DEVELOPMENT OF THE “NORTH AMERICAN MODEL” FOR
ARBITRATION OF TAX TREATY DISPUTES
Patricia A. Brown
I.
INTRODUCTION
The United States was relatively slow to adopt mandatory binding arbitration for the
resolution of tax treaty disputes. Although several of its tax treaties include provisions in the
mutual agreement procedure article allowing (but not requiring) arbitration of such disputes,
those provisions have never been used. The various model tax conventions issued by the United
States over the past several decades also have not provided for the arbitration of tax treaty
disputes.
This demonstrated reluctance was due primarily to a concern that the dominant form of
arbitration – the “independent opinion” model – would have a deleterious effect on the
functioning of the mutual agreement procedure. Ultimately, continuing frustration with its
inability to resolve tax treaty disputes with some countries led the U.S. competent authority to
conclude that some form of arbitration was necessary in order to ensure that taxpayers could rely
on a “speedy and efficient resolution of [its] dispute.”1 This led to a complete re-thinking of the
form of arbitration. While this alternative usually is described as “baseball arbitration” or, more
formally, “last best offer”, this limitation on the arbitrator’s decision-making capacity is actually
only one aspect of an overall approach that has been remarkably effective in practice. 2 An
appropriate name would be the “no opinion” model, but this paper will use the more neutral
“North American Model” to describe the approach because the form of the provision was the
result of negotiations between the United States and Canada.3
This short paper describes the development of the North American Model and the key
decisions that made it more acceptable to the Internal Revenue Service and the Treasury
Department than more traditional and legalistic approaches to arbitration.
II.
UNLOVED AND UNUSED – VOLUNTARY BINDING ARBITRATION
In its 1989 tax treaty with Germany, the United States for the first time agreed to a
provision allowing for the arbitration of disputes arising under the tax treaty. Submission of a
dispute to arbitration required the agreement of both competent authorities4 and the taxpayer.5
1
Report on the Hearing on Treaties Before the Committee on Foreign Relations of the United States Senate, July 17,
2007 (S. HRG. 110-305) (“Hearing Print”), p. 65.
2
See H. David Rosenbloom, “Mandatory Arbitration of Disputes Pursuant to Tax Treaties: The Experience of the
United States”.
3
The U.S.-Canada protocol in which the provision appeared was not signed until 2007, but the arbitration provision
was completed several years earlier. The first public appearance of a version of this approach was in the 2006
Protocol to the 1989 U.S.-Germany tax treaty, which has very few changes from the U.S.-Canada version.
4
Article 25(5) of the 1989 U.S.-Germany tax treaty.
5
Paragraph 1 of the Diplomatic Notes dated August 29, 1989 regarding procedures under Paragraph 5 of Article 25
(the “Diplomatic Notes”) of the 1989 U.S.-Germany tax treaty.
Under this provision, the taxpayer agreed upfront to be bound by the decision, whatever it might
be.6
The Diplomatic Notes anticipated the appointment of an arbitration board with respect to
each specific case. Although the Diplomatic Notes addressed issues regarding the composition
of the board, and how costs were to be allocated, very little was specified regarding the manner
in which the arbitration was to be conducted. With respect to a specific case, the competent
authorities could either instruct their chosen board on the procedures to be followed, or allow the
board to establish its own procedures.7 The Diplomatic Notes did state that taxpayers would
have the opportunity to present their views to the arbitration board.8
Cases were to be decided “on the basis of the Convention, giving due consideration to the
domestic laws of the Contracting States and the principles of international law.” 9 While the
decision in a particular case was to be binding on the competent authorities and the taxpayer, and
was to include an explanation of the board’s decision, it was not to have “precedential effect”.10
Of course, the decision would govern future tax years of the same taxpayer as long as the
relevant facts had not changed.11
More interesting is the statement that a board’s decisions “may also be taken into account
in other cases where appropriate.”12 Because the members of the arbitration board were subject
to the same confidentiality rules as the competent authorities themselves, it is hard to see how the
decisions would be used in other cases. A taxpayer would know to cite an earlier decision only
if its representative advised it that a particular argument had been a winner in an earlier case.
However, even that very general level of disclosure by its tax advisor might well violate the
confidentiality rules of the treaty. Presumably, the competent authority who had won an earlier
case would have to raise the argument of its own accord during its direct negotiations with the
other competent authority, without the knowledge of the taxpayer or its representative.
The provision provoked surprisingly little comment from the Senate Foreign Relations
Committee (“SFRC”) when it approved ratification of the U.S.-Germany Treaty.13 The
Committee’s report14 reflects its belief “that the tax system may have much to gain from use of a
procedure, such as arbitration, in which independent experts can resolve disputes with otherwise
may impede efficient administration of the tax laws.” The SFRC therefore effectively approved
an “experiment” in order to better understand the benefits and difficulties in such a procedure.
The SFRC’s discussion ended with a fairly mild statement that the appropriateness of the
6
Id. See also Paragraph 5 of the Diplomatic Notes.
Paragraph 3 of the Diplomatic Notes.
8
Paragraph 4 of the Diplomatic Notes.
9
Paragraph 5 of the Diplomatic Notes.
10
Id.
11
Id.
12
Id.
13
The staff of the Joint Committee on Taxation (“JCT”) generally writes an explanation for each tax treaty
considered by the SFRC, and identifies issues that the SFRC may want to consider in developing its
recommendation to the Senate regarding advice and consent to ratification. The addition of the arbitration provision
was eighth out of nine issues identified by the JCT with respect to the 1989 U.S.-Germany tax treaty.
14
See Committee Comments on Arbitration in the Report of the Senate Foreign Relations Committee on the Tax
Convention with the Federal Republic of Germany, July 27, 1990.
7
inclusion of such a provision in future treaties would depend on “experience under the provision
in the German treaty.”
In fact, similar provisions were added to treaties with several other countries in the
ensuing years. However, no cases were ever submitted to an arbitration panel under any of those
treaties.
As described by one former competent authority, if government-to-government
negotiations have become stuck, it is usually because neither government is willing to move
from its position.15 At that point, it is also unlikely that they will agree to allow third parties to
impose a resolution that would deviate from that position.
III.
THE INTRODUCTION OF MANDATORY BINDING ARBITRATION IN THE
UNITED STATES
A.
Background
Notwithstanding the lack of arbitration proceedings, by the early 2000’s, U.S. tax
authorities felt that they had enough “experience” to draft a provision that would actively
encourage resolution of cases under the mutual agreement procedure and ensure that taxpayers
would not be subject to double taxation even in cases where the competent authorities could not
agree.
While the details of the provision were hammered out with Canada, delays caused by
other open issues meant that the provision actually appeared first in a signed agreement in the
2006 Protocol to the 1989 U.S.-Germany tax treaty. The coincidence that the United States’ first
mandatory binding arbitration provision was going to replace its first voluntary binding
arbitration provision provided an opportunity to discuss the shortfalls of the voluntary arbitration
provision that was being replaced.
In particular, some had expressed concerns that the introduction of mandatory binding
arbitration would somehow impinge on U.S. sovereignty.16 For that reason, the provision was
carefully crafted as a continuation of the mutual agreement process in order to minimize such
concerns.17 As it turned out, there seems to have been no opposition to the idea of mandatory
arbitration as such on sovereignty grounds. Instead, it is clear that someone who had some
influence with the Committee would have preferred a more traditional and legalistic form of
arbitration, because then-Senator Joe Biden raised a dozen questions regarding specific aspects
of the new arbitration provision. As a result, there is an unusually rich public record regarding
the design of the provision and, in particular, perceived deficiencies in more traditional
approaches to arbitration. These are discussed in the rest of this section.
“TNI Interview: Carol Dunahoo”, Tax Notes International 271 (January 19, 2004), p. 274.
See, TNI Interview, supra, note 15, p. 273.
17
Id.
15
16
B.
Key Aspects of the North American Model
1.
Reducing Opportunities for Delay.
The voluntary arbitration provision in the 1989 U.S.-Germany Treaty did not provide any
timetable, not even for when arbitration would start. As a result, they never started.
Modern arbitration provisions generally provide that something will happen after two
years. This seems to be based on a general consensus that a “normal” timetable to reach a
competent authority agreement is about two years. Some agreements, particularly those that
relate to a legal question, may be resolved more quickly. Those that involve complicated facts
may take longer. However, by the end of two years, it usually is fairly clear whether the
competent authorities will in fact be able to reach an agreement.
The question is what happens at that point. Again, the voluntary arbitration provision
previously used by the United States stated that the two Contracting States would appoint a
board. The number of board members appointed by each Contracting State was not specified, so
would have to be decided at the time a board was constituted. The members appointed by the
two Contracting States would then appoint an unspecified number of board members (who could
be from either Contracting States or another OECD country). Once the board was constituted, it
would establish its own timetable, unless the competent authorities had determined it for them.
It seems an obvious design flaw to expect two countries that cannot agree on the resolution of a
case to reach a timely agreement on an external process to resolve it. One could expect a
significant amount of maneuvering in establishing the panel.
The North American Model seeks to eliminate delays by establishing a strict timetable.
The “commencement date” of a case is established when all the information necessary is
provided to both competent authorities. Two years after that date (or, if later, two years after the
date on which each of the concerned parties has agreed to confidentiality), the arbitration
proceeding will commence. Each of the Contracting States must appoint a single member of the
arbitration panel within sixty days. Within sixty days of the second such appointment, the two
members must appoint a third member, who is to act as chair. A country cannot delay the
proceedings by failing to appoint a member because the missing members would then be
appointed by a member of the Secretariat at the OECD, within sixty days of the failure (that is,
the same date that otherwise would have applied). The Contracting States must provide their
proposed resolutions within 90 days of the appointment of the chair; failure to do so will result in
forfeiture of the case. They may submit rebuttal papers within 180 days of appointment of the
chair. Presumably, there is an incentive to submit rebuttal papers even earlier, as the board also
must provide its determination with six months of the appointment of the chair.
Accordingly, once a case has been accepted into the mutual agreement process, the
taxpayer knows that there is a predictable endpoint by which time its case will be resolved. This
contrasts with the experience under the European arbitration convention, where there appears to
be significant slippage in terms of actually resolving cases once they have reached the point
where arbitration is required. Unfortunately, from the outside it is difficult to determine whether
this is due to a failure to appoint boards, or for the boards to schedule hearings, or for the boards
to reach agreement, or for the boards to draft opinions, or some other decision points. What is
clear is that the ability of parties to adhere to the strict timetable in the North American Model
depends on a series of other design decisions, which are discussed individually below.
2.
“Independent Opinion” vs. “Last Best Offer”.
This key design feature relates to the autonomy of the arbitration board. In “last best
offer” arbitration, the “arbitration board can resolve the case only by choosing the position of one
of the competent authorities.”18 This approach was adopted in the North American Model
because “the Treasury Department believes that mechanism is most likely to encourage the
competent authority to resolve the case before it reaches arbitration.”19 The hope is that the
competent authorities will be more reasonable in their negotiations,20 presumably because an
extreme position is less likely to be adopted by the arbitration board.
This contrasts with the “independent opinion” approach, where the arbitration panel can
reach any result it wants. There is a danger that an arbitration panel will want to “compromise”,
or will only be able to reach a consensus, by agreeing on a result that is between the positions of
the two competent authorities. In that case, a competent authority can be rewarded by being
unreasonable.
For example, assume that Company X, located in State A, imported widgets from its
subsidiary in State B. Company X has received a transfer pricing study that established an arm’s
length range as $20 to $32 per widget; it paid its subsidiary $25 per widget. State A believes that
the correct price is $22; State B argues that it is $60, well above a reasonable price. If the
members of the arbitration board want to “compromise” and end up in the middle of the two
positions, they might conclude that the correct price is around $40. In that case, State B “wins”,
as the panel has agreed on a price much higher than the arm’s length range. Moreover, there is
an incentive for State A to stake out a position even lower than the $22 it believes to be
appropriate. If State A argues for $15 per widget, then the midpoint between the two positions
falls below $40, so it is more likely to reach a result closer to the “real” price.
The last best offer approach is intended to eliminate this type of gamesmanship and drive
the two competent authorities to take more reasonable positions. In the example above, if the
board is forced to choose between $22 and $60, it is hoped that they will choose $22 as the more
reasonable number. State B should be afraid that an obviously unreasonable number will not be
chosen by the board; if so, State B is more likely to take a position closer to that of the other
competent authority. It is hoped that, once positive rather than negative behavior is rewarded,
more cases will be resolved during the discussions between competent authorities rather than
ever being referred to arbitration boards.
18
Hearing Print, p. 10 (Prepared Statement of John Harrington, International Tax Counsel, Department of the
Treasury).
19
Hearing Print, p. 66.
20
Id.
Some may be concerned that limiting the board’s options in this way decreases the
likelihood that the “right” result will be reached. This assumes that the process of discussion on
the arbitration panel will lead to enlightenment, not to compromise.
3.
Statement of a Rationale and Precedential Value.
The true innovation in the North American Model is the fact that it forbids the arbitration
board from providing a rationale for its decision. This approach is possible only because of the
use of last best offer, but is not required by it. That is, it is entirely possible to draft an
arbitration procedure that calls for last best offer resolution of the case with the arbitration board
providing a rationale. By contrast, it is hard to imagine that anyone would be satisfied receiving
an “independent opinion” determination that consisted only of a result, without some explanation
of how the board had reached its decision.21
This aspect of the North American Model clearly made someone very uncomfortable, as
it was the focus of multiple questions from Senator Biden.22 It seems fairly clear that the
questioner, as well as the Treasury Department, believed that the issuance of opinions would
create a new body of law, existing outside the domestic law of each State.23 It is possible to infer
from the tone of the questions that the questioner believed that the development of a body of law
would be a good thing.24
The Treasury Department’s answers suggest greater uncertainty about the benefits of
developing a body of law. For example, it conceded that, in certain contentious treaty
relationships, “there could be value to precedential arbitration decisions that play a role in
reducing future disputes in particular subject areas…”25 However, it also noted that it “would
have to give great weight to the concerns of ceding to an arbitration panel the authority to bind
the United States not only to a particular result but also to a particular interpretation and
application of a specific treaty.”26 There is the additional risk of decisions appropriate to one
treaty partner being used by taxpayers in applying other tax treaties; one concern is that that third
country treaty partner would not be bound by the decision.27 Ultimately, though, it appeared that
the question was largely moot, as those countries with which the United States had the most
21
See, however, Paragraph 3 of the Annex to Article 25 of the OECD Model, which suggests just such a possibility.
Although the author has the utmost respect for Vice President Biden, it is assumed that he is, and always has been,
much too busy to become an expert in various forms of arbitration.
23
Hearing Print, p. 65
24
See Hearing Print, p. 65, Question 9a (“Have you considered the option of allowing arbitration boards to provide
reasoned advisory opinions that are strictly advisory, which would not be legally binding on future arbitration
boards, but could nevertheless be considered helpful to competent authorities and taxpayers who want to understand
the thinking of the arbitrators in coming to a decision?”); also Question 9b (“Have you considered whether it would
be useful in the context of some treaty relationships, particularly more contentious ones, to provide the arbitration
board’s decisions with precedential value?”) and Question 9c (“Do you think that a model that provides that the
arbitral tribunal’s decisions shall have ‘no precedential value’ will create the same incentive to settle a case prior to
arbitration as existing examples in which the decisions have precedential value?”)
25
Hearing Print, p. 66.
26
Id.
27
Id.
22
difficult competent authority relationships were also more receptive to the “results only”
approach than to the idea of reasoned opinions.28
The Treasury Department also argued that the benefit of greater transparency “would
come at a significant cost”29 and would be inconsistent with the goal of increasing the efficiency
and effectiveness of the competent authority process. Requiring a rationale likely would cause
delays because members of the arbitration board would have to agree not only on the result, but
also on the reasons underlying the result.30 Because written explanations would create a new
body of law, submissions to the board likely would become lengthier and more time-consuming
to produce.31 Presumably, this is because, if the opinions of the board were to create new law,
then it is reasonable to expect that the submissions to the board would become more like legal
briefs submitted to a court, with the same levels of review within government. To accommodate
this level of review, governments might need more time to prepare their submissions,
undermining one of the rationales for using the mutual agreement procedure rather than
litigating.
Moreover, as the Treasury Department again pointed out, the North American Model is
structured as a continuation of the mutual agreement procedure, albeit with third parties making
the decision because the two governments were unable to reach an agreement through
negotiation. Because “MAP agreements are confidential and in general do not provide a
rationale”32 there seemed to be no compelling reason to provide rationales just because
agreement is reached in a different manner.
It also seems to be something of a fallacy to assume that a competent authority will
change its negotiating strategy only if the arbitrators are issuing reasoned opinions. If a
particular competent authority keeps making the same argument in arbitration after arbitration,
and losing each time, it will eventually stop making that argument because it knows it will gain
nothing, either during negotiations or an eventual arbitration, by making the argument. At some
point, it will understand that it is just wasting time and money. Of course, some countries will
take longer than others to admit defeat.
One additional concern that has emerged in more recent analyses by the Joint Committee
on Taxation is that the arbitration process will become the province of a relatively small group of
practitioners who are “in the know”.33 That seems likely to occur, as it already the case with
respect to the competent authority process itself. It is the nature of confidential proceedings that
only those who are involved know what has happened. This could be avoided only by
publishing opinions, not just having reasoned opinions. However, as the Treasury Department
pointed out, under last best offer, “decisions of previous panels are likely to be of limited value
in resolving a specific dispute, even if they relate to the same subject matter.”34
28
Id.
Hearing Print, p. 65.
30
Id.
31
Id.
32
Id.
33
See, e.g., discussion of mandatory arbitration in the Joint Committee on Taxation Explanation of the Proposed
Protocol to the Income Tax Treaty between the United States and Spain (June 17, 2014).
34
Hearing Print, p. 66.
29
4.
Written Submissions vs. Formal Hearing.
Most arbitration provisions assume that the arbitration board will hold some type of
proceeding at which evidence may be produced. The taxpayer may or may not participate in that
proceeding. If there is such a proceeding, then it will be necessary to decide on rules of evidence
and other procedural matters relating to legal proceedings.
The North American Model further streamlines the arbitration process by eliminating the
proceeding, thus making it possible to hold the parties to the strict timetable described above.
Instead, parties make their arguments and submit evidence only in writing. There is no hearing.
In essence, the North American Model assumes that two years of competent authority
discussions will, at the very least, have served to develop the facts, and all that is left is to reach a
decision. If the arbitrators have questions after reading the written submissions, they can be
submitted and answered in writing.
Accordingly, there is no need to have a physical space for a hearing, no need to find a
convenient date for all of the members of the arbitration board and the competent authorities to
meet for a hearing and no costs incurred in travelling for a hearing. The submissions can be
received by the arbitrators and the competent authorities wherever they happen to be when the
deadlines arrive. While it is possible that the members of the board may decide that they want to
meet to discuss the case, it is understood that in many of the arbitrations that have taken place
under the U.S.-Canada treaty, such discussions have taken place by conference call and the
determinations made quite quickly. The lack of a proceeding also makes it easier to ensure that
the taxpayer’s submission (in those cases in which the taxpayer is allowed to make a submission)
does not include information that was not provided to the competent authorities during the two
years before arbitration begins. This is advisable in order to prevent the taxpayer from gaming
the system by withholding information in order to surprise the tax authorities during the
arbitration process.
5.
Taxpayers’ Rights
While the decision of the arbitration board is binding on the competent authorities, the
taxpayer actually can opt out at any time. This also seemed to be mystifying to those more
familiar with traditional arbitrations.
The Treasury Department noted that this is completely consistent with the concept
underlying the North American Model, which is to enhance the mutual agreement procedure, not
replace it. A taxpayer can rescind its request for competent authority assistance at any time. As
the arbitration is simply a way to ensure that the mutual agreement process in fact results in an
agreement, the taxpayer also can opt out of the arbitration, even after a decision is reached.
According to the Treasury Department, the “arbitration process is not meant to limit in any way
the rights of the taxpayer to reject a MAP agreement and pursue remedies in court. 35 On the
other hand, it seems that the ability of the taxpayer to reject the results of the arbitration provides
35
Hearing Print, p. 68.
some leeway to be less legalistic in terms of establishing rules of procedure for use by arbitration
boards.36
After considering several treaties that included the North American Model, the Senate
Foreign Relations Committee insisted that future versions of the provision be changed in certain
ways that tend to protect the interest of taxpayers. For example, early versions did not allow the
taxpayer to submit a position paper because such a paper likely would be duplicative of the
position taken by one of the competent authorities. Later versions now allow the taxpayer to
submit such a position paper. None of these changes affects the fundamental way in which the
provision operates.
IV.
CONCLUSION
After considering and rejecting traditional, legalistic approaches to arbitration of tax
treaty disputes, the United States invested considerable time, energy and political capital into
developing a new model for arbitration. The intention was to ensure the efficient and effective
resolution of all cases (not only those that are decided through arbitration) by improving the
overall functioning of the relevant competent authority relationships. While changing some
details of the model would not change its fundamental character, there are a handful of key
decisions that are dependent on each other. As a result, the success of this approach depends on
adopting all of the provisions, rather than simply picking and choosing among a series of
options.
36
Hearing Print, p. 69.