Cross-border tax disputes: Intensifying global risks and developing resolution alternatives
The global tax audit and controversy environment is increasingly volatile. Cross-border tax audits are expanding dramatically and the resulting tax assessments are becoming problematic for all stakeholders.
In today's environment, multinational corporations (MNCs) struggle to keep pace with new developments and to adopt proactive approaches to the prevention and management of disputes. Through the implementation of country-by-country reporting (CbCR), increased joint and simultaneous audits and similar measures, detailed data is now readily available from jurisdiction to jurisdiction and is moving at lightning speed. The Organisation for Economic Co-operation and Development's (OECD) base erosion and profit shifting (BEPS) initiative has prompted both unilateral and multilateral measures in an increasingly interconnected global tax environment where data analytics are key to targeting MNCs for audits and imposing tax assessments.
The OECD's Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the Multilateral Instrument, or MLI) moved forward this past year, entering into force on July 1, 2018. It is seen as an important tool to manage dispute resolution through the use of an arbitration alternative. Nevertheless, the practical implementation of the arbitration option continues to be controversial and broad adoption in practice remains elusive.
Further, implementation of US Tax Reform is creating new areas of disagreement among taxpayers, the IRS and other stakeholders over recently enacted legislative provisions and new taxing rights, including the controversial BEAT rules. In addition, the International Compliance Assurance Programme (ICAP) pilot initiative remains a work in progress, with serious concerns expressed over its long-term viability unless agreement is reached on the definition of certain critical concepts related to "risk", and unless increased financial and other resources are provided by the participating territories.
OECD Action 14 developments (including the Peer Review Regime) continue to move forward, but with a significant divergence of views on certain key recommendations. At the same time, there are few areas that raise more concerns and differences of opinion than the taxation of the "digital world", and the focus on State Aid matters throughout Europe.
In short, a broad range of issues are now in the focus of tax administrations, corporations and others as risks and uncertainties continue to rise in the cross-border tax environment.
Global transparency and risk assessments
Over recent years, a tremendous amount of work has been undertaken on developing and employing tools to assist tax authorities in performing tax risk assessments. Most notable is the promulgation of CbCR requirements (adopted throughout the world) following the OECD's BEPS Action 13 deliverable. Merely one year out from the first year of compliance, many countries have started to exchange CbC Reports and "mine data" with the aim of identifying tax risks. Indeed, many tax authorities are keen to work with information technology consultants as they decipher how best to perform risk assessments, and they are developing sophisticated technological tools and data analytics to collect and analyze the data reported. Taxpayers, in turn, recognize the need to be proactive in ensuring they have employed a sound governance structure over people, processes, and technology to account for the proper reporting of data.
In addition to CbCR, in January 2018, the OECD launched the ICAP pilot initiative with eight participating tax administrations (Australia, Canada, Italy, Japan, the Netherlands, Spain, the UK and the US). The pilot is to run until mid-2019, with a possible wider roll-out. The ICAP involves the identification of "low-risk" transfer pricing and permanent establishment issues that can be eliminated from the audit process. As of late, however, there has been much discussion on the definition of what constitutes "low-risk" versus "high-risk" issues with divergent views on a territorial basis. Further, the logistical implementation of ICAP, including operational costs and human resource requirements, continues to be the focus of attention and debate. Moreover, although the ICAP pilot provides a tremendous opportunity for taxpayers and tax administrations to advance global tax certainty, its effectiveness ultimately will hinge on the trust developed between (and amongst) tax administrations and taxpayers. The building of the trust necessary to turn's ICAP's potential into reality remains a tall order. That being said, it is hopeful that the ICAP pilot will be successful and, in due course, will increase certainty for both multinational corporations and tax administrations.
The multilateral instrument ratification and arbitration
A significant component of the OECD's BEPS project is the Multilateral Instrument, which covers recommendations from the BEPS project affecting double tax treaties. The MLI, seen by many as a significant multilateral step forward in the effort to address BEPS concerns, entered into force on July 1, 2018 (following Slovenia's depositing the fifth ratification instrument on March 22, 2018).
The entry into force provision of the MLI for double tax treaty parties determines when its provisions come into effect for treaties between those parties. Different dates potentially apply for withholding taxes, other taxes, mutual agreement procedures to resolve disputes, and use of the arbitration alternative (where territories have actually chosen to apply arbitration). A significant number of the more-than 75 current signatories are expected to ratify the MLI and to lodge the instrument of ratification with the OECD in time for many of the provisions to be in effect from January 1, 2019.
The OECD's BEPS Action 14 (relating to more effective dispute resolution mechanisms) recommended the development of a minimum standard to improve cross-border dispute resolution processes, and provided for certain best practices for participating countries. Articles 16 and 17 of the MLI allow countries to incorporate these provisions into the agreements covered by the MLI, while Articles 18 through 26 incorporate a standard that can be applied by those countries wishing to adopt the binding arbitration alternative to resolve double tax disputes.
Articles 16 and 18 of the MLI are especially important for taxpayers involved in cross-border disputes. MLI Article 16 deals with cross-border dispute resolution through the Mutual Agreement Procedure (MAP). Although most taxpayers likely will welcome the modifications to the criteria for access to the MAP, many stakeholders may remain skeptical of various aspects, pending their ability to judge how these changes are implemented in practice. MLI Article 18 deals with Choice to Apply Part VI (Arbitration). The draft positions of approximately 30 territories indicate an intention to adopt the arbitration provisions. Many observers believe that a number of other territories are in favor of adopting mandatory binding arbitration, but some countries are keen to first see how the arbitration approach is applied in practice. Certain other territories are arguing strongly against using arbitration.
Additionally, in late 2017, the EU agreed to a Directive on Tax Dispute Resolution mechanisms, building on the EU Arbitration Convention that previously dealt with transfer pricing adjustments and the attribution of profits to permanent establishments. That Directive includes provisions similar in many respects to the MLI arbitration provisions, although there are important differences that will require EU member states to consider their proposed moves carefully. At bottom, the use of arbitration in resolving cross-border tax disputes continues to be the subject of intense debate and its eventual widespread use is still uncertain.
The peer review regime
Following the finalization of the OECD's Action 14, a "peer review regime" was initiated to evaluate compliance with the so-called minimum standards under it. The first tranche of countries to participate included Belgium, Canada, the Netherlands, Switzerland, the UK and the US (four of which failed to reach the OECD's 24-month target to resolve transfer pricing disputes, much of which failure was attributable to a lack of resources, inefficient communications and fundamental differences of opinion). This peer review regime is expected to take place in a phased approach, with round two evaluating whether participating countries have modified dispute resolution mechanisms in need of improvements.
In conjunction with this peer review regime there has also been a movement towards global training programs that aim to create consistency in tax examinations. For example, the IRS recently announced the launch of an annual program to train more than 100 examiners on dispute resolution and prevention. Although that program is in its initial stages, these efforts – both in the US and around the globe – are seen as a positive step where communication lines are opened, greater trust is achieved, and disputes can be resolved in a more timely and efficient manner.
US tax reform – increased uncertainty
The recent US Tax Reform will undoubtedly create new frontiers for tax audits and controversies. Specifically, the new US territorial based system, and in particular the new base erosion and anti-abuse tax (BEAT), has the potential to create disputes for multinational corporations with significant outbound-related party payments. One notable point of concern is whether the BEAT is inconsistent with US income tax treaties, in that the tax could potentially violate treaty non-discrimination provisions. As a result, it is uncertain whether MAP proceedings will be a viable alternative dispute resolution option in the context of BEAT liabilities. In addition, the impact of the BEAT on existing APAs may lead to further complexity and uncertainty. Many observers see US Tax Reform as initiating a new wave of audits and subsequent disputes in these and many other areas.
State aid investigations
State Aid investigations and decisions continue to emerge across Europe in many different areas. A recent example involves Germany and loss carryforward provisions where, under German tax law, a corporation must forfeit its loss carryforwards if more than half of its shares are transferred within five years. To address issues arising after the 2009 financial crisis Germany introduced the so-called "restructuring clause", which provided that a corporation could retain its loss carryforwards if its shares were transferred for the purposes of restructuring the corporate entity.
In 2011, the European Commission (EC) decided that the restructuring clause was selective (i.e., that it was State Aid) and ordered the recovery of the prohibited State Aid from the taxpayers that had benefited from the restructuring clause. Several corporate taxpayers asked the EU General Court to annul the EC decision, but the EU General Court upheld it. The taxpayers then asked the Court of Justice of the European Union (CJEU) to set aside the General Court judgment.
The CJEU held that the General Court erred by using the wrong reference framework in interpreting the restructuring rule. The EU General Court used the loss forfeiture rule as the reference framework, whereas it should have used the loss carryforward rules (a broader framework) instead. The CJEU held that the General Court's error (i.e., its defining the reference framework too narrowly) impaired the General Court's analysis.
Although the judgment of the CJEU was important in terms of defining how to determine the correct reference framework in fiscal State Aid cases, it does not provide much guidance on how to approach that question in a particular case. Therefore, this area likely will remain the subject of much debate and controversy going forward.
In another important State Aid case, the EC considered whether two sets of tax rulings governing the treatment of certain interest-free convertible loans had inappropriately lowered the tax basis of the Luxembourg companies and therefore constituted State Aid. The press release did not contain details regarding the legal reasoning of the EC, but it did mention that the EC considered whether the Luxembourg tax treatment of the loans reflected economic reality. The EC also considered whether the rulings endorsed an inconsistent treatment of the same transaction as both debt and equity, leading to non-taxation at all levels because the borrower deducted expenses similar to interest on the loan, while the creditor did not pay tax because Luxembourg tax rules exempt tax income from equity investments. The EC decided this is a more favorable treatment than that generally available under Luxembourg tax rules. Those rules exempt from taxation income received by a shareholder from its subsidiary, provided that income is, in general, taxed at the level of the subsidiary.
Although a number of high-profile cases involving the EC's approach to State Aid relate to transfer pricing matters, in other cases there appears to be a focus on the analysis of whether an arrangement gives rise to a deduction of an expense without a corresponding income inclusion. The EC's concerns may echo BEPS Actions and matters that have been further addressed through the European Union's anti-tax avoidance directives (ATAD I and ATAD II). The text of the recent decisions, once released, will be important to help taxpayers understand the EC's detailed reasoning and developing positions with respect to State Aid matters.
Taxing the digital world
On March 16, 2018, the OECD Inclusive Framework on BEPS ("IF" is a group of 113 countries) issued its paper, Tax Challenges Arising from Digitalisation – Interim Report 2018 (the Report). This Report was followed by the European Union (EU) Commission's recommendations for EU-wide adoption on similar topics, which were published on March 21, 2018. A number of countries around the world, including within the EU, have also proposed or adopted unilateral measures in recent months in the digital area.
Although some countries in both the IF and EU are keen to move quickly toward a new international allocation of corporate taxation rights that takes certain digital factors (such as contributions from users) into account, there are also countries within each group that do not believe this step is necessary. Both organizations recommend very different solutions to this divergence of views. Specifically, the IF group has proposed a two-year, detailed review of the issues, aiming to bring countries together. By contrast, the EU has recommended that EU countries assert the right to tax the (direct and indirect) profits generated from provision of digital services to users located in the EU, and levy turnover taxes until treaty partners agree to recognize this taxing right. It appears disagreement over these digital tax issues will remain an extremely high priority for the foreseeable future.
The global tax community continues to witness a dramatic expansion of cross-border tax audits and disputes. Historically active areas of controversy, such as transfer pricing and permanent establishments, remain a high priority for tax administrations. In addition, new areas of dispute are on the horizon, including taxation of the digital world, State Aid cases and issues arising from US Tax Reform (e.g., the BEAT).
At the same time, we are seeing new and expansive audit techniques around the globe, including the ICAP pilot program, joint and simultaneous audits and enhanced cooperation approaches. These areas will undoubtedly lead to more controversies and disputes – further burdening the already strained MAP system.
Finally, while the treaty-based arbitration option and bilateral and multilateral APAs hold promise for the future, both mechanisms are under serious pressure. It is unclear whether the arbitration alternative will be widely accepted among a significant number of territories with fundamentally different views on the arbitration concept. Theoretically, bilateral and multilateral APAs should be one of the preferred approaches to prevent and resolve tax audits and disputes for both taxpayers and tax administrations. But, APAs will only succeed if governments agree to provide a significant amount of human capital and devote financial resources to ensure the timely and efficient administration of these critical bilateral agreements. Until proactive steps are uniformly adopted, we expect to see a continued rise in contentious cross-border tax disputes.
The author would like to acknowledge and thank Crystal A. Thorpe, Clayton H. Collins, and Richard H. Lilley for their contributions to this article.