Pros and Cons of Safe Harbors, and Advice to Tax Authorities

Galveston, TX

Why is it worth weighing pros and cons of safe harbors*? Because the OECD’s June 6, 2012 draft endorses safe harbors and presents three sample memoranda that countries may use to negotiate bilateral safe harbors. Also, most would say that the IRS has been successful with instituting safe harbors on interest rates for intercompany loans, and safe harbors for certain routine services. The trend is toward the adoption of more safe harbors, not fewer.

PRO: 

  • Less likely to result in double taxation (for bilateral and multilateral safe harbors)
  • Less burdensome on taxpayers, tax authorities, and courts (lower compliance and administrative costs)
  • Safe harbors on routine situations allow taxpayers and tax authorities to focus resources on more complex situations (resource rationalization)
  • Increased taxpayer compliance
  • Provides taxpayers with greater certainty

CON:

  • May not be compatible with the arm’s-length principle
  • Transactional methods (e.g., CUP) when properly applied, are more precise and more accurate than a profit based methodology safe harbor
  • Potential for adverse selection if safe harbors are not arm’s length
  • Unilateral safe harbors could result in some taxpayers over reporting income in the safe harbor country
  • Some amount of tax revenue erosion
  • Published safe harbors may create rules of thumb for arm’s-length analyses, potentially biasing the results

ADVICE:

  • Safe Harbors should emulate arm’s-length results
  • Bilateral (or multilateral) safe harbors are more effective than unilateral ones in preventing double taxation
  • Safe harbors should be elective, not mandatory (a pro and a con of elective safe harbors is a general reduction in tax liability)
  • Mandatory safe harbors would be akin to formulary apportionment, which is not generally accepted nor is it arm’s length
  • Require taxpayers to commit to the safe harbor for a certain number of years, or require an advance notice of election to use the safe harbor (otherwise, taxpayers will electively choose the safe harbor only when it provides a better tax answer)
  • Use ranges to lessen chances of double taxation
  • Allow mutual agreement procedures to mitigate the risk of double taxation
  • Bilateral and multilateral safe harbors should be updated periodically to account for market changes

* The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2010), in Chapter IV, Section E, defines a safe harbor as “a statutory provision that applies to a given category of taxpayers and that relieves taxpayers from certain obligations otherwise imposed by the tax code by substituting exceptional, usually simpler obligations.”

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