Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, July 2008
Where a taxpayer considers that the assessing actions of one of the Contracting States to the Canada-U.S. Income Tax Convention (the Treaty) will result in double taxation, the taxpayer may present its case to the competent authority of the Contracting State of which the taxpayer is a resident. This triggers a process under which the competent authorities of the two states must endeavour to reach a resolution of the issue that is mutually acceptable to both competent authorities. The basic principles that govern this process are set out in Article XXVI – Mutual Agreement Procedure, commonly known as "MAP," and in Article IX. This provision also governs cases submitted for an Advance Pricing Agreement, which the governments undertake as competent authorities.
Prior to the Fifth Protocol to the Treaty (the Protocol), there has not been any satisfactory mechanism for resolving situations where the competent authorities were unable to reach a mutual agreement under the MAP. The Protocol amends the MAP to introduce mandatory arbitration in order to ensure timely resolution of MAP cases, as was emphasized in the introduction of the Protocol to the Foreign Relations Committee of the U.S. Senate by the Deputy Chief of Staff of the Joint Committee on Taxation (emphasis added):
"[U]nresolved competent authority proceedings appear to be a multinational occurrence. As a general matter, it is beneficial to resolve tax disputes effectively and efficiently. The new arbitration procedures included in the proposed protocol are intended to ensure that the mutual agreement procedures occur pursuant to a schedule and that all cases are resolved within a limited time period.
We understand that there are a significant number of competent authority cases pending between the U.S. and Canada, and that, historically, a substantial number of double taxation cases have not been satisfactorily resolved by the U.S. and Canadian competent authorities... While many expect that the proposed mandatory and binding arbitration procedures will be successful in resolving recurring issues and will encourage the competent authorities to settle cases without resort to arbitration, it will take time to ascertain if these procedures are effective or if unexpected problems arise."
The form of arbitration introduced by the Protocol is so-called "baseball" or "last best offer" arbitration whereby each of the two competent authorities provides a proposed resolution to an arbitration panel. The arbitration panel is then restricted to choosing between one of the two proposed resolutions. The benefits that the Treaty negotiators hoped to achieve from the last best offer method of arbitration was also addressed in the introductory comment of the Deputy Chief of Staff of the Joint Committee on Taxation, as follows:
"The last best offer approach is intended to induce the competent authorities to moderate their positions, including before arbitration proceedings would commence, and this to increase the possibility of a negotiated settlement."
Many of the important details with respect to the procedure governing an arbitration proceeding are set out in the exchange of notes attached as Annex A to the Protocol (the Arbitration Note). Paragraph 11 of the Arbitration Note provides that, unless any concerned person (essentially any taxpayer affected by the determination in either Contracting State) does not accept the decision of the arbitration board, the determination of the board constitutes a resolution by mutual agreement under Article XXVI of the Treaty and, consequently, is binding on both Contracting States. Each concerned person must, within 30 days of receiving the determination from the competent authority to which the case was first presented, advise that competent authority whether the person accepts the determination. The failure to advise the competent authority within the requisite time is considered a rejection of the determination.
There are three conditions that must be met before arbitration commences. The first condition is that tax returns have been filed either in the U.S. or Canada with respect to the tax years in issue. The second is that the case is not one that the competent authorities both agree, before the date on which arbitration proceedings would otherwise begin, is not suitable for arbitration. The third is that the taxpayer and all other "concerned persons" whose tax liability would be directly affected by the arbitration, as well as their advisers, agree to keep confidential all information received from the competent authorities and the arbitration board, other than the determination of the board. The latter condition effectively provides the affected taxpayers with a veto over whether arbitration is commenced by the competent authorities.
Where the competent authorities are unable to reach agreement, and subject to the taxpayer providing the requisite promise of confidentiality, arbitration proceedings are to begin two years after the "commencement date" unless the competent authorities have each previously agreed to a different date. For these purposes the "commencement date" is defined as the earliest date on which the competent authorities have both received the information necessary to undertake substantive consideration for a mutual agreement. The Arbitration Note sets out (and the Technical Explanation (TE) echoes) the information required by the competent authorities, including cases that were initially submitted to the competent authorities as a request for an Advance Pricing Agreement, as follows:
"In the case of the U.S., this information is (i) the information that must be submitted to the U.S. competent authority under Section 4.05 of Rev. Proc. 2006-54, 2006-49 I.R.B. 1035 (or any applicable successor publication), and (ii) for cases initially submitted as a request for an Advance Pricing Agreement, the information that must be submitted to the Internal Revenue Service under Rev. Proc. 2006-9, 2006-2 I.R.B. 278 (or any applicable successor publication). In the case of Canada, this information is the information required to be submitted to the Canadian competent authority under Information Circular 71-17 (or any applicable successor publication)."
The new arbitration provision is available for cases already under consideration by the competent authorities under the MAP article, as well as new cases arising after the date of the Protocol. The TE clarifies that for such cases, the "commencement date" that starts the two-year clock for the submission of an existing case to arbitration is the date on which the Protocol enters into force. However, by mutual agreement, the competent authorities can waive the two-year wait and move existing cases to arbitration on a faster timeline. In this regard, it is notable that the TE states that "the competent authorities are encouraged to develop and implement procedures for arbitration by January 1, 2009, and begin scheduling arbitration of otherwise unresolvable MAP cases in inventory (and meeting agreed criteria) prior to the two years from entry into force."
In addition to the conditions described above, arbitration is only available in cases that involve the application of those articles of the Treaty that the competent authorities have agreed upon by exchange of notes. In the Arbitration Note, Canada and the U.S. agree that arbitration should apply to the application of the provisions of the Treaty in respect of the residence of an individual, the existence of a permanent establishment, the attribution of business profits to a permanent establishment, transfer-pricing adjustments, and the apportionment of royalties to exempt and taxable amounts, along with other provisions that the competent authorities may agree to in the future. The competent authorities may agree that a particular case is not suitable for arbitration, but must do so before the arbitration proceeding for that case begins. It is expected that transfer-pricing adjustments levied by one of the countries against a taxpayer or a related party will be the most common subject of contentious disputes that result in arbitration.
The Arbitration Note and the TE each provide that the determination reached by an arbitration board shall be limited to a determination regarding the amount of income, expense or tax reportable to the Contracting States. The treatment of any associated interest or penalties shall be determined by applicable domestic law of the Contracting States. Further, although the determination of the arbitration board in a particular case shall be binding on the Contracting States in that case, it shall not state a rationale and shall have no precedential value.
The Arbitration Note provides that that the arbitration board must apply the following authorities in making its determination: (a) the provisions of the Treaty; (b) any agreed commentaries or explanations of Canada and the U.S. concerning the Treaty (presumably including the TE); (c) the laws of the U.S. and Canada to the extent they do not conflict; and (d) relevant OECD Commentary, Guidelines or Reports reporting relevant analogous portions of OECD Model Tax Convention.
The competent authorities are permitted to resolve the case by mutual agreement while it is before the arbitration board and thereby terminate the arbitration proceeding. Indeed, it is likely that the fact the entire position of one of the competent authorities will be rejected in its entirety by the arbitration panel will be a compelling influence on the two governments to come to a negotiated settlement either before arbitration begins or after the submission of proposed resolutions to the board, but before its final determination. In addition, the taxpayer may withdraw the request for competent authority relief under the MAP, which has the effect of terminating the arbitration proceeding.
Each arbitration board will consist of three members, one appointed by each Contracting State within sixty days of the commencement of the arbitration and the third (who serves as chair) appointed by agreement of the other two members. Both Canada and the U.S. agree to develop a non-exclusive list of individuals with familiarity in international tax matters who may potentially serve as the chair of the board. The TE states that it is agreed that the third member ordinarily should not be a citizen of either Canada or the U.S. The Arbitration Note provides that if the third member is not agreed to within a further 60 days, a Contracting State shall ask the highest ranking member of the Secretariat at the Centre for Tax Policy and Administration of the OECD who is not a citizen of either Contracting State, to appoint the chair.
Once the chair of the arbitration board is in place, each Contracting State has 60 days to submit its position in writing and a further 60 days to submit a written response to the position of the other Contracting State. If a state fails to make an initial submission within the deadline, the position of the other state is taken as binding. The arbitration board is granted the authority to adopt any procedures necessary for the conduct of its business, provided that the procedures are not inconsistent with the MAP set out in the Treaty or the exchange of notes. The arbitration board must deliver its determination in writing within six months of the appointment of its chair.
The strict timelines established by, and the initial procedural matters agreed upon in, the Arbitration Note accompanying the Protocol are an encouraging first step in the establishment of a system for the efficient resolution of contentious issues involving Canadian taxpayers and related parties in the U.S. However, in practice, there may be numerous taxpayers with disputes that have already been subject to the MAP process for well in excess of the two years required for arbitration to commence. It will be equally critical that Canada and the U.S. swiftly devote sufficient resources to the process, move to identify potential arbitrators and develop any requisite additional procedural rules in order to ensure that arbitration in fact operates as a viable alternative for resolving disputes in a timely manner.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.