Authors: Sriram P. Govind & Anjali Venugopal1.
The power of a State to impose an income tax burden on a person is attributable to its sovereignty. The sovereignty of a State with respect to taxation is dependant on the connection of income to the concerned person. Such a connection or nexus can be either personal or objective. For a natural person, this personal connection is usually owing to his residence, domicile or citizenship. For an artificial person with legal personality, the place of incorporation or place of effective management is usually considered a personal connection2. On the other hand, an objective connection is usually established when there is a nexus between the State and the stream of income, usually in cases where an income is sourced in the State. States can impose such sovereignty based on objective connection on a broad basis through legislation through propositions such as ‘effectively connected’3))income or income with a ‘business connection’4. The personal and objective connection of an income for establishing tax sovereignty are rarely exclusive of each other, and in many cases this leads to the same transaction being taxed in two or more states. Hence, arises the problem of double taxation5.
Liability of a person for taxation can be of two types – full tax liability and limited tax liability. In cases where a transaction has a personal connection between the person involved and the State, the State reserves the right to tax the person’s worldwide income6. This is called full tax liability. In cases where there is an objective connection between the stream of income and the State, only the income earned in the State is taxed. This is called limited tax liability7. This is what leads to the incidence of double taxation as the resident of a particular State gets taxed by that State owing to his residence (personal connection) and by the State where he earns his income owing to the income being sourced there (objective connection) for the same transaction. Such a case where one person gets taxed for the same income by different States is known as ‘juridical double taxation’8. Another form of double taxation arises when the same income is taxed in the hands of different persons. Such a situation is known as ‘economic double taxation’. Transfer pricing cases are the best examples of economic double taxation9.
Double taxation, whether juridical or economic, poses a serious threat to the economic relations between States since trade and investment can only be facilitated by lowering the overall tax burden on a transaction. While most contracting States have implemented unilateral rules to provide relief from double taxation, they have become incapable of avoiding jurisdictional overlaps in light of the increasing volume of cross-border transactions10. Many states therefore enter into bilateral tax treaties in order to eliminate instances of double taxation. These are referred to as Double Taxation Avoidance Agreements (DTAA). The primary purpose of such an agreement is to allocate exclusive taxing rights to one of the jurisdictions with respect to a particular transaction.
Points to remember
- 1 The Need for Alternative Dispute Resolution Mechanisms in International Tax Disputes
- 2 Resolution of Disputes under Tax Treaties: The Mutual Agreement Procedure
- 3 Arbitration under The Mutual Agreement Procedure: The 2008 OECD Model
- 4 Implementation of the Arbitration Provision: A Global Perspective
- 5 Conclusion: The Indian Perspective
The Need for Alternative Dispute Resolution Mechanisms in International Tax Disputes
The proliferation of Double Taxation Avoidance Agreements has created a new branch of tax law. As has been detailed above, these agreements come into play when a resident of one state has income sourced in another state. The problem mostly lies in the interpretation of various provisions of these treaties. Most tax treaties, on a global level, are modeled based on 3 model conventions – the OECD Model convention (mostly for developed nations), the UN Model convention (mostly for developing nations) and the US Model convention (for treaties entered into by the United States of America. Although all 3 conventions have their own unique way of treating certain incomes, they are principally similar, if not identical. Hence, as stated oft and now by Prof. Avi-Yonah11, International taxation is more or less a part of International law in the sense that treaties entered into by various nations are analogous to each other, which calls for a certain degree of uniformity. On most occasions, the provisions in most treaties are even worded in an exactly congruent manner. Notwithstanding this, as has always been with International law, the sovereignty of States allowing them to adjudicate on disputes within their territory in their own Courts has come in the way of this uniformity.
To term it in an undemanding fashion, Courts are interpreting similar provisions with similar phraseology all over the world in dissimilar fashion. Thus, there is no uniformity in interpretation of tax treaties and thus, no conclusive, accepted body for international tax jurisprudence as such. The major problem in this is that Courts, on a global level, have different attitudes towards law and interpretation of statutes and this varies from territory to territory. Interpretation of tax treaties is incidental to normal adjudication for courts and interpretation varies from system to system i.e. common law systems and civil law systems. Tax treaties transcend national law and become international law, and there is no single body like the ICJ to deal specifically with international tax cases and hence, there is no uniformity as such in tax jurisprudence12.
Although the tax treaties entered into by the respective nations deal with the question of allocation of taxing rights in most cases, the more pressing issue arises when a taxpayer is unhappy with the application of the treaty on his income. It is important to note that owing to a person’s residence, which provides for a person’s territorial nexus with a State, all disputes in relation to his income can be resolved in the domestic courts or tribunals via the various mechanisms provided for under the domestic law. Since international Tax Law is essentially a branch of International Law, there is always the possibility of disparity in the treatment of income in both jurisdictions concerned, especially since Courts in different jurisdictions are prone to interpret provisions in different ways13. In this light, it becomes necessary that in addition to the multitude of remedies offered to the taxpayer via the domestic courts, a more neutral remedy be provided.
Resolution of Disputes under Tax Treaties: The Mutual Agreement Procedure
As has been detailed above, although domestic remedies are available, the tax treaties themselves provide for a wholly exclusive remedy for taxpayers in form of the Mutual Agreement Procedure (hereinafter referred to as MAP), provided for under Article 25 of the Model Conventions. This can be considered a neutral method of tax treaty dispute resolution14. Let us first discuss the classical MAP, before proceeding to the amended MAP as under the 2008 OECD Model.
The MAP is initiated at the request of any taxpayer who claims that his income has not been taxed in accordance with the provisions of the treaty. Therefore, even if there is no double taxation, any taxpayer who feels that his income has been taxed in a way that is not permitted by the treaty could utilize the MAP provision15. Moreover, it is important to note that the MAP is provided in addition to the various domestic remedies available to the taxpayer and that he could utilize such remedies concurrently. Under the MAP, the taxpayer addresses his claim to the ‘competent authority’ of the State in which he or it is resident. If the competent authority is satisfied with the veracity of the claim and concludes that he cannot remedy it himself, it is upon him to present the claim to the competent authority of the other contracting State. As per the treaty, they shall ‘endeavour’ to find a solution16. Once a problem has been resolved, if the taxpayer accepts such decision, it shall be implemented irrespective of any limitations that are placed by domestic law.
Therefore, although the taxpayer initiates the procedure, it involves the competent authorities of both States as parties. Therefore, the method in which they devise a solution is completely at their discretion. Furthermore, since the term used in Article 25 is ‘endeavour’, the procedure can be wholly terminated if the authorities fail to devise an appropriate solution. Although there is no infallible interpretation that can be ascribed to this expression, what is apparent is that, the only obligation placed upon the competent authorities is to negotiate and use the best of their abilities to resolve the problem.
There are various apparent drawbacks in the classical system. Firstly, there is no fixed duration in which this procedure is to be completed in. Thus, the process many involve undue delay, which might result in a large amount of expenditure for the taxpayer (in the form of legal fees etc.) Secondly, as mentioned above, there is no guarantee of the dispute being resolved. Thirdly, even if the dispute is resolved, since the competent authorities are parties to the procedure and as the taxpayer is not involved, it may result in an unfavourable solution. Thus, one of the biggest drawbacks of this system is the lack of natural justice in its implementation, since the taxpayer receives no opportunity to present his case or defend himself based on any document that is used against him. Moreover, many taxpayers opt out of the system owing to the lack of transparency in the decision making process, as there is no compulsion on the authorities to give legally reasoned decisions17.
Thus, the MAP system has faced a lot of criticism from the business community owing to its lack of assurance, transparency and finality. Moreover, out of millions of cross-border transactions that take place every year, one can only find a few 100 MAP cases, and fewer amongst them in which a successful solution has been arrived at. Subsequently, the OECD has initiated a working group to examine the efficacy of mutual agreement procedures, which also dealt with the assessment of alternative dispute resolution mechanisms18. After comprehensive research and consultation with various stakeholders, the OECD adopted an amendment, in 2008, which improved upon the MAP system by including mandatory arbitration within its ambit.
Arbitration under The Mutual Agreement Procedure: The 2008 OECD Model
It is only natural that arbitration would be considered as an evident answer to the problem of resolution of international tax disputes. Arbitration has long been the preferred dispute resolution mechanism for economic based agreements such as Bilateral Investment Treaties (BITs), the North American Free Trade Agreement (NAFTA) and the Vienna Convention on the International Sale of Goods. This comparison is appropriate as although areas such as international tax, trade and investment have their own water-tight compartments, all of these areas work at promoting cross-border economic activity19.
The growing popularity of mandatory arbitration for tax treaty dispute resolution has outlived every sovereign’s everlasting reticence towards ceding fiscal sovereignty. Historically, there have been several proposals over the years touting for mandatory arbitration to be introduced for resolution of International tax disputes. In 1981 Annual IFA Congress held in Berlin, Lindencrona and Mattsson, together with Francke laid down a proposal for mandatory arbitration to supplement the mutual agreement procedure. In their proposal, arbitration could be resorted only when all other remedies are exhausted. In order to implement this proposal, they also suggested the creation of an International Institute for Arbitration in tax disputes. Carl S. Shoup also believed in arbitration that was voluntary, but binding in cases involving transfer pricing disputes. The International Chamber of Commerce (ICC) has also played a pivotal role in the promotion of arbitration as a viable means to resolve international tax disputes. In 1984, they published a position paper describing the shortcomings of the MAP system and why mandatory arbitration would add strength to the system20. In 2003, the International Fiscal Association also released a model treaty article dealing with arbitration along with a Memorandum of Understanding for implementation of the same. Prior to 2008, the OECD model adopted the position that mandatory arbitration would unnecessarily compromise jurisdictional sovereignty over fiscal disputes. Nevertheless, owing to the shortfalls of the MAP system as has been pointed out earlier, the 2008 version of the OECD model included mandatory arbitration within its ambit by adding paragraph 5.
Paragraph 5 provides that in cases where a person has presented an application to the competent authority of a Contacting State on the basis that the tax imposed by either of the Contracting States have resulted in that person being taxed in a way that is not in accordance with the provisions of the convention and where the competent authorities are unable to resolve the case within two years from its presentation to the competent authority of the other Contacting State, any unresolved issues shall be submitted to arbitration if the person so requests. Hence, the term ‘shall’ denotes the mandatory nature of the arbitration provision, while it remains voluntary as it is activated only upon request21.
However, the case cannot be submitted to arbitration if a court or administrative tribunal of either State has already rendered a decision on the same issue. Unless any party to the case does not accept the mutual agreement that implements the arbitration decision, the decision shall be binding on both Contracting States and shall be implemented notwithstanding any time limits in the domestic laws of these States.
It is interesting to note that the arbitration provision in the OECD Model differs largely from other commercial arbitrations to the extent that a lot of power and control is still in the hands of the competent authorities. Unlike arbitrations under other treaties, like Bilateral Investment Treaties (BITs), it is a supplementary remedy in tax treaties, in addition to the MAP procedure. In tax treaty arbitration, the arbitrators do not decide the case as such, but only on the issues presented to them. Eventually the determination of the case is in the hands of the competent authorities, who have to close the MAP. It is also pertinent to note that since only unresolved issues are submitted to arbitration, even pending arbitration, the competent authorities can arrive at a resolution, thus revoking the authority of the arbitral panel. The taxpayer has no involvement in the appointment of the panel either as this is again a responsibility conferred on the competent authorities. Nevertheless, if the panel allows, the taxpayer is allowed to make written or oral submissions, which makes this process more in line with the principles of natural justice. It is also to be noted that preliminary issues that are already decided by the competent authorities are binding on the arbitral panel22.
This may perhaps be a mechanism to reinforce the fact that the jurisdictional sovereignty of either of the States involved has not been compromised. The OECD Model Commentary for Para 5 of Article 25 provides further clarity as to the application of the mandatory arbitration provision. Certain points that can be noted from the Commentary have been listed below23:
• The mandatory arbitration provision should be effectuated in cases where there is no resolution of disputes under the classical MAP system provided for in paras 1 to 4 of Article 25. Nevertheless, if the competent authorities reach an agreement as to the matter in dispute through the classical system, para 5 cannot be invoked.
• It has been made clear that where the voluntary MAP process has not been made available in the tax treaties, the arbitration provision cannot be included.
• The time limit of 2 years is flexible and if the Contracting States deem fit, they can increase the time limit.
• The domestic law in certain countries does not allow resolution of disputes through arbitration. Para 5 cannot be added in treaties involving such countries.
• Although the decision made in the arbitration is binding on the Contracting parties with reference to the particular case, it serves as no precedent for future MAP proceedings.
• The arbitration panel should use expert opinion for resolution of disputes.
Therefore, in essence, tax treaty arbitration does away with the generally recognized limitations of the MAP system. In contrast to MAP, the arbitration process is more effective in avoiding double taxation and involves more taxpayer participation.
Implementation of the Arbitration Provision: A Global Perspective
The implementation of the provision has been growing steadily over the years. Initially, the arbitration provision was adopted in treaties involving States with a large amount of multi-lateral ties with each other like the United States-Canada treaty, the Australia-New Zealand treaty etc. This is in all probability because of the success of the provision depends on the negotiations between the respective competent authorities and where States have better ties, arbitration would remain more of a last resort.
In November, 2011, United Nations Committee of Experts on International Cooperation in Tax Matters adopted an update of UN Model Double Taxation Convention providing for mandatory arbitration in cases where disputes are not resolved by the MAP procedure. This has brought the UN Model in line with the OECD model to the extent that there is no disparity in the dispute resolution procedure in treaties signed by the developing and developed nations. Thus, the implementation of the provision has become easier, owing to the establishment of a uniform standard24.
Although the United States Model Convention does not contain an arbitration provision, several treaties entered into by the US in recent years have included a voluntary, mandatory, baseball-style arbitration provision. The American baseball arbitration system is where the two Contracting parties are asked to take opposing stands and where the arbitrator has to arrive at a decision based on one of these positions, leaving no real discretion to the arbitrator to go into the matter at hand25. The US-Germany treaty and the US-Belgium treaty, entered into in the year 2006, contain similar provisions in the MAP article. The US-France treaty entered into in 2009 also contains this provision. Similarly, Japan has embraced the mandatory arbitration provision in several of its treaties. The mandatory arbitration provision has been included in the new Japan-Netherlands treaty and the Japan-Hong Kong entered into in 2010. Another prominent example is Article 25A of the new France-Germany treaty.
Although arbitration is becoming increasingly accepted as a method for resolution of international tax disputes, one may notice that the developing nations such as India still show a fair degree of reservation towards inculcating this provision in their tax treaties. Most developing nations feel secure harbouring their investors and binding them by the Calvo doctrine, under which all disputes relating to an investor’s fiscal interests in the other State shall be dealt with by the courts of the source State. Thus, they are reluctant to relinquish their sovereignty by giving rights to a 3rd party arbitrator. Another reason why the arbitration provision has not been prominent in treaties involving developing nations is the lack of negotiation skills and business acumen in the competent authorities of these nations as compared to the developed nations. Since the arbitration provision gives all authority to the competent authority, developing nations are generally unwilling to introduce this provision. Another difficulty is the financial costs and burden placed on nations in the creation of a 3rd party arbitrator panel26.
Conclusion: The Indian Perspective
The Indian tax administration is appropriately famous for having a long arm when it comes to its taxation. This becomes even more accurate when we talk of cross-border transactions, involving tax treaties or transfer pricing. Although the domestic law in India provides for a multi-faceted dispute resolution device right from the administration to the Tribunal to the Courts, many taxpayers still find themselves disillusioned by the treatment meted out to their income. This is due to many reasons such as inconsistent interpretations by Courts, several changes in law with retrospective effect etc. Moreover, the many levels of tax adjudication in India provides for a lot of undue delay and expenditure, which might skew both the taxpayer’s chances of finding justice and also the veracity of tax jurisprudence coming out of a decision. India has seen more transfer pricing based disputes and litigation in the past 3 years than most other countries and the taxpayer on several occasions has come out of these disputes utterly disenchanted. In such a situation, the need for arbitration for the resolution of tax treaty disputes becomes paramount in India.
Another problem is that several taxpayers find India’s tax administration a bit complacent in the way they deal with their MAP applications. Although several MAP applications have been succesfully resolved, some drag on for years and become more trouble than what the double taxation relief is worth. Therefore, there is increasing consensus in the country that although arbitration might merely have a spectral role, it might be effective in increasing the speed and efficiency of the MAP system.
Given these considerations, the general conclusion that it is desirable to provide taxpayers with the option of arbitration also applies specifically to Indian taxpayers. Nevertheless, in India the arguments for international tax arbitration are yet to spread their wings and really circulate. Although the arbitration movement is only launching off, India should actively consider it rather than wait to see how it works overseas.
- 5th year and 4th year undergraduate law students at Symbiosis Law School, Pune [↩]
- See S. 6, Income Tax Act, 1961, India [↩]
- ((See S. 864(c)(ii), Internal Revenue Code, 1986, The United States of America [↩]
- See S. 9(1)(i), Income Tax Act, 1961, India. [↩]
- See Michael Lang, Introduction to the Law of Double Taxation Conventions, 2010, IBFD at p.23., [“Lang”]; see also Sriram P. Govind, Source Rule In Cross-Border Transactions: Southern Perspectives, The Indian Experience, available at: http://www.sef.hku.hk/aslea2011/private/paper/30.%20Sriram%20P%20Govind%20abstract.pdf (Last visited on 6th March, 2012), [“Govind”]. [↩]
- See S. 5, Income Tax Act, 1961, India [↩]
- See Lang, Introduction to the Law of Double Taxation Conventions, 2010, IBFD at p. 23, 24; see also S. 9, Income Tax Act, 1961, India [↩]
- See Richard L. Doernberg, International Taxation in a Nutshell, 8th Edition, Thomson West, at p. 2., [“Doernberg”] [↩]
- See Alfredo J. Urquidi, An Introduction to Transfer Pricing, New School Economic Review, Volume 3(1), 2008 at p. 32 [↩]
- See Govind, Source Rule In Cross-Border Transactions: Southern Perspectives, The Indian Experience, available at: http://www.sef.hku.hk/aslea2011/private/paper/30.%20Sriram%20P%20Govind%20abstract.pdf (Last visited on 6th March, 2012). [↩]
- See Reuven Avi-Yonah, International Tax as International Law: An Analysis of the International Tax Regime, 2007 [↩]
- See Sriram P. Govind, Making a Case for International Tax Tribunals, Moneycontrol.com, September 6, 2011, available at:
http://www.moneycontrol.com/news/the-firm/making-a-case-for-international-tax-tribunals_583400.html (Last Visited on 17 March, 2012). [↩]
- See Lang, Introduction to the Law of Double Taxation Conventions, 2010, IBFD at p. 147 [↩]
- See Doernberg, International Taxation in a Nutshell, 8th Edition, Thomson West, at p. 121 [↩]
- See H.D. Rosenbloom, Tax Treaty Abuse: Problems and Issues, 15 Law and Policy in International Business, 1983, 766. [↩]
- See OECD, Improving the Resolution of Tax Treaty Disputes, February 2007 [↩]
- See Lang, Introduction to the Law of Double Taxation Conventions, 2010, IBFD at p.148, 149 [↩]
- See Mukesh Butani, Arbitration has relevance in International Taxation, August 9, 2010, Business Standard, available at:
http://www.business-standard.com/india/news/arbitration-has-relevance-in-international-taxation/403933/ (Last visited on March 17, 2012). [↩]
- See Chloe Burnett, Internatiional Tax Arbitration, Sydney Law School Legal Studies Research Paper, No.08/31, 2008. [↩]
- See Dr Jean-Philippe Chetcuti, Arbitration in International Tax Dispute Resolution, 2001, Lex-E-Scripta, available at: http://www.inter-lawyer.com/lex-e-scripta/articles/tax-arbitration.htm#_ftn29 (Last visited on 18th March, 2012). [↩]
- See Arbitration in international tax matters, Paris: ICC – International Chamber of Commerce, (1998). [↩]
- See J. Morgan, Arbitration clauses in international tax treaties could benefit developing states, Tax notes international, Vol. 31 (2003), no. 7 ; p. 681-691 [↩]
- OECD, Commentary to the OECD Model Convention, available at:
http://www.oecd.org/document/37/0,3746,en_2649_33747_1913957_1_1_1_1,00.html (Last visited on 18 March, 2012). [↩]
- United Nations, Report of the Sub-Committee on Dispute Resolution, available at:
http://www.un.org/esa/ffd/tax/sixthsession/Report_DisputeResolution.pdf (Last visited on March 18, 2012). [↩]
- See Mccaffrey, US International Tax Guide 2011, 2011 [↩]
- Resolution of tax treaty conflicts by arbitration, IFA congress seminar series; Vol. 18e, (1994). [↩]