Tax base defense: time to update the model treaties.

• Author: Lowell, Cym H.

It is rare that, global transfer pricing strategies of multinational enterprises ("MNEs") find their way onto front page coverage in financial center newspapers and magazines. This has been the case in recent periods in a crescendo of criticism that grows in volume and intensity. It is as if such strategies are responsible for global economic problems. Not surprisingly, the tax authorities of the world, collectively represented by the Organization for Economic Cooperation and Development ("OECD') and the United Nations ("UN"), have announced intentions to address such matters.

For example, the European Commission has unveiled plans to "crack down on tax havens and aggressive tax planning by companies" to help EU states recover from economic downturn. (3) Similarly, the G-20 has asked the OECD to review applicable rules to reduce the ability of MNEs to shift profits to low taxation countries (i.e., tax base erosion)) In the United States, Treasury officials sing a consistent tune, advising that any broad tax reform must be focused on the base erosion fight. (5) These comments largely relate to the concerns of OECD member countries. Non-governmental organization ("NGOs") and other organizations are active members of the base erosion choir signing on behalf of non-member countries.

At the same time, there has been controversy between MNEs and non-OECD member countries concerning their own domestic tax base defense. This has occurred in the form of domestic tax policies of the so-called BRICS countries (Brazil, Russia, India, China, and South Africa, as well as other source countries). In addition, this group of countries has objected with increasingly strident voices to the impact of the OECD/UN model income tax treaties. (6)

There is nothing new in the focus on tax base erosion or MNE effective tax rate planning strategies ("MNE-ETR Strategies"), which has been building for many years. Indeed, much of the spread of transfer pricing documentation to more than 70 countries over the years has been a result of tax base defense considerations relating to MNE-ETR Strategies. (7)

As this process evolves, the tenor of public comment by the media, tax administrators, OECD and UN officials, and politicians tends to be a pillorying of MNEs and their tax planning arrangements as the bad guys in the base erosion drama. For their own part, MNEs, individually and collectively, have little ability to defend themselves in the public media.

As the crescendo of criticism of MNE ETR planning builds, a neutral observer might wonder whether existing model treaties provide: (i) protection for the tax base of the respective countries; and (ii) guidance to MNEs for framing their ETR Strategies (the "Foundational Questions")? In this regard, prevailing MNE-ETR Strategies did not arise from whole cloth in recent periods. Rather, they evolved over a long period of time, as have the substantive tax and transfer pricing policies of countries seeking to defend their respective tax bases.

The purpose of this article is to answer the Foundational Questions. These answers have either been forgotten or overlooked by all parties as the crescendo of criticism has grown.

Origin of OECD/UN Model Treaties

The OECD and UN model income tax treaties were designed to minimize income that would be allocated to source countries, with the residue allocated to residence countries. This process occurred in the 1920s, immediately following World War I. (8) Transfer pricing principles were ultimately developed to implement this same model.

The origins of these treaty...