Is tax treaty arbitration really a bad thing for developing countries?

I’m at the United Nations tax committee annual session this week, where I’ve learnt that I have to be careful what I write here, after a couple of posts from this blog were included in an input document [pdf]. Erk!

I’ve been taking the opportunity to discuss with delegates the recent article [£] by the chief of the UN committee’s secretariat, Michael Lennard, on the inclusion of arbitration in tax treaties with developing countries. Lennard begins from the concern that I’ve raised here too, which is that the BEPS Action Plan implies the use of a multilateral treaty to introduce mandatory arbitration clauses into existing tax treaties.

There are a number of potential problems with arbitration from a developing country perspective, which Lennard outlines, drawing on the experience of investment treaty arbitration. Briefly:

  • the cost of a full blown arbitration could be prohibitive for developing countries, forcing them to capitulate on some occasions, or alternatively stacking the process in favour of more wealthy countries who can afford the most skilled and experienced legal representatives.
  • Because transfer pricing expertise is limited in developing countries, it’s likely that most arbitrators themselves will come from developed countries, in which case their neutrality – or at least their sensitivity to the realities of developing country tax administration – might be questioned.
  • There is a range of concerns about the lack of transparency in arbitration outcomes, which is a problem for scrutiny (I’ve shared before a paper by Alison Christians on this topic), but could also mean that countries and lawyers only have their own experience to learn from, further biasing the arbitration process against developing countries to whom arbitration would be new.

Lennard also talks about a range of ways that arbitration might work better for developing countries. I’m just going to focus on one aspect of this, which is the ‘simplified procedure’ that is used in the UN model’s optional clause. (It’s also known as ‘baseball arbitration’, because it’s used in pay negotiations in the US baseball league).

Under the simplified procedure, the arbitrator doesn’t have to produce her own solution that tries to synthesise the concerns of the two sides. Instead she just chooses between one side’s position or the other.

Delegates I spoke to here said that the analogy with investment arbitration doesn’t hold when the simplified procedure is applied:

  • The costs are much lower, because there’s no need for lengthy meetings, the process demands much less time from the arbitrator, and – so one committee member said to me – you don’t need a lawyer to prepare written submissions.
  • The arbitration tends to move countries’ positions closer together, because it’s an all or nothing outcome, and a more conservative position might be more likely to succeed.
  • The democratic scrutiny point notwithstanding, transparency isn’t such a concern because the arbitrator is only permitted to choose one side, not to explain her reasoning – so there is very little to learn from past experience.

These discussions have certainly changed my thinking a bit, but I’m not sure that it is as clear-cut as those who favour arbitration suggest. In a judgement-based process, as opposed to a purely rules-based one, the quality of submissions is sure to affect the outcome. And it’s inevitable that an imbalance between countries in resources, expertise and experience will translate into an imbalanced outcome. Isn’t it?

BEPS Part 2: international politics and developing countries

sluto | beps

This graffiti is definitely about Base Erosion and Profit Shifting (Photo credit: feck_aRt_post)

I wrote earlier this week with some questions about UK tax policy and the OECD’s Action Plan on Base Erosion and Profit Shifting. A lot of the areas that it’s looking at are probably not going to affect smaller developing countries very much, but there are a few things worth highlighting. I also recommend Chris Lenon’s comments on the action plan, to which I’ll refer below.

Beyond the arm’s length principle

I thought it very interesting that the action plan concedes that some of the current problem with tax planning derives from the transfer pricing rules themselves:

multinationals have been able to use and/or misapply those rules to separate income from the economic activities that produce that income and to shift it into low-tax environments.

But the more significant rhetorical shift from the OECD is that it now appears to believe that solutions within the arm’s length principle (ALP) may not be enough. The ALP’s self-sufficiency has seemed to me to be an article of faith for the OECD secretariat every since I began working on tax. The action plan says:

special measures, either within or beyond the arm’s length principle, may be required with respect to intangible assets, risk and over-capitalisation to address these flaws.

Some academics are fond of arguing that the OECD abandoned the ALP in all bit name some time ago. So I wonder whether this is really a substantive change or just a rhetorical shift designed to underline that BEPS is a ‘radical rethink’.

Chris thinks that “[t]his is a clear indication that apportionment may be considered as the way to deal with high value intangibles.” It does seem to imply that the OECD may come more into line with the Chinese approach.

Tax reporting

Noting that “timely, comprehensive and relevant information on tax planning strategies is often unavailable to tax administrations”, the action plan proposes to:

Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNE’s provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.

Chris thinks that this is “very significant”, and that “business needs to develop a strategic response to the issue of transparency”. I think that it is worth considering in the context of the report to the OECD task force on tax and development last year [pdf], which outlined the information challenges faced by developing country tax authorities. The main value of a global report as proposed would be to give tax authority in country A some readily available information on a multinational’s operations in country B, if neither country is the head office. At the moment this is difficult to obtain, because the subsidiary in country A can’t be required to provide information on a sister company in country B, despite them being under common control. Tackling this problem through global documentation seems sensible.

A multilateral treaty and mandatory arbitration

I said when the original BEPS report came out that a multilateral treaty designed to update current treaties in one fell swoop has potential dangers for developing countries. They’re mostly excluded form the BEPS process, but a multilateral treaty could gain such momentum that it becomes obligatory for them to sign up, despite the difference of interests acknowledged by the existence of separate UN and OECD model bilateral treaties. The new UN tax committee‘s response to any multilateral treaty will surely be very significant.

As an example, the Action Plan implies that one area for change is in the area of mutual agreement procedures (MAPs) and arbitration:

Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

Alison Christians has written about her concerns about this in the past. Experience with investment treaties shows that developing countries should be wary of mandatory arbitration, yet they may find themselves with little choice if this makes it into a multilateral treaty.

G20 versus OECD

The new model of G20-OECD cooperation is intriguing. The Action Plan explains it as follows:

interested G20 countries that are not members of the OECD will be invited to be part of the project as Associates, i.e. on an equal footing with OECD members (including at the level of the subsidiary bodies involved in the work on BEPS), and will be expected to associate themselves with the outcome of the BEPS Project.

The equal footing part is new and unusual, but that last clause means that countries who have got used to stating their difference of opinion with the OECD will presumably want to think carefully. I will be very interested to see which of the non-OECD G20 members take up this invitation.