Hindsight taxation – OECD Proposals

Leon Harris

One of the things that spooks tax authorities the world over is that taxpayers may know more than they report. But tax authorities have a blunt weapon of retaliation – the ability to use hindsight when issuing tax assessments.

For example, suppose an Israeli  pharmaceutical company discovers a new herb and sells its’ intellectual property (IP) to an offshore company in the same group for a million dollars for further development. A year later it turns out the herb is a wonder-drug worth a billion dollars.  Can the Israeli tax authority apply hindsight and tax the billion instead of the million?

On June 4, the OECD issued a discussion draft on this thorny subject as Action 8 of its BEPS (Base Erosion Profit Shifting) program. The public has all of two weeks to submit comments. A version of this article is therefore being submitted post haste to the OECD. Israel joined the OECD in 2010.

OECD Proposals in a Nutshell:

The OECD refers to under-reporting by taxpayers as “information asymmetry”. The OECD discusses the desirability of short term agreements, price-adjustment clauses, milestone payments and even re-negotiation of contract pricing terms. But can a tax authority deem these to exist when they don’t?

The OECD says special considerations exist in the case of various under-developed “hard-to-developed-intangibles”

In such cases, the OECD recommends letting tax authorities make hidndsight adjustments to determine arm’s length pricing arrangements, if there are significant differences” between the original “ex ante” predictions and the subsequent “ex post” outcomes.

However, according to the proposals, no hindsight adjustment would apply where the taxpayer:

  • Provides full details of its original projections, including how risks were accounted for (e.g. probability-weighted) and how it considered reasonably foreseeable events; AND
  • Provides “satisfactory” evidence that any significant difference was due to unforeseeable or extraordinary developments, e.g. natural disaster or unexpected bankruptcy of a competitor.


Following are some comments on the OECD discussion draft:

  • The question of whether to allow tax authorities to use hindsight is important in all areas of the global economy, not only hard-to-value intangibles transferred between related parties. The final recommendations should be made more generally applicable to taxation.
  • The OECD has indicated that for tax purposes, value should be attributed to where it is generated. The draft report apparently makes no mention of this.
  • The term “significant” differences is vague and should be clarified. Otherwise, tax authorities make mountains out of mole-hills.
  • The term “satisfactory evidence” is also vague and should also be clarified.
  • The main problem is uncertainty, the tax stakes are massive. The solution  would be to have a safe harbor. We recommend letting taxpayers prepare at the outset a cash flow forecast and listing all relevant assumptions made. The assumptions should be carefully prescribed and include economic, commercial and technical assumptions with a range of predicted outcomes. This may be used to prove what was reasonably foreseeable at the outset. Not every taxpayer is a prophet.  The safe harbor would mean no subsequent hindsight taxation unless fraud can be proven (a criminal matter). Otherwise, both the taxpayer and the tax authority would be bound by the safe harbor.
  • The safe harbor may also include a sliding scale – this would further show good faith but should not be mandatory.

To sum up, the OECD condones taxation with hindsight in limited instances only in the case of hard-to-value intangibles, according to the latest proposals.

It remains to be seen what the OECD finally recommends and how countries like Israel translate all this into practice.

The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.

As always, consult experienced tax advisors in each country at an early stage in specific cases.

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