This chapter examines various administrative procedures that could be applied to minimise transfer pricing disputes and to help resolve them when they do arise between taxpayers and their tax administrations, and between different tax administrations. Such disputes may arise even though the guidance in these Guidelines is followed in a conscientious effort to apply the arm’s length principle. It is possible that taxpayers and tax administrations may reach differing determinations of the arm’s length conditions for the controlled transactions under examination given the complexity of some transfer pricing issues and the difficulties in interpreting and evaluating the circumstances of individual cases.
Where two or more tax administrations take different positions in determining arm’s length conditions, double taxation may occur. Double taxation means the inclusion of the same income in the tax base by more than one tax administration, when either the income is in the hands of different taxpayers (economic double taxation, for associated enterprises) or the income is in the hands of the same juridical entity (juridical double taxation, for permanent establishments). Double taxation is undesirable and should be eliminated whenever possible, because it constitutes a potential barrier to the development of international trade and investment flows. The double inclusion of income in the tax base of more than one jurisdiction does not always mean that the income will actually be taxed twice.
This chapter discusses several administrative approaches to resolving disputes caused by transfer pricing adjustments and for avoiding double taxation. Section B discusses transfer pricing compliance practices by tax administrations, in particular examination practices, the burden of proof, and penalties. Section C discusses corresponding adjustments (Paragraph 2 of Article 9 of the OECD Model Tax Convention) and the mutual agreement procedure (Article 25). Section D describes the use of simultaneous tax examinations by two (or more) tax administrations to expedite the identification, processing, and resolution of transfer pricing issues (and other international tax issues). Sections E and F describe some possibilities for minimising transfer pricing disputes between taxpayers and their tax administrations. Section E addresses the possibility of developing safe harbours for certain taxpayers, and Section F deals with advance pricing arrangements, which address the possibility of determining in advance a transfer pricing methodology or conditions for the taxpayer to apply to specified controlled transactions. Section G considers briefly the use of arbitration procedures to resolve transfer pricing disputes between countries.
Tax compliance practices are developed and implemented in each member country according to its own domestic legislation and administrative procedures. Many domestic tax compliance practices have three main elements: a) to reduce opportunities for non-compliance (e.g. through withholding taxes and information reporting); b) to provide positive assistance for compliance (e.g. through education and published guidance); and, c) to provide disincentives for non-compliance. As a matter of domestic sovereignty and to accommodate the particularities of widely varying tax systems, tax compliance practices remain within the province of each country. Nevertheless a fair application of the arm’s length principle requires clear procedural rules to ensure adequate protection of the taxpayer and to make sure that tax revenue is not shifted to countries with overly harsh procedural rules. However, when a taxpayer under examination in one country is a member of an MNE group, it is possible that the domestic tax compliance practices in a country examining a taxpayer will have consequences in other tax jurisdictions. This may be particularly the case when cross-border transfer pricing issues are involved, because the transfer pricing has implications for the tax collected in the tax jurisdictions of the associated enterprises involved in the controlled transaction. If the same transfer pricing is not accepted in the other tax jurisdictions, the MNE group may be subject to double taxation as explained in paragraph 4.2. Thus, tax administrations should be conscious of the arm’s length principle when applying their domestic compliance practices and the potential implications of their transfer pricing compliance rules for other tax jurisdictions, and seek to facilitate both the equitable allocation of taxes between jurisdictions and the prevention of double taxation for taxpayers.
This section describes three aspects of transfer pricing compliance that should receive special consideration to help tax jurisdictions administer their transfer pricing rules in a manner that is fair to taxpayers and other jurisdictions. While other tax law compliance practices are in common use in OECD member countries – for example, the use of litigation and evidentiary sanctions where information may be sought by a tax administration but is not provided – these three aspects will often impact on how tax administrations in other jurisdictions approach the mutual agreement procedure process and determine their administrative response to ensuring compliance with their own transfer pricing rules. The three aspects are: examination practices, the burden of proof, and penalty systems. The evaluation of these three aspects will necessarily differ depending on the characteristics of the tax system involved, and so it is not possible to describe a uniform set of principles or issues that will be relevant in all cases. Instead, this section seeks to provide general guidance on the types of problems that may arise and reasonable approaches for achieving a balance of the interests of the taxpayers and tax administrations involved in a transfer pricing inquiry.
Examination practices vary widely among OECD member countries. Differences in procedures may be prompted by such factors as the system and the structure of the tax administration, the geographic size and population of the country, the level of domestic and international trade, and cultural and historical influences.
Transfer pricing cases can present special challenges to the normal audit or examination practices, both for the tax administration and for the taxpayer. Transfer pricing cases are fact-intensive and may involve difficult evaluations of comparability, markets, and financial or other industry information. Consequently, a number of tax administrations have examiners who specialise in transfer pricing, and transfer pricing examinations themselves may take longer than other examinations and follow separate procedures.
Because transfer pricing is not an exact science, it will not always be possible to determine the single correct arm’s length price; rather, as Chapter III recognises, the correct price may have to be estimated within a range of acceptable figures. Also, the choice of methodology for establishing arm’s length transfer pricing will not often be unambiguously clear. Taxpayers may experience particular difficulties when the tax administration proposes to use a methodology, for example a transactional profit method, that is not the same as that used by the taxpayer.
In a difficult transfer pricing case, because of the complexity of the facts to be evaluated, even the best-intentioned taxpayer can make an honest mistake. Moreover, even the best-intentioned tax examiner may draw the wrong conclusion from the facts. Tax administrations are encouraged to take this observation into account in conducting their transfer pricing examinations. This involves two implications. First, tax examiners are encouraged to be flexible in their approach and not demand from taxpayers in their transfer pricing a precision that is unrealistic under all the facts and circumstances. Second, tax examiners are encouraged to take into account the taxpayer’s commercial judgment about the application of the arm’s length principle, so that the transfer pricing analysis is tied to business realities. Therefore, tax examiners should undertake to begin their analyses of transfer pricing from the perspective of the method that the taxpayer has chosen in setting its prices. The guidance provided in Chapter II, Part I dealing with the selection of the most appropriate transfer pricing method also may assist in this regard.
A tax administration should keep in mind in allocating its audit resources the taxpayer’s process of setting prices, for example whether the MNE group operates on a profit centre basis. See paragraph 1.5.
Like examination practices, the burden of proof rules for tax cases also differ among OECD member countries. In most jurisdictions, the tax administration bears the burden of proof both in its own internal dealings with the taxpayer (e.g. assessment and appeals) and in litigation. In some of these countries, the burden of proof can be reversed, allowing the tax administration to estimate taxable income, if the taxpayer is found not to have acted in good faith, for example, by not cooperating or complying with reasonable documentation requests or by filing false or misleading returns. In other countries, the burden of proof is on the taxpayer. In this respect, however, the conclusions of paragraphs 4.16 and 4.17 should be noted.
The implication for the behaviour of the tax administration and the taxpayer of the rules governing burden of proof should be taken into account. For example, where as a matter of domestic law the burden of proof is on the tax administration, the taxpayer may not have any legal obligation to prove the correctness of its transfer pricing unless the tax administration makes a prima facie showing that the pricing is inconsistent with the arm’s length principle. Even in such a case, of course, the tax administration might still reasonably oblige the taxpayer to produce its records that would enable the tax administration to undertake its examination. In some countries, taxpayers have a duty to cooperate with the tax administration imposed on them by law. In the event that a taxpayer fails to cooperate, the tax administration may be given the authority to estimate the taxpayer’s income and to assume relevant facts based on experience. In these cases, tax administrations should not seek to impose such a high level of cooperation that would make it too difficult for reasonable taxpayers to comply.
In jurisdictions where the burden of proof is on the taxpayer, tax administrations are generally not at liberty to raise assessments against taxpayers which are not soundly based in law. A tax administration in an OECD member country that applies the arm’s length principle, for example, could not raise an assessment based on a taxable income calculated as a fixed percentage of turnover and simply ignore the arm’s length principle. In the context of litigation in countries where the burden of proof is on the taxpayer, the burden of proof is often seen as a shifting burden. Where the taxpayer presents to a court a reasonable argument and evidence to suggest that its transfer pricing was arm’s length, the burden of proof may legally or de facto shift to the tax administration to counter the taxpayer’s position and to present argument and evidence as to why the taxpayer’s transfer pricing was not arm’s length and why the assessment is correct. On the other hand, where a taxpayer makes little effort to show that its transfer pricing was arm’s length, the burden imposed on the taxpayer would not be satisfied where a tax administration raised an assessment which was soundly based in law.
When transfer pricing issues are present, the divergent rules on burden of proof among OECD member countries will present serious problems if the strict legal rights implied by those rules are used as a guide for appropriate behaviour. For example, consider the case where the controlled transaction under examination involves one jurisdiction in which the burden of proof is on the taxpayer and a second jurisdiction in which the burden of proof is on the tax administration. If the burden of proof is guiding behaviour, the tax administration in the first jurisdiction might make an unsubstantiated assertion about the transfer pricing, which the taxpayer might accept, and the tax administration in the second jurisdiction would have the burden of disproving the pricing. It could be that neither the taxpayer in the second jurisdiction nor the tax administration in the first jurisdiction would be making efforts to establish an acceptable arm’s length price. This type of behaviour would set the stage for significant conflict as well as double taxation.
Consider the same facts as in the example in the preceding paragraph. If the burden of proof is again guiding behaviour, a taxpayer in the first jurisdiction being a subsidiary of a taxpayer in the second jurisdiction (notwithstanding the burden of proof and these Guidelines), may be unable or unwilling to show that its transfer prices are arm’s length. The tax administration in the first jurisdiction after examination makes an adjustment in good faith based on the information available to it. The parent company in the second jurisdiction is not obliged to provide to its tax administration any information to show that the transfer pricing was arm’s length as the burden of proof rests with the tax administration. This will make it difficult for the two tax administrations to reach agreement in competent authority proceedings.
In practice, neither countries nor taxpayers should misuse the burden of proof in the manner described above. Because of the difficulties with transfer pricing analyses, it would be appropriate for both taxpayers and tax administrations to take special care and to use restraint in relying on the burden of proof in the course of the examination of a transfer pricing case. More particularly, as a matter of good practice, the burden of proof should not be misused by tax administrations or taxpayers as a justification for making groundless or unverifiable assertions about transfer pricing. A tax administration should be prepared to make a good faith showing that its determination of transfer pricing is consistent with the arm’s length principle even where the burden of proof is on the taxpayer, and taxpayers similarly should be prepared to make a good faith showing that their transfer pricing is consistent with the arm’s length principle regardless of where the burden of proof lies.
The Commentary on paragraph 2 of Article 9 of the OECD Model Tax Convention makes clear that the State from which a corresponding adjustment is requested should comply with the request only if that State “considers that the figure of adjusted profits correctly reflects what the profits would have been if the transactions had been at arm’s length”. This means that in competent authority proceedings the State that has proposed the primary adjustment bears the burden of demonstrating to the other State that the adjustment “is justified both in principle and as regards the amount.” Both competent authorities are expected to take a cooperative approach in resolving mutual agreement cases.
Penalties are most often directed toward providing disincentives for non-compliance, where the compliance at issue may relate to procedural requirements such as providing necessary information or filing returns, or to the substantive determination of tax liability. Penalties are generally designed to make tax underpayments and other types of non-compliance more costly than compliance. The Committee on Fiscal Affairs has recognised that promoting compliance should be the primary objective of civil tax penalties. OECD Report Taxpayers’ Rights and Obligations (1990). If a mutual agreement results in a withdrawal or reduction of an adjustment, it is important that there exist possibilities to cancel or mitigate a penalty imposed by the tax administrations.
Care should be taken in comparing different national penalty practices and policies with one another. First, any comparison needs to take into account that there may be different names used in the various countries for penalties that accomplish the same purposes. Second, the overall compliance measures of an OECD member country should be taken into account. National tax compliance practices depend, as indicated above, on the overall tax system in the country, and they are designed on the basis of domestic need and balance, such as the choice between the use of taxation measures that remove or limit opportunities for noncompliance (e.g. imposing a duty on taxpayers to cooperate with the tax administration or reversing the burden of proof in situations where a taxpayer is found not to have acted in good faith) and the use of monetary deterrents (e.g. additional tax imposed as a consequence of underpayments of tax in addition to the amount of the underpayment). The nature of tax penalties may also be affected by the judicial system of a country. Most countries do not apply no-fault penalties; in some countries, for example, the imposition of a no-fault penalty would be against the underlying principles of their legal system.
There are a number of different types of penalties that tax jurisdictions have adopted. Penalties can involve either civil or criminal sanctions – criminal penalties are virtually always reserved for cases of very significant fraud, and they usually carry a very high burden of proof for the party asserting the penalty (i.e. the tax administration). Criminal penalties are not the principal means to promote compliance in any of the OECD member countries. Civil (or administrative) penalties are more common, and they typically involve a monetary sanction (although as discussed above there may be a non-monetary sanction such as a shifting of the burden of proof when, e.g. procedural requirements are not met or the taxpayer is uncooperative and an effective penalty results from a discretionary adjustment).
Some civil penalties are directed towards procedural compliance, such as timely filing of returns and information reporting. The amount of such penalties is often small and based on a fixed amount that may be assessed for each day in which, e.g. the failure to file continues. The more significant civil penalties are those directed at the understatement of tax liability.
Although some countries may refer to a “penalty”, the same or similar imposition by another country may be classified as “interest”. Some countries’ “penalty” regimes may therefore include an “additional tax”, or “interest”, for understatements which result in late payments of tax beyond the due date. This is often designed to ensure the revenue recovers at least the real time value of money (taxes) lost.
Civil monetary penalties for tax understatement are frequently triggered by one or more of the following: an understatement of tax liability exceeding a threshold amount, negligence of the taxpayer, or wilful intent to evade tax (and also fraud, although fraud can trigger much more serious criminal penalties). Many OECD member countries impose civil monetary penalties for negligence or willful intent, while only a few countries penalise “no-fault” understatements of tax liability.
It is difficult to evaluate in the abstract whether the amount of a civil monetary penalty is excessive. Among OECD member countries, civil monetary penalties for tax understatement are frequently calculated as a percentage of the tax understatement, where the percentage most often ranges from 10% to 200%. In most OECD member countries, the rate of the penalty increases as the conditions for imposing the penalty increase. For instance, the higher rate penalties often can be imposed only by showing a high degree of taxpayer culpability, such as a wilful intent to evade. “No-fault” penalties, where used, tend to be at lower rates than those triggered by taxpayer culpability (see paragraph 4.28).
Improved compliance in the transfer pricing area is of some concern to OECD member countries and the appropriate use of penalties may play a role in addressing this concern. However, owing to the nature of transfer pricing problems, care should be taken to ensure that the administration of a penalty system as applied in such cases is fair and not unduly onerous for taxpayers.
Because cross-border transfer pricing issues implicate the tax base of two jurisdictions, an overly harsh penalty system in one jurisdiction may give taxpayers an incentive to overstate taxable income in that jurisdiction contrary to Article 9. If this happens, the penalty system fails in its primary objective to promote compliance and instead leads to non-compliance of a different sort – non-compliance with the arm’s length principle and under-reporting in the other jurisdiction. Each OECD member country should ensure that its transfer pricing compliance practices are not enforced in a manner inconsistent with the objectives of the OECD Model Tax Convention, avoiding the distortions noted above.
It is generally regarded by OECD member countries that the fairness of the penalty system should be considered by reference to whether the penalties are proportionate to the offence. This would mean, for example, that the severity of a penalty would be balanced against the conditions under which it would be imposed, and that the harsher the penalty the more limited the conditions in which it would apply.
Since penalties are only one of many administrative and procedural aspects of a tax system, it is difficult to conclude whether a particular penalty is fair or not without considering the other aspects of the tax system. Nonetheless, OECD member countries agree that the following conclusions can be drawn regardless of the other aspects of the tax system in place in a particular country. First, imposition of a sizable “no-fault” penalty based on the mere existence of an understatement of a certain amount would be unduly harsh when it is attributable to good faith error rather than negligence or an actual intent to avoid tax. Second, it would be unfair to impose sizable penalties on taxpayers that made a reasonable effort in good faith to set the terms of their transactions with associated enterprises in a manner consistent with the arm’s length principle. In particular, it would be inappropriate to impose a transfer pricing penalty on a taxpayer for failing to consider data to which it did not have access, or for failure to apply a transfer pricing method that would have required data that was not available to the taxpayer. Tax administrations are encouraged to take these observations into account in the implementation of their penalty provisions.
The mutual agreement procedure is a well-established means through which tax administrations consult to resolve disputes regarding the application of double tax conventions. This procedure, described and authorised by Article 25 of the OECD Model Tax Convention, can be used to eliminate double taxation that could arise from a transfer pricing adjustment.
Article 25 sets out three different areas where mutual agreement procedures are generally used. The first area includes instances of “taxation not in accordance with the provisions of the Convention” and is covered in paragraphs 1 and 2 of the Article. Procedures in this area are typically initiated by the taxpayer. The other two areas, which do not necessarily involve the taxpayer, are dealt with in paragraph 3 and involve questions of “interpretation or application of the Convention” and the elimination of double taxation in cases not otherwise provided for in the Convention. Paragraph 10 of the Commentary on Article 25 makes clear that Article 25 is intended to be used by competent authorities in resolving not only problems of juridical double taxation but also those of economic double taxation arising from transfer pricing adjustments made pursuant to paragraph 1 of Article 9.
Paragraph 5 of Article 25, which was incorporated in the OECD Model Tax Convention in 2008, provides that, in mutual agreement procedure cases in which the competent authorities are unable to reach an agreement within two years of the initiation of the case under paragraph 1 of Article 25, the unresolved issues will, at the request of the person who presented the case, be resolved through an arbitration process. This extension of the mutual agreement procedure ensures that where the competent authorities cannot reach an agreement on one or more issues that prevent the resolution of a case, a resolution of the case will still be possible by submitting those issues to arbitration. Where one or more issues have been submitted to arbitration in accordance with such a provision, and unless a person directly affected by the case does not accept the mutual agreement that implements the arbitration decision, that decision shall be binding on both States, the taxation of any person directly affected by the case will have to conform with the decision reached on the issues submitted to arbitration and the decisions reached in the arbitral process will be reflected in the mutual agreement that will be presented to these persons. Where a particular bilateral treaty does not contain an arbitration provision similar to paragraph 5 of Article 25, the competent authorities are not obliged to reach an agreement to resolve their dispute; paragraph 2 of Article 25 requires only that the competent authorities “endeavour … to resolve the case by mutual agreement”. The competent authorities may be unable to come to an agreement because of conflicting domestic laws or restrictions imposed by domestic law on the tax administration’s power of compromise. Even in the absence of a mandatory binding arbitration provision similar to paragraph 5 of Article 25 in a particular bilateral treaty, however, the competent authorities of the Contracting States may by mutual agreement establish a binding arbitration procedure for general application or to deal with a specific case (see paragraph 69 of the Commentary on Article 25 of the OECD Model Tax Convention). It should also be noted that a multilateral Convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises2 (the Arbitration Convention) was signed by the Member States of the European Communities on 23 July 1990; the Arbitration Convention, which entered into force on 1 January 1995, provides for an arbitration mechanism to resolve transfer pricing disputes between European Union Member States.
To eliminate double taxation in transfer pricing cases, tax administrations may consider requests for corresponding adjustments as described in paragraph 2 of Article 9. A corresponding adjustment, which in practice may be undertaken as part of the mutual agreement procedure, can mitigate or eliminate double taxation in cases where one tax administration increases a company’s taxable profits (i.e. makes a primary adjustment) as a result of applying the arm’s length principle to transactions involving an associated enterprise in a second tax jurisdiction. The corresponding adjustment in such a case is a downward adjustment to the tax liability of that associated enterprise, made by the tax administration of the second jurisdiction, so that the allocation of profits between the two jurisdictions is consistent with the primary adjustment and no double taxation occurs. It is also possible that the first tax administration will agree to decrease (or eliminate) the primary adjustment as part of the consultative process with the second tax administration, in which case the corresponding adjustment would be smaller (or perhaps unnecessary). It should be noted that a corresponding adjustment is not intended to provide a benefit to the MNE group greater than would have been the case if the controlled transactions had been undertaken at arm’s length conditions in the first instance.
Paragraph 2 of Article 9 specifically provides that the competent authorities shall consult each other if necessary to determine appropriate corresponding adjustments. This confirms that the mutual agreement procedure of Article 25 may be used to consider corresponding adjustment requests. See also paragraph 10 of the Commentary on Article 25 of the OECD Model Tax Convention (“… the corresponding adjustments to be made in pursuance of paragraph 2 of [Article 9] … fall within the scope of mutual agreement procedure, both as concerns assessing whether they are well-founded and for determining their amount.” However, the overlap between the two Articles has caused OECD member countries to consider whether the mutual agreement procedure can be used to achieve corresponding adjustments where the bilateral income tax convention between two Contracting States does not include a provision comparable to paragraph 2 of Article 9. Paragraphs 11 and 12 of the Commentary on Article 25 of the OECD Model Tax Convention expressly state the view of most OECD member countries that the mutual agreement procedure is considered to apply to transfer pricing adjustment cases, including issues of whether a corresponding adjustment should be provided, even in the absence of a provision comparable to paragraph 2 of Article 9. Paragraph 12 notes that those States that do not agree with this view in practice find means of remedying economic double taxation in most cases involving bona fide companies by making use of provisions in their domestic laws.
Under paragraph 2 of Article 9, a corresponding adjustment may be made by a Contracting State either by recalculating the profits subject to tax for the associated enterprise in that country using the relevant revised price or by letting the calculation stand and giving the associated enterprise relief against its own tax paid in that State for the additional tax charged to the associated enterprise by the adjusting State as a consequence of the revised transfer price. The former method is by far the more common among OECD member countries.
In the absence of an arbitration decision arrived at pursuant to an arbitration procedure comparable to that provided for under paragraph 5 of Article 25 which provides for a corresponding adjustment, corresponding adjustments are not mandatory, mirroring the rule that tax administrations are not obliged to reach agreement under the mutual agreement procedure. Under paragraph 2 of Article 9, a tax administration should make a corresponding adjustment only insofar as it considers the primary adjustment to be justified both in principle and in amount. The non- mandatory nature of corresponding adjustments is necessary so that one tax administration is not forced to accept the consequences of an arbitrary or capricious adjustment by another State. It also is important to maintaining the fiscal sovereignty of each OECD member country.
Once a tax administration has agreed to make a corresponding adjustment it is necessary to establish whether the adjustment is to be attributed to the year in which the controlled transactions giving rise to the adjustment took place or to an alternative year, such as the year in which the primary adjustment is determined. This issue also often raises the question of a taxpayer’s entitlement to interest on the overpayment of tax in the jurisdiction which has agreed to make the corresponding adjustment (discussed in paragraphs 4.65-4.67). The first approach is more appropriate because it achieves a matching of income and expenses and better reflects the economic situation as it would have been if the controlled transactions had been at arm’s length. However, in cases involving lengthy delays between the year covered by the adjustment and the year of its acceptance by the taxpayer or a final court decision, the tax administration should have the flexibility to agree to make corresponding adjustments for the year of acceptance of or decision on the primary adjustment. This approach would need to rely on domestic law for implementation. While not ordinarily preferred, it could be appropriate as an equitable measure in exceptional cases to facilitate implementation and to avoid time limit barriers.
Corresponding adjustments can be a very effective means of obtaining relief from double taxation resulting from transfer pricing adjustments. OECD member countries generally strive in good faith to reach agreement whenever the mutual agreement procedure is invoked. Through the mutual agreement procedure, tax administrations can address issues in a non-adversarial proceeding, often achieving a negotiated settlement in the interests of all parties. It also allows tax administrations to take into account other taxing rights issues, such as withholding taxes.
At least one OECD member country has a procedure that may reduce the need for primary adjustments by allowing the taxpayer to report a transfer price for tax purposes that is, in the taxpayer’s opinion, an arm’s length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises. This adjustment, sometimes known as a “compensating adjustment”, would be made before the tax return is filed. Compensating adjustments may facilitate the reporting of taxable income by taxpayers in accordance with the arm’s length principle, recognising that information about comparable uncontrolled transactions may not be available at the time associated enterprises establish the prices for their controlled transactions. Thus, for the purpose of lodging a correct tax return, a taxpayer would be permitted to make a compensating adjustment that would record the difference between the arm’s length price and the actual price recorded in its books and records.
However, compensating adjustments are not recognised by most OECD member countries, on the grounds that the tax return should reflect the actual transactions. If compensating adjustments are permitted (or required) in the country of one associated enterprise but not permitted in the country of the other associated enterprise, double taxation may result because corresponding adjustment relief may not be available if no primary adjustment is made. The mutual agreement procedure is available to resolve difficulties presented by compensating adjustments, and competent authorities are encouraged to use their best efforts to resolve any double taxation which may arise from different country approaches to such year- end adjustments.
While corresponding adjustment and mutual agreement procedures have proved to be able to resolve most transfer pricing conflicts, serious concerns have been expressed by taxpayers. For example, because transfer pricing issues are so complex, taxpayers have expressed concerns that there may not be sufficient safeguards in the procedures against double taxation. These concerns are mainly addressed with the introduction in the 2008 update of the OECD Model Tax Convention of a new paragraph 5 to Article 25 which introduces a mechanism that allows taxpayers to request arbitration of unresolved issues that have prevented competent authorities from reaching a mutual agreement within two years. There is also in the Commentary on Article 25 a favourable discussion of the use of supplementary dispute resolution mechanisms in addition to arbitration, including mediation and the referral of factual disputes to third party experts.
Taxpayers have also expressed fears that their cases may be settled not on their individual merits but by reference to a balance of the results in other cases. An established good practice is that, in the resolution of mutual agreement cases, a competent authority should engage in discussions with other competent authorities in a principled, fair, and objective manner, with each case being decided on its own merits and not by reference to any balance of results in other cases. To the extent applicable, these Guidelines and proposals detailed in the Report on BEPS Action 14 (bearing in mind the difference between the minimum standard and best practices) are an appropriate basis for the development of a principled approach. Similarly, there may be a fear of retaliation or offsetting adjustments by the country from which the corresponding adjustment has been requested. It is not the intention of tax administrations to take retaliatory action; the fears of taxpayers may be a result of inadequate communication of this fact. Tax administrations should take steps to assure taxpayers that they need not fear retaliatory action and that, consistent with the arm’s length principle, each case is resolved on its own merits. Taxpayers should not be deterred from initiating mutual agreement procedures where Article 25 is applicable.
Concerns that have been expressed regarding the mutual agreement procedure, as it affects corresponding adjustments, include the following, which are discussed separately in the sections below:
A fundamental concern with respect to the mutual agreement procedure as it relates to corresponding adjustments is the failure to grant access to the mutual agreement procedure for transfer pricing cases. The undertaking to resolve by mutual agreement cases of taxation not in accordance with the Convention is an integral part of the obligations assumed by a Contracting State in entering into a tax treaty and must be performed in good faith. The failure to grant mutual agreement procedure access with respect to a treaty partner’s transfer pricing adjustments, may frustrate a primary objective of tax treaties. The work on Action 14 of the BEPS Action Plan directly addressed concerns related to the denial of access to the mutual agreement procedure with respect to a treaty partner’s transfer pricing adjustments by including, as element 1.1 of the Action 14 minimum standard, a commitment to provide access to the mutual agreement procedure in transfer pricing cases.
The Action 14 minimum standard also comprises a number of other elements intended to address more generally concerns related to the denial of access to the mutual agreement procedure. These include: a commitment to provide access to the mutual agreement procedure in cases in which there is a disagreement between the taxpayer and the tax authorities making an adjustment as to whether the conditions for the application of a treaty anti-abuse provision have been met or as to whether the application of a domestic law anti-abuse provision is in conflict with the provisions of a treaty (element 1.2); a commitment to publish rules, guidelines and procedures regarding the mutual agreement procedure (element 2.1) and to identify in that guidance the specific information and documentation that a taxpayer is required to submit with a request for mutual agreement procedure assistance (element 3.2); a commitment to clarify that audit settlements between tax authorities and taxpayers do not preclude access to the mutual agreement procedure (element 2.6); and a commitment to ensure that both competent authorities are made aware of requests for mutual agreement procedure assistance by either (i) amending Article 25(1) to permit requests to be made to the competent authority of either Contracting State or (ii) implementing a bilateral notification or consultation process for cases in which the competent authority to whom the case is presented does not consider the taxpayer’s objection to be justified (element 3.1).
Relief under paragraph 2 of Article 9 may be unavailable if the time limit provided by treaty or domestic law for making corresponding adjustments has expired. Paragraph 2 of Article 9 does not specify whether there should be a time limit after which corresponding adjustments should not be made. Some countries prefer an open-ended approach so that double taxation may be mitigated. Other countries consider the open-ended approach to be unreasonable for administrative purposes. Thus, relief may depend on whether the applicable treaty overrides domestic time limitations, establishes other time limits, or links the implementation of relief to the time limits prescribed by domestic law.
Time limits for finalising a taxpayer’s tax liability are necessary to provide certainty for taxpayers and tax administrations. In a transfer pricing case a country may under its domestic law be legally unable to make a corresponding adjustment if the time has expired for finalising the tax liability of the relevant associated enterprise. Thus, the existence of such time limits and the fact that they vary from country to country should be considered in order to minimise double taxation.
Paragraph 2 of Article 25 of the OECD Model Tax Convention addresses the time limit issue by requiring that any agreement reached by the competent authorities pursuant to the mutual agreement procedure shall be implemented notwithstanding the time limits in the domestic law of the Contracting States. Paragraph 29 of the Commentary on Article 25 recognises that the last sentence of Article 25(2) unequivocally states the obligation to implement such agreements (and notes that impediments to implementation that exist at the time a tax treaty is entered into should generally be built into the terms of the agreement itself). Time limits therefore do not impede the making of corresponding adjustments where a bilateral treaty includes this provision. Some countries, however, may be unwilling or unable to override their domestic time limits in this way and have entered explicit reservations on this point. OECD member countries therefore are encouraged as far as possible to extend domestic time limits for purposes of making corresponding adjustments when mutual agreement procedures have been invoked.
Where a bilateral treaty does not override domestic time limits for the purposes of the mutual agreement procedure, tax administrations should be ready to initiate discussions quickly upon the taxpayer’s request, well before the expiration of any time limits that would preclude the making of an adjustment. Furthermore, OECD member countries are encouraged to adopt domestic law that would allow the suspension of time limits on determining tax liability until the discussions have been concluded.
The work on Action 14 of the BEPS Action Plan directly addresses the obstacle that domestic law time limits may present to effective mutual agreement procedures. Element 3.3 of the Action 14 minimum standard includes a recommendation that countries should include the second sentence of paragraph 2 of Article 25 in their tax treaties to ensure that domestic law time limits (1) do not prevent the implementation of competent authority mutual agreements and (2) do not thereby frustrate the objective of resolving cases of taxation not in accordance with the Convention.
Where a country cannot include the second sentence of paragraph 2 of Article 25 in its tax treaties, element 3.3 of the Action 14 minimum standard states that it should be willing to accept an alternative treaty provision that limits the time during which a Contracting State may make an adjustment pursuant to Article 9(1), in order to avoid late adjustments with respect to which mutual agreement procedure relief will not be available. Such a country would satisfy this element of the minimum standard where the alternative treaty provision was drafted to reflect the time limits for adjustments provided for in that country’s domestic law. That alternative provision, as presented in the Report on BEPS Action 14, reads as follows: [In Article 9]:
3. A Contracting State shall not include in the profits of an enterprise, and tax accordingly, profits that would have accrued to the enterprise but by reason of the conditions referred to in paragraph 1 have not so accrued, after [bilaterally agreed period] from the end of the taxable year in which the profits would have accrued to the enterprise. The provisions of this paragraph shall not apply in the case of fraud, gross negligence or willful default.
Element 3.3 of the Action 14 minimum standard also states that such a country accept a similar alternative provision in Article 7 with respect to adjustments to the profits that are attributable to a permanent establishment.