Rosenbloom, H. David

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Sovereignty and the Regulation of International Business in the Tax Area

Case Western Reserve University School of Law

Canada-United States Law JournalVolume 20 | Issue Article 30January 1994Sovereignty and the Regulation of InternationalBusiness in the Tax AreaH. David RosenbloomFollow this and additional works at: https://scholarlycommons.law.case.edu/cusljPart of the Transnational Law CommonsThis Speech is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law Scholarly Commons.It has been accepted for inclusion in Canada-United States Law Journal by an authorized administrator of Case Western Reserve University School ofLaw Scholarly Commons.Recommended CitationH. David Rosenbloom, Sovereignty and the Regulation of International Business in the Tax Area, 20 Can.-U.S. L.J. 267 (1994)Available at: https://scholarlycommons.law.case.edu/cuslj/vol20/iss/30Sovereignty and the Regulation of International Business in theTax AreaH. David Rosenbloom*It is a great pleasure to return here to Cleveland and to the Institute. Ialways particularly enjoy conferences that deal with a variety of legalareas, of which tax is but one, because I know I can safely start byobserving that whatever you have heard about other subjects over thepast day or so, and whatever you will hear for the next day or so, arecompletely divorced from this area of law. Tax people live in their owncocoon. I am going to try today to make some generalizations about theissues we face, and their relationship to sovereignty, and I will try toavoid being too technical.There is a tremendous history of international cooperation in thetax area - probably greater than in any other legal area. The currentrules and principles, which enjoy a remarkable level of internationalagreement, trace back directly to work done by the League of Nationsin the 1920s. There are several modern institutions that have broughtthese principles forward, among which the Organisation for EconomicCooperation and Development in Paris is preeminent. The OECDCommittee on Fiscal Affairs does a fine job of maintaining a high levelof international understanding in the tax area. So we have long-stand-ing institutions. We have a long history of cooperation. We have manyunique things in the tax area that bear on today's topic.On the other hand, the short-term outlook is for some fairly pain-ful conflict, which is likely to mean dollars-and-cents cost to cross-bor-der investment. I do not think anyone knows quite what to do about it.Nor am I confident that anyone in a position to do anything is givingsufficient thought to the potential for that conflict.Let me explain. No area of law is closer to the subject of sover-eignty than taxation. When the Soviet Union imploded several yearsago, and the world was faced with fifteen or so newly independent ju-risdictions, one of the first manifestations on the world scene, if not inthe world press, was the development of fifteen new tax systems. Therestill exists a state of considerable tax-related activity in many of thosecountries, accompanied by tax treaty negotiations on an impressivescale. And there is a great deal of international work being done insupport of these developments.* Attorney specializing in international tax matters, Caplin & Drysdale. The following textwas compiled from the transcript of the remarks made by Mr. Rosenbloom at the Conference.2671Rosenbloom: Sovereignty and the Regulation of International Business in the TPublished by Case Western Reserve University School of Law Scholarly Commons, 1994CANADA-UNITED STATES LAW JOURNALDespite the worldwide consensus on the principles of internationaltaxation, it is fair to say that nations are quite reluctant to surrendertheir autonomy in this area. Other legal areas could be cited, but feel-ings seem to be more extreme in the tax area. Evidence for this state-ment can be found in many quarters. For example, common law coun-tries, such as both the United States and Canada, are unwilling toenforce the tax judgments of other countries in their courts, even whenthey stand prepared to enforce other kinds of judgments. In a modern,interconnected world this unwillingness borders on the inexplicable.The Organization for Economic Cooperation and Development hasbeen a godfather, if you will, to the development of a network of fourto five hundred tax treaties throughout the world, published in numer-ous volumes by the International Bureau of Fiscal Development in Am-sterdam. However, the OECD has been unsuccessful in translatingthese bilateral agreements into anything resembling a multilateraltreaty. Although there is near unanimity at the level of principle, inpractice and administration it is virtually impossible to pass beyond thebilateral level. I do not believe anyone knowledgeable about the taxarea would suggest that we are likely to see anything resemblingGATT or NAFTA ih this area any time soon. We are only barely ableto cope with the network of agreements that presently exist.Most international tax conventions, commonly called tax treaties,establish a dispute resolution mechanism, the Mutual Agreement Pro-cedure. Some of us think that is the heart of a tax treaty, and thateverything else is just guidance on how particularized disputes shouldbe resolved. A taxpayer, of course, is concerned about how its case willbe concluded, not general principles. So the Mutual Agreement Proce-dure is a very important aspect of the tax treaty network. Each taxtreaty has a provision defining the Mutual Agreement Procedure, bywhich representatives of the two countries, the competent authorities,are authorized to sort out disputes.There has been considerable debate in recent years about whethercountries will accept an arbitration mechanism in the Mutual Agree-ment Procedure. And there has been extreme reluctance on the part ofmost countries, particularly the United States, to do that in a meaning-ful way. There have been some small moves in the direction of arbitra-tion in the recent U.S. treaties with the Netherlands and Germany but,by and large, the United States (like most other countries) has insistedon retaining its autonomy in the tax area.As a final example of the degree to which countries insist uponsovereignty in tax matters, I would point to the problems and issuesthat have arisen within the United States, where states have invokedtheir freedom under the Constitution to develop their own tax systemsvirtually without constraints from the federal government. According tomy understanding, the same phenomenon is also found in Canada. In[Vol. 20:267 19942Canada-United States Law Journal, Vol. 20 [1994], Iss. , Art. 30https://scholarlycommons.law.case.edu/cuslj/vol20/iss/30Rosenbloom-SOVEREIGNTY AND THE TAX AREAfact, one of the things we were able to agree on in negotiating the U.S.-Canada Tax Treaty was that neither country had an appetite for put-ting constraints on its subnational jurisdictions.So there is considerable evidence, I think, that tax and sovereigntygo hand in hand. At the same time, I do not have to remind this groupthat developments in international commerce are placing unprece-dented strains upon national tax systems, as well as the network of bi-lateral tax agreements. And nowhere is that issue any sharper than inthe area generally referred to as "transfer pricing." Contrary to whatsome have implied, transfer pricing is not an inherently evil thing. It isnot something we should wish to do away with, much less somethingthat we can do away with. Transfer pricing refers simply to the factthat related parties transferring value, that is to say goods and services,between them must set a price. The price they set is called the transferprice. It is the price at which the value is transferred. There is nothingobjectionable about that and, in fact, transfer pricing is inevitable in aworld of separate legal entities under common control. However, therehas been a growing and very sharp focus in the last ten years or so ontesting the prices set by controlled parties against an objective stan-dard. That is the heart of the current international tax conflict. It is notthe only manifestation of such conflict, but it is one good example ofwhere we may be headed for some real problems.Most countries, of course, police the price at which their taxpayersbuy from or sell to related parties, and most countries of the world doso with a view to preventing abuse. They take a fairly tolerant attitudeof the relationship between parties under common control. They willstep in to adjust prices, but only when things are badly out of harmony.That has not, however, been the approach of the United States. Insteadof viewing transfer pricing as an area where rules are needed for thepurpose of preventing egregious practices, the United States has in-creasingly taken the position that a set of rules can be developed thatwill yield the "right" answer in any given case.Perhaps I evince some slight professional bias in suggesting thatthis tendency has been prompted by the economics profession, whichseems to believe that right answers are achievable in individual cases.The result has been a stream of new rules in the United States thatincreasingly define economic responses, economic approaches, to testingtransfer prices between related parties under the "arm's-length"method.Within the borders of the United States, the debate is not of anypractical importance because most related companies - and we are, ofcourse, talking mostly about corporate taxation here - file consoli-dated returns. Therefore, within our borders the increasing sophistica-tion of the transfer pricing rules has relatively little import, becauseone company's deduction is another's income. It all washes out when a3Rosenbloom: Sovereignty and the Regulation of International Business in the TPublished by Case Western Reserve University School of Law Scholarly Commons, 1994CANADA-UNITED STATES LAW JOURNALreturn is filed covering all companies in the affiliated group.However, foreign related parties are not included in consolidatedtax returns. They appear in consolidated financial reporting, but not inconsolidated tax reporting. And so, transactions between related partiesthat cross borders do implicate the transfer pricing rules, and it is pos-sible, and in the view of some even common, for taxpayers to use trans-fer pricing to shift income or deductions into or out of the UnitedStates. It has been this concern, and the added concern that the UnitedStates has lost revenues in recent years, that has led Congress to attackthe transfer pricing problem. This began with the 1986 Tax Act, butgained strength and momentum in the late 1980s with a particular fo-cus, it is fair to observe, on inbound investment from Japan.There have been repeated hearings in Congress on this subject anda great deal of rhetoric. Contributing to the problem is the very sub-stantial delay in tax administration in the United States, by comparisonwith other countries. In my own work, I am only just approaching themid-1980s in terms of the years under audit that are coming up forreview. The 1986 Tax Act was a very major piece of legislation, and Ihave not yet begun a case involving 1987 or subsequent years. My sus-picion is that Canada and most other countries are more current.We also have an independent court system, but one that is heavilydocument-oriented, in which litigation of a single case can easily takethree, four, five, or up to eight or even ten years. The cases are veryfact intensive, with warring experts on both sides fighting over theproper transfer price for transactions that took place many yearspreviously.We do not accord much discretion to our tax administrators in theUnited States. And thus we have come to believe that, if we are goingto change anything, we must change the rules. The net effect, as I amsure some of you know, is that we now have a two-volume InternalRevenue Code and six volumes of regulations.In sum, the transfer pricing area exhibits very detailed regulationswhich have taken a highly sophisticated economic view of how to testprices. In addition, we have placed upon taxpayers for the year 1994and thereafter the burden, a new burden, of documenting their transferprices in advance so that, when they are examined, they will have toshow that their prices follow some methodology. This is opposed to de-veloping a justification long after the fact when the examiner appearson the doorstep.All of this has given rise to international upheaval. The regulationsput out by the Treasury Department, first in proposed and then in tem-porary and final form, have been the subject of review by the OECD,which is writing its own report on transfer pricing. In addition, variouscountries have offered comments and criticisms of the United States'position.[Vol. 20:267 19944Canada-United States Law Journal, Vol. 20 [1994], Iss. , Art. 30https://scholarlycommons.law.case.edu/cuslj/vol20/iss/30Rosenbloom-SOVEREIGNTY AND THE TAX AREANor are these developments at the federal level the only pertinentones. You will recall that our states are substantially independent inthe tax field. While all of the above-described matters have been takingplace, there has been a simmering fifteen- or twenty-year controversyinvolving a number of U.S. states, but principally California, on a re-lated question. In the mid-1970s California despaired of the possibilityof testing transfer prices on an item-by-item arm's-length basis. To mea lot of what they said makes sense. They said, first, it is too timeconsuming. Second, testing on a transactional basis involves tremen-dous resources. And the correct or "right" transfer price is inherentlyunknowable. At what price would a controlled party have sold to an-other controlled party if the parties had not been related? This is ahypothetical question, an inherently unknowable kind of question, withan unknowable approach to resolution, which invites very complex, veryfact-oriented controversies and has very little that is objective about it.California threw up its hands as early as the 1970s and said, wewill not look at the transaction between the related parties. Instead, wewill determine how much income has been earned by the related par-ties in the aggregate, and we will develop a formula to split that profitbetween the related parties, a so-called formulary approach to transferpricing. On the merits, this has some appeal. Unfortunately, it has vir-tually no appeal when the federal government is simultaneously takinga transactional approach to the same issues.This has caused much international consternation and produced araft of litigation, of which the most recent manifestation is the famousBarclays case, just decided by the Supreme Court. The case had previ-ously been decided against Barclays twice. The Supreme Court granteddiscretionary review and has just decided against the taxpayer for athird time.Many people are talking about this subject, and it is highly contro-versial; a lot of companies are concerned about it. However, I believethe more immediate subject to be concerned about, in a conference onsovereignty, is not the threat of formulary taxation but refinements ofthe arm's-length method at the federal level. The increasing sophistica-tion infusing the transactional method may not be proceeding in a de-sirable direction.Other countries have reacted adversely to U.S. transfer pricing de-velopments. For example, Canada: On January 7, 1994 the FinanceDepartment and the Department of National Revenue issued a jointnews release endorsing the arm's-length method and referring to diffi-culties that may arise when a jurisdiction adopts another method. Theyfocus primarily on the so-called comparable profits method, by whichprofits of comparable companies are used to "back into," or impute, atransfer price. The release said that if companies adopted the compara-ble profits method to accord with the U.S. regulations, Canada would5Rosenbloom: Sovereignty and the Regulation of International Business in the TPublished by Case Western Reserve University School of Law Scholarly Commons, 1994CANADA-UNITED STATES LAW JOURNAL"not be able" to provide relief under the U.S.-Canada Income TaxTreaty.In recent weeks there have been reports that the Japanese havetaken a similar position. In addition, they have done something elsethat had been widely predicted: They have begun assessing transferpricing adjustments against U.S. companies, the most recent of whichbeing an approximately $150 million assessment against Coca-Cola®.It seems to me that all this debate and ferment are hidden fromthe public to a large extent because the subject is highly technical. Itfinds its way only occasionally into the press, for example when a politi-cian says something foolish on a related subject. However, what seemsto be going on here is the building of an international tax conflict ofunprecedented dimensions.The United States seems determined to follow its new, highly so-phisticated rules. Canada and the other OECD countries seem deter-mined not to give relief when adjustments using those rules are made.And taxpayers, especially those operating across borders, are in themiddle. Given the attitudes borne of sovereignty considerations that na-tions bring to the tax area, it is hard to predict where these develop-ments will lead. Conceivably, if the new transfer pricing rules proveimpractical, or inadequate from the perspective of Congress, the worldmay find itself in another acrimonious debate over the formularyalternative.[Vol. 20:267 19946Canada-United States Law Journal, Vol. 20 [1994], Iss. , Art. 30https://scholarlycommons.law.case.edu/cuslj/vol20/iss/30

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Sovereignty and the Regulation of International Business in the Tax Area

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