Cooperative and preventive programmes: the panacea to TP controversy?

The proliferation of transfer pricing audits and related controversy has significantly contributed to tax uncertainty for multinational enterprises (MNEs) in recent years. This article examines the impact of traditional double tax resolution remedies and cooperative and preventive programmes on the tax certainty agenda and their interaction with domestic transfer pricing audits, and provides suggestions for improvement at a time of unprecedented change in the wider international tax framework.

In recent years, transfer pricing issues have become one of the main subjects of tax litigation involving MNEs and tax administrations, if not the primary one. In addition, given the length of time it can take to complete transfer pricing interventions, it is common that tax administrations will seek to regularise issues identified in periods outside the scope of the original intervention. This has the effect of prolonging the tax controversy life cycle.

Not only has the volume and intensity of transfer pricing disputes increased, the way they are conducted has also evolved. Given the scarcity of available resources, tax administrations seek efficiency through technology solutions and the adoption of risk assessment procedures to focus on the greatest areas of tax risks. This risk-based approach has opened the door to new forms of cooperative and preventive programmes between tax administrations and taxpayers. These programmes add to an already complex web of interactions that MNEs are required to navigate when managing traditional dispute resolution mechanisms and controlling costly transfer pricing controversies.

Where an MNE is hit with a tax assessment in respect of a transfer pricing issue, there are two traditional routes to reduce or eliminate double taxation: apply for a domestic appeal procedure and/or apply for a mutual agreement procedure (MAP).

In most countries, it can take a very long time before all the judicial appeal mechanisms are fully exhausted. Furthermore, given the specialist nature of transfer pricing and the complexities involved, the outcome of this process can be fraught with uncertainty, and contradictory outcomes in different countries are not uncommon.

Given these uncertainties, MAPs have become increasingly popular in recent years. Where an arbitration clause exists in the relevant double taxation agreement, the elimination of double taxation will be guaranteed, although the profit outcome will be uncertain until final resolution. Resolution times, in general, are also much shorter than domestic appeals procedures.

However, considerable time and resources will inevitably be expended on the part of MNEs and tax administrations before resolution can be achieved. As such, preventive measures to avoid double taxation disputes in the first instance should be the objective of tax administrations and taxpayers.

While the resolution of a MAP does not generally set a precedent or bind the tax administrations involved outside the years within scope of the procedure, there may exist opportunities for future legal certainty through advance pricing agreements (APAs), taking advantage of the knowledge gained by the competent authorities in reviewing the MNE’s intragroup arrangements and transfer pricing model during the MAP process.

APAs are instruments through which tax administrations partially or fully validate a taxpayer’s transfer pricing model prior to the execution of related-party transactions. In many countries, APAs may also be applied retroactively where the tax administrations are willing to roll back the outcome of an APA to prior periods. The main benefit of an APA is the attainment of legal certainty (full certainty in the case of a bilateral or multilateral APA, or limited certainty in the case of a unilateral APA). However, tax administrations are overwhelmed by the growing number of APA requests and are struggling to provide sufficient resources to meet the demand.

The main consequence of these resource constraints is a delay in the processing of APAs, which sometimes leads to undesired outcomes. For example, the initiation of a domestic tax audit covering periods and issues that are the subject of an APA in progress has, in some instances, led to the suspension of the APA in favour of a domestic inspection procedure. This has the effect of nullifying part of the advantages of an APA (e.g., early resolution of disputes and an enhanced atmosphere of cooperation). A possible solution could come from the incorporation of regulations allowing for the suspension of domestic tax audit procedures where there is agreement between the tax administration(s) and affected taxpayer(s).

The ideal starting point for an APA is where there is no ongoing dispute between a taxpayer and tax administrations in respect of the relevant transaction(s). An agreed settlement position following the resolution of a tax audit may also represent a useful starting point for a future APA.

Being conscious of the need for more effective and efficient ways of avoiding and preventing double taxation, international organisations, particularly the OECD and the European Commission (EC), are promoting alternatives to the traditional dispute resolution mechanisms. Multilateral risk assessment programmes and joint audits are examples of recent cooperative and preventive programmes.

Dispute prevention focuses on early intervention to avoid potential conflicts. Most transfer pricing audits originate following an assessment of transfer pricing risks by tax authorities. Effective risk assessment processes are important for tax administrations (and taxpayers) as they ensure resources are being efficiently utilised and targeted at the right areas.

The OECD has developed the International Compliance Assurance Programme (ICAP) to promote tax assurance. The EC has also introduced a similar programme known as the European Trust and Cooperation Approach (ETACA), which is available for EU-headquartered MNEs. ICAP and ETACA are multilateral cross-border risk assessment programmes that are voluntary for tax administrations and MNE groups. They aim to facilitate open and cooperative multilateral engagements between MNE groups and tax administrations, with the aim of ultimately preventing unnecessary disputes.

Unlike traditional risk assessment procedures, MNEs have an important voice in ICAP and ETACA, and can assist tax administrations in understanding intragroup transactions when assessing risks. In addition, discussions between the relevant tax administrations can help in improving the consistency and interpretation of risk assessment processes.

Transactions covered in an ICAP and ETACA risk assessment will be classified as low risk (providing comfort but not legal certainty), or where the tax administrations cannot conclude on a low-risk outcome, the risk assessment will be classified as not low risk. ICAP also has an issue resolution mechanism whereby matters identified in the risk assessment may be resolved (e.g., jurisdictions may agree to transfer pricing adjustments and corresponding adjustments). However, this mechanism will depend on the legal framework in the jurisdictions of the relevant tax administrations involved.

In January 2024, the OECD released statistics from the 20 ICAP cases completed as of October 2023, involving 22 participating tax administrations. Some encouraging statistics include an average time of 61 weeks from the start of the ICAP process to the issuing of a risk assessment outcome. In addition, 80% of the MNEs taking part received only low-risk outcomes in all the main covered risk areas or a mix of low-risk and not low-risk outcomes in just one or two of these risk areas. Furthermore, in approximately a third of cases, at least one issue identified during a risk assessment was addressed within the ICAP process, avoiding an audit and a MAP.

However, these programmes are still very much at an embryonic stage. Participating tax authorities may naturally be attracted to these programmes as they can operate without binding their administration on any underlying issues or risks assessed. That said, a lack of available resources means that the number of cases per country can still be counted on one hand. Many MNEs also remain unconvinced that these programmes can offer sufficient reciprocal benefits commensurate with the investment of resources and transparency required and may be put off by a lack of legal certainty in comparison with APAs. Nevertheless, these programmes represent an innovative and progressive approach to dispute prevention and will be attractive to cooperative MNEs with a strong ethos of voluntary compliance.

Participating tax administrations should look to ensure that any best practices and learnings from operating within ICAP and/or ETACA can be incorporated into domestic risk assessment procedures where appropriate and applied consistently. There may also be scope for some tax administrations to develop more cooperative approaches to risk assessment with MNE groups before cases are escalated to audit.

The OECD and EC have attempted to enhance cooperation between tax administrations through joint or simultaneous audit mechanisms. In 2019, the FTA published a report on joint audits that made several recommendations on best practices in joint audits between different jurisdictions. The Multilateral Convention on Mutual Administrative Assistance in Tax Matters also provides a legal basis for cross-border multilateral interventions outside the EU. At an EU level, the DAC7 Directive (Council Directive 2011/16/EU on administrative cooperation in the field of taxation, as amended by Council Directive (EU) 2021/514 of 22 March 2021) provides an additional legal basis for joint audits with other EU member states from January 1 2024.

In theory, joint and simultaneous audits may streamline the number of individual unilateral audits and secure a consistent and coordinated approach among the tax administrations involved, leading to increased efficiencies for MNE groups and tax administrations. They may also provide opportunities to resolve issues or streamline the number of issues for MAPs.

In this regard, paragraph 4 of Article 12a of DAC7 reads as follows: “Where competent authorities of two or more Member States conduct a joint audit, they shall endeavour to agree on the facts and circumstances relevant to the joint audit and endeavour to reach an agreement on the tax position of the audited person(s) based on the results of the joint audit. The findings of the joint audit shall be incorporated in a final report. Issues on which the competent authorities agree shall be reflected in the final report and be taken into account in the relevant instruments issued by the competent authorities of the participating Member States following that joint audit.”

While DAC7 has introduced a more defined legal basis for joint audits between EU member states, the underlying governing processes and procedures on how auditors should conduct joint audits on a cross-border basis remain limited. Joint and simultaneous audits rely heavily on the ability of lead tax administrations to effectively coordinate audit procedures in an efficient manner. In certain instances, there is a danger that poor communication and coordination may increase the complexity of disputes and result in certain jurisdictions falling back on to unilateral actions. As such, further work will likely be needed to support how jurisdictions interact with each other during joints audits to increase their effectiveness.

While some tax administrations have shown an openness to multilateral activities (e.g., Germany, the Netherlands, and the Nordic states), other jurisdictions are still likely to remain sceptical of the benefits and feel they can achieve better results on a unilateral basis. Others may only be interested in taking part if the issue represents a risk to the tax base in their jurisdiction and may decline joint audits for risks perceived in the counterparty jurisdiction.

The current controversy environment encourages tax administrations and taxpayers to interact differently based on principles of risk assessment, cooperation, and prevention. MNEs need to develop holistic and bespoke strategies based on these principles to navigate a complex web of interactions that exists in managing traditional dispute resolution mechanisms and controlling costly transfer pricing controversies.

While there have undoubtedly been enhancements made to existing cooperative and preventive programmes in recent years, further improvements are required to progress the tax certainty agenda. In this regard, a change in mindset from tax administrations and taxpayers may be just as important as procedural developments in certain instances.

Perhaps cooperative and preventive mechanisms are not currently a panacea for all transfer pricing controversy but provide a foundation for a more efficient tax strategy based on tax certainty. It will also be important for the OECD to consider key learnings when developing dispute prevention and resolution mechanisms for the two-pillar solution.

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