Distinctions should be drawn among three broad categories of fiscal arbitration:
(1) tax controversies arising from business relationships;
(2) overlapping tax on one transactions by two or more countries; and
(3) disputes implicating tax issues between a foreign investor and the host state.
With respect to the first category (business relationships), several different scenarios arise.13 In the wake of a corporate acquisition, there might be questions on whether the buyer or the seller should bear taxes due for previously accrued tax liabilities. Or, an allegation might be made that the seller misrepresented corporate tax liabilities, either by reason of accounting irregularities or in hiding investigations by local revenue authorities. There might be issues about which party gets the benefits and/or burdens of credits and liabilities under a “tax allocation agreement” concluded pursuant to a corporate spin-off. In some instances, disputes among joint venture partners might arise with respect to whether one partner was authorized to make payments to a foreign country on behalf of another. Last but not least, taxpayers have been known to sue their advisers when advice about a tax shelter proves unfounded and leads to liability.14
Income tax treaties
There is also country-to-country arbitration under income tax treaties, a process recently endorsed by international organizations such as the OECD (Organization for Economic Cooperation and Development) and the ICC (International Chamber of Commerce), as well as several national fiscal authorities, including those of Austria, Belgium, Canada, Germany and the United States.15 Such tax treaty arbitration meets the needs of multinational corporate groups seeking symmetrical treatment of income inclusions and deductions in different countries.
The 2008 OECD Model Tax Convention on Income and on Capital, in the Mutual Agreement Procedure of Article 25(5) provides binding arbitration in relation to disputes implicating taxpayer disputes. The OECD also provides a sample memorandum of understanding to implement the arbitration process, including rules on time for submission of the case, terms of reference and qualifications of arbitrators. Article 25 has been adopted in several U.S. treaties, including those with Belgium, Canada, France and Germany
The OECD provision was intended to address situations such as the following. A royalty payment might be made by a French subsidiary to its American parent. As between the French and American tax authorities, different views might exist on the correct amount of royalty. The varying applications of national anti-avoidance measures, intended to prevent abusive “transfer pricing,” might result in income to the American parent without an equal deduction to the French subsidiary.
Although not double taxation in a juridical sense (given the separate corporate personalities of parent and subsidiary), such situations do present economic double taxation. The same income is taxed twice, to the extent that an inclusion in the American company’s taxable profits has not been offset by a corresponding deduction in France. The multinational’s position would be that of a stakeholder, willing to pay tax to either the United States or to France, but not to both countries. Tax treaty arbitration provides one hope for fiscal symmetry, thereby reducing the fiscal barriers to cross-border trade and investment.
Finally, arbitration of tax disputes occurs in the context of relationships between foreign investors and host states. On rare occasions, a government may agree on an ad hoc basis to arbitrate disputes over the quantum of a foreign investor’s tax liability.16
Much more common, however, are treaty-based claims by investors alleging that the host state imposed tax in a discriminatory or arbitrary manner, or used tax as a vehicle for expropriation without compensation.17 Such tax-related investment disputes remain qualitatively different from the commercial or tax treaty context. In an investment dispute, the very legitimacy of the tax is put into question.
The controversy does not concern shifting normal fiscal burdens between a buyer and a seller, or the tax authorities in the parent’s home state as opposed to the subsidiary’s country of incorporation. Rather, an assertion might be made that the governmental payment is not really a tax at all, but rather a disguised attempt at confiscation. This last category of tax arbitration forms the focus of this chapter.
No consensus exists on why tax measures should receive special attention in investment treaties. Raising revenue does constitute a core activity of all political collectivities. However, the same can be said of many other government functions (such as administration of justice or environmental protection) that regularly give rise to claims by foreign investors. For example, an effective judiciary remains vital to any concept of sovereignty.18 Nevertheless, court proceedings have long been a fertile source of state responsibility under both customary international law19 and modern investment treaties.20
Any explanation for the treaty carve-outs given to tax measures remains tentative, and unlikely to give complete satisfaction. However, one rationale may prove more right than wrong. The best account for taxation’s special status probably lies in the very nature of taxation. As mentioned earlier, tax constitutes a form of confiscation, thus opening the way to investor arguments (however misconceived) that an actionable taking of property has occurred. In particular, taxes lend themselves to characterization as a form of indirect or “creeping” confiscation, which might in principle give rise to claims under investment treaty provisions related to expropriation and discrimination.21
Unlike charitable contributions or purchases of goods and services, wealth transfer through taxation remains involuntary. Taxpayers have no option to say, “Sorry, we’ll just skip this year’s contribution.” The only escape lies in ceasing the activity that otherwise triggers the tax.22
In attempting to distinguish legitimate revenue measures from de facto confiscation through taxation, one is reminded of the line by U.S. Supreme Court Justice Potter Stewart reversing a movie theater’s obscenity conviction. Admitting an inability to define “hard core” pornography, Stewart added, “But I know it when I see it.”23 British judges sometimes apply a similar (but less risqué) characterization test. In deciding that a floating crane was not a “ship or vessel” for purposes of insurance policy, Lord Justice Scrutton referred to the gentleman who “could not define an elephant but knew what it was when he saw one.”24
Like elephants and obscenity, the contours of legitimate taxation leave many fuzzy edges that frustrate rigorous discussion. Although telling them apart is not always easy, differences do exist between what might be called “normal” and “abusive” taxes. The former aim to fund government. The latter are crafted to force abandonment of a business enterprise by ruining its economic value, or to provide an investor’s competitors with a beneficial fiscal framework that permits more favorable competition.
As discussed later, various treaty-based limitations come into play when an investor contends that an allegedly abusive tax violates some provision of an investment convention or free trade agreement. As also discussed in the following sections, the relevant distinctions go far beyond technical matters such as depreciation methods and timing of rebates, and touch on the very notion of revenue-raising legitimacy.25
Tax-related claims have not always benefitted from investment protection regimes. In the early 20th century, an arbitral tribunal took the view that fiscal measures by their nature did not constitute expropriation. Under this now-discredited doctrine, investors had no general recourse to arbitration for relief from abusive taxation.
The origins of the case, Kügele v. Polish State,26 lie in a part of Central Europe called Upper Silesia, now found in the southeast corner of Poland. 27 Following the First World War, the ethnically Polish portion had become an autonomous region, while the largely German-speaking areas remained in Germany. Following uprisings among the Polish-speakers, part of Upper Silesia was awarded to Poland pursuant to a Geneva Convention brokered by the League of Nations.28
To address claims by Germans for expropriation, the treaty established what seems to be the first modern European investment protection regime, giving investors a direct cause of action against the host country.29 The Arbitral Tribunal of Upper Silesia (officially “Tribunal Arbitral de la Haute Silésie”) provided an avenue for vindication of investor rights independent of either local courts or the diplomatic protection of the investor’s home state.
Under the label “license fees” (which today might be called excise taxes), Poland had imposed an allegedly confiscatory levy on a brewery owned by an ethnic German, which according to the owner was forced to cease business because of the tax. Claiming that the tax was tantamount to expropriation, the German proprietor filed a claim for compensation.
In a 1932 decision, the Arbitral Tribunal rejected the claim on the basis that taxation by definition cannot give rise to expropriation. According to the Tribunal, the imposition of a tax implies the existence of a business, which in turn presupposes that the enterprise has not been confiscated. An arbitral tribunal chaired by the eminent Belgian Professor, Georges Kaeckenbeeck, reasoned as follows:
The increase of the tax cannot be regarded as a taking away or impairment of the right to engage in a trade, for such taxation presupposes the engaging in the trade. … The trader may feel compelled to close his business because of the new tax. But this does not mean that he has lost the right to engage in the trade. For had he paid the tax, he would be entitled to go on with his business.30
Today, such reasoning would be difficult to imagine. As discussed in the following section, barriers to tax arbitration still exist. However, none of them rest on the view that fiscal measures somehow must be deemed non-arbitrable.
The current network of investment and free trade agreements was adopted to enhance economic cooperation and cross-border capital flows through a two-part regime: (i) substantive investor protections against discrimination, confiscation and other unfair governmental measures, and (ii) a relatively neutral dispute resolution mechanism in the event of disagreement on how those protections should operate.31 The cornerstone of most investment treaties lies in a prohibition of uncompensated expropriation of foreign-owned property, whether such expropriation be direct or indirect.32
In their interaction with tax measures, investment treaties often contain a level of complexity that tends to defy normal discourse. Multiple qualifiers and exceptions for exceptions apply with respect to even simple propositions. Other than insurance policies and revenue codes, few public documents present as many exegetical challenges.
For example, Article 21 of the ECT says that the treaty does not create rights or impose obligations with respect to taxation measures.33 Then it goes on to make an exception for the part of Article 10 related to non-discrimination and most-favored-nation provisions, which do apply to tax measures.34