In the past two decades, the ongoing process of the integration of national economies leading to globalisation, capital mobility and increased trade in services has lead to the evolution of cross-border tax challenges in several nations.
Models of tax competition in a flat and connected world are different than those necessary to ensure compliance in multiple jurisdictions dominated by cross-border flow of goods, business reorganisation and repatriation of profits. Further, as business models get sophisticated with respect to trade and flow capital, tax systems will have to evolve to necessarily deal with those changes.
Currently, disputes arising out of bilateral tax treaties are resolved through administrative and judicial appeal process and typically undergo the so called Mutual Agreement Procedure or MAP; within the confines of the treaties. As Indias dominance in trade, investments and commerce increases, coupled with new models of businesses, so would be our problems vis-a-vis cross-border tax issues. It would necessarily mean greater cost of administration for the government and enhanced compliance cost for the tax payers. This phenomenon coupled with time consuming and expensive judicial remedy should lead us to wonder why we have not debated upon alternate dispute resolution.
Internationally, the MAP experience has resulted in backlogs besides several unresolved cases. Many approaches were considered for supplementing the existing MAP mechanism and after deliberations recently, the Organisation for Economic Cooperation and Development (OECD) countries agreed to broaden the avenues available for resolution of tax disputes by introducing arbitrations in treaties, should other attempts to resolve disagreements fail.
Among others, the modification will potentially affect companies investing or trading outside of their home country. OECDs Committee on Fiscal Affairs has agreed to modify the OECD Model Tax Convention, which serves as a basis for negotiations, by including possibility of arbitration in cross-border disputes.
The European Commission Arbitration Convention is a flagship authority for the arbitration process on tax treaty disputes. Until recently, only transfer pricing disputes fell within its realm and its geographic scope was restricted to the EU territory. Within its framework, transfer pricing cases that remain unresolved for 2 years are referred to an advisory commission, charged with delivering its opinion on elimination of double taxation. Under the convention, an advisory commission is expected to deliver its opinion within 6 months. The competent authorities of the respective countries are required to take action within six months of the advisory commission opinion.
Countries outside the EU have commenced incorporating arbitration clauses to freshly negotiated tax treaties. Such arbitration clauses extend the competence of an arbitration board not only to cover transfer pricing disputes but to the entire scope of a tax treaty.
Recent notable example is that of the United States and Germany, who signed a protocol amending their 1989 treaty protocol. A mandatory binding arbitration process has been provided for settling certain issues that cannot be resolved through the MAP process. Further, the treaty provides for arbitration proceedings to speed up the resolution process, moderate the revenue authorities position, and assure eventual relief from double taxation. Under the provisions, issues relating to residence, permanent establishment, business profits, associated enterprises and royalties could be submitted to binding arbitration. These are precisely the issues India is continuing to grapple.
The arbitration panel comprises of three members: one each appointed by the competent authority and the two members appoint a third member. The third member cannot be a citizen of either treaty country and chairs the panel. The competent authority of each country has 90 days to submit a proposed resolution and a position paper and further 90 days to submit a reply. The panel must adopt the resolution of one of the two parties (a model referred to as baseball arbitration) within six months of the chairs appointment.
The panels determination is binding on the competent authorities, though the taxpayer has right to opt out of the process within 30 days. All parties to the proceeding must agree to terms of confidentiality and the panel is not expected to provide a rationale for its determination.
Most of the existing arbitration clauses in tax treaties provide that it is subject to mutual consent of the revenue authorities of both the states. Thus, it offers the possibility for an arbitration procedure in tax matters provided generally under the international law. Countries such as Netherlands have concluded treaties which allow referral to an arbitration board by either of the contracting nations
My experience in the past few years suggests that several cross-border tax disputes have arisen in India particularly with respect to transfer pricing and attribution of profits to permanent establishment of a foreign enterprise. The disputes have arisen partly due to the steep learning curve the tax administrators (and the tax payers) are experiencing and partly due to Indias insecure feeling of tax base erosion as an emerging economy advancing to developed economy. More issues are likely to arise and inconsistent principles are expected to evolve, particularly on transfer pricing and Permanent Establishment matters. It will take several years for issues to reach finality, besides the unproductive use of judiciarys time and expensive litigation process. The recent Morgan Stanley experience is a case in point. Tax experts are still grappling with key findings of the court. An issue that warrants debate is the need for India to consider tax arbitration for cross border tax disputes. In my view, the need to consider arbitration is a no-brainer.
The incorporation of arbitration provisions in Indian treaties would not mean surrender of fiscal sovereignty but would only act as a credible alternative to supplement existing provisions to seek efficient and effective resolution of tax disputes. It will go a long way to lend greater transparency and clarity to determination of tax liability of transnational corporations prevent double taxation, besides acting as a catalyst to attract enhanced FDI. In my view, the question should be how and when rather why. With India moving away from being merely an observer status country and closer to becoming a OECD member, arbitration seems as an inevitable option to seek speedy redressal to tax disputes.
Mukesh Butani The author is a Partner with BMR & Associates and views expresses herein are personal.