Arbitration to Settle Cross-Border Transfer Pricing Disputes between Competent Authorities Under Tax Treaties (11/26/12)

Reuters reports that the United States is having apparent success in using "baseball arbitration" to settle disputes under the mutual agreement procedure of the U.S. Canada Double Tax Treaty.  See Patrick Temple-West, International arbitration for tax disputes, "baseball" style (Reuters 11/15/12), here.  The treaty is here, with the Mutual Agreement Procedure Article XXVI.  Similar provisions are in other treaties and in the U.S. Model Treaty and the OECD Model Treaty.

The opening paragraphs of the article set the tone:

The United States remains undefeated in the nearly two years since it began settling corporate tax disputes with Canada through a winner-takes-all process popularly known as "baseball arbitration." 

Tax lawyers and accountants in both countries said the U.S. Internal Revenue Service had won three of the binding decisions and Canada none. They said the IRS had collected a significant sum of money, possibly in excess of $100 million. 

Launched in December 2010, the arbitrations follow the rules for settling salary disputes between Major League Baseball teams and their players. As in baseball, the two parties - revenue agents from the two countries - put forward a figure. 

As in baseball, third-party mediators settle disputes by picking the number they judge to be closest to the right answer. In the tax game, that's the amount a company pays. The winning country gets the tax revenue. The losing country goes home empty-handed. 

"It's baseball arbitration: One position wins and the other one loses," said Brian Trauman, a principal at Big Four accounting firm KPMG LLP. The cases that have been resolved have "really big dollars at stake," he said. 

Now the United States is adding an arbitration clause into tax treaties with other countries, hoping to broaden its winning streak to a global stage.

I have modified my Federal Tax Procedure Book to include these competent authority arbitration initiatives,  and, as modified, the discussion is (some footnotes omitted):

A. Traditional ADR. 

One of the hot topics in IRS practice has been for some time the use of ADR to resolve disputes with the IRS.  I mentioned above that mediation is now being used in Appeals and test programs for binding arbitration are now required.  ADR has been very successful in civil non-tax litigation, and the notion is that it can be used in appropriate cases to resolve disputes between the practitioner and the IRS. 

The IRS has tried ADR in transfer pricing cases.  In a landmark case, Apple Computer submitted transfer pricing to arbitration under the baseball arbitration procedure (i.e., the arbitrators must accept the most reasonable position of the parties rather than coming in between the parties' positions).  I won't get into the details, but the perception – perhaps not the reality – is that the IRS won the arbitration, so taxpayers have apparently been less willing to use ADR for such big ticket matters. fn2309  Nevertheless, there does appear to be significant mediation and arbitration activity both in Appeals and in litigation in the Tax Court, for which there is rarely public notice of the details.

fn2309  The perception may not be the reality because, although the arbitrators accepted the IRS position, the IRS had backed off substantially from the position in the notice of deficiency before finalizing its position with the arbitrators.  If the taxpayer was taking an extremely aggressive position to counterbalance the IRS’s initial position in the notice of deficiency but did not thereafter moderate the position as aggressively as the IRS did, the taxpayer would lose.  But the IRS may have had to give up a large part of the dollars originally at issue in order to prevail, so that the taxpayer really did prevail as to the dollars originally at issue. 

Not only is ADR available for disputes with the IRS, but it is also available where the disputes involve other countries.  This usually arises in transfer pricing disputes where the issue is whether the U.S. company has properly priced the goods and services it provides a related entity in a foreign country.  As noted earlier in text, that pricing, if respected, can determine where income is taxed and can thus erode the fisc of countries where the income is really earned.  The U.S. income tax treaties usually contain a Mutual Agreement Procedure requiring the competent authorities of the respective countries to resolve disputes to avoid double taxation; in a transfer pricing dispute, this would mean determining appropriate transfer prices for goods and services and calculating taxes accordingly.  This exercise has traditionally been done through country to country negotiations by their respective “competent authorities,” which are the offices related to their tax administrations that implement the treaties.  The process entails attempting in good faith to reach agreement; the competent authorities usually reach agreement, but not always.  ADR can be used to break deadlock between the competent authorities.  Some treaties thus now provide for arbitration, but any type of ADR – including arbitration – can be used by the competent authorities if they agree to do so.  It is reported that arbitration is being used with a number of competent authorities to resolved transfer pricing disputes.  For example, the U.S. and Canada have used baseball arbitration in transfer pricing disputes subject to the Mutual Agreement Procedure in our tax treaties. fn2312

fn 2312  Id. The article reports are that the IRS has succeeded in early rounds of baseball arbitration with Canada.  As with the Apple arbitration noted above, the perception of success in baseball arbitration simply as a result of the arbitrator picking one side’s number can be deceiving if that side gave up too much in presenting its number. 

I believe we will see more use of ADR in the disputes between taxpayers and the IRS.  I do not have prescience enough to be able to predict the precise shape of the ADR initiatives that will finally come into the regular bag of tricks the practitioner can invoke to meet his or her client's needs.  But I do know that this will increasingly be an opportunity that is and will be available.

These changes are to the current versions as follows:  footnoted version p. 685; nonfootnoted version p. 499.