Category: Annex I to Chapter IV – Bilateral Safe Harbours (MOU)

Sample Memoranda of Understanding for Competent Authorities to Establish Bilateral Safe Harbours

Chapter IV Annex I

Annex I to Chapter IV Sample Memoranda of Understanding for Competent Authorities to Establish Bilateral Safe Harbours Introduction This Annex contains sample Memoranda of Understanding (MOUs) for use by Competent Authorities in negotiating bilateral safe harbours for common categories of transfer pricing cases involving low risk distribution functions, low risk manufacturing functions, and low risk research and development functions. It is intended to provide countries with a tool to adapt and use in addressing, through bilateral safe harbours, important classes of transfer pricing cases that now take up a great deal of time and effort when processed on a case by case basis. Competent authorities are of course free to modify, add or delete any provision of the sample agreement when concluding their own bilateral agreements. Reasons for Concluding a Bilateral Safe Harbour MOU As described in Chapter IV, Section E.4 of these Guidelines, one of the potential problems arising from the use of unilateral transfer pricing safe harbours is that they may increase the risk of double taxation and double non-taxation. This can occur if the country granting the unilateral safe harbour shades the safe harbour towards the high end of an acceptable arm’s length profit range, while a treaty partner on the other end of the transaction disagrees with the assertion that the defined safe harbour profit level reflects arm’s length dealing. Some critics contend that there is a tendency for safe harbour profit ranges to increase over time, exacerbating this potential problem. It is also sometimes suggested that unilateral safe harbours can tend to force taxpayers into reporting higher than arm’s length levels of income, and to incur some resulting double taxation, as the price to be paid for administrative convenience and simplicity. Finally, unilateral safe harbours can, at times, provide a windfall to taxpayers whose specific facts might suggest that income above the safe harbour level would be more consistent with arm’s length dealing. These double tax and windfall issues would likely be quite pronounced in connection with safe harbours directed at some of the most common types of transfer pricing transactions. Transactions such as sales of goods to a local distribution affiliate for resale on a limited risk basis in the local market, contract manufacturing arrangements, and contract research arrangements could clearly raise these issues. It is perhaps for this reason that few countries, if any, have developed functioning safe harbours for dealing with these common types of transfer pricing issues. Distribution margins and manufacturing mark-ups can sometimes be quite consistent across geographies and across many industries. Therefore guidance on normal settlement ranges for these types of cases could have the effect of reducing the number of transfer pricing audits and reducing competent authority dockets and other transfer pricing controversy by a substantial margin if reasonable ranges of results could be agreed bilaterally and published. These types of cases could potentially be addressed through bilateral MOUs adopted and publicised by competent authorities. Some countries have adopted such arrangements on a bilateral basis. The general view of such countries is that treaty provisions based on Article 25(3) of the OECD Model Tax Convention provide sufficient authority to support a bilateral competent authority agreement on a safe harbour rule that would apply to numerous similarly situated taxpayers. Article 25(3) provides: “The competent authorities of the Contracting States shall endeavour to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the Convention. They may also consult together for the elimination of double taxation in cases not provided for in the Convention.” A competent authority agreement on a bilateral transfer pricing safe harbour should properly be characterised as a “mutual agreement” that “resolves difficulties or doubts arising as to the interpretation or application” of Article 9 of the Treaty. Although nothing would prevent the countries’ competent authorities from adopting safe harbour provisions under Article 25(3) on a multilateral basis if the conditions and circumstances so allow, the particular types of transactions described above are such that countries will often adopt a bilateral approach. If such MOUs existed, qualifying taxpayers would be able to manage their financial results to fall within the agreed safe harbour range, secure in the understanding that those results would be accepted in both countries agreeing to the MOU concerned. A commonly cited precedent for this type of approach is the agreement between the United States and Mexico regarding safe harbour profit ranges for maquiladora operations. A bilateral approach to the development of safe harbours would have a number of advantages over unilateral transfer pricing safe harbours: A bilateral approach executed through competent authority MOUs could increase the likelihood that safe harbour provisions do not result in double taxation or double non-taxation. Bilateral safe harbours could be tailored to the economics of a particular market and circumstances, and thus be compatible with the arm’s length principle. Bilateral safe harbours could be entered into on a selective basis with countries having similar tax rates, thus minimising the possibility that the safe harbour provision itself would create opportunities for transfer pricing manipulation and providing a means for limiting the application of the safe harbour to situations where transfer pricing risk is quite low. If the relevant countries desire, bilateral safe harbours could initially be limited to small taxpayers and/or small transactions in order to limit exposures to government tax revenue that might otherwise be created by the safe harbour. Safe harbours adopted by means of a competent authority MOU could be reviewed and modified from time to time by competent authority agreement, thus assuring that the provisions stay up to date and reflect developments in the broader economy. For developing countries with serious resource constraints, bilateral MOUs entered into with a number of treaty partners could provide a means of protecting the local tax base in common transfer pricing fact patterns without an inordinate enforcement effort. The following elements may be of relevance in the negotiation and conclusion of an MOU. 1)    Description of and criteria to be fulfilled by the