avoiding double taxation, is compulsory arbitration
that would eliminate such double taxation.
2. The EU solution:
The European Community arbitration convention of 1995 has adopted the
arbitration mechanism as a solution for transfer-pricing double taxation conflicts,
now within the European Union.3 The EU arbitration convention procedure is
grounded entirely on the arm’s-length standard as stated in the OECD model.
Thus, out of various norms on both sides of the Atlantic, there have emerged
generally uniform norms, though not identical, for determining the transfer prices
of MNEs, basically along the lines of the arm’s-length standard, and in general
conformity with the OECD model and most existing bilateral tax treaties.
Article 7 of the Arbitration Convention provides that whenever the competent
authorities of the two countries 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
2 See generally: Yitzhak Hadari, Resolution of International Transfer-Pricing Disputes, 30 CANADIAN TAX JOURNAL 29, 45 (1998); Chloe Burnett, "International Tax Arbitration"', 36 Australian Tax Rev. 173 (2007). 3 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 (hereinafter referred to as “the Arbitration Convention”). See generally Andreas Bernath, The Implications of the Arbitration Convention, JÖNKÖPING INTERNATIONAL BUSINESS SCHOOL. Available at: diva-portal.org/diva/getDocument?urn_nbn_se_hj_diva-548- 1__fulltext.pdf (last time verified July 12th 2008)
2 MNE initiated domestic legal proceedings, and appealed to local courts, the two-
year period will commence on the date of final judgment.4
The advisory commission consists of a Chairman, two representatives of each
competent authority concerned (or one representative if both competent
authorities so agree), and an even number of experts and independent persons
which are appointed by the mutual agreement authorities which are drawn from a
list of experts. The list is prepared by all Contracting States, nominating five
persons each. The experts must be nationals and residents of the EU. The
representatives and the independent persons then elect a Chairman; which
qualifies to be appointed to the highest judicial post in his country. 5
The MNE has the right to make any submissions and to appear in the
arbitration process.6 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;7 then, 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 of the advisory commission.8 But if
they fail to reach an agreement, the opinion prevails. 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.9 The most important feature of the procedure is the binding
power of the decision that resolves the dispute. Although the decision does not
4 Article 7(1) of the Arbitration Convention 5 Article 9(1) of the Arbitration Convention 6 Article 10(2) of the Arbitration Convention 7 Article 11(1) of the Arbitration Convention 8 Article 12(1) of the Arbitration Convention 9 Articles 4, 11, 12 of the Arbitration Convention
3 have the precedential value of a court decision, it may be published by the
competent authorities.10
The Arbitration Convention came into force on January 1, 1995 (then by the
EC) for the twelve old member states. The life span of the Convention was
initially set for five years, and extended for additional five years from January 1,
2000 and later was automatically extended for additional five-year periods, unless
objections were made by any of the contracting states.11
If an enterprise disputes the taxation of the intercompany transaction, by the
national tax authorities of the relevant member states, it may within three years of
the first notification of the action that results in double taxation, present its case to
the competent authority of its member state. According to Articles 6.2 and 7.1 of
the Convention, if this complaint is well-founded, the competent authority must
endeavour to resolve the case, within two years, by mutual agreement procedure
with the competent authority of the concerned states.
As stated, if the Competent authorities do not reach a resolution that
eliminates the international double taxation within two years, an advisory
commission would be appointed and the commission has to deliver within six
months an opinion resolving the double taxation.12
The advisory commission can request information, documents, and other
evidences, to be provided by the competent authorities or by the enterprises
involved.13
10 Article 12(2) of the Arbitration Convention 11 The Prolongation Protocol, entered into force on November 1st 2004, three months after all Member States had ratified it. Art. 3.2 states that it took effect from January 1st 2000 and thus provided for a retroactive application of the Arbitration Convention. 12 Art. 7(1) of the Arbitration Convention 13 Art. 10(1) of the Arbitration Convention
4 The advisory commission has to render its opinion on the basis of the arm's
length principle.14 The convention does not refer to specific criteria or rules to be
adopted, thus it leaves ample room for controversies. .
Although the competent authorities are the only parties to the procedure the
enterprises concerned are given an opportunity to participate as opposed to the
mutual agreement procedure under the bilateral tax treaties. As stated, the
enterprises may submit information, evidence, or documents that they see as
relevant, and the advisory commission may request the enterprises appearance
before it.15
After the submission of the commission opinion, the competent authorities of
the member states involved have an additional six months period to deliver a
decision which eliminates the double taxation. Although they may deviate from
the commission's opinion, if the competent authorities do not reach a final
decision within the six months period, they have to act according the
commission's opinion.
Codes of Conduct to MNEs in general and on transfer pricing documentation
of MNEs in particular, is expected to reduce the conflicts.16 The commission
proposed in 2005 that Member States would agree to an EU-Wide common
approach to transfer pricing documentation requirements that would consist of two
main elements: The "masterfile" would contain common standardized information
relevant for all EU MNEs as a general description of the transactions involved,
and the "country specific documentation" which would consist of a set
standardized documentation of each country involved.
14 Art.11(1) of the Arbitration Convention 15 Art. 10(2) of the Arbitration Convention 16 See "EU Proposes Transfer Pricing Code of Conduct", 40 Tax Notes International 688 (2005)
5 3. The OECD proposal for mandatory and binding arbitration:
The OECD released a report on February 2007 on a binding arbitration under
the mutual agreement procedure of article 25 of the OECD model convention,
supplemented by a mechanism that resolves the double taxation disputes.17
The OECD proposal suggests to add to article 25 of its model convention that if
the competent authorities are unable to reach an agreement to resolve the case
submitted to them within two years, any unresolved issues shall be submitted to
arbitration if the enterprises request so. The arbitration decision is binding on both
Contracting States and shall be implemented notwithstanding any time limits
according to local law.
It is not entirely clear if under the proposal the competent authority is obliged
to pursue the arbitration proceedings upon the taxpayer request, that is so in light
of the view that national competent authority has discretion whether or not to
accept the taxpayer initial request (subject to judicial review).18
For example in the YAMAHA Case19 the U.S. authorities refused to pursue
Yamaha's request for mutual assistance under the tax treaty with Japan, in an
allocation case between Yamaha Japan and its U.S. subsidiary. The district court
decided that it cannot compel the authorities to pursue the request. The result was
that the taxpayer only remedy was to litigate the case. On the other hand the
Israeli district court in JETECK TECHNOLOGIES case20 referred the Israeli taxpayer,
17 See OECD Website at, www.oecd.org/dataoecd/17/59/38055311.pdf for the full report “IMPROVING THE RESOLUTION OF TAX TREATY DISPUTES” (hereinafter: "The OECD Proposal"). 18 See e.g., Pierre Kerlan, International Disputes with Respect to Tax Conventions – The French View, in NEW YORK UNIVERSITY, INTERNATIONAL INSTITUTE ON TAX AND BUSINESS PLANNING (1977), at 232; but see Richard Hammer, Introduction to Competent Authority, Ibid at 171; Matthew T. Adams, The Procedure for Inoking Capital Authority Assistance Under United States Income Tax Treaties, Ibid at 188; John F. Avery Jones et al., The Legal Nature of the Mutual Agreement Procedure Under the OECD Model Convention-II, [1980] Brit. Tax Review. 13; Peter H. Dehen & Silke Bacht, Compatibility of the Recent OECD Proposals with Germany's Tax Dispute Resolution Mechanism, BULL. FOR INT’L FISCAL DOCUMENTATION 463, at 466 (Nov. 2006). 19 Yamaha Motor Corp. USA v. United States, 779 F. Supp 610(D.D.C. 1991). 20 Income Tax Appeal 1255/02 Jeteck Technologies Ltd. v. Assessing Officer (2005).
6 which initiated domestic litigation, to the mutual agreement procedure under the
Israel-Japan tax treaty, in a dispute regarding the characterization of the income of
the Israeli taxpayer in Japan, whether it is business income or royalties.
The OECD model provides, in other circumstances, that a case would not be
referred to arbitration if it was already decided in a domestic court or tribunal of
either country involved.
Another issue is if the taxpayer is bound by the arbitral award or he may still
litigate his case in domestic courts. It seems that the OECD model and the EU
take the latter approach. I prefer the other view, that the taxpayer should waive his
rights to local judicial remedies at the time of initiating arbitration proceedings
provided his rights are preserved and that the double taxation is eliminated.21
It is my opinion that the desired norm ought to be that the competent
authorities must refer the dispute to arbitration unless the request is not justified
on the face of it, e.g. the taxpayer pricing methods could not be justified under any
internationally accepted pricing methods, or the initial application to the
competent authority should be rejected because of strong state policy or
international comity arguments, and such decision should be subject to judicial
review (similar to the review of any administrative decision i.e. the competent
authorities must act and exercise their discretion in good faith and within the
range of reasonableness and proportionality according to acceptable standards of
equality and justice.)
4. Bilateral Tax Treaties
21 David Tillinghast, "Issues in the Implementation of the Arbitration Disputes arising under Income Tax Treaties" (2002) 56 Bull. Int'l Fiscal Doc.(2002).
7 In the past only few tax treaties included an arbitration clause, for example the
German-Sweden tax treaty convention.22 Another example is 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 arbitration commission if they have not reached
agreement within two years.23 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,
appointments will be made by the Permanent Court of Arbitration. Substantive
rules are also those of the tax treaty and international law, and the taxpayer has a
right of representation. The decision is binding.
Treaties containing an arbitration clause continue the same trend, providing
that upon the taxpayer’s consent, a case may be submitted to binding arbitration,
usually under 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.24 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
22 See Article 25A of the Treaty. 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 89 (Deventer, the Netherlands: Kluwer, 1994).(hereinafter: "IFA Resolution") 23 IFA Resolution, Ibid. 24 Ibid at 93.
8 consideration to domestic law” of the two states and the “principles of
international law.”25
A similar mechanism is contained in the US-Germany treaty of 199426, 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.27 Under the protocol, entered into force on December 2007, a new
mandatory and binding arbitration procedure under the mutual agreement clause
was concluded. If the competent authorities do not reach an agreement after two
years, the dispute should be submitted to a three-member panel. Each competent
authority submits its "best offer" and a supporting document, and the panel must
adopt one of the two offers within nine months after the appointment of the chair.
The decision has no precedential value and is binding unless the taxpayer rejects it
and there would be no further proceedings under the treaty.28 A similar provision
exists in the new U.S.-Belgium double taxation treaty of 200729, and the newly
signed protocol to the Canada-U.S. Tax Convention of 2007.30
These provisions, which are included in the aforementioned treaties or
protocols, include compulsory arbitration under the "last best offer method".
25 Ibid at 94 26 Ibid at 90 27 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 1199 (Deventer, the Netherlands: Kluwer, 1991) 28 Ingmar Doerr & Mitchell B Weiss, Changes to the Germany-U.S. Double Taxation Treaty, Tax Planning International Review 15 [Feb. 2008]. 29 Article 24(7) & Article 24(8); See generally THE NEW US-BELGIUM DOUBLE TAX TREATY A BELGIAN AND EU PERSPECTIVE (Anne Van De Vijver ed., 2008). 30 Protocol Amending the Convention Between Canada and the United States of 2007.
9 Under this method of arbitration the arbitration commission must accept one of
two proposed offers determining the transfer pricing involved. This arbitration
method is known as the "last best offer" or "baseball arbitration rule". Presumably,
limiting the board’s choice to one of the two proposals will encourage each
country to submit a reasonable proposal which will increase the chances it will be
chosen.31
Other earlier treaties, while including the arbitration alternative, lack express
procedures. Thus, according to the 1992 US-Netherlands treaty32, 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.
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. However the procedures are not specified
and have not been established yet.33
31 There are many variations of the arbitration methodology, for example, the arbitration procedures utilize the “last best offer” method. Under the “last best offer” method (also informally called “baseball arbitration” because it is similar to the arbitration method used to resolve major league baseball salary disputes), each of the treaty countries submits to the arbitration board a proposed resolution, and the board is required to adopt one of the proposals. The determination of the board is binding upon the parties. "The last best offer approach is intended to induce the competent authorities to moderate their positions, including before arbitration proceedings would commence, thus increasing the possibility of a negotiated settlement. The proposed arbitration procedures do not adopt the 'independent opinion' approach, under which the board is presented with the facts and arguments of the parties based on applicable law and then reaches its own independent decision based upon a written, reasoned analysis of the facts involved and applicable legal sources." Testimony of Thomas A. Barthold, Acting Chief of Staff of the Joint Committee on Taxation, TESTIMONY OF THE STAFF OF THE JOINT COMMITTEE ON TAXATION BEFORE THE SENATE COMMITTEE ON FOREIGN RELATIONS HEARING ON THE PROPOSED TAX TREATY WITH BELGIUM AND THE PROPOSED TAX PROTOCOLS WITH DENMARK, FINLAND, AND GERMANY (JCX-51-07), (July 17, 2007).
32 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) 33 Articles 25(5) of the treaty.
10 5. Conclusion
Compulsory arbitration as means of resolving double taxation disputes in general and transfer pricing issues of MNEs in particular, is gaining more support within the international community. This momentum is evident within the EU and the OECD, and in some bi-lateral double taxation treaties, and is expected to be included in additional treaties in the future.
Progress is being made with regard to transfer-pricing documentation aiming to reduce the number of conflicts.
The arbitration mechanism requires improvements of its procedures and of its access to the MNEs in all sincere economic double taxation transfer pricing disputes, its relationship to domestic litigation, and that its ultimate goal would be to end the relevant conflicts. Thus, in my opinion that tax payer should waive his rights to local judicial remedies at the time of initiating the arbitration proceedings, provided that his procedural rights during the arbitration are preserved and that the double taxation is eliminated.
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