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EU Tax Dispute Resolution:

The EU Tax Arbitration Convention - its strengths and its weaknesses
© 2001 Dr Jean-Philippe Chetcuti. All Rights Reserved.


1. Its strengths

1.1. Improvements on the OECD Model mutual agreement procedure

Taxpayers are now certain that a procedure will be started and that the double taxation will be eliminated.  Smaller businesses, which do not have the staff to deal with the frequently demanding and time-consuming area of double taxation cases, will now be more ready to risk stepping over the border and taking advantage of the Internal Market.  The long term hopes are that the MSs’ experience with the Convention, which goes only as far as to lay down a procedural framework, will lead to the development of substantive rules of Community law on transfer pricing between associated enterprises.[1]

1.2. The legal position of taxpayers

The fact that the only parties to the arbitration procedure are the Contracting States[2], these being the signatories of the Convention[3], does not mean that the taxpayers concerned do not entertain an interest in its outcome.  It is true that the competent authorities of the Contracting States are bound by the final decision, but ultimately, the relief or burden embodied in this decision is borne in its entirety by the taxpayer.  For this reason, the taxpayer has a legitimate interest and its legal position must be recognised.[4]  Of course, the taxpayer’s role in the mutual agreement procedure is justifiably limited but a taxpayer still merits the opportunity to actively participate in the procedure.[5]

1.2.1. Taxpayer’s right of initiative[6]
1.2.2. Competent authority not to abuse of its rights to refuse initiative

The competent authority may refuse to initiate the international procedure in cases which do not fall within the scope of the Convention (such as double taxation arising out of different interpretations of Convention terms), where the taxpayer’s claims are not well-founded and in serious penalty cases[7].  However, the Contracting States are bound by an obligation to perform the Convention in good faith and therefore should not abuse of these grounds for non-initiation to deprive the taxpayer of his rights under the Convention.

1.2.3. Right of recourse to remedies provided by domestic law

It would be unfair and unreasonable to deprive a taxpayer and his competent authority of his rights to seek the remedies available to him in the domestic courts.  In fact, according to the Convention, enterprises “may have recourse to the remedies available to them under the domestic law of the Contracting States concerned”.[8]  However, should a taxpayer avail himself of such a right, the two year time limit within which he is to call for formation of an arbitral commission starts running from the date of the judgement of the final court of appeal.

The Constitutions of some Contracting States prevent the competent authority from resolving cases by mutual agreement where such a solution derogates from the decisions of their judicial bodies.  In such cases, the Convention[9] precludes the initiation of the arbitral proceedings before the time provided for appeal has been allowed to expire or any appeal has been withdrawn by the enterprise before a decision has been delivered.[10] [11]

1.2.4. Right to a reasonable time framework

The length of the Convention proceedings is restricted.  It is no longer possible for a disagreement to hang in the balance for many years, with all the extra costs that it entails.

The time framework for the arbitral procedure should last long enough so as to permit an adequate presentation of the case, but should be expedient enough to afford the taxpayer a decision within a reasonable time.  These criteria are present in the Convention: the taxpayer has three years within which to submit his case; the competent authorities then have two years to negotiate an agreement; the commission has six months within which to deliver its opinion and then the competent authorities have another six months to contemplate whether to accept the arbitral decision or to agree on an alternative.[12]

1.2.5. Right to require discontinuation of the procedure

The Convention does not expressly provide the taxpayer with such a right.  However, despite the fact that the taxpayer is strictly speaking not a party to the proceedings, not only should he have the right of initiative but he should also have a corresponding right to terminate the proceedings. After all, the aim of the convention is to provide relief to the taxpayer, so if this aim is reached, why continue with proceedings to that effect?

1.2.6. Right to independent and impartial jurisdiction

This right depends very much on the composition of the tax arbitration commission and the nomination of its members under the Convention.  The independence and impartiality of the commission is fundamentally important for the taxpayer who is effectively and finally bound by its decision.  It is also argued that under the Convention, taxpayers are protected by the Convention on Human Rights (1950) and the Covenant on Civil and Political Rights (1981).

The qualifications required from the independent persons appointed by mutual agreement between the two competent authorities are that they must be persons of standing, competent and independent.  Moreover, their Chairman must possess the qualifications required for appointment to the highest judicial offices in his country or be a jurisconsult of recognised competence.[13]

In addition, there is a right of eviction of an independent member if such member works for the tax authorities of an involved Contracting State or if he works or has worked for the affected enterprise, or if he does not offer sufficient guarantee of objectivity.[14]

1.2.7. Right to appear or to be represented

The Convention expressly provides for the international principle of fair hearing.[15]  Thus the parties involved must be given the opportunity to be present or represented.  The taxpayer concerned also has the right to provide information, evidence or documentation.[16]  Implied in Article 10 is the principle of equality of arms which applies to the affected enterprise too as a semi-party with a separate interest of its own.  It should be given the opportunity to hear, improve and refute the presentations, arguments and evidence of the competent authorities.  Also implied is the right of access to information and evidence of the commission.

1.2.8. Right to refuse to provide certain information

The same right given to the competent authorities is given to the taxpayer to refuse to provide information not obtainable under domestic law or administrative practice or if it means the disclosure of any trade, business, industrial or professional secret or trade process, or information the disclosure of which would be contrary to public policy.[17]

1.2.9. Secrecy and confidentiality

“The members of the advisory commission shall keep secret all matters which they learn as a result of the proceedings.”[18]  This is one of the strongest features of any arbitral procedure in that it respects the confidentiality of the parties involved.   The Convention contemplates punitive action for breach of this obligation.

1.2.10. Right to require justification from commission

An implied obligation of the commission is to issue a reasoned opinion and therefore to supplement the opinion with a justification.  This ensures the accountability and transparency of the commission’s workings.

1.2.11. Taxpayer’s consent to publication

Even if publication of arbitral awards contributes to the consistency of future awards, it could impinge on the taxpayer’s right to confidentiality and business secrets.  Therefore, besides the agreement of the competent authorities, the consent of the taxpayer is required before publication can proceed.[19]

1.2.12. Fair allocation of costs of procedure

The costs of the arbitral procedure are to be shared equally by the Contracting States while the costs incurred by the affected enterprises have to be borne by the enterprises themselves.  Some authors have found this unjustified since the advisory commission has the right to request the parties to appear or be represented before it and to provide information, evidence or documents to it.[20]

1.2.13. The payment of interest

The Convention remains completely silent on the issue of interest and does not provide for the accrual of interest on late tax payments or on tax refunds.  The Convention does not purport to tackle the disparities between the domestic rules on interest.

2. Its weaknesses

2.1. Escape routes for Contracting States

The competent authorities of Contracting States, aware of transfer pricing abuses by MNGs of companies and unwilling to give up their sovereign jurisdictional authority, may resort to abusive ‘escape routes’ to exclude a particular case from the scope of the Convention.

2.1.1. Differences in interpretation

The Convention does apply to cases of double taxation caused by a conflicting interpretation of its terms, even if those terms condition the access to the Convention.  On this basis, a competent authority may refuse to initiate the Convention procedures using differences in interpretation as an easy excuse to keep a genuine transfer pricing case under its jurisdiction.  The serious penalty clause too can be applied to such abusive purposes, frustrating the object and effectiveness of the Convention and violating the international legal principles of performance in good faith of treaty obligations enshrines in Article 26 of the Vienna Convention on the Law of Treaties.

Admittedly, the drafters of the Convention, who could have been more articulate in the formulation and definition of terms, carry part of the blame.  “One of the very first points preliminary to making international conventions or agreements on double taxation is to define the terms so that there will be no possibility of misinterpretation.”[21]  Another possible solution would be the setting up of an EC Consultation Board, composed in such a way as to draw on the expertise of all MSs’ arbitration commissions and which will decide disputes regarding the meaning of the Convention’s terms.[22]

2.1.2. Complaint “well-founded”

The Convention gives the Contracting State the opportunity, before resorting to the mutual agreement procedure, to first determine whether the complaint appears to be justified (“well-founded”[23]) or abusive.  This resembles the phraseology used by the OECD Model in Article 25(2).[24]  However, Hinnekens disagrees that it is “within the scope of their due discretion whether mutual agreement procedures should be initiated”.[25]  Whilst acknowledging that Contracting States could abuse of this interpretation to escape its implications, he believes that a Contracting State may refuse to set in motion the international procedure only on grounds relating to the Convention.  This restrictive interpretation is in line with the autonomous international right granted to the taxpaying enterprise to present its case to its competent authority in view of an international resolution.  This right should be subjected only to the review of the necessary nature of the procedure and of the good faith of the request.

2.2. Weaknesses resulting from the legal nature of the Convention

The political decision of the MSs to adopt the convention form rather than the directive was based on the collective hesitance by the MSs to surrender a significant part of their fiscal sovereignty.  However, it is legitimate to compare the Convention with the two directives packaged with it in 1990, the Merger and Parent-Subsidiary Directives.

Whereas the Directives imposed on MSs the obligation of implementation in their domestic law, as a consequence of the transformation from directive to convention, the effective date of the Convention was delayed until the last signatory State (Portugal) submitted the instrument of ratification to the Secretary-General of the Council.[26]  Unlike the Directives which are not applicable indefinitely, the Convention was initially concluded for a period of five years, which were barely sufficient for the implications of its application to become evident.[27]  Its extension is surrounded with doubts and uncertainties as discussed in Chapter 3.

As far as three 1995 entrants, Austria, Finland and Sweden were concerned, the Convention required them to formally sign and ratify the Convention first before it could enter into force in their territories.  Unlike the two Direct Tax Directives, the Convention does not automatically apply to new MSs which have not been signatories to the Convention itself.[28]  On the other hand, like all international treaties, the Convention overrules national laws, whether passed before or after the ratification of the Convention itself.[29]

Another significant disadvantage owed to the legal form of the arbitral measure is that, unlike the case of Directives, the EC Commission is not entitled and obliged to supervise the correct and timely implementation and compliance of the Convention’s mandates.  Nor is it possible to submit to the adjudicative jurisdiction of the ECJ unless all MSs submit to it, which is presently not the case.[30]

2.3. Limitations on the subject of the Convention

Unlike the mutual agreement procedure contemplated in the OECD Model, the Convention procedures are limited to cases of double taxation which may arise following the adjustment of profits of associated enterprises.  Several affected groups, like the ICC, feel that this is unduly restrictive, as several other issues can and do arise.[31]  Thus issues like the classification of an entity, the characterisation of certain payments as dividends or interest, and other questions concerning the interpretation of the various countries’ DTCs fall outside the scope of the Convention.

It is hoped, by such groups, that the experiences of the Convention might convince them of the potential of these procedures in the resolution of a wider range of international tax disputes.

2.4. The arm’s length principle and unspecified methodology

The assessment and reallocation of income to an enterprise of a given Contracting State as well as the allocation of income between an enterprise of a Contracting State and its PE is to be based on the domestic laws of the Contracting States and, were a DTC modelled on the OECD Model has been entered into, on Articles 9 and 7(2) respectively of the OECD Model. 

Article 1 of the Convention refers to the principles set out in Article 4.  Article 4(1) is identical with Article 9(1) of the OECD Model and Article 4(2) is substantially identical with Article 7(2) of the OECD Model.[32]  However, the mutual agreement procedure, the advisory opinion and the final decision of the competent authorities will only be based on the substantive tax principles set out in Article 4 of the Convention and not on the Contracting States’ domestic law, whether such domestic provisions are identical with Article 4 or narrower or broader than such article.[33]  Killius argues that if Article 4(1) of the Convention is recognised as the sole substantive test for the Convention procedures[34], then the 1979 OECD Report on Transfer Pricing[35] should provide the competent authorities with the necessary guidance in applying it.

The profit allocation principle laid down in the Convention is the principle of arm’s length dealing and separate accounting.  The other possible method, not chosen by the Convention is that adopted by the United States for the purpose of State taxation, namely that of unitary taxation (formulary apportionment).  The plural form used in Article 1 (“principles”) merely refers to the applications of the arm’s length principle to the two types of ‘association’ to which the Convention applies. 

Arm’s length pricing is in line with the tax concepts of sovereignty, territoriality and the separate entity approach as well as the fairness and equity expected of the allocation of the multinational tax base, both to taxpayers and to the tax authorities.[36]

In essence, arm’s length pricing means that:

Profits of associated enterprises, and of branches and their head offices, should be determined as if they were dealing wholly independently from each other.[37]

The drafters chose a definition of the principle identical with, but without reference to, that found in the bilateral treaties.  This is largely due to the lack of such treaties between some MSs, and more potentially so, between the prospective MSs, as well as the often inconsistent wording of Articles 7(2) and 9.[38]

The Convention does not specify the arm’s length method to be applied.  This creates a choice among the transaction-oriented methods[39] and profit-oriented approaches[40].  It is argued that this lack of specificity was intentional on the part of the drafters as they “did not fancy venturing into this mine-field”.  For them, “any method is valid as long as it is based on the fiction of independence of the associated enterprises involved, rather than on blind formula apportionment of the total group profit among the individual companies in the group.”[41]

2.5. Lack of jurisdiction by the ECJ

It is understandable, in the light of the ECJ’s inexperience in the field of arbitration, that the Contracting State were unwilling to entrust the ECJ with the substantive review of the arbitral decision under the Convention.  However, the MSs deserve criticism for refusing to submit to the ECJ issues related to the correct practical application and implementation of the Convention’s rules.  The practical application and the correct interpretation of the Convention’s provisions is now left to the arbitrary discretion of each MS.  When the Convention becomes part of the domestic law of the MS, the judicial authorities of that MS assume unrestricted authority to regulate their country’s efforts to comply with the Convention.  The problem with this is that judicial decisions will differ from one MS to the other and the desirable uniformity of interpretation will not be achieved.[42]

2.5.1. Lack of post-award controls

It is unclear whether the post-award controls against violation of due process and excess of arbitrator’s authority are afforded to the taxpayer under the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, the Convention for the Protection of Human Rights and the International Covenant on Civil and Political Rights.  If not, the Convention should be revised to ensure the possibility of re-opening cases on the basis of serious procedural defects and of new facts following the decision.[43]

3. Suggestions for review

Various authorities on the subject have expressed themselves on the need for review of the Convention.  Dirk Schelpe formulates eleven recommendations for revising the Convention:[44]  As regards the improvement of the efficiency and uniformity of its procedures and principles, he suggests the following measures:

1.       the designation in the Convention of an authority (the ECJ) responsible for reviewing the commissions’ decisions if the Contracting States consider them unreasonable and to supervise and control the interpretation and application of the Convention by the MSs;

2.       the examination of the prospect of providing the possibility to re-open a case on the basis of new facts occurring after the delivery of the commission’s decision;

3.       the setting up of a group of delegates of commissioners from the Contracting States to enable the sharing of experience and the possible solution of substantive issues in possible disputes.

Schelpe recommends the extension of the scope of application of the Convention in the following way:

4.       to cover PEs of third country enterprises based in the EC;

5.       to include other conflicts concerning double taxation, particularly regarding the recharacterisation of payments and the interpretation of bilateral tax treaties;

6.       to include more expressly conflicts involving local income taxes;

7.       to cater more specifically to multiparty proceedings involving more than two enterprises and more than two Contracting States in a single procedure.

Finally, the following proposals concern the contractual effectiveness of the Convention:

8.       The Convention, amendments and extensions thereto should become effective as soon as a limited number of Contracting States has ratified it; and

9.       The prohibition of unilateral withdrawal from the proceedings once these have commenced.[45]

To expedite the workings of the arbitral commission which has a mere six months to do the job, it might be considered useful to establish an optional  set of standard rules of procedure which could be adopted flexibly by the commission on a case by case basis.  The competent authorities could agree on this at the outset of an arbitration procedure and should be allowed to apply other rules or to adapt them to the particular cases.  This proposal has a potential as a time saving measure for future consideration.  Possible areas for additional rules of procedure could include:[46]

·                     “The cost of the arbitration procedure; the costs to be covered, the remuneration of the independent members of the advisory commission.

·                     The determination of the competent authority which takes the initiative to set up the advisory commission.

·                     The form the opinion of the advisory commission is going to take.

·                     A common policy with respect to publication of the decision of the competent authorities.

·                     The language regime”[47]

4. Conclusion

It is clear that the Convention presents many advantages compared with the other existing procedures.   Admittedly, its principal significance lies not in the substantive principles which it incorporates.  After all, the arm’s length principle on which the Convention is based is identical with that provided in the OECD-based DTCs existing between MSs.  Rather, its innovation lies in the mandatory arbitral system which it introduces to the world of international tax disputes.  The Convention procedures are effective in that they guarantee the elimination of double taxation arising out of cross-border transfer pricing.  Moreover, its multilateral legal form is more suited than bilateral treaties in the area of transfer pricing which often involves more than two affected enterprises.  The major and fundamental setback of the EC Tax Arbitration Convention is the fact that it is currently inoperative, awaiting ratification by the last MS.

It is, however, clear that the elimination of double taxation issues caused by transfer pricing disputes currently is in deadlock.  The Convention is therefore not yet passé but certainly in an impasse.”[48]

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