Restricted DAFFE/CFA/WP6(96)2

Organisation de Coopération et de Développement Economiques OLIS : 29-Mar-1996

Organisation for Economic Co-operation and Development Dist. : 01-Apr-1996
__________________________________________________________________________________________
Or. Eng.
DIRECTORATE FOR FINANCIAL, FISCAL AND ENTERPRISE AFFAIRS
Restricted
DAFFE/CFA/WP6(96)2

COMMITTEE ON FISCAL AFFAIRS

Working Party No. 6 on the Taxation of Multinational Enterprises

THE ROLE OF ARBITRATION PROCEDURES IN RESOLVING TAX DISPUTES

(An issue paper by the Secretariat)

The attached document is submitted FOR DISCUSSION to Working Party No. 6 at its meeting on 17 April
1996.
Or. Eng.

31584

Document complet disponible sur OLIS dans son format d'origine

Complete document available on OLIS in its original format
DAFFE/CFA/WP6(96)2

TABLE OF CONTENTS

A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

B. Background of Arbitration in the OECD Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

C. Effects of a Tax Arbitration System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

D. Structural Issues in Developing a Tax Arbitration Procedure . . . . . . . . . . . . . . . . . . . . . 5

Mandatory or voluntary submission of disputes to arbitration . . . . . . . . . . . . . . . . . . . . . .7

Taxpayer participation in the arbitration procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Procedures for selection of arbitrators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
Evidentiary and other procedural rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
Applicable legal principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
Form and content of decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Effect of decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Costs of Arbitration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

E. Implementing a Tax Arbitration Procedure in the OECD Context . . . . . . . . . . . . . . . . 12

F. Parts for discussion by the Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

ANNEX Features of Some Existing Arbitral Arrangements . . . . . . . . . . . . . . . . . . . . . . 14

NOTES AND REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

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THE ROLE OF ARBITRATION PROCEDURES IN RESOLVING TAX DISPUTES

A. Introduction

1. As trade and investment have taken on an increasingly international character, the tax disputes
which such activities involve have likewise become increasingly international. And more particularly, the
disputes no longer involve simply taxpayers and the fiscal authorities but also concern disagreements
between the fiscal authorities themselves. In many of these situations, the taxpayer is primarily a stake
holder and the real parties in interest are the governments involved. Traditionally, problems of this sort
have been resolved through the mutual agreement procedures contained in double tax conventions. This
mechanism allows the competent authorities of the contracting states to reach a common solution to a
particular instance of double taxation arising from conflicting governmental views. However, the mutual
agreement procedure has some inherent limitations. First of all, from the taxpayer’s point of view, the
relief is discretionary with the fiscal authorities. More important, there is no assurance that the issue will
be resolved if the fiscal authorities, after consultation, can reach no agreement.

2. Similar problems of resolving conflicting governmental views have arisen in other settings. In the
context of international trade and investment, the General Agreement on Tariffs and Trade and its successor
the World Trade Organization, have developed increasingly sophisticated procedures and institutions to
resolve international trade disputes. The basic mechanism has been the use of what is essentially an arbitral
panel composed of independent persons who produced a reasoned legal ruling as to the issue in question1.
Similarly, the U.S.-Canada Free Trade Agreement and the expanded North American Free Trade Agreement
provide for an arbitration panel procedure to resolve disputes concerning antidumping or countervailing duty
issues2. Similar arbitral arrangements are present in the European Energy Charter and the U.S.-Iran Claims
Settlement Agreement.

3. The development of arbitral procedures in the trade area is driven by the need for a mechanism to
eliminate trade barriers which arise because of lack of governmental agreement. Such disputes cannot
effectively be dealt with in domestic courts, and where diplomatic attempts to resolve issues are
unsuccessful, it is necessary to have a procedure which can efficiently provide a neutral and binding
solution to the issue in question. While States have historically resisted the relinquishment of sovereignty
implicit in the agreement to a binding arbitration procedure, the clear benefits of such a procedure in the
trade area have overcome the traditional objections.

4. In the tax area as well, there has been a new interest in the use of arbitration to resolve tax disputes.
Most publicized is the European Community Tax Arbitration Convention3 but, in addition, an increasing
number of bilateral tax conventions have provisions for arbitration4. It seems likely that international tax
controversies will continue to increase in the future because of the relative and absolute increase in
international transactions. This is particularly true in the case of transfer pricing disputes, where more
aggressive enforcement is combined with more highly developed, and sometimes conflicting, transfer
pricing rules. In this setting, it is to be expected that there will be an increasing use of arbitration to
resolve tax issues. Indeed, if problems of unresolved tax controversies become too great and tax arbitration
procedures are not developed, there may be a pressure to subject the tax disputes to the conflict resolution
mechanisms developed in the trade and investment area. Against this background, the question is what role
the OECD should have in the development of tax arbitration procedures.

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B. Background of Arbitration in the OECD Context.

5. The possibility of the use of arbitration in tax disputes has long been recognized in the OECD work
on the Model Convention. Already in 1977, the Commentary to Article 25 mentions the possibility of
"independent arbitrators" who could be asked to give "advisory opinions."5 The current version of the
Commentary to Art. 25 also refers to the possible "solution" of arbitration and the European Community
Arbitration Convention as well as the developments in bilateral conventions concerning arbitration 6.

6. It is in the context of transfer pricing that arbitration has received the most attention by the OECD.
The 1984 Report on Corresponding Adjustments contains a discussion of the use of arbitration procedures
to insure that corresponding adjustments would be made on a consistent basis. After discussing some the
advantages and disadvantages of arbitration, the Report concludes that "for the time being" it was not
appropriate to recommend an arbitration procedure7. However, as indicated above, a number of changes
have taken place since the Report was written in 1984. The European Community arbitration procedure
was at that time only in draft form, the trade agreement dispute resolution procedures had not been so fully
developed, bilateral tax conventions had not begun to adopt arbitration procedures, and the dramatic
increase of interest in transfer pricing questions with their attendant potential for tax controversy had not
yet occurred. Accordingly, it seems appropriate at this time to analyze what the introduction of a tax
arbitration procedure would bring to international tax relations. The next two sections of this Note will
examine some of the effects which an arbitration procedure would have in the international tax context,
some of the technical alternatives in structuring an arbitration system, and how such a system might be
implemented.

C. Effects of a Tax Arbitration System

7. Three features are usually associated with the use of arbitration and explain in part the increased
use of arbitration in a variety of contexts. First, binding arbitration assures a final solution to a dispute
where negotiation and other dispute resolution techniques have failed. In addition, arbitration provides a
neutral forum for the resolution of disputes. This factor has been important in the expansion of arbitration
in intergovernmental disputes8. Arbitration also can offer an efficient and speedy resolution of disputes.
This has been a major factor in the expansion of international commercial arbitration. Each of these factors
is relevant in analyzing arbitration in an international tax setting.

8. One of the principal difficulties with the present system of dispute resolution in international tax
controversies is the lack of any mechanism to insure a final and consistent decision in cases in which the
competent authorities cannot settle the matter by negotiation. Lack of agreement will almost invariably
result in double taxation and a failure to carry out the basic purpose of the Model Convention. This has
been one of the arguments consistently put forward by the business community, including BIAC, in favour
of arbitration. A procedure through which unresolved issues can be submitted to arbitration would insure
that a transaction would be treated consistently by both fiscal authorities and thus allow the traditional
methods of double taxation relief to operate.

9. It is sometimes objected that the existence of an arbitration system would encourage taxpayers to
be more aggressive, especially in their transfer pricing practices, since at the end of the day they could be
assured of a process which would remove the possible "penalty" of double taxation. This seems an
unrealistic assessment of the tax planning process and, to the extent it is a concern, could be eliminated by

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excluding from the arbitration system cases in which the taxpayers conduct was egregious enough to subject
it to penalties under the domestic systems of the countries involved9.

10. Arbitration would also provide a neutral forum though which to resolve governmental disagreements
on tax issues. The most obvious situations are differing approaches to transfer pricing and the attribution
of profits to a permanent establishment. In cases like these the taxpayer currently has no "disinterested"
forum in which to make a case.

11. If the procedural rules governing the arbitration process are properly structured and coordinated with
the existing system, the tax issue in question can be more efficiently resolved. At the most simple level,
the process will involve only one determination which is binding on all parties rather than parallel(and
possibly multi-level) litigation in national tribunals. In addition, it would be possible to structure procedural
and evidentiary rules for arbitration which were directly responsive to the special circumstances of tax
disputes and avoided historically rooted and possibly inappropriate national rules. Moreover, since some
issues would be more suited to arbitration than others, the possibility of referring some questions for an
arbitral decision would free up the competent authorities to concentrate on the resolution of other matters
with an overall increase in efficiency. Finally, the mere possibility of an ultimate referral to arbitration may
encourage competent authority settlement.

12. The lack of an institutional mechanism to provide a final resolution of international tax disputes
is quite striking in the light of the above advantages which such a procedure would bring. The absence
of such a mechanism is also inconsistent with developments in other areas. Arbitral procedures are being
implemented in the trade context and there will undoubtedly be pressure to extend the scope of those
procedures to tax questions. The impact of unresolved tax disputes on trade and investment is undeniable
and the lack of a tax-based resolution mechanism invites the expansion of trade-related mechanisms to fill
the vacuum. The recent controversy over the inclusion of direct tax issues in the procedures of the General
Agreement on Trade in Services, despite its generally satisfactory ending, is illustrative of the way in which
such a development could occur. The failure to develop some sort of mechanism to deal with unresolved
tax disputes may well result in tax questions being subsumed under other less specific dispute resolution
procedures; indeed, the absence of a tax-based mechanism invites this result. Thus a tax arbitration
procedure not only would bring advantages viewed solely within a tax context but may be necessary to
forestall the imposition of procedures which would necessarily be less suitable for and not tailored to the
resolution of tax disputes.

D. Structural Issues in Developing a Tax Arbitration Procedure

13. The following materials discuss a number of the technical issues which must be dealt within the
structuring a tax arbitration procedure. In each situation, several alternative approaches will be discussed
with some analysis of the pros and cons of each and a recommended solution.

14. Special aspects of tax arbitration. There are a number of special features in tax arbitration which
would require modification of traditional arbitration regimes. Most important, tax arbitration combines both
private and governmental interests which must be accommodated. Thus decisions must be made about the
relative roles of the taxpayer(s) and the governments in initiating the proceedings, participating or
controlling the presentation of the case, resolving disagreements, and following or applying the ultimate
decision. These issues will be discussed in more detail below. Second, there is the relation of the

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arbitration procedure to the competent authority mechanism. The function of arbitration is not to supplant
mutual agreement procedures but to supplement them. Thus it would seem appropriate to limit arbitration
to those cases where the competent authority procedure has not been successful. In some tax arbitration
schemes, arbitration is required if the competent authorities have not been able to reach agreement within
a specific period of time, for example, two years10. Given the possible differing types of disputes which
might arise, it seems undesirable to impose an arbitrary time limit on the period after which a move to
arbitration is required. One could imagine particularly complex cases which could be satisfactorily resolved
in a competent authority procedure without recourse to arbitration if the procedure was allowed to take its
course. Premature referral to arbitration could result in duplication of work if the case were not "ripe" for
arbitration. In such situations, it might be possible to develop some sort of preliminary procedure under
which an arbitral panel could be formed and a case submitted to it in a preliminary fashion where the
panel’s role would be more in the nature of a mediator than of a decision making body11. In any event
an arbitrary time limit after which referral to arbitration is required seems unnecessarily restrictive.

15. On the other hand, it might be useful to have some minimum period during which the competent
authority procedures function before a case could be submitted for arbitration. The arbitration procedure
should in general be available only for exceptional or unusual cases in which good faith efforts to reach
a conclusion in the competent authority discussions have not been successful. Thus some sort of time limit
before which a case could be submitted may be a useful device to insure that the possibilities of a
competent authority settlement have been exhausted before recourse is made to arbitration.

16. Relation of arbitration to normal tax litigation process. In most situations, arbitration operates to
the exclusion of litigation. Indeed one of the purposes of establishing arbitration procedures in the first
place is to avoid the litigation process. Introduction of arbitration in the tax context involves some special
problems. First of all, the system of arbitration envisaged here is in part an extension of the competent
authority procedure. While country practices differ, it is clear that, in general, competent authority operates
"without depriving [taxpayers] of [their] ordinary legal remedies"12 including the right to litigate in
domestic courts. In addition, competent authority proceedings are possible even after an issue is finally
adjudicated in the residence state, though under the practice of many states, the competent authority is
bound by the court decision and is limited to seeking to have the other state take measures to relieve double
taxation13.

17. The question is how, if at all, these principles should be changed when arbitration is added to the
competent authority process14. In theory, it would be possible for the taxpayer to pursue domestic
administrative and judicial remedies while at the same time using the competent authority procedure, even
when that procedure might ultimately end in arbitration. However, there should be some limit on the
taxpayer’s right to follow parallel procedures where the competent authority procedure has been modified
to provide the taxpayer with the possibility of achieving a binding and consistent result. Thus at the time
in the competent authority process that the arbitration procedures would be opened, it would seem
appropriate to require the taxpayer to agree to terminate the parallel domestic proceedings. This would
insure the taxpayer the general right to a domestic hearing but would condition access to a binding and
consistent resolution of the issue on the waiver of that right.

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Mandatory or voluntary submission of disputes to arbitration.

18. All arbitration is in a sense voluntary in that the obligation to submit the dispute to arbitration is
not imposed by some third party but is a result of the decision of the parties. However, a distinction is
made between "pre-dispute" and "post-dispute" agreements to arbitrate. A "pre-dispute" agreement to
arbitrate covers future, as yet unknown disputes, and is commonly called "mandatory" arbitration. A
"post-dispute" agreement arises in connection with an already existing dispute and is limited to a
"voluntary" submission to arbitration of that dispute. With respect to the governments involved in tax
arbitration, it would be possible to provide in the Convention that all future disputes which could not be
resolved through the competent authority process would be submitted to arbitration, thus establishing a
"pre-dispute" agreement which would be controlling in the future. This kind of general commitment to
arbitration would strengthen the capacity of the competent authority procedure to carry out the purposes
of the treaty. As indicated above, it does not seem desirable to impose an arbitrary time limit after which
a case must be submitted to arbitration. The arbitration procedure envisioned here functions as an extension
of the competent authority procedure. It should come into play only after both competent authorities agree
that a resolution of the dispute by traditional means is unlikely. Thus the procedure would not be formally
mandatory but would be conditioned on an agreement by the competent authorities that no other means of
resolving the dispute was likely.

19. How to deal with the taxpayer in this context is somewhat more complex. There is no feasible way
for the taxpayer to agree to participate in an arbitration of all future disputes so in some sense its agreement
has to be "post-dispute." The question is a what point in the dispute resolution process that agreement
should be obtained. If, as discussed above, the taxpayer is to be allowed to continue domestic
administrative and judicial remedies while the initial stages of the competent authority procedure are going
on, it would seem reasonable to require the taxpayer’s consent to arbitration at the time when the competent
authorities thought arbitration appropriate. The taxpayer would thus be required to drop the parallel
domestic proceedings at that time. At that point, all of the dispute resolution procedure would be focused
on the arbitration process. If the time had come in the competent authority process when arbitration would
be appropriate and the taxpayer was not willing to participate, then it would seem appropriate to drop the
procedure and leave the taxpayer with his domestic remedies. This structure would give the taxpayer the
possibility of a final and consistent decision and would protect the fiscal authorities from parallel and
possibly inconsistent domestic litigation.

20. Situations to be submitted to arbitration. Since the arbitration process envisaged here grows out
of the competent authority procedure, it in principle could extend to all disputes "regarding the
interpretation or application" of the treaty. The question is whether there is any reason to limit the broad
scope of that language in the arbitration process. There is a considerable variation in existing tax arbitration
provisions. The E.C. Arbitration Convention, currently the most fully developed tax arbitration procedure,
is strictly limited to transfer pricing situations and the attribution of profits to permanent establishments.
These issues are clearly the most natural for the application of arbitration procedures. They are usually
heavily factual, involving complex factual situations with valuation difficulties. They are also issues in
which there is typically no one "right" answer but a range of answers. From the taxpayers’ point of view,
the most important thing is not "the" answer but that there is a consistent answer and it is exactly this result
that the arbitration procedure can achieve. In a similar vein, in a widely reported domestic tax case using
arbitration, the Apple Computer litigation in the United States Tax Court, the sole issue submitted for
arbitration was "the total income amount that [taxpayer] would have earned at arm’s length taking into

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account all sales, services, and use of intangible property transactions, if any, between [related
taxpayers]15."

21. There are related restrictions in other arbitration provisions. Some countries have in effect limited
arbitration to fact-finding questions, with the arbitration procedure functioning like a Master’s procedure
in domestic litigation. Other substantive restrictions have been imposed. Thus the United States-Germany
treaty excludes from arbitration "matters concerning the tax policy or domestic tax law of either Contracting
State16." The exact scope of this restriction is hard to determine but on its face it is not inconsistent with
a scope for arbitration which goes well beyond fact-finding. The basic charge of Article 25 to resolve
issues involving the "interpretation or application" of the treaty this language would permit interpretation
of purely treaty terms to be the subject of arbitration. On the other hand, issues involving strictly domestic
law, though involved in the "application" of the treaty, would not seem an appropriate subject for
arbitration17. A more difficult issue involves the issue of conflicting classification which is difficult to
categorize as either "domestic law" or "treaty interpretation." Though domestic law is involved, it would
seem appropriate to include such situations within an arbitration framework; the essential question is not
what domestic law is but which law should apply and that interpretative issue can be dealt with through
arbitration.

22. As a procedural matter, it would be useful for the arbitrators and the parties to establish a "Terms
of Reference"18 setting forth exactly the issue or issues which are within the competence of the arbitral
panel. This facilitates a later defense of the arbitral award should a question of the scope of the arbitrators’
authority arise. A separate question is whether arbitration should be excluded in situations in which the
taxpayers do not come to the table with "clean hands." The E. C. Arbitration Convention specifically
provides that the competent authorities are under no obligation to use the arbitral procedures contained in
the Convention if the taxpayers are subject to "serious penalties" in connection with transfer pricing
practices. In general, a limitation of this nature in the context of transfer pricing seems reasonable. It
forestalls overaggressive transfer pricing with the sanction that unrelieved double taxation may result from
inconsistent determination. In other situations, however, such a limit would seem unnecessary. It would
be difficult to identify the specific conduct for which the penalty was incurred with the particular issue
which was being presented for arbitration.

Taxpayer participation in the arbitration procedure

23. In the procedure outlined above, the taxpayer would not formally have the right to initiate the
arbitration procedure but would participate in the decision by agreeing to forgo its domestic administrative
and judicial remedies at the time the competent authorities decided to submit the case to arbitration. If, as
has been suggested, there is no time limit after which referral to arbitration is required, the basic decision
as to when to refer the case will rest with the competent authorities, though their obligation to refer the case
is unconditional. Once the case is submitted, the taxpayer should be permitted to appear and participate
in the proceedings, both directly and through representation. The respective competent authority and the
taxpayer will in most situations presumably have agreed on the positions to be taken. If there is a
disagreement, the taxpayer should have the right to presents its views separately but this should be an
unusual situation.

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24. A more difficult question is the taxpayer’s right to withdraw from the proceedings and reinstate its
domestic judicial remedies. Here, in the interests of finality, it seems the taxpayer should be bound by its
decision to utilize the arbitration forum. Adequate protection of the taxpayer’s right is provided the above
outlined procedure.

Procedures for selection of arbitrators

25. Following normal arbitration procedures, it would seem most logical for each competent authority,
in consultation with the taxpayer, to appoint at least one arbitrator. There would seem no need for any
particular stipulation of qualifications for an arbitrator as it would obviously be in the interests of all the
parties to have the most qualified and suitable participants. Typically, the selected arbitrators would in turn
select the third person or persons as the "neutral" arbitrator. However, if for some reason it is not possible
for the appointed arbitrators to agree on a third party, there should be some mechanism to handle this
deadlock. Typically some institutional body, presumably in this situation some instrument of the OECD,
would be authorized to fill the position. An alternative would be for the appointment of all the arbitrators
by an OECD body. This would give the arbitral panel more of the character of a court. While the use of
an independent appointing body might insure more fully neutral participants, from a practical point of view
it would seem preferable to leave the initial appointment with the parties.

Evidentiary and other procedural rules

26. Establishing evidentiary and other procedural rules can be handled in several ways. The simplest
would be to leave the matter to the arbitrators to develop the applicable principles on an ad hoc basis as
to witnesses, documents, forms of presentation of case, etc. Alternatively, whatever approach is used to
establish the arbitration procedure could set forth the basic procedures to be followed. Finally, reference
could be made to existing arbitration procedures such as the International Chamber of Commerce Rules
which deal with many of these questions. Any of these approaches would be feasible; the most important
thing is to avoid the overly technical and often arbitrary rules which in many cases typify domestic
procedure.

27. Whatever rules are developed, the material available to the arbitrators would be subject to the usual
restrictions on confidentiality and nondisclosure which are applied to tax information generally. It would
not seem appropriate to place time limits on the arbitral panel’s period of deliberation. Cases will
undoubtedly differ in difficulty and complexity and, as with procedures generally, there should be the
maximum flexibility possible.

Applicable legal principles

28. In most arbitration situations, the arbitral agreement will set out the legal principles which the
arbitrators are to follow. In the context of tax arbitration of the type envisaged here, the issue will involve
the "interpretation and application" of the treaty, and thus the kind of legal authority usually involved in
treaty interpretation will be relevant. Where domestic law of either of the parties is secondarily involved
in the interpretation of the treaty, those principles will also be significant. This may be especially true in
the case of undefined terms where the treaty equivalent of Model Convention Article 3(2) makes reference
to the law of the party "applying the treaty." The United States-German arbitration procedures also refer
to "the principles of international law" and allow the arbitrators to take into account decisions in prior

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arbitral decisions "where appropriate." This clearly recognizes the possibility of the development of an
"international" body of tax law which includes the precedents in the arbitral process.

29. Whatever the body of applicable law, it is important that the panel should be obligated to reach a
principled decision (whether or not the publication of a reasoned opinion is required is discussed below).
While the competent authorities, acting in an administrative capacity, may be authorized to reach an
agreement based on general considerations of equity or fairness19, it would seem unwise to explicitly
extend this approach to the arbitral procedure. The arbitrators have been selected on the basis of their
expertise and it is their exercise of this expertise which justifies their decision. In contrast to the competent
authority, their decision has a quasi-judicial character, displacing as it does the consideration the issue by
domestic courts. Thus constraining their decision by some sort of "rule of law" principle seems consistent
with the institutional role that arbitration is performing. This approach is expressly recognized in the
German-Swedish arbitration procedure which forbids any decision ex aequo et bono (amiable
composition)20.

Form and content of decision

30. The form and content of the decision will depend to a large extent on the nature of the issue
involved. If the question is essentially one of treaty interpretation, then a "reasoned" opinion of the type
typically found in judicial decisions would seem to be appropriate. If decisions were published, after
appropriate redaction of confidential or privileged information, the development of a body of "decisional"
law would be possible which would help to resolve issues in the future.

31. If the issue is one with important factual dimensions, several approaches would be possible. At
one extreme would be an approach based on "final offer" or "baseball" arbitration which was followed in
a recent domestic arbitration case in the United States21. Here each party is asked to submit to the panel
its "last best offer" and the panel’s role is limited to selecting one of the two amounts proposed. The
obvious advantage of such a procedure is that it forces each party to make a realistic assessment of its case
and would tend to encourage settlement in advance of the actual submission to arbitration as the positions
neared a middle ground. The disadvantage is the limit on the discretion of the panel to apply its expertise
and find a position which takes into account the competing aspects of the arguments. At the other extreme
would be a procedure under which the panel simply came up a single number without reasoning or analysis.
A middle position would give the panel discretion to arrive at its own decision but require that the
reasoning and analysis on which the decision was based be made public, at least to the parties. This would
provide some flexibility but at the same time impose on the panel the obligation of justifying the results
reached. While each approach has advantages and disadvantages, a "reasoned opinion" would seem best
suited to the development of more uniform approach to commonly recurring issues, especially in the
transfer pricing context.

Effect of decision

32. For the arbitration procedure to achieve the goal of finality, the decision should in principle be
binding on both the governments and the taxpayer (subject to the possibility of procedural review, discussed
below). In the procedure suggested above, the taxpayer, as a condition of having the case proceed to
arbitration, would be required to terminate all domestic litigation. It would not seem appropriate to allow
a reopening of the issue in the domestic courts after an arbitral decision had been reached. While the
decision may not be ideal from the taxpayer’s point of view, it had the initial choice of opting for a

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procedure which would insure a consistent treatment of the dispute. The taxpayer should not be given a
"second chance" to reopen the substantive issues in domestic courts. Similarly, the arbitral decision should
be binding on the fiscal authorities. Again, the one of the main purposes of the arbitration procedure is
to arrive at a consistent and binding decision, and once that step has been taken through the arbitral
decision, a policy of repose should require that the substantive issues are finally decided.

33. The E.C. Arbitration Convention takes a different tack and allows the competent authorities in effect
to reconsider the case for six months after the arbitral decision has been made. Only if the competent
authorities have not come to a decision in this period does the arbitral decision become binding. In this
procedure, the arbitral decision is in effect primarily a device to give the competent authorities a last chance
to resolve the issue. They must in effect ratify the decision before it is binding. This may be considered
as an unnecessary restriction on the effect of the arbitral decision. The procedure as here envisaged is not
simply an extension of the competent authority procedure but is intended as an independent process which,
once the time and effort have been expended to set it in motion and bring it to a conclusion, should be
finally binding on substantive matters. Finality with respect to procedural matters raises different issues.
There must be some procedure to insure that the arbitrators have followed the appropriate rules, whether
set out in the international agreement establishing the procedure or by the arbitrators themselves. One
possibility would be to allow the courts of each country to review the arbitral decision on limited procedural
grounds such as bias or corruption, exceeding the delegated authority in the decision, or violation of the
panel’s own procedural rules, etc.

34. Leaving review to national courts, however, would reintroduce the possibility of conflicting national
decisions concerning the same award. Another approach would be to provide for a supra-national reviewing
body which would supplant national courts. Such a procedure is provided for in the World Bank’s
International Centre for the Settlement of Investment Disputes (ICSID) and in the North American Free
Trade Agreement22. In the latter procedure, the bi-national panel decisions concerning trade disputes can
be reviewed by an "Extraordinary Challenge Committee" for limited procedural defects. In the context of
tax arbitration based on an OECD model, it would be possible to have a review body appointed by the
Committee on Fiscal Affairs or the matter could be referred to the Co-ordinating Body envisaged by Article
24 of the Mutual Administrative Assistance Convention.

35. Assuming that there are no procedural challenges to the arbitral award, it should be treated as a
final decision as to tax liability by the domestic courts of the jurisdiction asserting the liability, and normal
procedures for collection and assessment or refund would be applicable.

Costs of Arbitration

36. In principle the cost of the arbitral proceedings in general, including the compensation of the
arbitrators, should be borne by the governments involved, with common costs shared equally. However,
the costs of presenting the taxpayer’s case, providing testimony or documents, and independent
representation should be borne by the taxpayer.

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E. Implementing a Tax Arbitration Procedure in the OECD Context.

37. If a consensus could be reached on some variation of a tax arbitration procedure along the lines
outlined above, there are several alternatives for its implementation. The most limited step would be to
expand the discussion in the Commentary to Article 25 of the Model Convention to include a description
of the various approaches which could be taken to bilateral arbitration, setting forth alternatives along the
lines of the above description. More useful would be to provide a separate article in the Model Convention
which would actually set forth a coherent arbitration scheme. While Contracting States would in all
likelihood desire individual modifications in their bilateral negotiations which took into account the
particular circumstances of their constitutional, judicial, and administrative systems, the existence of a
completely elaborated system would increase the possibility of its adoption with modifications in bilateral
agreements.

38. A more comprehensive approach to implementing a system of tax arbitration would be the
development of a Multilateral Arbitration Convention, open initially to OECD, but also not excluding the
participation of non-Member countries (possibly those with which the OECD has developed some links).
To take into account the possibly differing views of arbitration, the treaty could be drafted with alternative
formulations of possible approaches set up against a background of common principles applicable to all
forms of arbitral procedures.

F. Parts for discussion by the Committee

39. The aim of the discussion at the January meeting is to provide some guidance to Working
Party No. 6 as regards the stance it should take in Part II of the revised transfer pricing guidelines on
arbitration (section F of Chapter VII is intended to address the issue). The Working Party can adopt one
of two approaches to drafting that section:

- It can provide an extensive discussion of the pros and cons of arbitration in the transfer
pricing area and give a considered opinion as to whether the OECD should develop an
Arbitration Procedure and, if so, perhaps provide some details of how this would work.

- Alternatively, the section could note briefly the arguments that have been put forward in
favour of arbitration and then state that the Committee intends to examine this issue further.

40. The discussion is also intended to elicit the views of Delegates on the ways in which an Arbitration
Procedure could work in practice, building upon the replies to a questionnaire that was sent out in 1992
(see DAFFE/CFA/WP6(93)10).

41. The Committee is asked for its views on these issues, specifically:
- Does it agree that the note should be passed to Working Party No. 6 for further
consideration?
- Of the two approaches outlined above, which would be preferable from the Committee’s
perspective?
- If the first approach were adopted, should the section conclude that the goal of any follow-
up should be to develop proposals for Arbitration?

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- And if this were the Committee’s view, which of the approaches set out in para. 37 and
38 should be preferred?

42. It is clear that at this stage any views expressed by the Committee must remain provisional since
many of the tactical issues reviewed in this note require further discussion.

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ANNEX

Features of Some Existing Arbitral Arrangements

1. U.S.-German Treaty

Ad hoc arbitration for each dispute;

Competent authority must be exhausted;

Voluntary on part of both competent authority and taxpayer;

All cases under Art. 25 covered but "generally" will not submit matter of "tax policy or domestic
law" of either state;

Each competent authority appoints at least one member and they select other members; no
provision for deadlock;

Members must be from OECD states; competent authority may specify further criteria;

Confidentiality and disclosure restrictions apply;

Procedures are determined by competent authorities; if no instructions from competent authorities,

then board establishes its own procedures based on "generally accepted principles of equity";

Taxpayers or representatives can present view to board;

Decision based on "due consideration" of domestic law and "principles of international law"; prior
decisions of the board, while not precedent, will be "taken into account";

Board will provide competent authorities with explanation;

Decision is binding on both taxpayers and Contracting States;

Costs in general are split between the Contracting States but may require taxpayer contribution as
condition of arbitration.

2. E. C. Arbitration Convention

Limited to transfer pricing situations and permanent establishment attribution of income;

Mandatory arbitration if competent authorities can’t agree within two years of submission of case;

Arbitration not required if parties’ actions in transfer pricing involved imposition of a "serious
penalty";

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Panel composed of two representatives of competent authority, at least two independent persons
and a chairman;

Decision is binding if competent authorities do not reach a different agreement within 6 months
of the decision;

Decision to be based on Art. 9(1) and Art. 7(2) of Model Convention;

General costs are to be shared equally by the governments though private parties bear their own
direct costs;

3. U.S. Tax Court arbitration in Apple Computer

Voluntary binding arbitration pursuant to Tax Court Rule 124 which deals with factual issues in
controversy;

Factual issue stipulated was "the total income that [taxpayer] would have earned at arm’s length";

Final offer style arbitration;

Arbitrators selected were a retired federal judge, an economist, and an industry expert selected from
lists provided by parties;

In general, federal rules of evidence apply; otherwise panel adopts own rules or uses American
Arbitration Association rules;

Decision based on majority vote;

Costs split but not joint liability;

Documents not a matter of public record;

No precedential use of findings;

Procedural review by Tax Court.

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NOTES AND REFERENCES

1. See Hudec, Enforcing International Trade Law, The Evolution of the Modern GATT System
(Butterworth, 1993). The GATT panel ruling must be submitted to and adopted by the GATT Council.
However, after the changes in procedure made by the Uruguay Round, neither the creation of the panel
nor the Council adoption of a panel result need be made by consensus.

2. See Moyer, Chapter 19 of the NAFTA: Binational Panels as the Trade Courts of Last Resort, 27 the
International Lawyer 707 (1993).

3. European Community Convention on the Elimination of Double Taxation in connection with the
Adjustment of Profits of Associated Enterprises 90/436/EEC of 23 July 1990.

4. Arbitration procedures in various forms are found in the following conventions: France-Germany;
United-States-Germany; United States-Mexico; United States-Netherlands; Netherlands-Canada;
Netherlands-Venezuela; Sweden-Germany.

5. Art. 25, Comm. para. 45 (1977).

6. Art. 25, Comm. para. 48 (1992).

7. Chapter III, para. 63.

8. One recent example is the United States-Iran Claims Settlement Agreement.

9. This is the approach taken by the E.C. Arbitration Convention. See Art. 8, para. 1.

10. See e.g., E.C. Arbitration Convention, Art. 7.1.

11. Some domestic court procedures involve a pretrial conference where the judge’s role is in part to
encourage the parties to settlement without trial. An arbitral panel could function in a similar way.

12. Art. 25, Comm. para. 6 (1992).

13. Art. 25, Comm. para. 24 (1992).

14. A separate but related question, the right of the taxpayer to appeal the arbitral decision to a domestic
court, is discussed below.

15. Apple Computer v. Commissioner, Stipulation for Resolution of Issue Through Voluntary Binding
Arbitration under Tax Court Rule 124, para I A.

16. United States-German Letter of Understanding, para. 1.

17. See Tillinghast, Choice of Issues to be Submitted to Arbitration Under Income Tax Conventions, in
Essays on International Taxation (Kluwer, 1993), 349, 353.

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18. Such a procedure is typical in commercial arbitration. See ICC Rules of Conciliation and Arbitration,
Art 13 (1).

19. See Art. 25, Comm. para. 27.

20. See Sweden-Germany, Art. 41, para. 5.

21. See note 15, supra.

22. See Park, Control Mechanisms in International Tax Arbitration, in Resolutions of Tax Treaty Conflicts
by Arbitration (Kluwer, 1994) 45. The author also suggests that existing multilateral arbitration
conventions and national arbitration statues may also already cover tax arbitration awards unless such
coverage is expressly excluded in the agreement establishing the arbitration procedure.

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