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Swiss Considerations on Digitalizing Final Offer Arbitration

Posted on Mar. 1, 2021

Peter R. Altenburger is a founding member and counsel at Altenburger Ltd. legal & tax in Kuesnacht-Goldbach, Geneva, and Lugano, Switzerland. Jonas Fischer is a mediator with the Swiss Chamber of Economic Commercial Mediation, the cofounder of EXPADR, and an affiliate with the Berkman Klein Center for Internet and Society at Harvard Law School.

In this article, the authors examine recent changes affecting Switzerland’s dispute resolution process and consider whether final offer arbitration can be digitalized.

The OECD’s base erosion and profit-shifting project has dramatically affected multinational enterprises’ tax world. While BEPS action 1 on taxation of the digital economy is still underway, BEPS action 13 on mandatory country-by-country reporting has been in full force since 2018. CbC reporting is a system in which all relevant information is automatically exchanged between participating countries.

Switzerland has had automatic exchange of information agreements with more than 50 countries since January 1, 2020.1 The United States, which has developed its own CbC reporting scheme, is not included on Switzerland’s list.2 Similarly, Switzerland is not on the list of the more than 50 countries with which the United States engages in CbC reporting.3

For CbC reporting, the OECD imposes a three-tiered approach to transfer pricing documentation. It consists of:

  • a master file, which contains relevant information applying to all MNE group members;

  • a local file referring specifically to material transactions of the local taxpayer; and

  • a CbC report containing information relating to the global allocation of the MNE’s income and taxes paid.

Under BEPS action 13, all MNEs with a consolidated turnover exceeding €750 million are required to prepare a CbC business data report. Table 1, which includes 10 columns, provides data in the form of an allocation of income, taxes, and employees by tax jurisdiction. Table 2 lists all constituent entities by tax jurisdiction regarding their main business activities selected from a pre-defined list of 13 options. Table 3 is optional and provides further information that would facilitate the understanding of the CbC report.4

Countries like Switzerland automatically share these CbC reports with a significant number of tax administrations for use in high-level transfer pricing and BEPS risk assessments. Exchanging the CbC reports will inevitably increase transparency of cross-border tax matters as well as the number of cross-border tax disputes.

BEPS action 13 must be read in conjunction with BEPS action 14, which deals with the improved effectiveness of the mutual agreement procedure. BEPS action 14 is a mandatory minimum standard, subject to stage 1 and stage 2 peer reviews. Mandatory arbitration is not, however, subject to any peer review. Even the most effective MAP cannot prevent important international tax issues from remaining unsettled because, for example, one of the competent authorities involved may not want to continue and leaves the negotiations with the tax issues unresolved.

There are three main sources of law regulating mandatory binding arbitration in cross-border tax disputes:

  • the multilateral instrument, which implements BEPS action 15; 5

  • the OECD model convention (condensed version, November 2017); and

  • bilateral memoranda of understanding entered into by the competent authorities, such as the memorandum of understanding signed between Australia and Switzerland on September 15, 2020.

These different sources of law have one thing in common: They all favor final offer arbitration, also referred to as “baseball” arbitration or “pendulum” arbitration, for cross-border tax disputes on quantifiable amounts. Final offer arbitration was developed in the late 1940s in the United States, where it was initially used to settle labor disputes. In later years, baseball arbitration appeared to be particularly useful as it allowed for the settlement of remuneration disputes arising between baseball players and their respective clubs, making this form of dispute resolution preferable over others.6 Final offer arbitration is also used by the WTO as a method for settling disputes in accordance with article 22.6 of the WTO’s dispute settlement understanding.

The bulk of all disputes on quantifiable amounts will inevitably involve transfer pricing issues. Examples may include which transfer price method applies, and what is the correct price under the arm’s-length principle.

Transfer Pricing Methods

Transfer pricing disputes are often not merely a choice between two amounts proposed by the two competent authorities involved, but also a dispute on the correct method selection. There are two principal approaches used to assess whether cross-border related-party transactions produce arm’s-length results.

Transaction-based methods require the identification of prices or margins from individual transactions and the comparison of these results to the prices or margins between independent third parties. Profit-based methods seek to benchmark the profits earned by controlled entities and unrelated parties performing similar functions and incurring similar risks. Transaction-based methods include the comparable uncontrolled price method, the resale price method, and the cost-plus method. Profit-based methods include the profit-split method and the transactional net margin method.7

There are five principal OECD methods for transfer pricing, and taxpayers must apply the most appropriate method for their case. The 2017 OECD transfer pricing guidelines indicate that transaction-based methods have priority over profit-based methods.8 The transfer pricing methods proposed by the OECD largely mirror the methods used in the United States for U.S. residents buying or selling tangible property, services, or intangibles from or to related foreign parties. Under U.S. law, there is a best-method rule9: The arm’s-length result of a controlled transaction must be determined under the method that provides the most reliable measure of the arm’s-length price. The challenge of choosing the appropriate method has been manifest in some early transfer pricing cases decided by U.S. courts.

An excellent example is Bausch & Lomb, a 1989 case decided by the U.S. Tax Court.10 The court ruled in favor of Bausch & Lomb Inc. (the U.S. parent corporation), finding that the IRS acted “unreasonably” in its allocation of income to the Irish subsidiary, Bausch & Lomb Ireland. Bausch & Lomb Inc. had purchased soft contact lenses from Bausch & Lomb Ireland for $7.50 per lens. The parent company applied the CUP method, while the IRS applied the cost-plus method, allowing the Irish subsidiary to invoice its production cost of $1.50 plus a 5 percent royalty. The Tax Court decided that Bausch & Lomb Inc. was not obligated to buy the lenses manufactured by its Irish subsidiary, thus rejecting the IRS’s argument that Bausch & Lomb Ireland was a mere contract manufacturer. The court applied the CUP method, allowing Bausch & Lomb Inc. to purchase the lenses that were manufactured in Ireland for $7.50. It rejected the 5 percent royalty rate and replaced it with a royalty rate amounting to 20 percent of Bausch & Lomb Ireland’s sales price.

The Tax Court’s 40-page decision could only be rendered after extensive expert opinions were taken into consideration. The economic analysis was far more complex than simply choosing between $7.50 and $1.50. The principal issue was the proper transfer pricing method to be applied: Was it the CUP method (as proposed by Bausch & Lomb Inc.) or the cost-plus method (as proposed by the IRS)? Determining the correct amount of royalties could not have been resolved by using final offer arbitration.

Mandatory Arbitration

If competent authorities are unable to settle a cross-border tax dispute within a period of two (or sometimes three) years, a taxpayer can refer the issue to arbitration. In broad terms, article 23 MLI distinguishes between the disposition of quantifiable amounts and “threshold questions” (such as where an individual is resident or whether there is a permanent establishment). Disputed issues involving quantifiable amounts are settled by applying final offer arbitration, while threshold questions are subject to an alternative procedure aimed at resolving the disputed issue.

Mandatory binding arbitration is triggered when the taxpayer makes a request in writing to one of the competent authorities involved. Arbitration procedures will usually start with the competent authorities jointly determining the questions to be resolved. This will constitute the case’s terms of reference.

In regular arbitration, if, for example, one party asks for 1 and the other party asks for 9, the court might add 1 and 9 and divide by 2 to reach a result of 5. Final offer arbitration is radically different in that the court must make a choice between either 1 or 9. Final offer arbitration can lead to a win-win situation as it spurs negotiated settlements at a very high rate.

The final offer arbitration procedure is straightforward because the tribunal must decide its award strictly based on either party’s proposal. The mere possibility of succumbing to the opposing party injects enough risk and uncertainty to force both parties to prepare reasonable offers. In other words, the procedure of final offer arbitration fosters rational, considerate, and comprehensible behavior during a dispute, and punishes a party for an exaggerated attempt to steer an arbitration tribunal in its favor.

The arbitration panel will usually consist of three arbitrators with experience or expertise in international taxation matters. They need not have experience as a judge or arbitrator. Each arbitrator must be impartial and independent from the competent authority, tax administration, and finance ministers of the contracting states and of all persons directly affected by the case. Each competent authority will appoint one arbitrator. The two arbitrators appointed will then elect a third arbitrator, who acts as chair of the arbitration panel.

The application of the MLI is limited to so-called covered agreements, and for most treaty countries, it will not be applicable. These countries may, however, refer to bilateral treaty clauses similar to article 25, paragraph 5 of the OECD model convention. The OECD model convention applies the same principles set forth in the MLI commentaries 63 to 85, as well as in the annex and commentaries. These are part of the commentaries on article 25, paragraph 5 of the OECD model convention.

Special attention should be given to note 23, which states that “given the nature of the ‘last best offer’ process, a face-to-face meeting of the arbitrators will typically not be necessary, and the arbitrators will be able to liaise between themselves and with both competent authorities by telephone or video conference.”

This situation is addressed in paragraph 4 of the sample competent authorities agreement included in the annex to article 25 of the OECD model convention, which adds that “if a face-to-face meeting involving additional costs is necessary, the Chair will first contact the competent authorities who will then decide when and where such meeting be held.”

It appears that regarding cross-border tax disputes, the OECD is gradually moving from a specialty procedure to a more widely applied, standardized procedure. Viewing the variety of fact patterns appearing in transfer pricing cases, it is one thing to provide for a single digital platform, which allows for videoconferencing and for the storage and exchange of documents, and quite another to develop sustainable algorithms, which could help the arbitrators to choose between two preliminary proposals. While it may be easy to develop an electronic case management system, it is likely much more complex if case-resolving algorithms are introduced in the arbitration.

The Impact of CbC Reporting

While the MLI and article 25, paragraph 5 of the OECD model convention provide a broad framework on how to cope with cross-border transfer pricing tax disputes triggered by the CbC report, there are important multilateral initiatives that also focus on how to mitigate its impact.

In 2019 the OECD launched the International Compliance Assurance Programme (ICAP), in which 20 countries participate. The ICAP is a voluntary program for a multilateral cooperative risk assessment and assurance process. It is designed to be an efficient, effective, and coordinated approach to providing increased tax certainty for particular activities and transactions to multinational groups willing to engage actively, openly, and in a fully transparent manner.

The ICAP does not provide an MNE with the kind of legal certainty available through an advance pricing agreement. It does, however, provide comfort and assurance when tax administrations participating in an MNE’s risk assessment consider a covered risk to be low risk. If an area is identified as needing further attention, work conducted in the context of the ICAP can improve the efficiency of actions taken outside the program. However, tax certainty also requires full transparency, which some MNEs may not be willing to undertake.

Conclusion

CbC reporting allows tax authorities around the world to automatically exchange data, giving them a detailed insight on how MNEs apply transfer pricing laws, rules, and regulations on a CbC basis.

While CbC reporting provides tax administrations with ample opportunities to assess their share of income taxes, the same does not apply at the MNE level. CbC reporting is an obligation imposed on an MNE to provide details on its transfer pricing system without, however, receiving anything in return. CbC reports are thus a one-way street. While tax authorities can coordinate and undertake multilateral initiatives (for example, joint audits), MNEs will need to pursue a reporting system (largely digitalized) that allows them to adequately protect their interests. What today is a final offer arbitration must soon be transformed into a digitalized final offer arbitration.

Ideally, governments and their resident MNEs will work together to develop a simple, easy-to-handle, and comprehensive platform supporting digitalized mandatory arbitration. This platform would also allow resident MNEs to defend against foreign governments, which may have a different view on how their intercompany transactions should be taxed. To this effect, a digitalized solution on the basis of cross-border final offer arbitration may well become a helpful and reliable tool allowing MNEs to reduce cross-border transfer pricing tax disputes.

FOOTNOTES

1 On June 16, 2017, the Swiss parliament approved the Multilateral Competent Authority Agreement on the Exchange of Country-by-Country Reports, and adopted the federal law implementing it. On September 29, 2017, the Federal Council issued a decree necessary to implement this law. On October 10, 2017, the Federal Council decided to enact the law, effective December 1, 2017.

2 The United States did not ratify the 2010 version of the OECD Multilateral Convention on Mutual Administrative Assistance in Tax Matters and cannot participate in the CbC reporting model proposed by the OECD.

3 There is no legal basis for allowing an automatic exchange of information on matters covered by CbC reporting between Switzerland and the United States. With the exception of the EU, the United States is the largest single direct investment economy for Switzerland, and the lack of any CbC reporting between the two countries is a significant omission.

5 The MLI is the result of BEPS action 15. Even though it is highly recommended by the OECD, it should be noted that, in the case of Switzerland (as well as many other countries), the number of double taxation conventions covered by the MLI includes only a small fraction of the double tax conventions into which Switzerland has entered.

6 Carl M. Stevens, “Is Compulsory Arbitration Compatible With Bargaining?” 5 Industrial Relations 38 (Feb. 1966); Josh Chetwynd, “Play Ball? An Analysis of Final Offer Arbitration, Its Use in Major League Baseball and Its Potential Applicability to European Football Wage and Transfer Disputes,” 20(1) Marq. Sports L. Rev. 100 et seq. (2009).

7 Mindy Herzfeld and Richard L. Doernberg, International Taxation in a Nutshell 370 et seq. (2018).

8 OECD Transfer Pricing Guidelines for Multilateral Enterprises and Tax Administrations, at 98 (July 2017).

9 Herzfeld and Doernberg, supra note 7, at 380 et seq.

10 Bausch & Lomb Inc. v. Commissioner of Internal Revenue, 92 T.C. 525 (1989), aff’d, 933 F.2d 1084 (2d Cir. 1991).

END FOOTNOTES

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