INSIGHT

Mandatory binding arbitration of tax disputes

By Martin Fry, Thomas Ickeringill
Dispute Resolution Tax Tax Disputes

In brief

This is a guide to the process, procedure and effect of mandatory binding arbitration under Australia's tax treaty network.

At the timing of writing, two of Australia's double taxation agreements (DTAs, in this instance - Germany and Switzerland) have been renegotiated to contain express arbitration provisions.

The remaining DTAs allow for arbitration only where:

  • they have been amended by the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI); and
  • both contracting jurisdictions accept the optional arbitration provisions1 –  this currently includes the United Kingdom, Canada, Singapore and New Zealand.

Not all DTAs have been amended by the MLI2 (at present, this includes the United States) and not all contracting states have accepted the optional arbitration provisions3 (at present, this includes China).

As the vast majority of Australia's DTAs are modelled on the OECD's Model Tax Convention on Income and Capital (MTC), as amended from time to time, any references to articles will be references to the 2017 version of the MTC. However, as the specific wording of each DTA may differ from that provided in the MTC, it is important to scrutinise the specific wording of the relevant DTA in each case.

The competent authority and mutual agreement procedure (MAP)

Under article 25 of the MTC, a taxpayer may apply for MAP where there has been, or there will be, double taxation. There must be a probability, not merely a possibility, of double taxation.4 In most cases, this will be the date of the Australian Taxation Office (ATO) issuing a notice of amended assessment following a transfer pricing audit, but it may arise earlier provided it is probable that double taxation will arise (eg, the ATO issuing its statement of audit position).

When a taxpayer applies for MAP, the competent authorities (CAs) must endeavour to resolve the dispute by mutual agreement. In Australia, the CA function is performed by the ATO, albeit by a team that is functionally and operationally separate from the audit team.

During MAP, the CAs may ask (or compel) the taxpayer to provide information or access to documents or witnesses. Whilst CAs are not compelled to reach agreement, they are required to use their 'best endeavours' to negotiate an outcome that alleviates double taxation.5 Although there is no predetermined 'form' of MAP, negotiations typically take place via email and periodic teleconferences between the CAs.

The taxpayer is not a party to these negotiations, but is expected to remain in close contact with both CAs. Taxpayers may play a passive role during the MAP process responding only if and when required, but it is generally advisable for taxpayers to maintain an active dialogue with both CAs during MAP.


Background to mandatory binding arbitration

Historically, the primary problem with MAP has been its inability to compel the CAs to reach agreement in a timely fashion or at all. This means that some MAP cases are not resolved efficiently, or in some cases ever. These concerns contributed to the advent of BEPS Action 14, which called for greater certainty and predictability for business by improving the effectiveness of MAP and raising the possibility of mandatory binding arbitration.

The work undertaken by the OECD and the Inclusive Framework on BEPS Action 14 culminated in the inclusion of Part VI in the MLI. Under article 18 of the MLI, jurisdictions may choose to incorporate Part VI into their existing DTAs where the other contracting jurisdiction simultaneously chooses to incorporate Part VI into their DTA with Australia.

Triggering mandatory binding arbitration

Under article 19 of the MLI, a taxpayer can refer a MAP dispute to arbitration if the dispute has remained unresolved for two years.6 Arbitration is triggered by the taxpayer making a request in writing to one of the CAs. For the purpose of calculating the two-year period, the relevant starting date is:

  • the date on which both CAs notify the taxpayer that they have received enough information to undertake a substantive consideration of the MAP dispute; or
  • if earlier, where neither CA requests further information – three months after the CA to which the request to commence MAP was made notified the other CA of the request; and
  • where either CA requests further information – three months after both CAs have received all requested information from the taxpayer.

The two-year period may be altered by agreement by the CAs, or may be extended if the CAs agree that the taxpayer has failed to provide information in a timely manner. The two-year period may also temporarily stop running if MAP is suspended by agreement of the CAs or because a case dealing with the same issues is pending before a domestic court or tribunal.

In the event the Commissioner makes a transfer pricing adjustment following an audit of a notice of amended assessment, the taxpayer must object to the assessment if it disagrees with it. Once the taxpayer objects, the Commissioner is then expected to make a decision on the taxpayer's objection, at which point the taxpayer will typically wish to appeal. This triggers domestic litigation and, therefore, potentially suspends the two-year period.

Strategically, because the time period stops running where a case dealing with the same issues is pending before a domestic court or tribunal, the taxpayer must consider whether and how to proceed with MAP and arbitration while still leaving the possibility of domestic adjudication open.

Australia has reserved its right to exclude from mandatory binding arbitration any case to the extent that it involves the application of Part IVA of the Income Tax Assessment Act 1936 (Cth). Therefore, even where double taxation arising from a transfer pricing dispute is subject to MAP and is facing international arbitration, there remains the prospect of domestic litigation running concurrently if Part IVA is potentially applicable. It is important to note that Part IVA contains not only Australia's longstanding general anti-avoidance rules (GAAR), but also:

  • Australia's specific transfer pricing anti-avoidance rule, known as the diverted profits tax (DPT), which seeks to ensure that the Australian tax payable by large multinational groups reflects the economic substance of the activities they carry on in Australia; and
  • Australia's specific permanent establishment profit attribution anti-avoidance rule, commonly known as the multinational anti-avoidance law (MAAL), which seeks to counteract schemes designed to limit a taxable presence in Australia.

The panel of arbitrators

Article 20 of the MLI provides that the arbitration panel is comprised of three individuals with expertise or experience in international tax matters. Each panel member must be impartial and independent of the CAs, the ministries of finance of the relevant countries, the taxpayer, and each of their advisors.

Each CA must select one panel member within 60 days of the request for arbitration. There are no restrictions on the nationality or residence of the relevant panel member. If either CA fails to appoint a panel member within 60 days, the Centre for Tax Policy and Administration (CTPA) of the OECD may be called upon to appoint a panel member.

The two panel members chosen by the CAs must select a third panel member to serve as Chair of the arbitration panel within 60 days of their appointment. The Chair cannot be a citizen or resident of either country to the dispute. If the panel members fail to appoint a Chair within 60 days, the CTPA of the OECD may similarly be called upon to appoint a Chair.

How an arbitration is run

Article 23 of the MLI provides for two alternate types of arbitration. The first type, final offer arbitration (commonly known as 'baseball arbitration'), is the default form of arbitration. The second type, independent opinion arbitration, may be selected instead of independent offer arbitration. Japan and Malta are the only two jurisdictions with which Australia has agreed to apply independent opinion arbitration.

The MLI provides a skeleton of the procedure to be followed in an arbitration. It is up to the CAs to agree the detailed rules and processes that will be followed, set out in memoranda of understanding (MoUs) between the CAs and expected to be made public.

In negotiating these MoUs, the CAs will draw upon the sample mutual agreement annexed to OECD commentary on article 25 (MTC Sample Agreement). Moreover, the procedure used in European tax arbitrations under the European Arbitration Convention,7 as set out in the relevant Directive,8 is likely to provide insight into the  form of MoUs between Australia and Member States of the European Union.

Final offer arbitration

Requires each CA to submit a proposed resolution to the issues in dispute. The arbitration panel then decides which proposed resolution it prefers with respect to each unresolved issue. The procedure of final offer arbitration is as follows:

Terms of reference

It is generally considered best practice for the CAs to set up terms of reference for the dispute. This would set out the key legal and factual issues in relation to which the CAs agree, and disagree, in order to highlight the matter(s) to be resolved by the panel. The MTC Sample Agreement notes it would be useful to involve the taxpayer in this process.

Proposed resolutions

Each CA must submit to the arbitration panel a written proposed resolution addressing all unresolved issues in dispute.

The proposed resolutions:

  • must be each CA's best and final offer on the monetary amounts;
  • is supported by a position paper containing, at a minimum, the key facts, the case made by the taxpayer, the CA's view of the merits of the taxpayer's case, how the CA proposes to resolve the dispute and the supporting arguments and evidence relied upon by the CA.

Where a case contains disputed threshold questions, such as whether a permanent establishment exists, the CAs may submit alternative proposed resolutions in respect of issues which are contingent on the determination of a threshold question.

The proposed resolutions of the CAs must be submitted by a date set by mutual agreement. Except in unusual circumstances, the MTC Sample Agreement's suggestion of a date 60 days after the panel has been established is generally appropriate.

Reply

Each CA is expected to deliver a submission addressing the proposed resolution of the other CA (and supporting position paper).

The reply must be submitted by a date set by mutual agreement. Except in unusual circumstances, the MTC Sample Agreement's suggestion of a date 60 days after the submission of the proposed resolutions (and supporting position papers) has been made is generally appropriate.

Arbitration

It is generally expected that final offer arbitration will be conducted entirely by paper.

The panel may convene a physical or virtual meeting with the CAs to clarify points of law or fact, but the actual arbitration is unlikely to entail a formal hearing.

The panel itself may meet physically or virtually to discuss the issues and reach a majority verdict, but neither the CAs nor the taxpayer take part in this process.

After the panel has considered the CAs' proposed resolutions, position papers and replies, it selects the proposed resolution it prefers in respect of each issue.

The defining feature of final offer arbitration is that the panel cannot propose a different resolution to those submitted by the parties. Rather, it is limited to selecting one of the two proposed solutions.

It is expected that the panel will arrange a teleconference in which the decision will first be communicated. The decisions must then be delivered in writing without any reasoning or explanation of the decision.

In line with the MTC Sample Agreement, it is generally considered best practice for the panel to hand down the decision within 60 days of the submission of the replies.

Independent opinion arbitration

Independent opinion arbitration is more akin to traditional commercial adjudication. The procedure of independent opinion arbitration is as follows:

Provision of information that may be necessary for the arbitration

Independent opinion arbitration requires each CA to submit to each arbitration panel member any information that may be necessary for the arbitration. Unless agreed otherwise, any information that was not available to the CAs prior to the request for arbitration is not to be taken into account. It is expected that the information provided includes, at a minimum, the key facts, the unresolved issues, the positions of the CAs and the supporting arguments and evidence relied upon by the CAs.

Arbitration

Consistent with the MTC Sample Agreement, it is considered best practice for the panel, once established, to hold one or more physical or virtual meetings with the CAs. These meetings are likely to take the form of a formal hearing in which the CAs have the opportunity to clarify their positions, articulate the arguments in support of them and rebut the assertions of the other CA.

Given the highly factual nature of transfer pricing disputes, the procedural and evidentiary rules to be set out in the MoUs are expected to cover the following matters:

  • Whether the taxpayer may make a formal submission to the arbitration panel. Given the taxpayer is directly affected by the decision, it would be appropriate for the taxpayer to play an active role in the meeting. This is consistent with European arbitration, whereby the taxpayer can provide any information, evidence or documents for consideration and appear before the arbitration panel.
  • Whether examination-in-chief, cross-examination and re-examination are permitted. Although this may increase the procedural complexity of the arbitration, it is generally accepted that the taxpayer is best placed to provide evidence on any facts in dispute.

Although the MoUs are yet to be finalised, the direct involvement of the taxpayer will increase the likelihood of the taxpayer accepting the arbitration decision. Even if the MoUs do not specify a formal role for the taxpayer, it may still be able to influence the arbitration through regular engagement during not only the arbitration process, but also the MAP process.

Decision

The arbitration panel decides on the resolution of each issue. The decision will be constituted by a simple majority of the arbitration panel members. Decisions are delivered in writing and indicate the sources of law relied upon and the reasoning on which the decision was based.

In line with the MTC Sample Agreement, it is generally considered best practice for the panel to deliver the decision within 365 days of the panel being established. Although the OECD commentary does not specify whether the decision must be provided to the taxpayer, to do so is consistent with principles of transparency and open justice given the taxpayer is directly affected by the decision.

The arbitration will terminate in certain circumstances

The arbitration will be terminated where, before the arbitration panel makes a decision, any of the following occurs:

  • a decision concerning the issues being arbitrated is rendered by a domestic court or tribunal;
  • the CAs settle the dispute by reaching a mutual agreement to resolve the issues in dispute; or
  • the taxpayer withdraws its request for arbitration or MAP.

 

Implementation and effect of the arbitration decision

Historically, the primary problem with MAP has been its inability to compel the CAs to reach agreement in a timely fashion or at all. This means that some MAP cases are not resolved efficiently, or in some cases at all. These concerns contributed to the advent of BEPS Action 14, which called for greater certainty and predictability for business by improving the effectiveness of MAP and raising the possibility of mandatory binding arbitration.

The work undertaken by the OECD and the Inclusive Framework on BEPS Action 14 culminated in the inclusion of Part VI in the MLI. Under article 18 of the MLI, jurisdictions may choose to incorporate Part VI into their existing DTAs where the other contracting jurisdiction simultaneously chooses to incorporate Part VI into their DTA with Australia. 

Additional considerations

Further it is worth considering:

  • Precedential value: Decisions of arbitration panels do not have any precedential value and are only binding in relation to the specific issues addressed.
  • Confidentiality: Information given and received during arbitration is treated as 'secret' in the same manner as information obtained by the CAs under their respective domestic laws. The CAs are responsible for ensuring that members of the arbitration panel and their assistants agree to this confidentiality obligation in writing prior to acting in the arbitration proceedings. Each person that presented the case and their advisors must also agree in writing not to disclose any information received during the course of the arbitration proceedings.
  • Costs: Each CA is expected to bear its own costs, the costs of its appointed panel member and half of the costs of the Chair.

Footnotes

  1. As at the time of writing, Belgium, Canada, Denmark, Finland, France, Ireland, Japan, Malta, Netherlands, New Zealand, Singapore and the United Kingdom. Arbitration provisions are expected to come into effect in relation to Australian disputes with Fiji, Italy, Papua New Guinea and Spain in the near future.

  2. As at the time of writing, Austria, Israel, Kiribati, the Philippines, Sri Lanka, Sweden, Taiwan, Thailand, the United States and Vietnam.

  3. As at the time of writing, Argentina, Chile, China, Czech Republic, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Norway, Poland, Romania, Russia, Slovakia, South Africa and Turkey.

  4. MTC 2017, Commentaries, Art 25, [14].

  5. MTC 2017, Commentaries, Art 25, [37].

  6. States can opt to extend this period to three years. As at the time of writing, the Australia–France DTA is the only DTA with a three year time period.

  7. Convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises (90/463/EEC).

  8. Council Directive (EU) 2017/1852 of 10 October 2017 on tax dispute resolution mechanisms in the European Union.