Preventing and Resolving Tax Treaties and Transfer Pricing Disputes

EDITOR JOÃO SÉRGIO RIBEIRO

PREVENTING AND RESOLVING TAX TREATIES AND TRANSFER PRICING DISPUTES

School of Law - University of Minho Research Centre for Justice and Governance 2018

Preventing and Resolving Tax Treaties and Transfer Pricing Disputes

Published in October 2018 by Escola de Direito da Universidade do Minho Campus de Gualtar – 4710-057 Braga (Portugal) Tel.: + 351 253 601 800 / 1 |www.direito.uminho.pt Editor: João Sérgio Ribeiro English Language Editing by Changyue Yin | Cindy Luo | Isabella Fierro Authors: Dhaval J. Sanghavi | Jian Wang | João Francisco Bianco João Sérgio Ribeiro| José M. Calderón | Ramon Tomazela Santos W.F.G. Wijnen | Xiaoqiang Yang Printed in Amares (Portugal) by Graficamares, L.da www.graficamares.pt Book cover by Pedro Rito Cover photo credits: http://bit.ly/2ODJW8H Typeset by Ana Rita Silva ISBN: 978-989-99766-9-6 Legal deposit: ?????/2018 Circulation of 100 copies

Table of contents

Foreword ……………………………………………………………………………… 7

Part I – Tax Treaties Disputes On the Convergence of Judicial Tax Treaty Interpretation – Wishful Thinking or an Observable Trend?

W.F.G. Wijnen …………………...………………………………….……………...… 11 New Trends in Tax Treaty Disputes Resolution João Sérgio Ribeiro ……………………………………………………...…...… 33 Trends in Judicial Tax Treaty Interpretation in India Dhaval J. Sanghavi ………………………………………………...…..…....… 51

Part II – Transfer Pricing Disputes Transfer Pricing: International Trends & Spanish Perspective José M. Calderón …………………….……….………………..………...…..… 73 Transfer Pricing Dispute Resolution in Brazil João Francisco Bianco | Ramon Tomazela Santos …………………...….…… 105 China’s Reforming of Transfer Pricing Rules in the Post-BEPS Era Xiaoqiang Yang | Jian Wang .……….…………………………………….… 135

Foreword In May 2018, a conference on “Preventing and Resolving Tax Treaties and Transfer Pricing Disputes” was held at the School of Law of the University of Minho as a joint initiative of JUSGOV, the LL.M. in European and Transglobal Business Law and the Masters in Tax Law. The idea of this event was suggested

by João Bianco whose involvement was paramount for its success.

The conference acknowledged the latest developments in the field of tax treaty and transfer pricing disputes resolution by analysing them in the light of new international and European rules and through the Brazilian and Spanish experiences.

The purpose of this book is to bring together the written contributions prepared by the speakers in the conference and by the authors who kindly accepted the invitation to contribute to this publication with two additional articles focusing on the Indian and Chinese experiences.

I would like to express my deep gratitude to my fellow authors: Dhaval J. Sanghavi, Jian Wang, João Francisco Bianco, José M. Calderón, Ramon Tomazela Santos, W.F.G. Wijnen, and Xiaoqiang Yang for their most kind availability in accommodating the preparation of their contributions in their extremely busy professional agendas and for bringing to this book their invaluable experiences.

In addition to the listed authors, this book could not have been produced without the conscientious efforts of Changyue Yin, Cindy Luo and Isabella Fierro, who edited the English language of the chapters it comprises.

Finally, I would like to express a word of gratitude to JUSGOV for creating a research atmosphere for projects like this to thrive and for providing financial support to this important publication.

JOÃO SÉRGIO RIBEIRO Academic coordinator of the conference and of this publication Vice-Dean of the School of Law of University of Minho Tax Law Professor Director of the LL.M. degree in European and Transglobal Business Law

PART I TAX TREATIES DISPUTES

On the Convergence of Judicial Tax Treaty Interpretation Wishful Thinking or an Observable Trend? *

W.F.G. Wijnen **

1. Introduction Tax treaties are traditionally concluded to avoid double taxation and to prevent fiscal evasion. An essential element has been added to this in the BEPS reports. The new preamble of the OECD Model 2018 clarifies that tax treaties are also concluded with a view to avoid double non-taxation. Nevertheless, the conclusion of a tax treaty is not an automatic guarantee that these objectives will be achieved. In many cases, such treaties are “the odd man out in the national legal game”. There is no international court to give guidance in the interpretation of tax treaties. Interpretation of these treaties is currently in the hands of national courts. They interpret tax treaties while using the national means at their disposal. As a consequence, courts in various countries may hand down different judgments. And then we are back where we started: the very double taxation or double non-taxation that such treaties aimed to avoid.

2. Divergent Interpretation of Tax Treaties Few subjects have been covered in the international tax literature as thoroughly as the interpretation of tax treaties. The subject has been discussed in numerous articles and dissertations and has been a popular topic at many con-

* This article is based on a previous article of the author, «Some Thoughts on Convergence and Tax Treaty Interpretation», in Bull. Intl. Taxn., Vol. 67, No. 11, 2013, Journals IBFD. ** Counsel to the Director of the Knowledge Centre, IBFD, Amsterdam, Professor of International Tax Law, LUISS, Rome, retired substitute judge, Court of Appeal‘s-Hertogenbosch, the Netherlands.

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ferences. This is due to tax treaties being a vulnerable legal instrument for various reasons.

Tax treaties, with fewer than 100 to 120 provisions in some 30 articles cover the domestic tax legislation of two states, legislation that is generally both extensive and detailed. Tax treaties are, therefore, necessarily worded in a general and abstract way and, consequently, do not always fit seamlessly into the national legislations that they are supposed to cover. Another factor which adds complication is the considerable increase of the complexity of tax legislation all over the world during the last decades. Compared to this, the OECD/UN Models that shaped the 4000 tax treaties in existence today remained an oasis of peace. Even after the most far-reaching changes under the recent BEPS reports, the structure and main content of these Models remain respectively unchanged after their introduction in 1963 and 1980. In contrast, the OECD/UN commentaries have been greatly expanded over the past 20 years largely reflecting the developments in international tax law. The further explanation for a great number of OECD/UN provisions that is being pursued by this has only increased the pressure on the interpretation of these provisions, one of the main questions being: to what extent is this more detailed explanation also valid for the already existing tax treaties? Paradoxically, the efforts of the OECD to decrease the divergent interpretations of the treaties by offering more detailed and extensive explanations appear to have the opposite effect.

Tax treaties are the subject of interpretation in the two treaty partner states by taxpayers, practitioners and tax authorities, but the final test of these treaties is found in court. Courts dealing with treaty issues often encounter fundamental problems of interpretation, which may differ from country to country.

One of the complicating factors is the interpretative methodology. In some countries, for example, the United Kingdom, the emphasis is placed more on the letter and structure of the law, but, in other countries, for example, Germany and the Netherlands, there is greater scope for a teleological interpretation.

As a result, the interpretation of treaty provisions by courts in the treaty partner states can diverge and, consequently, lead to double taxation. Of course, it may also result in double non-taxation, although this is something that taxpayers generally consider to be less hurtful.

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Tax treaties actually consist of four constituent building blocks, the first of which consists of OECD/UN-like provisions. With respect to the interpretation of such provisions, courts have the commentaries of the OECD/UN Models at their disposal. However, courts are not bound by these commentaries. There are scholars who have a different opinion on the matter, but the current orthodoxy is that the OECD/UN Models and the commentaries are, in principle, not more than a recommendation1. From this perspective, courts are free to interpret these treaty provisions how they see fit.

The second building block of tax treaties consists of provisions or legal terminology that are adopted from the domestic laws of one of the treaty partners. A provision or terminology of state A that is consolidated in the treaty does not create any problem for a court in state A, but in state B, it is different.

A court in state B that has to deal with a provision or terminology that is adopted from state A’s domestic law is saddled up with a notion it is not familiar with, given that it is not explained in a protocol to the treaty or a memorandum of understanding. Unilateral explanations in technical explanations (US) or explanatory memorandums (Netherlands and some other countries) added by the government to the tax treaty to inform parliament and the taxpayers in more detail about the meaning of the treaty and specific treaty provisions may be helpful, but for courts, they are not binding. There are examples where courts ignored such unilateral explanations or memorandums, but there are also examples where they followed them in situations where the explanation of the treaty partners in their unilateral instruments appeared to be similar2.

The third building block consists of innovative language created by the negotiators. Such provisions or terminology that is neither taken from the OECD/UN Models nor from the domestic laws of one of the treaty partners are rather vulnerable as they are not supported by an internationally recognized understanding or at least by a domestic familiarity in one of the states. There

1 FRANK ENGELEN, «Interpretation of Tax Treaties under International Law», in IBFD Doctoral Series, No. 7, 2004, Amsterdam, dissertation, Erasmus Universiteit Rotterdam.

2 See, for example, Netherlands: Supreme Court, 2 Sept. 1992, No. 27.252 (Tax Treaty Case Law IBFD) and Netherlands: Supreme Court, 4 Nov. 1992, No. 27.222 (Tax Treaty Case Law IBFD).

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are many instances where courts had to be creative to find an appropriate solution.

From the perspective of a common interpretation of tax treaties, the fourth building block is in fact the most counterproductive. It refers to the general interpretation provisions of Article 3(2) of the tax treaties that allows the application of domestic definitions with respect to terms that are not defined in the treaty. This means that a court in state A can apply the definition of the domestic law of state A, and likewise, a court in state B can apply the definition of the domestic law of state B. As most terms and notions are not defined in the treaty, this fourth building block opens a Pandora’s box. In this respect, a common interpretation is not guaranteed at all.

Last but not least, in applying a treaty provision, courts of different countries may appreciate facts differently. A court in state A may decide that a certain set of facts constitute a permanent establishment, whereas a court in state B dealing with exactly the same facts under the exact same circumstances decides that it is not a permanent establishment. The same applies to legal issues. A court in state A may characterize a severance payment as employment income within the meaning of Article 15 of the treaty, whereas a court in state B may characterize it as a pension within the meaning of Article 18 of the same treaty.

The vulnerability of tax treaties is well known. All these weaknesses are discussed over and over again in literature. There is no international court that takes care of the uniformity of the tax treaties as supreme courts are used to doing for the uniformity of the law in the domestic ambit. A definite remedy for the divergence of the interpretation of tax treaties by local courts is not available. Yet, there are signs that the attention for a common interpretation by courts is increasing. In section 3, some thoughts will be devoted to the common interpretation by courts of the two treaty partner states in the bilateral situation, and in section 4, the possibilities to converge the interpretation of tax treaties on a global scale will be examined.

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3. Bilateral Common Interpretation To some extent, interpretation problems lie in the bilateral situation addressed by the mutual agreement procedure (MAP) and more recently, by arbitration in tax treaties. However, a guarantee for achieving a common interpretation by the courts of the two treaty partner states is not there.

3.1. Mutual Agreement Procedure Under Article 25 of the OECD/UN Models, tax treaties usually allow the treaty partners to resolve interpretative problems by way of a MAP. MAPs resolve the direct needs in a bilateral situation, but no more than that. There is no guarantee that, for a given treaty issue, state A will reach the same agreement regarding this issue with state C as it had previously reached with state B. Therefore, with regards to the common interpretation of all treaties concluded by state A, the MAP is of limited value. In addition, courts are not bound by MAPs. There are quite a number of decisions in which courts deviated or ignored the agreement reached by the competent authorities of the treaty partners3.

3.2. Arbitration Despite all the previous discussion on this issue4, there is no arbitration commission with a general judicial authority in treaty cases. Such an arbitration commission would greatly contribute to the convergence of the interpretation of tax treaties. However, it is rather unlikely that such an authority will be established in the near future, as the OECD and, in its wake, the United Nations have

3 See, for example, Canada: Tax Court of Canada, 10 March 2017, No, 2017 TCC 37, in Sifto Canada Corp. v. Her Majesty the Queen (Tax Treaty Case Law IBFD).

4 See M. ZÜGER, «Arbitration under Tax Treaties, Improving Legal Protection in International Tax Law», in IBFD Doctoral Series, No. 5, IBFD, 2003, Online Books IBFD, and Z. ALTMAN, «Dispute Resolution under Tax Treaties», in IBFD Doctoral Series, No. 11, IBFD, 2005, Online Books IBFD.

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opted, following the example of the Arbitration Convention (90/436)5, for arbitration on a per treaty basis. And, to date, there is hardly any practical experience in this field.

Since the Arbitration Convention (90/436) on transfer pricing matters entered into force in 1995, only two cases have resulted in an arbitration procedure. In addition, since 1990, a number of countries have started to include arbitration provisions in their tax treaties. These arbitration provisions are not limited to transfer pricing issues, but they refer to all issues that might arise under tax treaties. Although, currently, approximately 200 tax treaties contain such provisions, and to the best of the author’s knowledge, no case has been submitted for arbitration. It seems that treaty partners rather efficiently use the twoyear period in which they should arrive at a solution under a MAP. Therefore, as long as arbitration is only possible if the treaty partners do not find a solution with regards to mutual agreement within two years, it is to be expected that arbitration will not flourish in the foreseeable future.

However, even if the arbitration were one day to become a regular judicial phenomenon, there is little chance that arbitration on a per treaty basis would ever result in a uniform interpretation of tax treaties. As arbitration commissions are not bound by the laws of the two treaty partner states, their decisions are not automatically taken as precedent by the courts of these states. In addition, within the concept of the Arbitration Convention (90/436) and Article 25(5) of both the OECD Model and the UN Model, each tax treaty has its own arbitration commission. In other words, there is no guarantee that arbitration under the A-B tax treaty will be identical to the arbitration in a similar case under the A-C or B-C tax treaties. From a global perspective, if it were assumed that all tax treaties provided for arbitration and that each treaty had its own arbitration commission, it is highly unlikely that similar cases would be treated in the same way by all the arbitration commissions all over the world. Consequently, it cannot be expected that arbitration on a per treaty basis could have the potential to contribute significantly to a common interpretation of the treaties concluded by a state or, more generally, to the convergence of the interpre-

5 Convention 90/436/EEC of 23 July 1990 on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises, EU Law IBFD.

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tation of tax treaties on a worldwide basis. It only solves the specific issue submitted for arbitration.

See the Annex for more detailed information about MAP and MAP arbitration.

3.3. A Common Interpretation Requirement As the common interpretation of tax treaties by courts is such a real issue, the question becomes whether or not there is some sort of unwritten rule that courts of state A must take into account the decisions of courts of the treaty partner state B in their decision-making process. In their General Report on “Interpretation of Double Taxation Conventions” for the International Fiscal Association (IFA) Congress 1993 in Florence, Italy, Vogel and Prokisch (1993) suggested that there is something akin to a “Gebot der Entscheidungsharmonie”, which can be translated into English as a “common interpretation requirement” or a “common interpretation obligation”, which is explained by the authors as follows: This principle means that Courts of one Contracting State should look at decisions made by courts of the other Contracting State when confronted with problems of interpretation and that they test whether their interpretation can be transferred. If they are plausible and if their application may lead to the avoidance of double taxation, they should at least be considered and any deviation from them should be explained explicitly and convincingly6.

However desirable this may seem, this statement is quite idealistic. It remains to be seen how courts could be compelled to take foreign decisions into account and how they could be forced to indicate in their decisions why they choose to deviate from a decision of a court in the treaty partner state. Without far-reaching international and national legal measures, this is destined to remain wishful thinking.

6 K. VOGEL & R. PROKISCH, «General Report», in Cahiers de droit fiscal international: Interpretation of Double Taxation Conventions, Vol. LXXVIII a, sec. 4.aa., Kluwer L. & Taxn. Pub., 1993, Online Books IBFD.

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However, even if this utopia were to materialize, this interpretation requirement should not go further than the obligation to look at the decisions of courts in the treaty partner state. Courts should be completely released from following or not following the decisions of foreign courts. Assume that state A has a tax treaty with state B and with state C and that a treaty issue is interpreted by a court in state B differently than by the court in state C. Which interpretation should the court in state A follow if it has to deal with the same treaty issue? If it has to deal with a case under the A-B tax treaty, it should follow the decision of the court in state B. This means, however, that if it subsequently has to deal with the same treaty issue under the A-C tax treaty, it should follow the court in state C. It is clear that in bilateral situations regarding the A-B and A-C tax treaties, the desired common interpretation would be realized. However, the odd effect is that state A is left with two different interpretations of the same treaty issue under its tax treaties with state B and state C. Thus, common interpretation by courts should not be regarded as a requirement or an obligation as it is nothing more than the most desirable concept.

4. Convergence of the interpretation of tax treaties The main question is whether there are in general any possibilities to stimulate the convergence of the interpretation of tax treaties by local courts in the absence of an international court. Or in other words, are there any possibilities to at least partially solve the lack of an international court?

4.1. OECD/UN Commentaries Without doubt, the Commentaries on the OECD/UN Models are a very important aid in respect of the convergence of the interpretation of tax treaties.

However, as already said under section 2, courts are not bound by these Commentaries. The importance that courts attach to the Commentaries also differs from country to country. In OECD member countries, such as Australia, Canada, the Netherlands and the United Kingdom, the OECD Commentaries are very important and have persuasive value. Courts in Austria and Germany

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usually rely on them. However, in France, the OECD Commentaries are merely used as a technical guide and in Italy courts only consider them to be of limited value7. The situation in non-OECD countries is not much different. There are countries, such as India, where courts make use of the OECD Commentaries.

However, there are also courts in other non-OECD countries that disregard the OECD Commentaries simply because their country is not a member of the OECD8. A further complicating factor is that the OECD/UN Commentaries that are intended to be an aid to the interpretation of tax treaties are themselves, to an increasing degree, the subject-matter of interpretation by the courts. Instead of being an aid to the treaty interpreter, the Commentaries give rise to interpretative problems. In addition, because the UN Commentaries do not provide for reservations or observations in the same way as the OECD Commentaries do, there is nowhere for states to record deviating interpretations in the UN Model.

Consequently, despite the efforts of the OECD and the UN to refine the commentaries to make them more productive in respect of the application of tax treaties, a uniform tax treaty interpretation by courts on the basis of these commentaries is still far from being achieved.

4.2. International Tax Language However useful reference to domestic law through the general interpretation rule of Article 3(2) of both the OECD Model and the UN Model may be, as said under Section 2, this also gives rise to the possibility of diverging interpretations by courts in the treaty partner states. As, in this treaty provision, the term “requires” as part of the sentence “unless the context otherwise requires” has a strong meaning, there is little room for courts to distance themselves from domestic law to develop an international tax language. Nevertheless, there are courts that referred explicitly to the existence of an international tax language

7 F. SEMINAR, «The Use of Foreign Court Rulings for Treaty Interpretation Purposes», IFA Congress Brussels, 2008.

8 See, for example, CN: Huancui District of Weihai City (Shandong Province), 3 Sept. 2010, Donghwa Industrial Corporation, weihuan xingchuzi, No. 31, 2010 (Tax Treaty Case Law IBFD).

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that is not linked with the domestic law9. There are also decisions where courts seem to refer to it implicitly10. However, even if there were more room for manoeuvre in this respect, it would be questionable whether a generally accepted international language could be developed by courts in their domestic isolation.

Apart from this, it remains to be seen whether or not the governments of countries would enthusiastically welcome such a development. As a rule, governments are greatly attached to their own domestic laws. Article 3(2) gives them a firm control over the matter. A relaxation of the strict formulation of this treaty provision is, therefore, not realistic, such that as yet little may be expected with regard to the convergence of tax treaty interpretation from the development of an international tax language.

4.3. Awareness of Foreign Case Law One of the fundamental problems regarding treaty interpretation is that judges are not aware of the decisions of their colleagues in other countries.

Judges are, therefore, unable to benefit from each other’s views and from the solutions found to specific issues. If one were a judge, where should one start to look, in particular, if decisions are not published or recorded in one central place? Another similar practical obstacle is language. How can a judge search a country’s jurisprudence if he does not understand the language? However, as a rule, many courts do not even get this far. Judges are generally fully oriented towards their national situation. It is their own national case law that influences their decisions. In this regard, foreign case law is an alien phenomenon. This may result from the constitutional role that judges have to fulfil or from the fact that being influenced by foreign case law is simply not done. There is, therefore, generally little recognition that foreign case law can offer important advantages on treaty issues.

See, for example, ZA: AC, 19 Aug. 1975, Downing v. Secretary for Inland Revenue (Tax Treaty Case Law IBFD) and AU: HCA, 22 Aug. 1990, Thiel v. Federal Commissioner of Taxation (Tax Treaty Case Law IBFD).

10 See, for example, Netherlands: Hoge Raad (Supreme Court), 3 July 1991, No. 25 308 (Tax Treaty Case Law IBFD).

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Such national isolationism is less evident in the Anglo-Saxon world. Aided by sharing the same language, judges in the Anglo-Saxon countries commonly look at decisions given by their colleagues in the Commonwealth. In countries such as Australia, Canada and India, courts frequently refer to foreign decisions. The same applies to courts in the United Kingdom, although to a lesser extent. However, outside the Commonwealth courts are not that used to refer to foreign decisions. In Germany and Austria, courts sometimes do so, albeit in Austria only to German case law. However, in France, reference to foreign case law is rather limited and such references in Italy are non-existent11.

4.4. Notification of Case Law to Treaty Partner States It has been suggested that the problem of the awareness of foreign case law could be resolved by extending the notification requirement of Article 2(4) of both the OECD Model and the UN Model to judicial decisions dealing with the interpretation of a tax treaty. In the IFA Report referred to in section 3.3., Vogel & Prokisch made a firm statement in this respect12. In addition, in the US Model (1981), such an extension was included. Article 2(2) of the US Model (1981)13 stated that, in addition to significant changes in their respective taxation laws, the contracting states should notify each other of “any officially published material concerning the application of the Convention, including explanations, regulations, rulings or judicial decisions”. This extension, however, disappeared from the US Model (2006)14 without any explanation. The reasons for this can only be guessed. In this regard, the handling of a steady stream of treaty case law creates an extra burden for the competent authorities of the treaty partner states. In particular, case law in foreign languages can exceed the practical capacity of competent authorities. It is, therefore, perhaps not surprising that this extension of the notification requirement did not survive the revision of the US Model (2006) and that it is not adopted in the OECD Model or the UN Model.

See supra note 7.

K. VOGEL & R. PROKISCH, «General Report», cit.

13 US Model Tax Convention on Income (16 June 1981), Models IBFD. 14 US Model Tax Convention on Income (15 Nov. 2006), Models IBFD. 11 12

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Given the extensive treaty networks that so many countries currently have, the notification of judicial decisions is not realistic and is condemned to remain a dead letter.

For the purpose of the convergence of the interpretation of tax treaties by courts, such an extension of notification to judicial decisions would only work if the competent authorities of the recipient state had to forward the cases onto the judiciary. Without an explicit order to the competent authorities to this effect in a tax treaty, the competent authorities could not be expected to do so on their own volition. However, even if the judiciary were to, in one way or another, obtain foreign treaty case law, the problems would remain, as the various judiciaries would not have the capacity to deal with foreign cases in so many different foreign languages.

4.5. Convergence of Interpretation through a Database One way to stimulate the use of foreign decisions by courts would be an international database in which the domestic case law on the interpretation of tax treaties would be made both available and accessible. Various authors have noted that such a database would be useful for legal practice and the development of the law15. Increasing the awareness of case law is in itself a much simpler way to stimulate convergence in the interpretation of tax treaties than the establishment of an arbitration commission or an international tax court. The institutionalization of such a commission or court would inevitably result in a loss of authority on the part of treaty partners. The magnitude of such a database and the costs involved have, however, generally prevented any initiatives being undertaken for a long period of time. At present, there are approximately 9,000 decisions dealing with the interpretation of tax treaties that would have to be collected from around the world and summarized in English. Given the number of cases, the English translation of cases from non-English speaking countries has been regarded from the outset as being prohibitive.

15 See, for example, K. VOGEL & R. PROKISCH, «General Report», cit., and K. VAN RAAD, «Tax Treaty Issues – Current and Future Developments», in Eur. Taxn, Vol. 36, No. 1, 1996, Journals IBFD.

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Currently, there are approximately 4,000 comprehensive tax treaties worldwide. The number of countries that do not have any tax treaties is falling rapidly. In contrast, the number of countries that have ten or more cases dealing with the interpretation of tax treaties is astonishingly small, being no more than 30 altogether. For the most part, these are Canada, India, New Zealand, South Africa, the Western European countries, the United States and a few countries, such as Brazil and Mexico, where a number of decisions have been given in recent years. Only 16 countries have a treaty case law of more than 50 decisions, i.e. the Netherlands (800), Germany (800), Belgium (550), France (400), the United States (310), Italy (300), Canada (225), Spain (200), Switzerland (200), Austria (190), Sweden (110), Norway (100), Denmark (70), Luxembourg (70), the United Kingdom (65) and India, in respect of which it is not yet possible to provide an accurate estimate. India is the country with most treaty cases and, to date, more than 3,500 Indian cases dealing with treaty issues have been identified.

Judicial protection under tax treaties is, therefore, not yet widely accepted. There are various reasons for this. There are countries with no judicial appeal at all in tax matters. It is also possible that taxpayers simply do not know how to take their case to court. In addition, it is possible that taxpayers do not have much faith in the decisions of courts because of the lack of expertise among the judges. Furthermore, there are countries in which it is considered to be a loss of face to go to court if a dispute with the tax authorities cannot be resolved through a compromise. Then, there are the countries, such as Ireland and the United Kingdom, where litigation is so time-consuming, and, therefore, so expensive, that taxpayers only go to court if no other option is available. For this reason, the number of cases in the United Kingdom (65) and Ireland (5) is rather limited at present.

Given the very large number of cases, it cannot be said that there is a lack of judicial protection in India. However, Indian case law is not only important for its numbers. India is the only non-OECD country with an established treaty case law. Therefore, India is in a unique position to develop case law on issues that are not dealt with in the case law of OECD member countries. In respect of subjects such as the distinction between the transfer of know-how and the furnishing of services in all their kaleidoscopic varieties, capital gains on the alien-

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ation of shares, international shipping business, transfer pricing and, it goes without saying, the concept of a permanent establishment, India has taken the lead among the non-OECD countries and has developed case law in respect of which there is no equivalent within the OECD. In 2000, the International Bureau of Fiscal Documentation (IBFD) began to record treaty case law and create a database for cases dealing with the interpretation of tax treaties, i.e. limited to comprehensive tax treaties on income and capital, as well as tax treaties concerning estates, inheritances and gifts. The ambition is to ultimately include every national court decision: not only the decisions of the supreme courts, but also those of the lower courts, and not only recent decisions, but also older ones16. The expectation is that the database will become a point of reference in particular because of its comprehensiveness. The IBFD Tax Treaty Case Law collection was launched at the beginning of 200517. At the time of the writing of this article, the collection contained approximately 8,500 decisions, around 8,000 of which are summarized and have the text in the original language included.

The IBFD Tax Treaty Case Law collection is also linked to the IBFD Treaties collection18. This makes it possible to navigate from a treaty article to the relevant cases and from the cases to the relevant tax treaty. All of the cases in the world dealing with the same treaty issue are directly searchable, as the search system is based on the articles and provisions of the OECD/UN Models. In addition, in order to facilitate the understanding of foreign cases, the Tax Treaty Case Law collection contains an extensive description of the organizational structure and the procedures of the judiciaries of the countries cited in the collection.

The Tax Treaty Case Law collection has the potential to contribute to the development of a uniform case law regarding tax treaties and, therefore, to be of particular interest to those judges who are concerned with tax treaty cases.

This is true not only for the countries that have already built up a respectable

16 There are other case law collections, such as P. BAKER, International Tax Law Reports, LexisNexis/Butterworths Tolley, 1999, but none have the ambition to include all treaty case law on a worldwide basis.

17 Tax Treaty Case Law IBFD, available at www.ibfd.org. A free two-week trial to this database is available on request.

18 Treaties IBFD, also available at www.ibfd.org.

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amount of tax treaty case law, but even more so for those where this has not yet happened. Therefore, ideally all judges of the world dealing with tax treaty cases should have access to this collection. However, budgetary constraints of the judicial libraries prevent most of them from accessing it19. If governments and international organizations such as the EU, OECD and UN do indeed consider it important that tax treaties should be interpreted uniformly, they should ensure that this collection is available to tax judges all over the world. The costs of this will at least be able to compete with the costs inherent to the institutionalization of an international court of justice in tax matters.

4.6. Convergence of Interpretation through an International Association of Tax Judges With regard to the convergence of the interpretation of tax treaties, having a collection where judges can become aware of the decisions of their foreign colleagues is one thing. An international organization where judges can meet regularly to discuss the subjects that they find relevant and the problems that they encounter in their daily practice is another indispensable component. In this respect, the eight judges attending the 2009 IFA Congress in Vancouver, Canada came together and decided to set up an International Association of Tax Judges (IATJ)20. Membership is open to all judges throughout the world dealing with tax cases. At the time of the writing of this article, the IATJ had approximately 150 members from around 35 countries. Although the membership is relatively small compared to the total number of judges that are involved in tax matters in the word, the members that attend the assemblies spread the message among their colleagues in their respective home countries. Since the IATJ’s founding in Rome in 2010, a two-day assembly has taken place every year in which tax technical issues and the developments in tax jurisdiction are discussed from a judicial perspective. Besides that, in the short period of its existence this organization has proven its raison d’être by participating in numerous

19 IBFD has made the Tax Treaty Case Law collection freely available to the members of the International Association of Tax Judges (see 4.6.).

20 See www.iatj.net.

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conferences, seminars and symposiums and extensive publications21. In its own way, the IATJ contributes to the convergence of tax treaty interpretation on a worldwide basis.

4.7. Recent Developments In March 2017, the OECD and IMF published a report on tax certainty in response to a request from the G20 Leaders the previous year. This report was based on an OECD survey of 700 businesses and 25 tax administrations.

Among the survey’s findings was a concern by business about tax authorities’ and courts’ inconsistent approaches towards the application of international tax standards. To the extent that these inconsistencies refer to the interpretation or application of tax treaties, the OECD is going to identify these inconsistencies and look at the treaty provisions that are the subject of the most frequent disputes between taxpayers and tax authorities in cooperation with the UN, if possible. The idea is to address the most disputed treaty provisions through better guidance, most especially through changes to the commentary on the OECD Model and, if necessary, to the OECD Model. Although the OECD has occasionally paid attention to domestic case law in its commentary to the Model22, such an integral examination of the problems judges encounter in interpreting treaty provisions has never happened before and is certainly a step forward.

This shows that the awareness is also being felt by the policy makers that it is ultimately the judge who determines how the treaties are read, whatever the OECD or treaty negotiator had in mind.

21 See, for example, «The Last Word in Tax Disputes, a Special Comparative Issue on Highest Tax Courts Celebrating 100 Years of Tax Litigation Before the Hoge Raad der Nederlanden», in Bull. Intl. Taxn., Vol. 70, No. 1/2, 2016, Journals IBFD. 22 For example, Germany: Federal Tax Court (Bundesfinanzhof), 30 October 1996, II R 12/92 (pipeline case) (Tax Treaty Case Law IBFD), and Italy: Corte Suprema di Cassazione (Supreme Court), 25 January 2006, No. 17206 (Tax Treaty Case Law IBFD).

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On the Convergence of Judicial Tax Treaty Interpretation

5. Conclusions As long as there is no overarching international court that can provide guidance in the interpretation of tax treaties, there can be no definite solution to the divergent interpretation of tax treaties by courts. The development of an international tax language, arbitration on a per treaty basis, notification of the treaty partner or a common interpretation requirement that is not adopted in the treaty and the domestic laws of the treaty partner states are not likely to solve the problem.

For the time being, a comprehensive treaty case law database is a most useful complement to the existing remedies. Such a database, where judges can benefit from the work of their foreign colleagues, and regular meetings where judges can exchange views and discuss among themselves the subjects that are most relevant to their professional activities have the potential to offer a not insignificant contribution to the convergence of judicial tax treaty interpretation, not only in a bilateral treaty relation but even on a worldwide basis.

There is even more. An observable trend is that the uniformity of tax treaty interpretation by courts is on the agenda of policy makers. The increased attention of the OECD to judicial decisions dealing with tax treaty interpretation is a not negligible development. A more adequate adaptation of the commentary and model based on the experiences gained by courts in the interpretation of treaties is undoubtedly an important step forward. Even though judges are not bound by the OECD/UN commentaries, they often reap the fruits of it. The convergence of the judicial interpretation of tax treaties on a worldwide basis is therefore no longer wishful thinking only.

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W.F.G. Wijnen

Annex Article 25 OECD Model: MAP and MAP Arbitration Professor Hans Mooij23 In the slipstream of the BEPS project, authorities have been undertaking considerable and genuine efforts to improve resolution of their tax treaty disputes – finally, after decades of neglect. The OECD succeeded in having elaborate provisions on mandatory binding MAP arbitration included in the MLI 24, be it on mere opt-in basis, and is presently submitting proper observation of MAP minimum standards25 to a stiff peer review process, and spreading best practices through its MAP Forum and Inclusive Framework 26. On its turn, the EU agreed on a new, comprehensive directive on double taxation dispute resolution27, replacing its prior Arbitration Convention on transfer pricing disputes28, which was generally considered a failure for the few arbitration cases it delivered.

Despite the appreciation these efforts deserve, some critical observations remain appropriate.

When a taxpayer disputes with a local tax authority of a country over proper application of a tax treaty, he may seek resolution through the legal means available under the domestic law of that country, i.e. ordinarily court litigation, and in some countries mediation or other instruments for ADR (alternative dispute resolution). But when the dispute is between tax authorities of dif-

23 LLM – International Tax Center, Leiden (Netherlands); TRIBUTE Foundation for international tax dispute resolution.

24 Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, Paris, 7 June 2017, Part VI, Articles 18-26.

25 BEPS Action 14 – 2015 Final Report.

26 This includes all OECD member countries, as well as a large number of non-member countries, among which, for example China and India.

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

28 Convention 90/436/EEC of 23 July 1990 on the elimination of double taxation in connection with the adjustment of profits of associated enterprises.

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On the Convergence of Judicial Tax Treaty Interpretation

ferent countries, this is a matter for the authorities to resolve among each other and for them alone. It would be unnatural, and unfair, if a taxpayer had to undertake effort and bear expense to have such dispute resolved that he has neither sought nor caused – and often ineffective, too, since a taxpayer may not have any particular position to argue in such dispute, apart from that double taxation caused by the dispute, of which he, after all, is victim.

It is therefore wholly appropriate for Article 25(1) of the OECD Model to rule that such dispute be subject to settlement between countries’ competent authorities over a MAP procedure, irrespective of the remedies provided by the domestic law. Authorities may uphold a MAP procedure while domestic resolution is still pending. This is legitimate from a view of practical efficiency, since a domestic resolution may end double taxation and thus make MAP resolution unnecessary.

Article 25(5) on MAP arbitration, however, excludes arbitration cases that have already been submitted to a domestic court decision. This may not be justified on grounds of efficiency anymore. Double taxation can actually be caused, or confirmed, by a court decision, and to resolve it MAP arbitration may be indispensable as the ultimate remedy. It is arguable, by contrast, that it is within the very objective of MAP arbitration to repair such an unwanted effect of a court decision. This proviso of Article 25(5) forces a taxpayer to choose between domestic litigation and MAP resolution after all, if he wants to preserve a right to claim MAP arbitration later on, should authorities eventually fail to settle amicably and in time. In practice, this choice may prove a tough one, given also the early stage of a dispute at which it inevitably has to be made. The inclination is predictable for a taxpayer to play safe, and to choose for domestic court litigation, which procedure he is familiar with and where he is entitled to represent his own interest, while accepting the risk that, if he loses, double taxation may remain unresolved indefinitely.

The only involvement by a taxpayer that is legally provided for under Article 25(1) is a right to claim a MAP procedure from authorities. The extent of taxpayer participation, if any, in actual MAP proceedings is a recent issue. A taxpayer is not admitted as a party in a MAP procedure, which may be just as well since a position in between disputing authorities might be uncomfortable.

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The taxpayer role, rather, is confined to that of factual witness. But a valuable role this may be nonetheless, since a taxpayer often is better aware than competent authorities of any trouble with treaty application and the circumstances that have given rise to it, as he experiences it in first instance. The OECD Commentary29 suggests that a taxpayer be permitted a presentation to either authority, but otherwise falls short of details on how a taxpayer might usefully participate in a MAP procedure. The discretionary nature of authorities’ resolutions and strict confidentiality of its proceedings have earned the MAP procedure a somewhat dubious reputation of being a ‘black box’. Some major countries, including the United Kingdom and the United States, have developed good practices of providing regular feedback to taxpayers on progress in a MAP procedure, and soliciting for their input at the start of MAP negotiations, and even later on if there is cause, e.g. in case of new information or change of an authority’s position. If these practices would spread more widely, captured preferably in public guidance, this might benefit not only taxpayer confidence and their choice for a MAP procedure, but also the procedure’s effectiveness.

In implementing MAP arbitration, there is international debate as to whether or not arbitral proceedings should provide for any hearings. The argument, that a hearing would only be a waste of time, may make sense, if a taxpayer has had ample opportunity already to present his views in the prior MAP procedure. But even then, it must be recognised that there may be arbitrators who feel the need for a hearing to derive their information from a taxpayer firsthand.

Authorities are supposed to resolve any case a taxpayer has properly claimed for their consideration in a MAP procedure, as a matter of treaty good faith. Article 25(2), literally, obligates to ‘endeavour to resolve’, and not actually resolve, but this is merely in recognition that a MAP resolution may still require consent from such other high authority, such as the Foreign Affairs office. This requires that authorities be committed to work together constructively, be sufficiently independent to review a case afresh and unbiased, and be properly empowered to overrule positions taken by local auditors previously engaged in a

29

Paras. 40(c) and 60 of the Commentary on Article 25.

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On the Convergence of Judicial Tax Treaty Interpretation

case. This is not to say that authorities always are in practice, and when they are, that amicable settlement would always be guaranteed. OECD and EU statistics30 show in particular for transfer pricing cases that authorities hardly succeed anymore in agreeing a settlement within 24 months time, probably due to the greater complexity and budgetary interest involved with such cases. What further happens to such pending cases, whether they become resolved after all, in MAP negotiations or domestically, remain unresolved, or are withdrawn by taxpayers, is not disclosed. Some refer in this respect to a ‘MAP gap’.

MAP arbitration is indispensable as a tie breaker to prevent endless, and often pointless, MAP negotiations. Sovereignty considerations despite, countries should not agree any more to tax treaties without making some provision or other for arbitration. Article 25(5) makes arbitration mandatory upon a taxpayer claim. The interest taxpayers have in arbitration as guarantee that MAP disputes and inherent double taxation will in any case be resolved, justifies allowing them a claim right. The EU Directive refers in this respect even to the basic human right of fair trial. It might seem somewhat embarrassing for authorities if it takes a taxpayer to chase them in living up to their treaty good faith obligation of resolving a MAP dispute. In fact, the OECD Commentary 31 suggests voluntary arbitration or voluntary ADR32, i.e. on authorities’ own initiative, but as far as known neither is much tried in practice. While according to the commentary both are ordinary options allowed under Article 25(3), it appears that in many countries authorities nonetheless would need special treaty clauses to authorize their use. Even then, as arbitration experts say, few parties may want to agree to arbitration voluntarily once it is known in a particular dispute what the stakes are, and what their chances are of losing the arbitration.

The default rules on arbitration procedures and appointment of arbitrators under the MLI and EU Directive, respectively, function as sanction against any authority’s uncooperative behaviour in setting up an arbitration process, as it may hope will not occur often. But at the same time, they also provide relief

OECD, Mutual Agreement Procedure Statistics for 2016, released on 27 November 2017; EU Joint Transfer Pricing Forum, Statistics on APAs in the EU at the End of 2015, released on 20 October 2016.

31 Para. 69 of the Commentary on Article 25.

32 Paras. 86 and 87 of the Commentary on Article 25.

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for knowledge or capacity issues as many authorities are known to face. The number of MAP arbitration cases so far is unknown, none having ever been published, but it is generally assumed to be little. The European Commission 33 reported over 900 pending MAP cases in the EU by the end of 2016 that due to their timing qualified for arbitration but had not went, for some reason or other.

In fact, it was this stunningly high number that gave the push for the EU Directive. Ad hoc procedures are still norm in MAP arbitration, and favoured by authorities generally for reason of sovereignty. A permanent arbitration court like the EU Directive suggests, is a long way off in reality. But expert case administration by external arbitration institutes, such as e.g. the Permanent Court of Arbitration (PCA) at the Peace Palace in The Hague 34, or non-compulsory lists of available arbitrators35 may offer authorities welcome support, and appears within easier reach.

The MLI and EU Directive, by their default arbitration rules, change the face of the MAP procedure. Originally, MAP arbitration was meant merely as a ‘nuclear option’, to force authorities into amicable settlement – if such settlement may still be called amicable under the circumstances – and otherwise best to avoid in practice. This is still found reflected in the limited scope of Article 25(5) that lacks any default arbitration procedure. Once effective, the MLI and EU Directive will create instrumentalities for arbitration that are ready to operate whenever the need arises. Arbitration may thus develop as the new norm in MAP resolution, leaving amicable settlement as alternative only if that is what authorities mutually prefer, and if they prove capable of achieving it within the limited time of two years, or three years in exceptional cases, they are allowed.

33 Opinion of the European Economic and Social Committee, at para. 3.3 (COM(2016)686 final – 2016/0338(CNS)).

34 The PCA is an intergovernmental organization and uniquely created to facilitate resolution of disputes between States.

35 The TRIBUTE Foundation offers such non-compulsory list of highly qualified and diverse experts in international taxation as a service to authorities or bodies seeking to appoint arbitrators or mediators in international tax disputes.

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JoĂŁo SĂŠrgio Ribeiro *

Introduction Dispute Resolution in the field of Tax Treaties is a very broad topic that covers many types of disputes, ranging from interpretation of tax provisions to transfer pricing issues. Although most of the mechanisms we will address apply to various types of conflicts, we will always analyse them in a general fashion. Therefore, we will not dwell on the specificities of a particular conflict, such as the ones involving transfer pricing issues. However, we will not overlook that the instruments we will be analysing can also be applied to transfer pricing or other specific conflicts in the realm of tax treaties.

We will start by presenting the traditional mechanisms of tackling tax treaty disputes and their shortcomings. Then, we will address the new developments, mainly in the OECD and the European Union context. Finally, we will close this overview with some challenges that, despite recent developments, the resolution of tax treaty disputes still faces, as well as possible solutions for those challenges.

1. Traditional Mechanisms to Tackle Tax Treaty Disputes When conflicts relate to qualification, that is, when they regard classification of a given item of income for tax treaty purposes, there are certain conflicts which can arise. However, since 2000 there has existed a version of the commentary, a solution that, although not widely accepted, can avoid such conflicts. We keep in mind the binding effect of the qualification at source when that classifi-

* Professor of Portuguese, European and International Tax Law at the School of Law of University of Minho, Braga, Portugal.

The author can be contacted at jribeiro@direito.uminho.pt.

João Sérgio Ribeiro

cation originates in the source state domestic law1. This solution, however, even in light of the commentary, covers only the situations in which the source state is required to take domestic law definitions into account, leaving out the situations where double taxation results from differences in treaty application to facts or in the interpretation of treaty rules2. In these situations, Mutual Agreement Procedure (MAP) would be the only solution to tackle the conflict.

However, not all scholars and courts accept the position conveyed by the commentary, which implies that when double taxation results from differences in domestic law classifications, the source classification should be followed.

There exists some controversy, to the extent that not all the authors or courts are prone to accept that solution3.

Furthermore, even if some scholars and courts rely on the commentary, which is only one means of interpretation, amongst others, those scholars and courts may advocate a static approach of the commentary interpretation, which implies that characterization made by the source state can only be taken into consideration in relation to those treaties negotiated and concluded after 2000.

From what was stated above, one has to conclude that the handiest resource, and sometimes the sole possibility of resolving conflicts, is the MAP. This mechanism, embodied in Article 25 of the Organisation for Economic Cooperation and Development (OECD) Model Convention, is a bilateral procedure, through which the taxpayer has the possibility of presenting his case to the competent authorities of the states involved when he considers that the application of tax provisions was not made in accordance with the tax treaty. For that, it is not necessary that taxes have already been imposed. It is enough that the taxpayer assumes that taxes will be imposed in a way contrary to the treaty.

Irrespectively of the possibility, in light of Article 25(3) of the OECD Model Convention, having competent authorities resolving an interpretation problem directly through a MAP without the need of having it started by a taxpayer,

See OECD commentary on Article 23, § 32.3.

See OECD commentary on Article 23, § 32.5.

3 First, although important, commentary is not binding. Moreover, there are some systematic and theological arguments that can be put forward against that position. See MICHAEL LANG, Introduction to the Law of Double Taxation Conventions, 2nd ed., Linde, Vienna, 2013, p. 59.

1 2

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we will devote our attention to the MAP started by the taxpayer. This is so because it is the only situation that can normally trigger arbitration. We say normally, because states are free, nevertheless, to extend the scope of paragraph 5 to also cover mutual agreement cases arising under paragraph 3 of Article 25 4.

The MAP has a very encompassing scope, therefore it can be used for all sorts of disputes including interpretation issues, disputes relating to the existence of permanent establishment and the profits attributed to it; withholding tax provisions, transfer pricing adjustments, and so forth.

Although popular, MAP’s efficacy has been questioned for several reasons. We will be addressing some of those reasons.

First, the fact that MAP does not always come to a successful end constitutes a serious obstacle to trade and investments and a threat to legal certainty.

According to the average statistics, one out of 10 cases submitted to MAP end without agreement5.

It is never too much to recall the paradigmatic case Boulez v. Commissioner , in which United States and German competent authorities did not man6

age, under a MAP, to solve the dispute on whether certain payments should be regarded as royalties or compensation for personal services. Qualification of the payments as personal services would imply tax liability in the United States, whereas they would be exempt if qualified as royalties. Mr. Pierre Boulez, an orchestra conductor, ended up being double taxed, for his income was taxed as royalties in Germany and again as personal services in the US. Second, under Article 25(2) of the OECD Model Convention, competent authorities have only to “endeavour” to resolve the case. That is, they are not forced to settle the dispute. According to some authors it is not even clear-cut whether the competent authority is obliged to initiate the MAP7.

Third, there is a disadvantage in that even if the outcome is an agreement, it does not have to be reached within a specific time limit.

4 5

See Commentary to Article 25, § 5, of the OECD Model Convention, § 73.

Cfr. MARCUS DESAX, «Tax Treaty Arbitration», in International Taxation, Vol. 6, March

2012.

6 7

84 T.C. 584 (1984).

See MICHAEL LANG, Introduction to the Law of Double Taxation Conventions, cit., p. 154.

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Fourth, other drawbacks exist, such as the limited involvement of the taxpayer in the MAP which seems restricted, in most situations, to the right to initiate it. Following that, further participation is unlikely to be allowed. This is irrespective of the fact that commentary states that contracting states give taxpayers certain guarantees which, according to Vogel 8, should imply the right to hearing and the possibility of obtaining information on how MAP is unfolding.

Finally, is it also problematic that the MAP is not transparent, and that the taxpayer is not aware of the reasons underlying the agreement.

Those and other unsatisfactory features of the MAP led to an important change to Article 25 in the 2008 OECD Model Convention update – an arbitration clause was included in Article 25(5). That provision determined that following the presentation of the case by the taxpayer under Article 25(1), where competent authorities are unable to reach an agreement to resolve the case within two years from the presentation of the case to them, unresolved issues shall be submitted to arbitration. This introduced arbitration as a mandatory mechanism of dispute resolution.

This particular type of arbitration was not conceived as an independent or automatic dispute resolution mechanism, but rather as an ancillary procedure to supplement the MAP9. Hence, the taxpayer has to request arbitration from one of the competent authorities. This can only occur when the competent authorities are unable to reach an agreement within MAP. Previously, this was initiated by the taxpayer because he/she deemed that the taxation was not done in accordance with the treaty at hand. Although reasons for this particular design are not clear-cut, one may attribute them to the need of preserving the MAP and avoiding sensitive constitutional issues such as relinquishing part of tax sovereignty.

The dependence of arbitration on the MAP translates into the following consequences: (i) only if competent authorities failed to reach an agreement may arbitration procedure be initiated; (ii) if there was an agreement on some part of the issues, only the unsolved issues may be submitted to arbitration; (iii)

8 See KLAUS VOGEL, Klaus Vogel on Double Taxation Conventions, Kluwer, London, 1999, Article 25, m.no 81, p. 1370.

9 See commentary to Article 25(5), § 64.

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if, for some reason, competent authorities, during the arbitration procedure and before it is finished, reach an agreement, arbitrators will be stopped from making a decision, because the arbitration procedure will be terminated; (iv) In some situation states may decide to allow the competent authorities to depart from the arbitration decision10.

As stated by Article 25(5)(b), other important features of this type of arbitrations are the following.

An arbitration request cannot be made if a decision on the unresolved issues has already been rendered by a court or administrative tribunal of either state11 . As a rule, the taxpayer, in order to pursue arbitration, has also to renounce his right to domestic remedies on the same issue12 The arbitration decision shall be binding on both contracting states and shall be implemented notwithstanding any time limits of the domestic laws of these states.

The procedure of such arbitration has to be decided through mutual agreement.

From what was described above, it may be concluded that there is a great difference between this type of arbitration and arbitration as it is normally conceived in other contexts, such as commercial arbitration or the World Trade Organization (WTO) dispute settlement.

The arbitration framework we have been describing has been well accepted by states. It is interesting to note that according to the International Bureau of Fiscal Documentation (IBFD) database (as of April 2017) there are 217 tax treaties in force in the English language that contain arbitration clauses similar to the one we have been dealing with13.

Although taxpayers do not participate in the appointment of arbitrators and are not involved in the way in which it evolves, which is very much in line with what happens with the MPA, there is a slight improvement in comparison

See commentary to Article 25(5), § 84.

The taxpayer when filing a request for arbitration should also supply a declaration stating that there is not a decision on the same issue rendered by a court or administrative tribunal.

12 See commentary to Article 25(5), § 82.

13 SRIRAM GOVIND & SHREYA RAO, «Designing an Inclusive and Equitable Framework for Tax Treaty Dispute Resolution: An Indian Perspective», in Intertax, Vol. 46, Issue 4, 2018, p. 321.

10 11

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with MAP. The taxpayer, besides presenting his position to the arbitrators in writing, may also, with permission of the arbitrators, present his position orally during the arbitration proceedings, which represents a slight improvement of the taxpayer involvement.

2. New Developments in Dispute Resolution There are very promising developments in the field of dispute resolution both in the context of OECD and in the European Union. We will look at them in these two arenas.

2.1. New Developments in Dispute Resolution in the OECD Context 2.1.1. BEPS Action Plan 14 Recently, in December 2014, under BEPS Action 14 Make Dispute Resolution Mechanisms more effective, promising solutions to overcome MAP inefficiencies were developed. One of the main inefficiencies that was addressed and to which we would like to draw readers’ attention was the absence of arbitration provisions in most treaties and the reluctance to move towards a universal mandatory MAP arbitration.

It is interesting to note that the release of OECD final reports on the BEPS took place on 5 October 2015. It was reported in Action 14 that the absence of arbitration deserved further attention in the context of the pursuit of the great goal of making dispute mechanisms more effective.

The way the report is organised mirrors the changes it envisages. It is divided in two parts. Part I devoted to Minimum standard, best practices and monitoring process, and Part II to Commitment to mandatory binding MAP arbitration.

By adopting the report on Action 14, countries agreed to implement important changes in the classical approach to dispute resolution. This new approach implies: the agreement on a minimum standard with respect to treaty related disputes resolution (mandatory for the countries which took part in the project), the establishment of a set of best practices which would be optional,

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and the creation of an effective monitoring mechanism. All these developments are coupled with the commitment to mandatory binding MAP arbitration which highlights the importance of this same mechanism. a) Minimum standards The minimum standards will ensure: (i) that treaty obligation to the MAP are fully implemented in good faith, and that MAP cases are resolved in a timely manner; (ii) the implementation of administrative processes that promote the prevention and timely resolution of treaty related disputes; and (iii) that taxpayers can access the MAP when eligible14.

In order to ensure the timely, effective and efficient resolution of treatyrelated disputes, several minimum standards were put forward. From that list of minimum standards, we would like to highlight the ones below.

Minimum standard 1.3 states that: “Countries should commit to a timely resolution of MAP cases: Countries commit to seek to resolve MAP cases within an average timeframe of 24 months. Countries’ progress toward meeting that target will be periodically reviewed on the basis of the statistics prepared in accordance with the agreed reporting framework15�16.

Minimum standard 1.7, paragraph 23 provides that footnote to paragraph 5 of Article 25 should be deleted and the commentary appropriately amended.

Minimum standard 3.1 determines an amendment of paragraph 1 of Article 25 of the OECD Model Convention is suggested to permit a request for MAP assistance to be made to the competent authority of either Contracting State. Replacing the requirement of the taxpayer to present the case to the competent authority of the contracting state of which he was a resident 17.

In the executive summary of the report on Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD. 15 In OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, referred to in element 1.5.

16 In OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, element 1.3.

17 It is interesting to note that in the 1967 Treaty between Australia and the United Kingdom allowed the taxpayers the right to present their case to the tax authorities of both contracting states.

14

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João Sérgio Ribeiro

b) Best Practices Action 14 also identified a number of best practices. From those practices we would like to highlight the following best practices for their special connection with treaty disputes in general 18.

Best practice 2: “Countries should have appropriate procedures in place to publish agreements reached (...)”19.

Best practice 6: “Countries should take appropriate measures to provide for a suspension of collections procedures during the period a MAP case is pending” 20. This practice makes sense since it is more difficult to enter into good faith MAP discussions when there is a prospect of refunding already collected taxes.

Best practice 7: “Countries should implement appropriate administrative measures to facilitate recourse to the MAP to resolve treaty-related disputes, recognising the general principle that the choice of remedies should remain with the taxpayer”21.

Cfr. MICHELLE MARKHAM, «New Developments in Disputes Resolution in International Tax», in Revenue Law Journal, Vol. 25, Issue 2015-2017, p. 26.

18 We will live aside practices that are more specific such as the ones dealing with Transfer Pricing.

19 In OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, p. 29.

20 In OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, p. 31.

21 In OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, p. 32.

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New Trends in Tax Treaty Disputes Resolution

Best practice 8: “Countries should include in their published MAP guidance an explanation of the relationship between the MAP and domestic law administrative and judicial remedies”22. c) Monitoring mechanism The evaluation of the implementation of the minimum standard to which all OECD countries, G 20 countries, and other countries committed, will be done by a peer monitoring process conducted by the Forum on Tax Administration (FTA) MAP Forum in order to ensure that the commitments embodied in the minimum standard are satisfied.

FTA MAP Forum is a subsidiary body of OECD Committee on Fiscal Affairs composed of commissioners from 46 OECD Countries and non-OECD countries, which agreed to work with the OECD to deliberate on general matters relating to those countries’ MAP programmes. In the framework of Action 1423 the members of the FTA MAP Forum will endeavour to report their MAP statistics and publish their MAP profiles on an OECD public platform. The FTA MAP Forum will also set the standard Terms of Reference and the Assessment Methodology, that is, the main documents necessary for the peer monitoring process and the assessment methods followed. The transparency attained by this reporting mechanism will create some peer pressure and therefore encourage dispute settlement, in the sense that countries which resolve disputes more swiftly are more attractive to investors. d) Commitment to a Mandatory Binding MAP As stated above, Part II includes a commitment by twenty states to the mandatory binding of MAP arbitration. For that purpose, a mandatory binding MAP arbitration provision was suggested to be developed as part of the negoti-

22 In OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, p. 32.

23 See OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, elements 1.5 to 2.2.

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ation of the multilateral instrument envisaged by Action 15 of the BEPS Action Plan. We will be looking at that in the next section.

2.1.2. Multilateral Instrument (MLI) and 2017 Update to OECD Model Convention Many of the measures proposed in BEPS Action Plan 14 were implemented through the 2017 update to OECD Model Convention and its Commentaries and the amendment of tax treaties through the MLI that emerged from Action 15. In other words, the MLI and the 2017 update of the OECD Model Convention were shaped by the BEPS action plan.

Before looking at those changes, just a brief word about the MLI. This instrument was adopted in November 2016 and made available for signature on 7 June 2017 when it was signed by 76 states. The MLI is meant to be applied alongside existing bilateral tax treaties to update them. It represents a very significant efficiency gain if compared to the alternative of having jurisdictions renegotiating bilaterally each of the more than 3000 treaties, which would take ages and would not be homogeneous.

As stated prior, the final report on Action 14 suggested that footnote to paragraph 5 of Article 25 of the OECD Model Convention was deleted. That paragraph was a safeguard clause that allowed countries to no opt for mandatory arbitration for reasons such as national law, policy or administrative considerations. That minimum standard was materialised both in the MLI and the 2017 version of the OECD Model Convention, encouraging countries to adopt mandatory arbitration, honouring, by doing so, the commitment to mandatory MAP arbitration, embodied in Part II of the report on Action 14.

We must say, though, that in the MLI the arbitration provisions contained in Part VI are much more detailed and somewhat clearer then Article 25(5) and related commentaries, including the sample agreement, of the 2017 update of OECD Model Convention. Part VI also takes care of procedural rules and characterises arbitration in a much more detailed fashion.

Leaving clarity and detail aside, there also other differences between the MLI and OECD Model Convention. Even if both under the MLI and the OECD

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Model Convention the request, in writing, for arbitration shall happen two years after a stalemate in the MAP, the MLI allows this period of two years to be extended by agreement and is subject to a notification to the taxpayer. Specific and distinct details in relation to notice and information requests prior to arbitration are also granted by the MLI, which distinguishes it from the OECD Model Convention arbitration regime24.

Both in the MLI and Article 25(5) and commentary either “baseball arbitration” (or “last final offer arbitration”) or “independent arbitration” is admitted. The default option is, however, the former 25. There was a change, though, in what concerns the OECD Model Convention, since until the 2014 update, independent arbitration was the primary method of arbitration provided by the commentary. Only as per 2017, did the OECD Model Convention suggest the baseball approach as the default method.

In baseball arbitration the panel of arbitrators decide the issue based on either of the proposed resolution without providing a reasoned opinion.

The independent arbitration implies a decision by the panel based on the tax treaty, domestic law and other resources, supported by references.

Despite the differences between the two types of arbitration, none of them has precedential value.

In both situations the arbitration decision is implemented by a MAP and only in that context is biding, except if the taxpayer does not accept the agreement26.

2.2. New Developments in Dispute Resolution in the European Union Context The European Union has a long history in terms of using arbitration as a tool to resolve tax dispute. We cannot forget the Arbitration Convention 90/436 EEC, of 23 July 1990, on the Elimination of Double Taxation in Connection with the Adjustment of Profits Associated Enterprises. However, this instrument had

See SRIRAM GOVIND & SHREYA RAO, «Designing an Inclusive and Equitable Framework for Tax Treaty Dispute Resolution: An Indian Perspective», cit., p. 322.

25 Cfr. Article23 of the MLI. 26 Which could be inferred if an action before a court or a Tribunal has not been withdrawn by the taxpayer.

24

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João Sérgio Ribeiro

a very limited scope, in the sense that it covered mostly transfer pricing issues (and also attribution of taxable income between permanent establishment and foreign office). Moreover, the Arbitration Convention was not a legal instrument under European Union Law, meaning that it was not automatically adopted by all Member-States. As a consequence of this latter feature, the MemberState can unilaterally withdraw from the Arbitration Convention.

A new directive on tax disputes resolution mechanisms in the European Union was approved which, although building on the Arbitration Convention experience, tries to overcome many of its shortfalls and also go beyond the scope of the convention. Directive 2017/1852 of 14 October 2017, irrespectively of the overlap with the Arbitration Convention was not created, in our opinion, to repeal it. The convention and the directive are, simply, different instruments and even if the new directive will render the convention a less obvious choice by taxpayers it does intend to replace it. In fact, in the preamble of the directive there is not a single reference to the convention 27.

Directive 2017/ 1857 has many similarities with the developments we analysed in the framework of OECD, namely the ones looked at under the MLI. In the same way that arbitration was integrated in the MAP, also in the context of the directive, arbitration (and also other dispute resolution mechanisms) is part of a MAP and only requested when the MAP fails to resolve the dispute.

The MAP proposed in the directive, in line with minimum standard 1.3 28, has a two-year time limit29 which is a valid improvement. This stops MAP from being extended indefinitely.

The final decision, even after the dispute resolution procedures are complete, is made by the competent authorities.

See for a similar position, GRACIA M.ª LUCHENA MOZO, «A Collaborative Relationship in the Resolution of International Tax Disputes and Alternative Measures for Disputes in a PostBEPS ERA», in European Taxation, IBFD, January 2018, p. 24; FILIP DEBELVA & JORIS LUTS, «The European Commission’s Proposal for Double Taxation Dispute Resolution: Turning the Tide», in Bulletin for International Taxation, Vol. 71, No. 5, 2017.

28 See OECD BEPS Action 14 on More Effective Dispute Resolution More effective: 2105 Final Report, OECD, element 1.3.

29 Article 4(1) of the Directive.

27

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Despite the similarities, we would say that the directive embodies a more refined version of the OECD developments, ensuring that dispute resolution suggested by BEPS action plans will be implemented in an organised, harmonised, and sound manner in the European Union. Some of the differences are: Rules concerning the form of complaints and the information that should be provided with them30; the rules on dispute resolution including the involvement of the Advisory Commission and the Alternative Dispute Resolution work are more detailed too, which adds to legal certainty.

Final decisions are always published in full or at the least summarising abstracts31.

Taxpayers’ rights also seemed more guaranteed to the extent that participation in the proceedings is much greater. Taxpayers, with the consent of competent authorities of the Member-States, appear or are represented before the Advisory Commission or Alternative Dispute Commission32.

The most relevant difference is the option that is given to the MemberStates to benefit from alternative dispute resolution mechanisms such as mediation, conciliation, instead of arbitration. This is important because it might happen that not every Member-State may have opted for mandatory arbitration in the framework of the MLI. It is true that also under 25(4) under the OECD Model (2017) there is scope to admit alternative mechanisms, which is reinforced by paragraphs 86 and 87 of the commentary by overtly allowing other supplementary resolution mechanisms. However, that option is much more apparent in the context of the directive where it has a totally different legal value, in the sense that it is considered not merely soft law, but hard law.

One of the implications of the reinforced legal value of the directive is the fact that it prevails over other instruments, including the MLI or tax treaties, in general. Meaning that if those procedures have simultaneously been started, they should be terminated once an Advisory Panel or an Alternative Dispute

Article 3 of the Directive.

Article 18 of the Directive.

32 Article 13(2) of the Directive.

30 31

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Resolution panel is appointed 33. Member-States have the discretion to set up either an Advisory Panel or an Alternative Dispute Resolution Panel.

The Advisory Commission corresponds roughly to the OECD Panel of Arbitrators when independent arbitration is adopted. The Alternative Dispute Resolution Commission is different from the Advisory Commission in terms of composition and represents a gateway to other forms of dispute resolution 34, such as “final offer” arbitration, conciliation and mediation 35.

3. Challenges and Possible Solutions a) Challenges Challenges relate mainly to the OECD instruments, but not much to European instruments. This can be explained by the fact that OECD is a source of soft law and not a binding instrument which affects the efficacy of the BEPS Package, and in particular the Minimum Standard and the Monitoring Mechanism. Hence, even if those measures have been formally approved by OECD and G 20 members, there is no legal sanction in case of non-compliance. Moreover, the great amount of discretion by the states, not only over the implementation itself, but also over the content of the measures taken, may jeopardise harmony and therefore, effectiveness.

A MLI and an OECD Model Convention including mandatory binding arbitration are surely important achievements. We cannot forget, nevertheless, that Part VI of the MLI is merely an option, meaning that, as a consequence, many states will not adopt it.

It is worrisome that some G20 countries, including China, Brazil, Russia and India refused to commit to mandatory binding arbitration 36 . To make things worse, no developing country supported binding arbitration.

See commentary on Article 25(5), mutatis mutandis, § 67.

See DANNY OOSTERHOFF, «New Rules to Resolve Tax Disputes», in International Transfer Pricing Journal, IBFD, January/February 2018, p. 16.

35 Only admissible in the framework of the Alternative Dispute Resolution Commission.

36 See MICHELLE MARKHAM, «New Developments in Disputes Resolution in International Tax», cit., p. 20.

33 34

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According to the statistics, MAP disputes are at a breaking point. Therefore, if arbitration is not adopted as binding and mandatory by as many countries as possible, the situation can become even worse37. Therefore, it is very problematic that OECD was not able to achieve consensus on mandatory binding arbitration in BEPS final report on Action 14. There is a positive note, though – The fact that until 2013, most of the MAP cases involved those 20 states that have committed to mandatory binding MAP arbitration in their bilateral treaties38.

Even if the OECD Model Convention provides for a mandatory binding arbitration, many states in the new conventions to be negotiated, having OECD Model as a basis, may not include the equivalent to Article 25(5), which brings challenges to a higher level.

Let’s hope that the peer pressure from countries which adopted mandatory binding arbitration, combined with trade policies, will force the procrastinators to make up their minds in the future.

There are also other problems that affect arbitration in the way it is designed, many in the OECD context and not the EU context, where most problems were overcome. Some of those shortcomings are39: - Access to arbitration can be extended forever, simply by fulfilling the obligation of notifying the taxpayer; - Some of the information required during a MAP may jeopardise the taxpayers’ right considering that information is obtained outside the wings of any exchange of information provision or agreement and may be used against the taxpayer, equating the effects of a fishing expedition; - Baseball arbitration coupled with unpublished opinions can be problematic and hard to harmonise with constitutional principles; - Even if arbitration, especially baseball arbitration tends to be fast, one cannot forget that arbitration is an extension of a MAP. Therefore, even if there is a positive commitment to the average timeframe of 24 months for the dis-

See MICHELLE MARKHAM, «New Developments in Disputes Resolution in International Tax», cit., p. 18.

38 See Executive summary of Final report on action 14 (p. 10).

39 In SRIRAM GOVIND & SHREYA RAO, «Designing an Inclusive and Equitable Framework for Tax Treaty Dispute Resolution: An Indian Perspective», cit., p. 324.

37

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putes to be resolved, it is a great deal of time, considering that very often disputes take several years before a MAP is started40; - The participation of the taxpayer in the arbitration procedure is very limited; - The relationship between the arbitration process and domestic remedies is a good example of that undesirable far too wide discretion. The fact the commentary allows, itself, a wide variety of options41 further corroborates the idea of lack of uniformity, even when agreeing that arbitration is not a problem.

Despite the drawbacks put forward arbitration is a very important step forward.

As for mediation and conciliation, although they do not allow the shortcomings pointed out to be overcome, they are helpful in promoting agreement in the framework of the MAP, especially in developing countries which have not adopted arbitration yet. The alternative mechanisms those countries simultaneously act as a stepping stone toward arbitration and as a provisional method of boosting the MAP. b) Possible Solutions The best solution, even if not a panacea for every challenge, would be the creation of an international court42 to resolve tax treaty disputes. We want to believe that something like that is already being prepared somewhere in the world. While it materialises in the specific context of the European Union, the Court of Justice of the European Union could play that role43.

Inspiration can be drawn from the treaty between Germany and Austria and the recent Court of Justice of the European Union (CJEU) ruling, C-648/15, 12 September 2017 that was triggered by that convention.

40 See MICHELLE MARKHAM, «New Developments in Disputes Resolution in International Tax», cit., p. 16.

41 See commentary to Article 25(5), §§ 76-79.

42 See GUSTAF LINDENCRONA & NILS MATTSSON, «Arbitration in Taxation: An Introduction», in Intertax, Vol. 42, Issue 3, 2014, pp. 161-162.

43 See ANA PAULA DOURADO & PASQUALE PISTONE, «Some critical thoughts on the Introduction of Arbitration in Tax Treaties», in Intertax, Vol. 42, Issue 3, 2014, pp. 158-160.

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The convention between Austria and Germany is unique, in the sense that under its Article 25(5), in the case of difficulties or doubts concerning the interpretation or the application of its provisions, for which no solution can be found during a mutual agreement procedure between the competent authorities, within a period of three years from the initiation of that procedure, the states’ parties are obliged, at the request of the taxpayer, to submit the dispute to the CJEU under an arbitration procedure pursuant to Article 273 of the Treaty on the Functioning of the European Union (TFEU).

The most interesting aspect of the case C-648/15 was not the material issue at stake, but the fact that the CJEU, by acknowledging its competence under Article 273 of TFEU to decide the case, functioned as a court of arbitration.

Notwithstanding the arguments contrary to this solution, a sound degree of harmonization in the field of dispute resolution would be attained. That is why we think this solution is quite inspiring, even though several arguments can be sustained against it. Let us look at those arguments 44.

One might say that CJEU judges are not tax treaty experts. It is true that in most cases they try to protect fundamental freedoms, often putting a strain on tax law principles. This observation should not be enough to reject their involvement in tax issues. CJEU has dealt with those issues several times and the mounting number of tax cases will certainly develop judges’ familiarity with those cases.

Moreover, a more general approach to tax treaties issues may have advantages, as they have a more pristine view of the matters. That is, they are free of preconceptions. At the end of the day, they are excellent professionals who are capable of adapting to different areas of law.

On the contrary, arbitrators are experts in the area, which implies that they have some preconceptions and a predetermined mind-set. They are very likely to follow their position in the case they are involved. Further, they are

44 The analysis carried out below follows in a close way the elaboration made by Claus Staringer. See CLAUS STARINGER, «Austria: CJUE Pending Case from Austria – Austria/Germany (C-648/15)», in Michael Lang et al (eds.), CJUE Recent Developments in Direct Taxation 2016, Linden, Wien, 2017, pp. 1-10.

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often selected by their public opinions which may make the involvement of professional judges more appropriate.

The procedures followed by the CJEU are more stable, which adds to taxpayer’s certainty, whereas arbitration procedures are too diverse and not always easy to harmonise with domestic law.

It can also be pointed out that enforcement of arbitration decisions is not always easy, considering that taxpayers have means to refuse an arbitration decision, both in the OECD Model Conventions45 and in the Directive on Tax Dispute Resolution46; which strikingly contrasts the enforcement of CJEU judgements that cannot be refused by taxpayers.

Further, CJEU decisions, besides being binding for the states which cannot refuse them even if they agree on a different decision, are also binding for taxpayers. The same does not happen in the context of the OECD Model Convention47 or the directive on dispute resolution, because states may decide to deviate from the opinion of the Advisory Commission or Alternative Dispute Resolution Commission48. This is so because CJEU decisions prevail over domestic court decisions, which does not happen in the context of OECD where arbitration is not possible if there is a court decision rendered on the same subject49.

Finally, it is important to highlight that the involvement of the CJEU has a deterrent effect in relation to non-commitment to agreement by the states, because the treaty between Austria and Germany, although in force for 16 years50, only recently triggered the involvement of the CJEU as a court of arbitration.

For all that was said, the creation of an international tax court or, while it does not materialise, the involvement of the CJEU in the strict context of European Member States, may be considered as sensible possible solutions.

See Article 25(5)(b) of the OCDE Model Convention.

It is required that the final decision is accepted by the affected persons. See Article 15(4) of the Directive.

47 See Article 25(5)(b) of the OECD Model Convention.

48 See Article 15(2) of the Directive.

49 See Article 25(5)(b) of the OECD Model Convention.

50 24 August 2000, signature; 18 August 2002, entry into force; 2003 effective.

45 46

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Trends in Judicial Tax Treaty Interpretation in India

Dhaval J. Sanghavi *

1. Introduction Courts in India have been known worldwide to be a factory, regularly churning out large number of decisions on international tax matters of global relevance. Since all judgments are in English and often as detailed as 100-120 pages in length, the judgments are regularly followed all over the world and even referred to in judgments of Courts of other countries.

It is to be noted that the Indian juridical system for tax matters has a particular flow of hierarchy. The ‘Income Tax Appellate Tribunal’ (ITAT) is a tax court which functions in the major cities in India. Matters from the ITAT may be appealed to the High Court. The various High Courts of the relevant State supersede the decisions of the ITAT. The Supreme Court of India supersedes all matters and decisions of all High Courts and ITATs. In terms of binding nature, decisions pronounced by one ITAT may have persuasive value in another ITAT, but the latter ITAT is not bound to follow the decisions of the former ITAT. Decisions pronounced by a High Court should be referred to and followed by that High Court and the local ITAT in all matters in relation to the same question of law. However, another state High Court is not bound to follow the decisions taken by the High Court of another state. Those decisions of another state High Court are only persuasive in nature and may be referred to for guidance.

India has 27 ITATs and 24 High Courts.

* International Tax Partner at Jitendra Sanghavi & Co., Mumbai, India. Visiting lecturer at LL.M. programs at ITC Leiden, University of Minho (Portugal), University of Zurich.

Assisted by Saloni Jain, Associate, Jitendra Sanghavi & Co., Mumbai, India.

Dhaval J. Sanghavi

One can thus imagine that if each ITAT and each High Court has a different view on a matter, then the number of conflicting decisions will be unruly, resulting in very high levels of uncertainty for taxpayers.

It is thus imperative for the Supreme Court to pronounce conclusive decisions on important questions of law, since the decision of a Supreme Court supersedes all other laws of the land and must be followed by all ITATs and High Courts of India.

This article attempts to highlight uniformity or lack thereof in decisions taken by the Courts in matters of important international tax principles and whether there is a predictable clarity or whether it is leaving the taxpayer with more uncertainty.

2. Treaty Entitlement to Intermediary Holding Companies A tax treaty1 is entered between two countries to eliminate double taxation that may result from taxation of the same income in the residence and source states, i.e. juridical double taxation. The beneficial provisions of a tax treaty can be availed by a person who is a resident of one of the contracting states who are parties to the tax treaty.

India has signed tax treaties with many countries where certain treaties have more favourable terms than the others. Persons who are not resident of such favourable tax treaty country have used such favourable treaties to reduce their Indian tax costs, by setting up an intermediary company resident in such favourable tax treaty country and routing transactions through such company.

This arrangement may be termed as ‘treaty shopping’.

Whether or not such intermediary companies should be entitled to the benefits of the favourable tax treaties has been a matter of substantial litigation.

1 Referred

to as a Double Tax Avoidance Agreement in the Indian context.

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Azadi Bachao Andolan (SC 2003) 2 – Treaty shopping In the Azadi Bachao Andolan case, the Supreme Court has ruled on the constitutional validity of Circular No. 789 of 2000 as per which Foreign Institutional Investors which are resident in Mauritius would not be taxable in India on income from capital gains arising in India on sale of shares of Indian companies. The circular was based on the background that India-Mauritius tax treaty defines ‘Resident of Mauritius’ to mean any person who is liable to taxation in Mauritius by reason of his domicile, residence, place of management or other criteria. Once the person is liable to taxation in Mauritius under any criteria, such person qualifies as a resident of Mauritius and should be eligible to the benefits of the treaty.

Jumping straight to the question of the residence of the companies in Mauritius, the Supreme Court ruled that it cannot judge the legality of treaty shopping by nationals of a third State merely because one section of thought considers it improper. The question of treaty shopping arises when tax authorities opine on how the law ought to be. However the law is uniform and unless expressly stated, its intendment cannot be assumed. Treaty Shopping may or may not have been intended by the two States at the time of entering into the IndiaMauritius tax treaty but many countries encourage it for non-tax reasons.

The Supreme Court further clarified that where a Tax Residency Certificate (TRC) has been issued by the Mauritian government, such certificate shall constitute sufficient evidence for accepting the status of residence and beneficial ownership and the India-Mauritius tax treaty can be applied accordingly. The Supreme Court stated that in the absence of a Limitation of Benefits clause, an entity cannot be denied entitlement to the benefits of the tax treaty.

2 Union of India vs. Azadi Bachao Andolan [2003] 132 Taxman 373 (SC). Azadi Bachao Andolan translates to ‘Save the Freedom Movement’.

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E Trade Mauritius Limited (AAR 2010) 3 – Dubious vs. bona fide transactions Having placed reliance on the Azadi Bachao Andolan case, the Authority for Advance Rulings (AAR) has further clarified that the Supreme Court appears to have differentiated between treaty shopping and the underlying objective of tax avoidance from the use of a colourable device. Designing transactions for tax avoidance which are within the framework of law are not prohibited. Conduit entities and transactions undertaken by such conduit entities are not illegal or invalid if these were set up for the purpose of treaty shopping.

However, transactions which are not supported by bona fide documents or conceal a different transaction are considered sham or a colourable device.

Such dubious transactions can be ignored. The AAR also laid down factors which it considered irrelevant in determining the beneficial ownership of shares – namely the source of funds traced to the holding company, holding company suggesting or negotiating the sale transaction, sale consideration being distributed to the parent, etc. This has been reiterated in the Vodafone Holdings BV case by the SC in 2012. The AAR stated that a TRC can be accepted only as a presumptive evidence of beneficial ownership.

Aditya Birla Nuvo Limited (HC Bom. 2011) 4 – Beneficial owner In another case, a US company AT&T USA entered into a joint venture agreement for investing in an Indian company. AT&T USA subscribed to the shares of the Indian company but its wholly owned subsidiary, AT&T Mauritius was allotted shares in the Indian company as a permitted transferee of its US parent. Since it was not the owner of shares, it was not liable to pay for such shares. All the shareholding rights (voting, selling, transfer rights) were vested in the US parent.

Due to lack of adequate documentation evidencing that the Mauritian company had decided on its own to purchase shares in the Indian company and

3 E-Trade

Mauritius Limited, In Re [2010] 190 Taxman 232 (AAR – New Delhi).

Birla Nuvo Limited vs. Deputy Director of Income Tax (International Taxation), 4(2), Mumbai [2011] 12 taxmann.com 141 (Bombay – High Court).

4 Aditya

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absence of shareholder participation, the High Court held that the Mauritian company were a mere permitted transferee and not the real owner of the shares.

The tax treaty between India and Mauritius could not be invoked. Whether AT&T Mauritius held a valid Tax Residency Certificate of Mauritius was considered irrelevant.

Vodafone International Holdings BV (SC 2012) 5 – Indirect transfers The Vodafone case is the most widely and globally discussed case coming out of the Indian stables. It is unavoidable to write about tax planning in India without referring to the Vodafone case.

The matter in the Vodafone case is not directly related to the discussion at hand since in the Vodafone case there was an indirect of transfer of shares of an Indian company due to the multi-tiered holding company structure transferred by way of transfer of shares of a Cayman Islands company.

Thus, the question of tax treaty protection did not arise since the transferor was resident in a country that did not have a tax treaty with India. The argument of the tax authorities in this case was that the multi-tiered holding structure is to be disregarded, the entire corporate veil should be lifted, and that in reality assets in India were being transferred. The Supreme Court has ruled in 2012 that Vodafone has acted within permissible rules of law. However, with a retrospective amendment to the Income Tax Act in 2012, the tax authorities are still pursuing the case.

AB Mauritius – I (AAR 2018) 6 – Name lender vs. beneficial owner In a recent ruling, the AAR accentuated the modus operandi at the time of acquisition of shares of the Indian company by the Mauritian company. To avail the benefit of a tax treaty, the AAR stated that a company must establish that it is acting on its own behalf and the asset which it seeks to alienate should actually belong to the company.

5 Vodafone 6

International Holdings B.V. vs. Union of India [2012] 17 taxmann.com 202 (SC).

AB Mauritius, In Re [2018] 90 taxmann.com 182 (AAR – New Delhi).

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It was observed that the decision to purchase shares of the Indian company was not made by the Mauritian company. Instead, the share purchase agreement was signed by the director of the parent of Mauritian company. The Mauritian company had no information of the decision to acquire shares of the Indian company until much after the completion of acquisition, when it was directed by its parent to merely ratify the transaction. Board of directors of the Mauritian company merely reiterated decisions of its parent and had no role in decision making process for acquiring shares of the Indian company. It had also not paid any consideration for purchase of shares. The entire consideration was discharged by the parent with no consideration payable by the Mauritian company as per the SPA. Thus the Mauritian company was only a name lender and not the beneficial owner of shares and hence not entitled to the benefits of the India-Mauritius tax treaty.

Skaps Industries India Private Limited (ITAT Ahm. 2018) 7 – TRC requirement The ITAT reiterated that entitlement to treaty benefits are available only to the residents of contracting states. As per the India-USA tax treaty, a resident of USA is a person who is liable to tax in the US by reason of his domicile, residence, citizenship, place of management, place of incorporation or any other criteria. Section 90(2) of the Indian Income Tax Act starts with a non-obstante clause stipulating that beneficial provisions of a tax treaty shall override other provisions of the Income Tax Act. The ITAT ruled that though section 90(4) of the Indian Income Tax Act requires the furnishing of a Tax Residency Certificate by a non-resident to claim treaty benefits, it cannot be treated as a limiting factor for claiming treaty benefits. However, the ITAT confirmed that a reasonable evidence for entitlement to treaty benefits shall always be required, whether in the form of TRC or otherwise.

7 Skaps Industries India (P.) Limited vs. Income Tax Officer, International Taxation, Ahmedabad [2018] 94 taxmann.com 448 (Ahmedabad. Trib.).

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JSH Mauritius Limited (HC Bom. 2018) 8 – Longevity test In this recent case, the Bombay High Court laid emphasis on the fact that shares were held for thirteen years before alienation by the company which was sufficient to conclude that the transaction was bona fide. The utilisation of sale proceeds, i.e. towards reinvestment in another group company, was also held as sufficient evidence that the alienator is not a shell company.

Author Comments It may be abundantly clear from the above, that the tax authorities have been very active and innovative in disregarding structures that are set up by companies in order to impose tax in India on transactions which would have otherwise been protected by a tax treaty and not taxable in India.

The Courts in India have been consistent in their view on entitlement of treaty benefits to residents of other countries, permitting holding company structures where the sanctity of the intermediary company is maintained and disregarding structures where the intermediary company is improperly interposed as merely a name lender. As long as the transactions are conducted properly by the interposed company itself, the Courts have refrained from disregarding the company and have respected the tax treaty entitlements.

With effect from 2012 9, section 90(4) of the Indian Income Tax Act requires that persons not resident in India shall submit a Tax Residency Certificate from the government of the country of which they are resident to claim relief under the tax treaty between India and their country of residence. This was added as an additional layer of procedural protection against treaty abuse.

India has been amending many of its tax treaties and including a Limitation of Benefits (LOB) clause among other amendments, clarifying that benefits of the tax treaties shall not be available to shell or conduit companies. These LOB provisions are being prospectively applied.

8 Commissioner of Income Tax (International Taxation)-3, Mumbai vs. JSH (Mauritius) Ltd. [2017] 84 taxmann.com 37 (Bombay – High Court).

9 Added by Finance Act 2012.

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With the introduction of LOB for transfer of certain shares, the TRC shall only be an evidence of residence and not a conclusive evidence for beneficial ownership of shares. The beneficial ownership shall be ascertained by applying the principles laid down in the LOB provisions of the treaty.

India has also introduced a General Anti Avoidance Rule (GAAR). The GAAR shall apply to any impermissible avoidance arrangement whose main purpose is to obtain a tax benefit. There are threshold limits to the applicability of GAAR and it is expected that a GAAR shall be applied only in rare deserving cases.

Considering the judicial rulings, the changes to the laws & procedures and the changing international tax planning landscape in the wake of BEPS, it is safe to say there is considerable certainty in Indian judiciaries’ approach to the use of intermediary holding companies for investments into India.

3. Treatment of fiscally transparent entities Eligibility to claim benefits of a tax treaty by fiscally transparent entities has been the subject matter of litigation time and again, especially in the context of the India-UK tax treaty.

Partnerships are opaque in India but fiscally transparent entities in the UK, leading to economic double taxation whereby the same income is taxed twice in the hands of different persons i.e. in the hands of the partnership firm in India without giving tax treaty benefits and the partners in the UK as residents of UK. Linklaters LLP (ITAT Mum. 2010) 10 The question whether a partnership being a “fiscally transparent entity” is entitled to the benefits under the tax treaty was raised for the first time by the Tribunal suo moto and not by the tax authorities. The Court asked whether the assessee, being a fiscally transparent entity, which is not a taxable entity under

10 Linklaters LLP vs. Income Tax Officer, International Taxation, Ward 1(1)(2), Mumbai [2011] 9 ITR(T) 217 (Mumbai – Trib.).

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the laws of UK, can be treated as a ‘resident of the United Kingdom within the meaning of that term under the India UK tax treaty, and whether, in this view of the matter, the assessee is entitled to the benefits of the tax treaty at all. The Court laid down that the controversy on residence is to be decided on the concept of ‘liable to taxation (in UK)’.

Residence is based on whether a “person” is “liable to tax’’ in either State owing to residence, domicile, place of management, etc. The residence definition is modelled around a principle as per which what matters from a country perspective is whether treaty protection is being sought in respect of income which is taxed in the treaty partner country or not. Thus in a situation where the entire income of a partnership firm is taxed in the UK – whether in its own hands or the hands of its resident partners individually, treaty benefits cannot be declined.

Schellenberg Wittmer (AAR 2012) 11 A view contrary to the above has been taken by the AAR wherein the assesse partnership firm has been denied benefits of the India-Switzerland tax treaty. The assesse was a fiscally transparent entity in Switzerland and all its partners were residents of Switzerland itself.

The AAR has laid emphasis on the term “person” used in the definition of “resident” under the tax treaty. As per the tax treaty, person includes among other things, body of individuals or entities which are taxable under the laws in force of either Contracting State. According to the AAR, unless the body of individuals or entity is taxable in the concerned State, it will not be a person.

Since the assessee partnership is formed in Switzerland, it should be seen whether it is a taxable entity under the Swiss law. A partnership firm is not a taxable entity in Switzerland. Unlike the definition of person u/s 2(31) in the Indian Income Tax Act, 1961 which explicitly includes partnership firms within its ambit, the Swiss law does not have a corresponding definition of person.

11

Schellenberg Wittmer, In Re [2012] 24 taxmann.com 299 (AAR – New Delhi).

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Thus the AAR held that even though the definition of person in the treaty is inclusive, it cannot be deemed to apply to partnership firms.

Thus the AAR ruled against the assesse because the partnership firm does not satisfy the prerequisite of being a person, and consequently it cannot be entitled to the benefits of the tax treaty. This position taken by AAR stands to differ from the conclusions arrived at in Linklaters LLP and P&O Nedlloyd Ltd. cases where the ITAT and Supreme Court have considered it sufficient for partnerships to be taxable units in India to qualify as persons even if they are not taxable units in UK in those cases.

It further ruled that, in situations where fiscally transparent entities are denied benefits under a tax treaty, the partners shall not be entitled to benefits under their respective tax treaties on their share of income from partnership. It should be noted that the AAR ruling is not in line with the OECD report on partnerships as per which partners should be entitled to tax treaty benefits in such cases.

General Electric Pension Trust (AAR 2006) 12 The matter of treatment of trusts under tax treaties came up before the AAR. Apart from partnerships, also trusts are fiscally transparent entities. The AAR has analysed the term “resident” as given in the India-USA tax treaty and as per Article 4 of the treaty, “Residents of USA’’ shall be those persons who are liable to tax in USA subject to the provisos given in the Article. As per proviso (b), for income derived by a trust among other specified entities, the term resident shall apply only to the extent such income of the trust is subject to tax in USA either in the hands of the trust or its beneficiaries. Thus while for persons other than specified entities, it is sufficient that they are liable to taxation in USA irrespective of actual taxation, it is not so for specified entities like trusts.

Trusts or their beneficiaries shall be subject to actual taxation and not be exempted from tax in USA. In the event of such exemption, trusts are not consid-

12

General Electric Pension Trust, In Re [2006] 150 Taxman 545 (AAR – New Delhi).

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ered as residents of USA and consequently not entitled to claim benefits under the tax treaty.

Chiron Behring GmbH & Co. (HC Bom. 2013) 13 The Mumbai High Court held that benefits of the India-Germany tax treaty cannot be denied to limited partnerships that paid trade tax covered by the treaty and possessed a TRC issued by the German government evidencing that the partnership was a taxable unit in Germany.

As per the treaty, a person includes any taxable unit in Germany. The TRC issued by the German government was considered as sufficient evidence of the firm being a taxable unit in Germany. Further, a resident is a person who is liable to tax under the laws of Germany by reason of domicile, residence, place of management, etc. The limited liability partnership was filing a trade tax return in Germany which was a tax covered under the tax treaty thereby making the firm a resident of Germany.

It was held that while the OECD commentary does not allow fiscally transparent entities such as partnership firms to treaty entitlement, the benefit prescribed under a specific tax treaty cannot be denied on the basis of the OECD commentary. The specific provisions shall prevail to that extent.

P&O Nedlloyd Limited (SC 2016 and HC 2014) 14 Emphasis of this case was on ascertaining whether the LLP was a “person” eligible to claim treaty benefits. While, a LLP is not a taxable unit in UK and hence not a person under the laws of UK, LLPs are considered as firms in India and firms are included in the definition of persons in the Indian Income Tax Act, 1961. As per the Indian Income Tax Act, a firm shall have the meaning

13 Director of Income Tax (International Taxation) vs. Chiron Behring GmbH & Co. [2013] 29 taxmann.com 199 (Bombay – High Court).

14 P&O Nedlloyd Ltd. vs. Assistant Director of Income Tax, International Taxation –II, Kolkata [2014] 52 taxamnn.com 468 (Calcutta – High Court).

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assigned to it in the Indian Partnership Act, 1932 and shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008.

Since a UK LLP was a person for the purposes of the Income Tax Act, and further, by attempting to bring the income to tax in the hands of the LLP, the tax authorities were inadvertently themselves treating the LLP as a person, the tax authorities could not then argue that the UK LLP was not a person for the purposes of the India UK tax treaty. Thus the UK LLP was entitled to be covered by the provisions of the India UK tax treaty.

Author Comments By way of a protocol 15 and a clarification by the CBDT 16 to the India UK tax treaty, the definition of ‘person’ was amended to delete the exclusion of UK partnerships. Also the term ‘resident’ was amended to include partnership firms, estates or trusts to the extent the income is subject to tax in that country either in its hands or in the hands of its partners or beneficiaries.

Until recently, the applicability of tax treaties to fiscally transparent entities was being assumed in transactions and tax treaty provisions were applied without being questioned. That is now becoming an important consideration for taxpayers and tax authorities alike, especially due to the tax treatment arbitrage between nations.

Divergent views in fiscally transparent entities involving different countries is expected due to the emphasis on the nature of the fiscally transparent entity with reference to non-tax laws too, as was seen in the P&O Nedlloyd and Linklaters LLP cases.

Besides non-tax laws to determine treatment of fiscally transparent entities as persons, emphasis is certainly to be laid on subject to tax and not just on liable to tax, in order to determine the residence and eligibility of tax treaty benefits.

15 Notification 16 Circular

No. 10/2014, dated 10 February 2014.

No. 2/2016, dated 25 February 2016.

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4. Fixed Place & Other Permanent Establishments Presence of a foreign enterprise’s Permanent Establishment (PE) in India is relevant for determining taxability of income having nexus to India. Business profits of a non-resident attributable to Indian operations shall be liable to tax in India if it has a PE in India.

Thus, it is of prime importance to determine whether there exists a PE of the foreign enterprise in India. In recent times, a number of landmark judgements and rulings have been pronounced by the Courts and AAR dealing with the many contentious matters associated with PEs. We have discussed a few such decisions which, although not exhaustive, lay down in a consistent manner important principles for determination of a PE in India.

MasterCard Asia Pacific Pte. Ltd. (AAR 2018) 17 This is one of the most recent and significant rulings on PE issues in India. The assesse, MasterCard Asia Pacific, is engaged in processing of card payment transactions for Indian customers through the MasterCard Network infrastructure physically located in India, partly owned by its 100% subsidiary in India. The case analyses whether a PE is constituted in India owing to the existence of MasterCard Network and a subsidiary in India. The matter was decided against the taxpayer MasterCard Asia Pacific.

‘Fixed Place PE’ has been analysed by the AAR with regard to the MasterCard Network, the local banks carrying out the settlement function and the subsidiary in India. To create a Fixed Place PE, the AAR has laid down three tests viz. permanency, a fixed place and disposal. Additionally, it would be necessary to examine whether the activities performed in India are preparatory or auxiliary in character. The AAR states that it is sufficient that the fixed place is at the disposal of the foreign company till the time it is required by the business and permanence does not mean forever. The fixed place should be at the disposal of the foreign enterprise; however, it need not have a formal or legal

17

MasterCard Asia Pacific Pte. Ltd. In Re [2018] 94 taxmann.com 195 (AAR – New Delhi).

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right to use it. Merely having control or the right to use such fixed place is sufficient. The space need not be exclusively used by the foreign company. Equipment need not be fixed to the ground but should remain at a particular site to qualify as fixed place PE. To determine whether the work performed is preliminary or auxiliary, it is necessary to see whether the functions performed in India by the foreign company itself or on its behalf are important and crucial in the context of the overall functions performed by the company. Having relied upon the commentary by Klaus Vogel, it is clarified that activities done for one self may be preparatory or auxiliary. However, when done for a third party would not be so. The nature of work, clerical or otherwise, amount of fees paid, etc. are irrelevant factors for determining the significance of work done. In view of the above factors, MasterCard Asia Pacific was found to have a Fixed Place PE in India in the form of MasterCard Network infrastructure, settlement banks and its subsidiary.

To create a Service PE, the AAR lays down three principle tests viz. services shall be provided within India, the 90 days threshold as per tax treaty should be crossed, and work carried on by persons shall be in connection with the service in question and not any other work. Services should be performed by either employees or other personnel engaged by the foreign company only.

Employees of another organisation (i.e. employees of the settlement bank in India) providing services to the foreign company in their capacity as employees of that other organisation cannot result in the creation of a Service PE. However, employees of MasterCard Asia Pacific visiting India for furtherance of business shall fulfil all the conditions of constituting a service PE. A Dependent Agent PE is also created when a subsidiary is legally and economically dependent on its parent. Subsidiaries that secure orders wholly or almost wholly on behalf of the parent and that too habitually, qualify as dependent agent PEs under the India-Singapore tax treaty. Since the Indian subsidiary was working only for MasterCard Asia Pacific and liaising between MasterCard Asia Pacific and its customers in India for securing orders on its behalf, it constituted a dependent agent PE.

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Nokia Networks OY (ITAT Delhi Special Bench 2018) 18 Although the tests laid down in this decision are similar to the MasterCard case as regards a fixed place PE, the conclusion arrived at by the Tribunal is in favour of the assesse unlike the MasterCard case.

As regards fixed place PE, some important points for consideration have been stated by the ITAT apart from the basic tests which are similar to the MasterCard case. There need not be premises if they are not required or available and simply having a certain amount of space at its disposal can also result in a fixed place of business. Such PE should have characteristics of stability, productivity and dependence and should amount to a virtual projection of the foreign enterprise on the soils of India. Fixed place alludes to some kind of a particular location, physically located premises or some place in physical form. However, telephone, fax or car cannot amount to physically located premises. Moreover business should be carried on through such fixed place to qualify as a PE. Providing assistance to employees of the foreign company visiting India for networking, negotiation and signing of supply contracts in the form of telephone, car or fax cannot be considered as carrying on business through such facilities.

Further as in the case of MasterCard case, the nature of activities carried on in India shall not be preparatory or auxiliary to constitute a PE. Signing the supply contracts, networking and negotiating before the supply of goods are only preparatory and auxiliary activities.

Further, the scope of dependent agent PE has been explained in much detail by the ITAT. A dependent agent carries on activities for the principal which are subject to the principal’s instructions and comprehensive control resulting in legal dependence. Dependent agents do not bear any entrepreneurial risk resulting in economic dependence. Such agents must have sufficient authority to bind the principal’s participation in the business activities that it is conducting on his behalf. Given the above factors, Nokia India was not reckoned as a dependent agent PE of the foreign company because none of the activities of the

18 Nokia Network OY vs. Joint Commissioner of Income Tax, Non-Resident Circle, New Delhi [2018] 94 taxmann.com 111 (Delhi - Trib.) (SB).

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foreign company pertaining to supply contracts were carried on by Nokia India.

Being a subsidiary, Nokia India may have been in complete control of the foreign company and subject to its instructions. However, the control was not exercised for carrying on the supply functions of the foreign company and thus cannot lead to creation of a dependent agent PE. E-Funds IT Solution Inc (SC 2017) 19 E-Fund India performed back office operations in respect of ATM management, electronic payments, decision support and risk management services rendered by E-Fund USA to customers located outside India.

This case is different from the MasterCard case in the sense that the ultimate consumers are not located in India but outside India. Thus the single most important ingredient for constituting a service PE, that the enterprise must furnish services ‘within India’ through employees or other personnel is absent since the customers are located outside India and have received services outside India. Further, as per the OECD commentary what matters is that the services shall be performed in India through an individual present in India. If any customer, resident or otherwise, would have received a service in India, it would be sufficient. However it is not so in the case of E-Funds. Thus no Service PE is created.

The concept of fixed place PE has been well explained in either of the two cases summarised above. In line with them, the E-Fund case also places utmost reliance on the ‘disposal’ test. However it has been clarified that merely giving access to certain premises without having the right to use it or have control upon it would not lead to creation of a PE in India.

Secondly, main business and revenue earning activity should be carried on from the fixed place of business in India which should be at their disposal. Since the Indian subsidiary is only rendering support services, it would not give rise to a fixed place PE.

19 Assistant Director of Income Tax-1, New Delhi vs. E-funds IT Solution Inc. [2017] 86 taxmann.com 240 (SC).

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Further it has been clarified that 100% Indian subsidiaries do not automatically become location PEs if some business is outsourced to them. Even if foreign companies have saved and reduced their expenditure by transferring business of back office operations to the Indian subsidiary, it would itself not create a fixed place or location PE because they are separate and independent entities and are entitled to provide services to their parent who are separate taxpayers. The concept of dependent agent PE has been analysed from a different perspective in this case where importance has been placed on the independence of a subsidiary.

Formula One World Championship Ltd. (SC 2017) 20 This is the landmark judgement that was pronounced by the Supreme Court and deals exclusively with the creation of a Fixed Place PE. The Court has emphasized that a twin condition needs to be satisfied to constitute a fixed place PE: existence of a fixed place of business; through that place, business of the enterprise is wholly or partly carried out.

The Buddh International Circuit was a fixed place owned by Jaypee, an Indian Company. The Formula One Grand Prix was held here, which is the business activity of Formula One World Championship Ltd (FOWC). The question is whether the Buddh Circuit was put at FOWC’s disposal for carrying on its business activities.

FOWC entered into a Race Promotion Contract with Jaypee giving it rights to stage, host and promote the event for a consideration. Jaypee had given back all commercial rights to FOWC and its affiliates vide other agreements which were eventually exploited through the actual conduct of the race in India. Omnipresence of FOWC and its tag over the event was loud, clear and firm.

As long as the race was conducted in India and the income was generated in India, it is immaterial that the race was conducted only for 3 days in a year as long as the event remains under the control of FOWC throughout its duration.

20 Formula One World Championship Ltd. vs. Commissioner of Income Tax. (International Taxation)-3, Delhi [2017] 80 taxmann.com 347 (SC).

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FOWC along with its affiliates had real and dominant control of the event. Thus the Buddh Circuit was put at FOWC’s disposal.

The Buddh Circuit was construed as a virtual projection of the foreign enterprise FOWC on the soils of India. The Buddh Circuit possessed all the three characteristics of a PE as stated by Philip Baker: stability, productivity and dependence. Thus it created a Fixed Place PE of FOWC in India.

Steel Authority of India Limited (ITAT Delhi 2007) 21 Moving to the other aspects of a PE in India, another highly litigated concept is that of a ‘Supervisory PE’. This section shall highlight the conflicting views taken by the Tribunal in the context of Supervisory PE owing to installation projects in India.

In the given ruling, the Tribunal has dealt with the issue of supervisory activities in connection with installation projects constituting a PE in India under the India-Germany tax treaty. It has concluded that supervisory services must be rendered by the foreign company at installation sites in India. However, there is no condition stipulating that activities shall be rendered at sites where the installation services are also being rendered by such foreign company. The Tribunal further explains that it is in view of this reason, where the building site, construction, assembly project or installation may not belong to the foreign company thereby not giving it control and domain over the premises, that the condition of supervisory activities constituting PE would arise only if they continued for a period of 6 months has been stipulated.

Thus, even if the installation or assembly project does not belong to the foreign company, supervisory activities by themselves can constitute a PE if they cross the time period threshold.

21 Steel Authority of India Ltd. vs. Assistant Commissioner of Income Tax, Circle 23(2), New Delhi [2007] 105 ITD 679 (Delhi – Trib.).

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GFA Anlagenbau GmbH (ITAT Delhi 2014) 22 Contrary to the above decision of ITAT, in the instant case under the India-Germany tax treaty, it has held that supervisory activities do not constitute a fixed place of business if the assessee renders services from the project sites of its clients and does not by itself own or operate such sites independently. It is merely providing services under the terms contracted by its clients and has no fixed place of business in India. It has concluded that supervisory activities by themselves cannot constitute a PE as they are to be in connection with a building, construction or activity of the non-resident himself.

Author Comments It is also pertinent to note that the “disposal test� was of paramount importance in both the cases, MasterCard and Nokia, for analysing a fixed place PE. The Courts have also defined certain parameters to determine when a place of business is at the disposal of the foreign enterprise. Varied views have been taken by the Courts on whether any business was carried on through the fixed place of business depending on whether certain activities are merely preparatory and auxiliary to the core business of the foreign enterprise or whether the activities carried on in India are part of the core business of the foreign enterprise.

5. Conclusion The judiciary in India is well known for its meticulous and detailed analysis of questions before it, for guidance referring to the OECD Model, the Commentary to the OECD Model, other OECD reports like the Partnership Report, foreign court judgments, Klaus Vogel on Double Taxation Conventions, renowned global experts on international taxation and even in some cases having foreign experts present in Court as expert witnesses.

22 GFA Anlagenbau GmbH vs. Deputy/Assistant Commissioner of Income Tax (International Taxation)-I, Hyderabad [2014] 47 taxmann.com 313 (Hyderabad Trib.).

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Being a Common Law country, the decisions of the Courts are very relevant to the day to day practice of law in India and thus the onus is on the Courts, specially the higher Courts to give clarity to the taxpayer on matters involving diverse interpretation of law.

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PART II TRANSFER PRICING DISPUTES

Transfer Pricing: International Trends & Spanish Perspective

José M. Calderón *

Preliminary Remarks The purpose of this paper is to examine the new transfer pricing framework derived from the OECD/G20 BEPS Project from an international and Spanish perspective.

This piece of work has three parts. First, the main characteristics of the new transfer pricing framework derived from the BEPS Project are analysed.

The second part is devoted to the analysis of the Spanish regulation on transfer pricing. And lastly, this article highlights the main practical implications that the new global transfer pricing framework has for multinational companies.

1. The BEPS Initiative and Its Impact on the Transfer Pricing Framework

1

The BEPS Project & Action Plan has reshaped the arm’s length (ALS) international standard. The changes introduced by the BEPS Initiative in the ALS occurred because transfer pricing has become one of the most visible and controversial topics in the global tax avoidance debate during the last decade.

* Professor at University of La Coruña, Spain.

1 This section of the article has been elaborated taking into account the following bibliography: WITTENDORF, «BEPS Actions 8-10: Birth of a New Arm’s Length Principle», in TNI, January 25, 2016, pp. 331 et seq.; PANKIV, «Post-BEPS application of the Arm’s Length Principle», in ITPJ, November/December 2016; STORCK, PANKIV &TAVARES, «Global Transfer Pricing Conference: Transfer Pricing in a Post-BEPS World», in ITPJ, May/June, 2016; DE RUITER, «The Future of Transfer Pricing», in TNI, October, 2017; ERNICK, «Can the OECD Remain an International Tax

José M. Calderón

As a reaction to the manipulation of the ALS for base erosion and profit shifting purposes by some MNEs, the BEPS Initiative adopted a new transfer pricing framework that establishes more economic substance and higher level of tax transparency.

With regard to substance, the new TP framework, on the one hand, addresses the mismatches where profits are being taxed vs. where people responsible for generating these profits are located; on the other hand, it provides more alignment between value creation and the taxation of the profits of Multinational Companies (MNEs).

Regarding the increasing level of tax transparency, the new TP framework provides tax authorities with information to carry out audits better and to determine that the “fair share” of taxes is being paid by MNEs. The BEPS Substance recommendations were developed through Actions 810 of the BEPS Action Plan, and they have been included in the 2017 OECD Transfer Pricing Guidelines (OECD TP Guidelines). The BEPS recommendations on transparency are included in the BEPS Final Reports on Action 13 (TP Documentation: the Country by Country Reporting, and new Master & Country file standards that provide a more analytic model of reporting), Action 5 (Spontaneous Exchange of information of tax transfer pricing rulings/APAs on certain intragroup transactions), and Action 12 (Tax Disclosure rules).

Standard-Setting Organization?», in TM Int´l J 745, 45, 2016; HEGGMAIR, «The New Interpretation of the Arm’s Length Principle: a Post-BEPS Evaluation», in ITPJ, July/August 2017; BRAUNER, «Transfer Pricing in BEPS: First Round – Business Interests Win (But, not in Knock-out)», in Intertax, Vol. 43, No. 1, 2015; MANTEGANI & CHANDLER, «Strategic Dispute resolution in a PostBEPS World», Bloomberg BNA, in TM Int´l J 317, 46, 2017; SILVERZTEIN & LE NAUREÈS, «Country-by-Country Reporting: Handbook on Effective Tax Risk Assessment», in ITPJ, January/February, 2018; HOOR, «The Revised OECD TP Guidance on Intangibles», in TNI, April 23, 2018; EY 2017 Tax Risk and Controversy Survey Series: Finding Your Glow: How Businesses Optimize Their Tax Function, 2017; EY 2016 Transfer Pricing Survey Series – How Anti-BEPS Policies Are Changing Transfer Pricing; EY 2106-17 – Transfer Pricing Series – Controversy Avoidance and Resolution; EY 2016-17 Transfer Pricing Survey Series – Operationalizing Global Transfer Pricing. Key Steps for Translating Strategy into Practice; EY 2016 Transfer Pricing Series – In the Spotlight: a New Era of Transparency and Risk; EY 2017 Tax Risks and Controversy Survey Series – Dimming the Glare; Kpmg, The BEPS Ripple Effect, 2017; and TURINA, «Back to the Grass Roots: the Arm´s length Standard, Comparability and Transparency –Some Perspectives from the Emerging World», in WTJ, May 2018.

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The 2015 BEPS final reports did not finish the revision of the TP framework, and in that sense, it can be mentioned in some areas where the OECD is developing new guidance in line with the BEPS principles adopted by the G20 in 2015: • Profit Split Method common guidance; • Intragroup financial transactions guidance; • Hard-to-Value Intangibles (HTVI) guidance; • Digital Economy taxation rules that have potential impact on the nexus & profit allocation standards; • Development of new mechanisms for preventing tax controversy: the OECD announced in May 2018 further development of Chapters IV & VII of the TP Guidelines.

The main messages from the BEPS initiative (Actions 7-10) could be summarized as follows: • A much broader definition of Permanent Establishments; • The retention of the arm’s length standard; - Rejection of alternative approaches as well as the formulary apportionment system; • Rejection of significant returns for bare legal asset ownership/mere contractual allocation of risk: - Functionless entities will receive free return at best under the ALS. • New profit allocation model based on economic and functional substance and not only on contractual profit allocation: - Mere legal ownership of an asset (IP) does not determines profit allocation from the exploitation of such asset; - Performance of relevant functions (DEMPE) and assumption & control of significant risks are needed; - More polycentric (decentralized) profit allocation model for MNEs: profit & loss allocation based on substance and functions performed by each member of the MNE group (functional value creation model); - New TP requires more alignment between the business model & TP policy.

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• Transparency measures support the implementation of BEPS Actions 710 allowing focus on high risk transfer pricing models: - Country-by-Country Reporting: • Global operations & country-by-country analysis; • CbC R allows tax authorities to carry out cross-country comparison of the global profit allocation of the MNEs: not based on transactions.

- Reinforced transfer pricing documentation standards: • More analytical model, pseudo-global value chain approach.

- Enhanced co-operation and information exchange between tax administrations (rulings/APAs, disclosure rules); - Development of tax administrations practice and legislation to enforce two-sided transfer pricing analysis in high-risk cases.

The main implications of the new ALS framework post-BEPS for the tax authorities and the taxpayers could be established in the following terms: • The new paradigm creates greater levels of coordination related to the application of the ALS: BEPS brings a more developed standard (new version of the OECD TP Guidelines 2017, more flesh on the TP skeleton); • New framework (BEPS) transforms the ALS into an “anti-abuse” tool (beyond its original nature: profit allocation measure); - The OECD is trying to curb and dismantle certain aggressive tax planning schemes and perceived abuses undertaken by MNEs with regard to base erosion & profit shifting through contractual allocation of assets & risks (i.e., cash boxes); • New profit allocation model based on functional value creation (and the new risk allocation framework) determines a more demanding and complex compliance standard.

- The ultimate assessment of the relative importance of contributions is a very subjective exercise (different tax administrations may have different views, which creates higher risks of double taxation or multiple taxation).

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And the BEPS measures to be implemented by the different jurisdictions that result from the BEPS final reports adopted by the OECD and the G20 on October 2015 are the following: • Action 13 Measures (CbC R) constitute a “minimum standard” (mandatory); • Action 5 Measures (Exchange of information of tax rulings/APAs), constitute a “minimum standard” (mandatory); • Actions 7, 8-10 measures (Permanent Establishment and Transfer Pricing) constitute a “recommendation” (non-mandatory but it is considered “international soft-law” resulting from the OECD TP Guidelines that are connected with tax treaties (Articles 9 & 25 of the OECD Model) and domestic legislation, that is Soft-law with Hard-law effects).

• Action 12 measures (Aggressive Tax Planning Disclosure rules) constitute a “Best Practice”.

• Action 14 measures (Mutual Agreement Procedure improvements) constitute a “minimum standard”, but the new arbitration procedures are just a “best practice”.

With regard to the BEPS measures implemented by the different jurisdictions, high levels of effective and global implementation of the minimum standards resulting from BEPS2 can be pointed out: • 1st Country-by-Country Reporting: - As of January 2018, 60 jurisdictions have introduced legislation to impose CbC R filing obligation for relevant multinational enterprises (MNEs).

• 2nd Master File/Local File post-BEPS: - As of January 2018, 34 jurisdictions have introduced legislation to impose Master and local files (in line with the Action 13 Final report) for relevant multinational enterprises (MNEs).

• 3rd Countries that signed the MCAA on CbC R: 68 countries have signed the Multilateral Competent Authority agreement for the automatic Exchange of the CbC reports filed by the MNEs.

2 OECD/G20, Country-by-Country Reporting – Compilation of Peer Review Reports (Phase 1), May 2018.

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• 4th Transfer Pricing Substantive Domestic Legislation: At least 30 jurisdictions have implemented (or proposed) an amendment of their domestic TP framework to align it with the 2017 TP Guidelines. Some other countries “implement” the new BEPS framework through tax administration “enforcement” of the domestic law in the light of the 2017 OECD TP Guidelines.

2. The Spanish Transfer Pricing Framework This section of the article provides an overview of the Spanish transfer pricing regime. In this sense, it should be noted that the new Ley del Impuesto sobre Sociedades (Corporate Income Tax Law, LIS)3 has enacted significant changes in the regulation of the Spanish transfer pricing regime, some of which are intended to align Spanish legislation with the OECD Transfer Pricing Guidelines of 20104. The modernization of this regime also includes the incorporation of certain measures recommended by the OECD and the G20 in their Base Erosion and Profit Shifting (BEPS) Initiative. It is also impossible to disregard how the Spanish tax administration applies the latest trends in international taxation and transfer pricing, which includes the use of tax management risks tools and the establishing of specialized units such as the Oficina Nacional de Fiscalidad Internacional (the State Central Office of International Taxation) and teams in this area.

2.1. The Importance of Transfer Pricing for Cross-Border Entities Operating in Spain The transfer pricing regime constitutes the backbone of the LIS. It could be said that any material transaction, i.e. domestic or cross-border, carried out between related parties must pass an “arm’s-length test”, inasmuch as the Spanish tax administration routinely supervises the level of compliance of such

3 ES: Ley del Impuesto sobre Sociedades (Corporate Income Tax Law, LIS), Law 27/2014 of 27 November 2014.

4 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD 2010), International Organizations’ Documentation IBFD.

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transactions with the transfer pricing regime. Previously, most of the audits carried out by the tax administration focused on inbound intra-group transactions and were implemented using a “multiple tool approach”. To that end, the application of the general anti-abuse rules (GAAR), fraus legis (abuse of law), anti-sham transactions and recharacterization provisions, as well as the inversion of the burden of proof with regard to the reality and economic rationality of any structure, were the primary mechanisms for the tax regularization and the reassessment of inbound transactions5.

However, in recent decades, tax administration’s increasing attention on both inbound and outbound transactions indicates a likely change of approach in the audits undertaken by the tax administration. In particular, an increasing number of transfer pricing audits and a more aggressive approach by the tax administration can be observed, especially with regard to financial expenses, leveraged acquisitions, reorganizations and restructurings, management services, transactions involving valuable intangibles and loss-making entities6. The new audit’s focus on the transfer pricing aspects of international structures is combined with the widespread use of the general and special anti-abuse provisions. The tax administration has also made use of the provisions relating to permanent establishments (PEs) as contained in tax treaties that Spain has concluded to counter certain restructuring transactions, thereby resulting in a widening of the concept of a PE in Spain7.

5 See C. MORA-GIL, M. PÉREZ AGUILAR & J.M. GIL-ROBLES, «Spain´s Treatment of Management Service Expenses between Related Parties», in Tax Notes Intl., 30, 2, 14 April 2003; C. PALAO TABOADA, «El Rigor de la prueba en materia de precios de transferencia», in Revista de Contabilidad y Tributación, 196, 1996, pp. 113 et seq.; A. COLLADO & A. DELGADO, Pasado, presente y futuro de los precios de transferencia en España, in Fiscalidad Internacional, Estudios Financieros, 2001, pp. 625 et seq.; M. LLANSO, Operaciones Vinculadas, in Impuesto sobre Sociedades, Vol. 1, Cuatrecasas ed., Civitas, 1998, pp. 744 et seq.; C. GARCIA-HERRERA, Precios de transferencia y otras operaciones vinculadas en el Impuesto sobre Sociedades, IEF, 2002; and J. M. CALDERÓN, «Spanish Courts Address Transfer Pricing Legislation», in Tax Notes Intl., 26, 1, April 2002.

6 See the Resolución de 8 de Enero de 2018, de la Dirección General de la Agencia Estatal de Administración Tributaria, Public Ruling of the State Agency of Tax Administration, AEAT, which contains the general guidelines of the por la que se aprueban las directrices generals del Plan Anual de Control Tributario y Aduanero 2018, Annual Plan of Tax and Customs Control, 2018, section II, point 2, regarding international tax planning.

7 See N. CARMONA FERNÁNDEZ, «The Concept of Permanent Establishment in the Courts: Operating Structures Utilizing Commission Subsidiaries», in Bull. Intl. Taxn., 67, 6, 2013;

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In this respect, it is important to note that the tax administration has actively participated in the OECD/G20 BEPS Focus Group. The tax administration is also supportive of the OECD/G20 BEPS initiative and Action Plan, particularly with regard to Actions 8-10, Aligning Transfer Pricing outcomes with Value Creation 8 , and Action 13, Transfer Pricing Documentation and Country-byCountry Reporting9. The reform of the corporate income tax of 2014 anticipated several BEPS trends and/or recommendations established by the OECD and G20 BEPS initiative in introducing anti-hybrid instrument rules, new limits on the deductibility of financial expenses, an expanded controlled foreign company (CFC) regime and more robust transfer pricing rules. In addition, it should be noted that Spain was the first country to implement, by way of hard law rules, Action 13 of the OECD/G20 BEPS initiative on transfer pricing documentation and Country-by-Country (CbC) reporting10.

2.2. The Spanish Regulatory Framework for the Arm’s-length Principle The substantive transfer pricing provisions is contained in Article 18 of Law 27/201411, which was approved on 27 November 2014. This provision establishes the basic framework for the application of the arm’s-length principle in Spain. In particular, Article 18 of the LIS provides the primary substantive rules that are developed by the Corporation Income Tax (LIS) regulations regarding the following issues: • The mandatory application of the arm’s-length principle in the valuation of transactions between related parties and the discretionary power on the part of the tax administration to disregard such transactions undertaken;

and E. MARTÍNEZ-MATOSAS & J. M. CALDERÓN, «Subsidiary Constituted PE, Supreme Court Rules», in Tax Notes Intl., 65, 10, 5 March 2012, and «Spanish Court Rules on Permanent Establishments in Dell», in Tax Notes Intl., 68, 4, 22 October 2012.

8 OECD, Actions 8-10 Final Report 2015 – Aligning Transfer Pricing Outcomes with Value Creation (OECD 2015), International Organizations’ Documentation IBFD. 9 OECD, Action 13 Final Report 2015 – Transfer Pricing Documentation and Country-by-Country Reporting (OECD 2015), International Organizations’ Documentation IBFD. 10 ES: Real Decreto (Royal Decree) 634/2015 of 10 July 2015, por el que se aprueba el Reglamento del Impuesto sobre Sociedades (Regulations on the Corporation Income Tax).

11 ES: Ley (Law) 27/2014 of 27 November 2014.

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• The definition of related parties; • The transfer pricing methodologies; • The transfer pricing documentation requirements; • The special rules regarding the provision of intra-group services and specific valuation methodologies with regard to transactions between shareholders and professional entities that are adjusted to conform to economic reality; • The secondary adjustment material rules and the procedure for excluding its application by the restitution of the excess of income paid between related parties; • The specific transfer pricing auditing procedures; • The specific transfer pricing penalties; • The procedures regarding advance pricing agreements (APAs); and • The rules for the application of cost-sharing arrangements.

Royal Decree 634/2015 of 201512 sets out the regulations with respect to the LIS that contains the relevant procedural and substantive provisions regarding transfer pricing audits. These provisions include, inter alia, the rules regarding APAs and cost-sharing agreements, secondary adjustments, and the restitution and/or repatriation of income within an audit. The LIS regulations also set out the following three-tier transfer pricing documentation requirements: (1) the Master File; (2) the Local File; and (3) the CbC report, based on the full implementation of Action 13 of the OECD/G20 BEPS initiative, which apply to persons or entities involved in related-party transactions. The transfer pricing documentation requirements have been in effect in Spain since 2006, following the introduction of Law 36/200613, which applies to tax periods beginning on or after 1 December 2006. This includes the clear transfer of the burden of proof to the taxpayer and a change in the penalty regime.

The tax administration has not elaborated in any public ruling or administrative circular regarding the application of the transfer pricing legislation, despite the lack of domestic administrative guidance on main issues referred to with regard to the practical application of the transfer pricing law. In this re-

12 13

ES: Real Decreto (Royal Decree) 634/2015 of 10 July 2015.

ES: Ley (Law) of 29 Nov. 2006.

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spect, it should be noted that the tax administration and practitioners, and even the courts, primarily rely on OECD transfer pricing soft law in applying the transfer pricing regime in Spain14. This situation can be criticized considering the significant level of legal uncertainty deriving from a transfer pricing regime that only sets out basic principles but does not elaborate on any specific rules covering the main practical aspects of the LIS15.

It is true that Spanish transfer pricing regime explicitly endorses the application of the OECD Transfer Pricing Guidelines and those of the EU Joint Transfer Pricing Forum (EUJTPF). In particular, the Explanatory statement to the LIS provides that: the interpretation of the provision that regulates these (related) transactions (Article 18 of the LIS) has to be performed, precisely, in accordance with the OECD Transfer Pricing Guidelines as well as with the recommendations of the European Joint Transfer Pricing Forum, to the extent that these (soft-law materials) do not contradict such provision or the LIS regulations16.

The explanatory statement to LIS constitutes the primary legal basis invoked by tax administration and practitioners with regard to arriving at an interpretation of the substantive transfer pricing regime that accords with the OECD Transfer Pricing Guidelines. In this context, it should be emphasized that Article 18 of the LIS only provides basic principles with regard to the application of the arm’s-length principle, but neither this law provision nor the LIS regulations contain a complete framework for dealing with the main technical aspects of the transfer pricing practice. For instance, basic issues, such as the use of a “market range”, “comparability adjustments” and “comparables”, i.e. local, Pan-European, etc., that could be used by taxpayers and have not yet been regulated.

14 N. CARMONA FERNÁNDEZ, Nuevo Régimen Fiscal de las operaciones vinculadas, Ciss, 2016, pp. 37 et seq.

15 With regard to the lack of a complete transfer pricing framework in Spain and the indirect reference to the OECD to “fill the domestic regulatory gap”, see J. M. CALDERÓN, «The OECD Transfer Pricing Guidelines as a Source of Tax Law: Is Globalization Reaching the Tax Law?», in Intertax, 35, 1, 2007.

16 All quotations of Spanish law and regulations are the author’s unofficial translations.

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For the first time, the LIS also introduces the possibility for the tax administration to disregard and reconstruct related party transactions, but the conditions and limits for the use of this new administrative power have not yet been regulated clearly, soundly or consistently17. As noted before, the lack of a complete substantive transfer pricing regime is a very significant source of legal uncertainty which can cause multiple tax disputes and controversies at the domestic and international level.

The framework of transfer pricing in the LIS is based on the premise that the OECD Transfer Pricing Guidelines constitute and apply as a “pseudo-regulation” in providing detailed technical rules that fill the “domestic regulatory gap” and permit the suitable practical application of the arm’s-length principle in Spain. However, this is neither the legal nature nor the function of the OECD Transfer Pricing Guidelines and, therefore, such an improper use of the OECD Guidelines, in the author’s opinion, is flawed from a legal and practical perspective18.

In this vein, it should also be noted that the LIS does not refer to a specific version of the OECD Transfer Pricing Guidelines. The ambiguous reference to the OECD Transfer Pricing Guidelines poses the classic international tax issue in reference to the dynamic and/or ambulatory versus static interpretation of the law in the light of the corresponding OECD soft law. This issue is, currently,

17 In the same vein and expanding this criticism, see A. GARCÍA PRATS, «La recaracterización de Operaciones y Normas Antiabuso», in Carmona Fernández (ed.), supra n. 14, at chapter 18, pp. 664 et seq., and J. M. CALDERÓN & A. J. MARTÍN JIMÉNEZ, «El Procedimiento de Comprobación de las Operaciones Vinculadas», in Carmona Fernández (ed.), cit., chapter 17, pp. 575582. These authors remarked on the problems of this new “recharacterization power” with regard to the constitutional principles of legality and legal certainty, as well as on the lack of a clear rules dealing with the relationship between the new “disregard rule” and the secondary adjustment clause (Article 18.11 of the LIS) and the GAARs as set out in ES: Ley General Tributaria (General Tax Law, LGT), Articles 13, 15 and 16. In addition, the level of consistency of the new disregard provision in Article 18 of the LIS with the OECD/G20 BEPS initiative it is far from clear, inasmuch as the new conception of the “non-recognition clause” of the related parties transactions provided by the OECD, supra n. 8, at paras.1.1119-11125 is based on a “commercial rationality” test. On this issue, see also: D. CAÑABATE CLAU, Precios de Transferencia en las operaciones de reestructuración empresarial, Francis Lefebvre, Madrid, 2016, pp. 75 et seq., and 128 et seq.; and J. CALDERÓN, «La evolución del marco valorativo y de reconocimiento de las operaciones intragrupo», in Revista Interactiva de Actualidad Tributaria, AEDAF, October 2016.

18 J. M. CALDERÓN, Precios de Transferencia e Impuesto sobre Sociedades, Tirant lo blanc, 2005.

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particularly important inasmuch as it is far from clear whether or not, at present, or in the future, the transfer pricing framework in Article 18 of the LIS, and Articles 13 to 36 of the LIS regulations19 can, or must, be interpreted in accordance with the Final Report on Actions 8-10 of the OECD/G20 BEPS initiative20. Traditionally, the tax administration has pursued and followed a dynamic interpretation of tax treaties and the domestic law in accordance with the last version of the OECD international taxation soft law materials available, i.e., the OECD Model (2014)21, the OECD Transfer Pricing Guidelines, the Report on the Attribution of Profits to Permanent Establishments of 200822, etc.23. Consequently, it can be anticipated that, from the perspective of consistency, this practice will be followed with regard to the Final Reports of 2015 of the OECD/G20 BEPS initiative, particularly once the OECD Council issues a recommendation to the OECD member states to follow such BEPS reports and when the new updated version of the OECD Transfer Pricing Guidelines is adopted, including the changes provided by the BEPS Final Report (Actions 8-10).

19 The interpretation of the Spanish transfer pricing documentation framework established

by Articles 13-16 of the LIS regulations in accordance with the OECD is derived from the Explanatory Statement to the LIS regulations.

20 This issue is also relevant from an EU perspective, taking into account the current approach of the European Commission with regard to the application of the State aid provisions of the Treaty on the Functioning of the European Union (TFEU) Articles 107 et seq., OJ C-306 (2007). In this regard, it should be taken into account the EU Commission Notice on the notion of State aid (19 May 2016), as well as the DG Competition WP on State Aid and Tax Rulings (3 June 2016); these EU documents provide a conditional endorsement of the OECD Transfer Pricing Guidelines to the application of the state aid provisions.

21 OECD Model Tax Convention on Income and on Capital (26 July 2014), Models IBFD. 22 OECD, Attribution of Profits to Permanent Establishments (OECD 2008).

23 The Spanish Audiencia Nacional (National Court, AN) and the Supreme Court have decided on the limits of the interpretation of the Spanish law in accordance with the OECD soft law, in establishing that such OECD material cannot be used as the legal base for determining the taxable income and expenses of the taxpayers where Spanish tax law does not establish a clear rule on the matter, i.e. the model to be used for the attribution of free capital to PEs. In this respect, see ES: AN, 10 July 2015, rec. 281/2012 and the Supreme Court rulings of 21 February 2017 (rec. 2970/2001) and of 19 October 2016 /rec. 2558/2015). Notable authors have also noted how the post-BEPS OECD TP Guidelines (2017) give rise to a new arm’s length principle and, in that sense, its implementation at a domestic level requires the enactment of hard law measures [see J. TOBIN, «Intangible BEPS Risks», in TM International Journal, 45, 2016, p. 226, and J. WITTENDORF, «BEPS Actions 8-10: Birth of a New Arm’s-Length Principle», in Tax Notes Int’l., 25 January 2016, pp. 331 et seq.

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In addition, the LIS does not provide a reconciliation rule between the OECD Transfer Pricing Guidelines and the recommendations of the EUJTPF. As these are autonomous sources of transfer pricing soft law, the lack of a rule resolving any conflicts between them is another source of legal uncertainty and controversy that should be resolved.

The Spanish domestic rules regarding the attribution of profits to PEs give rise to the same kind of problems involving the substantive transfer pricing domestic framework. Nevertheless, the new LIS24 has, in some sense, clarified that the internal dealings between a head office and PEs abroad are related transactions that must be reported in accordance with the principles established in the (2008) OECD Report on the Attribution of Profits to Permanent Establishments. In addition, the authorised OECD approach (AOA) only applies when a tax treaty that is in force provides such a model of attribution of profits to PEs25.

Finally, the relevant treaty network and the EU Arbitration Convention (90/436)26/27 must be considered as part of the Spanish transfer pricing domestic framework, inasmuch as these provide an important and useful mechanism for resolving international transfer pricing controversies. All of the tax treaties that Spain has concluded a mutual agreement procedure (MAP), and associated enterprises provisions that broadly follow those which are provided for in Articles 9 and 2528 of the OECD Model (2010)29. Furthermore, the Protocol (2011)30 to

ES: Ley (Law) 27/2014 of 27 Nov. 2014.

Articles 18.2.i) and 8, 22.5 and 31.4 LIS. For a comment on these provisions, see J. M. CALDERÓN, Tributación de los Beneficios Empresariales, in Carmona Fernández (ed.), cit., pp. 221 et seq.

26 Arbitration Convention 90/436/EEC of 23 July 1990 on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises, EU Law, IBFD [hereinafter: the EU Arbitration Convention (90/436)].

27 A. J. MARTIN JIMÉNEZ & J. M. CALDERÓN, Los precios de transferencia en la encrucijada del siglo XXI, chapter V, Netbiblo, 2012, pp. 234 et seq.

28 ES: Real Decreto (Royal Decree) 1794/2004 of 18 November 2008, which provides the domestic rules for the application of the MAP and arbitration procedures in the tax treaties that Spain has concluded.

29 OECD Model Tax Convention on Income and on Capital (22 July 20140).

30 Protocol between the Swiss Confederation and the Kingdom of Spain amending the Convention for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital signed at Bern on 26 April 1966, and its Protocol, as amended by the Protocol signed at Madrid on 29 June 2006 (Hereinafter Referred to as "The Amending Protocol") (27 July 2011).

24 25

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the Spain-Switzerland Income and Capital Tax Treaty (1966)31 and the SpainUnited Kingdom Income and Capital Tax Treaty (2013)32 both include a clause providing arbitration procedures with regard to the resolution of international tax controversies, which encompasses reassessments for transfer pricing disputes. It should also be noted that the Spanish tax administration and courts33 consider Article 9 of the tax treaties based on the OECD Model as an autonomous legal base for disregarding related transactions, a position that cannot be shared when taking the nature and function of this provision into account.

2.3. The Primary Features of the Spanish Transfer Pricing Regime 2.3.1. The Arm’s-length Principle: Material Rules and Enforcement Procedures Article 18.1 of the LIS provides for the mandatory application of the arm’slength principle by taxpayers, in the sense that the domestic and international transactions between related persons or entities must be assessed at an arm’slength price. This is understood as the price that would have been agreed upon between unrelated parties dealing under normal open market conditions.

The arm’s-length principle is conceived as a self-standing mandatory valuation standard that taxpayers must apply to tax compliance by the Spanish self-assessment system. Consequently, the income and expenses to be reported by the taxpayers with regard to a corporation’s income tax compliance must be Convention between Spain and the Swiss Confederation for the Avoidance of Double Taxation with respect to Taxes on Income and Capital (unofficial translation) (26 April 1966).

32 Convention between the Kingdom of Spain and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital (14 March 2013).

33 See the decisions of the Spanish Tribunal Supremo (Supreme Court, TS) in ES: TS, 18 July 2012, No. Rec. 3779/09; ES: AN, 11 December 2014, No. Rec. 317/2011; and of the Spanish Tribunal Económico Administrativo Central (Central Economic-Administrative Court, TEAC) in ES: TEAC, 5 November 2015, No. Rec. 05110/2012. See also N. CARMONA FERNÁNDEZ, «Recaracterización de operaciones por aplicación del régimen de vinculación fiscal», in Carta Tributaria, No. 2, pp. 1-2, May 2015. It should be noted that the Supreme Court ruling of 31 May 2016 (No. Rec. 58/2015, Peugeot case), held that Article 9 of the tax treaties cannot be invoked as a legal base for disregarding related transactions (see: J. CALDERÓN, «La evolución del marco valorativo y de reconocimiento de las operaciones intragrupo», in Revista Interactiva de Actualidad Tributaria, AEDAF, October 2016).

31

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consistent with the transfer pricing methods used to establish or test the application of the arm’s-length principle. However, differences between income and expenses for bookkeeping and tax purposes can arise, considering that the arm’slength market value and the fair value are not necessarily the same and that these valuations apply in different circumstances.

Despite this, the tax administration has adopted a restrictive position regarding the application of self-initiated transfer pricing adjustments made by taxpayers, in emphasizing the need for the consistent application of the book value with the arm’s-length principle, and thereby countering potential tax planning34. In this context, it should be noted that self-initiated adjustments can give rise to double taxation35 as well as secondary adjustments. The LIS 36 envisages the application of secondary adjustments by the tax administration when a primary adjustment has been made37. In relation to such secondary adjustments, the difference between the assessed arm’s-length value and the value agreed upon by the parties has, for the related parties, the tax treatment that corresponds to the juridical nature of the transaction realized38. The LIS clarifies that, where the link is defined in light of the relationship between the shareholder and the entity, the difference referred to, in proportion to the entity´s degree of

34 In this regard, see the rulings of the Spanish Dirección General de Tributos (General Directorate of Taxes, DGT) in ES: DGT, 7 February 2008, V0249/2008; ES: DGT, 10 November 2010, V240210; and ES: DGT, 17 February 2011, V0382-11, as well as the commentaries provided by members of the tax administration, i.e., E. SANZ GADEA, Fiscalidad de los Precios de Transferencia, chapter 6, CEF, 2010, and I. HUIDOBRO, «Documentación Contable y Fiscal: Asimetrías», chapter 23, in Carmona Fernández (ed.), cit., pp. 817 et seq. A more flexible position has been adopted by several authors, including M. TRAPÉ VILADOMAT, «Ajustes Valorativos y Normas de Contabilidad», in Carmona Fernández (ed.), cit., chapter 3, pp. 101 et seq., and J. M. CALDERÓN, «Algunas consideraciones sobre la prestación de servicios intragrupo en el marco de la nueva regulación de operaciones vinculadas», in Carta Tributaria, No. 8, February 2008.

35 The Spanish domestic MAP regulations do not envisage the possibility to commence a MAP where taxpayer-initiated adjustments are affected that are contrary to those provided for by some other countries, such as the United States. In this regard, see I.R.S. Revenue Procedure 2015-40, Administrative Documentation IBFD, and B. GLEICHER & N. GARD, «Revenue Procedure 2015-40: The New Chapter in Competent Authority», in TM International Journal, 45, 12 February 2016, p. 71.

36 Article 18.11 LIS. 37 The Spanish lawmaker has followed ES: TS, 27 May 2014, Rec. Ord. 8/2009, in which the TS held that the material rules dealing with the secondary adjustment had to be regulated by law.

38 J. GONZALEZ CARCEDO, «Ajustes Secundarios», in Carmona Fernández (ed.), cit., pp.

515 et seq.

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participation, is considered to be: (1) dividends, whenever such a difference is in favour of shareholders; or (2) contributions made by shareholders to the entity’s equity, whenever the difference is in favour of the entity. Secondary adjustments do not apply if the parties have agreed to repatriate the excess of profits as assessed by the tax administration39. Neither the LIS nor the LIS regulations state the procedure for making such a refund or what evidence must be provided in this regard. As a result, this “regulatory gap” is yet another source of legal uncertainty40.

It should again be emphasized that Law 27/2014 introduced the possibility that the tax administration can disregard and reconstruct a related party transaction, but that the conditions and limits for the use of this new administrative power have not been clearly stated in a sound and consistent manner.

Consequently, the arm’s-length clause set out in Article 18 of the LIS does not only constitute a valuation standard for profit and loss allocation, inasmuch as it also provides a special recharacterization provision. This can be applied to related transactions when the tax administration considers that these transactions differ from what independent parties would have agreed in the same circumstances. It can, therefore, be said that the Spanish lawmaker has created a new “Pandora’s box” that can be “opened” by the tax administration in a number of cases, without establishing the corresponding legal framework and limits for its application41.

39 It can be argued that the Spanish lawmaker followed the recommendation of the EUJTPF on Secondary Adjustments that was included in European Commission, Communication on Transfer Pricing (COM(2014) 315 final, Brussels 4.6.2014).

40 M. ORTEGA CALLE & M. CUENCA MIGUEL, «Examining Proposed Changes to Spain´s Transfer Pricing Reporting Requirements», in Bloomberg BNA Transfer Pricing Rpt., 25 May 2015, p.

3, and M. ORTEGA CALLE & D. PEREZ MUNOZ, «Analysis of Transfer Pricing Amendments in Spain´s Corporate Income Tax Law», in Bloomberg BNA Transfer Pricing Rpt., 23, 19 February 2015, p.

1330.

41 Hopefully, the interpretation of the “non-recognition rule” in Article 18.10 of the LIS in accordance with OECD TP Guidelines (2017), paras. 1.119 to 1.128 could result in a more tempered application of this rule in Spain. In this regard, it must be emphasized that the new guidance deriving from the OECD TP Guidelines (2017) limits the application of the “non-recognition” or “disregard principle” to exceptional cases where the related transactions undertaken viewed in their entirely lack commercial rationality and no comparable transactions between independent entities exist. Consequently, when these transactions posse commercial rationality, in constituting, for example, a legitimate business transaction for sound business reasons, the application of this rule, i.e.

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The LIS has also established two special rules regarding intra-group services and transactions with tax havens. On one hand, the intra-group services legal framework in Article 18.5 of the LIS broadly follows Chapter VII of the OECD Transfer Pricing Guidelines and, in fact, the nature, object and purpose of this clause are no longer set out as a rule determining the tax deductibility of inbound management fees. However, the new clause does not regulate critical aspects for the practical application of the arm’s-length principle. In particular, the rules do not contain an indication of the concept of “shareholder and stewardship activities” and, in this sense, it is unclear whether or not “global functions” constitute an intra-group service42. The same can be said about the “benefit test”, inasmuch as it is unclear which standard applies, i.e. the general or the specific benefit test43. The law does not provide special rules for low-value adding intra-group services, as recommended by Actions 8 to 10 of the OECD/G20 BEPS Final Report on Actions 8 to 1044. It also should be noted that Actions 8 to 10 of the BEPS Action Plan have relevant consequences to the application of the

non-recognition, is not permitted, even when the transaction cannot be regarded being between independent parties, inasmuch as it is not an appropriate application of the arm’s length principle and would also constitute an arbitrary exercise of administrative power contrary to the object and purpose of the tax treaties. It should be noted that the new BEPS guidance dealing with the disregard principle authorizes the tax administration to recharacterize contractual transactions that are not consistent with the conduct of the related parties. Such a recharacterization or “delineation alignment” power can only be used for setting out the factual substance of the commercial or financial relationships between the parties and, in that sense, it does not permit the tax administration to substitute the transaction undertaken for other transaction that independent parties would have been carried out. As a result, it could be argued that the recharacterization rule so established does not constitute an application of the “non-recognition” principle, despite the fact that OECD, supra n.

8 has developed a number of new allocation parameters that can be used by tax administrations to delineate the related transactions according with their “factual substance”. In fact, these new parameters of substance for profit and loss allocation not only affect to the assessment of the value of related transactions, but also determine the related parties to whom the income, or the expenses, must be attributed. See J. CALDERÓN, «La evolución del marco valorativo y de reconocimiento de las operaciones intragrupo», cit.

42 In this context, the Tribunal Superior de Justicia de Cataluña (Superior Court of Cataluña, TSJCat) has held that global functions constitute shareholder activities with regard to the application of an individual’s income tax exemption for carrying out work abroad (see ES: STSJCat, 10 Dec. 2015, Rec. 543/2012).

43 With regard to these issues, see J. M. CALDERÓN, «Prestación de Servicios Intragrupo», in Fiscalidad de los Precios de Transferencia, chapter 10, T. Cordon ed., CEF, 2016.

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arm’s length principle to intra-group services dealing with any kind of intangibles45, but the Spanish domestic transfer pricing regulatory framework does not provide any specific rule on the matter beyond an implicit reference to the OECD Transfer Pricing Guidelines.

On the other hand, Article 19 of the LIS establishes the obligation to apply the arm’s-length principle and to prepare the transfer pricing documentation for all transactions undertaken with tax havens. This requirement does not apply to transactions carried out with entities that reside in an EU or a European Economic Area (EEA) Member State where there is effective exchange of tax information; the taxpayer can demonstrate that the transactions have valid economic reasons and that the entities engage in economic activities.

To obtain legal certainty in regards to the application of the transfer pricing law, taxpayers may request the tax administration to issue rulings on related party transactions before they are carried out. Such a request must be filed together with a proposal based on the arm’s-length principle. On the other hand, the Spanish tax administration can also make agreements with other tax administrations to determine the arm’s-length market value of the transactions jointly, i.e. bilateral APAs. The new provision, which is set out in the LIS 46, is an improvement on the previous regime regarding APAs, as it extends the period of validity to six years, which encompasses the previous year, and, when the time limit for filing the tax return has not yet expired, the current year and the following four years. An APA can also be rolled back to tax periods to when a tax return has already been filed, even where the tax administration has made a reassessment.

Consequently, APAs may now cover all tax periods prior to the period in which they are concluded as long as the right of the tax administration to determine the tax debt through the issuance of an assessment has not become time-barred and there is no final assessment regarding the transactions that are

45 See V. DURAN, Operaciones sobre Intangibles, in Régimen fiscal de las operaciones vinculadas Secundarios, chapter 8, Ciss, 2011.

46 Article 18.9 LIS.

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subject to the APA request47. In this way, an APA may give taxpayers the opportunity to settle disputes with the tax administration. APAs can also be used for the applying the Spanish Patent Box regime48.

With regards to the procedural rules for the enforcement of the arm’slength principle, it should be noted that the Spanish domestic law establishes a mandatory rule providing bilateral or correlative adjustments for transfer pricing49. Such adjustments may be made within the framework of a tax audit, but there are no specific rules for transfer pricing controls50. As a result, the Spanish legislation has only regulated for the procedural situations that can arise as a result of a transfer pricing adjustment. In particular, there are various defenses that can be employed by a taxpayer and other related parties, resident or nonresident, to argue against a primary transfer pricing adjustment made by the tax administration. The legislation does not clarify the procedure for applying a secondary adjustment and how to prevent it from invoking the restitution and/or repatriation rule. This procedural regulation on transfer pricing should be connected to the new regulation introduced into the Ley General Tributaria (General Tax Law, LGT) by Law 34/2015. The LGT, therefore, now contains a rule that determines the interaction between the domestic procedures when reviewing the legality of transfer pricing adjustments and the international dispute resolution mechanisms51. This interplay rule suspends the processing of a review procedure before a national court when a taxpayer has invoked an international pro-

47 Articles 21-36 LIS regulations. See also C. SERRANO & F. RUBIO, «Acuerdos Precios de Valoración», in Carmona Fernández (ed.), cit., pp. 671 et seq.; J. HORTALÁ, «Los Acuerdos Previos de Valoración», in Carmona Fernández (ed.), cit., chapter 20, pp. 771 et seq.; and R. PALACIN ET AL., Impuesto sobre Sociedades, Vol. II, cit., chapter 12, pp. 300 et seq. (EY 2013). With regard to cost contribution agreements, see R. LOPEZ DE HARO, «Los acuerdos de reparto de costes», in Carmona Fernández (ed.), cit., pp. 265 et seq., and R. PALACIN, «Acuerdos de Reparto de Costes», in T. Cordón (ed.), Fiscalidad de los Precios de Transferencia, Ed. CEF, Madrid, 2010, pp. 475 et seq.

48 Articles 39-44 LIS regulations. See also M. T. SOLER ROCH & E. GIL GARCÍA, «Encouraging Research and Development (and Innovation) in the Spanish Tax System», in Bull. Intl. Taxn., 70, 8, sec. 3, 2016.

49 Article 18.10 LIS. 50 See Article 18.10 of the LIS and Article 19 of the LIS regulations.

51 Additional Disposition 21 of the LGT, as amended by ES: Ley (Law) 34/2015 of 21 September 2015.

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cedure for the resolution of a tax dispute. Such a possibility has many implications and poses numerous practical issues52.

2.3.2. Transfer Pricing Methodologies The transfer pricing methodologies provided by the LIS are in line with the OECD Transfer Pricing Guidelines. To determine the arm’s-length market value, the law established that one of the following five methods should be applied: (1) uncontrolled price method; (2) the cost-plus method; (3) the resale price method; (4) the profit split method; and (5) the transactional net margin method (TNMM). Where these methods cannot be applied, other generally accepted methodologies and valuation techniques could be acceptable, provided that such methodologies respect the arm’s-length principle53.

The old rule, which established a hierarchy for the application of the transfer pricing methodologies, has been removed. In other words, priority is no longer given to the comparable uncontrolled price (CUP), cost-plus or resale price methods.

The LIS has embraced the use of the most appropriate methodologies, which must now be selected on the basis of various factors, including the characteristics of the controlled transaction, the availability of reliable information and the degree of comparability with uncontrolled transactions. Consequently, it can be said that Spanish domestic law is now in line with the stipulations in the OECD Transfer Pricing Guidelines regarding the application of transfer pricing methodologies54. Although in the author’s view, a preference for the application of the CUP method can be inferred in the OECD Transfer Pricing Guidelines of 2010, and moreover, the Spanish transfer pricing law and practice are not fully consistent with this. The tax administration has also indicated some

52 On these issues see J. M. CALDERÓN & A. J. MARTÍN JIMÉNEZ, «El Procedimiento de Comprobación de las Operaciones Vinculadas», cit., chapter 17, pp. 575 et seq.

53 In applying these different methods, it is necessary to describe the aggregates, percentages, rates, interest rates, discount rates and other variables on which these methodologies were based and to support the reasonableness and consistency of the assumptions made.

54 L. JONES, «Métodos para determinar el valor de mercado de las operaciones vinculadas», in Carmona Fernández (ed.), cit., pp. 177 et seq.

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distaste for a widespread application of the TNMM by taxpayers55. As a result, transfer pricing practice reveals various conflicts, particularly regarding the selection of the most appropriate methods and comparables, the application of the aggregation of transaction rules, the application of financial and intra-group corporate services rules, i.e. inbound and/or outbound, the use of secret comparables, and the market range56.

The regulations established the need to undertake a comparability analysis for determining the arm’s-length price of the transactions effected57. Such an analysis must take into account the characteristics of the markets and the goods or services involved, as well as the functions and risks assumed or assets employed by the parties involved. The contractual terms of the transactions and the company’s strategies must also be considered. In this respect, it should be noted that the new domestic rule empowering the tax administration to disregard and recharacterize the related transactions so undertaken, combined with the OECD/G20 BEPS initiative Final Report on Actions 8 to 10 regarding expanded guidance on the delineation of the transactions, increase the critical function of the comparability analysis and require the application of a qualified approach by taxpayers.

With respect to the use of comparables, there appears to be a preference for Spanish comparables on the part of the Spanish tax administration. In this context, the Iberian database “Sabi” provides information on more than one million companies. If Spanish comparables are not available, Pan-European comparables are normally accepted. The Tax Administration also uses Bureau van Dijk’s Pan-European Amadeus database to undertake its own analyses using external comparables.

AEAT Director´s ruling, which contains the general guidelines of the 2016 Annual Plan of Tax and Customs Control, point 3 (international tax planning). Curiously, in the past, the tax administration has invoked the application of the TNMM when this method was not included in the transfer methods list provided by the domestic tax law.

56 A. J. MARTÍN JIMÉNEZ & J. M. CALDERÓN, «Distribution Agreements between Independent Parties, Royalties and the Use of Secret Comparables to Fix the Royalty», in Tax Treaty Case Law around the Globe 2014, chapter 18, E.C.C.M. Kemmeren et al. (eds.), IBFD/Linde, 2014.

57 Article 17 LIS regulations.

55

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With respect to financial transactions, the use of common databases, such as Bloomberg, is acceptable. Secret comparables are not generally used, and the courts have held that the use of secret comparables conflicts with the rules of due process58.

With respect to preferences in benchmarking, the tax administration generally focuses on the interquartile range in a TNMM analysis. In this regard, the tax administration uses a 25% independence threshold and multiple year averages.

There is no legal provision for year-end adjustments and retroactive adjustments in the Spanish regulations. In fact, as noted above, self-initiated adjustments are not clearly excluded by the Spanish tax law, but the Spanish DirecciĂłn General de Tributos (General Directorate of Taxes, DGT) has held that such adjustments can constitute a violation of the compulsory fair value accounting principle.

With respect to the interrelationship between the transfer pricing and the customs values, there has traditionally been a low-level of communication between the income tax and the customs authorities, but recently, mechanisms have been put in place to achieve better coordination. However, the lawmaker introduced a new clause into the LIS of 2014, which reversed several tax court decisions establishing that customs valuation assessments have a binding valuation effect on the application of corporate income tax59.

For instance, the TEAC has held that the use of secret comparables could affect the right of the defense regarding taxpayers and give rise to serious problems of defenselessness. It is a consolidated doctrine of the TEAC that tax assessments must be motivated and, when secret comparables and data are used, that motivation does not exist, as taxpayers do not have access to all the data that underlie a tax assessment. This means that there is no possibility of contradicting such data (see ES: TEAC, 14 March 2008, R.G. 133/06; ES: TEAC, 11 September 2008, R.G. 1510/07, ES: TEAC, 4 December 2008, R.G. 1462/07; and ES: TEAC, 3 October 2013, R.G. 2296/12).

59 Article 18.14 of the LIS establishes that the market value resulting from the application of the transfer pricing provision only applies to income taxes, unless a legal clause states otherwise.

This provision of the LIS also states that the market value determined in accordance with the law governing other taxes does not apply to income taxes, except where a legal disposition provides otherwise. The Supreme Court has, however, held in two decisions that the market value assessed by the customs administration can be used income tax purposes (see EC: TS, 30 November 2009, No. Rec. 3582/2003 and ES: TS, 11 December 2009, No. Rec. 4113/2003). Consequently, the new rules in the LIS reverse this jurisprudence of the Supreme Court.

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2.3.3. Definition of Related Parties The LIS contains extensive rules that define the nature of related parties.

Nonetheless, the tax reform implemented in 2014 has narrowed the definition of related parties to be in line with the international practice. It no longer applies in a scenario involving an entity and the members of or the investors in another entity, where both entities belong to the same group. Another legal situation that is no longer treated as a controlled transaction is one in which remuneration is paid by an entity to its directors, where both are official directors and those acting as such for their activities as directors. In addition, as in other OECD member countries, for shareholders and entities to be deemed related parties, they must now have common ownership of at least 25% as opposed to 5% under the previous law, or 1% for listed shares on a regulated market.

Despite this, the concept of a “related party” for transfer pricing purposes is still a widely used term and applies to a very broad range of cases. Regardless, the Spanish transfer pricing practice over the last few decades does not conflict with the associated companies clause in Article 9 of the tax treaties that Spain has concluded.

In this context, the following individuals and entities are deemed to be related for transfer pricing purposes: • A corporation or a company, or a partnership with legal personality, or any type of entity and its shareholders or partners. Nevertheless, for there to be relevant relationships between a company and its shareholders or partners, there must be a holding of shares equal to or greater than 25% with respect to unquoted shares.

• An entity and its directors are both “de jure” and “de facto” directors respectively, but the remuneration paid by an entity to its directors regarding their activities does not make them related parties.

• A company and the spouses, lineal ascendants and lineal descendants of its shareholders, partners or directors.

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• Two companies that, in accordance with the provisions of Article 42 of the Spanish Código de Comercio (Commercial Code, CCo)60, meet the requirements to form part of a single group of companies. A group exists when one company has, or could have, control over another or others under the criteria established in Article 42 of the CCo, regardless of residence or the obligation to prepare consolidated annual accounts61.

• An entity and the directors of another entity when both entities belong to the same mercantile group as defined by Article 42 of the CCo. • A company and the spouses, or lineal descendants or ascendants of the shareholders, or partners of another company where both companies belong to the same mercantile group.

• Two entities where one of the entities has an indirect interest of at least 25% in the capital or equity of the second entity.

• Two companies in which the same shareholders or partners, or their spouses or lineal descendants or ascendants, hold in both companies, directly or indirectly, at least 25% of either the capital or equity.

• A Spanish resident entity and its foreign PEs62.

According to this broad concept of related parties, the Spanish transfer pricing rules apply to any type of transaction between such related parties where both parties are Spanish tax residents, as well as to transactions where only one party is a Spanish resident. In this context, it should be noted that related transactions undertaken by PEs located abroad (as part of a Spanish resident company) fall within the scope of the Spanish transfer pricing regime,

ES: Código de Comercio (Commercial Code, CCo).

A group exists when one company has or could have control over another or others under the criteria established in Article 42 of the CCo, regardless of the residence of the parties or their obligation to prepare consolidated annual accounts. Regarding the meaning of the term “control”, this exists when a company meets any of the following three conditions with regard to another or other companies: (1) ownership of the majority of the voting rights; (2) entitlement to appoint or to dismiss a majority of corporate directors; and (3) the possibility, together with other shareholders, of obtaining a majority of corporate directors when consolidated accounts are prepared and within the two preceding financial years.

62 ES: Ley del Impuesto sobre la Renta de No Residentes (Law on Income Tax on Non-Residents, LIRNR) also considers non-resident companies and their PEs in Spain to be related parties.

60 61

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regardless of whether or not such transactions are tax exempt under Article 22 of the LIS. Related transactions carried out by a non-resident company, with no PE in Spain, which is subject to the CFC regime, could also be covered by the transfer pricing regime, as provided by the LIS. 2.3.4. Transfer Pricing Documentation Requirements Spanish domestic law establishes the obligation to prepare and keep transfer pricing documentation. Disclosure of qualified related transactions through a specific tax form is also required (Form 232)63. Transfer pricing documentation and the related transactions’ mandatory disclosure rules (Form 232) are the primary tax risk management mechanisms used by the tax administration in selecting targets for transfer pricing audits.

Previously, Spanish documentation requirements were in line with those of the EUJTPF. However, in this regard, it should be noted that Law 27/2014 changed the transfer pricing documentation tax policy with respect to periods starting on or after 1 January 2016, based on the full implementation of Action 13 of the OECD/G20 BEPS initiative 64. Accordingly, a three-tiered documentation model has been established requiring the taxpayers to keep the following types of documentation: (1) a global document for the group, i.e. the master file; (2) a document for each group entity, i.e. the local or country file, and (3) a Country-by-Country Report containing certain information related to the global allocation of the MNE´s income and taxes paid, together with certain indicators of the location of economic activity within the MNE group.

The documentation covers domestic and international transactions. However, transactions within the same fiscal unit are exempt from the documenta-

Form 232, adopted through Finance Order HFP/816/2017, establishes the obligation of corporate taxpayers to report and provide information with regard to its transactions with related parties. Form 232 requires the taxpayer to report not only the identification details of the parties and the amounts of the transactions, but also to identify the relationship between the parties, the type of the transaction from 11 standardized categories and the valuation method that the parties have used to set or test the transfer price.

64 For tax periods beginning 1 January 2015, the documentation requirements were the same as in 2014.

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tion requirements. The LIS also includes a general reference to the proportionality and sufficiency principles regarding the obligation to elaborate on and maintain the transfer pricing documentation65.

The tax administration can require the provision to give further information during a tax audit regarding the related party transactions. The tax administration also routinely uses the exchange of information clauses in the tax treaties that Spain has concluded, as well as EU administrative mutual assistance mechanisms, in the transfer pricing audits of multinational enterprises (MNEs).

Spanish domestic law contains certain exemptions regarding documenting related party transactions, including the following: • Exemptions by volume: - for those corporate income tax taxpayers whose transactions carried out with the same related party do not exceed EUR 250,000 at market value, taking into account the total transactions carried out by the same related party; - entities whose net sales do not exceed EUR 10 million in the period and the related party transactions do not exceed EUR 100,000, excluding those with listed tax havens66; and - entities with a consolidated turnover between EUR 10 and EUR 45 million can apply for a “simplified regime”67.

In general, records must be kept for a period of four years from the conclusion of the voluntary period for the filing the annual corporate income tax return for tax purposes and six years from the end of the period for accounting and corporate purposes. Notwithstanding this, when a corporate taxpayer has pending net operating losses or tax credits generated before the four-year statute of limitation period, it should keep the relevant documentation for at least 10 years.

66 Such small and medium-sized enterprises (SMEs) must comply with their documentation obligations by way of the preparation of an official model that has been approved by the tax administration.

67 In such circumstances, documentation is less than the “general regime” is required, as no Master File must be submitted and the requirements of the Local File are unchanged, but with a more limited content with regard to the general regime. For instance, it is not necessary to provide a comparability analysis, but the selected comparables used to test the transfer pricing policy must be identified. The simplified transfer pricing documentation must include the following four sets of information: (1) a description and the amount of the controlled transactions; (2) data on the taxpayer and the related parties; (3) the transfer pricing methods selected; and (4) the comparable data used and the related arm’s-length range. It should be noted that the simplified regime cannot be applied in the following five circumstances: (1) with regard to transactions entered into with related entities by individual income taxpayers in the course of an economic activity; (2) in relation to share 65

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• Exemptions by transaction characteristics, i.e.: - those performed between entities within tax consolidation groups; - those performed between economic interest groupings or temporary business alliances and their shareholders; - those carried out within the scope of an initial public offering, i.e. public offerings of shares or tender offers.

The regulations of the LIS that mandate the new transfer documentation requirements, in accordance with Action 13 of the OECD/G20 BEPS initiative, incorporate a requirement for CbC reporting, in addition to the Master File and Local File.

Finally, it should be noted that Spanish companies are also required to provide detailed information on transactions with related parties in their public annual financial statements, which are filed with the Commercial Registry and are, therefore, publicly available and at the disposal of the tax administration.

Most Spanish MNEs have also endorsed the “Good Tax Practices Code” as developed by the Código de Buenas Prácticas Tributarias (State Agency of Tax Administration, AEAT) in cooperation with the larger business taxpayer forums and, therefore, can be subject to a higher threshold of tax transparency. In particular, companies that have endorsed such “cooperative tax compliance general framework” must disclose further details of their tax strategies, transfer pricing policies and primary related transactions68.

transfers; (3) in respect of business transfers; (4) regarding real estate transactions; and (5) for transactions involving intangible assets.

68 See Código de Buenas Prácticas Tributarias (Code of Good Tax Practices) issued by the AEAT on 20 July 2010. The AEAT was updated on April 2015 to widen the catalogue of good tax practices as well as to implement new mechanisms in respect of procedural fairness that can be invoked by taxpayers that abide by the rules. On the application of the Spanish cooperative tax compliance framework, see J. M. CALDERÓN & A. QUINTAS, Cumplimiento Tributario Cooperativo y Buena Gobernanza Fiscal en la Era BEPS, Aranzadi-Thomson Reuters, 2015. See also J. M. CALDERÓN & A. QUINTAS, «The concept of Aggressive Tax Planning Launched by the OECD and the EU Commission in the BEPS Era: Redefining the Border between Legitimate and Illegitimate Tax Planning», in Intertax, 44, 3, 2016.

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2.3.5. Transfer Pricing Penalties The Spanish transfer pricing penalty regime is quite formalistic. It is also connected to the level of compliance with the documentation requirements.

The Spanish laws that enacted the new LIS did not change the transfer pricing penalties regime provided for in the previous LIS, even though this regime had been the subject of strong criticism and controversy69 to the extent that the Tribunal Supremo (Supreme Court, TS)70 and the Spanish Tribunal Constitucional (Constitutional Court, TC)71 have decided on the potential overriding effects that this regime could have regarding certain constitutional principles.

The new LIS72, therefore, provides for a penalty regime that is more in line with the principles of legality and legal certainty than the previous one and has also reduced the economic effect of the penalties.

In this sense, it has been established, on the one hand, that the failure to comply with the documentation requirements specified in the LIS regulations may result in major penalties. These penalties can result from not having maintained the correct documentation or from not applying the arm’s-length principle, i.e. market value.

When the assessment undertaken by the tax administration does not produce a tax adjustment, the penalty is EUR 1,000 per fact or EUR 10,000 per group omitted, inaccuracy recorded or false facts presented. However, the maximum amount of this penalty is limited to the lesser of the following two amounts: (1) 10% of the amount of the transactions carried out by the company in a given year; and (2) 1% of the net sales of the relevant entity. In this context, it should be noted how the LIS regulations define the terms “group of relevant

69 A. J. MARTIN JIMÉNEZ & J. M. CALDERÓN, Los precios de transferencia en la encrucijada del siglo XXI, cit., pp. 275 et seq.

70 ES: TS, 8 February 2011, no. 8/2009, and ES: TS, 27 May 2013, no. rec.8/2009.

71 ES: TC, 11 July 2013, STC 145/2013.

72 Article 18.13 LIS. See also C. GÓMEZ MOURELO, «Régimen sancionador de las operaciones vinculadas», in Carmona Fernández (ed.), cit., chapter 26, pp. 875 et seq.

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data”73 and “single relevant data” for specific purposes of transfer pricing penalties.

On the other hand, when the tax administration undertakes an adjustment of the pricing of a transaction, the penalty may be up to 15% of the gross adjustment.

These sanctions are compatible with aggravated circumstances, such as resisting, obstructing or negating the actions of the tax administration. When additional corporate income tax or other taxes, such as individual income tax or the non-residents income tax are due following a transfer pricing adjustment, any late tax payment is also liable to interest.

No penalties are imposed where the documentation requirements have been complied, even if the tax administration reassesses the value of the related transactions. In some sense, it could be argued that the LIS provides a kind of penalty protection regime when taxpayers comply with the documentation requirements and adopt a reasonably arguable arm’s-length position. This can be inferred from the Spanish jurisprudence on tax penalties. Finally, the implications of the imposition of penalties regarding the application of the EU Arbitration Convention (90/436) should be noted, inasmuch as the access of taxpayers to this dispute resolution mechanism can be denied when serious transfer pricing penalties are imposed74.

Articles 15.3 and 16.6 of the LIS regulations define a “group of relevant data” to be those aggregate date describing: (1) the group´s structure and composition; (2) the related transactions and amounts involved; (3) the functions, risks and assets regarding related transactions; and (4) the group transfer pricing policy and valuation methods used by the group. The LIS regulations also define “single relevant data” to be: (1) the identification of any of the members of the corporate group; (2) the identification of any intangible and/or fees involved; and (3) any intra-group agreement, APA or competent authority procedures initiated by the group.

74 See Article 8 of the EU Arbitration Convention (90/436) and Article 26.1.c of the Spanish domestic regulations on MAPs. Point 8 of the Code of Conduct for the application of the EU Arbitration Convention of 2015 recommends that the tax administration applies Article 8 of EU Arbitration Convention (90/436) only in exceptional cases of serious tax fraud and the willful violation of the arm’s-length principle. See also EUJTPF, Summary Report on Penalties COM(2009)472 final, and J. M. CALDERÓN & A. J. MARTIN JIMÉNEZ, «La Aplicación del Convenio de Arbitraje 90/436/CEE en materia de eliminación de la doble imposición en ajustes de precios de transferencia entre empresas asociadas», in Manual de Fiscalidad Internacional, chapter 3, IEF, 2016, pp. 1124-1125.

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2.4. Final Remarks on the Spanish Transfer Pricing Framework As can be inferred from this article, it can be said that Spain has a modern transfer pricing regime, and that, at the same time, this regime is complex from a practical perspective. The Spanish lawmakers and tax administration also follow the latest trends and international developments regarding transfer pricing and international taxation. Certainly, it could be pointed out that the full implementation of the BEPS transfer pricing package at the domestic level can bring a new wave of substantive regulatory changes as well as a new transfer pricing audit model (based on tax risk management tools) for large taxpayers.

All in all, in the author’s opinion, the Spanish regime is constructed on a regulatory model excessively based on the soft law of the OECD to the extent that it does not precisely regulate a number of technical aspects necessary for compliance with the transfer pricing rules. This deficiency in the regime creates problems of legal certainty and has given rise to a number of tax disputes that could result in residual double taxation. It could also be argued that there is a need to develop a genuine national policy on transfer pricing, which could then be coordinated with the tax policies and regulations with respect to corporate income tax. This would represent both a challenge and a possible new frontier.

3. Post-BEPS Trends & Challenges For Taxpayers With Regard To Transfer Pricing Compliance and Practice The TP post-BEPS context is characterized by a more intense focus on tax control of tax compliance of MNEs over whether or not they pay the “fair share of taxes” in the countries where they do business. In the same vein, it can be pointed out that the tax administrations are more assertive, given they have better tools to supervise large taxpayers and to enforce the more demanding TP standards (substance + transparency).

Therefore, from the MNEs perspective, it can be said that the new TP framework intensifies the tax risks resulting from tax compliance with the new

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ALS standard. The more remarkable tax risks deriving from the new TP framework would be the following: • More risks derived from substance requirements (Intangibles); • More risks derived from transparency (actions 5, 12 & 13); • More risks resulting from new range of enforcement tools of the tax authorities; • More risks derived from new tax authorities auditing and challenging the TP policies of the MNEs: not only OECD tax administrations but also emerging countries tax authorities.

Considering all of these factors and features that transform the transfer pricing global framework, it is clear that MNEs have to face the challenge of navigating a new tax risk landscape that results from a more demanding TP standard of tax practice, an explosion of reporting, transparency and complexity, new tax administration enforcement tools and more aggressive positions on tax audits, shorter, faster and broader TP audit and controversy life cycle, and a higher level of uncertainty over what constitutes acceptable tax planning in a post-BEPS world.

Therefore, the post-BEPS TP practice is more demanding for the MNEs, and consequently, taxpayers need to review and implement a more robust TP policy and governance procedures. As a collateral effect of this transformation of the TP global framework, the tax function priorities are changing from compliance and TP planning (Effective Tax Rate, ETR) to tax risk management as their top priority75. In this sense, MNEs need to implement tax strategies and well-documented TP policies that are globally consistent and “audit ready” for levels of unprecedented scrutiny by tax authorities in almost every country.

Thus, the pro-active management of tax risks and controversies constitute, in some sense, a sub-product of the BEPS era.

75 THOMAS, NOVAK &LOWELL, «Evolution of Advance Pricing Agreement Processes: Current and Future Experience in the United States», in ITPJ, March/April 2018, pp. 172 et seq.

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João Francisco Bianco * Ramon Tomazela Santos **

1. Introduction The integration of national economies has increased substantially over the years, creating a rise in cross-border activities. Transfer pricing rules are placed at the epicenter of such cross-border transactions as a mechanism to control the prices charged on transactions between related parties for the purpose of determining the tax base of corporate income tax.

Given the intensifying level of cross-border activities, the use of the mutual agreement procedure (MAP) set forth in Article 25 of tax treaties modeled after the OECD Model Tax Convention has increased over the years in relation to transfer pricing disputes, particularly because double taxation can have a substantially detrimental impact on the effective tax rate borne by multinational enterprises (MNEs). However, regardless of its importance in solving transfer pricing issues, the MAP has often been criticized as an ineffective mechanism for dispute resolution. This is due to the lack of an obligation placed on the competent authorities to effectively reach an agreement, lack of time limits for the resolution of the disputes, lack of effective participation of taxpayers, lack of

* PhD and Masters of Law in Tax Law at the University of São Paulo (USP). Director at the Brazilian Institute of Tax Law (IBDT). Member of the International Association of Tax Judges. Former Judge of the Administrative Council of Tax Appeals (CARF) in Brazil. Professor of international taxation at the Brazilian Institute of Tax Law (IBDT). Visiting Professor at the University of Minho. ** PhD Candidate and Masters of Law in Tax Law at the University of São Paulo (USP).

LL.M. in international taxation at the Vienna University of Economics and Business (“Wirtschaftsuniversität Wien”). Member of the Academic Committee of the Brazilian Institute of Tax Law (IBDT).

Visiting Professor in Postgraduate Courses in Brazil.

João Francisco Bianco | Ramon Tomazela Santos

suspension of the tax credit enforceability during the procedure, as well as inadequate implementation in developing countries, among other issues 1.

In this context, this article aims to analyze the resolution of transfer pricing disputes from a Brazilian perspective. To that end, the article begins with a general analysis of Brazilian transfer pricing rules, highlighting their divergences from the OECD Transfer Pricing Guidelines. Next, the text analyzes Article 9 of the OECD Model Tax Convention and the primary and correlative transfer pricing adjustments to address the impacts of the absence of paragraph 2 of Article 9 in the tax treaties concluded by Brazil. Finally, the article examines the main issues involved in the use of the MAP for the resolution of transfer pricing disputes in Brazil, with particular reference to Normative Ruling RFB No. 1,669/2016 and Brazil’s resistance to arbitration.

2. Overview of Brazilian Transfer Pricing Rules As commonly known, transfer pricing rules aim to avoid price manipulation in transactions carried out between associated enterprises and, at the same time, safeguard the allocation of taxable income within an MNE that operates in different countries.

Transfer pricing rules are based on the assumption that prices charged on transactions between related parties, precisely because they are not subject to free-market conditions, may deviate from those that would have been charged by unrelated parties in comparable transactions carried out under similar circumstances. Thus, as associated enterprises are not subject to usual market pressures and have the freedom to define their respective prices conveniently, transfer pricing rules are enacted to avoid the transfer of profits to countries with a lower tax burden, within a group policy of tax savings.

Considering that the manipulation of prices allows a corporate group to benefit from the different level of tax burdens between two countries, thereby reducing the worldwide tax burden supported by an MNE, transfer pricing

1 SRIRAM P. GOVIND & LAURA TURCAN, «Cross-Border Tax Dispute Resolution in the 21st century: A Comparative Study of Existing Bilateral and Multilateral Remedies», in Derivatives & Financial Instruments, 19, 5, 2017, p. 2.

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rules establish specific methods to avoid price manipulation in such internal dealings based on three fundamental pillars: (i) Legal entities within the same corporate group must be treated as independent parties; (ii) Contractual arrangements between the legal entities must be the starting point for the transfer pricing analysis, but they can be disregarded when their legal forms are not consistent with the underlying economic substance; (iii) Prices must be compared to those practiced by unrelated parties in comparable transactions2.

Brazil introduced transfer pricing rules in 1996 with the enactment of Law No. 9,430/1996, which aims to control the artificial transfer of profits to related parties abroad and to individuals or companies that are located in lowtax jurisdictions or that are subject to privileged tax regimes. To achieve this goal, this law established a set of methods to determine the maximum deductible price for import transactions and the minimum taxable revenue for export transactions3. Thus, the transfer pricing control in Brazil functions to preserve domestic tax bases and avoid the artificial transfer of profits in cross-border transactions through legal provisions that determine the maximum deductible cost on import transactions, as well as the minimum taxable revenue on the export transactions carried out by Brazilian taxpayers.

In relation to import transactions, Brazilian transfer pricing rules essentially state that the costs incurred by Brazilian companies, with respect to their imports, that exceed certain specified parameters are not deductible for tax purposes. In regards to export transactions, transfer pricing rules establish that, if Brazilian companies charge less for their exports than certain parameters, the difference between the revenue recorded in the accounting books and the min-

2 RAFFAELE PETRUZZI, «The Arm’s Length Principle: Between Legal Fiction and Economic Reality», in Transfer Pricing in a Post-BEPS World, Michael Lang et. al. (eds.), Kluwer, 2016, pp. 1112.

3 BRUNO FAJERSZTAJN & RAMON TOMAZELA, «Preços de transferência. Frete, seguro e tributos devidos na importação e o método PRL», in Revista Direito Tributário Atual, No. 29, IBDT/ Dialética, 2013, p. 84.

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imum revenue established by the method is subject to corporate income tax (IRPJ) and social contribution on net profits (CSLL).

Strictly speaking, Brazilian transfer pricing rules are unique, departing from the international standard found in the OECD Transfer Pricing Guidelines Transfer for Multinational Enterprises and Tax Administrations (“OECD Transfer Pricing Guidelines”)4. The main differences are the following: • Brazil has not adopted the arm’s-length standard in full, primarily opting for the use of predetermined profit margins, subject to some exceptions.

• Brazil does not adopt the ‘best method rule’, according to which taxpayers should adopt the transfer pricing method that provides the most reliable arm’s-length result. Under the Brazilian transfer pricing rules, taxpayers may choose any of the methods admitted under the law.

• Brazil does not apply transfer pricing rules to royalties, fees for technical assistance and scientific or administrative costs. These are subject to quantitative restrictions with respect to the deduction of expenses and to a withholding tax on the remittance of the income to the beneficiary abroad.

• Brazil does not permit the application of transactional profit methods (i.e., the profit split method and the transactional net margin method (TNMM)).

• Brazil does not provide correlative and secondary adjustments.

• Brazil does not enter into advance pricing agreements (the possibility of modifying profit margins by act of the Minister of Finance, according to Article 20 of Law No. 9,430/1996, is not considered an advance pricing agreement, but a mere modification of the percentage).

• Brazil uses safe harbours that prevent the application of the transfer pricing methods to determine the parameter price if the taxpayer complies with these provisions.

• Brazil restricts free comparability, as a way of reducing subjectivity and uncertainty in the application of the law.

Brazilian transfer pricing practice is an alternative for the protection of tax revenues against base erosion and profit shifting. The recent proposals pre-

4 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD, 2017.

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sented in Actions 8, 9 and 10 of the OECD/G20 BEPS initiative to ensure that transfer pricing outcomes are in line with value creation indicate that the current regime based on the arm’s-length standard is not adequate to handle the changes in the global corporate business environment. In the view of the Brazilian Tax Administration, it is difficult to achieve significant results with free comparability and functional analysis, while predetermined profit margins, at the very least, ensure a minimum level of taxation in Brazil 5.

In addition, it is too complex and costly for developing countries to apply the arm’s length standard adopted by the OECD. Consequently, the adoption of a more straightforward mechanism, such as predetermined profit margins, permits developing countries to counter the manipulation of profits between related parties. Thus, instead of comparing prices charged between related companies with prices practiced by independent parties, Brazilian transfer pricing rules compare intergroup prices with a standard price determined by the methods set forth in Law No. 9,430/19966.

Moreover, despite the risk of economic double taxation, predetermined profit margins may bring about greater certainty for taxpayers, as it is possible to know in advance that, once the methods are applied, the amount to be taxed will not induce significant litigation.

Brazilian transfer pricing rules may also produce inductive effects. This can happen when export revenues recognized under the predetermined profit margins are below the amount that would be due under the arm’s length stand-

This rationale is inherent in the Brazilian model based on the use of predetermined margins, safe harbors and restrictions on free comparability. Thus, Brazilian transfer pricing legislation intends to avoid a problem that is recognized by all transfer pricing practitioners. As commented

by Jean-Pierre Vidal: “The most problematic point is not a surprise for many transfer pricing practitioners: good comparables are scarce or absent. Theoretically, the arm’s length price can always be found because comparables always do exist. However, in practice, market comparability is much more difficult to achieve than one would think. Since uniqueness and market imperfections are at the heart of the economic profit made by multinationals, it would only seem natural that the necessary comparables do not and cannot exist”.

(JEAN-PIERRE VIDAL, «The Achilles’ Heel of the Arm’s Length Principle and the Canadian GlaxoSmithKline Case», in Intertax, 37, Issue 10, 2009, p. 519).

6 ERIC MORAES DE CASTRO E SILVA, «Predetermined Margins in the Brazilian Transfer Pricing Rules and their Compatibility (or not) with the World Trade System», in Revista de Direito Tributário Atual, No. 39, IBDT, 2018, p. 124; RICARDO M. GREGÓRIO, “Restrições da comparabilidade, margens predeterminadas e liberdade de escolha de métodos”, in Tributos e Preços de Transferência, Volume 4, L. E. Schoueri (eds.), Dialética, 2013, p. 349.

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ard, thereby creating an indirect stimulus for export transactions. Conversely, when the tax adjustment required by predetermined profit margins in import transactions exceeds the amount that would be due under the arm’s length standard, the purchase of foreign products is discouraged 7.

Pursuant to Article 23 of Law No. 9,430/1996, for transfer pricing purposes, the following parties are considered related to a Brazilian company: • its head office if domiciled abroad; • its affiliate or branch domiciled abroad; • an individual or legal entity, resident or domiciled abroad, which is characterized as its parent (controlling) or associated company; • a legal entity domiciled abroad that would be characterized as its subsidiary or associated company; • a legal entity domiciled abroad, if it and the company domiciled in Brazil are under common corporate or administrative control, or if at least 10% of the corporate capital of each of them is owned by the same individual or legal entity; • an individual or legal entity, resident or domiciled abroad, that together with a legal entity domiciled in Brazil, has a holding in the capital of a thirdparty entity, and the sum of which characterises them as controlling or associated companies; • an individual or legal entity, resident or domiciled abroad, that is associated with a Brazilian company in a consortium or condominium, when defined as such in the Brazilian legislation, in any venture; • an individual resident abroad who is a relative of kin up to the third degree, a spouse or a companion of any of its directors or of its controlling partner or shareholder in a direct or indirect investment; • an individual or legal entity, resident or domiciled abroad, that is its exclusive agent, distributor, or dealer for the purchase and sale of goods, services or intangible rights; and

7 ERIC MORAES DE CASTRO E SILVA, «Predetermined Margins in the Brazilian Transfer Pricing Rules and their Compatibility (or not) with the World Trade System», cit., p. 125.

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• an individual or legal entity, resident or domiciled abroad, in which the legal entity domiciled in Brazil is its exclusive agent, distributor, or dealer for the purchase and sale of goods, services, or intangible rights.

Finally, Brazilian tax laws also state that the transfer pricing rules shall apply to transactions performed between a Brazilian company and any foreign persons located in low-tax jurisdictions or subject to a privileged tax regime, regardless of whether or not there is a relationship between them.

3. Transfer Pricing Methods in Brazil In transactions subject to transfer pricing control, the values registered on the company’s accounting, commercial invoices, import or export documents and payment receipts are considered inadequate for determining the IRPJ and CSLL tax bases. Due to the possibility of price manipulation in transactions between related parties, Law No. 9,430/1996 requires a comparison between the actual price and the standard price, which is defined by the application of one of the methods established by the law8.

With respect to import transactions, Brazilian transfer pricing rules set forth four methods for assessing the maximum costs that can be deducted by taxpayers. These methods are summarized in the table below:

Brazilian transfer pricing rules do not affect the parties’ autonomy to stipulate prices of the respective transaction, within the freedom of contract guaranteed by the Private Law. Consequently, it does not hinder the freedom to determine the actual price of a transaction, which must be compared to the standard price exclusively for tax purposes. Thus, the criterion used by a corporate group to set the prices of its internal transactions precedes the application of transfer pricing rules.

Once the actual price of a transaction is freely established by the parties, the taxpayer in Brazil will have to use one of the methods allowed by the law to define the standard price, which will be considered for tax purposes.

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Method

Definition

Compared independent prices (PIC)

The average prices of identical or similar goods, services, or rights in the Brazilian market or any other market, in purchases and sale transactions and under similar payment conditions.

Cost plus profit (CPL)

The average cost of production of identical or similar goods, services, or rights in the country where they are originally produced, plus the taxes charged by such country on the exportation, plus a profit margin of 20% of the cost, before the addition of tax.

Resale price less profit (PRL)

The average resale price of the goods or rights minus unconditional discounts granted, taxes levied on the sales, commissions paid, and a profit margin that may vary between 20 and 40 percent, depending on the economic sector.

Quotation price on imports (PCI)

The daily average values of the quotation of commodities subject to public prices on internationally recognized commodities exchanges and futures.

Except for the import of commodities, with respect to which the application of the PCI is mandatory9, taxpayers in Brazil are free to calculate the standard price on imports according to any of the methods described in the table above. However, the chosen method must be applied consistently throughout the calendar year to each type of product or service imported. If the import price effectively applied exceeds the highest standard price calculated according to the method chosen, the excess is not deductible for corporate tax purposes.

In regards to export transactions, the Brazilian transfer pricing rules state that specified methods must be used to assess the minimum revenue to be taxed in Brazil. These methods are set out in the table below:

9

Article 18, paragraph 16, of Law No. 9,430/1996.

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Method

Definition

Export sales price (PVEx)

The arithmetical average of the sales price on exports of the company itself to other customers or by other Brazilian companies providing similar services, goods and intangible rights in the same tax year, under similar payment conditions.

Production or acquisition cost plus taxes and profit (CAP)

The arithmetical average of production costs of the services, goods and intangible rights exported, plus taxes imposed in Brazil and a profit margin of 15% on the costs plus taxes.

Wholesale price in the destination country, less profit (PVA)

The arithmetical average of the sales price of identical or similar goods in the destination country wholesale market, under similar payment conditions, less taxes imposed in that country and a 15% profit margin on the wholesale price.

Retail price in the destination country, less profit (PVV)

The arithmetical average of the sales price of identical or similar goods in the destination country retail market, under similar payment conditions, less taxes imposed in that country and a 30% profit margin on the retail price.

Quotation price on exports (PECEX)

The daily average values of the quotation of commodities subject to public prices on internationally recognized commodities, exchanges and futures.

In general, companies domiciled in Brazil have the option to choose, among the methods available in Law No. 9,430/1996, one method that best suits their interests, except for PCI and PECEX, which are mandatory for transactions with commodities.

As can be seen, contrary to what happens in international practice, Brazilian tax law adopted predetermined profit margins in the control of transfer prices, in a clear concession to the principle of practicability. This means that the main focus of Brazilian tax law is to avoid base erosion and the artificial transfer of profits through the manipulation of prices, to the detriment of the calculation of the wealth effectively manifested in each jurisdiction, according to the assets, risks and functions assumed by each contracting party involved in the legal transaction (functional analysis).

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It should be noted that the methods set forth by Law No. 9,430/1996 are strict and objective, meaning that the taxpayer is not entitled to apply alternative methods to prove that the price actually practiced reflects the market standard, free of interference and manipulation. Likewise, tax authorities are not allowed to use alternative methods to arbitrate the parameter price with the purpose of avoiding profit shifting.

When it comes to financial transactions, Article 22 of Law No. 9,430/1996 provides that interest subject to transfer pricing rules will only be deductible for IRPJ and CSLL purposes up to an amount that does not exceed the following rates, increased by a spread based on the market average to be defined by the Minister of Finance: (i) market rates of sovereign securities issued by the Federative Republic of Brazil on the foreign market in US dollars, in the event of transactions at prefixed US dollar rates; (ii) market rates of sovereign securities issued by the Federative Republic of Brazil on the foreign market in Brazilian reais, in the event of transactions abroad at pre-fixed rates; and (iii) the London Interbank Offered Rate – LIBOR, for the term of six months, in other cases.

Similarly, in the case of loans granted by a domestic entity to a related party abroad, the lender in Brazil must recognize the minimum interest revenue at an amount determined in accordance with the rates established above, increased by the spread determined by the Minister of Finance.

The spread to be determined by the Minister of Finance must be based on the market average. Currently, Ordinance MF No. 427/13 provides for a spread of 3.5% for the deductibility of interest expenses and a spread of 2.5% for interest revenues.

Since the enactment of Law No. 12,715/2012, all loan agreements (registered or not registered with the Central Bank) should now comply with the transfer pricing rules. Prior to the amendment, only interest payments performed under loan agreements not registered with the Central Bank were sub-

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ject to the transfer pricing rules. These rules are applicable to loan agreements from as far as 2013, regardless of their registration with the Central Bank.

Finally, it is important to mention that this registration before Brazil’s Central Bank is still required for regulatory purposes. Loan agreements concluded before their entry into new law (i.e., before 31 December 2012) remain subject to the prior transfer pricing rules.

4. Transfer Pricing Disputes and Correlative Adjustments As commonly known, transfer pricing rules based on the arm’s-length standard essentially requires that, for tax purposes, the prices charged in controlled transactions should be compared to those charged in comparable transactions between independent parties in comparable circumstances10. The underlying idea is that transactions between associated enterprises should not disrupt the neutrality of economic choice, free competition, and the fair distribution of revenues among countries from taxes paid on a global scale 11.

However, transfer pricing is not an exact science, and if two countries disagree on the interpretation of the OECD’s arm’s-length standard, the parties may resort to using the MAP. Even between countries that completely adhere to the arm’s-length standard enshrined in Article 9 of tax treaties, tax disputes may arise in practice, given that the OECD Transfer Pricing Guidelines allow for different transfer pricing methods. Therefore, a range of different outcomes may emerge depending on the choice of method, the functional analysis carried out, the selection of comparables, the identification and allocation of synergies, and the attribution of intangible related returns among other factors. Accordingly, even if the same method is applied by both contracting states, disputes may arise in the delineation of the transaction, the interpretation of the func-

CONRAD TURLEY, DAVID G. CHAMBERLAIN & MARIO PETRICCIONE, A New Dawn for the International Tax System: Evolution from past to future and what role will China play?, IBFD, 2017, Online Books IBFD. 11 ADAM BIEGALSKI, «The Arm’s Length Principle: Fiscalism or Economic Realism? A Few Reflections», in Intertax, 38, Issue 3, 2010, p. 177.

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tional analysis, the distribution of risks, and the definition of profit margins, etc.12.

In this context, the complexity of transfer pricing rules, the involvement of multiple jurisdictions, and the large amounts generally involved contribute significantly to the higher risk profile of transfer pricing issues. Additionally, in the current period of global recession, particularly in the post-BEPS world, tax authorities have become increasingly more focused on transfer pricing issues13.

However, the problem mentioned above becomes far worse when addressing the interaction between Brazilian transfer pricing rules and transfer pricing rules based on the OECD Transfer Pricing Guidelines. A common divergence emerges, for instance, when the foreign company uses the transactional net margin method (TNMM), currently the most used transfer pricing method14 based on ratios derived from financial statements, while the Brazilian company uses the traditional transfer pricing methods allowed in Brazil. Due to the use of predetermined profit margins, Brazilian transfer pricing rules will frequently lead to diverging outcomes in comparison with the international practice and, consequently, lead to double taxation or double non-taxation as well. In the case of double taxation, the other country may refuse to make a correlative adjustment when the profit allocated to the Brazilian company does not reflect the arm’s-length principle15.

Article 9 of the OECD Model Convention allows adjustments in the taxable profit of an enterprise to reflect the true taxable profit that would have been LUC DE BROE, «The State Aid Review against Aggressive Tax Planning: Always Look a Gift Horse in the Mouth», in EC Tax Review, 24, Issue 6, 2015, p. 292.

13 STEVEN C. WRAPPE, «Chapter 1: Introduction to Transfer Pricing and Dispute Resolution», in Transfer Pricing and Dispute Resolution: Aligning strategy and execution, A.J. Bakker & M.M. Levey (eds.), IBFD, 2011, Online Books IBFD. 14 AITOR NAVARRO, «Literature review: Joseph Andrus & Richard Collier. Transfer Pricing and the Arm’s length Principle After BEPS (Oxford University Press, 2017)», in Intertax, 46, Issue 6/7, 2018, p. 599.

15 The problem of divergences between states in the application of Article 9, paragraph 2, of the OECD Model Convention was long anticipated by Thogei Nielsen, a tax law professor at the University of Copenhagen: “The only problem might be that what is acceptable in one country may be labeled tax avoidance in another, and that the new principles demanding corresponding adjustments (model treaty art. 9(2)) still have a long way to go before they may prove a realistic tool in the daily life of international taxation” (THOGEI NIELSEN, «The Arm’s Length Test: A Rule of Law – or an Excuse for Arbitrary Taxation?», in Intertax, 7, Issue 8, 1979, p. 296) 12

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earned if the transaction occurred between independent parties16. In contrast, when transactions between associated enterprises are performed at arm’s length, in accordance with open market commercial terms, Article 9 of the OECD Model Convention prevents adjustments in the taxable profits17.

According to Article 9(1) of the OECD Model Convention, tax authorities can adjust the taxable income of an entity by adding the portion of income eliminated by pricing manipulation in a transaction between associated enterprises to the income to be taxed in that country 18. Evidently, the amount of tax adjustment can only be determined based on the domestic tax law because of the negative effect of double tax treaties that do not have the power to constitute, by themselves, the tax obligation19.

However, in regards to the compatibility of predetermined profit margins with tax treaties, it should be noted that Article 9(1) of the OECD Model Convention does not give states carte blanche to apply transfer pricing rules, regardless of their compatibility with the arm’s-length standard20.

Although double tax treaties solely limit the right to tax and cannot be used to perform profit adjustments without a legal basis in domestic laws 21, national legislators are not completely free to use any method they choose to determine whether a transaction between associated enterprises follows or vio-

16 MARTIN LEHNER, «Article 9 – Associated Companies», in History of Tax Treaties – The Relevance of the OECD Documents for the Interpretation of Tax Treaties, Thomas Ecker & Gernot Ressler, Linde, 2011, p. 39.

17 ANDREAS FROSS, «Debt-Equity Ratios, Earning Stripping Rules and the Arm’s Length Principle», in International Group Financing and Taxes, Linde, 2012, pp. 42-43.

18 OECD, Model Tax Convention on Income and on Capital – Condensed Version, OECD, 2017, p.

226.

19 According paragraph 2 of the Commentaries on Article 9: “No re-writing of the accounts of associated enterprises is authorised if the transactions between such enterprises have taken place on normal market commercial terms (on an arm’s length basis)” (OECD, Model Tax Convention on Income and on Capital – Condensed Version, OECD, 2017, p. 226).

20 RAMON TOMAZELA SANTOS, «As Regras Brasileiras de Subcapitalização e os Acordos Internacionais de Bitributação – A Incompatibilidade da Lei No. 12.249/ 2010 com o Princípio Arm’s Length e com a Cláusula de não-Discriminação», in Revista Dialética de Direito Tributário, No. 234, Dialética, 2015, pp. 110-119.

21 ALBERTO XAVIER, Direito Tributário Internacional do Brasil, 8th ed., Forense, 2015, p. 385.

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lates the arm’s-length standard22. On the contrary, to comply with Article 9(1) of the OECD Model, profit adjustment mechanisms adopted by domestic laws of the contracting states must reflect open-market conditions23.

The compliance of Brazilian transfer pricing rules with the arm’s-length standard fundamentally depends on the quality and accuracy of the predetermined profit margins to reflect such open-market conditions24. Consequently, the problem effectively arises when those predetermined profit margins do not reflect such market conditions25. In practical cases, due to the very limited range of profit margins by economic sectors, Brazilian transfer pricing rules often overtax some transactions and under-tax others, given that the markup required by the method may be higher or lower than the profits actually obtained by taxpayers from an economic perspective26.

In this context, if the tax adjustment determined by the Brazilian transfer pricing rules in a concrete case does not reflect the arm’s-length standard, Article 9(1) of the tax treaty at issue would prevent such adjustment in cross-border transactions carried out with an associated enterprise domiciled in the other contracting state27. If this were not the case, Article 9 of tax treaties would be absolutely superfluous, as the end result would be the same regardless of the existence of a tax treaty between the two contracting states.

Indeed, in the absence of a double tax treaty, domestic tax laws would be freely applied to adjust the taxable profits because of the lack of boundaries curbing the right of either contracting state to tax. On the other hand, if a double tax

22 RAMON TOMAZELA SANTOS, «Territorial Tax Systems: Motivations and Key Considerations for Effective Change», in Tax Notes International, 89, 10, 2018, pp. 932-933.

23 LUÍS EDUARDO SCHOUERI, Preços de Transferência no Direito Tributário Brasileiro, 3rd ed., Dialética, 2013, pp. 441-442.

24 In the words of Alessandro Turina: “It then seems quite clear that the arm’s length nature of this type of approach would basically depend on the quality and accuracy of the predetermined margins” (ALESSANDRO TURINA, «Back to Grass Roots: The Arm’s Length Standard, Comparability and Transparency – Some Perspectives from the Emerging World», in World Tax Journal, 10, 2018, p. 323).

25 ALBERTO XAVIER, Direito Tributário Internacional do Brasil, 8th ed., cit., p. 388.

26 As an example, the World Bank report on transfer pricing states: “Brazil’s unique transfer pricing regime specifies several methodologies that are not consistent with the arm’s-length principle (in the traditional sense)” (WORLD BANK, Transfer Pricing and Developing Economies, 2016, p. 171).

27 LUÍS EDUARDO SCHOUERI, Preços de Transferência no Direito Tributário Brasileiro, cit., pp. 441-442.

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treaty is in place, domestic tax laws would still be free to determine the profit adjustment according to any criteria in the domestic law that supposedly reflect the arm’s-length standard.

This would render Article 9 of the OECD Model Convention completely inoperative, superfluous, insignificant, and meaningless.

Thus, to be compatible with Article 9 of the Model Convention, the profit adjustment set by domestic laws may not lead to an increase of the tax base above what is required by the arm’s-length standard28. The wording of the treaty provision clearly dictates that the tax adjustment must reflect “profits which would (...) have accrued to one of the enterprises”.

This shows that, although the Brazilian transfer pricing rules are simpler than the OECD Transfer Pricing Guidelines and more effective in countering base erosion and profit shifting, they can give rise to several tax disputes involving double taxation that arises in cross-border transactions, given that countless variables may influence the actual profit margin obtained by the independent parties dealing at arm’s-length conditions29.

As Brazilian domestic transfer pricing rules are primarily based on predetermined profit margins, with few exceptions, Brazil wisely does not include Article 9(2) of the OECD Model Convention in its tax treaties. Thus, Brazil does not apply a correlative adjustment to avoid economic double taxation derived from transfer pricing adjustments.

Indeed, to avoid economic double taxation, Article 9 of the OECD Model Convention provides two different levels of adjustment, namely: (i) the first profit adjustment made in the transaction between associated companies intends to reflect the market value – arm’s length price (“primary adjustment”);

LEONARDO FREITAS DE MORAES E CASTRO, «Normas Brasileiras de Preços de Transferência e o Artigo 9 dos Acordos de Tributação: Hipótese de Treaty Override?», in Revista de Direito Tributário da APET, No. 23, MP Editora, 2009, pp. 84-90.

29 Alessandro Turina asserts that: “Although the option of using predetermined margins has the advantage of both certainty and administrability, since it makes transfer pricing control much simpler, it is intuitive that the fixed margins will not be adequate in all possible circumstances, given the countless variables that influence the determination of a suitable margin” (ALESSANDRO TURINA, «Back to Grass Roots...», cit., p. 323).

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(ii) the second adjustment is made by the resident state of the beneficiary, based on Article 9(2) of the OECD Model Convention, to eliminate the economic double taxation generated by the profit adjustment and carried out by the first state (“correlative adjustment”)30.

Article 9(2) of the OECD Model Convention essentially provides that when a contracting state makes tax adjustments in the profit of an associated company to reflect the arm’s length standard, the other contracting state shall make equivalent adjustments in the resulting counterpart of the commercial or financial transaction, to avoid double taxation.

Despite the use of the expression “shall make an appropriate adjustment” in Article 9(2) of the OECD Model Convention, which suggests that the “corresponding adjustment” is mandatory, it is understood that such an obligation only arises when the primary adjustment reflects arm’s-length conditions31. In this sense, J. Scott Wilkie argues that the other contracting state is allowed to make its own determination of whether or not and to what extent the primary adjustment by the first state reflects the arm’s-length standard and justifies the “corresponding adjustment” to avoid economic double taxation 32.

As previously mentioned, Brazil does not reproduce Article 9(2) of the OECD Model Convention in its tax treaties, given that, due to the predominant adoption of fixed profit margins in Law 9,430/1996, it may be difficult to prove that the tax adjustment made in Brazil to correct the deviation of profits corresponds to the arm’s-length standard33.

However, even if Brazil does not include Article 9(2) in its tax treaties, other countries may choose to make a correlative adjustment to avoid economic double taxation based on their domestic tax laws or a MAP.

OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 227.

OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 227.

32 J. SCOTT WILKIE, «Article 25: Mutual Agreement Procedure», in Global Tax Treaty Commentaries, IBFD, 2016, p. 36.

33 According to paragraph 6 of the Commentaries on Article 9, “the adjustment is due only if State B considers that the figure of adjusted profits correctly reflects what the profits would have been if the transactions had been at arm’s length” (OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 227).

30 31

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The main evidence of this can be found in Action 14 of the BEPS Project, in which the OECD stated that the MAP can be used to resolve economic double taxation resulting from transfer pricing adjustments, even if the tax treaty between the two countries does not consider Article 9(2)34.

Apart from the primary and correlative adjustments provided in the OECD Model Convention, it is important to point out that domestic tax laws may require – or permit – a secondary transfer pricing adjustment in the taxpayers’ accounting books to reflect the profits they actually ascertained in the controlled cross-border transaction.

Indeed, after a primary transfer pricing adjustment, it is not uncommon to have funds in the hands of one associated enterprise when, in accordance with such adjustment, they should be in the possession of another associated enterprise. Thus, to make the actual allocation of funds consistent with that previous transfer pricing adjustment, some countries may adopt, combined or isolated, the following procedures: (i) to authorize the taxpayer to carry out a corrective transaction to transfer the funds to the associate enterprise, in line with the primary transfer pricing adjustment (e.g. international credit and debit notes); (ii) to impose constructive transactions, whereby the excess of funds in the hands of one associated enterprise are deemed to have been transferred to the other associate enterprise (e.g. constructive dividends, constructive informal capital contributions, and constructive loans) 35.

Secondary transfer pricing adjustments are entirely based on domestic tax law, so there is no specific treaty provision regulating this subject. Article 9 of the OECD Model Tax Convention does not deal with secondary transfer pric-

34 OECD. Making Dispute Resolution Mechanisms More Effective. Action 14: 2015 Final Report.

Paris: OECD, 2015, pp. 14-29. In the same sense, see: OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 432.

35 As an example, Section 4848-1(g)(3)(i) of the Income Tax Regulations of the United States establishes that “appropriate adjustments must be made to conform a taxpayer’s accounts to reflect allocations made under section 482. Such adjustments may include the treatment of an allocated amount as a dividend or a capital contribution (as appropriate), or, inappropriate cases, pursuant to such applicable revenue procedures as may be provided by the Commissioner (see § 601.601(d)(2) of this chapter), repayment of the allocated amount without further income tax consequences”.

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ing adjustment, which is why it neither forbids nor requires tax administrations to make such secondary adjustments.

The 2017 OECD Transfer Pricing Guidelines do not provide much guidance on secondary transfer pricing adjustments. Nonetheless, the OECD clearly states that the primary and correlative transfer pricing adjustments change the allocation of taxable profits within the corporate group, in which case a secondary transfer pricing adjustment may be required to make the actual allocation of profits consistent with the primary and correlative transfer pricing adjustments36. The OECD also acknowledges that, in certain countries, taxpayers are allowed to implement an effective transaction to conform its accounting books to the primary transfer pricing adjustments. In such cases, the transfer of funds to associated enterprises abroad may be conducted through an additional price payment or a refund of the price paid37.

After this brief analysis of the three types of transfer pricing adjustments (primary adjustment, correlative adjustment and secondary adjustment), it is important to note that Brazilian tax legislation only explicitly regulates primary transfer pricing adjustments. As a result, the use of correlative transfer pricing adjustments to resolve double taxation cases derived from diverges between Brazilian transfer pricing rules and the arm’s-length standard is very limited in practice, either because the other contracting state may claim that the predetermined profit margins adopted by Brazil do not lead to an arm’s-length outcome, or because Brazil does not reproduce Article 9, paragraph 2, of the OECD Model Convention in its tax treaties.

36 This paragraph reads as follows: “Corresponding adjustments are not the only adjustments that may be triggered by a primary transfer pricing adjustment. Primary transfer pricing adjustments and their corresponding adjustments change the allocation of taxable profits of an MNE group for tax purposes but they do not alter the fact that the excess profits represented by the adjustment are not consistent with the result that would have arisen if the controlled transactions had been undertaken on an arm’s length basis. To make the actual allocation of profits consistent with the primary transfer pricing adjustment, some countries having proposed a transfer pricing adjustment will assert under their domestic legislation a constructive transaction (a secondary transaction), whereby the excess profits resulting from a primary adjustment are treated as having been transferred in some other form and taxed accordingly” (OECD. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, cit., p. 195).

37 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, cit., p. 197.

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Finally, before concluding this topic, it is worth noting that both Brazilian transfer pricing rules and transfer pricing rules based on the OECD Guidelines have different structural flaws, including the following:

Structural flaws of Brazilian transfer pricing rules

Structural flaws of OECD transfer pricing rules

- the impossibility of producing evidence by the taxpayer, who is not allowed to prove that its commercial or financial trans-actions complied with the arm’slength standard;

- lack of comparable transactions to use for identifying the transfer price;

- shortages in the range of predetermined profit margins, which should capture the specificities of each economic segment; - high risk of economic double taxation in cross-border transactions; -high risk of under-taxation or overtaxation of profits in Brazil; - the non-application of the transfer pricing rules for royalties and payments derived from administrative assistance, which are subject to quantitative limitations; - absence of correlative and secondary transfer pricing adjustments; - failure to effectively use the mutual agreement procedure to resolve transfer pricing disputes; - lack of tax rulings and advance pricing agreements;

- the absence of a single correct result, as the arm’s-length price is a range, which admits fluctuations; - high compliance and monitoring costs - the vulnerability of transfer pricing rules to profit-shifting strategies involving intangible assets and contractual risks; - a lack of legal certainty for foreign investors because the results of the application of transfer pricing rules are unpredictable and the amounts involved in related tax assessment notices have significantly increased; - the inability of transfer pricing methods to capture synergy and other effects from the integration of legal entities into international corporate groups; - lack of effective coordination among countries to align transfer pricing outcomes (for example, mutual agreement procedures, advance pricing agreements, and tax rulings); - the high costs involved in bilateral or multilateral advance pricing agreements;

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- structural limitations of Brazilian transfer pricing methods to capture certain types of transactions, such as financial investments, sales of equity participations, guarantee agreements, and transfer of intangibles, among others.

- the poor and inadequate alignment between existing transfer prices rules and the rapidly changing business environment; - the absence of a solid theoretical approach for the identification of value creation, as proposed by the OECD during the BEPS project; and - the increasing complexity of the arm’slength standard and the functional analysis has reached a level that borders on irrationality.

5. Dispute Resolution Mechanism As commonly known, the mutual agreement procedure allows taxpayers to request an intergovernmental dispute resolution by way of negotiations between the competent authorities of the contracting states38.

Within the BEPS Project, the OECD acknowledged that the tax measures suggested to combat aggressive tax planning structures could increase the risk of double taxation and, consequently, tax treaty related disputes39. For this reason, Action 14 of the BEPS Action Plan restated that countries should ensure the effectiveness of the dispute resolution mechanism contained in their tax treaties, allowing the taxpayer to initiate the MAP, irrespective of the remedies provided

38 ROLAND ISMER & SOPHIA PIOTROWSKI, «A BIT Too Much: Or How Best to Resolve Tax Treaty Disputes?», in Intertax, 44, Issue 5, 2016; MARINA LOMBARDO, «The Mutual Agreement Procedure – A tool to overcome interpretation problems?», in Fundamental Issues and Practical Problems in Tax Treaty Interpretation, M. Schilcher & P. Weninger (eds.), Linde, 2008; FOTINI AVARKIOTI, «Trends of the Mutual Agreement Procedure», in Tax Treaty Policy and Development, M. Stefaner & M. Züger (eds.), Linde, 2005; ANA PAULA DOURADO &, PASQUALE PISTONE, «Some Critical Thoughts on the Introduction of Arbitration in Tax Treaties», in Intertax, 42, Issue 3, 2014; FERNANDO SERRANO ANTÓN, La Resolución de Conflictos en el Derecho Internacional Tributario: Procedimiento Amistoso y Arbitraje, Arazandi/Thomson Reuteurs, 2010.

39 JACQUES MALHERBE, «BEPS: The Issues of Dispute Resolution and Introduction of a Multilateral Treaty», in Intertax, 43, Issue 1, 2015, p. 91.

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by the domestic law, when the actions of one or both of the contracting states result or will result in taxation not in accordance with the tax treaty.

To be fully compliant with the minimum standard established in Action 14 of the BEPS Project, Brazil will have to amend and update its tax treaty network to establish an effective dispute resolution mechanism. As Brazil decided not to sign the Multilateral Instrument40, the only way now to be compliant with the minimum standard established under the BEPS Action 14 is to update its tax treaties via bilateral negotiations.

In this respect, it should be noted that Brazil is a member of the Inclusive Framework on BEPS established by the OECD in January 2016, which brings together over 100 countries and jurisdictions to collaborate on the implementation of the BEPS Package. The objective of the Inclusive Framework is to ensure, by means of a peer review process, that the four minimum standards action plans – harmful tax practices (BEPS 5), tax treaty abuse (BEPS 6), Country-byCountry reporting (BEPS 13) and dispute resolution mechanisms (BEPS 14) – will be effectively implemented and applied by countries committed to BEPS 41.

Hence, to meet the minimum standard, Brazil will have to grant effective access to MAP in tax treaty related disputes.

All Brazilian tax treaties allow for the MAP to resolve tax treaty related disputes. However, the MAP has not been extensively used in Brazil either due to a natural preference for domestic remedies or due to legitimate concerns related to its efficacy within the Brazilian tax system.

However, the MAP has been recently regulated, for the first time, within the Brazilian legislation, upon the publication of the Normative Ruling RFB No.

40 The absence of Brazil at the signing ceremony was justified on the basis of the complexity of the Multilateral Instrument, which intends to amend several bilateral tax treaties through a single instrument. According to the Brazilian Tax Administration, this innovative procedure could generate lengthy discussions in the Brazil’s National Congress, thereby delaying the approval of the Multilateral Instrument for years, a result that would be undesirable (see RAMON TOMAZELA, «Brazil’s absence from the Multilateral BEPS Convention and the new amending protocol signed between Brazil and Argentina», in Kluwer International Tax Blog, 2017, p. 1).

41 ARNAUD DE GRAAF & KLAAS-JAN VISSER, «BEPS: Will the Current Commitments and Peer Review Model Prove Effective?», in EC Tax Review, 27, Issue 1, 2018, p. 45.

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1,669/2016. Before this publication, the lack of regulation was constantly pointed out as a possible reason for the scarce usage of the MAP in Brazil 42.

Despite the merits involved in such regulation, the Normative Ruling RFB No. 1,669/2016 has several shortcomings.

Firstly, the Normative Ruling RFB No. 1,669/2016 does not contain clear guidelines on access to the MAP. Although the Normative Ruling explains how a taxpayer can make a MAP request and what information and documentation should be included in such request, there are still many questions concerning how such a procedure will work in practice, especially in regards to transfer pricing disputes that derive from divergences between the Brazilian predetermined profit margins and the arm’s-length outcome.

Secondly, Article 4 of the Normative Ruling RFB No. 1,669/2016 only covers taxation that contradicts a tax treaty provision, while under Article 25(3) of the OECD Model Tax Convention, a regular MAP also extends to cases of double taxation of income that do not fall within the scope of a tax treaty but can nevertheless, be solved voluntarily by the contracting states.

Thirdly, the Normative Ruling RFB No. 1,669/2016 has no rules regarding taxpayer participation in the MAP, even though it is the taxpayer that initiates the procedure and provides documentation and information to the competent authorities. Thus, the most interested party in solving the tax dispute cannot actively contribute to the achievement of a favorable outcome. Ideally, the taxpayer should be allowed to make a presentation to the competent authorities, with the possibility of submitting oral or written considerations regarding the relevant facts under discussion43.

In this respect, Philip Baker and Pasquale Pistone assert that the participation of the taxpayer plays an important role for the MAP since it excludes

42 MATEUS CALICCHIO BARBOSA, O Procedimento Amigável nos Acordos de Bitributação Brasileiros, São Paulo, Quartier Latin, 2018, p. 127.

43 As pointed out by Philip Baker and Pasquale Pistone, in an ideal model of MAP, countries should achieve a commonly agreed interpretation of all relevant facts and legal questions with the direct involvement of taxpayers (PHILIP BAKER & PASQUALE PISTONE, «BEPS Action 16: The Taxpayers’ Right to an Effective Legal Remedy Under European Law in Cross-Border Situations», in EC Tax Review, 25, Issue 5/6, 2016, pp. 340-341).

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possible discretionary negotiations between the tax authorities in relation to other pending cases between the same contracting states44.

Fourthly, Article 8, paragraph 1, of the Normative Ruling excludes the possibility of initiating the MAP in cases where the matter has already been submitted to administrative or judicial litigation and a decision has already been rendered, even if it may still be challenged through an appeal.

This restriction provided in the Normative Ruling discourages the initiation of the MAP by taxpayers in Brazil, considering that, in cases of tax assessment notices, the filling administrative defense is necessary to suspend the enforceability of the tax credit45. Thus, in practical terms, the taxpayer who files an administrative defense against a tax assessment notice can start the MAP only when the first instance administrative decision is given.

Nevertheless, according to paragraph 45 of the Commentaries on Article 25 of the OECD Model Convention, the taxpayer should only withdraw, wholly or partially, from the judicial or administrative discussion at the time of the implementation of the solution reached in the MAP. See the following excerpt: “42. The case may arise where a mutual agreement is concluded in relation to a taxpayer who has brought a suit for the same purpose in the competent court of either Contracting State and such suit is still pending. In such a case, there would be no grounds for rejecting a request by a taxpayer (...)

45. (...) In short, therefore, the implementation of such a mutual agreement should normally be made subject: - to the acceptance of such mutual agreement by the taxpayer, and - to the taxpayer’s withdrawal of the suit at law concerning those points settled in the mutual agreement”46.

Thus, there is no need to prevent the initiation of the MAP in cases where the matter has already been submitted by the taxpayer to either administrative or judicial litigation. The withdrawal of the judicial lawsuit or the administrative proceeding should only be required at the moment of the implementation of the solution reached by the countries within the MAP. This measure is re-

PHILIP BAKER & PASQUALE PISTONE, «BEPS Action 16...», cit., pp. 341-342.

Article 151, item III, of the National Tax Code.

46 OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 445.

44 45

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quired because the tax administration is not allowed to deviate from a court decision through a MAP. Tax authorities are obliged to follow court decisions, and, therefore, once a judicial decision has been rendered in a particular case, it is not possible to override that decision by means of a MAP 47. That is why the taxpayer is required to withdraw any lawsuit and renounce the exercise of any domestic legal remedies relating to the issues under discussion before the implementation of the MAP decision48.

Moreover, the OECD provides in the Best Practice 6 of Action 14 of the BEPS Project that countries must take the necessary measures to ensure the suspension of the tax credit during the MAP. It reads as follows: “Best practice 6: Countries should take appropriate measures to provide for a suspension of collections procedures during the period a MAP case is pending”49.

The suspension of the enforceability of the tax credit is essential in preserving the effectiveness of the MAP, as well as in ensuring that the taxpayer will not have to collect the tax supposedly due and then request a refund (“solve et repet”) in the event of a favorable outcome in the dispute resolution 50.

In addition, since the taxpayer may be subject to the collection of taxes in two contracting states, it is not practical compel him/her to collect the tax or to adopt administrative measures in both jurisdictions to suspend the enforceability of the tax credit required in each country.

Despite the restrictive wording of the Normative Ruling RFB No. 1,669/ 2016, as the request for initiating the MAP is based directly on the tax treaty itself and this mechanism for the solution of controversies can be framed in the broader concept of administrative proceedings (instrument for the control of administrative acts), it is fair to say that, from a legal standpoint, the MAP may

LYDIA-ELISAVET SOFRONA, «The MAP in Greece: New Domestic Procedural Framework Enhances Effectiveness of Cross-Border Dispute Resolution», in European Taxation, 57, 12, 2017, p. 548.

48 ALBERTO XAVIER, Direito Tributário Internacional do Brasil, 7th ed., Forense, 2010, p. 167.

49 OECD, Making Dispute Resolution Mechanisms More Effective, Action 14: 2015 Final Report. cit., p. 31.

50 OECD, Making Dispute Resolution Mechanisms More Effective, Action 14: 2015 Final Report. cit., p. 31.

47

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fall under Article 151, Item III, of the National Tax Code, as an administrative proceeding that suspends the enforceability of the tax credit.

Fifthly, the Normative Ruling RFB No. 1,669/2016 does not contain any rule regarding the publication of the MAP decision. According to the OECD, while the decision would not be in any sense a formal precedent, its publication could influence the course of other cases that seek to avoid subsequent disputes and lead to a more uniform approach to the same issue 51. It follows that the publication of decisions rendered by the competent authorities under the MAP, in addition to contributing to the increase of transparency in the relations between Tax Administration and taxpayers, can also prevent future disputes on the same subject, thereby enhancing the tax treaty interpretation in Brazil. To publish such decisions, specific information protected by confidentiality and tax secrecy can be removed from the text to be published, which currently occurs in Brazil with the decisions published that comply with the law on access to public information (Law No. 12,527, of 18 November 2011).

Specifically, in relation to transfer pricing disputes, the wording of Article 5, paragraph 2, of the Normative Ruling RFB No. 1,669/2016 suggests that Brazil will grant access to the MAP in transfer pricing cases that lead to double taxation, even in the absence of Article 9(2) of the OECD Model Convention in its tax treaties. This procedure would be the most appropriate in the light of Action 14 of the OECD/G20 BEPS initiative, which introduced a minimum standard for improving dispute resolution mechanisms. In this Action Plan, the OECD stated that countries should somehow provide access to the MAP in transfer pricing cases52 even in the absence of a treaty provision based on Article 9(2) of the OECD Model Convention53/54.

51 Paragraph 32 of the OECD Commentaries on Article 25 of the OECD Model Tax Convention (OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 482).

52 As pointed out by Taco Wiertsema, “participating countries will be required to incorporate corresponding transfer pricing adjustments in line with article 9(2) of the OECD Model in covered tax treaties or opt out in favour of committing to otherwise making such adjustments or resolving such cases through MAP” (TACO WIERTSEMA, «Council Directive on Double Taxation Dispute Resolution Mechanisms: Resolving Companies’ Areas of Concern?», in Derivatives & Financial Instruments, 19, 5, 2017, p. 10.

53 OECD. Making Dispute Resolution Mechanisms More Effective. Action 14: 2015 Final Report. cit., pp. 14-29.

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In this respect, a concrete problem that may arise lies in the lack of experience of Brazilian tax authorities with transfer pricing rules based on the OECD Transfer Pricing Guidelines. Generally, developing countries already suffer from the lack of specific teams dealing with MAP cases and skilled personnel to handle sophisticated transfer pricing disputes55. The situation in Brazil is probably worse, because, in addition to the lack of a specific team dealing with MAP cases, Brazilian tax authorities have no expertise with transfer pricing methods fully based on the arm’s-length standard.

As countries are only obliged to use their best efforts to resolve the situation of the taxpayer56, it remains to be seen whether Brazil will effectively grant tax relief in transfer pricing cases to avoid economic double taxation. Indeed, one of the main reasons for the inefficacy of the MAP lies in the fact that the competent authorities have no obligation to arrive at a solution, which is a problem that can only be solved with mandatory arbitration57.

This issue highlights the importance of mandatory binding arbitration, which may be used when the competent authorities of the member states involved cannot agree on a transfer pricing solution that eliminates double taxation58. A typical dispute could involve, for example, the standard price to be attributed to a particular transfer of goods, due to the differences between the

54 A similar statement may be found in paragraph 11 of the OECD Commentaries on Article 25 of the OECD Model Tax Convention, which reads as follows: “When the bilateral convention does not contain rules similar to those of paragraph 2 of Article 9 (...) the mere fact that Contracting States inserted in the Convention the text of Article 9, as limited to the text of paragraph 1 (...) indicates that the intention was to have economic double taxation covered by the Convention. As a result, most member countries consider that economic double taxation resulting from adjustments made to profits by reason of transfer pricing is not in accordance with – at least – the spirit of the convention and falls within the scope of the mutual agreement procedure set up under Article 25” (OECD, Model Tax Convention on Income and on Capital – Condensed Version, cit., p. 432).

55 CARLOS PROTTO, «Mutual Agreement Procedures in Tax Treaties: Problems and Needs in Developing Countries and Countries in Transition», in Intertax, 42, Issue 3, 2014, p. 176.

56 According to Anne Van de Vijver: “While states have to make reasonable efforts to find a common understanding, there is in principle no binding obligation to reach an agreement” (ANNE VAN DE VIJVER, «International Double (Non-)taxation: Comparative Guidance from European Legal Principles», in EC Tax Review, 24, Issue 5, 2015, p. 247.

57 SRIRAM GOVIND & SHREYA RAO, «Designing an Inclusive and Equitable Framework for Tax Treaty Dispute Resolution: An Indian Perspective», in Intertax, 46, Issue 4, 2018, p. 316.

58 MICHELLE MARKHAM, «The Resolution of Transfer Pricing Disputes through Arbitration», in Intertax, 33, Issue 2, 2005, p. 70.

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predetermined profit margins adopted in Brazil and the complete transfer pricing assessment based on the arm’s-length standard.

Besides allowing for dispute resolution when the MAP fails, mandatory binding arbitration is important because it puts pressure on tax authorities to resolve treaty-related disputes before the arbitration takes place59. Although some countries are reluctant to give up their tax sovereignty in favor of a decision rendered by an arbitration panel, arbitration clauses included in tax treaties may urge the competent authorities to solve MAP cases in an early stage, making it more effective and providing more legal certainty60. Nevertheless, within the framework of the BEPS Multilateral Convention, the mandatory arbitration is intended to apply only to countries that explicitly choose to introduce this mechanism in their tax treaties61, which is not the case for Brazil.

As a matter of fact, the introduction of mandatory binding arbitration in tax treaties is a highly controversial topic in Brazil.

In brief, Brazilian tax authorities argue that arbitration is incompatible with the national tax system, based on “the principle of non-availability of the tax credit”, implying that tax authorities may not dispose of the tax credit properly constituted in accordance with domestic tax laws. For this reason, Brazil has no arbitration clause in its tax treaties.

It is time for Brazil to change its opinion against arbitration. When there is uncertainty and/or controversy about the interpretation of a treaty provision that restricts a contracting state’s right to tax, the very existence of the tax credit is no longer absolute and definite62. If this is the case, “the principle of non-availability of the tax credit” does not apply, and the mandatory binding arbitration is perfectly reasonable and even desirable.

59 HUGH AULT & JACQUES SASSEVILLE, «2008 OECD Model: The New Arbitration Provision», in Bulletin for International Taxation 5/6, 63, IBFD, 2009, pp. 208-214.

60 CARLOS PROTTO, «Mutual Agreement Procedures in Tax Treaties...», cit., p. 178.

61 As highlighted by Gracia Mozo: “A key point in the Final Report, however, is the lack of consensus among the participating states on compulsory arbitration as a supplementary MAP resolution mechanism” (GRACIA M. LUCHENA MOZO, «A Collaborative Relationship in the Resolution of International Tax Disputes and Alternative Measures for Dispute Resolution in a Post-BEPS Era», in European Taxation, 58, 2018, p. 22).

62 DANIEL DIX CARNEIRO, Os Conflitos Tributários Internacionais e sua Possível Solução pela Via Arbitral, Quartier Latin, 2014, pp. 243-246.

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It is true that arbitration may affect a country’s sovereignty and limit its ability to unilaterally determine the taxes due under its domestic laws. However, insofar as a country concluded a tax treaty that voluntarily limits its own jurisdiction, it already restricted part of its sovereign power to determine its own tax policy without interference of the other contracting state. It follows that the arbitration is only an additional procedure within the MAP to resolve tax treaty related disputes63/64, particularly in cases involving transfer pricing, permanent establishment, and income allocation, among others.

In this context, it is important to bear in mind that arbitration can yield considerable benefits both for governments and taxpayers.

On the one hand, from a governmental standpoint, the benefits of tax arbitration derive from the signal sent to foreign taxpayers in relation to its intention to comply with international obligations. This message may hopefully lead to a potential increase in economic activity, foreign investments and tax collection due to the elimination of double taxation. The government may also benefit from the opportunity to provide to its own taxpayers better protection against the imposition of unfair taxes by other countries65.

Furthermore, the inclusion of independent transfer pricing experts gives the arbitration panel more credibility, esteem and relevance, beyond that of a meeting of competent authorities under the MAP, thereby enhancing the arbitration panel’s stature as a third and independent body separate from the competent authorities of the countries involved66. In practice, an arbitration conducted by industry experts may even free the tax authorities, on a personal level, from the burden of rendering a decision against the Tax Administration 67.

Technically speaking, the competent authority does not act as a regular member of the Tax Administration in the MAP, but rather as a representative of a con-

63 PHELIPPE TOLEDO PIRES DE OLIVEIRA, «Action 14 of the OECD/G20 Base Erosion and Profit Shifting Initiative: Making Dispute Resolution More Effective – Did Action 14 “Piggyback” on the Initiative?», in Bulletin for International Taxation, 71, 1, 2017, p. 4.

64 LUÍS EDUARDO SCHOUERI, «Arbitragem no Direito Tributário Internacional», in Revista Direito Tributário Atual, No. 23, IBDT/Dialética, 2009, p. 305.

65 ZVI DANIEL ALTMAN, Dispute Resolution under Tax Treaties, Online Books IBFD, 2006.

66 MICHELLE MARKHAM, «The Resolution of Transfer Pricing Disputes through Arbitration», cit., p. 70.

67 ZVI DANIEL ALTMAN, Dispute Resolution under Tax Treaties, cit.

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tracting state in a public international law proceeding, during which it deals with the interpretation of the relevant tax treaty provisions68. In such a circumstance, the competent authority should enjoy a high degree of discretion as compared to a regular “ex-officio” revision. In any case, the arbitration may reduce this type of administrative constraint and, consequently, the bias in MAP outcomes.

On the other hand, from a taxpayer’s perspective, arbitration assures that a decision will be rendered by an arbitrator if both countries fail to reach an agreement in relation to the case at hand. Thus, arbitration offers an incentive for compromise and for dispute resolution during the MAP. Such an incentive derives from the increase of legal costs at the arbitration stage, as well as from the risk of obtaining an unfavorable decision69.

Moreover, as if that were not enough, with the arbitration clause, a country loses part of its ability to adopt inconsistent interpretations to circumvent the obligations assumed in its tax treaties. More importantly, the arbitration may increase the general levels of compliance with tax treaty obligations and, consequently, taxpayers will be afforded an enhanced level of protection. Thus, apart from being a response to the shortcomings of the MAP, mandatory arbitration has been designed to solve cross-border tax controversies in a way that increases legal certainty and predictability for the taxpayers 70.

Unfortunately, from a practical standpoint, it is highly unlikely that Brazil will change its position about this topic in the near future.

LYDIA-ELISAVET SOFRONA, «The MAP in Greece...», cit., p. 548.

ZVI DANIEL ALTMAN, Dispute Resolution under Tax Treaties, cit.

70 ELIZABETH SNODGRASS, «Tax Controversies and Dispute Resolution under Tax Treaties: Insights from the Arbitration Sphere», in Derivatives & Financial Instruments, 19, 5, 2017, p. 5.

68 69

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6. Conclusion As discussed thoroughly in this article, divergences between Brazilian transfer pricing rules and transfer pricing rules based on the OECD Transfer Pricing Guidelines can easily lead to economic double taxation.

The possibility of using correlative transfer pricing adjustments to resolve such double taxation cases is very unlikely, either because the other contracting state may claim that the predetermined profit margins adopted by Brazil do not lead to an arm’s length result, or because Brazil does not reproduce Article 9, paragraph 2, of the OECD Model Convention in its tax treaties.

The remaining alternative to resolve such double taxation issues is the MAP, which is provided in all tax treaties concluded by Brazil.

In practice, the MAP has not been frequently used in Brazil, due to the various deficiencies of this mechanism of dispute resolution. Normative Ruling RFB No. 1,669/2016 took a step in the right direction when regulating the MAP in Brazil, but there are still several flaws that need to be corrected to make this mechanism of dispute resolution useful and efficient in Brazil.

For the future, Brazil should review its position of resistance to mandatory arbitration, mainly in a scenario of fierce tax competition, since there is no point in offering foreign investors a tax treaty network if disputes between contracting states cannot be effectively remedied in a timely manner.

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China’s Reforming of Transfer Pricing Rules in the Post-BEPS Era

Xiaoqiang Yang * Jian Wang **

1. Introduction In the last several years, the OECD and G20 have jointly initiated a project to counter the base erosion and profit shifting (“BEPS Project”). According to the OECD, BEPS refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations1. To address tax avoidance, the OECD set out 15 Actions with domestic and international instruments in the BEPS Project, where transfer pricing is a crucial element. Specifically, actions in relation to transfer pricing consist of Actions 8-10 with the purpose of aligning profits with the place where economic activities are performed and value is created, and with Action 13 “transfer pricing documentation”.

As a key member of G20, China has actively participated in the BEPS Project, and taken this opportunity to revamp its international tax regimes. With respect to transfer pricing rules, the State Administration of Taxation (“SAT”) has issued a series of regulations: Bulletin 42 on transfer pricing documenta-

* Professor of tax law and appraisal Law at Sun Yat-sen University School of Law, Guangzhou, China. Chinese correspondent for the International VAT Monitor of IBFD. He has been working for the new Chinese VAT Law legislation with the invitation from MoF and NPC since 2008. ** Currently works on the international tax team of China Investment Corporation. Bachelor and Master of Laws in Tax Law at the University of Sun Yat-Sen University. Adv. LL.M. in international taxation at the International Tax Centre, Leiden University. Previously worked in Ernst & Young Amsterdam office and Loyens & Loeff Hong Kong office. The author would like to thank Robert Jan van Lie Peters, tax advisor in Loyens & Loeff, for his previous guidance in transfer pricing.

1 Available at http://www.oecd.org/tax/beps/.

Xiaoqiang Yang | Jian Wang

tion 2 , Bulletin 64 on advance pricing agreements (“APAs”) 3 and Bulletin 6 special tax investigations, adjustments and mutual agreement procedures (“MAPs”)4, to comprehensively revise the previous outdated transfer pricing regime under Circular 25. These new Bulletins have greatly integrated the recommendations of OECD BEPS Actions (mainly BEPS Actions 8-10, Action 13), while incorporated certain rules with typical ‘Chinese characteristics’.

2. Bulletin 42: transfer pricing documentation On 29 June 2016, the SAT released the long-awaited Bulletin 42 to introduce China’s domestic rules as adoption of the OECD’s BEPS Action 13. Similar to the OECD BEPS Action 13 final report, Bulletin 42 includes a 3-tier documentation requirement: (i) master file, (ii) local file and (iii) Country-by-Country Reporting (“CbCR”). In addition, it includes requirements for taxpayers to prepare special files for cost sharing agreements and thin-capitalization. The application of Bulletin 42 has retroactive effect as of 1 January 2016.

2.1. Master file A Chinese entity that is part of a multinational enterprise (“MNE”) group is required to prepare a master file during the current fiscal year if:

Bulletin on Issues Relating to the Enhancement of the Declaration of Related Party Transactions and Administration of Contemporaneous Documentation, SAT Bulletin [2016] No. 42, dated 29 June 2016, retroactively effective from 1 January 2016. Chinese version available at http://www. chinatax.gov.cn/n810341/n810755/c2208516/content.html.

3 Bulletin of the State Administration of Taxation on Issues Concerning the Improvement of the Administration of Advance Pricing Arrangements, SAT Bulletin [2016] No. 64, dated 11 October 2016, effective from 1 December 2016. Chinese version available at http://www.chinatax.gov.cn/n8103 41/n810755/c2292979/content.html.

4 State Administration of Taxation’s Bulletin on the Administrative Measures for Special Tax Investigation and Adjustments and Mutual Agreement Procedures, SAT Bulletin [2017] No. 6, dated 17 March 2017, effective from 1 May 2017. Chinese version available at http://www.chinatax. gov.cn/n810341/n810765/n2511651/n2511713/c2712540/content.html.

5 Circular of the State Administration of Taxation on Printing and Distributing the Implementing Measures for Special Tax Adjustments (for Trial Implementation), Guo Shui Fa [2009] No. 2, dated 8 January 2009, retroactively effective from 1 January 2008.

2

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● the Chinese entity has related party transactions and the aggregate of

which exceeds RMB 1 billion during the year; or ● the Chinese entity is involved in cross-border related party transactions

and the ultimate holding company of the MNE group, which consolidates the Chinese entity in its financial statements, has already prepared a master file itself.

A master file should provide a high level overview of the MNE’s global operations and policies and include the following points: ● organizational chart; ● description of the business, which includes the ‘profit drivers’, the sup-

ply chain and the main geographic markets of the major products/services, intra-group service agreements, a brief functional and value creation analysis and a description of recent restructurings, if any; ● intangibles, which include the overall descriptions of the MNE group’s

strategies for R&D and intangibles, lists of intangibles with substantial impact on transfer pricing arrangements and their respective owners, essential intangible agreements, such as cost sharing agreements, transfer pricing policies for R&D and intangibles, as well as important transfers of ownership with respect to intangibles and/or usufructs; ● financial arrangements, which include related and main unrelated

transactions; ● financial and tax positions, which include the annual consolidated fi-

nancial statement and a list of the applicable APAs of the MNE group.

If a comparison is made between the contents of the master file requirements under Bulletin 42 with those of the OECD’s BEPS Action 13 Report, no material differences can be identified. Therefore, if other members of the MNE group has prepared a master file, the Chinese entity can greatly rely on it to comply with its master file obligation.

The master file should be prepared within 12 months of the end of the fiscal year of the ultimate holding company of the group, and should be pro-

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vided within 30 days upon receipt of the request from China’s tax authorities (“CTA”).

2.2. Local file It is required to prepare a local file, if during the current fiscal year a Chinese entity has: ● an annual amount of related party transfers of tangible assets that ex-

ceeds RMB200 million; ● an annual amount of related party transfers of financial assets that ex-

ceeds RMB100 million; ● an annual amount of related party transfers of intangible assets that ex-

ceeds RMB100 million; or ● an annual amount of other related party transfers that exceeds RMB40

million.

The local file should provide detailed information about related party transactions and include the following: ● descriptions of the MNE group’s Chinese local entities; ● descriptions of shareholder relationships (direct and indirect) of the

MNE group’s Chinese local entities; ● descriptions of related party transactions entered into by the MNE

group’s Chinese local entities, including, among others, a value chain analysis, Chinese local entity’s outbound investments and intra-group services; ● a comparability analysis; ● a (substantiated) transfer pricing method selection.

If a comparison is made between the contents of the local file requirements under Bulletin 42 with those of the OECD’s BEPS Action 13 Report, some material differences can be identified.

First, the inclusion of a value chain analysis in the documentation is required by the SAT. The purpose of including a value chain analysis is to substantiate and ensure that profits are taxed in the jurisdiction where economic

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activities occur and where value is created. From a teleological perspective, it can therefore be argued that the inclusion of the value chain analysis in the local file is in accordance with the purpose of the OECD BEPS rules. However, the SAT requires the financials of all the related parties along the value chain to be provided, which imposes quite a heavy burden on the Chinese entities. In addition, once the CTA receives the financials of all the related parties, the information obtained (e.g. revenue, headcounts, costs, etc.) may facilitate the use of controversial value contribution allocation methods.

Notably, when conducting the value chain analysis, the impact of location specific advantages (“LSAs”) should be taken into account as well, pursuant to application of the Chinese transfer pricing principles in this respect.

In addition to the above, intra-group services are also under scrutiny, and explicit and extensive information in this respect is required to be reported in the local file. Together with released Bulletin 6 on the special tax adjustments on intra-group service fees, the CTA keeps close tabs on the outbound service fee payments.

Furthermore, it is included in Bulletin 42 that all outbound investments made by MNE’s Chinese local entities should be included in local files. This requirement to disclose foreign investments indicates that the CTA will put more emphasis on the governance of controlled foreign corporations (“CFCs”).

The local file should be prepared before 30 June of the following year after the fiscal year where the information relates, it and should be provided within 30 days upon receipt of the request from the CTA. 2.3. CbCR A Chinese entity that is part of an MNE group is obliged to prepare the CbCR if: ● the Chinese entity is the ultimate holding company of an MNE group

and the MNE group’s consolidated revenue for the last fiscal year exceeds RMB5.5 billion; or ● the Chinese entity is delegated by the MNE group as the reporting enti-

ty for CbCR purposes.

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The CTA is entitled to request the Chinese entity to submit CbCR if the CTA fails to obtain the CbCR through information exchange from the state of ultimate holding company. It should be noted that in May 2016, China signed the so-called Multilateral Competent Authority Agreement (“MCAA”) for the automatic exchange of CbCRs. Up until April 2018, China has activated the automatic exchange relationship under the MCAA with the UK, France and Germany, which will be effective for taxable periods starting on or after 1 January 20176.

Consistent with the proposed CbCR template prepared by the OECD, the Chinese CbCR rules require aggregated country-by-country data of constituent entities and should cover information about revenue, profits (and losses) before income tax, income tax paid (on cash basis), income tax incurred, stated capital and accumulated earnings, number of employees, and tangible assets other than cash and cash equivalents.

If a comparison is made between the contents of the CbCR requirements under Bulletin 42 with those of the OECD’s BEPS Action 13 Report, no material differences can be identified.

CbCR should be submitted in the Statement of Corporates of the People’s Republic of China on Annual Related-Party Transactions during the annual corporate income tax return declaration period. In China, the annual corporate income tax return declaration should normally be conducted before 31 May of the next calendar year.

Chinese entities that fail to comply with the documentation requirements (including providing incorrect or incomplete documents) will be subject to a fine up to RMB50,000. In addition, when the CTA makes special tax adjustments and additional tax assessments need to be imposed, a ‘punitive interest penalty’ that equals the RMB loan benchmark rate published by the People’s Bank of China plus 5 percent points would apply.

6

Available at http://www.oecd.org/tax/beps/country-by-country-exchange-relationships.htm.

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2.4. Special filing requirements for cost sharing agreements and thin-capitalization Chinese entities are required to prepare a special file for cost sharing agreements once they have signed or implemented them.

A special file is required as well with respect to thin-capitalization, if the taxpayer wants to prove that its related party debt level is still consistent with the arm’s length principle, even though its debt to equity ratio exceeds specified ratios. Currently these specified thin-capitalization ratios, where interest can in principle be deducted, are set at 5:1 for financial institutions and at 2:1 for all the other situations.

Since the information for the special files was already included under the applicable reporting requirements of Circular 2, the new special filing rules are not expected to have substantial additional impact on MNE’s Chinese local entities and Chinese MNEs. 3. Bulletin 6: special tax investigations, adjustments and MAPs Bulletin 6 is an Administrative Decree that has taken effect nationwide in China as of 1 May 2017. It governs China-involved cross-border related party transactions. Transactions between domestic related parties that are part of an MNE group are in principle excluded from any transfer pricing adjustments, as long as such transactions do not decrease China's overall tax revenue.

Bulletin 6 has adopted some of the OECD BEPS Actions, such as the provisions on intangibles, the comparability analysis and transfer pricing methods as well as the updates of MAPs. It also introduces in writing some of the transfer pricing practice that the CTA has been applying for the last few years. Examples thereof are the possibility to perform tax audits on the payments to ‘low-substance’ entities, the ‘simple-function’ entities, and on the use of ‘asset valuation method’ for the related-party equity/asset transfers. In addition, Bulletin 6 has affirmed China’s emphasis on the following items: LSAs, value chain analysis, intra-group service fee.

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3.1. Special tax investigations, adjustments Bulletin 6 prescribes that special tax investigations may be carried out for all the matters set out in Chapter 6 of the Corporate Income Tax Law in China, including transfer pricing, thin capitalization, CFCs and general anti-avoidance rules (“GAAR”).

More specific to the special tax investigations on transfer pricing, Bulletin 6 integrates some rules that were introduced in earlier regulations, or that were in practice applied by the CTA in conducting transfer pricing audits. These, for example, consist of: (i) payments to ‘low-substance’ entities; (ii) ‘simple-function’ entities; and (iii) toll manufacturing.

3.1.1. Payments to ‘low-substance’ entities Bulletin 6 prescribes that the CTA may conduct special tax investigations, if payments to overseas related parties without substantial activities (e.g. a typical BVI company without ‘real’ activities), that have been claimed for tax deduction, are not at arm’s length.

Prior to Bulletin 6, the CTA could directly deny the deductibility of outbound payments to ‘low-substance’ entities without the necessity to audit the transfer pricing documentation provided by the entity under Bulletin 16 7. Since Bulletin 6 now affirms that the arm's length principle applies for all types of outbound payments to related parties, this provides protection for Chinese entities to the extent that such payments to ‘low-substance’ entities are at arm’s length.

3.1.2. ‘Simple-function’ entities Bulletin 6 prescribes that Chinese entities engaged in the provision of single-function manufacturing (toll or contract manufacturing), simple distribu-

7 State Administration of Taxation’s Bulletin on Enterprise Income Tax Issues Related to Outbound Payments by Enterprises to Overseas Related Parties, SAT Bulletin [2015] No. 16, dated 18 March 2015. Bulletin 16 was repealed after the release of Bulletin 6.

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tion or contract R&D for overseas related parties shall in principle maintain a reasonable profit level.8 If such entities assume risks and incur losses (e.g. risks and losses associated with faulty decisions, capacity under-utilization, R&D failures, etc.) that should have been borne by overseas related parties, the CTA may conduct special tax investigations.

In addition, such Chinese entities shall also prepare local files for the lossmaking year if they have incurred losses, whether or not they reach the documentation preparation threshold in Bulletin 42.

3.1.3. Toll manufacturing Bulletin 6 prescribes that the CTA may make adjustments by including the value of materials and equipment legally owned by the overseas principal when determining the profits for a toll manufacturer, if comparable entities cannot be found. Working capital adjustments are allowed to be made in practice. However, the profit margin changes due to working capital adjustments should not exceed 10%; otherwise a reselection of comparable entities is required.

This reaffirms a long-standing position in practice that the CTA may determine a toll manufacturer’s profits by selecting entities with a different business model (e.g. contract manufacturers) as comparable entities. As a consequence, if the similar approach is applied for contract manufacturers, the cost of raw materials and equipment may be included in the toll manufacturer’s total cost base for the determination of its remuneration in China.

8 In October 2016, China submitted an updated China Chapter of the United Nations Practical Manual on Transfer Pricing for Developing Countries. In the updated China Chapter, it states that if an MNE has multiple Chinese entities and each entity performs a single function, the CTA will consider these entities and their functions as a whole to determine the returns each entity should earn in China. This was not written in Bulletin 6, however it is not clear if the CTA will take this approach in similar cases. If so, it is expected that more profits will be allocated and retained in China.

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3.2. Provisions on intangibles 3.2.1. Entitlement to intangible-related returns Bulletin 6 does not refer to the definition of legal ownership and economic ownership of the intangible9; instead, it directly prescribes that when determining the allocation of returns to intangibles, the key factors that should be considered include the functions of development, enhancement, maintenance, protection and exploitation (“DEMPE”) as proposed under the BEPS Actions 810 Report; it also includes ‘promotion’ as an additional value-contributing factor.

The explicit inclusion of ‘promotion’ reinforces the historical emphasis by the CTA on the importance of Chinese ‘market promotion’ and Chinese ‘consumer product awareness building’ as value drivers for marketing intangibles, such as foreign brands. In cases where the profit split method is adopted, the CTA may claim that a portion of profits should be allocated to the ‘promotion’ activities in China since it contributes to the value creation of the intangible.

Bulletin 6 further prescribes that a pure legal owner of intangibles should not receive any intangible-related return, and a capital-rich entity, which merely provides funds without actually performing relevant functions or assuming relevant risks, is only entitled to a financing-related return. These provisions are consistent with the contents of the BEPS Actions 8-10 Report.

3.2.2. Special adjustments on royalty payments Bulletin 6 specifically prescribes that the CTA may make transfer pricing adjustments on the following three types of outbound royalty payments if the payments do not comply with the arm's length principle: (i) a royalty paid for an intangible that does not bring economic benefit to the payer of the royalty;

9 In the BEPS Actions 8-10 Report, economic ownership of intangible is decisive to be entitled to intangible-related returns. Generally, the company entitled to economic ownership of intangible performs important functions, assumes risks relating to development, enhancement, maintenance, protection and exploitation of the intangible.

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(ii) a royalty paid to a legal owner that does not contribute to the value creation of the intangible; and (iii) a royalty paid to offshore holding/financing companies with the main purpose of financing or listing for incidental benefits arising from such financing or listing activities.

3.2.3. Tax audit case on outbound royalty payments In the released Qingdao case10, two types of outbound royalty payments were under the scrutiny of transfer pricing adjustments. The first is related to technology where the Chinese entity kept paying royalty after the technology was being declared outdated. The other is related to a long-term license of a patented technology where the Chinese entity kept paying royalty based on a fixed rate for 20 years. From the opinion of local CTA, such royalty payment shall be reduced by year, since the underlying technology would become less advanced as time goes by. The local CTA then determined to make a transfer pricing adjustment and finally levied an additional corporate income tax (plus interest) of RMB 14.95 million.

With respect to the adjustment on the 2nd type of royalty payments, Bulletin 6 specifically prescribes that royalties paid or received should be timely adjusted. If, for example, functions performed, assets used, or risks assumed by the entity have changed during the use of intangibles while the entity does not make a timely adjustment, the CTA may conduct a special tax adjustment.

3.3. Intra-group service fee 3.3.1. General rules Bulletin 6 prescribes that an arm’s length intra-group service fee should be beneficial, i.e. bringing ‘direct and indirect economic benefits’ to the service recipient. It further provides that the following six types of services should be considered as ‘non-beneficial’ (i.e. and thus non-arm’s length):

10

See http://www.ctaxnews.net.cn/html/2016-06/28/nw.D340100zgswb_20160628_3-07.htm?div=

-1.

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● service activities that have already been purchased or already been per-

formed by the service recipient; ● service activities, such as control, management and supervision, to per-

form the investor’s direct and indirect investment interests; ● service activities that are not specifically provided to the recipient but

bring incidental benefits to recipient as a group member; ● service activities that have already been compensated via other related

party transactions; ● service activities that are not relevant to functions performed and risks

assumed, or operational needs of the recipient; and ● other service activities that provide no direct or indirect economic bene-

fits to the recipient or that a third-party would not pay for or perform in-house.

In the previous Bulletin 16, the SAT introduced six tests to verify whether or not the underlying service activities are allowed to be deducted. Specifically, the six tests consist of: need test (i.e. if it is relevant to the entity’ functions, risks or operations), remuneration test (i.e. if it is shareholder/stewardship activity), duplication test (i.e. if it has already been purchased or performed by the service recipient), value creation test (i.e. if the benefit is not incidental, but identifiable, reasonable value creation), authenticity test (i.e. if it has already been compensated in other related party transactions) and benefit test (i.e. if it provides direct or indirect economic benefits). Although Bulletin 16 was repealed after the introduction of Bulletin 6, the SAT inherited the six tests and incorporated them more specifically in the six types of ‘non-beneficial’ service activities mentioned above.

An obvious deviation of Bulletin 6 from the BEPS Actions 8-10 Report is that Bulletin 6 does not include a simplified approach for low value-adding intra-group services11. This reflects the constant stance of the CTA that all intragroup service activities run a high risk to shift profits out of China. It can be expected that outbound intra-group service fee payments will increasingly be scrutinized by the CTA.

11 In the BEPS Actions 8-10 Report, for the qualifying low value-adding intra-group services, a simplified approach where profit mark-up on costs of 5% is recommended.

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3.3.2. Tax audit case on outbound service fee payments In the released Anshan case12, a local Chinese entity was audited since it paid an abnormally substantial amount of outbound service fee payments, which sharply decreased its profits in China. Local CTA required the local Chinese entity to provide a breakdown of all the service items and adopted the six tests under Bulletin 16 to verify whether or not these outbound service fee payments are deductible.

In application for the six tests, the CTA reached the following main conclusions: ● since the Chinese entity does not perform any sales functions, it does

not need service activities such as product development service, market research service, product application supporting service; ● since the parent company had been compensated by previous royalties,

it should not charge a resource planning service fee separately; ● since the Chinese entity could normally conduct financial and human

resource services by themselves, these service activities are not considered to be provided by the parent company absent Chinese entity’s operational needs.

After several rounds of negotiation, the local Chinese entity finally agreed to pay the additional tax and interest.

Noticeably, under Bulletin 6, the “finance, tax, human resource and legal activities carried out for the purposes of the MNE group’s decision making, supervision, control and compliance” are normally considered non-beneficial. It seems that the beneficial nature of such activities is denied since they are considered as shareholder activities under Bulletin 6. However, in practice, many such activities will overlap with a Chinese entity’s actual business needs. In this respect, (at least) part of them should be considered beneficial since the Chinese entity would be willing to pay for receiving such services in independent/unrelated situations. Consequently, if the MNE group is able to present an accurate and complete transfer pricing documentation, in which a split is made

12

See http://www.ctaxnews.net.cn/html/2015-12/22/nw.D340100zgswb_20151222_1-05.htm?div=

-1.

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between the beneficial and non-beneficial parts of the services, it should be able to defend and uphold that part of the service fee where payments are at arm’s length and can be deducted.

3.4. Comparability analysis and transfer pricing methods 3.4.1. Contractual arrangement Bulletin 6 prescribes that when conducting a comparability analysis with respect to contractual arrangements, the entity’s ability to execute the contracts, its actual conduct in executing the contracts, and the ‘reliability’ of the related parties entering into the contractual arrangements should be considered.

Although Bulletin 6 does not formally introduce the risk allocation principles as proposed under the BEPS Actions 8-10 Report, the CTA may use the 13

above-mentioned factors to challenge the contractual allocation of risks between related parties and make adjustments accordingly.

3.4.2. LSAs Bulletin 6 prescribes that when selected comparable entities are in a different economic environment from the tested Chinese entities, the CTA shall analyse LSAs such as ‘location savings’ and ‘market premium’ and select appropriate transfer pricing methods to determine how much profits should be allocated to the LSAs. In 2012, the SAT firstly expressed its views on ‘location savings’ and ‘market premium’ in the chapter “China Country Practices” in the UN Transfer Pricing Manual14. According to the China Chapter, location savings refer to the net cost savings derived by an MNE when it sets up its operations in a low cost

In the BEPS Actions 8-10 Report, it determines that risks contractually assumed by a party that cannot ‘control’ this risk or does not have financial capacity to assume the risks, will be allocated to the party that does exercise such control and does have the financial capacity to assume the risks.

14 Available at http://www.un.org/esa/ffd/tax/documents/bgrd_tp.htm.

13

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jurisdiction, while market premium relates to the additional profit derived by a multinational company by operating in a jurisdiction with unique qualities impacting on the sale and demand of a service or product (e.g. automotive industry, luxury goods sector). It further provides a four-step approach to consider the issue of LPAs: (i) identify if an LSA exists; (ii) determine whether the LSA generates additional profit; (iii) quantify and measure the additional profits arising from the LSA; (iv) determine the transfer pricing method to allocate the profits arising from the LSA. On September 17, 2015, the SAT released a discussion draft of the revised Special Tax Adjustment Implementation Rules 15, which for the first time included the concept of LSAs in Chinese transfer pricing rules. The Draft requires Chinese taxpayers to consider local economic factors in determining transfer pricing methods and comparability when selecting comparable companies, as well as to take LSAs into account when determining the presence of intangibles and their value. On one hand, China has taken the view of the OECD that LSAs are comparability factors rather than intangible assets. On the other hand, China still insists that there should be more profits attributed to China by taking the LSAs into consideration as ‘profit allocation key’ or ‘profit driver’. Now the concept of LSAs has been written in the comparability analysis under Bulletin 6, and also in the Bulletin 42 and Bulletin 64.

In practice, it is expected that MNEs may face an increasing number of cases where the CTA makes transfer pricing adjustments based on LSAs. However, Bulletin 6 does not further provide guidance on how to allocate profits to the impact of LSAs. MNEs may find it difficult to determine whether LSAs exist, and how to quantify the profits if it exists in each specific case. In this respect, MNEs can choose to formalize their pricing with the CTA through APAs in advance.

15

Chinese version available at http://hd.chinatax.gov.cn/hudong/noticedetail.do?noticeid=577376.

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3.4.3. (In)appropriate use of the transactional net margin method (“TNMM”) Bulletin 6 prescribes that the TNMM should not be used to determine the at arm’s length profit of an entity with ‘significant intangibles’. The concept of ‘significant intangibles’ is derived from ‘unique and valuable intangibles’ as proposed under the BEPS Actions 8-10 Report, although different wording is used.

In practice, the TNMM has been prominently used for a long time as the ‘default’ TP method in China for the remuneration of ‘routine’ and low risk manufacturing and sales activities. However, currently the CTA tends to put more emphasis on the value contribution analysis (i.e. DEMPE function analysis, plus ‘promotion’) of the intangibles and the LSA analysis. It can therefore be expected that use of the TNMM will be further limited in the future, whereas the profit split method may be considered as the preferred transfer pricing method by the CTA in many cases.

3.4.4. Asset valuation method and other methods When selecting the appropriate TP methods, Bulletin 6 also includes the ‘asset valuation method’ and a ‘catch-all method’, which is described as: other methods that can align profits with economic activities and value creation.

The asset valuation method comprises: (i) the cost method (i.e. preparation/creation cost of the asset), (ii) the market method (i.e. benchmarking market price of similar assets) and (iii) the income method (i.e. a discounted cash flow method), which are typical valuation techniques used by independent valuators. The asset valuation method is an alternative approach when there is a lack of reliable comparable. In practice, it has been widely used to determine the at arm's length price of related party equity/asset transfers, transfer of going concern, etc. We expect it would continue to be frequently used in these scenarios after the formal inclusion.

One noticeable point is that Bulletin 6 does not include the controversial value contribution allocation method (similar to global formulary apportionment), which was included in the previous Discussion Draft. It is not fully clear

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if the omission of the value contribution allocation method in Bulletin 6 should be seen as the SAT confirmation of OECD’s viewpoint that the global formulary apportionment method is not considered at arm’s length. In fact, in the updated China Chapter on the United Nations Practical Manual on Transfer Pricing for Developing Countries, when the CTA found that the risk-based TNMM method cannot allocate sufficient remuneration to the Chinese entity (e.g. a contract or toll manufacturer), it proposes, among other options, to apply a global formulary approach based on the value chain analysis as an alternative 16. It is not clear if the CTA will refer to this source to apply to the value contribution allocation method in practice. Also, the broadly worded ‘other methods’ seems to leave room for the CTA to adopt the value contribution allocation method in practice as well.

3.5. MAPs Bulletin 6 prescribes that MAPs can be applied to bilateral/multilateral APAs and special tax adjustments in one jurisdiction, which would result in corresponding adjustment in another jurisdiction. If the Chinese entity would like to initiate a MAP, it should directly apply to the SAT, instead of local CTA. According to Bulletin 6, the SAT may initiate a MAP upon the request of an entity or the competent authority of the other contracting state. Prior to Bulletin 6, China did not have domestic rules governing the launching of a MAP upon request by a treaty partner country's competent authority in relation to a transfer pricing adjustment. This expansion under Bulletin 6 shows the SAT's increasing support for the MAP program, which is in line with the OECD’s BEPS Actions as well.

4. Bulletin 64: APAs Faced with ever increasing transfer pricing audits risk, seeking to sign APAs for advance certainty is one of the efficient methods for MNEs to manage

16 See http://www.un.org/esa/ffd/wpcontent/uploads/2016/10/12STM_CRP2_Att12_ChinaCountryPractice.pdf.

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the potential risk. In October 2016, the SAT released Bulletin 64 to streamline the APA procedures with the purpose of facilitating a more widespread use of APAs among MNEs and tax authorities.

4.1. Applications Under Bulletin 64, APA is applicable for entities with an annual related party transaction amount exceeding RMB 40 million for three continuous years prior to the year in which the “Notice on Tax Matters” was issued by the incharge CTA notifying the acceptance of the entity’s intent for an APA. Meeting this application threshold does not seem difficult, but in practice, due to a lack of manpower at the level of tax authorities, lots of applications were stuck at different stages of APA procedure. In this respect, Bulletin 64 has further provided a prioritized list17 and blacklist to bifurcate whether or not to accept the application.

Noticeably, if an entity has submitted complete documents, which contain complete and accurate analysis on value/supply chain and LSAs use reasonable transfer pricing and calculation methods, the in-charge CTA can prioritize its APA application. This is consistent with SAT’s emphasis on the value chain analysis and LSAs in Bulletin 42 and Bulletin 6.

17

Tax authorities may prioritize an entity’s APA application if:

● the entity has duly declared its related party transactions and prepared contemporaneous

documentation; ● the entity has an A-level tax payment credit rating; ● the tax authority has already imposed a special tax adjustment on the entity and the case has been closed; ● the entity has not undergone any substantial change when an application is filed to renew an APA; ● the entity has submitted complete documents, which contain complete and accurate analysis on value/supply chain and LSAs and use reasonable transfer pricing principles and calculation methods; ● the entity proactively cooperates with the tax authority; ● the bilateral APA/multilateral APA partner country is willing to conclude the APA; or ● other factors exist that may facilitate the conclusion of the APA. 152

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4.2. Procedures Bulletin 64 also set out six stages of an APA procedure: (i) pre-filing meeting; (ii) letter of intent; (iii) analysis and evaluation; (iv) formal application; (v) negotiation and signing; and (vi) implementation and monitoring.

Compared with the procedure under Circular 2, a significant change under Bulletin 64 is to move the stage of analysis and evaluation ahead of formal application. This allows the in-charge CTA to carry out evaluation at an earlier phase before formally accepting the application.

If one takes a close look at the required information at each stage, the entity is required to provide a brief explanation of whether or not there exists any LSAs at the pre-filing meeting stage. At the letter of intent stage, the entity should provide analysis of value/supply chain and of LSAs. Then, at the analysis and evaluation stage, the in-charge CTA will assess the accuracy and reasonableness of the analysis of value/supply chain and of LSAs. This seems to indicate, in the author’s opinion, that provision of analysis of value/supply chain and of LSAs is no longer one of the conditions to be prioritized for the APA application, but ‘should-have’ in the preparation.

4.3. Recent updates On 8 October 2017, the SAT released the China Advance Pricing Arrangement Annual Report (2016)18. In 2016, 8 unilateral advance pricing agreements (“UAPAs”) and 6 bilateral advance pricing agreements (“BAPAs”) were signed, which has seen a slight increase compared with those in 2015. Up until 31 December 2016, 84 UAPAs and 55 BAPAs have been signed by the SAT. Among all the signed APAs, the 2016 Annual Report further provides the following statistics: ● transfer of the right of usage or ownership of tangible assets accounts

for 65.6% of all the related party transactions;

18

Available at http://www.chinatax.gov.cn/n810214/n810606/c2873201/content.html.

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● the TNMM has been predominantly adopted in China’s APAs, which

accounts for 77.4% of the total; ● the most common industry covered is manufacturing, which accounts

for 83.5% of the total.

These statistics come with no surprise, if one takes into account China’s role as ‘world factory’ during the last decades. However, in the 2016 Annual Report, the SAT reiterates the merit of having high quality quantitative analysis of intangibles, LSAs in its prioritized list. It is expected that there will be more and more transactions in relation to the transfer of ownership or the right to use intangible assets going to the APA procedure, and transfer pricing methods such as profit split method will be more widely used.

5. Conclusion International tax regime, including transfer pricing, has been fundamentally changed due to the BEPS Project. This time, China has not been left behind.

On the contrary, the SAT moved quite rapidly to reform its transfer pricing rules to be more in alignment with the new international standards developed under the BEPS Project. What is more, the SAT has been actively advocating its own transfer pricing rules with typical ‘Chinese characteristics’: LSAs, importance of promotion in the value creation of intangibles, value chain analysis, value contribution allocation method, etc.

For MNEs conducting business in China, China’s reforming of transfer pricing rules brings along certainty to a large extent: since China’s new transfer pricing rules are now similar to those proposed by the BEPS Project, MNEs can reasonably predict whether or not their adopted transfer pricing policies will comply with the rules in China. It also reduces the possibilities of arbitrary decisions by local CTAs in the absence of any transfer pricing guidance. However, MNEs should be fully aware of those specific transfer pricing rules in China and conduct a thorough analysis. If MNEs can prove that their transfer pricing positions in this respect are based on a sound application of the arm’s length principle, they should be able to hold firm to them.

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