Caterpillar v Comm'r and the Rule of Law in International Tax

James P. Fuller has an interesting summary of the recently-filed Caterpillar case in his latest U.S. Tax Review [gated], in which he laments the competent authority breakdown and argues that the case would have been better off going to treaty-based arbitration, rather than to domestic judicial decision-making channels. I disagree with this conclusion because, given the structure of tax treaty arbitration today, it would--at best--provide a remedy for only one taxpayer at great cost, while the judicial route potentially creates rule of law upon which all can rely. If competent authority arbitration were instead to create a publicly viewable resolution, I could agree with Fuller because what is needed is (1) a multilateral solution to a multilateral problem and (2) a solution with precedent-making force.

Per Fuller:

Caterpillar Inc. has petitioned the Tax Court for a redetermination of income tax deficiencies that resulted from the IRS's allocation of royalty income to it from its Belgium and French subsidiaries. 

While the case was only recently docketed and has not yet been decided, I thought it worth discussing the case as it results from a breakdown in the competent authority process. It is, of course, the very process that is designed to prevent the consequences faced by Caterpillar. There should be no need for the taxpayer to litigate in one country or the other when treaty relief is an available remedy and the countries involved can settle the issue between themselves. 

Following a 1990 reorganization that pushed management power, responsibility, and accountability to subsidiaries such as Caterpillar Belgium and Caterpillar France, the taxpayer entered into amended license agreements with those subsidiaries limiting the maximum royalty in any given year to each subsidiary's net income from the sale of Caterpillar products. Also, if the subsidiary suffered a post-effective-date net operating loss, it would pay no royalty for that year and could carry the loss forward as a negative adjustment to future years' income for purposes of the royalty calculation. 

... The IRS ... concluded that the relief-from-royalty provision in the Belgian and French license agreements did not comport with the arm's-length standard under section 482.

 Fuller points out that there are "several Tax Court cases that permitted related-party license agreement provisions" like Caterpillar's, and as to which the IRS subsequently acquiesced. He goes on to discuss Caterpillar's attempt to obtain competent authority relief, which failed because the French and Belgian tax authorities disagreed with the US position, and US Appeals simply went along with the IRS decision despite these other rulings that would suggest reconsidering the issue, for litigation hazard purposes at minimum:

The Belgian and French tax authorities, having a thorough knowledge of the local operations of the Caterpillar subsidiaries in their respective countries, looked at the same facts that were addressed by the IRS exam team and found that Caterpillar's royalty limitation provision required no adjustment. Caterpillar subsequently had the adjustment reviewed in an IRS Appeals office proceeding. The IRS Appeals officer simply accepted the IRS exam team's economist's report. 

...it appears from Caterpillar's Tax Court petition that the IRS exam team's economist simply used that agreement as grounds for asserting that such a relief-from-royalties' provision is inappropriate, and not at arm's length.

Fuller notes the dual-bureaucracy created by two simultaneous review procedures, i.e., competent authority and internal appeals, and concludes that binding arbitration of the competent authority procedure, rather than resort to the US judiciary, would have been the better approach:

If the two countries' competent authority negotiators cannot reach an agreement, then there should be some form of compelled arbitration to bring about an agreement. Otherwise, the taxpayer is stuck in the middle. A taxpayer should not have to litigate its case in one country or the other (or both) simply because the U.S. competent authority negotiators could not reach an agreement with the foreign country's competent authority negotiators. This is especially true in a situation such as that faced by Caterpillar: The Tax Court has already held that such provisions are appropriate in related-party license agreements.

I appreciate Fuller's argument about the taxpayer's bind, but as I have noted before, if the case went the way of binding arbitration, in the long run the issue could potentially never be settled, since the decision in arbitration would be completely confidential and therefore not accessible or applicable to other taxpayers. That makes international tax dispute resolution much more expensive than it has to be, all because the powers that be have prioritized absolute taxpayer confidentiality over the rule of law. I think that is a miserable trade-off as well as being an unnecessary one: as this case shows, the taxpayer is willing to sacrifice some measure of its own confidentiality in order to get resolution in domestic law, so it is not clear why international law should be so different. (The arguments for difference are weak--see my analysis in the link above.)

The competent authority route, which (by being duplicative as in this case) already increases costs for producing the rule of law, would only be exacerbated by arbitration, because Caterpillar's problem would be perfectly preserved for another day, another taxpayer, and another expensive litigation involving multiple parties and governments.

Therein lies the conundrum for international tax law in the current status quo: either we can get taxpayer-specific outcomes but no rule of law (arbitration) or we can get unilateral rule of law but no international resolution (domestic appeals). I am not sure which to prefer, since both are bad for international tax law.

Accordingly, I am glad to see the Caterpillar case go forward in a forum which is open to public view and that, if not settled in the interim, then becomes a part of the body of law, creating more certainty for taxpayers going forward. However, I am unhappy that the forum is unilateral and potentially preserves an unsolvable problem for the taxpayer if the Court agrees with the US position, since France and Belgium will not be consulted in the process and can be expected to continue to disagree with the IRS view of things.

As a result, I can only agree with Fuller that the better route would be bilateral/multilateral decision-making via arbitration if that decision-making is, like internal judicial decision-making, open and accessible to public view.

Another paper on arbitration-as-law

There seems to be a surge of articles on arbitration-as-law lately: the latest, Judging Lite: How Arbitrators Use and Create Precedent, involves empirical research involving hundreds of US arbitration award records, and it provides some interesting insights.  The article was reviewed on jotwell, excerpt:

...The criticisms include the concern that widespread arbitration mandates will lead to a privatization of public law, with arbitrators that are not bound by public law authorities producing awards of no precedential value. 

...Mark Weidemaier worked from [various databases of arbitration awards].  He analyzed these awards to gauge the extent to which arbitrators cited and engaged with precedent. 

Weidemaier, not surprisingly, found very little citation to precedent in securities awards because reasoned opinions accompanying those awards are extremely rare.  Among labor awards, 48.6% cited to at least one precedent, as did 66.7% of employment awards, and 71.8% of class action awards. 

...Weidemaier attributed the differences in types of authorities cited to the different nature of each type of arbitration.  Labor arbitration is concerned predominantly with interpreting and applying collective bargaining agreements and is frequently fact-based, making it more likely that arbitrators will not cite any precedent and more likely that when they do cite precedent, it will be other arbitration awards.  Employment awards are much more likely to be adjudicating statutory claims, resulting in arbitrators looking to judicial authority interpreting the statute.  Arbitral authority is far less relevant.  Class awards look more to judicial authority but many deal with whether class arbitration is permitted under the contract and, consequently, in Weidemaier’s view, they are more likely than employment awards to look to arbitral awards interpreting similar contracts.

... Candidly acknowledging many limitations to his study, Weidemaier found no evidence outside of securities arbitration that arbitrators were deciding cases in an ad hoc fashion.  Rather, he noted, the process has become highly legalized and arbitrators appear to be trying to follow the public law when it is at issue before them.  ... he suggests that judges discuss arbitral authority in their opinions, thereby providing valuable feedback to the arbitrator community.

Jotwell reviewer Martin Malin calls Weidermaier's article "required reading for all participants in the on-going debate over arbitration mandates." You can read his whole review here.

WTO overwhelmed with disputes

Simon Lester notes a deluge of cases: "they keep coming, and it may be starting to strain the WTO's resources." He cites this report from Reuters:

The WTO's 157 members have launched 26 trade disputes so far in 2012, the most since 2003 and three times more than the eight new complaints filed in 2011. 

According to an internal WTO document seen by Reuters, the WTO decided to reallocate staff to the disputes team to deal with the increasing number and complexity of legal cases....

As well as moving staff, the trade body also advertised for a senior dispute settlement lawyer, at a starting salary of around 161,900 Swiss francs ($175,300), and is seeking short term candidates to help deal with the caseload.

Interesting development, especially against the backdrop of increased scrutiny and questions about the legal nature of these decisions.

If arbitration acts like law, it should act like law

A paper recently posted on SSRN says investment treaty arbitration tribunals are facing pressure to conform to legal review standards since they are recognized as performing law-like functions. Required reading for anyone who wants to think about arbitration in tax treaties.

Anthea Roberts, The Next Battleground: Standards of Review in Investment Treaty Arbitration. Abstract:

We are witnessing growing calls by States, academics and NGOs for investment arbitral tribunals to recognize that they are engaged in a form of international judicial review and thus should adopt appropriate levels of deference when reviewing the legislative, executive and judicial acts of respondent States. Some draw on domestic public law comparisons, arguing that tribunals should adopt deferential standards of review when adjudicating upon governmental conduct. Others rely on international comparisons, invoking notions such as the margin of appreciation doctrine that some international courts adopt when reviewing State actions for conformity with international obligations. Whether and when investment treaty tribunals should adopt deferential standards of review represents the next battleground for those who conceptualize investment treaty arbitration as a form of global governance.

Are WTO dispute settlements "Law"?

From Simon Lester, yet another reminder for those studying tax treaty arbitration that the issues are many and difficult. When basic questions of enforceability can't be answered in an area of the law where things are fairly well developed and are subject to ongoing extensive public vetting and debate, it serves as a warning of what lies ahead for international tax dispute resolution. From the post:

There is some famous scholarly debate on whether WTO dispute settlement rulings are binding.  Here's a media take on it, from the CBC news (in the context of the Ontario feed-in-tariff case):  The World Trade Organization appears to have upheld a [discrimination] complaint against the Province of Ontario's green energy program. ...reports Monday suggest the affected parties have been notified of the [WTO]'s decision to side with the complainants...The WTO ruling is non-binding, meaning Ontario could simply ignore it and not face any monetary punishment. But such a move would likely be met with the implementation of tariffs against any Ontario-made goods in Japan and the EU.

Simon thinks the word "binding" does not tell us much if retaliatory tariffs could be imposed in the event Ontario ignored the ruling. Instead, he says "the key question is how effective the enforcement mechanism is."

I'd agree-it's equivalent to the maxim that "tax administration is tax policy." In international tax there is no doubt that the question is not the substance of standards, rules, or even norms, but rather what countries actually do, and that happens daily through hundreds and maybe thousands of completely opaque diplomatic interactions (competent authority agreements). Adding arbitration to this mix adds yet another layer of administration and enforcement mechanisms and all the attendant problems that go along with them.