Now that arbitration is available within the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention as a supplementary dispute resolution tool, the next logical question is when do we get to use it?  The short answer is that it may take a while before an arbitration process is fully operational in an efficient manner, especially if your jurisdiction has yet to negotiate or sign an arbitration agreement or protocol. However, if you believe that you may be in need of international tax arbitration in the near future, the good news is that OECD Member countries have agreed to modify the OECD Model Tax Convention to include an arbitration option within the existing Mutual Agreement Procedure (MAP) process. The option to arbitrate combined with improvements to the existing MAP process, as described in the recently released OECD documents entitled ‘Improving the Resolution of Tax Treaty Disputes’ and ‘Manual on Effective Mutual Agreement Procedures (MEMAP),’ should have a considerable impact on how tax disputes are resolved.

MAP is the mechanism in tax treaties that allows two signatory countries to resolve international tax disputes. A transfer pricing adjustment levied by one of the countries against a taxpayer or a related party is the most common single cause of these disputes. In nearly all cases the taxpayer is subject to double taxation. The fact that MAP offers a bilateral solution generally makes it the obvious, low risk, and most efficient route for relief from taxation on the same, or essentially the same, income by two jurisdictions. Although the intent is that arbitration will be a rare occurrence, used only for the most difficult and contentious MAP cases, in reality there may be a long line up of taxpayers waiting for relief via MAP arbitration.

The arbitration option
With the release of the above-mentioned OECD publications, there is now an established framework for counties to revise their treaties as well as their MAP processes to include mandatory and binding arbitration. In that respect, Germany and the United States have already signed a protocol amending their tax treaty to allow for arbitration and supposedly a Canada-US protocol on arbitration is not far behind. However, a new protocol or treaty with an arbitration provision is just part of the first stage in establishing an arbitration process. In fact, some countries may just skip this stage entirely and opt for the establishment of an arbitration process via a memorandum of understanding under their existing MAP article. Once a mandatory and binding arbitration process has been agreed to by the contracting states to solve double taxation or taxation not in accordance with convention, the second and equally critical stage is the implementation of the actual arbitration procedures. Although this may seem rather straight forward after reviewing the OECD’s extensive guidance on the arbitration framework, there are still considerable issues for the competent authorities to address in order to get an arbitration process up and running in an effective manner, such as additional procedural rules, the selection of a list of potential arbitrators, and dedicated financial and administrative resources.

Certainty in resolving double taxation cases is the most obvious advantage to the inclusion of arbitration within MAP. The standard wording of the MAP article in most existing treaties provides that contracting states ‘shall endeavour’ to find a solution, which does not compel the competent authorities to resolve double taxation. In a growing number of contentious and complex transfer pricing cases, tax administrations are more inclined to decide that, although they have endeavoured, they are unable to find a solution to resolve double taxation. Addressing this issue is the wording of the new Paragraph 5 to Article 25 of the OECD Model Tax Convention and its Commentary, which provides for a conclusive resolution to international tax disputes by way of a mandatory and binding arbitration process for MAP cases over two years old.

Another advantage to the OECD guidance on arbitration is its flexibility in the method of application. The so-called ‘streamlined procedure,’ where the competent authorities put forth the whole case (or the last remaining unresolved element of a case) for determination through the baseball arbitration model, seems to be best suited for transfer pricing disputes.  To avoid prolonged delays, such as those experienced under the EU Arbitration Convention, the competent authorities would be well advised to take great care in the choosing the arbitration model and mode of application.

In addition, the OECD model adeptly mitigates the risk of judicial review of MAP arbitration decisions by incorporating arbitration within the existing MAP process, thereby conferring upon the taxpayer the rights afforded to them under the traditional MAP process. In most cases this means the taxpayer has the right to reject an arbitration decision. Therefore, even though the taxpayer is not a direct participant in the MAP or arbitration discussions, at the end of the day they do have the choice to accept or decline the decision.
Potential pitfalls of arbitration

There are very few practitioners within the international tax community that would criticise the overall positive direction of the OECD’s recent guidance on the MAP process. But guidance is just that, guidance. If countries significantly deviate from Paragraph 5 of Article 25 of the OECD Model Tax Convention and its Commentary or falter in the implementation or execution of the mode of application agreement, there could be significant flaws in their arbitration processes.

Beyond the administrative decisions on the arbitration framework, picking an arbitrator is a key decision leading up to a case specific arbitration that will undoubtedly affect the outcome. In choosing an arbitrator, competent authorities will want to consider critical attributes such as suitability (demeanour and character), qualifications, and above all independence and objectivity. Choosing the wrong arbitrator may delay a decision or even jeopardise the resolution of double taxation.

One of the greatest potential risks to the effective and efficient operation of MAP, and in turn arbitration within MAP, may actually depend upon the competent authorities’ expectations of the arbitration process. If a competent authority expects arbitration to shore up their existing MAP process, where arbitration effectively inherits a considerable portion of the competent authority caseload, there could be significant ramifications for taxpayers and tax administrations alike.

Long time advocates of a MAP arbitration process have always thought that arbitration, especially ‘baseball style’ arbitration, would enhance the traditional MAP process by encouraging the competent authorities to acquiesce on weak or questionable positions prior to the expiration of the initial two years. However, some observers have noted growing caseloads in some jurisdictions that seem to be slated for arbitration, whether there is a current process in place or not. Some competent authority staff may now be coming to the realisation that they may not have to make that tough decision on a moderately difficult or large dollar MAP case, since there is an alternative in arbitration just months away. This perceived reliance upon an arbitration process to resolve what many would consider to be mainstream cases was not the intended result of the OECD’s work. Indeed, the OECD was mandated to establish a supplemental dispute resolution process to address not only the issue of certainty but that of timeliness as well. But one can’t help but look at the backlog of cases scheduled for processing under the EU Arbitration Convention and wonder if that is the future for MAP proceedings around the world. It would be an unfortunate miscarriage of the OECD findings and its revisions to the OECD Model Tax Convention if arbitration in effect hinders the long-term functionality of the MAP process.

There is no doubt the viability and efficiency of MAP rests with the competent authorities. The onus is upon them to guard against undue delay and promote a pragmatic, principled approach to the resolution of cases within the targeted two years, whether an arbitration process exists or not. Even if the taxpayer requests arbitration, the competent authorities should continue to work diligently towards resolution beyond the initial two-year period.

Although two years is often cited as a reasonable amount of time to resolve a double taxation case, in actual fact, two years is often unrealistic for competent authorities to move a complex case far enough along the stages of MAP to determine whether arbitration is warranted or required. In many instances, the gathering of relevant information from the taxpayer as well as the additional time required to properly assess the issues may cause undue delays and complicate the taxpayer’s decision to transition from traditional MAP to arbitration.

Traditional MAP and APA’s
Since most taxpayers are concerned about the risks associated with transfer pricing disputes and the resulting double taxation, there continues to be a great deal of interest in how one gets relief from double taxation in the most efficient and effective manner. In principle from a taxpayer’s perspective, as long as the result is relatively quick and reasonable, treaty relief via MAP is the way to go.

The traditional MAP process is still the mainstay for resolving double taxation.  The 25 Best Practices featured in the OECD’s ‘Manual on Effective Mutual Agreement Procedures (MEMAP)’ provide guidance on the longstanding problems of the MAP process and set the foundation for a consistent application of MAP processes around the world. As more countries implement and adhere to these Best Practices on MAP there will be a network of MAP programs with similar policies and procedures, which will certainly enhanced the competent authorities’ interaction.

For the more complex, controversial, and recurring transactions or issues such as intangibles, it may be best for taxpayers to apply for a bilateral Advance Pricing Arrangement (APA), if available. An APA would resolve not only years subject to double taxation (via an APA rollback) but also filed years that have yet to be audited and future years as well. The result is one process covering a number of audit cycles, prospective tax certainty on covered transactions, and lower long-term compliance costs.