The Inflation Reduction Act of 2022[1] was signed into law by President Biden on August 16, 2022 and added new section 4501 to the Internal Revenue Code,[2] imposing an excise tax on certain repurchases of corporate stock. The new provision applies to repurchases of stock after December 31, 2022. On December 27, 2022, the Internal Revenue Service (the “IRS”) and the Department of the Treasury (“Treasury”) issued Notice 2023-2 (the “Notice”) to provide taxpayers with interim guidance addressing the application of the new excise tax.
The Statute
New section 4501(a) imposes a tax equal to one percent of the fair market value of any stock of a “covered corporation” that is repurchased by that corporation (and certain affiliates) during the taxable year. The statute defines a “covered corporation” to include any domestic corporation the stock of which is traded on an established securities market[3] and defines a “repurchase” that triggers the excise tax as a redemption described in section 317(b), with certain exceptions, as well as any transaction determined by the Secretary of the Treasury (the “Secretary”) to be an “economically similar” transaction.[4]
The value of stock repurchases subject to the excise tax is reduced by the fair market value of any repurchases that fall within one of six statutory exceptions,[5] including repurchases in connection with certain corporate reorganizations, repurchases under a $1 million de minimis threshold, and repurchases in connection with certain retirement plan contributions. The stock repurchase excise tax base also is reduced by the fair market value of any issuances of the covered corporation’s stock during its taxable year (the “netting rule”).[6] No income tax deduction is allowed for the payment of the excise tax.[7]
The statute provides the Secretary with authority to prescribe regulations and other guidance as necessary to carry out and prevent the avoidance of the purposes of the excise tax, to address special classes of stock and preferred stock, and to provide for the application of rules involving the acquisition of the stock of certain foreign corporations.[8]
Notice 2023-2: Key Provisions
Notice 2023-2 provides initial guidance and operating rules for the excise tax, including some welcome news, but does not provide all of the relief for which taxpayers and practitioners had advocated. It also previews anticipated procedures for reporting and paying the tax and requests comments on various aspects of the tax and the implementation of the tax. The IRS and Treasury have imposed a 60-day deadline for comments, although the first day of that 60-day period does not begin until the Notice is published in the Internal Revenue Bulletin, which could be as early as this week. The following discussion is a high-level summary of the most notable provisions in the Notice.
Definitions: “Redemptions” and “Economically Similar Transactions”
Consistent with section 4501(c)(1), the Notice states that, for purposes of the stock repurchase excise tax, a repurchase means either a section 317(b) redemption or an economically similar transaction.[9] The Notice goes on to provide two exceptions to the section 317(b) rule, as well as lists of transactions that are economically similar and transactions that are not economically similar.
Section 317(b) Redemptions Carved Out of Repurchase Treatment
As noted above, the Code contains six exceptions to repurchase treatment.[10] The Notice provides an exclusive list of section 317(b) redemptions that are not treated as repurchases for purposes of the excise tax:[11]
- Section 304(a)(1) transactions. Under section 304(a)(1), a transaction involving two commonly controlled corporations in which one corporation acquires the shares of the second corporation from the controlling person(s) is treated as a distribution in redemption of the acquiring corporation’s deemed issued stock. The Notice provides that the deemed redemption is not a repurchase for purposes of the excise tax regardless of whether section 302(a) or (d) applies to the deemed redemption, while also disregarding the stock deemed issued under section 304(a)(1) for purposes of the netting rule (discussed below).[12]
- Payments of cash in lieu of fractional shares. A payment by a covered corporation of cash in lieu of the issuance of a fractional share in connection with a section 368(a) reorganization, a section 355 distribution, or pursuant to the settlement of an option or similar financial instrument is not treated as a section 317(b) redemption if the cash received by the shareholder in lieu of the fractional share represents a mere rounding off of the shares issued in the exchange or settlement, the payment is carried out solely for administrative convenience or other non-tax reasons, and the amount of cash paid to the shareholder in lieu of a fractional share does not exceed the value of one full share of the stock of the covered corporation.[13]
Economically Similar Transactions
Section 4501(c)(1)(B) authorizes the IRS and Treasury to issue regulations applying the stock repurchase excise tax to “economically similar transactions” that may not fit the technical definition of a section 317(b) redemption. The Notice provides an exclusive list of five transactions that the IRS and Treasury have deemed to be economically similar transactions:[14]
- Acquisitive reorganizations. The exchange by shareholders of a target covered corporation of their target corporation stock in a reorganization is economically similar to a repurchase by the target corporation. Notably, although the term “acquisition reorganization” does not include section 368(a)(1)(B) reorganizations, it does include reorganizations qualifying under section 368(a)(1)(A) by reason of section 368(a)(2)(E).[15]
- Recapitalizations. The exchange by shareholders of a covered corporation of their stock in the covered corporation for new stock issued by the covered corporation in a recapitalization described in section 368(a)(1)(E) is economically similar to a repurchase by the recapitalizing covered corporation.
- F reorganizations. The exchange by shareholders of a covered corporation of their stock in the transferor corporation (as defined in Treas. Reg. § 1.368-2(m)(1)) as part of a reorganization described in section 368(a)(1)(F) is economically similar to a repurchase by the transferor corporation.
- Split-offs. In the case of a split-off by a covered corporation pursuant to section 355 and section 356 as it relates to section 355, the exchange by the distributing corporation’s shareholders of their distributing corporation stock for controlled corporation stock or other property is economically similar to a repurchase by the distributing corporation.
- Complete liquidations to which both section 331 and section 332 apply. If a covered corporation liquidates in a transaction to which section 331 applies to certain shareholders and section 332 applies to other shareholders, the section 331 components are economically similar to repurchases by the covered corporation, whereas the section 332 components are not repurchases.[16]
Although, at first blush, the inclusion of tax-free transactions on the “demon” list of economically similar transactions may be disturbing, the “qualifying property exception,” discussed below, should reduce the repurchase amount to zero if there is no boot (other than cash in lieu of fractional shares) involved in the transaction.
Not Economically Similar Transactions
The Notice also includes a nonexclusive list of transactions that are treated as not economically similar to a repurchase, although the list identifies only two such transactions: complete liquidations covered solely by section 331 or by section 332(a), and divisive section 355 transactions other than split-offs.[17]
Three points regarding the “angel” list bear mentioning. First, because this “angel” list is nonexclusive (and the “demon list” is exclusive), taxpayers presumably have the ability to treat other similar transactions as not economically similar to a repurchase, especially given that section 3.04(4)(a) of the Notice provides an exclusive list of economically similar transactions.[18] Second, the inclusion of section 331 complete liquidations on the list should provide welcome relief to many special purpose acquisition companies (commonly known as “SPACs”), for which the potential application of the excise tax to their unwinds presented challenging issues.[19] Third, the Notice does not state that section 331 liquidations are not treated as section 317(b) redemptions, leaving some uncertainty that would benefit from clarification.[20]
Specified Affiliates and Surrogate Foreign Corporations
Section 4501(c)(2)(A) treats the acquisition of stock of a covered corporation by a specified affiliate of that covered corporation, from a person that is not the covered corporation or a specified affiliate of the covered corporation, as a repurchase by the covered corporation. Section 4501(d) includes special rules with respect to acquisitions of stock of certain foreign corporations and certain surrogate foreign corporations (i.e., foreign corporations that are subject to the anti-inversion provisions of section 7874).[21] The Notice provides additional detail as to when these provisions are triggered, including by adding a per se rule in situations in which a transaction is undertaken with a principal purpose of avoiding the stock repurchase excise tax.
Fair Market Value of Repurchased Stock
Although section 4501 imposes an excise tax on stock repurchases within a particular tax year, the statute does not specifically address how and when the repurchased stock is valued. Section 3.06 of the Notice fills in some of these timing and valuation details. Under this portion of the Notice, stock is treated as repurchased at the time that ownership of the stock transfers to the covered corporation or to the applicable acquiror for federal income tax purposes (or, in the case of economically similar transactions, at the time of the exchange).
The Notice first provides that the fair market value of repurchased stock is its market price (regardless of whether the market price is the price at which the stock was repurchased). The Notice then prescribes four methods for determining the market price of repurchased stock that is traded on an established securities market: (i) the daily volume-weighted average price on the repurchase date; (ii) the price at the close of day on the repurchase date; (iii) the average of the high and low prices on the repurchase date; and (iv) the trading price at the time of the repurchase. If the date on which the repurchase occurs is not a trading day, the market price is determined on the immediately preceding trading date.
The covered corporation must use the same method of determining the market price of repurchased stock that is traded on an established securities market for all repurchases that occur during the covered corporation’s taxable year. If the repurchased stock is not traded on an established securities market, the market price of the repurchased stock is determined as of the repurchase date under the principles of Treas. Reg. § 1.409A-1(b)(5)(iv)(B)(1).
Section 3.08 of the Notice provides that similar rules apply for valuing stock issued by the covered corporation for purposes of applying the netting rule (discussed below), other than stock issued to an employee (for which the fair market value of the stock is determined under section 83 as of the date the stock is issued or provided to the employee).
Statutory Exceptions to the Excise Tax and Elaboration by the Notice
Under section 4501(e), repurchases that occur in one of six types of transactions are excluded from the excise tax. The excepted transactions listed in the statute are:
- Tax-free reorganizations. To the extent that a repurchase is part of a reorganization (within the meaning of section 368(a)) and no gain or loss is recognized on the repurchase by the shareholder by reason of the reorganization;
- Employer-sponsored retirement plans. Stock repurchased (or an amount of stock equal to the value of the stock repurchased) that is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan;
- De minimis repurchases. Stock repurchased where the total value of the stock repurchased during the taxable year does not exceed $1,000,000;
- Dealer transactions. Under regulations prescribed by the Secretary, in cases in which the repurchase is by a dealer in securities in the ordinary course of business;
- Repurchases by RICs and REITs. Repurchases by a section 851 regulated investment company or a real estate investment trust; and
- Dividend-equivalent repurchases. Repurchases treated as a dividend under the Code.
Section 3.07 of the Notice contains details with respect to the statutory exceptions to the excise tax contained in section 4501(e) and provides that a repurchase that is described in a statutory exception under section 4501(e) is treated as a reduction in computing the covered corporation’s stock repurchase excise tax base.
Reorganization Exception
The Notice expands on the statute’s first exception for reorganizations under section 368(a)[22] by more specifically defining situations that are treated as transactions that do not result in gain or loss to the shareholder. The Notice does so by adding a “qualifying property exception” that reduces the stock repurchase excise tax base, interpreting the statutory exception not to have a “cliff effect,” in which a transaction must be entirely tax free, but instead to have a broader “to the extent” exception, in which the exception applies to the extent the shareholders receive qualifying property (i.e., property the receipt of which does not give rise to gain or loss to the shareholder under section 354 or 355[23]) in one of four types of qualifying transactions:
- a repurchase by a target corporation as part of an acquisitive reorganization;
- a repurchase by a covered corporation or a covered foreign surrogate corporation as part of an section 368(a)(1)(E) reorganization;
- a repurchase by a transferor corporation as part of an section 368(a)(1)(F) reorganization; and
- a repurchase by a distributing corporation as part of a split-off (whether or not part of a section 368(a)(1)(D) reorganization).
Thus, if section 354 or 355 applies to any of these transactions, the qualifying property exception will reduce the covered corporation’s stock repurchase excise tax base. Conversely, to the extent that an exchanging shareholder receives property other than qualifying property in such a transaction, the qualifying property exception will not apply with respect to such non-qualifying property.
The approach of the Notice provides welcome relief to taxpayers who were concerned that a penny of boot in an otherwise tax-free reorganization would cause the entire transaction to be treated as a repurchase, but this portion of the Notice likely is a disappointment to those who had hoped that guidance would provide that boot received in a reorganization would be excepted from the excise tax. In this regard, a reorganization with boot, even if fully sourced or funded by the acquiring corporation, will be subject to the excise tax to the extent of the boot.[24] This is to be distinguished from taxable transactions – the Notice makes clear that the funding source of the cash (as determined under general tax principles) is determinative in fully taxable transactions.[25] Relatedly, in a fully taxable reverse subsidiary cash merger where the transitory merger subsidiary incurs debt to fund a portion of the purchase price, the debt-financed portion will be subject to the excise tax because the target corporation is treated as redeeming its own stock in exchange for the borrowed cash received by the target’s shareholders in the merger.[26]
Retirement Plan Exception
The Notice provides some helpful guidance with respect to the statutory exception to the excise tax for stock contributions to employer-sponsored retirement plans.[27] Specifically, the Notice clarifies that contributions need not be for the same class of stock as was subject to the repurchase, although different valuation rules apply in determining the amount of the reduction to the excise tax base when different classes of stock are repurchased and contributed.[28] The Notice provides additional rules for determining the fair market value of stock repurchased by a covered corporation in the context of this exception, as well as a special timing rule for contributions made to a retirement plan.[29]
Dealer in Securities Exception
The Notice prescribes general rules for repurchases by a dealer in securities in the ordinary course of business.[30] Specifically, the Notice states that the exception is available for dealers in securities only if the dealer accounts for the stock as securities held primarily for sale to customers in the dealer’s ordinary course of business, disposes of the stock within a time period consistent with the holding of the stock for sale to customers in the ordinary course of business, and does not sell or otherwise transfer the stock to an applicable acquiror or the covered corporation, as applicable, other than a sale or transfer to a dealer that otherwise satisfies the requirements of the exception.
Exception for Repurchases Treated as Dividends
The Notice adds a rebuttable presumption that repurchases to which section 302 or section 356(a) applies do not qualify for the statutory exception for dividends under section 4501(e)(6).[31] A covered corporation may rebut this presumption with regard to a specific shareholder by establishing with “sufficient evidence” that the shareholder treats the repurchase as a dividend on the shareholder’s tax return. This evidentiary requirement is likely to present challenges for widely held public corporations because the Notice requires that the covered corporation obtain certification from the shareholder that the repurchase constitutes a redemption treated as a section 301 distribution under section 302(d) or that the repurchase has the effect of the distribution of a dividend under section 356(a)(2), including evidence that applicable withholding occurred if required.
The Netting Rule
As mentioned above, section 4501(c)(3) provides for a taxpayer-friendly downward adjustment to the amount subject to the stock repurchase excise tax for the fair market value of any stock issued by the covered corporation during the tax year. The Notice describes this adjustment as the “netting rule” and clarifies certain valuation and timing rules.[32] The Notice also provides an exclusive list of situations that do not qualify for the rule (and therefore do not reduce the excise tax base of the covered corporation),[33] including a no-double-counting rule that eliminates netting with respect to transactions exempted from the scope of the tax under section 4501(e), discussed above.
The Notice confirms what might be considered a taxpayer favorable timing mismatch in the text of the statute.[34] Specifically, although section 4501 applies only to repurchases occurring after December 31, 2022,[35] the netting rule permits reductions with respect to a covered corporation’s issuances of stock occurring at any time during the entire taxable year. The Notice specifically states that, “solely in the case of a covered corporation that has a taxable year that both begins before January 1, 2023, and ends after December 31, 2022, that covered corporation may, solely with regard to any covered repurchases during that taxable year to which the stock repurchase excise tax applies, apply the netting rule to reduce the fair market value of the covered corporation’s covered repurchases during that taxable year by the fair market value of all issuances of its stock during the entirety of that taxable year.”[36]
Reporting Requirements
The Notice provides that the excise tax must be reported on Form 720, Quarterly Federal Excise Tax Return.[37] (On December 30, 2022, the IRS issued in draft form, Form 7208, Excise Tax on Repurchase of Corporate Stock, that taxpayers will be required to attach to the Form 720.[38]) The IRS and Treasury expect the forthcoming proposed regulations to provide that the excise tax will be reported once per taxable year on the Form 720 that is due for the first full quarter after the close of a taxpayer’s taxable year. The Notice gives, as an example, a taxpayer with a taxable year ending on December 31, 2023, which would report its stock repurchase excise tax on the Form 720 for the first quarter of 2024, due on April 30, 2024.
Comments Requested and Additional Future Coverage
Section 6 of the Notice requests comments on both specific and general issues, including the need for: special rules for redeemable preferred stock or other special classes of stock or debt; the determination of the fair market value of the stock repurchased; factors that should be considered in guidance regarding indirect ownership for purposes of whether a corporation or a partnership is a specified affiliate; whether special rules for bankrupt or troubled companies are needed; and whether additional rules should be added to prevent the avoidance of tax in the context of certain financial arrangements.
Reliance and Effective Date of Forthcoming Regulations
Until the issuance of the forthcoming proposed regulations, taxpayers may rely on the rules described in the Notice.[39]
Although regulations typically are effective when finalized, under section 7805(b)(2), final regulations issued within 18 months after the August 16, 2022, enactment of this new provision can have retroactive effect. Section 7805(b)(3) also permits certain anti-abuse regulations to have retroactive effect, but this provision presents challenges under the Administrative Procedure Act that, in our experience, make the IRS and Treasury less willing to rely on it.[40]
Additional Observations
It is likely that tax planners will revisit commonly used techniques in the M&A area, such as the market-standard reverse subsidiary cash merger. As noted above, to the extent the merger subsidiary is debt-financed, the target corporation is treated as incurring the debt and redeeming its own stock, which will cause the debt-financed portion of the acquisition proceeds to be included in the excise tax base. For this reason, there may be interest in alternative structures that avoid such redemption treatment, such as structures that place the leverage at a holding company level.
Interestingly, the Notice was one of two that the IRS and Treasury issued on December 27, both providing interim guidance with respect to recent legislation (the other, Notice 2023-7, addresses the new corporate alternative minimum tax and will be the subject of another client alert). In the past, in implementing new legislation, the IRS and Treasury have often chosen to issue proposed/temporary regulations without first issuing a notice. It is possible that the court cases challenging the validity of regulations, particularly those challenges involving the Administrative Procedure Act, have caused the government to be more cautious in promulgating regulations without providing meaningful opportunity for stakeholder input.
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[1] As was the case with Tax Cuts and Jobs Act, the Senate’s reconciliation rules prevented changing the Act’s name. Therefore, the Inflation Reduction Act is actually “An Act to provide for reconciliation pursuant to title II of S. Con. Res. 14.” Pub. L. No. 117–169, tit. I, § 10201(d), 136 Stat. 1831 (Aug. 16, 2022).
[2] Unless indicated otherwise or clear from context, all “section” references are to the Internal Revenue Code of 1986, as amended (the “Code”), all “Treas. Reg. §” are to the Treasury regulations promulgated under the Code, and all “§” references are to sections of Notice 2023-2.
[3] Section 4501(b).
[4] Section 4501(c)(1).
[5] Section 4501(e). These exceptions and their treatment in the Notice are discussed below.
[6] Section 4501(c)(3).
[7] Section 275(a)(6).
[8] Section 4501(f).
[9] § 3.04(2).
[10] Section 4501(e). For a discussion of these exceptions, see “Statutory Exceptions to the Excise Tax” below.
[11] § 3.04(3).
[12] § 3.04(3)(a).
[13] § 3.04(3)(b).
[14] § 3.04(4)(a). In the description of each transaction, the term “covered corporation” includes a “covered surrogate foreign corporation” as appropriate. The fact that the list is exclusive provides welcome certainty to taxpayers.
[15] The final regulations would benefit from an overlap rule to address transactions described in both section 368(a)(1)(B) and section 368(a)(2)(E) in which the consideration includes voting stock described in section 351(g)(2).
[16] This would occur, for example, in a situation in which a covered corporation has an 80-percent corporate shareholder and one or more minority shareholders.
[17] § 3.04(4)(b).
[18] Moreover, it appears that § 3.04(4)(b) is unnecessary in light of § 3.04(4)(a).
[19] The Notice does not contain an exception for redemptions of preferred stock, despite some requests from the SPAC industry and others for such an exception.
[20] See, e.g., Rev. Rul. 79-401, 1979-2 C.B. 128, in which the IRS ruled that the liquidating distribution at issue was “a ‘redemption’ within the meaning of section 317(b) of the Code, which defines that term for purposes of section 303 [i.e., for purposes of part I of subchapter C], even though section 317(b) does not apply to section 331.”
[21] Only surrogate foreign corporations that were acquired in transactions described in section 7874(a)(2)(B) after September 20, 2021 are subject to these rules. Further, presumably these rules apply only to surrogate foreign corporations subject to section 7874(a)(2)(B) and not to corporations subject to section 7874(b), which are treated as domestic corporations for purposes of chapter 37 of the Code.
[22] Section 4501(e)(1).
[23]Stock-for-stock exchanges relying solely on section 1036 generally are not section 317(b) redemptions, nor apparently are they “economically similar” transactions (because they were not included in the Notice’s exclusive list).
[24] § 3.09 Ex. 19.
[25] § 3.09 Exs. 3 and 4.
[26] § 3.09 Ex. 4.
[27] Section 4501(e)(2).
[28] § 3.07(3).
[29] § 3.07(3)(d).
[30] § 3.07(4)(a).
[31] § 3.07(6).
[32] § 3.08(2)-(3).
[33] § 3.08(4).
[34] § 2.07.
[35] Pub. L. No. 117–169, tit. I, § 10201(d), 136 Stat. 1831 (Aug. 16, 2022).
[36] § 3.07(2).
[37] § 4.
[38] https://www.irs.gov/pub/irs-dft/f7208–dft.pdf.
[39] § 5.03.
[40] See Liberty Global, Inc. v. United States, No. 1:20-CV-03501-RBJ, 2022 WL 1001568 (D. Colo. Apr. 4, 2022), in which the court found temporary regulations issued under section 245A invalid despite the IRS’s argument that section 7805 replaced the notice and comment requirement of the Administrative Procedure Act. https://www.govinfo.gov/content/pkg/USCOURTS-cod-1_20-cv-03501/pdf/USCOURTS-cod-1_20-cv-03501-0.pdf.
This alert was prepared by Michael A. Benison, Michael J. Desmond, Anne Devereaux, Matt Donnelly, Pamela Lawrence Endreny, Eric B. Sloan, and Edward S. Wei.
Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax and Global Tax Controversy and Litigation practice groups:
Tax Group:
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 (0) 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213-229-7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212-351-2474, [email protected])
Benjamin Fryer – London (+44 (0) 20 7071 4232, [email protected])
Brian R. Hamano – Los Angeles (+1 310-551-8805, [email protected])
Kathryn A. Kelly – New York (+1 212-351-3876, [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
Loren Lembo – New York (+1 212-351-3986, [email protected])
Jennifer Sabin – New York (+1 212-351-5208, [email protected])
Hans Martin Schmid – Munich (+49 89 189 33 110, [email protected])
Eric B. Sloan – Co-Chair, New York/Washington, D.C. (+1 212-351-2340, [email protected])
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224 /+1 212-351-2344), [email protected])
John-Paul Vojtisek – New York (+1 212-351-2320, [email protected])
Edward S. Wei – New York (+1 212-351-3925, [email protected])
Lorna Wilson – Los Angeles (+1 213-229-7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, [email protected])
Global Tax Controversy and Litigation Group:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202-955-8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202-887-3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202-887-3612, [email protected])
*Anne Devereaux is an of counsel working in the firm’s Los Angeles office who is admitted only in Washington, D.C.
© 2023 Gibson, Dunn & Crutcher LLP
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A new ruling by a federal court of appeals could dramatically reduce the penalties that the Department of Justice and other federal agencies are able to extract in many cases, including negotiated resolutions. The U.S. Court of Appeals for the Third Circuit in Philadelphia held in United States v. Banks that judges may not use intended loss—instead, they may rely only on actual loss—to calculate the range of criminal penalties applicable in fraud cases. As significant as that ruling is, the court’s reasoning extends beyond criminal sentencings for fraud offenses. It will reduce the penalties that courts can impose for a wide array of other federal criminal offenses. But more broadly, its impact will be felt in deferred prosecution agreements (“DPAs”), non-prosecution agreements (“NPAs”), and other negotiated resolutions where a penalty is based on the United States Sentencing Guidelines.
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The Banks decision, and other cases following its reasoning, may result in significantly lower penalties in a wide array of settlement agreements and contested criminal proceedings, such as:
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When sentencing criminal defendants—both natural persons and corporations—federal courts are required to consider the sentencing range calculated using Guidelines promulgated by the United States Sentencing Commission (the “USSG” or “Sentencing Guidelines”).[1] These sentencing ranges are expressed as months in prison or monetary fines. Courts need not sentence within the calculated range, but those ranges have a strong influence on the outcome. In 2021, for example, federal courts sentenced defendants within the Guideline range nearly half the time.[2] Moreover, the Department of Justice and other federal agencies such as the Securities and Exchange Commission frequently look to these sentencing ranges as the starting point for settlement resolutions, including DPAs and NPAs.
Each Sentencing Guideline includes “commentary,” which provides additional instruction from the Commission on how that Guideline is to be applied to particular cases. With very few exceptions, courts have traditionally treated the commentary as binding on a court’s Guideline calculation.[3] That is because the Supreme Court held in 1993 in Stinson v. United States, consistent with the agency deference doctrine the Court set forth in Bowles v. Seminole Rock & Sand (and reinforced later in Auer v. Robbins), that the Commission’s commentary amounts to an agency’s interpretation of its own legislative rule, and as such the commentary must be given controlling weight unless it is plainly erroneous or inconsistent with the Guideline.[4]
However, in 2019 the Supreme Court held in Kisor v. Wilkie[5]—a VA benefits case—that deference is not appropriate to agency interpretations of their own rules unless, after exhausting all the “traditional tools” of construction, the rule is “genuinely ambiguous.”[6] Without such ambiguity, there is no plausible reason to defer to the agency: “the regulation then just means what it means—and the court must give it effect, as the court would any law.”[7] Only if genuine ambiguity remains after considering the text, structure, history, and purpose of a regulation, may a court consider binding the agency’s comments; and even then the agency’s reading must still fall “within the bounds of reasonable interpretation” before it binds a court.[8]
Courts across the country have begun applying the rationale in Kisor to Guidelines commentary, most recently in United States v. Banks.[9] There, the Third Circuit analyzed USSG § 2B1.1, the Guideline for fraud and theft offenses. Under that Guideline, the offense level increases as the amount of “loss” resulting from the defendant’s offense increases.[10] For its part, the commentary defines loss as the higher of “actual loss” or “intended loss,” the latter of which includes the “pecuniary harm that the defendant purposely sought to inflict” even if such harm “would have been impossible or unlikely to occur.”[11] The defendant in Banks tried to execute a check kiting scheme in which he deposited $324,000 in bad checks into an account and sought to withdraw the funds before the bank learned the checks were not supported by sufficient funds.[12] There was no actual loss—the banks did not allow the attempted withdrawals—so the court relied on an intended loss of $324,000 to more than double the offense level, leading to a much longer sentencing range.[13] The Third Circuit reversed and sent the case back for resentencing. Invoking Kisor, the court concluded there was no genuine ambiguity in the meaning of “loss” in § 2B1.1 and, thus, the Commission’s commentary had “impermissibly expand[ed] the word ‘loss’ to include both intended loss and actual loss.”[14]
The Third Circuit is not alone in concluding that Kisor limits the deference courts owe to commentary in the Sentencing Guidelines. Earlier, in 2021, the Sixth Circuit in United States v. Riccardi struck down another part of the definition of loss in the commentary to Section 2B1.1, this time rejecting a requirement to treat each stolen credit card or gift card as a loss of at least $500.[15] Four other circuits—the First, Second, Tenth, and Eleventh—have resisted the impact of Kisor, at least where circuit precedent has expressly addressed a particular provision in the commentary, unless and until the Supreme Court holds that Kisor changes the deference owed in the Sentencing Guidelines context.[16] In the Fourth Circuit, two three-judge panels came to contradictory holdings regarding the impact of Kisor.[17] And the Fifth Circuit has granted en banc review in a case where the panel had determined it was bound by pre-Kisor circuit precedent.[18]
The Supreme Court will likely be called upon to resolve the split in the circuits over the deference that courts owe to Commission commentary after Kisor. In the meantime, a number of enhancements to penalties based on commentary in the Guidelines Manual—enhancements that form the basis for settlement negotiations with DOJ in many white collar matters—are vulnerable to challenge in circuits where courts apply Kisor to the Guidelines. These include:
- Intended Loss in Fraud and Theft Cases: This is the part of the definition of “loss” that the Third Circuit rejected in Banks. In many cases a fraud scheme is stopped before any loss occurs, meaning the sentencing range—which can no longer be based on the intended loss—will be significantly lower than in the past.[19]
- Pecuniary Gain in Fraud and Theft Cases: The Commission commentary to USSG § 2B1.1 also directs courts to “use the gain that resulted from the offense as an alternative measure of loss only if there is a loss but it reasonably cannot be determined.” But the word “gain” does not appear in the Guideline; only the word “loss” does. Thus, when a sentence range is determined under Section 2B1.1, the government will no longer be able to fall back on the amount of gain as an alternative to loss.
- Commingled Funds in Money Laundering Cases: The money laundering guideline, USSG § 2S1.1(a)(2), ties the offense level to the “value of the laundered funds.” Yet the Commission commentary states that court should use the value of commingled funds if the defendant is unable to “provide[] sufficient information to determine the amount of criminally derived funds without unduly complicating or prolonging the sentencing process.” This commentary tries to do two things that are not found in the language of the Guideline: it would allow an enhancement for more than the “value of the laundered funds” and it would shift the burden from the government to the defendant to prove the amount that was laundered. Kisor and Banks prevent courts from deferring to this commentary.
- Pattern of Unlawful Activity in Offenses Under the Bank Secrecy Act: In the Guideline covering structured transactions and similar offenses, USSG § 2S1.3(b)(2), the penalty is increased if the defendant “committed the offense as part of a pattern of unlawful activity.” The Commission commentary defines a “pattern” as “at least two separate occasions.” Under the reasoning of Kisor and Banks, that commentary is vulnerable because conventional definitions generally suggest at least three instances to be considered a pattern.[20]
- Penalties for Related Conduct in Tax Offenses: In the Guideline applicable to tax offenses, USSG § 2T1.1(c), the tax loss is defined as “the total amount of loss that was the object of the offense.” The Commission commentary expands on this language by directing courts to consider “all conduct violating the tax laws . . . as part of the same course of conduct or common scheme or plan unless the evidence demonstrates that the conduct is clearly unrelated.” This commentary is vulnerable to attack for expanding the meaning of “the offense” and creating a presumption that other conduct is related to (and thus included within) the offense.[21]
- Credit for Cooperation by Corporate Defendants: In calculating the appropriate fine range for corporate defendants, the Guidelines direct courts to determine the entity’s “culpability factor,” which includes consideration whether that entity “fully cooperated.”[22] The Commission commentary purports to require more than “full[]” cooperation, though, by stating it must be “thorough” and “timely.” Moreover, the commentary states that “[t]o be thorough, the cooperation should include the disclosure of all pertinent information,” which implicates important privilege protections including the attorney-client privilege. Corporations will have strong arguments that they deserve cooperation credit without satisfying the language in the commentary.
These are just a few ways in which cases like Banks threaten to upend sentencing outcomes. And because the Department of Justice and some other agencies rely on Sentencing Guidelines calculations in negotiated resolutions, this recent development will also be an important tool in settlement discussions, including those leading to NPAs and DPAs. These types of resolutions have become a mainstay in recent years,[23] and counsel representing individuals and corporations will want to be alert to the opportunity to challenge government efforts to increase penalties in ways that were accepted as unavoidable for many years. Simply put, the normal government playbook in settling white collar criminal matters may no longer rest on solid footing, and savvy advocates can strategize how to gain from these opportunities.
It will be important for counsel to be prepared to engage with the government on its expected efforts to distinguish cases like Banks on various grounds, including that the challenged commentary for other Guidelines is within a realm of ambiguity or that it is a reasonable interpretation. Gibson Dunn will continue to monitor the impact of Kisor on the Sentencing Guidelines and ways in which penalties can be reduced based on this development.
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[1] 18 U.S.C. § 3553(a)(4)(A).
[2] United States Sentencing Commission, Statistical Information Packet Fiscal Year 2021, available at https://www.ussc.gov/sites/default/files/pdf/research-and-publications/federal-sentencing-statistics/state-district-circuit/2021/1c21.pdf
[3] Stinson v. United States, 508 U.S. 36, 42-43 (1993).
[4] Id. at 44-45; Bowles v. Seminole Rock & Sand Co., 325 U.S. 410 (1945); Auer v. Robbins, 519 U.S. 452 (1997).
[5] 139 S.Ct. 2400 (2019).
[6] Id. at 2404.
[7] Id. at 2415.
[8] Id. at 2404.
[9] See United States v. Banks, No. 19-3812, 2022 WL 17333797 (3d Cir. Nov. 30, 2022).
[10] Id. at *1.
[11] USSG § 2B1.1, app. note. 3.
[12] Id.
[13] Id.
[14] See id. at *6–7.
[15] United States v. Riccardi, 989 F.3d 476 (6th Cir. 2021).
[16] See United States v. Lewis, 963 F.3d 16, 24 (1st Cir. 2020), United States v. Tabb, 949 F.3d 81 (2d Cir. 2020), United States v. Richardson, 958 F.3d 151 (2d Cir. 2020), United States v. Lovelace, 794 Fed App’x 793 (10th Cir. 2020); United States v. Mellon, No. 21-12248, 2022 WL 4091736 (11th Cir. Sept. 7, 2022).
[17] Compare United States v. Campbell, 22 F.4th 438 (4th Cir. 2022) (holding that Kisor limited Stinson’s scope); United States v. Moses, 23 F.4th 347 (4th Cir. 2022) (holding that “Kisor did not overrule Stinson’s standard for the deference owed to Guidelines commentary”).
[18] United States v. Vargas, 35 F.4th 936 (5th Cir. 2022).
[19] For example, bank fraud cases based on alleged misrepresentations on loan applications often involve intended loss values (the value of the loan) that are far greater than the actual losses sustained by the banks. In United States v. Morgan, 18-CR-108-EAW, (WDNY 2019), a case in which Gibson Dunn was counsel, DOJ alleged $500 million in losses in a 114-count indictment when the actual losses were far lower. The government’s recent wave of Paycheck Protection Program (“PPP”) and related COVID-19 related fraud cases show similar disparities between intended and actual losses. In December 2021, DOJ charged four defendants in connection with a PPP fraud scheme where the intended losses (the amount sought in forgivable PPP loans) was $35 million, but the defendants obtained only $18 million. See Four Charged in $35 Million COVID-19 Relief Fraud Scheme, Dec. 15, 2021, available at https://www.justice.gov/opa/pr/four-charged-35-million-covid-19-relief-fraud-scheme.
[20] See Sedima, S.P.R.L. v. Imrex Co., Inc., 473 U.S. 479, 496 n.14 (1985) (“Indeed, in common parlance two of anything do not generally form a ‘pattern.’”).
[21] USSG § 1B1.3.
[22] USSG § 8C2.5(g).
[23] See Gibson Dunn 2021 Year-End Update on Corporate Non-Prosecution Agreements and Deferred Prosecution Agreements, February 3, 2022, available at https://www.gibsondunn.com/2021-year-end-update-on-corporate-non-prosecution-agreements-and-deferred-prosecution-agreements/; see also U.S. Sent’g Comm’n, The Organizational Sentencing Guidelines: Thirty Years of Innovation and Influence 12, 12 n.101 (Aug. 2022), https://www.ussc.gov/sites/default/files/pdf/research-and-publications/research-publications/2022/20220829_Organizational-Guidelines.pdf (acknowledging that “criminal prosecutions resulting in a sentencing are only one method by which an organization’s violations of the law can be addressed by the authorities” and citing both the DOJ Justice Manual and Gibson Dunn’s year-end alert on corporate DPAs and NPAs).
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following leaders and members of the White Collar Defense & Investigations or Global Tax Controversy & Litigation practice groups:
White Collar Defense and Investigations Group:
Joel M. Cohen – New York (+1 212-351-2664, [email protected])
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Charles J. Stevens – San Francisco (+1 415-393-8391, [email protected])
F. Joseph Warin – Washington, D.C. (+1 202-887-3609, [email protected])
David Debold – Washington, D.C. (+1 202-955-8551, [email protected])
Matt Benjamin – New York (+1 212-351-4079, [email protected])
Global Tax Controversy and Litigation Group:
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202-955-8693, [email protected])
Sanford W. Stark – Washington, D.C. (+1 202-887-3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202-887-3612, [email protected])
© 2023 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
It has been quite a few months in the United Kingdom, with three governments, two budgets (of sorts) and a cost of living crisis not seen since the 1970s. In an age of 24-hour media coverage, tax policy continues to be heavily debated and not always in a constructive way. Consequently, the political climate makes UK tax policy difficult to predict and trying economic times seem set to remain for the next 18-24 months.
This alert contains the key recent changes to, and policy announcements on, UK business taxes, including the latest EU measures which may impact the UK. We have also summarised the latest position on UK implementation of the OECD BEPS 2.0 initiative.
In the new year, we expect that attention will turn to likely policy direction on debt deductibility, corporate and individual taxation consequences of international mobility and cross border changes on intangible taxation – and we anticipate issuing further client alerts on these matters. On debt deductibility in particular, it is worth noting that the EU DEBRA initiative remains under debate, as well as ongoing amendments to domestic interest limitation regimes like the UK CIR, which were introduced following the BEPS 4 action report. However, these regimes were designed in an environment with low interest rates globally. As interest rates increase and such increases seem likely to be for the long term, it may be the case that ratio based regimes need amending to mitigate unintended deductibility issues for third party debt.
In the meantime, on behalf of the Gibson Dunn tax team, we wish all of our readers a happy festive season!
Please do not hesitate to contact us with any questions or requests for further information.
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I. Key changes in the Autumn Statement
b. VAT on Fund Management Services
VI. Proposed Amendments to the Tax Rules for Real Estate Investment Trusts
c. UK-Brazil Double Tax Treaty
a. Update on Pillar 1 and Pillar 2 Consultations
b. UK Implementation and Autumn Statement
UK TAX UPDATE – DECEMBER 2022
A. Domestic developments
I. Key changes in the Autumn Statement
a. Thresholds
| The government delivered its Autumn Statement on 17 November 2022 (the “Autumn Statement”), in which it announced the fixing and raising of a number of tax thresholds. |
Following the reversal of many of the measures announced in the Growth Plan 2022, the government delivered its Autumn Statement, which provided for the alteration of a number of tax thresholds as part of a plan which aims to repair public finances whilst tackling the cost of living crisis.
The income tax Personal Allowance, the higher rate threshold and the National Insurance contributions (NICs) upper earnings and upper profits limits are to be fixed for a further two years until April 2028. Additionally, the NICs primary threshold, the lower profit limit and the NICs secondary threshold will be fixed until such date. Further, the income tax additional rate threshold will be reduced from £150,000 to £125,140 from April 2023. The government has legislated for the income tax measures in the Autumn Finance Bill 2022 and will legislate for NICs changes in affirmative secondary legislation in early 2023. The government also announced that the dividend allowance will be reduced from £2,000 to £1,000 from April 2023, followed by a further reduction to £500 from April 2024. Similarly, the capital gains tax annual exempt amount will be reduced to £6,000 from April 2023 and £3,000 from April 2024.
Following the decision to proceed with the increase of the main rate of Corporation Tax to 25% from 1 April 2023, as initially announced in the Spring Budget 2021, the government confirmed that the bank Corporation Tax Surcharge will be reduced from 8% to 3%. In addition, it was announced that the rate of Diverted Profits Tax will be increased from 25% to 31%. Further announcements included the fixing of the inheritance tax nil-rate bands for a further 2 years until April 2028, and confirmation that the previous increases to the nil-rate thresholds of Stamp Duty Land Tax for all purchases of residential property and residential purchases by first-time buyers will be reversed from 31 March 2025.
b. Energy Profits Levy
| It was announced in the Autumn Statement that the Energy Profits Levy (“EPL”), which was introduced on 26 May 2022, will be increased to 35% from 1 January 2023 and will remain in place until 31 March 2028. Additionally, the Investment Allowance (“IA”) has been reduced from 80% to 29% for all investment expenditure, other than decarbonisation expenditure. |
Following the significant hike in oil and gas prices at the end of 2021 and in early 2022, and to help fund more cost-of-living support for UK families, on 26 May 2022 the government announced a new EPL, being a new 25% surcharge on the extraordinary profits made in the oil and gas sector. Subsequently, it was announced in the Autumn Statement that the EPL will increase to 35% from 1 January 2023 and will remain in place until 31 March 2028, representing a change from the initial proposed end date of 31 December 2025. The EPL is in addition to the 30% Ring Fence Corporation Tax and the 10% Supplementary Charge paid by in-scope energy companies, taking the combined rate of tax on profits for such companies to 75%. The aim of this measure is to ensure that oil and gas companies that will continue to benefit from a prolonged period of increased prices will be taxed accordingly. Additionally, the IA, which was initially introduced by the government to provide an incentive for the oil and gas sector to invest in UK extraction, has been reduced from 80% to 29% for all investment other than decarbonisation expenditure. The purpose of this reduction is to ensure that, under the increased levy rate, the existing cash value of the IA is broadly maintained. Decarbonisation expenditure will continue to qualify for an IA rate of 80%, a measure aimed to support the sector’s target to reduce carbon emissions by 50% by 2030 and key commitments in the North Sea Transition Deal in the transition to Net Zero.
c. R&D Relief
| A number of changes to the R&D tax relief scheme were announced in the Autumn Statement, including the increase in the R&D credit rate and decrease in the small and medium-sized enterprises (“SME”) credit rate and SME additional deduction. |
The government announced in the Autumn Statement that for expenditure incurred on or after 1 April 2023, the R&D credit rate will increase from 18% to 20%, the SME additional deduction will decrease from 130% to 86%, and the SME credit rate will decrease from 14.5% to 10%. These measures have been largely introduced to improve the competitiveness of the R&D scheme and underpin a move towards the development of a simplified, single scheme, the design of which the government intends to consult on. Additionally, the government has stated that, ahead of the Budget, it will work closely with industry to understand whether further support is necessary for R&D intensive SMEs without significant change to the overall cost for supporting R&D. As initially announced in the Autumn Budget 2021, qualifying expenditure under the R&D scheme has been extended to include data and cloud computing costs.
II. Consultations
a. Sovereign Immunity
| In July, the UK government published a consultation on potential reforms to the UK’s sovereign immunity rules. Currently, sovereigns are afforded exemption from all direct UK tax. The UK government proposes to narrow the exemption to UK-source interest and put the (narrower) exemption on legislative footing. If implemented, the proposals would bring (amongst others) trading and rental income earned by sovereigns (including sovereign wealth funds) within the scope of UK tax. |
The doctrine of sovereign immunity derives from principles of international law, and is not codified in UK law. Currently, the UK government’s interpretation of the doctrine exempts sovereign states (and, potentially, the funds and bodies through which they act) from direct UK tax. As a practical matter, the immunity is typically availed of through bilateral, confidential correspondence between the UK and the sovereign recipient in question, with HMRC considering whether the exemption should apply to particular bodies/entities on a case-by-case basis. Paragraph INTM860180 of HMRC’s International Tax Manual notes, however, that a “legal entity that is separate and distinct from the foreign Government [cannot avail of the immunity] even though that government may own the whole of the share capital”.
The consultation includes the following proposals:
- Eligibility: Governments (including the states of a federation, but not including municipalities) should be eligible for the exemption. Views have been invited as to whether entities controlled by governments should be exempt.
- Scope: The exemption would be limited to UK-source interest only, to the extent “not related to trading activities” (a proviso on which no detail is offered). Rebasing to the date the proposals are introduced would apply for non-resident capital gains tax purposes. By way of justification, the consultation: (i) acknowledges the material cost of the exemption (particularly in light of the expansion of the non-resident capital gains tax charge in 2019); and (ii) draws comparisons with other jurisdictions, noting that the proposed limitations “are comparable to the approach taken by other countries such as the US and Australia”. Significantly, this comparison is based on an overly broad (and, some might say, simplistic) view of other regimes, in particular the tax exemption afforded by section 892 of the US Internal Revenue Code, which in the context of US real estate investments for example, may allow a qualifying section 892 investor to enjoy tax exemption in relation to certain sales of shares in a US real property holding company or a REIT, and in relation to certain qualifying income from a REIT.
- Administration: Each sovereign body would only be granted (the revised narrower) immunity following a formal application to, and approval from, HMRC. Irrespective of whether granted, tax registration, reporting and payment rules would apply to sovereigns in the same way as they apply to non-UK residents currently.
- Commencement: It is proposed that the changes would apply: (i) for income and gains recognised, for corporation tax purposes, in accounting periods ended on or after 1 April 2024; and (ii) for natural persons, from 6 April 2024.
Input is also sought regarding difficulties that would be faced if a sovereign’s “qualified” or “institutional” investor status elsewhere in the UK tax code was removed e.g. for the purposes of reliefs, such as the substantial shareholding exemption, the UK Real Estate Investment Trust rules and the Qualifying Asset Holding Company regime, which may be dependent on a taxpayer’s shareholders having such status. In this context, the consultation notes that “the government is not minded to change how all of these areas of the tax code operate in relation to sovereign persons”.
In addition to increasing the tax costs for sovereigns investing in the UK, the proposals may have wider implications for investors into the UK. For example: (i) if a sovereign’s status as a qualified or institutional investor was lost, this could impact the tax position of the UK taxpaying groups into which the sovereign invests; and (ii) funds that have feeder funds (or other structural divisions) specific to exempt investors may (absent generous transitional rules) need to restructure to move sovereign capital into non-exempt pools. These concerns have been raised by various respondents to the consultation. The consultation closed on 12 September 2022. The proposals in the consultation pre-date the current government’s tenure. However, given the potential tax revenue that the proposals would generate, it is expected that the current government will be similarly interested in taking this forward.
b. VAT on Fund Management Services
| In December 2022, the government published a consultation on the VAT treatment of fund management services. The government intends to codify both the existing UK exemptions and retained EU law into UK statute to provide a consolidated single source of law regarding the VAT liability of a supply of fund management services. These legislative changes include a defined criteria to determine which funds are considered Special Investment Funds (“SIFs”), the relevant VAT exemption of which is currently provided under EU law. |
The government has recently published a consultation on the VAT treatment of fund management services. This forms part of a wider focus towards developing the UK’s framework for financial services regulation in order to support a dynamic, stable and increasingly competitive financial services sector.
The VAT treatment of fund management services in the UK is largely derived from EU law. Specifically, Article 135(1)(g) of EU VAT Directive 2006/112/EC (the “Directive”) provides for the VAT exemption of the management of SIFs, while the management of funds that do not qualify as SIFs are subject to the standard rate of VAT (currently 20%). The Directive was transposed into domestic law, with Items 9 and 10 of group 5 of Schedule 9 to the VAT Act 1994 (“VATA 1994”) listing specific types of exempt funds. On the basis that there is no definition of a SIF in existing legislation and considering the wider uncertainty that this causes to businesses, the government intends to codify both existing UK exemptions and retained EU law into UK statute. This is intended to provide further clarity in relation to the VAT treatment of fund management in the UK and consequently simplify the decision-making process involved in identifying the VAT liability of a supply of fund management services for stakeholders. These developments also reflect the government’s wider agenda to remove retained EU law post-Brexit (see below for further discussion on this).
The government has stated in its consultation that it intends to retain the list of exempt fund types currently comprising Items 9 and 10 of group 5 of Schedule 9 to the VATA 1994 (to ensure the continuity of treatment of existing funds), but also intends to introduce relevant case law and guidance into UK law in order to establish defined criteria to determine which funds fall within the SIF exemption. Notably, it is proposed to break from the criteria set out in the European Commission’s EU VAT Committee guidelines by excluding the existing requirement that funds qualifying as SIFs must be subject to “State Supervision”. The government’s reasoning is that this requirement is unnecessary given that such funds must be intended for retail investors and simplifying the policy is also of wider interest. Additionally, the government intends to ensure the correct interpretation of the requirement that such funds must be a collective investment vehicle by providing a clear definition of “collective investment” in the legislation. It is understood that this definition will broadly mirror that provided within the Financial Services and Markets Act 2000, which the industry is familiar with.
It is clear that the government’s approach is intended to broadly maintain the scope of the current VAT exemption. However, it may be disappointing for some stakeholders that zero rating of fund management services has not been considered. This may not be surprising given the current environment. Nevertheless, such a development would further strengthen the position of the UK’s financial services sector.
III. Transfer Pricing
| Transfer pricing has received significant attention in recent years, and has accounted for an increased amount of the tax take in the UK and other western European countries in recent times. At the EU level, there have been some helpful cases in relation to application of transfer pricing rules by member states but a number of uncertainties remain. In the UK, the focus has shifted to documentation and evidencing arm’s length transactions in a context where transfer pricing is expected to be subject to greater scrutiny. |
Transfer pricing has been receiving a lot of attention in the last few months. Perhaps most importantly, the Court of Justice of the European Union (“CJEU”) has given its judgement in the long running ‘Fiat’ Case (Case C-885/19).
To recap, in 2015 the European Commission (“EC”) concluded that Fiat had been granted unlawful state aid by Luxembourg in respect of a finance company within the Fiat group. The EC’s decision centred on the transfer pricing principles used to support the arm’s length return received by the finance company from other Fiat group members. Fiat challenged the EC’s decision but the General Court of the European Union (“GCEU”) dismissed the appeal in 2019. On 8 November 2022 the CJEU overturned the 2015 and 2019 decisions.
In doing so, the CJEU’s key finding was that the GCEU and the EC had wrongly considered the general objectives of corporate income tax. Rather, they should have considered Luxembourg’s application of the arm’s length principle solely by reference to Luxembourg’s domestic laws and guidance. Implicit in this conclusion is that the arm’s length principle is not inherent in the prohibition on state aid itself.
The impact of the CJEU’s decision could have wide ramifications for a number of clients. We know of at least three cases pending before the CJEU where the EC has adopted similar reasoning to that which was dismissed by the CJEU in ‘Fiat’. There are several others we are aware of which are under investigation by the EC. The impact of the Fiat decision could be helpful to the taxpayers in these cases.
On a related note, the CJEU has also given its decision in another transfer pricing case: X GmbH (Case C-431/21). The decision was made on 13 October 2022 and, at first glance, the conclusions appear reasonably innocuous. In summary, the CJEU concluded that German laws relating to transfer pricing record keeping and documentation in respect of cross-border transactions did not violate freedom of establishment principles. These laws imposed penalties and surcharges for non-compliance with transfer pricing documentary requirements which were the subject of the case before the CJEU.
While the legality of the penalties and surcharges is of some consequence, probably the more interesting point for most arising from this case is a reminder of the inherent conflict between transfer pricing and freedom of establishment. Many jurisdictions consider that intra-jurisdiction transfer pricing rules would be redundant and simply an administrative burden. There is some sense in this point of view: there is very little reason for a tax authority to object to returns being artificially increased and taxed in one company in its jurisdiction at the expense of another in the same jurisdiction. In theory, the taxable profit for that jurisdiction should, in the round, be the same notwithstanding a non-arm’s length transaction between two entities within that jurisdiction. The result is that many jurisdictions only apply transfer pricing rules to cross-border transactions and this is where the conflict arises. Any rule which applies to (and potentially penalises) taxpayers undertaking cross-border transactions but not domestic transactions is at risk of challenge on the grounds of being an obstacle to freedom of establishment.
The CJEU has had a number of opportunities (including in the case of X) to determine that transfer pricing rules are not contrary to freedom of establishment principles simply by virtue of applying to cross-border transactions only. However, the CJEU has declined to make such a determination and instead has considered whether the measures (the penalties and surcharges in the case of X) are appropriate and proportionate (if they are, they are permissible notwithstanding that they hinder freedom of establishment). The result is that many (if not all) cross-border transfer pricing measures within the EU remain liable to challenge and may need to be shown to be appropriate and proportionate on a case by case basis.
On the topic of transfer pricing documentation, new rules will come into force in the UK to align its documentation requirements with the OECD’s recommendations. Current UK rules do not require a ‘master file’ (containing information required by all members of a multinational group) and a ‘local file’ (relating to transactions of the UK entity only), while the OECD’s guidance requires both. From April 2023, UK taxpayers which are large multi-national businesses (those with turnovers above €750 million) will be required to maintain both and to provide them to HMRC for inspection on 30 days’ notice. However, the UK’s rules are expected to go further than their OECD equivalents by further requiring evidence of how the local file is prepared. This is referred to as a ‘summary audit trail’ and further consultation and regulations are expected in due course.
IV. Retained EU Law Bill
| From 31 December 2023, any EU law that the government deems should remain in effect will be assimilated into domestic legislation. Accordingly, any EU law not preserved shall cease to have effect in the UK. |
“Retained EU Law” refers to law created at the end of the “Brexit” transition period and consists of EU-legislation that was implemented in our domestic legislation in the European Union (Withdrawal) Act 2018, to avoid significant gaps appearing in the UK legal system due to a potential mass exodus of previously applying EU law. However, in order to allow the UK to adapt these “inherited” laws, the Retained EU Law Bill (the “Bill”) was published, with the principal effect being that any retained EU law contained in EU-derived secondary legislation and retained direct EU legislation will expire on 31 December 2023 (although certain pieces of retained law may be extended to 2026) unless otherwise specifically preserved. This will not impact the Northern Ireland Protocol which shall continue to apply as regards Northern Ireland.
The intention of this is to allow the Government to repeal and replace retained EU Law more easily. Any preserved EU Law that remains in force after the sunset date will be assimilated into the domestic statute book of the UK. Accordingly, the principle of the supremacy of EU law and directly effective EU rights will end on 31 December 2023, meaning that no general principle of EU law will be part of domestic law after 31 December 2023.
The Bill does not impact the current position whereby, when interpreting retained EU law, rulings of the CJEU will be binding when they were made prior to 31 December 2020, and “advisory” (i.e. they can be applied by the courts if the CJEU ruling matches the facts at hand) following this date. However, the Bill does allow lower courts to make references to the higher courts (e.g. the Court of Appeal or Supreme Court) to ask them to reconsider a binding CJEU ruling where they believe it is of general public importance to do so. This will allow lower courts that currently must follow pre-31 December 2020 rulings to effectively draw any inconsistencies to the attention of higher courts to allow a quicker transition away from EU case-law “supremacy”. Additionally, Devolved Law Officers will be given a procedure to refer or intervene in cases regarding retained case law.
The full extent of the impact of the Bill is yet to be seen. While there is support for the Bill by allowing the Government to finally move away from EU rules (almost three years after Brexit actually occurred), there is concern that the government has not announced a key list of legislation that it wishes to reform, suggesting that the sunset date of 31 December 2023 may have been an arbitrary date which may be pushed back further.
V. QAHC
| The ‘Qualifying Asset Holding Company’ (“QAHC”) regime has been amended to refine and clarify certain elements. |
In February 2022 we reported on the new UK tax regime applicable to QAHCs. That report can be found here. The Finance Bill 2023 makes three clarificatory changes to refine the QAHC regime.
The first two changes relate to funds and the genuine diversity of ownership condition. For context, a condition of the QAHC regime is that the company seeking to benefit from the regime is at least 70% owned by ‘Category A’ investors. A lot of funds which are set up as partnerships will be Category A investors by virtue of being: (i) ‘collective investment schemes’; which (ii) meet the ‘genuine diversity of ownership’ test. Each of these two tests presented a potential problem for some funds.
The problem with using the term ‘collective investment scheme’ is that it excludes any entity (subject to very limited exceptions) which is a body corporate under its domestic law. With effect from 1 April 2022, bodies corporate, which would be collective investment schemes had they not been bodies corporate, can be treated as collective investment schemes for the purposes of the QAHC rules. What is not clear is whether the intention of the change is to widen the ambit of the definition of a collective investment scheme significantly or to solve for a very narrow technical concern. The technical concern is that certain non-UK (notably Delaware) fund entities can theoretically be both partnerships and bodies corporate under their domestic law. On a narrow reading, this change simply deals with this issue and allows such an entity to be treated as a collective investment scheme. However, the change also potentially brings other corporate fund vehicles (which would not be considered as also being partnerships) and companies which would not traditionally be seen as funds at all within the definition of collective investment scheme. It remains to be seen whether HMRC will clarify the intention either in guidance or amended legislation.
Having established that an entity is a collective investment scheme, in order to be a Category A investor, it must meet the ‘genuine diversity of ownership’ condition. This condition is broadly that the entity is widely marketed. This presented an issue for funds where investors participated via a number of parallel vehicles which, taken together, met the genuine diversity of ownership condition but, individually, did not. With effect from a date to be confirmed, parallel funds which do not, alone, meet the genuine diversity of ownership condition can be treated as meeting the conditions where the collective investment schemes with which they are associated meet the conditions. The conditions for showing sufficient association with the other fund vehicles are very prescriptive. Broadly there must be a commonality of assets, holding structure, terms of investment and fund management between the various parallel collective investment schemes in order to aggregate them for the purposes of the genuine diversity of ownership test. This is certainly good news in the simplest of scenarios (for example, where some investors invest through a blocked entity while others invest on a flow through basis for US tax purposes but the fund terms and downstream investment structure are otherwise identical). In more complex scenarios where certain investors have enhanced or investor specific fund or side letter terms, it is not clear that all parallel vehicles would benefit from this aggregation.
Finally, with effect from 20 July 2022, the QAHC regime’s anti-fragmentation rules have been extended. When testing whether a QAHC has at least 70% Category A investors, the interests of direct investors are aggregated with interests which that same investor holds through another investor in the would-be QAHC. Because a QAHC is itself a Category A investor if it invests in another would-be QAHC, it was possible to dilute the ultimate Category A investor holding below 70% by having the same non-Category A investor holding an interest of less than 30% in both the would-be QAHC and the QAHC investing in it. This change prevents this from happening by treating interests held through other QAHCs as held directly.
VI. Proposed Amendments to the Tax Rules for Real Estate Investment Trusts
| It was announced on 9 December 2022 that the tax rules for Real Estate Investment Trusts (“REITs”) will be amended with effect from April 2023 to remove the requirement for a REIT to own at least three properties, where a single commercial property worth at least £20 million is held and to amend the rule that applies to properties disposed of within three years of significant development activity. |
In a statement made by the Chancellor on 9 December 2022, it was announced that the tax rules for REITs would be amended with effect from April 2023. Firstly, the new rules will remove the requirement for a REIT to own at least three properties to qualify as having a tax-exempt business in respect of its property rental business, where the REIT holds a single commercial property worth at least £20 million. This is a welcome measure, particularly for smaller companies and start-ups as it should facilitate their access to the REIT regime. Secondly, the government intends to amend the rule that provides that a property is deemed to be sold in the course of a trade if it is sold within three years of significant development activity, although it has not yet been confirmed what this amendment will be. Where this rule currently applies, the property is treated as having been disposed of in the course of the residual business of the REIT and therefore any gain arising on the disposal is subject to corporation tax. The government has stated that such change is designed to ensure that this rule operates in line with its original intention.
B. International Developments
I. EU Updates
a. BEFIT Consultation
| The EC has published a call for evidence and consultation regarding its new proposal for an EU-wide consolidated corporate tax base (the so-called “Business in Europe: Framework for Income Taxation”, or “BEFIT”). Certain aspects of the EC’s thinking appear to borrow from the OECD’s Pillar 1 and Pillar 2 proposals. |
The intention of BEFIT is to reduce compliance costs, and complexity, by introducing a single, coherent, tax base across EU Member States (with a view to increasing EU competitiveness).
The BEFIT Consultation illustrates that the BEFIT proposal is still in its infancy, and that the EC is still in an exploratory phrase. The BEFIT Consultation notes that potential policy choices open to Member States range from maintaining the status quo (effectively shelving the project) to adopting a Directive mandating the material features of the proposed common tax base (including, following in the OECD’s Pillar 1 footsteps, rules for the allocation of taxing rights between EU Member States). If action is to be taken, the BEFIT Consultation posits a number of potential options in formulating a proposal:
- “In-scope” taxpayers: The proposal could: (i) mirror the OECD’s Pillar 2 proposals by limiting the application of BEFIT to multinational groups with annual global revenues in excess of €750 million; or (ii) adopt a wider scope, so that small and medium enterprises could (either on a mandatory, or an “opt-in” basis) benefit from the enhanced simplicity the proposal aims to offer. The BEFIT Consultation notes, in particular, the EC’s preference for any measure not to exclude particular sectors from its scope.
- Calculation of tax base: The proposal could: (i) use the consolidated financial accounts as a starting point, and introduce limited adjustments thereto; or (ii) introduce prescriptive and detailed rules for calculating the tax base (akin to the approach adopted by most EU Member States under their existing local rules).
- Allocation of the tax base: As with Pillar 1 rules, the BEFIT Consultation contemplates that, once calculated, the consolidated tax base would be allocated between the EU Member States in which the group has a (yet to be defined) taxable presence. It is contemplated that rules determining the “taxable presence” in this context would “reflect the source of the underlying income generation”. The most significant nexuses for this purpose are considered to be the location of labour, tangible assets and sales by destination (although it is noted that intangible assets could present a fourth nexus by reference, for example, to where research and development and marketing costs are incurred).
- Interaction with non-EU tax systems: The proposal recognises that transfer pricing rules would still be necessary to the extent that the taxpayer group includes EU and non-EU members that transact with one another. In this respect, the BEFIT Consultation contemplates that existing transfer pricing rules could be maintained, or guidance could be produced for Member States with a view to applying transfer pricing rules on a simplified basis.
It remains to be seen whether BEFIT will gain wider traction. It is notable, for example, that it would require unanimous approval from all Member States and that the EU’s previous attempts to create a consolidated tax base, in 2011 and again in 2016, have failed. In addition, developments since the proposal was first mooted in 2021 may encourage caution, including: (i) a worsening economic background (which could render Member States reluctant to cede control over taxing rights); and (ii) the increasing complexities that have mired the OECD’s BEPS 2.0 project. Against that background, it remains to be seen whether the BEFIT will succeed where its predecessors have failed. While the EC has indicated that it is targeting Q3 2023 for adoption, it seems likely to be longer before clarity emerges.
b. ATAD III Update
| In mid-2021 the EC published a draft directive to tackle the use of shell companies by limiting the tax reliefs available to them (so-called “ATAD III”, discussed in our February 2022 Quarterly Tax Alert, which can be found here). The European Parliament’s Committee on Economic and Monetary Affairs (“CEMA”) has subsequently proposed that ATAD III’s implementation be deferred by 12 months, in addition to proposed amendments to the scope of the proposal and the substance required to be demonstrated thereunder. However, questions remain as to whether, and (if so) in what form, ATAD III will be implemented. |
In May 2022, CEMA recommended that ATAD III’s proposed effective date be pushed back (from 1 January 2024 to 1 January 2025, respectively). Other key amendments proposed by CEMA included: (i) widening the exemption applying to “regulated financial undertakings” (to similarly exempt their subsidiaries); and (ii) permitting an entity to outsource day-to-day operations to associated enterprises in the same jurisdiction without this causing the former to be an “at risk” (i.e. an entity that is required to positively confirm, in its annual return, that it meets specified substance requirements).
However, in September 2022, different CEMA members/sub-groups proposed (at times contradictory) amendments to the draft ATAD III directive:
- Some proposed amendments strengthen the scope and requirements of the directive, e.g. by removing the exemption for regulated financial undertakings entirely (in contrast to the approach in May).
- Other amendments ease the practical burden and cost of the directive, e.g. by deleting the requirement that entities should have at least one local director that is not a director of any other unconnected entity (a requirement that would materially restrict the ability to engage local corporate service providers to assist with governance).
- Timing wise, the amendments reflected the proposed effective date of 1 January 2025 recommended in May 2022. However, elsewhere, amendments propose that an entity’s substance is assessed over a two year look-back period starting, for the first time, on 1 January 2024 (which may suggest a 1 January 2026 effective date).
While CEMA was due to vote on the proposed amendments on 30 November 2022, the outcome is yet publicly available.
Depending on the final form of the directive, it is conceivable that an entity’s income and activities from 1 January 2023 onwards could determine whether it has sufficient substance and is capable of accessing treaty reliefs (e.g. if the proposed two year look-back is implemented and the directive takes effect on 1 January 2025). It is hoped that greater clarity about the scope of, and timing for implementation of, the rules is available before then, so taxpayers can plan their affairs accordingly.
c. UK-Brazil Double Tax Treaty
| On 29 November 2022, the UK and Brazil entered into a double tax treaty (“DTT”) which shall, once in force (and assuming that no further amendments are made), apply to income tax, corporation tax and capital gains tax in the UK. |
Historically, Brazil has been one of very few major jurisdictions that did not have a DTT with the UK. However, on 29 November 2022, following just 3 months of formal negotiations, the UK and Brazil (the “Contracting States”) entered into a DTT, which will come into force once both countries have complied with their respective domestic procedures to implement such treaty.
Assuming no further amendments are made to the DTT before it is implemented, the DTT shall apply to income tax, corporation tax and capital gains tax in the UK (and federal income tax and social contribution on net profit in Brazil). Generally, the DTT is a comprehensive DTT, and includes a number of bespoke provisions, including an “offshore activities” clause, a limitation of benefits clause and a mutual agreement procedure (“MAP”).
The treaty will act to reduce, rather than eliminate, withholding tax rates on both interest and royalties (albeit having a greater effect on payments from the UK where the “pre-treaty” headline rate is higher (at 20%) than Brazil (at 15%)). One notable exception to this is for pension schemes, in relation to which interest (and dividends) paid by a company resident in either Contracting State to a pension scheme established in the other state are exempt from tax in the jurisdiction of residence of the payor. Additionally, as a result of the DTT including a non-discrimination article, it brings interest payments made between the Contracting States within the scope of the qualifying private placement (“QPP”) exemption. The QPP exemption is an exemption from paying UK withholding tax on interest paid on certain unlisted debt securities, but requires the creditor to be resident in a “qualifying territory” (being a territory with which the UK has a double tax treaty). The QPP exemption is particularly useful where a double tax treaty reduces withholding tax on interest, as opposed to eliminating it (as is the case here), providing an alternative method to be able to pay interest free from UK withholding tax.
The treaty also includes provisions relating to withholding tax on dividends, although as neither Contracting State currently imposes withholding tax on dividends, this provision appears to be “future-proofing”. That said, article 10(5) of the treaty introduces a bespoke provision, which states that where a resident of a Contracting State has a permanent establishment in the other Contracting State, that permanent establishment may be subject to a tax withheld at source in accordance with the law of that other Contracting State, but at a rate not to exceed 10 per cent of the gross amount of the profits of that permanent establishment determined after the payment of the corporate tax related to such profits. Thus, Brazil or the UK would theoretically be permitted to impose tax withholding at source on the after tax profits of a permanent establishment of a resident of the other state, which raises several practical and procedural questions (notably, on how such taxation would be collected in practice).
The “offshore activities” clause expands the scope of a permanent establishment to include activities which are carried on offshore in either Brazil or the UK in connection with the exploration, exploitation or extraction of the seabed and subsoil and their natural resources situated in that state. It is likely this clause was introduced due to the “Blue Amazon”, an area off the coast of Brazil that is known to be abundant in natural and mineral wealth, and an increase in attention that such area is receiving from companies who want to engage in deep-sea mining in international waters. The result of the “offshore activities” clause in the treaty is that any profits that a UK company makes from engaging in such activities will be taxable in Brazil.
Article 9 of the treaty enshrines a customised transfer pricing related provision for associated enterprises in Brazil and the UK, broadly allowing either Contracting State to override non-arm’s length arrangements between associated enterprises in Brazil and the UK and tax their profits accordingly (with express recognition of the need to respect corresponding adjustments in the other Contracting State).
It is also worth noting that the treaty allows for withholding on fees for technical services, which is presumably to accommodate the existing Brazilian domestic withholding tax on payments to non-residents with respect to certain managerial, technical and/or consultancy services. Interestingly, the treaty provision (article 13) institutes a ‘sliding scale’ approach, with the treaty rate of withholding on such fees reducing from 8% to 4% and then to 0% at the end of two years and four years respectively.
As noted above, the treaty also includes a bespoke limitation on benefits clause which must be complied with in order for the benefits of the treaty to apply. Companies that are resident in either Contracting State are only entitled to benefit from the DTT if such person is a “qualified person” (which includes, among others, individuals, the relevant state itself and traded companies). Additionally, a resident of a Contracting State is entitled to benefit from the DTT with respect to income derived from the other Contracting State, regardless of whether the resident is a qualified person, if the resident in engaged in the active conduct of a business in the first Contracting State and the income is derived from that business. Additionally, there is a carve-out for any transaction if it is reasonable to conclude that obtaining the benefit of the DTT was one of the principal purposes of the transaction.
The DTT also includes a MAP, whereby any taxpayer shall have three years to present any issues that arise as a result of the interpretation of the DTT. Such taxpayer must present their case to the competent authority in the Contracting State in which the taxpayer is resident, following which both Contracting States shall work together to resolve such issue.
II. BEPS 2.0
a. Update on Pillar 1 and Pillar 2 Consultations
| There have been further developments relating to both Pillar 1 and Pillar 2 over the past few months. Recently, however, the main focus has shifted towards the implementation of Pillar 2 into domestic law. The main focus of this in the UK was the publication of draft legislation for the new Multinational Top-Up Tax (“MTT”) which broadly follows the OECD’s model rules in its implementation. Additionally, in the Autumn Statement, the Chancellor announced the intention to introduce a qualifying domestic minimum top-up tax in the UK. |
Pillar 1
As we reported previously, the members of the OECD’s Inclusive Framework on Base Erosion and Profit Sharing have reached high-level agreement for changes to international tax-nexus rules under the so-called “Pillar 1” rules, which provide for a new right for “market jurisdictions” to tax “Amount A” (being 25% of profits that exceed a normal rate of return (10%)), and a new standardised methodology for taxing, on a fixed-return basis, marketing and distribution activities (so-called “Amount B”), although this has received limited consideration since its announcement, up until the release of a consultation in December 2022 (see below).
Since our last update (see here), there have been a number of key developments in relation to “Pillar 1”, via a number of consultations:
- In June 2022, the responses to the consultation on tax certainty aspects (which proposed mechanics for addressing widespread concerns about risks of double taxation and dispute resolution in respect of Amount A) were published. The proposals contemplate the rights for a multinational enterprise (“MNE”) to seek clearance as to whether it is in scope, and seek advance clearance on the methodology such MNE takes for calculating Amount A (which will apply for future periods). The proposals also provide for an “after the event” multilateral review binding on all relevant jurisdictions in respect of periods that have ended. Respondents generally felt that these were welcome proposals, due to tax certainty being a critical aspect for the Pillar 1 rules. However, concerns were raised as to whether taxpayers will be able to obtain clearances within reasonable time frames, and whether tax authorities will have sufficient resources to meet taxpayer demands in relation to such clearances.
- In July 2022, the OECD released the “Progress Report on Amount A of Pillar One” (which can be read here), which is a consultation document released for the purpose of obtaining further input from stakeholders on the technical design of Amount A. The Progress Report acts as a general update on the status of Pillar 1, and includes the draft rules thus far. Additionally, the Progress Report introduces three new concepts for Pillar 1: Segmentation (Amount A may apply to certain segments of an MNE if such segment meets both the revenue and profitability test), a Marketing and Distribution Profits Safe Harbour (reducing profit allocable to a jurisdiction where the MNE already has a physical taxable presence), and rules in relation to the elimination of Double Taxation. The consultation was intended to elicit any final comments that stakeholders have in relation to any aspect of the rules, with the intention of finalising the rules in 2023, ahead of implementation in 2024. Generally, respondents expressed concern about the excessive administrative pressure that could be imposed on companies if the approach for computing Amount A is not simplified. Respondents also raised their concerns that the introduction of Amount A as a global concept would deserve a global approach for administration and elimination of double taxation, which does not currently exist, and may lead to uncertainty and potential hardship for companies/groups in scope. In light of these responses, there are still a significant number of specific comments that the OECD will have to consider/address before Amount A is ready for implementation.
- On 8 December 2022, the OECD released a consultation on the design elements of Amount B (the first consultation released in relation to Amount B). Amount B is intended to provide a simplified and streamlined approach to the application of the arm’s length principle to in-country baseline marketing and distribution activities following inclusive framework members identifying that transfer pricing disputes are common with respect to distribution agreements between related parties. The consultation outlines the proposed scope, pricing methodology, documentation requirements and tax certainty impact of Amount B, and specific questions for stakeholder input and public commentators have been included for each of these topics (for further information on the proposals, see the consultation document here). Responses must be received by 25 January 2023 for review by the OECD, with a summary of the responses received expected to be published shortly thereafter.
Pillar 2
As we have reported previously (see here), the Pillar 2 rules (collectively the “GloBE” rules) have been developed extensively over the past few years. Since our last update, additional technical guidance on the model rules has been published (in March 2022 – for the guidance in full, see here). Additionally, in March 2022, the Implementation Framework Secretariat released a call for input on the Implementation Framework of Pillar 2. The responses to the call for input have flagged a few areas where stakeholders feel the rules still need further development. For example:
- Under the penalty regime for non-compliance, there were calls from respondents for a grace period during which honest mistakes will not trigger penalties.
- Respondents have called for standardised returns to minimize the excessive burden that Pillar 2 may impose already, in particular calling for the GloBE returns to be filed with the tax authority of the parent, and each other member of the MNE, within 15 months of the end of the reporting year in question.
- Calls for safe harbours for members of MNEs which are not intended to fall within the scope of the new rules (i.e. members who are likely to be taxed above the 15% minimum rate).
In response to the March 2022 consultation, on 20 December the Inclusive Framework released an implementation package relating to Pillar 2. The implementation package consists of guidance on Safe Harbours and Penalty Relief, a public consultation document on the GloBE Information Return and a public consultation document on tax certainty for the GloBE rules.
The guidance on Safe Harbours and Penalty Relief includes the agreed terms of a Transitional Country-by-Country Reporting Safe Harbour that broadly removes the obligation of calculating the GloBE effective tax rate for an MNE’s operations in lower-risk jurisdictions during the initial years of implementation of the rules, therefore providing relief to MNEs in respect of their compliance obligations as they are coming to terms with the operation of the rules. The guidance also sets out a framework for the development of Simplified Calculations Safe Harbours that would reduce the number of computations and adjustments an MNE is required to make under the GloBE rules or allow the MNE to undertake alternative calculations to demonstrate that no GloBE tax liability arises in relation to a particular jurisdiction. Lastly, the guidance outlines the Transitional Penalty Relief Regime, which requires a jurisdiction to give careful consideration as to the appropriateness of applying penalties or sanctions in connection with the filing of a GloBE Information Return where a tax administration considers that an MNE has taken “reasonable measures” to ensure the correct application of the GloBE rules.
The second document in the implementation package, a public consultation on the GloBE Information Return, seeks input from various stakeholders on the amount and type of information that MNEs should be expected to collect, retain and/or report under the GloBE rules, possible simplifications to the GloBE Information Return, as well as the ability of the MNE Group to provide alternative data points.
The final document in the implementation package, a public consultation on tax certainty for the GloBE rules, seeks input from stakeholders in relation to various scenarios where differences in interpretation or application of the GloBE rules between jurisdictions may arise and whether such stakeholders would suggest other mechanisms for ensuring the consistent and coordinated application of the GloBE rules, which are not currently being considered.
Nevertheless, subject to further tweaks to reflect the above, the Pillar 2 rules are essentially finalised. Accordingly, the responsibility now turns to inclusive framework members to implement domestic rules in accordance with the model rules in time for implementation in 2024.
b. UK Implementation and Autumn Statement
On 20 July 2022, draft legislation to implement the new MTT in the UK was released (see here). The MTT, the UK’s version of Pillar 2, works as follows:
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- It must first be determined if the group in question is a consolidated group. A consolidated group includes an entity in which no other entity has a controlling interest (and which has a controlling interest in other entities) (i.e. the parent company), and the entities whose assets, liabilities and income are included in the financial statement of the parent. The consolidated group must contain members in multiple territories, or in the alternative at least one member must have a permanent establishment outside the UK.
- Next, any “excluded entities” must not be considered part of the consolidated group. Excluded entities include:
- qualifying service entities (an entity that is 95% owned by one or more excluded entities, and either only carries out activities that are ancillary to the activities of its owners, or almost all of its activities consist of the holding of assets or the investment of funds for the benefit of its owners);
- qualifying exempt income entities (an entity that is 85% owned by one or more excluded entities, and almost all of the entity’s income is excluded dividends or excluded equity gains);
- a governmental entity;
- an international organization;
- a non-profit organization; and
- a pension fund.
Additionally, if the ultimate parent entity of the group is an investment fund, a UK REIT or an overseas REIT, a governmental entity, an international organisation, a non-profit organisation or a pension fund, that entity will be an excluded entity too.
- Next, to determine if the consolidated group is a qualifying multinational group for the purposes of the legislation, in at least two of the previous four accounting periods the non-excluded members of the group must have had revenue that exceeds €750 million (or equivalent pro rata revenue if the accounting period is shorter than 1 year).
- Next, the responsible member of the qualifying multinational group must be determined. In most circumstances, the ultimate parent will be the responsible member (if it is subject to Pillar 2 tax under the income inclusion rule). However, if the ultimate parent company is not subject to Pillar 2 tax under the income inclusion rule, an intermediate parent member may be the responsible member. The responsible member will be the member that is liable to pay the top-up amount for the group for the territory in which it is located.
- Once a qualifying multinational group has been determined, the effective tax rate (“ETR”) of the group must be determined as follows:
- The adjusted profits (or losses) for each member of the group in the accounting period in question must be determined.
- Next, the total losses of those members that made a loss in the accounting period in question should be subtracted from the total profits of those members who made a profit in the accounting period in question. If the result is less than 0, the ETR shall be treated as 15% for these purposes.
- Next, the “combined covered tax balance” for the standard members of the group must be determined. The “covered taxes” for these purposes are very broad, but generally include any taxes on profits of that member in the territory in which it is located. The covered tax balance for a member is the tax expense incurred by the member for that period (taking into account any adjustments under the legislation, including the allocation of taxes from one member to another under the MTT legislation). If the combined covered tax balance is 0 (i.e. no covered tax has been paid by any members) the ETR shall be 0% for these purposes.
- Lastly, the combined covered tax balance shall be divided by the combined profits and losses of the members (under “b” above), and multiplied by 100, to give the ETR for the qualifying multinational group.
- Assuming that the ETR calculated above is less than 15%, the top-up amount under the MTT for the territory that the responsible member is incorporated in must then be calculated. To calculate the top-up amount for a territory:
- The ETR of the standard members of the group (as calculated above) should be subtracted from 15%.
- Next, the losses for the members that made a loss should then be subtracted from the profits of the members that made a profit in the period in question.
- Then, the substance based income exclusion should then be deducted from the profits of the group (these are carve outs for payroll expenses and tangible assets for the period in question).
- Lastly, the profits after such deductions shall be multiplied by the difference between the ETR and 15%, which gives the top-up amount for the territory in question.
- The responsible member is then responsible for paying such top-up amount to the tax authorities in the jurisdiction in which it is located.
The MTT rules are still in draft form, and therefore are not yet finalised. As noted above, from the draft legislation it appears that investment funds and UK REITs will be excluded under the MTT rules by virtue of being an excluded entity. Additionally, subsidiary holding companies will likely fall within the definition of qualifying service entities to the extent that they are simply holding companies, meaning the only non-excluded entities in such structures for the purposes of the draft legislation will likely be portfolio companies, being the only companies whose main activity is not simply holding assets (i.e. companies who will not be “qualifying service entities”).
It is possible in certain scenarios where there is a master holding company, under an investment fund structure, holding a number of portfolio companies, that the master holding company would be an excluded entity, thereby meaning that there is no “responsible member” (as there is no entity that (i) is not an excluded entity, and (ii) holds a direct or indirect ownership interest in a member of the group that has a top-up amount) for the purposes of the MTT draft legislation. Accordingly, in such circumstances, it appears from the draft legislation that no top-up tax payment would be required in light of there being no responsible member. However, it is important to note that if there are portfolio company groups under the master holding company, there could be a responsible member for these purposes (being the holding company of the portfolio company group that engages in business and also holds interests in other portfolio companies), and the MTT could still apply in that case.
In addition to the MTT, at the Autumn Statement, the Chancellor announced the intention to introduce a qualifying domestic multinational top-up tax (“QDMTT”). The new QDMTT will require large groups, including those operating exclusively in the UK, to pay a top-up tax where their UK operations have an effective tax rate of less than 15%. No further detail has been released into this proposed QDMTT, although the government have stated that the QDMTT will be legislated for in the Spring Finance Bill 2023.
c. EU/ROW Implementation
In March 2022, the EC released a draft directive for the implementation of Pillar 2 in EU member states. Generally, the EC directive mirrors the model rules as set out by the OECD. However, in order to comply with other EU rules, the directive, as drafted, would apply equally to wholly domestic groups as it would to MNEs (as defined in the OECD rules). The draft directive was initially vetoed by Poland, and then vetoed by Hungary (while Poland later withdrew its veto). On 12 December 2022, it was announced that EU member states had finally reached agreement to implement a minimum 15% tax rate on multinational and domestic groups or companies with a combined annual turnover of at least €750 million as the Committee of Permanent Representatives reached the required unanimous support. It was later announced on 14 December 2022 that Poland had vetoed the agreement again, but this veto was quickly withdrawn later that same day.
Other countries are undertaking a similar process to the UK to begin domestic implementation of Pillar 2. For example, Australia has confirmed that an implementation framework is due to be completed by the end of 2022 to support domestic implementation in Australia of the model rules, with consultations being published to obtain input from interested parties on how Australia can best engage with the Pillar 2 rules. Additionally, on 12 August 2022, the U.S. Congress passed the new Inflation Reduction Act which imposes a 15% corporate minimum tax rate on certain large corporations (effectively targeted at companies that report significant income but pay minimal US federal income tax). The new corporate minimum tax will apply to tax years beginning after 31 December 2022 (for more information on the corporate minimum tax, see our client alert from 29 July 2022 here).
As we move into 2023, we expect to see further domestic top-up tax regimes being announced. It is yet to be seen how such differing regimes will interact, but there is certainly a risk that such competition may create a “race to the bottom”, possibly causing countries to lose sight of the OECD’s end-goal, and ultimately diminishing the effectiveness of such regimes.
III. Mandatory Disclosure
| Recent developments illustrate a trend towards increased mandatory reporting to, and exchange of information between, tax authorities. Such developments include additional OECD rules for reporting on cryptoassets, UK consultations on the adoption of OECD Model Mandatory Disclosure Rules (“MDR”) and Model Reporting Rules for Digital Platforms, and the UK becoming a signatory to two new multilateral treaties for the exchange of information between tax authorities. |
Following the success of the Common Reporting Standard (“CRS”) developed by the OECD in 2014 (providing for the collection by intermediaries, and exchange, of financial account information), the OECD has been a significant source of model mandatory disclosure rules:
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Reporting obligation |
UK status |
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Mandatory Disclosure Rules (2018) |
· Intermediaries required to report on: (i) arrangements designed to counteract CRS reporting and/or (ii) certain offshore arrangements to disguise beneficial ownership. · Information reported is exchanged upon request / spontaneously (if foreseeably relevant to recipient tax authority). |
· Jan 2021: UK announced its limited implementation of DAC6 (mirroring the scope of the MDR) and its intention to replace DAC6 with the MDR (see our May 2021 Client Alert here). · Nov 2021: UK published, and consulted on, draft rules implementing the MDR (in place of DAC6). The draft contemplated that reportable arrangements implemented on or prior to 29 October 2014 would need to be disclosed. · Nov 2022: Response to consultation published. UK government announced reporting of historic reportable arrangements would be limited to those implemented on or after 25 June 2018. · Nov 2022: UK signs a multilateral agreement for automatic exchange of information reported under the MDR (together with 15 other jurisdictions, incl. Cayman, Bermuda and Isle of Man). · Early 2023: MDR intended to be implemented in the UK. |
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Reporting by Platform Operators with respect to Sellers in the Sharing and Gig Economy (2020) |
· Digital platform operations required to report (annually by 1 January) on persons selling goods/services via platforms (e.g. those offering accommodation), including where the seller is established and the income it earns. · Information reported will be exchanged with seller’s home tax authority. |
· Mar 2021: EU adopts DAC7 which broadly implements OECD rules (but extends scope to sale of goods, and transport services e.g. Uber). · Jul 2021: UK publishes consultation on implementation of the rules. · Jul 2022: Responses to UK consultation published. UK government confirms that: (i) following DAC7, scope will extend to the transport platforms; (ii) there will be no exclusion for smaller platforms and (iii) no reporting will be required regarding sellers not profiting from payments received, or making <30 sales (for which they receive <€2,000) in a reporting period. · Nov 2022: UK (together with 22 other jurisdictions, including Luxembourg, Netherlands, Spain and Estonia) signs a multilateral agreement for automatic exchange of information reported under the rules. · 1 Jan 2022: Rules to take effect. |
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Crypto-Asset Reporting Framework (“CARF”) (2022) |
· Obligation for intermediaries (e.g. exchanges, wallet providers) to report on transactions in crypto-assets undertaken by customers. The standard is akin to CRS for crypto-assets. · Proposal to expand scope of CRS to include electronic money products and Central Bank Digital Currencies. |
· Mar 2022: OECD consults on proposed CARF. · Oct 2022: CARF is published in final form. · UK government has not announced whether it intends to implement CARF, but is widely expected to. While HMRC already has significant powers (under domestic laws and treaties) to request information from third parties relating to crypto-assets (and is widely reported to have exercised such powers), CARF would automate and expediate the process. |
Despite a large proportion of the OECD’s resources being directed toward the progression of the Pillar 1 and Pillar 2 projects (discussed further above), it is notable that the OECD continues (at the urging of the G-20) to expand the scope of its model mandatory reporting rules. Such regimes represent a significant tool in tax authorities’ efforts to minimise tax avoidance, tax evasion, and the so-called resultant “tax gap”. The scope of such rules is therefore expected to expand in the coming years, as tax authorities seek to increase tax revenue. When the UK left the EU, HMRC lost automatic access to the information gathered by Member States under DAC6 and DAC7. However, the UK’s adoption of two of the OECD’s mutual exchange conventions in November 2022 (to which some EU Member States are signatories) indicates that any Brexit-related impact on the information automatically exchanged by, and in favour of, HMRC is likely to be short-lived.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or the authors in London:
Sandy Bhogal (+44 (0) 20 7071 4266, [email protected])
Benjamin Fryer (+44 (0) 20 7071 4232, [email protected])
Bridget English (+44 (0) 20 7071 4228, [email protected])
James Chandler (+44 (0) 20 7071 4211, [email protected])
William Inchbald (+44 (0) 20 7071 4264, [email protected])
Isabella Fladée (+44 (0) 20 7071 4172, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
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On October 20th, the Committee on Foreign Investment in the United States (CFIUS) released its first-ever guidelines to industry on enforcement and penalties for violations of the Committee’s regulations designed to detect and mitigate national security risks arising from foreign investment. The enforcement guidelines (i) clarify the types of conduct that constitute a violation, (ii) discuss the Committee’s procedure for imposing a penalty, and (iii) highlight aggravating and mitigating factors that will influence the Committee’s penalty calculation. While the guidelines do not accompany any apparent change to CFIUS’s statutory authority, they appear to be part of an effort to increase transparency of a committee long-viewed as secretive—and also may signal increased use by the Committee of its enforcement and penalty authorities.
The issuance of the Guidelines is therefore noteworthy in several respects:
- Their issuance is another in a series of signals from the U.S. government of its intense focus on protecting national security interests, inclusive of U.S. technological leadership;
- The Guidelines provide a more transparent, public roadmap for how violations will be assessed and processed; and
- The Guidelines establish a voluntary self-disclosure mechanism for violations that has parallels with other agencies, though stops short of offering specific incentives for such disclosures.
Hear from our experienced national security and CFIUS practitioners about the impact of the guidelines, what they may mean in future enforcement actions, and how they fit into the Biden Administration’s broader focus on using industrial and economic tools in the service of national security priorities.
PANELISTS:
Stephenie Gosnell Handler is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher, where she advises clients on complex legal, regulatory, and compliance issues relating to international trade, cybersecurity, and technology matters. Ms. Handler has prior experience advising clients on diverse global cybersecurity and technology matters, including strategic legal issues, data localization, regulatory compliance, risk management, governance, preparedness, and data and export control and sanctions requirements.
David Burns is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher and Co-Chair of the firm’s National Security Practice Group. He is a former Principal Deputy Assistant Attorney General of the National Security Division of the Department of Justice. His practice focuses on white-collar criminal defense, internal investigations, national security, and regulatory enforcement matters. Mr. Burns represents corporations and executives in federal, state, and regulatory investigations involving securities and commodities fraud, sanctions and export controls, theft of trade secrets and economic espionage.
Samantha Sewall is an associate in the Washington, D.C. office of Gibson, Dunn & Crutcher and a member of the firm’s International Trade Practice Group. Ms. Sewall advises clients on compliance with U.S. legal obligations at the intersection of global trade, foreign policy, and national security, focusing her practice on compliance with U.S. economic sanctions, export controls, national security reviews of foreign direct investment (CFIUS), and anti-boycott laws.
MCLE CREDIT INFORMATION:
This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.
Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.
Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 hour.
California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.
With the midterm elections behind us, we now know what the 118th Congress will look like and have a better sense of what the Legislative and Executive Branches will focus on over the next two years. Join us for a recorded presentation that provides an overview of the 118th Congress. We forecast what legislation could gain traction in the Senate and House and lay out what the Biden Administration priorities could look like with divided government.
Topics discussed:
- Review of Midterm Election Results
- Overall Landscape – 118th Congress
- Antitrust – Overview of Notable Legislation and Potential Action
- Energy – Discussion of Potential Legislative and Executive Efforts
- Environmental, Social, and Corporate Governance – Review of Likely Oversight Activity and Other Congressional Action
- Financial Services – Regulation Versus Deregulation Efforts
- Government Contracting – Potential Administration Action
- Healthcare – Likelihood of Executive and Legislative Actions
- Infrastructure – Overview of Administrative Implementation Efforts and Expected Oversight
- Labor – Expected Administrative Actions and the Likelihood of Legislative Wins
- National Security – Review of Executive Efforts and Potential Congressional Compromises
- Taxes – Short Term Versus Long Term Efforts
- Technology – Overview of Congressional Oversight and Legislation
- Trade – Review of Administrative Efforts
PANELISTS:
Michael Bopp is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher. He chairs the Congressional Investigations Subgroup and he is a member of the White Collar Defense and Investigations Crisis Management Practice Groups. He also co-chairs the firm’s Public Policy Practice Group and is a member of its Financial Institutions Practice Group. Mr. Bopp’s practice focuses on congressional investigations, internal corporate investigations, and other government investigations.
Roscoe Jones is a partner in Gibson, Dunn & Crutcher’s Washington, DC office, co-chair of the Firm’s Public Policy Group and a member of the Congressional Investigations practice group. Mr. Jones’s practice focuses on promoting and protecting clients’ interests before the U.S. Congress and the Administration, including providing a range of public policy services to clients such as strategic counseling, advocacy, coalition building, political intelligence gathering, substantive policy expertise, legislative drafting, and message development.
Danny Smith is of counsel in the Washington, D.C. office of Gibson, Dunn & Crutcher and a member of the Public Policy practice group. Danny’s practice focuses on advancing clients’ interests before the U.S. Congress and the Executive Branch. He provides a range of services to clients, including political advice, intelligence gathering, policy expertise, communications guidance, and legislative analysis and drafting.
Amanda H. Neely is of counsel in the Washington, D.C. office of Gibson, Dunn & Crutcher and a member of the Public Policy practice group. Prior to rejoining the firm, she served as Director of Governmental Affairs for the Senate Homeland Security and Governmental Affairs, and General Counsel to Senator Rob Portman. She has represented clients undergoing investigations by several congressional committees, including the Senate Health, Education, Labor, and Pensions Committee.
MCLE CREDIT INFORMATION:
This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.5 credit hours, of which 1.5 credit hours may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.
Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.
Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.5 hours.
California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.
On December 2 and 3, 2022, the G7 (the United States, Canada, France, Germany, Italy, Japan and the United Kingdom) and Australia,[1] and the Council of the European Union (“EU”)[2] (collectively, the “Price Cap Coalition”), announced the setting of a price cap of $60 per barrel on seaborne crude oil which originates in or is exported from Russia (“Price Cap”). The Price Cap is implemented as an exception to a general prohibition on providing certain services for the maritime transportation of seaborne Russian-origin oil which had previously been announced or was in effect in some of the Price Cap Coalition member jurisdictions (“Price Cap Programs” or “Programs”).
The setting of the Price Cap is the result of close collaboration among the Price Cap Coalition members, and is another tangible examples of multilateral cooperation since the war in Ukraine began. The Price Cap Coalition itself represents a departure from traditional multilateral institutions (e.g., the UN Security Council), and the simultaneous implementation of the Price Cap Programs across several jurisdictions speaks to the strong alignment amongst the West and its allies against Russian aggression in the Ukraine.
The Price Cap Programs are not a monolith, as the three jurisdictions will implement the aligned principles of the Price Cap in slightly different ways, which adds complexity for global compliance.
In this alert we will set forth in a Q&A format the critical elements of the Price Cap Programs in the U.S., the UK and the EU, comparing and contrasting where key differences exist, although such differences are relatively slight given the high degree of coordination between the implementing jurisdictions. Readers should be aware that the other Price Cap Coalition members are implementing respective Price Cap Programs as well, which are not addressed in this particular analysis.
Question 1: What are the Price Cap Programs and when do the measures take effect?
The Price Cap Programs are laws and regulations that prohibit the provision of certain services that support the maritime transport of Russian-origin crude oil and petroleum products from Russia to third countries or from a third country to other third countries, unless the oil or petroleum product has been purchased at or below the relevant Price Cap. The current Price Cap only applies to Russian-origin crude oil and became effective along with the applicable prohibitions on December 5, 2022. A separate price cap with respect to Russian-origin petroleum products will be announced by February 5, 2023, when the applicable prohibitions on petroleum products go into effect. See Question 3 below for detail on the distinction between the products covered under each of these respective price caps and prohibitions.
Following months of volatility in supplies and rising prices in the wake of Russia’s further invasion of Ukraine, the Price Cap Programs establish a framework for the transport of seaborne Russian oil and petroleum products intended to reduce upward pressure on energy prices globally and maintain a stable supply of these products on the global market. While the Price Cap Programs were conceived as a mechanism to curtail Russia’s ability to generate revenue from the sale of its energy resources, they are also designed to avoid imposing a blanket ban on the provision of all services relating to the transport of Russian oil and petroleum products, which could have far reaching and unintended consequences on global energy markets as well as on third countries that may already be experiencing economic impact as a result of the war in Ukraine.
The focus of the Price Cap-related restrictions is on maritime transport to third countries, not to the implementing jurisdictions themselves. Each of the U.S., UK and EU either have already banned or are in the process of phasing out the import of Russian-origin crude oil and petroleum products to their own respective jurisdictions.
While the Price Cap is set in U.S. dollars, purchases of Russian oil and petroleum products in any other currency are also implicated. If the price per barrel of the products within scope is denominated in a currency other than U.S. dollars, it must be converted for purposes of calculating whether the price falls within the Price Cap. The EU has issued specific guidance on the conversion rate to be used.[3] While guidance issued by the European Commission is not legally binding, it is viewed as highly persuasive within the EU, and other members of the Price Cap Coalition may draw upon the EU’s approach.
Shipping, freight, customs and insurance costs are not included in the Price Cap. These costs should be invoiced separately and at commercially reasonable rates. Regulators have noted that unusually high costs and fees are a red flag that may indicate attempts to circumvent the Price Cap.[4] Market participants should strengthen invoicing protocols, if needed, to separately itemize and track such costs and fees and conduct risk-based due diligence where such amounts may be inflated for the purpose of evading the cap.
Question 2:
What are the various implementing laws and regulations of the U.S., EU and UK Price Cap Programs?
|
U.S. Department of the Treasury, Office of Foreign Assets Control (“OFAC”) |
EU Council of the European Union and European Commission |
UK Office of Financial Sanctions Implementation (“OFSI”) |
|
|
Primary Legal Act |
Determination Pursuant to Section l(a)(ii) of Executive Order 14071: Prohibitions on Certain Services as They Relate to the Maritime Transport of Crude Oil of Russian Federation Origin. (published Nov. 21, 2022 and effective at 12:01 a.m. eastern standard time on Dec. 5, 2022)[5] Determination Pursuant to Sections l(a)(ii), 1b and 5 of Executive Order 14071: Price Cap on Crude Oil of Russian Federation Origin. (published on and effective as of 12:01 a.m. eastern standard time on Dec. 5, 2022)[6] (Collectively, the “U.S. Determinations”) |
Establishing the legal basis for the price cap: Council Decision (CFSP) 2022/1909 amending Decision 2014/512/CFSP concerning restrictive measures in view of Russia’s actions destabilising the situation in Ukraine (Oct. 6, 2022)[7] Council Regulation (EU) 2022/1904 amending Regulation (EU) No 833/2014 concerning restrictive measures in view of Russia’s actions destabilising the situation in Ukraine (Oct. 6, 2022)[8] Implementing the price cap: Council Decision (CFSP) 2022/2369 amending Decision 2014/512/CFSP (Dec. 3, 2022)[9] Commission Implementing Regulation (EU) 2022/2368 amending Council Regulation (EU) No 833/2014 (Dec. 3, 2022)[10] Council Regulation (EU) 2022/2367 amending Regulation (EU) No 833/2014 concerning restrictive measures in view of Russia’s actions destabilising the situation in Ukraine (Dec. 3, 2022)[11] |
Chapter 4IA of the Russia (Sanctions) (EU Exit) Regulations 2019[12] Regulation 60HA of the Russia (Sanctions) (EU Exit) Regulations 2019[13] |
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Guidance |
OFAC Guidance on Implementation of the Price Cap Policy for Crude Oil of Russian Federation Origin (“U.S. Guidance”)[14] |
European Commission Guidance on the Oil Price Cap[15] (“European Commission Guidance”) |
His Majesty’s Treasury Industry Guidance on the Maritime Services Prohibition and Oil Price Cap[16] (“OFSI Guidance”) |
Question 3: What products are covered by the Price Cap Programs and when does the Price Cap apply?
The various Price Cap Programs apply to Russian origin crude oil as described by Harmonized System (“HS”) code 2709, and Russian origin petroleum products as described by HS code 2710. HS codes are administered by the World Customs Organization and are adopted nearly uniformly across all countries.
|
HS Code |
Description |
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2709 |
Petroleum oils and oils obtained from bituminous minerals, crude. Includes Clean Condensate. |
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2710 |
Petroleum oils and oils obtained from bituminous minerals, other than crude; preparations not elsewhere specified or included, containing by weight 70% or more of petroleum oils or of oils obtained from bituminous minerals, these oils being the basic constituents of the preparations; waste oils. Includes HSFO, VGO, Kerosene. |
For Russian crude oil, the Price Cap begins at the embarkment of Russian oil to sea, and lasts until the first landed sale of such oil, after customs has been cleared in a jurisdiction outside Russia. Any intermediary trade at sea as well as all ship-to-ship transfers must also occur at or below the Price Cap. The Price Cap will still apply if, after clearing customs, the oil is reintroduced into maritime commerce without undergoing origin-changing substantial transformation (as described in greater detail below).
Whether crude oil can be deemed to be of Russian origin will be determined with reference to non-preferential rules of origin. Non-preferential rules of origin are traditional customs rules used to determine the origin of products traded outside the remit of bilateral or multilateral trade agreements. The introduction of the Price Cap Programs has not changed the way in which these rules apply to determine the origin for customs purposes of Russian crude oil and petroleum products. Crude oil will not be deemed Russian origin or be subject to the Price Cap in the following circumstances:
- Substantial transformation: where Russian origin oil undergoes a substantial transformation in a country other than Russia, for example as a result of processing or due to a material stage of manufacturing which alters the key features of the product, it will no longer be deemed Russian origin. Generally speaking, substantial transformation includes refinement, as well as other economically justifiable actions via which the oil becomes a new product (i.e., “with a new name, character and use”) or falls under a different HS code. Merely mixing or blending Russian crude oil with other non-Russian oil is generally not sufficient to constitute substantial transformation. Note that the legal tests and rules governing activities that qualify as “substantial transformation” may vary across the EU, UK and U.S. and may be product-specific.
- De minimis amount: In line with the normal application of non-preferential rules of origin, crude oil originating in a country other than Russia will not be deemed Russian origin merely because it was mixed with a de minimis amount of Russian crude oil by virtue of being transported in a container or tank which previously contained Russian origin crude. An example of a de minimis amount would be an un-pumpable amount of oil (e.g., a “tank heel”) that cannot be removed without causing damage to the container.
- Non-Russian oil transiting through Russia: Crude oil that can be verified as originating from a third country will not be considered Russian origin crude oil subject to the Price Cap even if it is transported through or is departing from Russia. This is consistent with the application of non-preferential rules of origin, as mere transport of goods is not an origin-conferring activity. For example, according to guidance provided by the Price Cap Coalition members, Kazakh origin oil transported through the Caspian Pipeline Consortium or the Atyrau-Samara pipeline is generally not subject to the Price Cap. However, the EU guidance notes that oil subject to the Price Cap remains so even if mixed with oil which is not subject to the Price Cap, and the Price Cap is to be applied to the relevant proportion of such commingled oil.[17] Operators may reasonably rely upon a certificate of origin provided in the ordinary course of business, but they must be alert to circumstances that suggest the a certificate has been falsified or is otherwise erroneous. Note that for this particular exception to apply, the EU and the UK require that the oil being transported through Russia be owned by a non-Russian person.
Question 4: What do the Price Cap Programs prohibit and to whom do the respective prohibitions apply?
The chart below summarizes the key prohibition in the Price Cap Programs:
|
|
U.S. |
EU |
UK |
|
Key Prohibitions |
Maritime Transport: It is prohibited to export, re-export, sell, or supply, directly or indirectly, Covered Services (as defined below) to any person located in the Russian Federation where the purchase price of the underlying Russian origin crude oil exceeds the Price Cap.[18] |
Maritime Transport: It is prohibited to trade, broker or transport, including via ship-to-ship transfer, crude oil and petroleum products which originate in Russia or which have been exported from Russia unless the price per barrel of such products does not exceed the Price Cap.[19] |
Maritime Transport: It is prohibited to directly or indirectly supply or deliver by ship, including via ship-to-ship transfer, crude oil and petroleum products which originate in Russia or which are consigned from Russia from a place in Russia to a third country, or from one third country to another third country (i.e., countries that are neither the UK, the Isle of Man or Russia).[20] |
|
“Covered Services” means the provision of the following categories of services, as they relate to the maritime transport of Russian origin crude oil:
|
Ancillary Services: It is prohibited to directly or indirectly provide the following ancillary services in relation to the maritime transportation of Russian origin oil and petroleum products:
unless the purchase price per barrel of such products does not exceed the Price Cap.[22] |
Ancillary Services: It is prohibited to directly or indirectly provide the following ancillary services in pursuance of or in connection with an arrangement whose object or effect is the supply or delivery by ship of covered crude oil and oil products:
General Licenses are made available for otherwise prohibited activities relating to products sold at or below the Price Cap. |
|
|
Jurisdictional Scope |
Applies to U.S. persons, defined to include:
|
Applies:
|
Applies to: |
The U.S. Guidance offers additional detail on the categories of services that are “Covered Services.” This guidance is summarized below:
- Trading/commodities brokering: Buying, selling, or trading commodities directly or brokering such transactions on behalf of others.
- Financing: Any commitment to provide economic resources, such as investments, funds, advances, grants, loans, guarantees or letters of credit. Note however that the following activities are specifically carved out as not constituting covered financial services:
- The processing, clearing, or sending of payments by an intermediary bank that does not have any direct account relationship with the person providing the Covered Services; or
- Foreign exchange transactions and clearing commodities futures contracts.
- Shipping: Owning, operating or chartering a ship to carry cargo or transport freight, as well as brokering such relationships and serving as a vessel agent.
- Insurance: Providing insurance and protection and indemnity (“P&I”) services, whether satisfying claims for property damage or assuming risks of existing insurance policies originally underwritten by other insurance carriers, and providing liability insurance for maritime liability risks associated with the operation of a vessel.
- Flagging: Registering a vessel (including maintaining such registration) with a country’s national registry of vessels. However, de-flagging vessels that are transporting Russian oil above the Price Cap is excluded.
- Customs brokering: Assisting importers and exporters to meet requirements governing imports and exports, excluding legal services or assistance meeting the requirements of U.S. sanctions.
In the EU, Council Regulation (EU) No 833/2014 and European Commission Guidance provide some definitions and explanations related to the scope of prohibited activities:
- Technical assistance: “Any technical support related to repairs, development, manufacture, assembly, testing, maintenance, or any other technical service, and may take forms such as instruction, advice, training, transmission of working knowledge or skills or consulting services, including verbal forms of assistance.”[28]
- Brokering services: Services related to “(i) the negotiation or arrangement of transactions for the purchase, sale or supply of goods […] or of financial and technical services, including from a third country to any other third country, or (ii) the selling or buying of goods […] or of financial and technical services, including where they are located in third countries for their transfer to another third country.”[29] In the context of the EU Price Cap Program, the European Commission stated that the Price Cap Program applies widely to a range of brokering services such as “commodities brokering, insurance brokering, customs brokering, [and] ship brokering.”[30]
- Financing or financial assistance: “Any action, irrespective of the particular means chosen, whereby the person, entity or body concerned, conditionally or unconditionally, disburses or commits to disburse its own funds or economic resources, including but not limited to grants, loans, guarantees, suretyships, bonds, letters of credit, supplier credits, buyer credits, import or export advances and all types of insurance and reinsurance, including export credit insurance;” note that “payment as well as terms and conditions of payment of the agreed price for a good or a service, made in line with normal business practice, do not constitute financing or financial assistance.”[31]
Similar to the EU, the UK Russia (Sanctions) (EU Exit) Regulations 2019 and UK sanctions guidance provide definitions of the services caught:
- Financial services: means any service of a financial nature, including (but not limited to) payment and money transmission services, charge and debit cards, travellers’ cheques and bankers’ drafts[32], insurance or re-insurance, and other related services.[33]
- Funds: means financial assets and benefits of every kind.[34]
- Brokering services: means any service to secure, or otherwise in relation to, an arrangement, including involving the selection or introduction of persons as parties or potential parties to the arrangement; the negotiation of the arrangement; the facilitation of anything that enables the arrangement to be entered into; or the provision of any assistance that in any way promotes or facilitates the arrangement.[35]
Question 5: Are there any applicable exceptions or licenses?
Yes, the Price Cap Programs do contain certain exceptions and licenses:
- Russian oil loaded before the Price Cap effective date: Russian oil that is loaded onto a vessel at the port of loading before 12:01 a.m. EST on December 5, 2022 and unloaded at the port of destination before 12:01 a.m. EST on January 19, 2023 is not subject to the Price Cap. This means that providers of Covered Services (in the U.S. terminology), or providers of relevant Ancillary Services (in the UK and EU terminology), can provide such services related to Russian origin crude oil that meets these terms without respect to the Price Cap.
- Sakhalin-2 project: The U.S.,[36] the UK,[37] and the EU,[38] each permit the provision of services related to maritime transportation of Russian origin crude oil originating from the Sakhalin-2 project until September 30, 2023 (U.S. and UK), or June 5, 2023 (EU), as long as such oil is destined solely for importation into Japan.
- Imports into certain EU member states: The U.S.,[39] EU,[40] and UK,[41] each permit the provision of services for maritime transportation of Russian origin crude oil if it relates to permissible importation of such oil into Bulgaria, Croatia, or landlocked European Union Member States, consistent with the terms of pre-existing EU exceptions.
- Processing of payments: The UK issued a General License indefinitely authorizing certain institutions to process, clear or send payments from any person/entity in connection with activities that would otherwise breach the prohibition to provide financial services and funds relating to maritime transportation of certain oil and oil products, subject to certain conditions.[42] As noted above, the U.S. also authorizes similar activities by way of definitional carve out related to what constitutes covered “financial services,” as opposed to using a General License.
- Emergencies: The U.S.,[43] EU,[44] and UK[45] each authorize otherwise prohibited services that are necessary to address vessel emergencies related to crew health or safety or protection of the environment. The exception does not cover the sale of the subject cargo. In the UK, any person purporting to act under this exception must notify OFSI within 5 working days of the act using the appropriate form.[46] In the EU, operators must notify the national competent authority immediately once the event has been identified.
- Specific licenses: The availability of specific licenses for activities not within the Price Cap differ across the three principal jurisdictions. In the U.S., if a provider of Covered Services becomes aware that it is providing a Covered Service for Russian oil purchased above the Price Cap, they must immediately stop providing such services and contact OFAC. If the U.S. person has complied with the attestation process (described below) and believes that it should continue to provide services despite violations by third parties, the U.S. provider may submit a written application for a specific license, which OFAC will consider on a case-by-case basis. In the UK, a specific licence may be applied for to deal with an extraordinary situation (one that is unexpected, unavoidable, and not recurring) by filling out the relevant application form and returning it to OFSI.[47] Note that in neither jurisdiction will specific licences be issued retroactively. Note that the EU has not issued any General Licenses. All the derogations from the prohibitions are contained in the main body of Council Regulation 833/2014.
Question 6: What are the U.S., UK and EU Price Cap Program compliance obligations and diligence expectations (including attestation and reporting requirements)?
Each of the principal jurisdictions has gone to significant lengths to provide tailored compliance and recordkeeping guidance to the various actors within the maritime transportation services supply chain. Notably, the U.S., UK and EU have each set forth a detailed attestation process by which maritime transportation industry actors can benefit from a “safe harbor” from prosecution arising out of violations by third parties. By obtaining price information or an attestation from relevant counterparties, ship owners, charterers, insurers, financial institutions and others throughout the maritime supply chain may substantially mitigate their risk of non-compliance arising out of misrepresentations or evasive actions taken by third parties in violation of the Price Cap Programs. Relevant authorities in the three principal jurisdictions have indicated that compliance with the recordkeeping and attestation framework will generally shield a service provider from the otherwise strict liability regime.
With respect to the compliance framework, the U.S., UK and EU have divided maritime transportation service providers into three tiers. In general terms, Tier 1 actors are those who have access to price information in the ordinary course of business (e.g., commodities brokers and importers). Tier 2 actors are those who have direct relationships with Tier 1 actors (e.g., financial institutions engaged in trade finance and charterers). Tier 3 actors are those who have direct relationships with Tier 2 actors (e.g., ship owners and insurers). At each tier, a service provider that obtains price information or, where it is not practical to request price information, obtains an attestation from the tier above it, and otherwise conducts appropriate, risk-based due diligence, will be eligible for the safe harbor and generally will not be the target of an enforcement action. To qualify for the safe harbor, price information and/or an attestations must be retained for five years. Further, actors must act reasonably and in good faith when relying on price information or an attestation and should follow up on any red flags that may suggest price information or an attestation is misleading or unreliable.
The table below provides a side-by-side comparison by jurisdiction of the documentary, due diligence and reporting requirements expected of actors within each tier.
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|
Tier 1 Actors with direct access to price information |
Tier 2 Actors who are sometimes able to request and receive price information in the ordinary course of business |
Tier 3 Actors who do not regularly have access to price information in the ordinary course of business |
|
Actors |
U.S./UK/EU. Including, but not limited to:
|
U.S./UK/EU. Including, but not limited to:
|
U.S./UK/EU. Including, but not limited to:
|
|
Price Information and Attestations |
U.S. and EU. Tier 1 actors must retain and share price information, or provide an attestation, to Tier 2 or Tier 3 actors, as needed. Price information may be documented in invoices, contracts or receipts/proof of accounts payable. Price should be invoiced separately from shipping, freight, customs, and insurance costs. |
U.S. and EU. Tier 2 actors request and retain price information or an attestation from Tier 1 actors or customers/counterparties. Tier 2 actors must also provide price information or an attestation to Tier 3 actors, as needed. |
U.S. and EU. Tier 3 actors must receive an attestation from Tier 1 or Tier 2 actors or customers/counterparties regarding compliance with the price cap. For insurers and ship owners, they may include price cap compliance language in relevant contracts. |
|
UK. Tier 1 actors must, on request, share with Tier 2 and Tier 3 actors information on: i. the unit price; ii. details as to the most recent transaction (including point of departure and ultimate destination, the unit price of the oil at the time of the transaction and the Price Cap at the time of the transaction); and iii. details of the Price Cap at the time of sharing the price information. If the above is not practicable, a signed attestation that the price paid on a per-barrel basis (i.e. the unit price) does not breach the Price Cap set out in the GL on the date of the transaction. |
UK. Tier 2 actors must: i. request and retain price information or an attestation form from their Tier 1 counterparty (or in the case of financial institutions, downstream customer or subcontractors); ii. share price information/attestation with any counterparty that requests it; and iii. undertake appropriate due diligence to satisfy themselves, based on the information available, of the reliability and accuracy of any price information/attestation received. A service provider must not proceed with any transaction if it has not received price information/attestation within 5 days of such request. |
UK. Tier 3 actors must: i. ensure any counterparty has committed not to purchase Russian oil or oil products above the Price Cap – either through provision of a signed attestation or inclusion of an attestation in contractual obligations; and ii. undertake appropriate due diligence to satisfy themselves, based on the information available, of the reliability and accuracy of any price information/attestation received. |
|
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Reporting Obligations |
U.S. U.S. persons are not required to report transactions in compliance with the Price Cap. U.S. persons are required to reject participation in an evasive transaction or a transaction that violates the Price Cap, and report such rejection to OFAC consistent with existing reporting requirements. EU. EU operators are not required to report transactions in compliance with the Price Cap. Tips or information regarding possible circumvention should be reported to national competent authorities or via the EU whistle-blower tool. |
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UK. UK persons are required to report to HM Treasury each time an activity purporting to be permitted under the GL is undertaken. These activities must be notified to HM Treasury within 40 days of each transaction. Where there are multiple activities undertaken within a 30-day period, the Tier 1 actor may combine them into one consolidated report. All UK involved persons must report to HM Treasury as soon as practicable if they know or have reasonable cause to suspect a person is a designated person or has violated the Price Cap. |
UK. UK persons are required to ask and receive confirmation that the Tier 1 actor has reported to HM Treasury as required under the GL. This confirmation can be received on a quarterly basis. Where confirmation is not received, a Tier 2 actor is required to report to HM Treasury within 60 days and withdraw their services as soon as reasonably practicable. No confirmation is required for transactions with a non-UK Tier 1 actor, but notification to HM Treasury of this situation within 60 days, which can be undertaken on a quarterly basis. All UK involved persons must report to HM Treasury as soon as practicable if they know or have reasonable cause to suspect a person is a designated person or has violated the Price Cap. |
UK. When dealing directly with a Tier 1 actor, UK persons are required to ask and receive confirmation from the Tier 1 actor that it has reported to HM Treasury as required under the GL. This confirmation can be received periodically, in line with the attestation process described above. Where confirmation is not received, a Tier 3 actor is required to report this to HM Treasury within 60 days and withdraw their services as soon as reasonably practicable. No confirmation is required for transactions with a non-UK Tier 1 actor, but notification to HM Treasury of this situation is required within 60 days, which can be undertaken periodically, in line with the attestation process described above. All UK involved persons must report to HM Treasury as soon as practicable if they know or have reasonable cause to suspect a person is a designated person or has violated the Price Cap. |
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Record Keeping Obligations |
U.S. To be eligible for the safe harbor, U.S. service providers must retain relevant records, including price information or attestations as well as all other relevant business records, for five years. EU. EU operators are expected to retain relevant records for a minimum of five years from the date of transport. UK. All involved persons must keep accurate and complete records demonstrating compliance with the terms of the relevant general license, which should include the following information: i. a description of the activity taking place; ii. a description of the nature of any goods, services or funds to which the activity relates; iii. the date of the activity or the dates between which the activity took place; iv. the value and/or quantity of any goods, services or funds to which the activity relates; v. the person’s name and address; vi. the name and address of any consignee of goods to which the activity relates or any recipient of services or funds to which the activity relates; vii. the name and address of the end-user of the goods, services or funds to which the activity relates (in so far as known); viii. the name and address of the supplier of any goods to which the activity relates; and ix. copies of any attestation produced or supplied. UK persons must retain documentation related to a transaction conducted under a GL for a minimum of 4 years beyond the end of the calendar year in which the record was created. |
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Due diligence expectations |
U.S. U.S. service providers must continue to implement and perform the standard due diligence practices that are customary for their industry and for a person in their role in a particular transaction in order to be eligible for the safe harbor. U.S. persons should review all relevant documentation received in the ordinary course of business to determine whether a transactions is prohibited or whether there are red flags that indicate potential circumvention. EU. EU operations have to perform appropriate due diligence calibrated according to the specificities of their business and the related risk exposure, accounting for the tier they are in, in order to ensure compliance. UK. As noted above, UK persons must undertake appropriate due diligence to satisfy themselves, based on the information available, of the reliability and accuracy of any price information or attestation received. |
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OFAC and the HM Treasury have published a sample attestation form, which can be accessed here and here, respectively. The European Commission has published a similar attestation form in its guidance.[48]
Service providers are not required to adopt the exact language provided by the sample attestations in order to be afforded the safe harbor; depending on a service provider’s role in the transaction, they may tailor the sample language based on the availability of information available to them and the identity of their counterparty. Furthermore, depending on timing, the attestations may state that the Russian oil was or will be purchased in compliance with the Price Cap. Note that an authorized representative of the customer or counterparty must sign the attestation for it to be effective.
Given that a violation of the prohibition can lead to civil or criminal penalties, it is important that service providers follow the relevance guidance on due diligence and recordkeeping, on top of carrying out their existing due diligence practices. As a general point of compliance, service providers should update their internal procedures and standard forms to incorporate requirements for price information or requests for signed attestations. Service providers should also provide regular training to staff on how to identify red flags in the supply chain or signs of fraud in price documentation.
Finally, OFAC and OFSI have a wide remit to take actions against those who willfully breach, evade, avoid, cause a violation of, or attempt to violate the Price Cap Program. The U.S. Guidance provide several examples of conduct that could elicit an enforcement response, including a purchase of Russian origin oil above the Price Cap while knowingly relying on U.S. service providers who provide covered services, or knowingly providing false information, documentation, or attestations to a service provider. Evasive tactics such as using side deals to obfuscate the “real” purchase price paid by an intermediary or the ultimate purchaser may also warrant civil or criminal penalties.[49] Similarly, UK guidance notes that enforcement actions will be taken against those who falsify the information on attestations.[50]
In the EU, national competent authorities in EU Member States are in charge of sanctions enforcement. As such, they will be in charge of determining whether the Price Cap measures are being circumvented. In doing so, national competent authorities will consider whether the EU operator took the appropriate steps to ensure compliance with the Price Cap. It is important to remember that liability for inchoate offences (such as conspiring to commit) or offences of complicity (such as aiding, encouraging, abetting, assisting) take effect through the domestic legal orders of EU Member States. These laws can vary significantly from one EU Member State to another (including on key issues such as jurisdiction or the required mental element).
Conclusion
As is apparent from the above analysis, the U.S., UK and EU Price Cap Programs are quite similar in their focus and applicability from a general sense, but there are nuances among the various Programs which impose slightly different requirements on service providers based on their jurisdiction.
It remains to be seen whether other countries will eventually join the Price Cap Coalition and/or agree to implement similar restrictions in the future, which could create additional complexity in the global energy supply chain where Russian origin oil or petroleum products are involved.
Notably, the level of the Price Cap may not have resulted in as significant an impact as was anticipated prior to its imposition, as the price of Russian Urals crude has been declining since December 1, 2022 through the implementation of the Price Cap on December 5, 2022, and as of the publication of this alert, is already trading below $55 per barrel. We would expect to see further impact and disruption from the Price Cap Programs if, and likely when, the Price Cap Coalition lowers the Price Cap of $60 per barrel of crude oil in the future.
The higher the global market clearing price for oil is above the Price Cap, the more distortions in the market we would expect to see, along with some potential unpredictable effects including supply challenges, more sophisticated sanctions evasion efforts and networks, or more meaningful push back from Russia. Already the Price Cap has resulted in some unintended hiccups, such as creating a bottleneck of tankers blocked at the Bosphorous and Dardanelles straits by Turkish authorities requiring vessels to produce evidence of proper P&I insurance, even though a significant number of the tankers may not have been transporting Russian origin oil.[51]
Finally, given the global nature of energy markets, there are various other externalities which could affect market prices for crude oil and the effectiveness and implications of the Price Cap, including decisions by OPEC to alter production levels, or other actions affecting the overall supply of oil in the market (for example, OFAC recently issued a license authorizing Chevron to resume extraction and exportation to the U.S. of Venezuelan crude).[52]
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[1] See Statement of Treasury Sec’y Janet L. Yellen on the announcement of the price cap, U.S. Dept of the Treasury (December 2, 2022), https://home.treasury.gov/news/press-releases/jy1138; Statement of the G7 and Australia on a price cap for seaborne Russian-origin crude oil, published by the German Federal Foreign Office (December 2, 2022), https://www.auswaertiges-amt.de/en/newsroom/news/g7-australia-price-cap-seaborne-russian-origin-crude-oil/2567026.
[2] See Official Press Release by the European Council (December 3, 2022), https://www.consilium.europa.eu/en/press/press-releases/2022/12/03/russian-oil-eu-agrees-on-level-of-price-cap/.
[3] See FAQ 3 of the European Commission Guidance on the Oil Price Cap, available at https://finance.ec.europa.eu/system/files/2022-12/guidance-russian-oil-price-cap_en_0.pdf.
[4] See, e.g., OFAC Guidance on Implementation of the Price Cap Policy for Crude Oil of Russian Federation Origin, Nov. 22, 2022, available at https://home.treasury.gov/system/files/126/price_cap_policy_guidance_11222022.pdf.
[5] Available at https://home.treasury.gov/system/files/126/determination_11222022_eo14071.pdf.
[6] Available at https://home.treasury.gov/system/files/126/20221205_Price_cap_determination.pdf.
[7] Available at https://eur-lex.europa.eu/eli/dec/2022/1909/oj. Note that Council Decisions are only binding on those to whom they are addressed, i.e. Member States. Regulations are needed to make Decisions apply automatically and uniformly within each Member State.
[8] Available at https://eur-lex.europa.eu/eli/reg/2022/1904/oj.
[9] Available at https://eur-lex.europa.eu/eli/dec/2022/2369/oj.
[10] Available at https://eur-lex.europa.eu/eli/reg_impl/2022/2368/oj. Note that Implementing acts by the Commission are legally binding and set conditions to ensure the uniform application of EU laws.
[11] Available at https://eur-lex.europa.eu/eli/reg/2022/2367/oj.
[12] Available at https://www.legislation.gov.uk/uksi/2022/1122/regulation/4/made.
[13] Available at https://www.legislation.gov.uk/uksi/2022/1122/regulation/5/made.
[14] OFAC Guidance on Implementation of the Price Cap Policy for Crude Oil of Russian Federation Origin, Nov. 22, 2022, available at https://home.treasury.gov/system/files/126/price_cap_policy_guidance_11222022.pdf; See also U.S. Publishes Preliminary Guidance on the Implementation of a Maritime Services Policy and Related Price Exception for Seaborne Russian Oil, published by Gibson, Dunn & Crutcher LLP (September 19, 2022), https://www.gibsondunn.com/us-publishes-preliminary-guidance-on-implementation-of-maritime-services-policy-and-related-price-exception-for-seaborne-russian-oil
[15] European Commission Guidance on the Oil Price Cap, available at: https://finance.ec.europa.eu/system/files/2022-12/guidance-russian-oil-price-cap_en_0.pdf.
[16] His Majesty’s Treasury Industry Guidance on the Maritime Services Prohibition and Oil Price Cap, available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121744/Russian_Oil_Services_Ban_-_HMT_Industry_Guidance.pdf
[17] See FAQ 8 of the European Commission Guidance on the Oil Price Cap.
[18] Determination Pursuant to Section l(a)(ii) of Executive Order 14071: Prohibitions on Certain Services as They Relate to the Maritime Transport of Crude Oil of Russian Federation Origin, available at https://home.treasury.gov/system/files/126/determination_11222022_eo14071.pdf.
[19] Arts. 3n(4) and 3n(6)(a) of Council Regulation (EU) No 833/2014, as amended.
[20] Reg. 46Z9B of The Russia (Sanctions) (EU Exit) Regulations 2019.
[21] Determination Pursuant to Section l(a)(ii) of Executive Order 14071: Prohibitions on Certain Services as They Relate to the Maritime Transport of Crude Oil of Russian Federation Origin, available at https://home.treasury.gov/system/files/126/determination_11222022_eo14071.pdf.
[22] Arts. 3n(1) and 3n(6)(a) of Council Regulation (EU) No 833/2014, as amended.
[23] Reg. 46Z9C and 46Z9D of The Russia (Sanctions) (EU Exit) Regulations 2019.
[24] See Executive Order 14071, 87 Fed. Reg. 20999 (Apr. 6, 2022), https://home.treasury.gov/system/files/126/14071.pdf.
[25] Art. 13 of Council Regulation (EU) No 833/2014.
[26] Note that this includes a British overseas territories citizen, a British National (Overseas) or a British Overseas citizen, a person who under the British Nationality Act 1981 is a British subject, or a British protected person within the meaning of the British Nationality Act 1981.
[27] See s. 21 of the Sanctions and Anti-Money Laundering Act 2018 available here: https://www.legislation.gov.uk/ukpga/2018/13/section/21
[28] Art. 1(c) of Council Regulation (EU) No 833/2014.
[29] Art. 1(d) of Council Regulation (EU) No 833/2014.
[30] Guidance on oil price cap, published by the European Commission (December 3, 2022), https://finance.ec.europa.eu/document/download/a4ae6bb7-538b-4b54-ad21-f22c4412ddb5_en?filename=guidance-russian-oil-price-cap_en_0.pdf, Question 19.
[31] Art. 1(o) of Council Regulation (EU) No 833/2014.
[32] OFSI Guidance on General guidance for financial sanctions under the Sanctions and Anti-Money Laundering Act 2018 available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1100991/General_Guidance_-_UK_Financial_Sanctions__Aug_2022_.pdf
[33] See s. 61 of the Sanctions and Anti-Money Laundering Act 2018 for further details.
[34] See s. 60 of the Sanctions and Anti-Money Laundering Act 2018 for further details.
[35] See regulation 21 of the Russia (Sanctions (EU Exit) Regulations 2019
[36] General License No. 55 Authorizing Certain Services Related to Sakhalin-2, Russian Harmful Foreign Activities Sanctions Regulations, 31 CFR part 587, published by OFAC (November 22, 2022), https://home.treasury.gov/system/files/126/russia_gl55.pdf.
[37] By virtue of General License INT/2022/2470156, available here https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121733/2470156_Sakhalin_Island_GL.pdf.
[38] Art. 3n(6)(c) and Annex XIX of Council Regulation (EU) No 833/2014, as amended.
[39] General License No. 56 Authorizing Certain Services with Respect to the European Union, Russian Harmful Foreign Activities Sanctions Regulations, 31 CFR part 587, published by OFAC (November 22, 2022), https://home.treasury.gov/system/files/126/russia_gl56.pdf.
[40] Council Regulation (EU) 2022/879 of June 3, 2022.
[41] By virtue of General License INT/2022/2470156, available here https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121733/2470156_Sakhalin_Island_GL.pdf.
[42] GL INT/20222/2470056, available here https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121732/2470056_Correspondent_Banking_GL.pdf.
[43] General License No. 57 Authorizing Certain Services Related to Vessel Emergencies, Russian Harmful Foreign Activities Sanctions Regulations, 31 CFR part 587, published by OFAC (November 22, 2022),https://home.treasury.gov/system/files/126/russia_gl57.pdf.
[44] Art. 3n(9) of Council Regulation (EU) No 833/2014, as amended.
[45] Regulation 61 of The Russia (Sanctions) (EU Exit) Regulations 2019
[46] Available here https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121882/Maritime_transportation_and_associated_services_notification_of_use_of_emergency_exception__.docx.
[47] Available here https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121881/Extraordinary_Situation_Specific_Licence_Application_form_.docx
[48] See European Commission Guidance on the Oil Price Cap, p. 19.
[49] See U.S. Guidance, p. 6.
[50] See His Majesty’s Treasury Industry Guidance on the Maritime Services Prohibition and Oil Price Cap, available at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1121744/Russian_Oil_Services_Ban_-_HMT_Industry_Guidance.pdf
[51] See Butler, Daren and Sezer, Can, “Turkey oil tanker logjam snarls Russia oil sanctions,” Reuters (Dec. 9, 2022), available at: https://www.reuters.com/world/oil-tankers-waiting-pass-through-istanbuls-bosphorus-strait-rises-20-shipping-2022-12-09/.
[52] General License No. 41 Authorizing Certain Transactions Related to Chevron Corporation’s Joint Ventures in Venezuela, Venezuela Sanctions Regulations, 31 CFR part 591, published by OFAC (November 26, 2022), https://home.treasury.gov/system/files/126/venezuela_gl41.pdf
The following Gibson Dunn lawyers prepared this client alert: David Wolber, Felicia Chen, Jane Lu, Nikita Malevanny, Irene Polieri, Michelle Kirschner, Samantha Sewall, Judith Alison Lee, Stephenie Gosnell Handler, and Adam M. Smith.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or the following members and leaders of the firm’s International Trade practice group:
United States
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, [email protected])
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Marcellus A. McRae – Los Angeles (+1 213-229-7675, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Annie Motto – Washington, D.C. (+1 212-351-3803, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, [email protected])
Sarah L. Pongrace – New York (+1 212-351-3972, [email protected])
Samantha Sewall – Washington, D.C. (+1 202-887-3509, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, [email protected])
Asia
Kelly Austin – Hong Kong (+852 2214 3788, [email protected])
David A. Wolber – Hong Kong (+852 2214 3764, [email protected])
Qi Yue – Hong Kong – (+852 2214 3731, [email protected])
Fang Xue – Beijing (+86 10 6502 8687, [email protected])
Europe
Attila Borsos – Brussels (+32 2 554 72 10, [email protected])
Nicolas Autet – Paris (+33 1 56 43 13 00, [email protected])
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Patrick Doris – London (+44 (0) 207 071 4276, [email protected])
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, [email protected])
Penny Madden – London (+44 (0) 20 7071 4226, [email protected])
Benno Schwarz – Munich (+49 89 189 33 110, [email protected])
Michael Walther – Munich (+49 89 189 33 180, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Over the last few years, market conditions have changed so dramatically that today, no matter its products or services, every company is also in the environmental business. Prompted by the real-world impacts of climate change, many consumers now demand environmental action from corporations and prefer to buy products marketed as environmentally friendly. Many companies therefore market their products as “net-zero” or “carbon neutral”—and make pledges to be, as a business, “net-zero” by a certain date. In support of these pledges, companies often buy carbon credits from voluntary carbon markets to offset or mitigate their carbon emissions voluntarily.
Voluntary carbon markets present opportunity, but also create financial, regulatory, and litigation risks. Because the voluntary markets are often fragmented, suffer from a lack of transparency and, above all, are not subject to any statutory common standards, there is a lack of trust in the credits issued under these system which also limits the tradability of the credits.
This quarterly newsletter aggregates the knowledge and experience of Gibson Dunn attorneys around the globe as we help our clients across all sectors navigate the ever-changing landscape of voluntary carbon markets.
The following Gibson Dunn lawyers assisted in the preparation of this alert: Susy Bullock, Abbey Hudson, Brad Roach, Lena Sandberg, Jeffrey Steiner, Jonathan Cockfield, Arthur Halliday*, Yannis Ioannidis, Alexandra Jones, Mark Tomaier, and Alwyn Chan.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Environmental, Social and Governance (ESG), Environmental Litigation and Mass Tort, Global Financial Regulatory, or Energy practice groups, or the following authors:
Environmental, Social and Governance (ESG) Group:
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Environmental Litigation and Mass Tort Group:
Abbey Hudson – Los Angeles (+1 213-229-7954, [email protected])
Global Financial Regulatory Group:
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])
Energy, Regulation and Litigation Group:
Lena Sandberg – Brussels (+32 2 554 72 60, [email protected])
Oil and Gas Group:
Brad Roach – Singapore (+65 6507 3685, [email protected])
*Arthur Halliday is recent law graduate in the Los Angeles office who is not yet admitted to practice law.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On December 14, 2022, the Securities and Exchange Commission (“SEC” or “Commission”), in a rare unanimous vote, adopted final rules on the affirmative defense to insider trading liability and new disclosures related to insider trading. The final rules: (i) add new conditions to the affirmative defense to insider trading pursuant to a contract, instruction, or plan intended to satisfy the conditions of Exchange Act Rule 10b5-1(c) (a “Rule 10b5-1 plan”), (ii) introduce new periodic disclosure requirements related to insider trading, including with respect to company insider trading policies and procedures and the adoption and termination of Rule 10b5-1 plans by directors and officers, and director and officer equity compensation awards made close in time to the company’s disclosure of material nonpublic information (“MNPI”), and (iii) require identification of transactions made pursuant to a Rule 10b5-1 plan on Forms 4 and 5, and require that bona fide gifts be reported on Form 4 within two business days rather than after year-end on Form 5. The final rules are thematically aligned with the rule proposal issued by the Commission in December of last year[i] – also in a unanimous vote – but with meaningful changes and the addition of several carve outs, particularly for companies.
The adopting release is available here and a Fact Sheet is available here. The final rules will become effective 60 days after publication in the Federal Register (the “Effective Date”), at which point any Rule 10b5-1 plan thereafter adopted or modified should comply with the new requirements. Companies will be required to comply with the new periodic disclosure requirements in the first filing that covers the first full fiscal period that begins on or after April 1, 2023 (i.e., the second-quarter Form 10-Q for a company with a December 31 fiscal year-end). Smaller reporting companies have until the first filing covering a period that begins on or after October 1, 2023 to comply (i.e., the fiscal 2023 Form 10-K for a company with a December 31 fiscal year-end). Section 16 insiders will be required to comply with the amendments to Form 4 beginning with reports filed on or after April 1, 2023. Set forth below is a summary of the final rules and some considerations for companies and insiders.
Summary of Final Rules
New Conditions for Rule 10b5-1 Plans. The rules introduce new conditions on the availability of the affirmative defense to Rule 10b-5 liability pursuant to a Rule 10b5-1 plan. Any plans adopted after the Effective Date must comply with the new conditions or the person adopting the plan will not be able to rely on the affirmative defense. Note that these changes do not affect the affirmative defense available under an existing Rule 10b5-1 plan that was entered into prior to the Effective Date, unless it is modified in a manner that is treated as an adoption of a new plan (described below) after the Effective Date.[ii] The new conditions for Rule 10b5-1 plans consist of the following:
- Cooling-Off Period. In a significant change from the rule proposal, the final rules do not require any cooling-off period for companies. Rule 10b5-1 plans adopted by directors and officers[iii] must provide that trading under the plan cannot begin until the later of: (a) 90 days after the adoption of the Rule 10b5-1 plan; or (b) two business days following the disclosure of the company’s financial results in a Form 10-Q or 10-K for the fiscal quarter in which the plan was adopted, or, for foreign private issuers, in a Form 20-F or 6-K that discloses the company’s financial results. The required cooling-off period for directors and officers is capped at a maximum of 120 days after the Rule 10b5-1 plan’s adoption. Persons other than directors and officers are subject to a 30 day cooling-off period following a Rule 10b5-1 plan’s adoption. Notably, certain changes to Rule 10b5-1 plans are treated as the adoption of a new plan. The final rules codify that any change to the amount, price, or timing of the purchase or sale of the securities (including a change to a written formula or algorithm, or computer program affecting these terms, the “Essential Terms”) underlying a Rule 10b5-1 plan constitutes a termination of such plan and the adoption of a new plan, triggering the same cooling-off period described above. Other changes that do not alter the Essential Terms, such as an adjustment for stock splits or a change in account information, will not trigger a new cooling-off period.[iv]The cooling-off period requirements of the final rules appear less burdensome on directors and officers as compared to the proposed rules, but they are more complex and introduce uncertainty as to when the first purchase or sale under the plan can occur. The proposed rules contemplated an inflexible 120 day cooling-off period for the Rule 10b5-1 plans of directors and officers.[v] Under the final rules, the cooling-off period for directors and officers will vary between 90 and 120 days, depending on when/whether a Form 10-K or Form 10-Q is filed during this period.
- Director and Officer Certifications. When adopting a Rule 10b5-1 plan, directors and officers must include a representation in the Rule 10b5-1 plan certifying, at the time of the adoption of a new or modified plan, that: (a) they are not aware of MNPI about the company or its securities; and (b) they are adopting the plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5. Because the plan is typically a form document prepared by the broker-dealer, counsel for directors and officers should review the plan to ensure that this new representation is included in any new or modified Rule 10b5-1 plan entered into after the Effective Date.
- Prohibition on Overlapping Plans. A person (other than the company) may not have another outstanding (and may not subsequently enter into any additional) Rule 10b5-1 plan for purchases or sales of any class of securities of the company on the open market during the same period. Unlike the proposed rules, the final rules permit several exceptions. A person may have two separate Rule 10b5-1 plans so long as (a) the later-commencing plan does not begin trading during the cooling-off period that would have applied if the later-commencing plan was adopted on the date the earlier-commencing plan terminates, and (b) the plans meet all other conditions applicable to Rule 10b5-1 plans.In addition, the final rules provide an exception to allow for separate Rule 10b5-1 plans for “sell-to-cover” transactions in which an insider instructs their agent to sell securities in order to satisfy tax withholding obligations at the time an equity award vests. An insider may maintain additional eligible Rule 10b5-1 plans so long as the additional plans only authorize qualified sell-to-cover transactions, where the plan authorizes an agent to sell only such securities as are necessary to satisfy tax withholding obligations in connection with the vesting of a compensatory award, such as restricted stock or restricted stock units, and the insider does not otherwise exercise control over the timing of such sales. It is important to note that this exception does not extend to sales incident to the exercise of option awards, as the SEC posits that option exercises create a risk of opportunistic trading.[vi]The final rules clarify that a series of separate contracts with different broker-dealers or other agents acting on behalf of the person (other than the company) may be treated as a single Rule 10b5-1 plan, provided that the contracts with each broker-dealer or other agent, when taken together as a whole, meet all of the applicable conditions of, and remain collectively subject to, Rule 10b5-1(c)(1). In such a scenario, the modification of any of the individual contracts will be considered a modification of the other contracts constituting the Rule 10b5-1 plan. Substituting a broker-dealer or other agent with another broker-dealer or other agent would not be considered a modification so long as the Essential Terms are not changed. Although the final rules introduced these exceptions, it also expanded the scope of the prohibition relative to the proposed rules. Under the proposed rules, the prohibition would have only applied to the same class of the company’s securities,[vii] whereas the final rules prohibit overlapping plans for any class of the company’s securities. In the adopting release, the SEC recognized that, given the likelihood that the values of different classes of a given company’s securities are highly correlated, allowing the use of multiple plans for trading in the securities of a company would allow for opportunistic behavior.[viii]
- Restrictions on Single-Trade Plans. A person (other than the company) may not have more than one single-trade Rule 10b5-1 plan during any 12-month period. The defense will only be available for a single-trade plan if such a person had not, during the preceding 12-month period, adopted another single-trade plan that qualified for the affirmative defense, meaning that an ineligible plan does not preclude the availability of the affirmative defense for another plan.[ix] As with the prohibition on overlapping plans, the final rules introduce an exception to this restriction for “sell-to-cover” plans. A single-trade plan is one “designed to effect” (e.g., has the practical effect of requiring) the purchase or sale of securities as a single transaction. A plan is not designed to effect a single transaction where the plan (a) leaves the person’s agent discretion over whether to execute the plan as a single transaction, or (b) provides that the agent’s future acts will depend on events or data not known at the time the plan is entered into (such as a plan to execute specified sales or purchases at each of several given future stock prices) and it is reasonably foreseeable at the time the plan is entered into that it may result in multiple transactions.[x]
- Act in Good Faith. The person entering into a Rule 10b5-1 plan must act in good faith with respect to the Rule 10b5-1 plan. This requirement extends the existing requirement – i.e., to enter into the Rule 10b5-1 plan in good faith – from the time of adoption through the duration of the Rule 10b5-1 plan. This departs from the proposed rules, which would have required the Rule 10b5-1 plan to be “operated” in good faith,[xi] a term that many commentators found ambiguous.
New Periodic Reporting Requirements. The final rules introduce the following new periodic reporting requirements:
- Quarterly Disclosure of Trading Arrangements. In Forms 10-Q and 10-K, companies will be required to disclose whether, during the company’s last fiscal quarter, any director or officer adopted or terminated (i) any contract, instruction or written plan for the purchase or sale of securities of the company that is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) (e.g., a Rule 10b5-1 plan), or (ii) a “non-Rule 10b5-1 trading arrangement.” A non-Rule 10b5-1 trading arrangement is a written trading arrangement that complies with the old Rule 10b5-1 affirmative defense (circa 2000 to 2022) but does not comply with the new affirmative defense conditions of Rule 10b5-1(c). The SEC requires disclosure for these arrangements to make clear that one cannot avoid disclosure of trading plans that are structured to comply with alternative liability defenses other than the Rule 10b5-1 affirmative defense.[xii]Companies will also be required to indicate whether the arrangement is a Rule 10b5-1 plan or non-Rule 10b5-1 trading arrangement and provide a description of the material terms, other than with respect to price, such as:
- The name and title of the director or officer;
- The date of adoption or termination of the trading arrangement;
- The duration of the trading arrangement; and
- The aggregate number of securities to be sold or purchased under the trading arrangement.
Unlike the proposed rules, the final rules do not require disclosure of whether the company adopted a Rule 10b5-1 plan or non-Rule 10b5-1 trading arrangement.[xiii] The proposed rules also did not specifically carve out price from the material terms of Rule 10b5-1 plans or non-Rule 10b5-1 trading arrangements that are required to be disclosed.[xiv]
- Annual Disclosure of Insider Trading Policies and Procedures. Companies will be required to disclose in Forms 10-K or 20-F and proxy and information statements whether they have adopted insider trading policies and procedures governing the purchase, sale, and other dispositions of their securities by directors, officers, and employees, or the company itself that are reasonably designed to promote compliance with insider trading laws, rules, and regulations, and any listing standards applicable to the company. If a company has not adopted such insider trading policies and procedures, it must explain why it has not done so. The disclosure may be incorporated by reference from the proxy statement into the Form 10-K if the proxy statement is filed within 120 days of the fiscal year-end. A copy of the insider trading policies and procedures must be filed as an exhibit to Form 10-K and 20-F.
- Disclosure of Certain Equity Awards Close in Time to Release of MNPI. In their discussions of executive compensation (i.e., in Part III of Form 10-K or a proxy statement), companies will be required to discuss their policies and practices on the timing of awards of stock options, stock appreciation rights (“SARs”) or similar option-like instruments in relation to the disclosure of MNPI by the company, including how the board determines when to grant such awards (e.g., whether the awards are granted according to a predetermined schedule). Companies must also discuss whether, and if so, how, the board or compensation committee takes MNPI into account when determining the timing and terms of an award, and whether the company has timed the disclosure of MNPI for the purpose of affecting the value of executive compensation.In addition, if, during the last completed fiscal year, stock options, SARs or similar option-like instruments were awarded to a named executive officer (“NEO”) within a period beginning four business days before the filing of a periodic report, or the filing or furnishing of a current report on Form 8-K that discloses MNPI (including earnings information), and ending one business day after the filing of such report, the company must provide information concerning each such award for the NEO on an aggregated basis in the following tabular format:
|
Name |
Grant date |
Number of securities underlying the award |
Exercise price of the award ($/Sh) |
Grant date fair value of the award |
Percentage change in the closing market price of the securities underlying the award between the trading day ending immediately prior to the disclosure of material nonpublic information and the trading day beginning immediately following the disclosure of material nonpublic information |
|
PEO |
|||||
|
PFO |
|||||
|
A |
|||||
|
B |
|||||
|
C |
The window in which awards will trigger disclosure is significantly reduced from the proposed rules, which would have covered 14 days both before and after the relevant filing.[xv] The final rules also clarify that a Form 8-K reporting a material new option award grant under Item 5.02(e) would not trigger the disclosure requirement, and removes company share repurchases as events that would trigger disclosure.
This new disclosure requirement will not affect foreign private issuers.
- Inline XBRL Tagging. The periodic disclosure requirements outlined above will be required to be tagged in Inline XBRL.
New Beneficial Ownership Reporting Requirements. The amendments add a checkbox to Forms 4 and 5 for insiders to indicate whether the reported transaction is pursuant to a plan that is “intended to satisfy the affirmative defense conditions” of Rule 10b5-1(c). In addition, insiders will be required to report dispositions of bona fide gifts of equity securities on Form 4 (rather than Form 5), thereby shortening the deadline to report gifts from 45 days after fiscal year-end to two business days following the date of execution. The final rules do not adopt the proposed second checkbox for indicating a transaction was made pursuant to a plan that did not qualify for Rule 10b5-1(c).[xvi]
Importantly, the adopting release builds on the note from the proposing release that opined that gifts are subject to Section 10(b) liability, and the SEC reiterated that the affirmative defense of Rule 10b5-1(c)(1) is available for any bona fide gift of securities.[xvii]
Observations and Considerations for Companies and Insiders
Insider trading policies should be updated as of the Effective Date, but existing Rule 10b5-1 plans do not need to be amended unless any Essential Terms are modified after the Effective Date. Companies should update their current insider trading policies and procedures (including any separate Rule 10b5-1 plan guidelines), to amend any provisions that conflict with the final rules. For example, many companies already require their employees’ Rule 10b5-1 plans to have cooling-off periods. If the cooling-off periods permissible under a company’s policy are shorter than those under the final rules, the policy should be updated to reflect the required cooling-off periods, subject to the grandfathering accommodations for Rule 10b5-1 plans existing prior to the Effective Date. Companies may consider removing policy provisions requiring insiders to trade only through Rule 10b5-1 plans in light of the final rules, which will require disclosure of the number of shares insiders intend to sell under such plans. This disclosure could cause an unfavorable market price reaction and become a topic of discussion in shareholder engagement or a point of contention for shareholder activists, causing a chilling effect on the use of Rule 10b5-1 plans by insiders. Some companies may determine to instead encourage insiders to trade during ordinary open window periods after pre-clearance from the company’s general counsel, at least with respect to transactions other than sell-to-cover trades. In addition, with the new requirement to file insider trading policies and procedures as an exhibit to the Form 10-K, companies may want to revisit their policies to make sure they are sufficiently robust.
Companies should consider waiting at least two business days following the release of MNPI to make equity compensation awards. The new disclosure requirement regarding equity awards made close in time to the release of MNPI is meant to combat the practice of “spring-loading,” in which equity grants are made immediately before positive MNPI is released so that executives benefit from the increased share price when the MNPI is made public. Companies should be aware of the optics of making awards close to the public release of MNPI, and can mitigate potential concerns by waiting at least two business days following the release of MNPI before making equity awards. This will entail coordinating board and board committee meeting and/or schedules with the reporting calendar for periodic reports and any planned Form 8-K filings.
Corporate insiders should be cautious when gifting while aware of MNPI. The SEC has historically been silent with respect to the liability of gifts under Section 10(b). With the Commission’s reaffirmations in the adopting release, corporate insiders who are aware of MNPI should proceed with caution when gifting company securities, as they could be liable if they gift securities when they are aware of MNPI and while knowing (or being reckless in not knowing) that the donee would sell the securities prior to the disclosure of the MNPI. Many, if not most, non-profit organizations have a policy of immediately selling any securities received as a gift, as they are not in the business of holding securities. Companies also may want to revisit how their insider trading policies apply to gifts.
There are no new share repurchase requirements for companies, but this is likely to change. The single new condition on Rule 10b5-1 plans applicable to companies is the requirement to act in good faith, as companies are carved out from the other new conditions, allowing them to implement overlapping and multiple single-trade plans, all without cooling-off periods. Although the proposed rules contemplated periodic disclosure requirements with respect to a company’s adoption and termination of Rule 10b5-1 plans, these provisions were removed in the final rules. However, the Commission noted in the adopting release that it is continuing to consider whether regulatory action is needed to mitigate the risk of misuse of Rule 10b5-1 plans by companies, such as in the share repurchase context.[xviii] The SEC is still working on final rules for share repurchase disclosure, which were originally proposed alongside the insider trading rules last year. The SEC recently reopened the comment period for the share repurchase rule proposal so that commenters could consider a SEC Staff memorandum analyzing the impact of the new excise tax on share repurchases on the potential economic effects of the SEC’s rule proposal.[xix]
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[i] For our discussion of the proposed rules, see Gibson Dunn Client Alert, SEC Proposes Rules on Insider Trading, Rule 10b5-1 and Share Repurchases (Dec. 23, 2021).
[ii] Insider Trading Arrangements and Related Disclosures, Exchange Act Release No. 96492 (Dec. 14, 2022) (the “Adopting Release”) at III, available at https://www.sec.gov/rules/final/2022/33-11138.pdf.
[iii] The term “officer” refers to how that term is defined in Exchange Act Rule 16a-1(f).
[iv] Adopting Release at II.A.1.c.
[v] See Rule 10b5-1 and Insider Trading, Exchange Act Release No. 93782 (Dec. 15, 2021) (the “Proposing Release”), at II.A.1, available at https://www.sec.gov/rules/proposed/2022/33-11013.pdf
[vi] Adopting Release at II.A.3.c.
[vii] Proposing Release at II.A.3.
[viii] See Adopting Release at II.A.3.c.
[ix] Id.
[x] Id.
[xi] Proposing Release at II.A.4.
[xii] See Adopting Release at II.B.1.c.
[xiii] See Id.
[xiv] See Proposing Release at II.B.1.
[xv] Proposing Release at II.C.
[xvi] See Proposing Release at II.B.4.
[xvii] See Proposing Release at II.B.2.; Adopting Release at II.E.3.
[xviii] Adopting Release at II.A.1.c.
[xix] Reopening of Comment Period for Share Repurchase Disclosure Modernization, Exchange Act Release No. 96458 (Dec. 7, 2022), available at https://www.sec.gov/rules/proposed/2022/34-96458.pdf.
The following Gibson Dunn attorneys assisted in preparing this client update: Aaron K. Briggs, Joel M. Cohen, Thomas J. Kim, Brian J. Lane, Ronald O. Mueller, Lori Zyskowski and Matthew L. Dolloff.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Securities Enforcement or Securities Regulation and Corporate Governance practice groups:
Securities Enforcement Group:
Joel M. Cohen – New York (+1 212-351-2664, [email protected])
Richard W. Grime – Washington, D.C. (+1 202-955-8219, [email protected])
Mark K. Schonfeld – New York (+1 212-351-2433, [email protected])
Securities Regulation and Corporate Governance Group:
Aaron Briggs – San Francisco (+1 415-393-8297, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
Julia Lapitskaya – New York (+1 212-351-2354, [email protected])
James J. Moloney – Orange County (+1 949-451-4343, [email protected])
Ron Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Michael J. Scanlon – Washington, D.C. (+1 202-887-3668, [email protected])
Michael Titera – Orange County (+1 949-451-4365, [email protected])
Lori Zyskowski – New York (+1 212-351-2309, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
The IRS and Treasury released proposed regulations on December 9, 2022 that, according to the preamble to the proposed regulations, is aimed at eliminating an approach taken by some consolidated groups to minimize income inclusions of their “pro rata share” under sections 951 (“subpart F” income) and 951A (“GILTI”). The preamble describes the approach involving the “shifting” of ownership in the stock of lower-tier controlled foreign corporations (“CFCs”) between different members of the group during a taxable year.[1]
Background
Under section 951(a)(2)(A), a United States shareholder’s “pro rata share” of subpart F income or GILTI of a lower-tier CFC generally is the amount that would have been distributed with respect to the CFC stock that the shareholder owns, directly or indirectly, if, on the last day in the CFC’s taxable year in which it is a CFC, the CFC had distributed (pro rata) its subpart F income and GILTI income (or, if the CFC was not a CFC for its entire year, a proportionate amount of that income). Section 951(a)(2)(B) requires the shareholder’s inclusions be reduced by the amount of any dividends received with respect to such stock by any other person during that taxable year (with the amount of the reduction generally capped at a portion of the subpart F income and GILTI, respectively, of the CFC for the part of the year during which the shareholder did not directly or indirectly own the CFC stock).
Under section 959(b), the earnings and profits of a lower-tier CFC attributable to amounts that are, or have been, included in the gross income of a United States shareholder as subpart F income or GILTI, generally is not, when distributed to an upper-tier CFC, included in the gross income of the upper-tier CFC for purposes of computing the upper-tier CFC’s subpart F income or GILTI. In the preamble to the proposed regulations, the IRS and Treasury observed that, as a result of the 2017 Tax Cuts and Jobs Act, “there is (and will continue to be) a substantial amount of previously taxed earnings and profits (“PTEP”) in the U.S. tax system.”
Proposed Regulations
The proposed regulations would provide that, when stock of a lower-tier CFC is transferred within a consolidated group, the consolidated group members are treated as a single United States shareholder so that the member that owns (within the meaning of section 958(a)) the lower-tier CFC stock at the end of the year cannot reduce its subpart F or GILTI inclusion by reason of section 951(a)(2)(B) for section 959(b) distributions by the lower-tier CFC before the transfer. The new rule would apply to taxable years for which the original consolidated income tax return is due (without extensions) after the date on which a Treasury decision adopting these rules as final regulations is published in the Federal Register.
Example 1 of the proposed regulations describes a situation in which P owns M1 and M2, and all three entities are U.S. corporations that together file a consolidated return. Throughout Year 1, M1 owns all of the stock of CFC1, which, in turn, owns all of the stock of CFC2. In Year 1, CFC2 has $100 of subpart F income. M1’s pro rata share of CFC2’s subpart F income for Year 1 is $100, which M1 includes in its gross income under section 951(a)(1)(A). In Year 2, CFC2 has $80 of subpart F income and distributes $80 to CFC1 (the “CFC2 Distribution”). Because the distribution consists of subpart F income, and because it is made to an upper-tier CFC, section 959(b) applies, and CFC1 is not required to include it in gross income. On December 29 of Year 2, M1 transfers all of its CFC1 stock to M2 (in an exchange described in section 351(a)). As a result, on December 31 of Year 2 (the last day of Year 2 on which CFC2 is a CFC), M2 owns all of the stock of CFC1, which owns all of the stock of CFC2.
Under current law, because M2 owned the CFC1 stock on the last day of Year 2, sections 951(a)(2)(B) and 959(b) require M2 to reduce its subpart F inclusion by the $80 dividend from CFC2 to CFC1, subject to a cap based on the portion of the year during which CFC2 was owned by M1, even though M1 and M2 are both members of the same consolidated group. Because the transfer occurred on December 29, the operation of section 951(a)(2)(B) would result in a substantial reduction in any subpart F inclusion with respect to CFC2 for Year 2.
The proposed regulations would provide that section 951(a)(2)(B) would not apply to this fact pattern because all of the members of the P consolidated group are treated as a single United States shareholder for purposes of determining the portion of the tax year in which a shareholder did not own the stock of a CFC. Accordingly, because M1 and M2 (both members of the P consolidated group) together owned the stock of CFC2 for all of Year 2, M2 would be treated as owning the stock of CFC2 for the entire year. Thus, the section 951(a)(2)(B) multiplicand would be $0 (0 days (the number of days that M2 did not own CFC2 stock)), and M2 would be required to include the full (unreduced) $80 subpart F income in its gross income under section 951(a)(1)(A).
Example 2 of the proposed regulations shows the application of the same rule in the context of the transfer of a lower-tier CFC between two upper-tier CFCs; as in the first example, there is no reduction in the aggregate inclusion amount by reason of section 951(a)(2)(B). The example goes on to note that the two members of the consolidated group must include their pro rata shares of the lower-tier CFC’s subpart F income based on their relative ownership of the lower-tier CFC on December 31 of Year 2.
Additional Guidance Expected; “No Inference”
The IRS and Treasury are widely expected to issue additional proposed regulations addressing issues involving PTEP, an area that is closely related to subpart F and GILTI inclusions, so it is somewhat surprising that the government saw fit to issue this short and discrete proposed regulation as a standalone item rather than including it in the larger guidance package. In addition, it is notable that the proposed regulation includes “no inference” language, meaning that taxpayers are forewarned that the IRS may consider challenging positions contrary to rule of the proposed regulations before their finalization.
Please contact any Gibson Dunn tax lawyer for updates on this issue.
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[1] Prop. Treas. Reg. § 1.1502-80(j) (Dec. 9, 2022). All “section” references are to the Internal Revenue Code of 1986, as amended, and all “Prop. Treas. Reg. §” are to the proposed regulations. Because the rule contained in the proposed regulations would apply only in the context of consolidated groups, the IRS and Treasury included the proposed regulations in the section 1502 consolidated return regulations rather than in the regulations governing either subpart F and GILTI inclusions under sections 951 and 951A, or the distribution of previously taxed earnings and profits under section 959.
This alert was prepared by Mike Desmond, Matt Donnelly, Pamela Endreny, Eric Sloan, Jeffrey M. Trinklein, and Anne Devereaux.
Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax and Global Tax Controversy and Litigation practice groups:
Tax Group:
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 (0) 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213-229-7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212-351-2474, [email protected])
Benjamin Fryer – London (+44 (0) 20 7071 4232, [email protected])
Brian R. Hamano – Los Angeles (+1 310-551-8805, [email protected])
Kathryn A. Kelly – New York (+1 212-351-3876, [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
Loren Lembo – New York (+1 212-351-3986, [email protected])
Jennifer Sabin – New York (+1 212-351-5208, [email protected])
Hans Martin Schmid – Munich (+49 89 189 33 110, [email protected])
Eric B. Sloan – Co-Chair, New York (+1 212-351-2340, [email protected])
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224 /+1 212-351-2344), [email protected])
John-Paul Vojtisek – New York (+1 212-351-2320, [email protected])
Edward S. Wei – New York (+1 212-351-3925, [email protected])
Lorna Wilson – Los Angeles (+1 213-229-7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, [email protected])
Global Tax Controversy and Litigation Group:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202-955-8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202-887-3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202-887-3612, [email protected])
*Anne Devereaux is an of counsel working in the firm’s Los Angeles office who is admitted only in Washington, D.C.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
With ongoing challenges of the COVID-19 pandemic, the Russia-Ukraine conflict and other global developments and trends, companies have been navigating a challenging 2022 capital raising market. Join partners of Gibson Dunn’s Capital Markets and Securities Regulation and Corporate Governance practice groups, as they provide an overview of market activity in 2022 and how companies have reacted to the market impact of these developments. This webcast also discusses thoughts on 2023 capital raising and the key issues and opportunities that may impact companies considering capital raise transactions in the next year.
PANELISTS:
Hillary H. Holmes is a partner in the Houston office of Gibson, Dunn & Crutcher, Co-Chair of the firm’s Capital Markets practice group, and a member of the firm’s Securities Regulation and Corporate Governance, Energy, M&A and ESG practice groups. Ms. Holmes’ practice focuses on capital markets, securities regulation, and corporate governance. She is Band 1 ranked by Chambers USA in capital markets for the energy industry and recognized in nationwide Energy Transactions and M&A/Corporate. Ms. Holmes represents issuers and underwriters in all forms of capital raising transactions, including IPOs, registered offerings of debt or equity, private placements, joint ventures, structured investments, and sustainable financings. Ms. Holmes also frequently advises companies, boards of directors, special committees and financial advisors in M&A transactions, and conflicts of interest and other special situations.
Tom Kim is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher and a member of the firm’s Securities Regulation and Corporate Governance practice group. Mr. Kim focuses his practice on advising companies, underwriters and boards of directors on registered and exempt capital markets transactions, SEC regulatory and reporting issues, and corporate governance, as well as on general corporate and securities matters. Mr. Kim has been recognized by Chambers USA in the Securities Regulation: Advisory category since 2015. Mr. Kim served for six years as the Chief Counsel and Associate Director of the Division of Corporation Finance at the SEC.
Robyn E. Zolman is Partner-in-Charge of the Denver office of Gibson, Dunn & Crutcher, where she practices in the firm’s Capital Markets and Securities Regulation and Corporate Governance practice groups. Ms. Zolman represents clients in connection with a broad range of capital markets transactions. She advises clients with respect to SEC registered and Rule 144A offerings of investment grade, high-yield and convertible notes, as well as initial public offerings, follow-on equity offerings, at-the-market equity offering programs, PIPE offerings and issuances of preferred securities. In addition, she has extensive experience with tender offers, exchange offers, consent solicitations and corporate restructurings. Ms. Zolman also regularly advises clients regarding securities regulation and disclosure issues and corporate governance matters, including Securities and Exchange Commission reporting requirements, stock exchange listing standards, director independence, board practices and operations, and insider trading compliance.
Robert D. Giannattasio is of counsel in the New York office of Gibson, Dunn & Crutcher and practices in Gibson Dunn’s Capital Markets Practice Group, Securities Regulation and Corporate Governance Practice Group, and Global Finance Practice Group. Mr. Giannattasio has a broad corporate and capital markets practice representing issuers and underwriters on a variety of public and private debt and equity offerings, including acquisition financings, investment-grade and high-yield debt offerings, IPOs and follow-on equity offerings, and liability management transactions.
Daniel Burton-Morgan is head of Americas Equity Capital Markets Syndicate at Bank of America Securities, having taken on the role in November 2020. Prior to this, he was Head of UK & Ireland Equity Capital Markets (August 2018 to November 2020) having previously been Head of the EMEA Equity Capital Markets Syndicate for over five years. In total Daniel has over 16 years of experience in UK Investment Banking and Global ECM, starting at Merrill Lynch in 2006. In his previous role Daniel worked on over 200 transactions including sell-downs in ABN, Renault, Lloyds Banking Group, Evonik, Engie, Nordea, ENEL and EADS, IPOs of Aena, Auto Trader, Worldpay, Moncler and Allied Irish Banks, and capital raises for E.On, Barclays, Standard Chartered and Unicredit. Daniel graduated from the University of Warwick with a First Class degree in Management in 2006.
Laurie Campbell joined the Global Capital Markets Division at Bank of America in 2005. She is head of the group responsible for coverage of investment grade companies in the Technology and General Industries sectors. Prior to joining Bank of America, Laurie was a Managing Director in Debt Capital Markets at Goldman Sachs from 1997 to 2003. From 1992 to 1997 Laurie was a Principal with Morgan Stanley in their Debt Capital Markets group. She also worked as an Associate in Corporate Finance at Salomon Brothers from 1989 to 1992. Laurie received an M.B.A. from the University of Western Ontario in 1989 and a Bachelor of Commerce from McGill University in 1983.
Reprinted by permission. Copyright © 2023 Bank of America Corporation (“BAC”). The information is provided “as is” and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.
Join us for a recorded 60-minute briefing covering key developments in the executive compensation space. Mike Scanlon, Tino Salazar and Krista Hanvey outline recent legislative and regulatory developments and provide practical tips to help you prepare for proxy and incentive compensation grant season.
Topics to be discussed:
- The SEC’s new Pay versus Performance disclosure requirements
- The SEC’s new Clawback rule requirements and DOJ focus on such policies
- State law restrictive covenant trends and how they may affect your grant agreements
- ESG performance metrics in incentive compensation
PANELISTS:
Krista P. Hanvey is Co-Chair of Gibson Dunn’s Employee Benefits and Executive Compensation practice group and Co-Partner-In-Charge in the firm’s Dallas office. She counsels clients of all sizes across all industries, both public and private, using a multi-disciplinary approach to compensation and benefits matters that crosses tax, securities, labor, accounting and traditional employee benefits legal requirements. Ms. Hanvey has significant experience with all aspects of executive compensation, health and welfare benefit plan, and retirement plan compliance, planning, and transactional support. She also routinely advises clients with respect to general corporate and non-profit governance matters.
Michael J. Scanlon is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher. He is a member of the firm’s Securities Regulation and Corporate Governance, Securities Enforcement, and Corporate Transactions Practice Groups, and has an extensive practice representing U.S. and foreign public company and audit firm clients on regulatory, corporate governance, and enforcement matters. Mr. Scanlon advises corporate clients on SEC compliance and disclosure issues, the Sarbanes-Oxley Act of 2002, and corporate governance best practices, with a particular focus on financial reporting matters. He frequently represents both accounting firms and public company clients on SEC and PCAOB accounting and auditing matters, including financial statement materiality and restatement issues, internal control issues, auditor independence, and other accounting-related disclosure issues.
Tino Salazar is an associate in the Los Angeles office of Gibson, Dunn & Crutcher. He is a member of the firm’s Corporate Department and a member of the firm’s Executive Compensation and Employee Benefits Practice Group. His practice focuses on all aspects of executive compensation and employee benefits. Mr. Salazar’s practice encompasses tax, ERISA, accounting, corporate, and securities law aspects of equity and other incentive compensation plans and executive employment and severance arrangements.
MCLE CREDIT INFORMATION:
This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.
Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.
Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 hour.
California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.
This webcast covers key developments to be aware of as you prepare your 2023 proxy statement, including recent and upcoming SEC rulemaking and comment letters, proxy season trends and investor and proxy advisor updates.
PANELISTS:
Aaron K. Briggs is a partner in Gibson Dunn’s San Francisco, CA office, where he works in the firm’s securities regulation and corporate governance practice group. Mr. Briggs’ practice focuses on advising public companies of all sizes (from pre-IPO to mega-cap), with a focus on technology and life sciences companies, on a wide range of securities and governance matters. Before rejoining Gibson Dunn, Mr. Briggs served for five years as Executive Counsel – Corporate, Securities & Finance, at General Electric Company. His in-house experience—which included responsibility for SEC reporting and compliance, board governance, proxy and annual meeting, investor outreach and executive compensation matters, and included driving GE’s revamp of its full suite of investor communications (proxy statement, 10-K, earnings releases, and integrated report)—provides a unique insight and practical perspective on the issues that his clients face every day.
Julia Lapitskaya is a partner in the New York office of Gibson, Dunn & Crutcher. She is a member of the firm’s Securities Regulation and Corporate Governance and its ESG (Environmental, Social & Governance) practices. Ms. Lapitskaya’s practice focuses on SEC, NYSE/Nasdaq and Securities Exchange Act of 1934 compliance, securities and corporate governance disclosure issues, corporate governance best practices, state corporate laws, the Dodd-Frank Act of 2010, SEC regulations, shareholder activism matters, ESG and sustainability matters and executive compensation disclosure issues, including as part of initial public offerings and spin-off transactions.
Geoffrey E. Walter is an associate in the Washington, D.C. office of Gibson, Dunn & Crutcher and a member of the firm’s Securities Regulation and Corporate Governance Practice Group. Mr. Walter advises public companies and their boards of directors on a wide range of corporate law matters, including securities and corporate governance practices and disclosure issues, compliance with SEC regulations and executive compensation disclosure issues, shareholder engagement and activism matters, insider trading and other company policies, and shareholder proposals and responses to SEC inquiries. Mr. Walter also has experience advising nonprofit organizations on issues related to corporate governance.
MCLE CREDIT INFORMATION:
This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.
Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.
Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 hour.
California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.
All communications between EU-qualified external lawyers and their clients benefit from Legal Professional Privilege
In a recent judgment, the European Court of Justice underlined the importance of Legal Professional Privilege in the EU and expanded its scope and nature as compared to the previous situation. The judgment underlines the importance of the fundamental right of respect of communications between a client and their lawyer, and provides reassurance to companies that irrespective of their scope or nature, such communications do not need to be provided to public authorities.
The background to the dispute
The case in question relates to EU legislation (Directive 2011/16/EU) that requires all intermediaries involved in potentially aggressive cross-border tax-planning that might lead to tax avoidance and evasion to report relevant practices to the competent tax authorities. The obligation also covers those who provide advice in that regard, although each EU Member State may grant lawyers (“lawyer-intermediaries”) a waiver from that obligation where it would breach Legal Professional Privilege (LPP) protected under national law. In such a situation, the lawyer-intermediary must nevertheless notify other intermediaries or the relevant taxpayer of their reporting obligations under the relevant legislation.
On that basis, the Flemish decree which transposed the Directive outlined that a lawyer-intermediary must inform other intermediaries that he or she could not fulfil the relevant reporting obligations him- or herself. Two lawyers’ professional organizations argued in front of the Belgian Constitutional Court that by providing even this information, lawyer-intermediaries would breach LPP. The European Court of Justice (ECJ) ruled on this issue on 8 December 2022 in response to a request for guidance from the Belgian Constitutional Court.
The ECJ judgment
The judgment first outlines a number of general principles about the sanctity of communications between lawyers and clients and the nature of LPP itself, even though this was not in itself the subject matter of the request for guidance from the Belgian Constitutional Court. It invokes both the EU Charter of Fundamental Rights as well as case-law of the European Court of Human Rights to highlight:
- the confidentiality of correspondence between individuals and the strengthened protection in that regard to exchanges between lawyers and their clients;
- that such protection covers not only the activity of defence but also legal advice;
- the secrecy of such legal consultation must be guaranteed, both with regard to its content and to its existence;
- individuals who consult a lawyer must therefore have a legitimate expectation that their lawyer will not disclose to anyone, without their consent, that they are being consulted.
Against this backdrop, the judgment goes on to answer the specific request for guidance in relation to the Directive. It holds that the obligation for a lawyer to notify other intermediaries of their obligations under the Directive is in itself an interference of the fundamental right of respect of communications between lawyer and client because those other intermediaries become aware of the identity of the notifying lawyer-intermediary, of their assessment that the arrangement at issue is reportable and of their having been consulted in connection with the arrangement
Since even fundamental rights are not absolute, the judgment then assesses whether such interference is justified in terms of whether it is necessary to achieve a general interest. It holds that the interference is not strictly necessary, inter alia because the reporting obligation of the Directive is clear and already applies to all relevant intermediaries without it being necessary for a lawyer to be involved.
The Court therefore holds that the obligation to notify set out in the Directive infringes the fundamental right of respect for communications between a lawyer and their client.
Implications of the judgment
Beyond the specific subject-matter of the case, the judgment is significant because of the importance it attaches to LPP and the expansion of its scope and nature. These issues were not the specific subject-matter of the request for guidance from the Belgian Constitutional Court and so it is noteworthy that the ECJ, sitting in its Grand Chamber composition, sought to highlight them. By importing provisions from the EU Charter of Fundamental Rights and jurisprudence of the European Court of Human Rights, the judgment significantly expands the nature of LPP in the EU. Under the previous case-law (e.g. the AM&S and Akzo cases), LPP covered only communications relating to the defence of a client or earlier communications related to the subject-matter of the investigation. In practice, this raised questions about which pre-investigation communications could benefit from LPP.
The judgment means that this question is now moot – there is no longer any potential temporal or subject-matter limitation to the notion of LPP in the EU since all communications between lawyers and clients are presumed to benefit from such protection. In practice therefore, clients will no longer be subject to any uncertainty about whether and if so which lawyer-client communications benefit from LPP in the EU. Clients continue to need to be aware that in the EU, in contrast to the situation in the United States, communications with in-house lawyers are not deemed to benefit from LPP and only EU-qualified lawyers benefit from LPP under the EU rules.
The following Gibson Dunn lawyers prepared this client alert: Nicholas Banasevic* and Christian Riis-Madsen.
Gibson Dunn’s lawyers are available to assist in addressing any questions that you may have regarding the issues discussed in this update. For further information, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Antitrust and Competition practice group:
Antitrust and Competition Group:
Nicholas Banasevic* – Managing Director, Brussels (+32 2 554 72 40, [email protected])
Christian Riis-Madsen – Co-Chair, Brussels (+32 2 554 72 05, [email protected])
Ali Nikpay – Co-Chair, London (+44 (0) 20 7071 4273, [email protected])
Rachel S. Brass – Co-Chair, San Francisco (+1 415-393-8293, [email protected])
Stephen Weissman – Co-Chair, Washington, D.C. (+1 202-955-8678, [email protected])
*Nicholas Banasevic is Managing Director in the firm’s Brussels office and an economist by background. He is not an attorney and is not admitted to practice law.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
The U.K. Financial Conduct Authority (the “FCA”) Final Notice against Julius Baer International Limited (“JBIL”)[1], including the imposition of a fine of more than £18 million, marks the latest in a series of enforcement actions against FCA authorised firms relating to failings in arrangements with third party intermediaries. In this alert, we draw out the key themes from those enforcement actions, highlighting particular areas of FCA concern and focus, and set out some practical steps that firms can take so as not to fall foul of regulatory requirements and expectations.
The JBIL Final Notice
JBIL, an investment advisory and wealth management firm, was found by the FCA to have failed to conduct its business with integrity, failed to take reasonable care to organise and control its affairs and failed to be open and cooperative with the FCA.[2] The finding, in particular, that JBIL failed to act with integrity stands out, with there being very few cases where the FCA has considered that there has been a breach of Principle 1 of its Principles for Businesses.[3]
The FCA concluded that JBIL facilitated finder’s arrangements between Bank Julius Baer (“BJB”) and an employee (the “Finder”) of a number of holding companies incorporated in various jurisdictions which owned the residual non-Russian assets of a Russian oil group (the “Client Group Companies”). Under these arrangements, BJB paid finder’s fees to the Finder for introducing Client Group Companies to Julius Baer. This was done on the understanding that the Client Group Companies would then place large cash sums with Julius Baer from which Julius Baer could generate significant revenues.
In particular, uncommercial FX transactions were made in which the Client Group Companies were charged far higher than standard rates, with the profits being shared between the Finder and Julius Baer. The Finder received commission payments totalling approximately USD 3m as a result of these arrangements. These fees were improper and together with the uncommercial FX transactions showed a lack of integrity in the way in which JBIL was undertaking this business.
Further, the FCA found that JBIL failed to have adequate policies and procedures in place to identify and manage the risks arising from the relationships between JBIL and finders (external third parties that introduced potential clients to Julius Baer in return for commission). This included having no policies which defined the rules surrounding the use of finders within JBIL until after June 2010. Policies introduced after that date were found to be inadequate.
Finally, JBIL became aware of the nature of these transactions – including the commission payments to the Finder – in 2012 and suspected that a potential fraud had been committed. However, it did not report these matters to the FCA immediately, as required, or at all until July 2014.
Previous FCA enforcement action against other firms
As noted above, the JBIL Final Notice follows a number of Final Notices imposed on other firms by the FCA. These range from Final Notices for not taking reasonable care to establish and maintain effective systems and controls for countering the risks of bribery and corruption associated with making payments to overseas third parties who assisted in winning business from overseas clients, to a Final Notice issued earlier this year relating to, broadly, the third-party introducers it used in its insurance business and bribes being made by such persons.
Key themes
(1) Policies and procedures
One recurring theme from the Final Notices is that the firms had failed to ensure that they had adequate policies and procedures in place to identify and manage the risks of using the third party intermediaries. For example, prior to 11 June 2010, there were no policies which defined the rules and guidelines to be adopted in respect of the use of finders within the Julius Baer group or JBIL. After that date, JBIL relied on BJB policies and procedures in relation to finders, which were inadequate, and other entities within the Julius Baer group were responsible for managing and overseeing key aspects of finder relationships, including the contractual terms and payment of fees. As a result, JBIL failed to ensure that it identified and managed potential conflicts of interests, both between finders and its clients and between the Julius Baer group and its clients. JBIL also failed to ensure that clients were properly informed of its arrangements with finders and consented to any payments made to finders. A particular similarity between the JBIL Final Notice and previous Final Notices is that firms have had an over-reliance on group procedures, which were not, on their own, sufficient. Firms should, therefore, be cognisant of their own regulatory responsibilities and not simply follow a group-wide policy without ensuring that the policies appropriately cover their own activities.
(2) Systems and controls
Principle 3 requires a firm to take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. In the JBIL Final Notice, it was determined that the conduct of the relationship with the Client Group Companies highlighted serious issues with JBIL’s control environment. Amongst other things, the FCA found that JBIL: (i) did not have a sufficient understanding of the relationships between finders and introduced clients to enable it to identify potential conflicts of interests and did not have sufficient information or oversight to identify any other risks that might arise from relationships with finders; (ii) was not able to take steps adequately to monitor or control the risks arising from relationships with finders, or to assess whether it was appropriate for Julius Baer to maintain such relationships at all; and (iii) was not able to and did not control the disclosure of relationships with finders to clients.
Interestingly, in the JBIL Final Notice and previous Final Notices, the FCA has been critical of the firms in question for not having taken into account relevant key publications produced by the FCA that should have served as a warning and guidance to them. For example, in the JBIL Final Notice, the FCA specifically referred to the “financial crime risks presented by firms’ use of Finders [having] been highlighted by the Authority in publications and enforcement action against firms including Aon (6 January 2009), Willis (21 July 2011) and Besso (17 March 2014)”. This is a clear message that firms should be monitoring the publication of relevant guidance by the FCA and seeing if any lessons can be learned from enforcement action against other market participants.
Another recurring theme of the Final Notices in this space has been what the FCA perceives as inadequate governance, including the manner in which risks, including those relating to financial crime, were presented to certain committees did not enable them to assess the risks holistically and relevant risks and issues were not appropriately escalated to control functions. It is vital, therefore, that firms ensure: (i) the flow of appropriate MI to the relevant committees; (ii) that such information is properly scrutinised and, where necessary, challenged; (iii) that individuals with appropriate skills and experience are sitting on the Board or relevant committees; and (iv) that individuals holding important roles such as the MLRO function are at a sufficiently senior level.
(3) Communicating with the FCA
It is interesting to contrast the views of the FCA on how JBIL and other firms have communicated with it prior to and throughout the enforcement process. In the JBIL Final Notice the FCA noted that “[on] 22 May 2014, [JBIL] reported potential acts of bribery and corruption to UK law enforcement. It referred to payments made by BJB to [the Finder] in finder’s fees and stated that the payments may have been tainted by a ‘scheme’ by [the Finder] and [another individual], to defraud the [Client] Group Companies of money. [JBIL] informed the [FCA] of this on 7 July 2014”. Whilst firms will always want to take time to establish the facts before reporting potential issues to regulators, care must be taken to avoid overly long delay. In this case, the FCA highlighted the gap between the date of internal escalation of serious concerns and the date on which the FCA were notified of the issue: “The [FCA] expects to be notified of allegations of financial crime immediately and should have been promptly informed about the concerns raised on 30 November 2012”.
By contrast, in other Final Notices, the FCA has acknowledged the assistance that firms have provided to it during its investigation when coming to the amount of the fine issued. Firms should, therefore, give great consideration to how and when they communicate with the FCA. This is particularly important in the context of ensuring that firms appropriately comply with their Principle 11 notification obligations.
Practical steps
We set out below a table of examples of “good” and “poor” practice that should assist firms in their approach to ensuring they are complying with FCA expectations in the context of relationships with third party intermediaries, primarily viewed through an anti-bribery and corruption lens. It is informed by the FCA’s guidance in Chapter 13 of its “Financial Crime Thematic Reviews” guide.
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Examples of “good practice” |
Examples of “poor practice” |
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Governance |
|
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Clear, documented responsibility for anti-bribery and corruption apportioned to either a single senior manager or a committee with appropriate terms of reference and senior management membership, reporting ultimately to the Board. |
Failing to establish an effective governance framework to address bribery and corruption risk. |
|
Regular and substantive MI to the Board and other relevant senior management forums, including: an overview of the bribery and corruption risks faced by the business; systems and controls to mitigate those risks; information about the effectiveness of those systems and controls; and legal and regulatory developments. |
Failing to allocate responsibility for anti-bribery and corruption to a single senior manager or an appropriately formed committee. |
|
Where relevant, MI includes information about third parties, including (but not limited to) unusually high commission paid to third parties. |
Little or no MI sent to the Board about bribery and corruption issues, including legislative or regulatory developments, emerging risks and higher risk third-party relationships or payments. |
|
Assessing bribery and corruption risk |
|
|
The firm takes adequate steps to identify the bribery and corruption risk. Where internal knowledge and understanding of corruption risk is limited, the firm supplements this with external expertise. |
The risk assessment is a one-off exercise. |
|
Risk assessment is a continuous process based on qualitative and relevant information available from internal and external sources. |
Efforts to understand the risk assessment are piecemeal and lack coordination. |
|
Firms consider the potential conflicts of interest which might lead business units to downplay the level of bribery and corruption risk to which they are exposed. |
Risk assessments are incomplete and too generic. |
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The bribery and corruption risk assessment informs the development of monitoring programmes; policies and procedures; training; and operational processes. |
Firms do not satisfy themselves that staff involved in risk assessment are sufficiently aware of, or sensitised to, bribery and corruption issues. |
|
Policies and procedures |
|
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The firm clearly sets out the behaviour expected of those acting on its behalf. |
The firm has no method in place to monitor and assess staff compliance with anti-bribery and corruption policies and procedures. |
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The team responsible for ensuring the firm’s compliance with its anti-bribery and corruption obligations engages with the business units about the development and implementation of anti-bribery and corruption systems and controls. |
Staff responsible for the implementation and monitoring of anti-bribery and corruption policies and procedures have inadequate expertise on bribery and corruption. |
|
There should be an effective mechanism for reporting issues to the team or committee responsible for ensuring compliance with the firm’s anti-bribery and corruption obligations. |
|
|
Third party relationships and due diligence |
|
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Where third parties are used to generate business, these relationships are subject to thorough due diligence and management oversight. |
A firm using intermediaries fails to satisfy itself that those businesses have adequate controls to detect and prevent staff using bribery or corruption to generate business. |
|
Third-party relationships are reviewed regularly and in sufficient detail to confirm that they are still necessary and appropriate to continue. |
The firm fails to establish and record an adequate commercial rationale for using the services of third parties. |
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There are higher, or extra, levels of due diligence and approval for high risk third-party relationships. |
The firm is unable to produce a list of approved third parties, associated due diligence and details of payments made to them. |
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There is appropriate scrutiny of, and approval for, relationships with third parties that introduce business to the firm. |
There is no checking of compliance’s operational role in approving new third-party relationships and accounts. |
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The firm’s compliance function has oversight of all third-party relationships and monitors this list to identify risk indicators, such as a third party’s political or public service connections. |
A firm assumes that long-standing third-party relationships present no bribery or corruption risk. |
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Evidence that a risk-based approach has been adopted to identify higher risk relationships in order to apply enhanced due diligence. |
A firm relies exclusively on informal means, such as staff’s personal knowledge, to assess the bribery and corruption risk associated with third parties. |
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Enhanced due diligence procedures include a review of the third party’s own anti-bribery and corruption controls. |
No prescribed take-on process for new third-party relationships. |
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Inclusion of anti-bribery and corruption-specific clauses and appropriate protections in contracts with third parties. |
A firm does not keep full records of due diligence on third parties and cannot evidence that it has considered the bribery and corruption risk associated with a third-party relationship. |
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Providing good quality, standard training on anti-bribery and corruption for all staff. |
|
__________________________
[1] https://www.fca.org.uk/publication/final-notices/julius-baer-international-limited-2022.pdf.
[2] The FCA also published decision notices for three connected individuals (available here).
[3] The most recent instance prior to this was the Coverall Worldwide Ltd Final Notice in 2016: https://www.fca.org.uk/publication/final-notices/coverall-worldwide-ltd.pdf.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact the Gibson Dunn lawyer with whom you usually work, any member of Gibson Dunn’s Global Financial Regulatory team, or the following authors in London:
Michelle M. Kirschner (+44 (0) 20 7071 4212, [email protected])
Matthew Nunan (+44 (0) 20 7071 4201, [email protected])
Martin Coombes (+44 (0) 20 7071 4258, [email protected])
Chris Hickey (+44 (0) 20 7071 4265, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On November 21, 2022, Governor Hochul signed into law Bill A8092B, which amends the New York Labor Law (“NYLL”) to provide a new potential claim for employees who are retaliated against for taking lawful absences from work. The amendments also expressly prohibit employers from using “no-fault” attendance policies that penalize employees for taking protected absences. The new provisions of NYLL will be effective on February 20, 2023.
New Anti-Retaliation Provisions
When effective, the NYLL will prohibit employers from discharging, threatening, penalizing, discriminating or retaliating against an employee “because such employee has used any legally protected absence pursuant to federal, local, or state law.” Legally protected absences include absences taken pursuant to federal and state leave laws, such as the Family and Medical Leave Act (“FMLA”), the New York State and City Paid Sick Leave Laws, and the New York State Paid Family Leave Law.
The amendments will also restrict New York employers from maintaining “no-fault” attendance policies whereby an employer assigns “points” to employees for certain absences and imposes disciplinary action against employees who reach a certain number of points. The amended law expressly prohibits employers from imposing “any demerit, occurrence, any other point, or deductions from an allotted bank of time, which subjects or could subject an employee to disciplinary action, which may include but not be limited to failure to receive a promotion or loss of pay” when an employee takes a protected leave. This effectively prohibits no-fault attendance policies in New York to the extent that a policy penalizes employees for absences covered by an applicable leave law.
Legal Landscape
Employers are already prohibited from penalizing employees for taking protected leave under many statutes that are covered by these amendments to the NYLL. For example, the U.S. Department of Labor and some courts have interpreted the FMLA to prohibit employers from assessing points under no-fault attendance policies for FMLA-protected leave. See Woods v. START Treatment & Recovery Centers, Inc., 864 F.3d 158 (2d Cir. 2017). Moreover, the New York City Sick Leave Law specifically prohibits the “maintenance or application of an absence control policy that counts safe and sick leave as an absence that may lead to or result in an adverse action.”
New York legislators have nevertheless expressed concern that these existing protections are not sufficient to curb employers’ use of no-fault attendance policies in a manner that penalizes employees for taking protected leave. This law therefore aims to “make clear” that the practice of assessing points for any leave taken pursuant to applicable law is not permitted.
In addition to reinforcing existing law, these amendments allow employees to pursue claims against employers for retaliation for taking leave under any applicable leave law. For example, whereas the New York Paid Family Leave Law and the New York City Sick Leave Law only allow for administrative enforcement, the NYLL contains a private cause of action that allows employees to seek back pay, front pay, reinstatement, and/or liquidated damages when employees experience retaliation related to protected leaves.
The amendments will also permit the State to impose higher fines for violations of the anti-retaliation provisions of leave laws. For example, employers that violate the New York City Sick Leave Law may be fined up to $2,500 for each violation. Under the amended NYLL, the State Department of Labor is authorized to impose fines of up to $10,000 for initial violations (and up to $20,000 for subsequent violations) of the same anti-retaliation prohibitions.
Key Takeaways for Employers
In light of the impending amendments, New York employers should review their policies – and revise them if necessary – to ensure they do not penalize employees for taking protected leave. Companies that currently utilize no-fault policies might also wish to train managers and HR personnel to ensure compliance with this new law.
The following Gibson Dunn attorneys assisted in preparing this client update: Harris Mufson, Alex Downie, and Mimra Aslaoui.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Labor and Employment practice group, or the following:
Zainab N. Ahmad – New York (+1 212-351-2609, [email protected])
Mylan Denerstein – New York (+1 212-351-3850, [email protected])
Gabrielle Levin – New York (+1 212-351-3901, [email protected])
Danielle J. Moss – New York (+1 212-351-6338, [email protected])
Harris M. Mufson – New York (+1 212-351-3805, [email protected])
Jason C. Schwartz – Co-Chair, Labor & Employment Group, Washington, D.C.
(+1 202-955-8242, [email protected])
Katherine V.A. Smith – Co-Chair, Labor & Employment Group, Los Angeles
(+1 213-229-7107, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Senator Kyrsten Sinema (I-AZ) announced on December 9, 2022, that she would change her party registration from the Democratic Party to Independent. In an interview with CNN’s Jake Tapper, she explained: “I know some people might be a little bit surprised by this, but actually, I think it makes a lot of sense.” Elaborating in an op-ed in the Arizona Republic, Senator Sinema declared that she “never fit in perfectly with either national party,” and pledged to “to continue doing exactly what I promised—to be an independent voice for Arizona.”
As a result of the party switch, the question arises whether Senate Democrats will have 51 seats in the Senate (technically 48 Democrats and three Independents who caucus with the Democrats) as expected after the Georgia runoff. The answer is Senator Sinema’s switch does not necessarily change the Senate’s voting math. As detailed below, we explain what may have motivated Senator Sinema to identify as an Independent and how her switch impacts the Senate’s business going forward. In short, Senator Sinema’s switch likely won’t impact the Democrats’ narrow control of the Senate.
Background on Senator Sinema’s Party Switch
Senator Sinema’s party switch—timed to be announced after Senator Raphael Warnock’s (D-GA) runoff victory in Georgia—likely has to do with the changing politics in Arizona and Senator Sinema’s attempt to secure her own re-election in 2024. It may be an attempt to thread the needle of maintaining political support from Senate Democrats’ campaign resources while heading off a party primary challenge from the progressive left.
Democratic Primary:
Senator Sinema’s decision likely turned on concerns about a strong primary challenger from within the Democratic Party, bolstered by concerns that her recent votes have motivated the party’s campaign arm to throw its support behind a challenger. Recent polling suggests that Senator Sinema’s next primary race may be a close one, as her numbers have steadily declined with Democrats in her home state. No candidates have formally announced challenges to Senator Sinema, but Phoenix-area Representative Ruben Gallego (D-AZ) has been publicly forecasting a primary run for some time.
By leaving the Democratic Party, Senator Sinema avoids a primary challenge and possibly puts herself in a three-way general election in November 2024. The assumption may be that positioning herself as an “Independent,” rather than a Democrat, may allow her to fare better with Republican and Democratic voters in a general election and force Democrats to support her campaign. But it also runs the risk that a three-way race may lead to a Republican being elected senator from Arizona in 2024. Indeed, by abandoning the Democratic Party, a question arises whether Senator Sinema will further alienate the voters that used to be her base. And the National Democratic Party will have a decision to make on whether to support a “Democrat” in the 2024 Arizona Senate election or to back Senator Sinema. But backing Senator Sinema could upset the Democratic base who may or may not turn out to support an “Independent” and cost Democrats a U.S. Senate seat in Arizona.
Arizona:
Demographic changes and shifting ideological blocs have redrawn the map of Democratic focus—and no state perhaps better exemplifies that shift than Arizona. The state has become a critical focus for Democrats in recent years. Arizona is the most recent Sun Belt state to morph from a solidly red state to a critical purple pickup for Democrats—beginning with Senator Sinema’s own narrow defeat of then-sitting Senator Martha McSally in 2018. That victory marked Democrats’ first win of an open Arizona Senate seat since 1976, and signaled to national party leadership, per the New York Times, “a remarkable shift in Arizona’s political landscape,” after the state had been a “Republican bastion for decades.”[1]
Democrats’ strategic reorientation towards Arizona has already paid dividends. This midterm cycle, Democrats invested major talent and resources to successfully protect an endangered Senate seat, as Senator Mark Kelly (D-AZ) kept the seat he won in 2020’s special election, and even more remarkably for the once solidly-red state, picked up a governorship with the election of Secretary of State Katie Hobbs (D-AZ), with whom Senator Sinema has maintained a close relationship for years.
Senator Sinema no doubt understands these changes and the need to appeal to Independents and moderate Republicans in her state. Indeed, more than a third of Arizona’s voters identify as “other” and Republicans outnumber Democrats by more than 166,000.
Party Resources:
Senator Sinema’s move will have major consequences for continued party investments in Arizona, especially in her upcoming reelection bid. Party leadership could choose to 1) continue to back Senator Sinema, as they do with Maine’s Independent Senator Angus King, 2) sit back and watch or 3) actively support a Democratic challenger. Now that she’s formally renounced her party membership, at least nominally, the Democratic Senatorial Campaign Committee (DSCC), Senate Majority PAC, and other party campaign instruments may not support her in 2024, or choose to invest resources in a party challenger instead. However, the fact that Senate Democratic leadership is not seeking to punish Senator Sinema for her switch may suggest that—at least as of now—the DSCC is likely to back her again in 2024.
Independents have traditionally faced an uphill battle in national politics—from fundraising to organizing to marshalling the support of elected officials—that Senator Sinema herself is likely familiar with (the now-U.S. Senator ran for the Arizona House of Representatives as an Independent and lost). While Senator Sinema is known as a strong fundraiser, the DSCC standing back would mean “she would lack party resources—like a ground game—that are critical for voter turnout, particularly in a sprawling state like Arizona.”
As described above, by positioning herself as an Independent, Senator Sinema is betting that the Democratic Party will eventually support her, but if she loses that bet and the Party supports a “Democrat” and not her, she runs the risk of allowing a Republican to win the Senate race.
Personal Brand:
Senator Sinema actively practices bipartisanship, from friendships with Republican senators to playing a key role in advancing bipartisan legislation to President Biden’s desk this Congress. Her commitment to bipartisanship may also have motivated her party switch decision. In her op-ed explaining her decision, Senator Sinema wrote, “[i]n catering to the fringes, neither party has demonstrated much tolerance for diversity of thought. Bipartisan compromise is seen as a rarely acceptable last resort, rather than the best way to achieve lasting progress.”
These words are consistent with Senator Sinema’s past positions since she ran for the U.S. Senate. From her first election to the Senate, she has sworn to “be an independent voice for all Arizonans.” In her announcement interview with Tapper, she reiterated: “I’ve never fit neatly into any party box. Removing myself from the partisan structure—not only is it true to who I am and how I operate, I also think it’ll provide a place of belonging for many folks across the state and the country, who also are tired of the partisanship.”
Even before running for the Senate, Senator Sinema has done things her own way, from the beginnings of her career as a Green Party activist to more recent moves sending Democrats in the Senate back to the drawing board to gain her support for key legislation. Once a staffer on Ralph Nader’s 2000 presidential campaign, Senator Sinema has become progressively more moderate as she climbed from a 2004 win in the Arizona House of Representatives to a 2010 Arizona Senate seat, then a 2012 U.S. House of Representatives win. Senator Sinema won each of those races as a Democrat.
What This Means for the Senate
To understand the potential importance of Senator Sinema’s switch to being an Independent on the U.S. Senate, one must first understand how the change from a 50-50 Senate to a 51-49 Senate would change the overall dynamics of the institution. The Georgia U.S. Senate runoff led to a 51-49 U.S. Senate, which was supposed to change the chamber and firm up Democratic control in several ways:
- Establish a real majority in committees. Democrats have chaired Senate committees the past two years, but there was equal representation on committees, which increased the chances of a tie vote that required time-consuming “discharge” votes on the Senate floor. It also meant that Democratic committee chairs could not issue subpoenas without Republican support. As a result, subpoenas were not used by Senate committees in the 117th Congress. With a 51-49 Senate, Democrats would have one more member than Republicans on all committees, ensuring legislation and nominees would advance if all Democratic caucus members stick together. Democrats would now also have a larger budget and bigger staffs.
- Advancing judicial and executive nominations. For the last two years, with a 50-50 Senate, Republicans were able to slow down the nominations process since the committees had equal representation. If a tie vote occurred in committee, the full Senate must first vote to bring the nomination to the Senate floor and then vote on the nomination itself. Now, with a 51-49 Senate, a Democratic-controlled Senate may be able to more quickly advance nominations through the confirmation process and have more cushion to deal with absences at full Senate confirmation votes on nominees.
- Manchin and Sinema influence. With Democrats having a 51 seat majority in the U.S. Senate, one theory is that Senators Joe Manchin (D-WV) and Sinema would have less influence over the legislative process. While 60 votes are usually required to advance most legislation in the Senate, certain items can pass on a simple majority vote using the budget reconciliation process or for nominations. But that forced Democrats to have no room for defections (or absences) and Senators Manchin and Sinema were at times difficult to win over. But with a 51 seat majority, it is more likely that Democrats can pass legislation or nominations without the support of either Manchin or Sinema if all other Democratic Senators are onboard.
- Less reliance on the Vice President to break ties. A 50-50 Senate has been a weight on Vice President Kamala Harris, who has had to limit her travel in order to be available for tiebreaking votes in the Senate. In fact, Vice President Harris has broken 26 ties in the last two years, the most by a Vice President in nearly 200 years. But a 51-49 Senate, after the Georgia runoff, was supposed to lessen the burden on the Vice President who the Senate may rely on less to break legislative ties in the Senate.
The main question in Washington after Senator Sinema’s announced party switch was how would her decision impact Democratic control over the U.S. Senate. In other words, would the Senate in fact still be a 51-49 Senate or would it go back to effectively being a 50-50 Senate, effectively denying the benefits Democrats expected after the Georgia runoff victory? While Senator Sinema’s move generated significant news coverage, it is not expected to change the balance of power in the Senate. In an interview with Politico, Senator Sinema herself said, “I don’t anticipate that anything will change about the Senate structure. I intend to show up to work, do the same work that I always do. I just intend to show up to work as an independent.”
In the words of Punchbowl News, “Sinema declared that ‘nothing will change about [her] values or behavior’ in announcing her party switch, and top Democrats seem to have accepted that.” Indeed, both the White House and Majority Leader Chuck Schumer (D-NY) have released conciliatory statements regarding the switch.
Most importantly, while Senator Sinema has declined to publicly say whether she will caucus with Senate Democrats, she has stated explicitly she would not caucus with Republicans. Senator Sinema has also indicated, and Leader Chuck Schumer (D-NY) has confirmed, that she will keep her current committee assignments. As Punchbowl put it, by keeping her committee assignments, “Sinema is effectively caucusing with the Democrats,” even if she does not describe it that way.
The other two Senate Independents, Senators Angus King (I-ME) and Bernie Sanders (I-ME), both consistently vote, caucus with, and hold committee positions with Senate Democrats. At the same time, Senator Sinema has said—unlike Senators King and Sanders—she won’t attend weekly Democratic Caucus meetings (which she rarely did anyway), and isn’t sure whether her desk will remain on the Democratic side of the Senate floor.
Senator Sinema is known for bucking her party and frequently allies with Republicans on various legislative efforts. She is currently engaged in last-minute bipartisan talks with Senator Thom Tillis (R-N) on an immigration deal that she hopes could pass in the lame duck session.
Nevertheless, a review of her voting record on the Bipartisan Safer Communities Act, the CHIPS and Science Act, the Respect for Marriage Act, and other legislation shows she is farther to the left than the Republican Party on social issues, even if she is farther to the right of Democrats on economic issues. For instance, Senator Sinema has voted with the Democratic Party 93% of the time, and has publicly stated she doesn’t expect her voting record to change after her switch to become an Independent.
Moreover, Senator Sinema has supported every one of President Biden’s judicial nominees—an unlikely position for a Senate Republican—not to mention voting to impeach then-President Donald Trump twice. Underscoring this, a top aide to Minority Leader Mitch McConnell (R-KY) sent a note to lobbyists and supporters after the party switch highlighting Senator Sinema’s liberal voting record.
With Senator Sinema keeping her committee assignments, the day-to-day operation of the Senate is not expected to change. Following Senator Warnock’s reelection in the Georgia runoff, Democrats will hold a majority in the Senate beginning on January 3, 2023, and that will not change. Likewise, even with Senator Sinema’s switch, Democrats will be a majority on Senate committees—unlike in the current Congress, in which committees are tied. This means Senate Democrats will be able to move nominations more quickly, advance party legislative priorities out of committees with greater ease, and issue subpoenas without Republican support. Moreover, the Vice President will be needed less often to break tie votes.
_______________________________
[1] Senator Sinema’s 2018 victory was particularly noteworthy in a midterm Senate cycle that saw the end of much of the caucus’s moderate wing—Senators Joe Donnelly (D-IN), Heidi Heitkamp (D-ND), and Claire McCaskill (D-MO) each lost their seats after multiple terms in the Senate.
The following Gibson Dunn attorneys assisted in preparing this client update: Michael D. Bopp, Roscoe Jones, Jr., Daniel P. Smith, Amanda Neely, Wynne Leahy, and Alex Boudreau.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work or the following lawyers in the firm’s Congressional Investigations or Public Policy practice groups:
Michael D. Bopp – Chair, Congressional Investigations Group, Washington, D.C. (+1 202-955-8256, [email protected])
Roscoe Jones, Jr. – Co-Chair, Public Policy Group, Washington, D.C. (+1 202-887-3530, [email protected])
Amanda H. Neely – Washington, D.C. (+1 202-777-9566, [email protected])
Daniel P. Smith* – Washington, D.C. (+1 202-777-9549, [email protected])
*Daniel P. Smith is admitted only in Illinois; practicing under the supervision of members of the District of Columbia Bar under D.C. App. R. 49.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Please join us for this 60-minute program. The panel covers key developments to be aware of headed into the 2022 Form 10-K reporting season, including recent SEC rulemaking and comment letters, disclosure trends and other developments.
PANELISTS:
Thomas J. Kim is a partner in the Washington D.C. office of Gibson, Dunn & Crutcher, LLP, where he is a member of the firm’s Securities Regulation and Corporate Governance Practice Group. Mr. Kim focuses his practice on a broad range of SEC disclosure and regulatory matters, including capital raising and tender offer transactions and shareholder activist situations, as well as corporate governance, environmental social governance and compliance issues. He also advises clients on SEC enforcement investigations – as well as boards of directors and independent board committees on internal investigations – involving disclosure, registration, corporate governance and auditor independence issues.
Mike Titera is a partner in the Orange County office of Gibson, Dunn & Crutcher and a member of the Firm’s Securities Regulation and Corporate Governance Practice Group. His practice focuses on advising public companies regarding securities disclosure and compliance matters, financial reporting, and corporate governance. Mr. Titera often advises clients on accounting and auditing matters and the use of non-GAAP financial measures. He also has represented clients in investigations conducted by the Securities and Exchange Commission and the Financial Industry Regulatory Authority. Mr. Titera’s clients range from large-cap companies with global operations to small-cap companies in the pre-revenue phase. His clients operate in a range of sectors, including the retail, technology, pharmaceutical, hospitality, and financial services sectors.
David Korvin is a corporate associate in the Washington, D.C. office of Gibson, Dunn & Crutcher, where he currently practices in the firm’s Securities Regulation and Corporate Governance Practice Group. Mr. Korvin advises public companies and their boards with respect to corporate governance, federal securities, financial reporting and accounting, insider trading, stock exchange, shareholder engagement, ESG and executive compensation matters. Prior to joining Gibson Dunn, Mr. Korvin was an attorney at the Securities and Exchange Commission in the Division of Corporation Finance, where he handled the legal review of Securities Act and Exchange Act filings and served as a member of the Shareholder Proposal Taskforce.
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On December 7, 2022, President Biden signed into law the “Speak Out Act” (S.B. 4524), which prohibits the enforcement of pre-dispute non-disclosure and non-disparagement clauses in disputes relating to claims of sexual assault or sexual harassment. Among other things, the Act is intended to combat sexual harassment and assault in the workplace by ensuring that “victims and survivors have the freedom to report and publicly disclose their abuse” so that perpetrators may be held accountable and workplaces may be “safer and more productive for everyone.” S.B. 4524 § 2. The Act applies only to non-disclosure and non-disparagement clauses signed before a dispute arises, meaning that it does not prohibit such provisions in settlement or severance agreements.
In light of Congress’s findings that non-disclosure and non-disparagement provisions “can perpetuate illegal conduct by silencing those who are survivors of illegal sexual harassment and assault or illegal retaliation” and “shielding perpetrators and enabling them to continue their abuse,” the Speak Out Act makes such clauses judicially unenforceable in sexual assault or sexual harassment disputes where the conduct is alleged to have violated federal, state, or tribal law. S.B. 4524 §§ 4(a), 1(6). The Act applies to disputes alleging nonconsensual sexual acts, nonconsensual sexual contact, or sexual harassment. Id. §§ 4(a), 1(3)–(4).
A non-disclosure clause is defined as “a provision in a contract or agreement that requires the parties to the contract or agreement not to disclose or discuss conduct, the existence of a settlement involving conduct, or information covered by the terms and conditions of the contract or agreement.” S.B. 4524 § 3(1). A non-disparagement clause is defined as “provision in a contract or agreement that requires 1 or more parties to the contract or agreement not to make a negative statement about another party that relates to the contract, agreement, claim, or case.” S.B. 4524 § 3(2).
The law does not impact an employer’s right to protect trade secrets or proprietary information. S.B. 4524 § 4(d). The Act also does not impact the applicability of state laws governing pre-dispute non-disclosure and non-disparagement clauses to the extent they provide the same or greater protections than the Speak Out Act. S.B. 4524 § 4(c).
The Speak Out Act follows legislation limiting the enforcement of arbitration clauses in employment agreements for sexual assault and discrimination cases. The Ending Forced Arbitration of Sexual Assault and Sexual Harassment Act of 2021, enacted in March of 2022, prohibits the enforcement of pre-dispute agreements requiring employees to arbitrate sexual assault or harassment claims.
Notes for Employers
- Does Not Prohibit Non-Disclosure and Non-Disparagement Clauses. The Act does not prohibit employers from entering into non-disclosure and non-disparagement provisions with their employees, nor does it prevent employers from enforcing such clauses in most circumstances. The Act only prevents the enforcement of non-disclosure and non-disparagement provisions in connection with disputes relating to sexual harassment and sexual assault. (Other federal and state laws and regulations, such as the Defend Trade Secrets Act and SEC Rule 21F-17, may require or provide for carve-outs from such clauses for certain protected whistleblowing activities.)
- No Effect On Settlement Agreements. The Act only applies to non-disclosure and non-disparagement agreements “agreed to before the dispute arises.” S.B. 4524 § 4(a). The Act therefore does not place any limitations on non-disclosure and non-disparagement agreements reached as part of a settlement of sexual harassment and sexual assault claims. Note, however, that many states have laws, such as California’s Silenced No More Act (Cal. S.B. 331) and Section 5-336 of the New York General Obligations Law (N.Y. Gen. Oblig. § 5-336), that place limitations on the use of non-disclosure and non-disparagement provisions in settlement agreements.
- Not Retroactive. The Act only applies to claims filed after its enactment, and does not affect the enforceability of non-disclosure and non-disparagement clauses in connection with disputes filed before December 7, 2022. S.B. 4524 § 5.
The following Gibson Dunn attorneys assisted in preparing this client update: Gabrielle Levin and Kelley Pettus.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Labor and Employment practice group, or the following:
Gabrielle Levin – New York (+1 212-351-3901, [email protected])
Jason C. Schwartz – Co-Chair, Labor & Employment Group, Washington, D.C.
(+1 202-955-8242, [email protected])
Katherine V.A. Smith – Co-Chair, Labor & Employment Group, Los Angeles
(+1 213-229-7107, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On December 7, 2022, the Legislative Council (“LegCo’) of the Hong Kong Special Administrative Region (“HKSAR”) passed the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 (“Amended AMLO”) into law. On the same day, the LegCo’s Bills Committee also published a report (“Report”), providing clarification on certain concepts under the Amended AMLO, and explained the postponed timeline for the commencement of the licensing regime for virtual asset service providers (“VASPs”).[1]
In our previous client alert[2], we explained the proposal by the Government of the HKSAR (“Government”) to introduce a licensing regime for VASPs by amending the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (“AMLO”). In this client alert, we explain and provide our views on the additional clarification provided on the licensing regime for VASPs, the updated timeline for the commencement of the licensing regime, and next steps.
I. Recap on the Key Proposals Under the Amended AMLO
The Amended AMLO introduces a licensing regime for VASPs, and imposes statutory anti-money laundering and counter-terrorist financing (“AML/CTF”) obligations on VASPs in Hong Kong. Some of the key takeaways are as follows:
- The operation of a virtual asset (“VA”) service will become a “regulated function”, such that VASPs will, in the future, be required to apply for a licence from the Securities and Futures Commission (“SFC”), before they can operate in Hong Kong.
- The licensing regime for VASPs is primarily intended to capture the operation of a VA exchange. However, the Government could expand the scope of “VA service” to cover other forms of VA activities, when the Government considers it necessary to do so in the future.
- The licensing requirements to be imposed on VASPs is likely to be modelled on existing requirements for the SFC’s licensing of regulated activities under the Securities and Futures Ordinance. This includes the fitness and properness requirements, and the requirement for a licensed VASP to have at least two responsible officers.
- The SFC has discretion to impose a range of licensing conditions on a VASP licensee, including conditions relating to financial resources, risk management policies and procedures, management of client assets, virtual asset listing and trading policies, prevention of market manipulation and abusive activities, avoidance of conflicts of interest, among other requirements that can be imposed by the SFC as a licence condition.
- Licensed VASPs will be required to comply with existing requirements under the AMLO on customer due diligence and record-keeping requirements, which will be comparable to traditional financial institutions.
- A new enforcement regime applicable to VASPs will be introduced. Under the Amended AMLO it will be a criminal offence to carry on a business of providing VA service without a VASP licence and to issue advertisements relating to an unlicensed person’s provision of VA service. It will also become a criminal offence to make fraudulent or reckless misrepresentations with the intention to induce others to invest in VAs and an offence to employ deceptive or fraudulent device, scheme or act, directly or indirectly, in a transaction involving VAs (which is likely to capture market manipulation activities).
- Relevantly, the offences of making fraudulent or reckless misrepresentations or employing deceptive or fraudulent devices, schemes or acts, are not limited to transactions on licensed VASPs and as such will capture all individuals and/or firms engaging in this type of conduct with a substantial nexus to Hong Kong.
- The SFC will be granted a significant range of supervisory powers over licensed VASPs. This includes the power to enter the business premise of a licensed VASPs to conduct routine inspections of business records, request production of documents and other records, and to investigate non-compliance and impose disciplinary sanctions against licensed VASPs in contravention.
II. The Applicability of the VASP Regime to Non-Fungible Tokens
Under the Amended AMLO, “VA” generally captures a cryptographically secured digital representation value that:
- is expressed as a unit of account or a store of economic value;
- either:
- functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services, or for the discharge of debt, or for investment purposes; or
- provides rights, eligibility or access to vote on the management, administration or governance of the affairs in connection with any cryptographically secured digital representation of value;
- can be transferred, stored or traded electronically; and
- satisfies other characteristics prescribed by the SFC.
In our previous alert, we noted that the proposed definition of “VA” did not capture non-fungible tokens (“NFTs”). This point was picked up during the LegCo meetings. The SFC has clarified that the assessment of whether an NFT is a VA needs to take into account its terms and features. In most cases, NFTs which merely represent a “genuine digital representation of a collectable” is unlikely to be captured by the definition of “VA” under the Amended AMLO; however where the NFT go beyond the scope of a collectable, for example where it contains fungible elements or allows holders to vote on its arrangement, then this may cause the NFT to be “a medium of exchange accepted by the public” or “a digital representation of value that providers holders with rights, eligibility or access to vote”, and therefore it will fall under the ambit of a VA.[3]
The Government further explains that if a specific NFT is seen to be a VA, persons trading that specific NFT will require a licence if those dealings amount to a “VA service”, i.e., if the specific NFT is traded through the operation of an exchange. In other words, if the trading occurs on a peer-to-peer basis, the persons would not be deemed as operating an exchange and their activities would not fall within the scope of a “VA service”, and therefore a VASP licence is not required.[4]
III. The Requirement of Providing VA Services to Professional Investors Only
In our previous client alert, we noted the proposal that, in order to promote investor protection, the licensing regime for VASPs will, at the initial stage, stipulate that VASPs can only provide services to professional investors (“PI Restriction”), and that this restriction will be imposed by the SFC as a licence condition. At that time, we observed that the use of the phrase “initial stage” and the proposal to impose the PI Restriction by way of a licensing condition, rather than in the legislation itself, suggested that the SFC may possibly allow expansion of VASP services to retail investors down the track when VA markets become more mature and regulated.
It appears that the Government recognises that VA markets have become more mature since the licensing regime for VASPs was first proposed. On October 31, 2022, the Government issued its policy statement on the development of VAs in Hong Kong[5] (“Policy Statement”), where the Government stated that it recognised the increasing acceptance of VA as a vehicle for investment allocation by global investors, be they institutional or individual. It was noted in the Policy Statement that the SFC would be conducting a public consultation on how retail investors may be given a suitable degree of access to VA under the new licensing regime for VASPs, while being careful and cautious about the risks to retail investors, including by enhancing investor education and ensuring that suitable regulatory arrangements are in place.
The Report provides further clarification on the Government’s position on the PI Restriction requirement, and notes that the PI Requirement will be imposed on licensed VASPs as a licensing condition at the initial stage. However it further states that the SFC will conduct a consultation on the detailed regulatory requirements on the new VASP regime; and during the consultation the SFC will consider whether to allow non-professional investors (i.e. retail investors) to partake in VA transactions with licensed VASPs, provided that additional investor protection measures are in place.[6]
The SFC’s thinking on the investor protection measures to allow retail investors to trade VAs with licensed VASPs will likely become clearer after the SFC publishes its consultation paper on the regulatory requirements under the new VASP regime.
IV. Postponement to the Commencement of the Amended AMLO and the Licensing Regime for VASPs
In the Report, the Government proposed to postpone the commencement of the Amended AMLO and the licensing regime for VASPs. Set out below is a summary of the original timeline and the new timeline for the commencement of the Amended AMLO and the licensing regime for VASPs, as well as the timing implications for the transitional period and the deadline to submit an application to the SFC under the licensing regime for VASPs.
|
Event |
Original timeline |
New timeline |
|
Commencement date of the Amended AMLO. Note that the criminal offences for fraudulent or reckless misrepresentations, or employing deceptive or fraudulent devices, schemes or acts, in relation to VA transactions, commences from this date. |
January 1, 2023 |
April 1, 2023 |
|
Commencement date of the licensing regime for VASPs (“VASP Regime Commencement Date”). |
March 1, 2023 |
June 1, 2023 |
|
Start date for the 12 months transitional period (“Transitional Period Start Date”) for any corporation that has been carrying on the business of providing a VA service in Hong Kong immediately before the VASP Regime Commencement Date (“Existing VASPs”), during which time the Existing VASP can carry on VA service in Hong Kong without a VASP licence. |
Starting from March 1, 2023 |
Starting from June 1, 2023 |
|
Deadline of the 9 months period for Existing VASPs to file an application to the SFC for a licence under the licensing regime for VASPs, in order to be deemed to be licensed from the day after the expiry of the 12 months’ transitional period (“Application Deadline”). |
By no later than December 1, 2023 |
By no later than March 1, 2024 |
Existing VASPs that file an application to the SFC by the Application Deadline will be deemed to be a licensed VASP from the day after the expiry of 12 months from the Transitional Period Start Date (i.e. June 2, 2024) until the SFC has made a decision to either approve or reject their licence application, or the licence applicant withdraws their application.
The Report notes that the postponement is intended to provide the Government and the SFC more time to work out the implementation details of the new regulatory regime, including public consultation work by the SFC on the regulatory requirements for licensed VASPs. The postponement is also intended to allow more time for the VASPs sector to prepare for the introduction of the licensing regime.
We will continue to closely monitor developments in this area, and will provide a more detailed update when the SFC publishes its public consultations on the regulatory regimes for licensed VASPs.
___________________________
[1] “Report of the Bills Committee on Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022”, LC Paper No. CB(1)855/2022 (December 7, 2022), published by the Legislative Council, available at https://www.legco.gov.hk/yr2022/english/bc/bc05/reports/bc0520221207cb1-855-e.pdf
[2] Hong Kong Introduces Licensing Regime for Virtual Asset Services Providers (June 30, 2022), published by Gibson, Dunn & Crutcher LLP, available at https://www.gibsondunn.com/hong-kong-introduces-licensing-regime-for-virtual-asset-services-providers/
[3] Paragraph 13 of the Report
[4] Paragraph 14 of the Report.
[5] “Policy Statement on Development of Virtual Assets in Hong Kong”, published by the Financial Services and the Treasury Bureau on October 31, 2022, available at https://gia.info.gov.hk/general/202210/31/P2022103000454_404805_1_1667173469522.pdf
[6] Paragraph 27 of the Report.
The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Arnold Pun, and Jane Lu.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Digital Asset Taskforce or the Global Financial Regulatory team, including the following authors in Hong Kong:
William R. Hallatt (+852 2214 3836, [email protected])
Grace Chong (+65 6507 3608, [email protected])
Emily Rumble (+852 2214 3839, [email protected])
Arnold Pun (+852 2214 3838, [email protected])
Becky Chung (+852 2214 3837, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
I. Introduction
Over the last few months, several European Union (“EU”) Member States have announced that they intend to withdraw from the Energy Charter Treaty (the “ECT”). At the time of writing, Germany, Slovenia, Poland, the Netherlands, France, Spain and Luxembourg have made such announcements.
The timing of these announcements preceded the expected vote by the Contracting Parties to the ECT regarding amendments to the text of the 1994 ECT (the “Modernised ECT”). The vote was scheduled to take place on 22 November 2022. However, reportedly due to a failure by the European Commission to gain the consensus of EU Member States—a majority of which are Contracting Parties to the ECT—the vote was called off at the eleventh hour. It has now been postponed until April 2023. If adopted in April 2023, the Modernised ECT will enter into force 90 days after its ratification by three-fourths of the treaty’s Contracting Parties. The Modernised ECT, if adopted, contains notable changes to the scope of investment protection afforded by the treaty.
We provide a summary of these developments and their potential impact on international arbitration claims brought by investors in ECT Contracting Parties.
II. The ECT
The ECT is a multilateral investment treaty, that entered into force in 1998, which establishes a legal framework in order to promote long-term international cooperation in the energy sector.
The ECT obliges the states who are Contracting Parties to the treaty to encourage and create stable, equitable, favourable, and transparent conditions for investors of other Contracting Parties.[1] In order to qualify for the protection afforded by the ECT, investments must be associated with “Economic Activity in the Energy Sector”. In practice, this includes activities such as inter alia (i) oil and gas exploration, (ii) construction and operation of power generation facilities, including those powered by renewable energy sources such as wind, solar, and hydro, and (iii) decommissioning of energy related facilities, including oil rigs, oil refineries and power generating plants.[2]
Each Contracting Party gives its unconditional consent to the submission of disputes between a Contracting Party and an investor of another Contracting Party relating to an investment to international arbitration.[3]
III. Amendments to the ECT
Since 2017, discussions have been underway regarding efforts to negotiate and agree a modernised text of the ECT. On 24 June 2022, it was announced that the Contracting Parties reached an agreement in principle on the modernised text. The Modernised ECT contains certain notable changes.
As explained by the Energy Charter Secretariat, the proposed changes include:
- Alignment between the ECT and the Paris Agreement, which is a legally binding international treaty on climate change.[4] For example, the EU and the UK have opted to carve-out fossil fuel related investments from investment protection under the ECT, including for existing investments after 10 years (instead of 20 years under the current ECT).[5]
- A provision stating that an investor from a Contracting Party that is part of a regional economic integration organisation (“REIO”), such as the EU, cannot bring an investor-state arbitral claim against another Contracting Party member of the same REIO—i.e., prohibiting what is referred to as “intra-EU arbitration”.[6]
- A narrowed definition of a qualifying “investment” and “investor” under the treaty. An “investment” must fulfil a list of characteristics, such as the commitment of capital, the expectation of gain or profit, be made for a certain duration or involve the assumption of risk. An “investor” cannot hold the nationality—or permanent residency—in the Contracting Party hosting the investment, and must demonstrate that it carries on substantial business activity in the host state.[7]
- Provision for a list of measures that constitute a violation of the ECT’s fair and equitable treatment (“FET”) standard, including a description of the circumstances that give rise to an investors’ legitimate expectations.[8]
- Clarification that the treaty’s expropriation provision covers indirect expropriations, identifying in this context the types of measures that cannot be considered an indirect expropriation.[9]
- Provision that the treaty’s observance of undertakings clause—i.e., umbrella clause—only applies to breaches of specific written commitments made through the exercise of governmental authority.[10]
As noted, it is anticipated that the ECT Contracting Parties will vote in April 2023 on whether to formally adopt the Modernised ECT. If adopted, the Modernised ECT will enter into force 90 days after its ratification by three-fourths of the treaty’s Contracting Parties.
IV. Announced Intention by Contracting Parties to Withdraw from the ECT
In parallel to these developments, several ECT Contracting Parties—that are also EU Member States—have announced that they intend to withdraw from the ECT. At the time of writing, Germany, Slovenia, Poland, the Netherlands, France, Spain and Luxembourg have made such announcements. It is reported that Austria is also considering withdrawal.
These Contracting Parties have cited various reasons for their intention to withdraw. The reasons appear generally to centre around complaints that the ECT impedes their ability to tackle climate change. Relatedly, there are around a billion Euros’ worth of outstanding ECT arbitral awards rendered against EU Member States—a figure which continues to grow, and which EU Member States may be keen to limit insofar as possible.
Withdrawal, however, does not take immediate effect. Rather, Article 47 of the ECT (Withdrawal) contains what is referred to as a “sunset clause”, which provides that, following formal notification of a Contracting Party’s withdrawal from the ECT, the withdrawal shall take effect one year after the notification is given.[11] Further, the protections afforded by the ECT shall continue to apply to pre-existing investments made in the territory of a Contracting Party for a period of 20 years after the withdrawal has taken effect—i.e., “the sunset period”.
Additionally, in the face of the announcements regarding withdrawal, the Energy Charter Secretariat, which provides the Energy Charter Conference “with all necessary assistance for performance of its duties,”[12] issued a Guidance Note explaining that withdrawal from the ECT may need to conform with Article 62 on the Vienna Convention on the Law of Treaties[13] (the “VCLT”).
Article 62 of the VCLT only allows a state—as a matter of general international law—to withdraw from a treaty due to “fundamental changes of circumstances” that were “essential” for the decision to enter into the treaty, and which “radically” transform the obligations created by the treaty so that its further implementation becomes unduly burdensome.[14] In addition, the change of circumstance relied on as the reason for withdrawal must have been unforeseen by the contracting parties to that treaty.
The Energy Charter Secretariat also observed that the International Court of Justice, in Gabčíkovo-Nagymaros Project (Hungary/Slovakia), did “not consider that new developments in the state of environmental knowledge and of environmental law can be said to have been completely unforeseen.”[15]
As a result, the analysis as to whether an ECT Contracting Party can validly withdraw from the ECT is not straightforward. And the issue of withdrawal may be subject to challenge, for example by investors bringing claims in international arbitration against Contracting Parties that have purported to withdraw from the ECT.
Against this backdrop, the European Parliament passed a resolution on 24 November 2022, “urg[ing] the Commission to initiate immediately the process towards a coordinated exit of the EU from the ECT and calls on the Council to support such a proposal”.[16] Although this resolution is not binding on the European Commission, it is an indication of the EU’s intention as regards the ECT. For the EU to withdraw from the ECT, the Council of the EU—which is one of the EU’s legislative bodies and is comprised of representatives from the EU Member States—would need to formally approve a withdrawal from the ECT by the EU. This is a very recent development, so precise details as to the path ahead are not yet clear.
V. Implications for Potential Claims by Investors Against ECT Contracting Parties
The developments outlined above carry several implications, some of which overlap:
- Investors in ECT Contracting Parties may seek to submit claims to international arbitration before a vote is passed and the Modernised ECT becomes effective, because they will presumably want their claims to come under the current ECT’s standards of investment protection.
- A Contracting Party’s attempt to withdraw from the ECT altogether may not impact an investor’s ability to commence international arbitration in the short-to-medium term, given the ECT’s 20-year sunset clause.
- Withdrawal is likely to become a contested issue in individual cases. The Energy Charter Secretariat suggested that Article 62 of the VCLT would apply to any attempt to withdraw from the ECT. In this context, the reasons given by a Contracting Party for its withdrawal may need to be assessed against Article 62’s criteria on an individualised basis. As a result, international arbitration tribunals confronted with claims by investors against a state that has purported to withdraw from the ECT may have to rule on the validity of that withdrawal as a jurisdictional issue.
- If the Modernised ECT is adopted next year, an ECT Contracting Party can choose both to ratify the Modernised ECT and pursue withdrawal in parallel, since these are independent issues. Indeed, a Contracting Party wishing to minimise international arbitration claims against itself may well choose to vote for and ratify the Modernised ECT—with its narrower investor protections—and pursue withdrawal on a longer timeline.
- Finally, it is worth noting that if the Modernised ECT is not adopted at the vote scheduled for April 2023, the scope of investment protection offered under the current ECT will continue to remain in force for Contracting Parties.
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[1] ECT, Article 10.
[2] ECT, Article 1(5).
[3] ECT, Article 26(3)(a).
[4] It was adopted by 196 Parties at COP 21 in Paris, on 12 December 2015, and entered into force on 4 November 2016. See UNFCC, The Paris Agreement, available here.
[5] See Energy Charter Secretariat, Public Communication explaining the main changes contained in the agreement in principle, 24 June 2022, 1. Definitions – Pillar 2: Flexibility, available here.
[6] Id., 6. Regional Economic Integration Organisation (REIO).
[7] Id., 2. Investment Protection – Definitions of Investment and Investor.
[8] Id., 2. Investment Protection – Definition of Fair and Equitable Treatment.
[9] Id., 2. Investment Protection – Definition of Indirect Expropriation.
[10] Id., 2. Investment Protection – Umbrella clause.
[11] ECT, Article 47(2).
[12] ECT, Article 35.
[13] VCLT, Article 62.
[14] Energy Charter Secretariat, Sunset Clause (Article 47 of the ECT) in relation to Article 62 of the Vienna Convention on the Law of Treaties (VCLT), 3 November 2022, available here.
[15] Ibid.
[16] European Parliament resolution of 24 November 2022 on the outcome of the modernisation of the Energy Charter Treaty (2022/2934(RSP)), at 20, available here.
The following Gibson Dunn lawyers assisted in the preparation of this client update: Jeff Sullivan KC, E Jin Lee, and Theo Tyrrell.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s International Arbitration, Judgment and Arbitral Award Enforcement or Transnational Litigation practice groups, or any of the following:
Jeff Sullivan KC – London (+44 (0) 20 7071 4231, [email protected])
Cyrus Benson – London (+44 (0) 20 7071 4239, [email protected])
Penny Madden KC – London (+44 (0) 20 7071 4226, [email protected])
E Jin Lee – New York (+1 212 351 5327, [email protected])
Theo Tyrrell – London (+44 (0) 20 7071 4016, [email protected])
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