Washington, D.C. partner F. Joseph Warin, San Francisco partner Winston Chan, Los Angeles associate Chris Jones and San Francisco associate Duncan Taylor are the authors of “Self-Reporting to the Authorities and Other Disclosure Obligations: The US Perspective” [PDF], Chapter 4 in The Practitioner’s Guide to Global Investigations 2023, Volume I: Global Investigations in the United Kingdom and the United States, Seventh Edition, published by Global Investigations Review in January 2023.

Each year we offer our observations on new developments and highlight select considerations for calendar-year filers as they prepare their Annual Reports on Form 10-K. This alert touches upon recent rulemaking from the U.S. Securities and Exchange Commission (“SEC”), comments letters issued by the staff of the SEC’s Division of Corporation Finance (the “Staff”), and trends among reporting companies that have emerged throughout the last year.

An index of the topics described in this alert is provided below.

I. Trends in Human Capital Disclosure.

II. Trends in Climate Change Disclosure.

III. Disclosure Trends and Considerations Related to Macroeconomic Issues and Current Events.

A. Tailoring of COVID-19 Disclosure.
B. Increased Discussion of Geopolitical Conflict.
C. Expanded Disclosure of Supply Chain Disruptions and Mitigation Efforts.
D. More Detailed Discussion of Inflation Risks and Impacts.
E. Increased Discussion of Rising Interest Rates.
F. Inflation Reduction Act of 2022.

IV. Updated Staff Guidance on Non-GAAP Measures.

A. Question 100.01 – Misleading Adjustments.
B. Question 100.04 – Individually Tailored Accounting Principles.
C. Question 100.05 – Improper Labels and Descriptions.
D. Question 100.06 – Limits of Explanatory Disclosure.
E. Question 102.10 – Equal or Greater Prominence.

V. Cybersecurity Disclosure Considerations.

VI. Reminder Regarding Past Amendments to Financial and Business Disclosure Requirements in Regulation S-K.

VII. Technical and Other Considerations.

A. New Filing Requirement for Glossy Annual Reports.
B. Clawback Check Boxes on Cover Page.
C. Item 201(e) Performance Graph and Pay-vs-Performance.

I. Trends in Human Capital Disclosure

Since 2021, companies have been required to include in their Form 10-K[1] a description of the company’s human capital resources, to the extent material to an understanding of the business taken as a whole, including the number of persons employed by the company, and any human capital measures or objectives that the company focuses on in managing the business (such as, depending on the nature of the company’s business and workforce, measures or objectives that address the development, attraction and retention of personnel).

The rule adopted by the SEC did not define “human capital” or elaborate on the expected content of the disclosures beyond the few examples provided in the rule text. This principles-based approach has resulted in significant variation among companies’ disclosures. With two years of human capital disclosure now available, we recently conducted a survey of the substance and form of human capital disclosures made by the S&P 100 in their Forms 10-K for their two most recently completed fiscal years. While company disclosures continued to vary widely, we saw companies generally expanding the length of their disclosures (79% of S&P 100 companies) and covering more topics (66% of S&P 100 companies), and also noted a slight increase in the amount of quantitative information provided in some areas. For a more detailed summary of our findings from this survey, please see our recently published client alert, “Evolving Human Capital Disclosures.”[2]

Our survey looked at seven primary categories of human capital disclosure, which were broken down further into 17 different disclosure topics.

1. Workforce Composition and Demographics. Nearly all S&P 100 companies discussed workforce composition and demographics to some degree. Diversity, equity, and inclusion continued to be the most common disclosure topics, with 96% of S&P 100 companies including a qualitative discussion of their commitment to diversity, equity, and inclusion. The level of discussion ranged from generic statements expressing support of diversity in the workforce to detailed examples of actions taken to support underrepresented groups and increase representation in the workforce. Of S&P 100 companies, 61% included statistics related to gender representation and 59% included statistics related to racial representation (compared to 47% and 43% in the previous year, respectively). Most of these companies provided statistics for their workforce as a whole; however, an increased subset (37% in the most recent year, compared to 22% in the previous year) included separate statistics for different classes of employees and/or their boards of directors. We continue to see only a relatively small number of companies disclose full-time/part-time employee metrics (17% of the S&P 100) and workforce turnover rates (23% of the S&P 100).
2. Recruiting, Training, Succession. Over 90% of S&P 100 companies discussed talent attraction, retention, and development. These were mostly qualitative disclosures discussing programs and benefits in place to recruit and maintain talent. There was no increase in the number of companies that covered succession planning.
3. Employee Compensation. Of companies surveyed, 85% included disclosure relating to employee compensation, generally providing a qualitative description of the compensation and benefits program offered to employees. Although 41% of companies surveyed included a discussion of pay equity practices in their 2021 Form 10-K (compared to 30% in 2021), quantitative measures of pay gaps based on gender or racial representation continued to be uncommon (12% of companies surveyed in 2022 compared to 11% in 2021).
4. Health and Safety. Of S&P 100 companies, 78% included disclosures relating to workplace health and safety. Disclosures primarily focused on the companies’ commitment to safety in the workplace and compliance with applicable regulatory and legal requirements, but quantitative disclosures on workplace safety, such as historical and/or target incident or safety rates, were uncommon (10% of companies surveyed in 2022).
5. Culture and Engagement. Discussions on culture and engagement increased from the prior year, with a majority of S&P 100 companies explaining how they monitor culture and employee engagement. Some companies also included disclosures centered on practices and initiatives undertaken to build and maintain culture, including diversity-related and inclusion initiatives.
6. COVID-19. Companies continued to include information regarding COVID-19 and its impact on company policies and procedures or on employees generally (71% of companies surveyed in 2022, compared to 66% in 2021). We expect that some companies may slim down their disclosure related to COVID-19 impacts in their next Form 10-K.
7. Human Capital Management Governance and Organizational Practices. The percentage of S&P 100 companies discussing human capital management governance and/or organizational practices (such as oversight by the board of directors or a committee and the organization of the human resources function) increased from 41% in 2021 to 57% in 2022.

While we anticipate that human capital disclosure will continue to evolve under the existing principles-based requirements, per the SEC’s recently released Fall 2022 Regulatory Flexibility Agenda, we expect the SEC to propose more prescriptive rules in the first quarter of 2023 that will significantly change the landscape. SEC chair Gary Gensler has instructed the Staff “to propose recommendations for the Commission’s consideration on human capital disclosure…. This could include a number of metrics, such as workforce turnover, skills and development training, compensation, benefits, workforce demographics including diversity, and health and safety.”

II.  Trends in Climate Change Disclosure

In March 2022, the SEC issued proposed rules on climate change disclosure requirements that, if adopted as proposed, will require disclosure of extensive and detailed climate-related information, including climate-related risks and opportunities, board oversight of climate-related risks, amount of greenhouse gas emissions, attestation of reporting on emissions, and a separate financial statement footnote on the impact of climate change. The proposed rules generated extensive positive and negative feedback from investors, companies, politicians, and others, and we believe it is unlikely that the SEC will adopt the rules as proposed. For a summary of the proposed climate change disclosure rules, please see our prior client alert, “Summary of and Considerations Regarding the SEC’s Proposed Rules on Climate Change Disclosure.”[3]

While there are no new SEC requirements on climate change disclosure that directly impact the 2022 Form 10-K, Form 10-K comment letters issued by the Staff over the past year underscore the Staff’s expectation of climate-related disclosures in response to existing requirements. The Staff initially issued a number of comment letters relating exclusively to climate-change disclosure issues in the fall of 2021. This was followed by the Staff publishing a sample comment letter related to climate-change disclosure issues on its website in September 2021.[4] Based on a review of comment letters issued in 2022, a growing trend we saw was the SEC asking for more quantification around climate-related disclosures. Resolution of comments often required more than one round of responses as the Staff honed in on a company’s analysis of whether a specific disclosure item was material.

The general focus of these climate-related comments fall under four general areas:

1. The impact of climate legislation, regulation, and international accords. For example, the Staff has asked companies to disclose the risks they face as a result of climate-change legislation, regulation, or treaties to the extent such risks are reasonably likely to have a material effect on the company’s business, financial condition, and results of operations.
2. The indirect consequences of climate-related regulation or business trends. For example, the Staff has asked for additional detail on indirect consequences, such as increased demand for goods that may produce lower emissions, increased competition to develop new products, and any anticipated reputational risks resulting from operations or services that produce material emissions.
3. The physical effects of climate change. For example, the Staff has placed a particular emphasis on quantifying material weather-related damage to property, weather-related impacts on major customers and suppliers, and cost and availability of insurance.
4. The material expenditures for climate-related projects and increase in compliance costs. For example, the Staff has requested quantification of any material past and/or future capital expenditures for climate-related projects for each of the periods for which financial statements are presented.

For companies reviewing their existing climate-related disclosures in their Form 10-K, a few items to consider in light of these Staff comments include:

• Tailor climate-related disclosures to the company’s business and financial condition, rather than generic discussions on climate change. For example, the Staff may ask a company to provide specific disclosure, if material, as to the impact on the company’s business of climate change risks disclosed in the risk factor section.
• Consider whether certain climate-related matters should be disclosed not only qualitatively, but also quantitatively. For example, if climate-related capital projects have become a significant portion of overall capital expenditures spending, the comment letters indicate that quantitative disclosure may be warranted.
• As part of the disclosure controls and procedures for the 2022 Form 10-K filing, review ESG materials publicly disclosed by the company, such as the company’s sustainability report, to determine whether any of the information in them is material under federal securities laws. Based on Staff comments, the Staff may look at these additional disclosures outside a company’s SEC filings and ask what consideration was given to including these disclosures in the Form 10-K. To the extent information disclosed in sustainability reports is not material for purposes of SEC rules, as we previously advised in our prior client alert, “Considerations for Climate Change Disclosures in SEC Reports,”[5] appropriate disclaimers to that effect should accompany such disclosures.

III.  Disclosure Trends and Considerations Related to Macroeconomic Issues and Current Events

An increased Staff focus on current events and macroeconomic trends kicked off in 2020 as public companies began disclosing impacts of the COVID-19 pandemic on their operations. At the time, the Staff issued CF Disclosure Guidance: Topic No. 9 (published March 25, 2020)[6] and CF Disclosure Guidance: Topic No. 9A (published June 23, 2020),[7] specifically regarding how companies should assess and disclose the impact of COVID-19; however, the guidance provides helpful instruction as companies evaluate the impact of other macroeconomic events, such as ongoing geopolitical conflicts, increased inflation, rising interest rates, and recessionary concerns. Below are a few general tips when drafting disclosure around current events and macroeconomic trends:

• Avoid generic disclosure of current events; be specific as to how these factors impact financial performance and operations.
• Avoid static disclosure of current events; update prior year disclosure to reflect impact during fiscal year 2022, as well as any known trends and uncertainties for 2023 and beyond.
• Confirm disclosure of current events and macroeconomic trends is consistent through the relevant parts of Form 10-K, such as the business section, risk factors, management’s discussion and analysis of financial condition and results of operations (“MD&A”), forward-looking statement disclaimer, and notes to the financial statements.

Set forth below are discussions of some of the major current events and macroeconomic trends that may impact a company’s disclosure in the upcoming Form 10-K.

A.  Tailoring of COVID-19 Disclosure

The COVID-19 pandemic continues to impact public companies, though the direct and indirect impacts on a company’s operations or financial condition or on its industry may have changed significantly since the 2021 Form 10-K filing. As companies take a fresh look at their existing COVID-19 disclosure, discussions should be tailored to highlight actual impacts realized in 2022, and risk factors may need to be slimmed down to focus on the material risks that COVID-19 still presents. For some companies or select industries, discussion of COVID-19 as a trend or risk may still be a prominent disclosure for the 2022 Form 10-K, particularly for companies and industries whose supply chains continue to be impacted.

B.  Increased Discussion of Geopolitical Conflict

With the ongoing Russian invasion of Ukraine, public companies may need to discuss the conflict’s direct and indirect impacts on their operations and financial condition. In May 2022, the Staff published a “Sample Comment Letter Regarding Disclosures Pertaining to Russia’s Invasion of Ukraine and Related Supply Chain Issues.”[8] In the letter, the Staff emphasized that companies should provide detailed disclosure, to the extent material, regarding (i) direct or indirect exposure to Russia, Belarus, or Ukraine through operations or investments in such countries, securities trading in Russia, sanctions imposed or legal or regulatory uncertainty associated with operating in or existing in Russia or Belarus, (ii) direct or indirect reliance on goods or services sourced in Russia or Ukraine, (iii) actual or potential disruptions in the company’s supply chain, or (iv) business relationships, connections to, or assets in, Russia, Belarus, or Ukraine. Similar to Staff comment letters on climate-related disclosure, comment letters received by public companies in the fall of 2022 on the Russia-Ukraine conflict have requested more specific, including quantified, information on the impacts to the company’s operations and financial condition.

Companies should undertake similar disclosure analyses to determine whether direct or indirect impacts of emerging geopolitical conflicts, such as rising tensions between China and Taiwan, should be discussed in any sections of the upcoming Form 10-K.

C.  Expanded Disclosure of Supply Chain Disruptions and Mitigation Efforts

In a somewhat related vein, companies experiencing supply chain difficulties should consider whether discussion of those issues in their risk factors and MD&A is sufficient. In comment letters recently issued to companies that mentioned supply chain disruptions, the Staff requested that the companies specify whether these challenges materially impacted the company’s results of operations or capital resources and quantify, to the extent possible, how the company’s sales, profits, and/or liquidity have been impacted. Several comment letters have also requested that companies discuss any known trends or uncertainties resulting from mitigation efforts undertaken and whether those efforts have introduced new material risks, including those related to product quality, reliability, or regulatory approval of products.

D.  More Detailed Discussion of Inflation Risks and Impacts

With the rise of inflation in 2022, companies should consider whether their disclosures regarding inflation impacts and risks are adequate. Depending on the effect on a company’s operations and financial condition, additional disclosure in risk factors, MD&A, or the financial statements may be necessary. In recent comment letters, the Staff has focused on how current inflationary pressures have materially impacted a company’s operations and sought disclosure on any mitigation efforts implemented with respect to inflation. If inflation is identified as a significant risk, the Staff requested companies to quantify, where possible, the extent to which revenues, expenses, profits, and capital resources were impacted by inflation.

For example, one company received the following comment: “We note your risk factor indicating that inflation can have an adverse impact on your business and on [y]our customers. Please update this risk factor if recent inflationary pressures have materially impacted your operations. In this regard, if applicable, discuss how your business has been materially affected by the various types of inflationary pressures you are facing” (emphasis added). Another company received this comment: “In various sections of your filings as well as earnings releases, you identify inflation as a significant risk you are experiencing, and indicate that there are various sources for the inflation you are experiencing. Please revise your future filings to discuss and quantify, where possible, the extent to which your revenues, expenses, profits, and capital resources have been impacted by inflation. Identify the drivers of inflation that most affected your options, and discuss your mitigation efforts. Provide us with your proposed disclosures in your response” (emphasis added).

E.  Increased Discussion of Rising Interest Rates

In the current environment of relatively high interest rates, companies should also consider whether the recent rate increases and uncertainty regarding future rate changes are adequately discussed. In recent comment letters, the Staff has asked companies to expand their discussion of rising interest rates in the Risk Factors and MD&A sections to specifically identify the actual impact of recent rate increases on the business’s operations and how the business has been affected.

It is also critical that companies confirm that their disclosures in Item 7A (Quantitative and Qualitative Disclosures About Market Risk) are up-to-date and responsive to the requirements of Item 305 of Regulation S-K.

F.  Inflation Reduction Act of 2022

In August 2022, the Inflation Reduction Act of 2022 (the “Act”) was signed into law. One of the aspects of the Act was the introduction of a 1% excise tax on certain corporate stock buybacks. More specifically, the Act would impose a nondeductible 1% excise tax on the fair market value of certain stock that is “repurchased” during the taxable year by a publicly traded U.S. corporation or acquired by certain of its subsidiaries. The taxable amount is reduced by the fair market value of certain issuances of stock throughout the year. The Act also imposes a 15% corporate minimum tax and extends and expands tax incentives for clean energy. To the extent any provisions of the Act may impact a company’s business or financial condition, additional disclosure regarding the impact of the Act may need to be added to the risk factors, MD&A or the financial statements for the 2022 Form 10-K. For more information regarding the Act, please see our prior client alert, “Update: Senate Passes Revised Version of Inflation Reduction Act of 2022; Carried Interest Changes Omitted and Tax on Corporate Stock Buybacks Added.”[9]

IV.  Updated Staff Guidance on Non-GAAP Measures

In 2022, the Staff, through comment letters issued during Form 10-K reviews, continued to focus on whether non-GAAP measures disclosed in periodic reports, earnings releases, and other earnings materials complied with Regulation G and Item 10(e) of Regulation S-K, as applicable. Issues emphasized in those comment letters include (i) whether certain performance measures should have been identified as non-GAAP measures, (ii) whether identified non-GAAP measures were presented with the most directly comparable GAAP measure at the appropriate prominence level, and (iii) the appropriateness of adjustments in non-GAAP measures. With respect to adjustments, care must be taken when deciding whether to adjust for current events, such as COVID-19 or the Russia-Ukraine conflict. Adjustments are typically only appropriate when they directly relate to a nonrecurring event and are clearly calculable and separable.

On December 13, 2022, the Staff announced an update to its Compliance and Disclosure Interpretations (“C&DI”) on Non-GAAP Financial Measures. Many of the changes memorialize positions taken by the Staff in recent comment letters or provide additional detail about those positions. A discussion of the significant changes is provided below, and a marked version of the impacted C&DIs is available in our prior post on the Gibson Dunn Securities Regulation and Corporate Governance Monitor, “SEC Updates Non-GAAP C&DIs.”[10]

A.  Question 100.01 – Misleading Adjustments

Question 100.01 was revised to emphasize that a company’s individual facts and circumstances affect whether an adjustment makes a non-GAAP measure misleading. Using the pre-update example (i.e., a non-GAAP performance measure that excludes normal, recurring, cash operating expenses may be misleading), the updated C&DI illustrates this by noting that:

• When evaluating what is a “normal, operating expense,” the Staff considers the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry, and regulatory environment.
• The Staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as “recurring.”

B.  Question 100.04 – Individually Tailored Accounting Principles

Question 100.04, which was completely rewritten, continues to include a prohibition on individually tailored accounting principles, but has now been supplemented with the following additional examples of adjustments that would run afoul of this prohibition:

• accelerating the recognition of revenue as though it was earned when customers were billed, when GAAP requires it to be recognized ratably over time;
• presenting revenue on a net basis when GAAP requires it to be presented on a gross basis (and vice versa); and
• changing the basis of accounting for revenue or expenses to a cash basis when GAAP requires it to be accounted for on an accrual basis.

C.  Question 100.05 – Improper Labels and Descriptions

New Question 100.05 memorializes the Staff’s position, often expressed through comment letters, that a non-GAAP measure can be misleading if it (or any adjustment made to the GAAP measure) is not appropriately labeled and clearly described. Three examples are provided of labels that would be misleading because they do not reflect the nature of the non-GAAP measure:

• a contribution margin that is calculated as GAAP revenue less certain expenses, labeled “net revenue”;
• a non-GAAP measure labeled the same as a GAAP line item or subtotal even though it is calculated differently than the similarly labeled GAAP measure, such as “Gross Profit” or “Sales”; and
• a non-GAAP measure labeled “pro forma” that does not meet the pro forma requirements in Article 11 of Regulation S-X.

D.  Question 100.06 – Limits of Explanatory Disclosure

New Question 100.06 explains that a non-GAAP measure could be so inherently misleading that even extensive, detailed disclosure about the nature and effect of each adjustment would not prevent it from being materially misleading. No examples are provided.

E.  Question 102.10 – Equal or Greater Prominence

Question 102.10, which relates to the equal or greater prominence rule, was broken into subparts and supplemented with more detailed explanations and additional examples of disclosures that the Staff believes violate Item 10(e) of Regulation S-K, including the following situations:

• Ratios. When a ratio is calculated using a non-GAAP financial measure and the most directly comparable GAAP ratio is not presented with equal or greater prominence.
• Charts/tables/graphs. When charts, tables, or graphs of non-GAAP financial measures are used and charts, tables, or graphs of the comparable GAAP measures are not presented with equal or greater prominence.
• Reconciliations. When a reconciliation begins with the non-GAAP financial measure or appears to constitute a non-GAAP income statement.
• Non-GAAP Income Statements. When a non-GAAP income statement is presented, even if it is not a full income statement; “most of the line items and subtotals found in a GAAP income statement” is objectionable to the Staff.

V.  Cybersecurity Disclosure Considerations

Cybersecurity risks and incidents continue to remain a focus for the SEC. In March 2022, the SEC proposed amendments to its existing rules to enhance and standardize disclosures regarding cybersecurity risk management, strategy, governance, and incident reporting by public companies. The proposed amendments would require, among other things, disclosure about (i) material cybersecurity incidents, (ii) a company’s policies and procedures to identify and manage cybersecurity risks, (iii) the board of directors’ oversight of cybersecurity risk, (iv) the board of directors’ cybersecurity expertise, and (v) management’s role and expertise in assessing and managing cybersecurity risk and implementing cybersecurity policies and procedures. For more information about the proposed rules, please see our prior client alert, “SEC Proposes Rules on Cybersecurity Disclosure.”^[11]

While the final rules have not yet been adopted, companies should review their existing cybersecurity risk disclosure and confirm that their disclosure controls, particularly related to incident reporting, are sufficient. In addition, when considering disclosure, companies may want to be mindful of the October 2022 updates that Institutional Shareholder Services (“ISS”) made to its Governance QualityScore methodology, which added new factors on information security, including whether the company discloses its third-party information security risks and whether the company experienced a third-party information security breach.[12] We note that comments issued by the Staff in the fall of 2022 reflect a heighted focus on cyberattacks (both in terms of potential risks and actual incidents), particularly in light of the ongoing Russia-Ukraine conflict.

VI.  Reminder Regarding Past Amendments to Financial and Business Disclosure Requirements in Regulation S-K

For calendar year-end reporting companies, the 2021 Form 10-K was the first Form 10-K incorporating the SEC’s amendments to certain financial and business disclosure requirements of Regulation S-K, including Item 303 for MD&A. Adopted in November 2020, these amendments generally emphasized a principles-based approach to disclosure and eliminated certain prescriptive disclosure requirements. While virtually all reporting companies took advantage of certain of these disclosure requirements in their 2021 Form 10-K, such as removing the selected financial data in Item 6, many companies did not make drastic changes to their existing disclosure and opted to retain other disclosures notwithstanding the eliminated mandates, such as the tabular disclosure of contractual obligations.

Recent comment letters show that the Staff continues to seek additional disclosures responsive to certain aspects of the Regulation S-K amendments, including the requirement to discuss underlying reasons for material changes in line items and the requirements regarding critical accounting estimates. For example, companies that cited multiple factors impacting their financial results in MD&A have been requested by the Staff to revise future disclosures to further describe material line item changes and the underlying reasons for such changes in both quantitative and qualitative terms, including the impact of offsetting factors. In addition, companies whose disclosure of critical accounting estimates did little more than repeat portions of their significant accounting policy disclosure were asked to revise future disclosures to explain why each critical accounting estimate is subject to uncertainty and, to the extent the information is material and reasonably available, how much each estimate and/or assumption has changed over a relevant period, and the sensitivity of the reported amounts to the material methods, assumptions and estimates underlying its calculation.

For more information about the amendments to Regulation S-K, see our prior post, “Summary Chart and Comparative Blackline Reflecting Recent Amendments to MD&A Requirements Now Available.”[13]

VII.  Technical and Other Considerations

A.  New Filing Requirement for “Glossy” Annual Reports

In June 2022, the SEC adopted amendments mandating that annual reports sent to shareholders pursuant to Exchange Act Rule 14a-3(c) (i.e., “glossy” annual reports) must also be submitted to the SEC in the electronic format in accordance with the EDGAR Filer Manual. The amendments supersede the Staff guidance provided in 2016 stating that the SEC would not object if companies post their glossy annual reports to security holders on their corporate websites for at least one year in lieu of furnishing paper copies to the SEC.

These annual reports will be in PDF format and filed using EDGAR Form Type ARS. One technical concern with submitting “glossy” annual reports through EDGAR is file size limitations. The “glossy” annual reports are typically larger files as compared to other EDGAR filings because they tend to contain extensive graphics. In the final rule, the SEC noted that electronic submission in PDF format of the glossy annual report should capture the graphics, styles of presentation, and prominence of disclosures (including text size, placement, color, and offset, as applicable) contained in the reports. Accordingly, companies should be mindful of the file size of their glossy annual report and conduct test runs in advance to make sure that EDGAR is able to handle the file size or evaluate whether the PDF file can be compressed.

B.  Clawback Check Boxes on Cover Page

As part of the final clawback rules adopted by the SEC on October 26, 2022, new checkboxes will be added to the cover pages of Forms 10-K, 20-F, and 40-F. Companies must indicate by check boxes on their annual reports whether the financial statements included in the filings reflect a correction of an error to previously issued financial statements and whether any such corrections are restatements that required a recovery analysis. The SEC’s adopting release noted that, “[p]articularly as it relates to ‘little r’ restatements which typically are not disclosed or reported as prominently as ‘Big R’ restatements, the check boxes provide greater transparency around such restatements and easier identification for investors of those that triggered a compensation recovery analysis.”

While the effective date for the SEC’s clawback rule is January 27, 2023, companies do not need to adopt a clawback policy until after the stock exchanges’ listing standards implementing the SEC rule are proposed, adopted, and become effective, which could be as late as November 28, 2023. In the meantime, it is not clear whether the SEC will require companies to include these checkboxes on the Form 10-K cover page. Each check box will constitute an inline XBRL element, so once EDGAR is set up to expect these new elements, it is possible that filings could get rejected unless the elements are included. (A similar issue cropped up last year for companies that tried to file their Form 10-K without tagging the independent auditor name, location, and/or PCAOB ID number.) As of this writing, the official Form 10-K available through the Forms List on the SEC website[14] has not been updated to include these new check boxes.

C.  Item 201(e) Performance Graph and Pay Versus Performance

As a reminder, companies have the option of including the stock price performance graph required by Item 201(e) of Regulation S-K, which shows the company’s total shareholder return (TSR), in the Rule 14a-3 annual report to security holders (distributed in connection with the proxy statement) or the Form 10-K itself (assuming a “10-K wrap” is used to comply with Rule 14a-3). Beginning in this year’s proxy statements, companies will be required to provide disclosure that satisfies the new pay versus performance disclosures required by Regulation S-K Item 402(v). (For a summary of the final pay versus performance rules, please see our prior client alert, “SEC Releases Final Pay Versus Performance Rules.”)[15] These new disclosure requirements include comparisons to a peer group that may be the peer group identified in the Regulation S-K Item 201(e) performance graph. To the extent companies would like to use the Item 201(e) peer group in their pay versus performance disclosures, they will want to make sure the group identified in last year’s Form 10-K or Rule 14a-3 annual report is the one that they want to use for their initial pay versus performance disclosure in the proxy statement. If a company wants to use a different peer group in the 2022 Form 10-K (and the pay versus performance disclosure) than the one in last year’s performance graph, it will need to, per Regulation S-K Item 201(e)(4), “explain the reason(s) for this change and also compare the [company’s] total return with that of both the newly selected index and the index used in the immediately preceding fiscal year.”

__________________________

[1] See Modernization of Regulation S-K Items 101, 103, and 105, Release No. 33-10825 (August 26, 2020), available at https://www.sec.gov/rules/final/2020/33-10825.pdf.

[2] Available at https://www.gibsondunn.com/evolving-human-capital-disclosures.

[3] Available at https://www.gibsondunn.com/summary-of-and-considerations-regarding-the-sec-proposed-rules-on-climate-change-disclosure/.

[4] See Sample Letter to Companies Regarding Climate Change Disclosures (September 22, 2021), available at https://www.sec.gov/corpfin/sample-letter-climate-change-disclosures.

[5] Available at https://www.gibsondunn.com/considerations-for-climate-change-disclosures-in-sec-reports/.

[6] Available at https://www.sec.gov/corpfin/coronavirus-covid-19.

[7] Available at https://www.sec.gov/corpfin/covid-19-disclosure-considerations.

[8] See Sample Letter to Companies Regarding Disclosures Pertaining to Russia’s Invasion of Ukraine and Related Supply Chain Issues (May 3, 2021), available at https://www.sec.gov/corpfin/sample-letter-companies-pertaining-to-ukraine.

[9] Available at https://www.gibsondunn.com/update-senate-passes-revised-version-of-inflation-reduction-act-of-2022-carried-interest-changes-omitted-tax-on-corporate-stock-buybacks-added/.

[10] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=468.

[11] Available at https://www.gibsondunn.com/sec-proposes-rules-on-cybersecurity-disclosure/.

[12] Interestingly, under the current QualityScore methodology, companies that disclose an immaterial information security breach in the last three years may see an improvement in their Audit & Risk Oversight score as a result of ISS’s preference for more, rather than less, disclosure of cyber incidents, even if immaterial.

[13] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=432.

[14] Available at https://www.sec.gov/forms.

[15] Available at https://www.gibsondunn.com/sec-releases-final-pay-versus-performance-rules/.

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The following Gibson Dunn attorneys assisted in preparing this client update: Justine Robinson, Mike Titera, David Korvin, and Thomas Kim.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work in the Securities Regulation and Corporate Governance and Capital Markets practice groups, or any of the following practice leaders and members:

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
James J. Moloney – Orange County, CA (+1 949-451-4343, [email protected])
Lori Zyskowski – New York, NY (+1 212-351-2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])
Michael A. Titera – Orange County, CA (+1 949-451-4365, [email protected])
Aaron Briggs – San Francisco, CA (+1 415-393-8297, [email protected])
Julia Lapitskaya – New York, NY (+1 212-351-2354, [email protected])

Capital Markets Group:
Andrew L. Fabens – New York, NY (+1 212-351-4034, [email protected])
Hillary H. Holmes – Houston, TX (+1 346-718-6602, [email protected])
Stewart L. McDowell – San Francisco, CA (+1 415-393-8322, [email protected])
Peter W. Wardle – Los Angeles, CA (+1 213-229-7242, [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.

A Survey of Disclosures from the S&P 100 During the Two Years Following Adoption of the Securities and Exchange Commission Rule

Human capital resource disclosures by public companies have continued to be a focus since the U.S. Securities and Exchange Commission adopted the new rules in 2020; not only for companies making the disclosures, but employees, investors, and other stakeholders reading them.  This alert serves as an update to the alert we issued in 2021, “Discussing Human Capital: A Survey of the S&P 500’s Compliance with the New SEC Disclosure Requirement One Year After Adoption,” and reviews disclosure trends among S&P 100 companies, each of which has now included human capital disclosure in their past two annual reports on Form 10-K.  This alert also provides practical considerations for companies as we head into 2023.

The overall takeaway from our survey, which categorized disclosures into 17 topic areas, was that companies are generally expanding the length of their disclosures, covering more topics, and including slightly more quantitative information in some areas.  We note the following trends regarding the S&P 100 companies’ disclosures compared to the previous year:

• Seventy-nine companies increased the length of their disclosures, though the increases were generally modest.
• Sixty-six companies increased the number of topics covered.
• The prevalence of 16 topics increased and one remained the same.
  • The most significant year-over-year increases in frequency involved the following topics: talent attraction and retention (67% to 91%), employee compensation (68% to 85%), quantitative diversity statistics on race/ethnicity (43% to 59%) and gender (47% to 61%), workplace health and safety (51% to 65%), and pay equity (30% to 41%).
  • The only topic that did not see an increase in frequency was succession planning, which remained at 17%.
• Eight-five companies included more qualitative details in their disclosures compared to the previous year, including information relating to diversity, equity, and inclusion (“DEI”) initiatives and programs and the board’s role in overseeing human capital initiatives, although the depth of the additional detail provided varied greatly between companies.
  • In this most recent year, DEI was discussed by 96% of companies (89% in the previous year), and 37% of companies (22% in the previous year) went beyond qualitative DEI information and disclosed quantitative data regarding the breakdown of DEI statistics by job type or level (executive level, etc.).
  • Disclosure regarding the role of the board (or a human capital-focused committee) in overseeing human capital jumped to 44% of companies this most recent year from 26% the previous year.
• The topics most commonly discussed this most recent year generally remained consistent with the previous year. For example, DEI, talent development, talent attraction and retention, COVID-19, and employee compensation and benefits remained the five most frequently discussed topics, while succession planning, full-time/part-time employee split, quantitative pay gaps, culture initiatives, and quantitative workforce turnover rates continued to be the five least frequently covered topics.
• Within each industry, the trends that we saw in the previous year regarding the frequency of topics disclosed generally remained the same.

I. Background on the Requirements

On August 26, 2020, the U.S. Securities and Exchange Commission (the “Commission”) voted three to two to approve amendments to Items 101, 103, and 105 of Regulation S-K, including the principles-based requirement to discuss a registrant’s human capital resources to the extent material to an understanding of the registrant’s business taken as a whole.[1]  Specifically, public companies’ human capital disclosure must include “the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the development, attraction and retention of personnel).”  One dissenting commissioner criticized the amendment for failing to even require disclosure of “commonly kept metrics such as part time vs. full time workers, workforce expenses, turnover, and diversity.”[2]

As discussed below, following the change in presidential administration, the Commission has indicated that it plans to revisit the human capital disclosure requirements and potentially adopt more prescriptive rules in the future.[3]

While companies disclosures under the principles-based rules varied widely, our survey was able to introduce some comparability.  The next two sections show the relevant data from our survey.[4]

II.  Disclosure Topics

Our survey classifies human capital disclosures into 17 topics, each of which is listed in the following chart, along with the number of companies that discussed the topic in 2021 and the number of additional companies that discussed the topic in 2022.  Each topic is described more fully in the sections following the chart.

A. Workforce Composition and Demographics

Of the 100 companies surveyed, 99 included disclosures relating to workforce composition and demographics in one or more of the following categories:

• Diversity and inclusion. This was the most common type of disclosure, with 96% of companies including a qualitative discussion regarding the company’s commitment to diversity, equity, and inclusion, up slightly from 89% the previous year.  The depth of these disclosures varied, ranging from generic statements expressing the company’s support of diversity in the workforce to detailed examples of actions taken to support underrepresented groups and increase the diversity of the company’s workforce.  Many companies also included a quantitative breakdown of the gender or racial representation of the company’s workforce: 61% included statistics on gender and 59% included statistics on race (compared to 47% and 43% in the previous year, respectively).  Most companies provided these statistics in relation to their workforce as a whole; however, an increased subset (37% in the most recent year compared to 22% in the previous year) included separate statistics for different classes of employees (e.g., managerial, vice president and above, etc.) and/or for their boards of directors.  Some companies also included numerical goals for gender or racial representation—either in terms of overall representation, promotions, or hiring—even if they did not provide current workforce diversity statistics.
• Full-time/part-time employee split. While most companies provided the total number of full-time employees, only 17% of the companies surveyed included a quantitative breakdown of the number of full-time versus part-time employees the company employed, up only slightly from 14% the previous year.  Similarly, we saw a number of companies that provided statistics on the number of seasonal employees and/or independent contractors or a breakdown of employees by geographical location.
• Unionized employee relations. Of the companies surveyed, 34% stated that some portion of their workforce was part of a union, works council, or similar collective bargaining agreement, up slightly from 32% the previous year.[5]  These disclosures generally included a statement providing the company’s opinion on the quality of labor relations, and in many cases, disclosed the number of unionized employees.
• Quantitative workforce turnover rates. Although a majority of companies discussed employee turnover and the related topics of talent attraction and retention in a qualitative way (as discussed in Section II.B. below), only 23% of companies surveyed provided specific employee turnover rates (whether voluntary or involuntary), up slightly from 18% the previous year.

B. Recruiting, Training, Succession

Of the companies surveyed, 96% included disclosures relating to talent and succession planning in one or more of the following categories:

• Talent attraction and retention. These disclosures were generally qualitative and focused on efforts to recruit and retain qualified individuals.  While providing general statements regarding recruiting and retaining talent were relatively common, with 91% of companies including this type of disclosure (compared to 67% in 2021), quantitative measures of retention, like workforce turnover rate, were uncommon, with less than 23% of companies disclosing such statistics (as noted above).
• Talent development. The most common type of disclosure in this area related to talent development, with 93% of companies including a qualitative discussion regarding employee training, learning, and development opportunities, up from 80% the previous year.  This disclosure tended to focus on the workforce as a whole rather than specifically on senior management.  Companies generally discussed training programs such as in-person and online courses, leadership development programs, mentoring opportunities, tuition assistance, and conferences, and a minority also disclosed the number of hours employees spent on learning and development.
• Succession planning. Only 17% of companies surveyed addressed their succession planning efforts (unchanged from 2021), which may be a function of succession being a focus area primarily for executives rather than the human capital resources of a company more broadly.

C. Employee Compensation

Of the companies surveyed, 85% included disclosures relating to employee compensation, up from 68% the previous year.  All of those companies included a qualitative description of the compensation and benefits program offered to employees.  Of the companies surveyed, 41% addressed pay equity practices or assessments (compared to 30% in 2021), and substantially fewer companies (12% of companies surveyed in 2022 and 11% in 2021) included quantitative measures of the pay gap between diverse and nondiverse employees or male and female employees.

D. Health and Safety

Of the companies surveyed, 78% included disclosures relating to health and safety in one or both of the following categories:

• Workplace health and safety. Of the companies surveyed, 65% included qualitative disclosures relating to workplace health and safety, up from 51% in the previous year, typically with statements around the company’s commitment to safety in the workplace generally and compliance with applicable regulatory and legal requirements.  However, 10% of companies surveyed provided quantitative disclosures in this category, generally focusing on historical and/or target incident or safety rates or investments in safety programs.  These disclosures tended to be more prevalent among industrial and manufacturing companies.  Many companies also provided disclosures on safety initiatives undertaken in connection with COVID-19, which is discussed separately below.
• Employee mental health. In connection with disclosures about standard benefits provided to employees, or additional benefits provided as a result of the pandemic, 41% of companies disclosed initiatives taken to support employees’ mental or emotional health and wellbeing, up from 31% the prior year.

E. Culture and Engagement

In addition to the many instances where companies mentioned a general commitment to culture and values, 62% of the companies surveyed discussed specific initiatives they were taking related to culture and engagement in one or more of the following categories:

• Culture and engagement initiatives. Of the companies surveyed, 23% included specific disclosures relating to practices and initiatives undertaken to build and maintain their culture and values, up from 14% in the previous year.  These companies most commonly discussed efforts to communicate with employees (e.g., through town halls, CEO outreach, trainings, or conferences and presentations) and to recognize employee contributions (e.g., awards programs and individualized feedback).  Many companies also discussed culture in the context of diversity-related initiatives to help foster an inclusive culture.
• Monitoring culture. Disclosures about the ways that companies monitor culture and employee engagement were much more common, with 56% of companies providing such disclosure, up from 51% the previous year.  Companies generally disclosed the frequency of employee surveys used to track employee engagement and satisfaction, with some reporting on the results of these surveys, sometimes measured against prior year results or industry benchmarks.

F. COVID-19

A majority of companies (71% of those surveyed compared to 66% in 2021) included information regarding COVID-19 and its impact on company policies and procedures or on employees generally.  COVID-19-related topics addressed ranged from work-from-home arrangements and safety protocols taken for employees who worked in person to additional benefits and compensation paid to employees as a result of the pandemic and contributions made to organizations supporting those affected by the pandemic.

G. Human Capital Management Governance and Organizational Practices

Over half of the companies (57% of those surveyed compared to 41% in 2021) addressed their governance and organizational practices (such as oversight by the board of directors or a committee and the organization of the human resources function).

III. Industry Trends

One of the main rationales underlying the adoption of principles-based—rather than prescriptive—requirements for human capital disclosures is that the relative significance of various human capital measures and objectives varies by industry.  This is reflected in the following industry trends that we observed:[6]

• Technology Industries (E-Commerce, Internet Media & Services, Hardware, Software & IT Services and Semiconductors). For the 20 companies in the Technology Industries, 90% discussed talent development and training opportunities, talent attraction, recruitment and retention, employee compensation, and diversity.  Relatively uncommon disclosures among this group included part-time and full-time employee statistics (10%), culture initiatives (15%), succession planning (10%), and quantitative pay gap (10%).
• Finance Industries (Asset Management & Custody Activities, Consumer Finance, Commercial Banks and Investment Banking & Brokerage). For the 13 companies in the Finance Industries, a large majority included quantitative diversity statistics regarding race (85%) and gender (85%).  The same number of companies also included qualitative disclosures regarding employee compensation (85%), and, compared to other industries discussed below, a relatively higher number discussed pay equity (62%) and quantified their pay gap (38%).  Relatively uncommon disclosures among this group included part-time and full-time employee statistics, unionized employee relations, quantitative workforce turnover rates, and succession planning (in each case less than 16%).

IV. Disclosure Format

The format of human capital disclosures in companies’ annual reports continued to vary greatly.

Word Count.  The length of the disclosures ranged from 109 to 1,995 words, with the average disclosure consisting of 960 words and the median disclosure consisting of 949 words.  Compare this to 2021, which saw a range of 105 to 1,931 words, with an average of 823 words and median of 818 words.

Metrics.  While the disclosure requirement specifically asks for a description of “any human capital measures or objectives that the registrant focuses on in managing the business” (emphasis added), our survey revealed that 25% of companies determined not to include disclosure in any of the quantitative categories we discuss above, and 10% did not include any type of quantitative metrics in their disclosure beyond headcount numbers (down from 36% and 14%, respectively, in 2021).  Given the materiality threshold included in the requirement and the fact that it is focused on what is actually used to manage the business, this is not a surprising result.  It was common to see companies identify important objectives they focus on, but omit quantitative metrics related to those objectives; however, that group has been shrinking as more companies include metrics.  For example, while 96% of companies discussed their commitment to diversity, equity, and inclusion (compared to 89% in 2021), only 61% and 59% of companies disclosed quantitative metrics regarding gender and racial diversity, respectively (compared to 47% and 43%, respectively, in 2021).

Graphics.  Although the minority practice, 24% of companies surveyed also included charts or other graphics, up from 21% the previous year, which were generally used to present statistical data, such as diversity statistics or breakdowns of the number of employees by geographic location.

Categories.  Most companies organized their disclosures by categories similar to those discussed above and included headings to define the types of disclosures presented.

V. Comment Letter Correspondence

Comment letter correspondence from the staff of the Division of Corporation Finance (the “Staff”), which often helps put a finer point on principles-based disclosure requirements like this one, has shed relatively little light on how the Staff believes the new requirements should be interpreted.  Consistent with what we found at this time last year, the comment letters, all of which involved reviews of registration statements, were generally issued to companies whose disclosures about employees were limited to the bare-bones items companies have discussed historically, such as the number of persons employed and the quality of employee relations.  From these companies, the Staff simply sought a more detailed discussion of the company’s human capital resources, including any human capital measures or objectives upon which the company focuses in managing its business.  There were also a few comment letters where the Staff asked companies to clarify statements in their human capital disclosures.  Based on our review of the responses to those comment letters, we have not seen a company take the position that a discussion of human capital resources was immaterial and therefore unnecessary.

VI. Conclusion

During the most recent year, we generally saw companies expanding the length of their human capital disclosures, covering more topics, and including slightly more quantitative information in some areas; however, the principles-based nature of the disclosure requirements has continued to result in companies providing a wide variety of disclosures, with significant differences in depth and breadth.

Given how high the Human Capital Management Disclosure rulemaking appears on the Fall 2022 Reg Flex Agenda (it appears as an action item for the first quarter of 2023), it seems unlikely we will see another year pass without more prescriptive rules being proposed and possibly adopted.

There has been no shortage of investors, politicians, and activists chiming in with input on the forthcoming rules.  For example, earlier this year, several members of Congress wrote a letter asking the Commission to resist requests for more specific and quantitative disclosures on human capital, which expressed particular concerns about requiring metrics on full-time employees, part-time employees, independent contractors, subcontractors, or contingent employees.[7]  In June 2022, the Working Group on Human Capital Accounting Disclosure, a group composed of academics and former SEC officials, submitted a rulemaking petition requesting the Commission to require more financial information about human capital in companies’ disclosures.[8]

Until the Commission proposes and adopts new rules governing the disclosure of human capital management, however, we expect the wide variance in Form 10-K human capital disclosures to continue.  As companies prepare for the upcoming Form 10-K reporting season, they should consider the following:

• Confirming (or reconfirming) that the company’s disclosure controls and procedures support the statements made in human capital disclosures and that the human capital disclosures included in the Form 10-K remain appropriate and relevant. In this regard, companies may want to compare their own disclosures against what their industry peers did these past two years, including specifically any notable additional disclosures made in the past year.
• Setting expectations internally that these disclosures likely will evolve. As shown by the measurable increase in disclosure in the second year of reporting, companies should expect to develop their disclosure over the course of the next couple of annual reports in response to peer practices, regulatory changes, and investor expectations, as appropriate.  The types of disclosures that are material to each company may also change in response to current events.
• Addressing in the upcoming disclosure, if not already disclosed, the progress that management has made with respect to any significant objectives it has set regarding its human capital resources as investors are likely to focus on year-over-year changes and the company’s performance versus stated goals.
• Addressing significant areas of focus highlighted in engagement meetings with investors and other stakeholders. In a 2021 survey, 64% of institutional investors surveyed cited human capital management as a key issue when engaging with boards (second only to climate change at 85%).^[9]
• Revalidating the methodology for calculating quantitative metrics and assessing consistency with the prior year. Former Chairman Clayton commented that he would expect companies to “maintain metric definitions constant from period to period or to disclose prominently any changes to the metrics.”

__________________________

[1] See 17 C.F.R. § 229.101(c)(2)(ii).

[2] See Regulation S-K and ESG Disclosures: An Unsustainable Silence, available at https://www.sec.gov/news/public-statement/lee-regulation-s-k-2020-08-26.

[3] Commission Chair Gary Gensler’s Fall 2022 Unified Agenda of Regulatory and Deregulatory Actions (the “Fall 2022 Reg Flex Agenda”) shows “Human Capital Management Disclosure” as being in the proposed rule stage.  Available at https://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST&currentPub=true&agencyCode&showStage=active&agencyCd=3235.

[4] Note that companies often include additional human capital management-related disclosures in their ESG/sustainability/social responsibility reports and websites and sometimes in the proxy statement, but these disclosures are outside the scope of the survey.

[5] While never expressly required by Regulation S-K, as a result of disclosure review comments issued by the Division of Corporation Finance over the years and a decades-old and since-deleted requirement in Form 1-A, it has been a relatively common practice to discuss collective bargaining and employee relations in the Form 10-K or in an IPO Form S-1, particularly since the threat of a workforce strike could be material.

[6] For purposes of our survey, we grouped companies in similar industries based on both their four-digit Standard Industrial Classification code and their designated industry within the Sustainable Industry Classification System.  The industry groups discussed in this section cover 33% of the companies included in our survey.

[7] Available at https://www.warner.senate.gov/public/index.cfm/2022/2/warner-brown-call-on-sec-to-update-human-capital-disclosures-so-that-companies-report-the-number-of-employees-who-are-not-full-time-workers.

[8] Available at https://www.sec.gov/rules/petitions/2022/petn4-787.pdf.

[9] See Morrow Sodali 2021 Institutional Investor Survey, available at https://morrowsodali.com/insights/institutional-investor-survey-2021.

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The following Gibson Dunn attorneys assisted in preparing this update: Meghan Sherley and Mike Titera.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work in the Securities Regulation and Corporate Governance practice group, or any of the following practice leaders and members:

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
James J. Moloney – Orange County, CA (+1 949-451-4343, [email protected])
Lori Zyskowski – New York, NY (+1 212-351-2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])
Michael A. Titera – Orange County, CA (+1 949-451-4365, [email protected])
Aaron Briggs – San Francisco, CA (+1 415-393-8297, [email protected])
Julia Lapitskaya – New York, NY (+1 212-351-2354, [email protected])

Labor and Employment Group:
Jason C. Schwartz – Washington, D.C. (+1 202-955-8242, [email protected])
Katherine V.A. Smith – Los Angeles (+1 213-229-7107, [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.

On December 27, 2022, the Internal Revenue Service (the “IRS”) and the Department of the Treasury (“Treasury”) issued Notice 2023-7 (the “Notice”) to provide important interim guidance on the new corporate alternative minimum tax (the “CAMT”) enacted under the Inflation Reduction Act of 2022.[1]  The Notice describes forthcoming regulations that are expected to be consistent with the interim guidance provided in the Notice and retroactive to January 1, 2023 (the date that the CAMT became effective).  Taxpayers may rely on the interim guidance until the proposed regulations are issued.  Accordingly, we expect this guidance to inform Q1 2023 estimated tax payments and financial reporting for affected taxpayers.

The Notice provides necessary and welcome guidance in many respects, but there remain significant open issues.

The Statute

For taxable years beginning after December 31, 2022, the CAMT requires certain corporations (each, an “Applicable Corporation”) to pay U.S. federal income tax on their adjusted financial statement income (“AFSI”) at a rate of at least 15 percent.[2]  A corporation is an Applicable Corporation if it — together with the other members of its controlled group — averages more than $1 billion of AFSI over a three-year testing period.  For a U.S. subsidiary of a foreign-parented multinational group to be an Applicable Corporation, the subsidiary also must have AFSI of $100 million or more over the same three-year testing period (taking into account the AFSI only of the domestic members of the group and the “effectively connected” AFSI of each foreign member), with certain adjustments.[3]

Key Provisions of the Notice

The Notice provides a safe harbor for determining whether a corporation will constitute an Applicable Corporation for the corporation’s first taxable year beginning after December 31, 2022.  In addition, the Notice includes interim guidance regarding (i) a safe harbor for determining Applicable Corporation status and certain rules relating to controlled groups, (ii) how certain acquisitive and divisive transactions are taken into account, (iii) the calculation of AFSI for certain distressed corporations, and (iv) the treatment of depreciable property and certain tax credits for purposes of calculating AFSI.  Below is a high-level summary of the key provisions of the Notice.

1. Applicable Corporation Determination – Safe Harbor and Certain Group Rule

a. Safe Harbor

For purposes of calculating AFSI to determine Applicable Corporation status, the statute requires a number of complex adjustments to the income or loss reported on a corporation’s financial statements.  To simplify this determination, the Notice includes a safe harbor that allows a corporation, for its first taxable year beginning after December 31, 2022, to disregard the numerous adjustments required by the statute.  Under the safe harbor, the corporation can simply use the income or loss reported on the corporation’s consolidated financial statements, with limited adjustments, but must apply a reduced AFSI threshold of $500 million (or $50 million in the case of a U.S. corporate subsidiary of a foreign-parented multinational group).

For corporations that are under the $500 million AFSI threshold of the safe harbor, the safe harbor simplifies what otherwise could be a burdensome (and time-sensitive, given upcoming estimated tax payments) determination.  Note that if a corporation does not satisfy the safe harbor, it can still avoid being an Applicable Corporation under the statutory computational and threshold rules.

b. Consolidated Groups, Corporate Partners, and Foreign-Parented Multinational Groups

The application of the CAMT to consolidated groups, partnerships, and multinational corporations is of critical importance.  The Notice clarifies some aspects of these rules but leaves open several questions.

• Single-entity treatment for consolidated groups. The Notice provides that a consolidated group is treated as a single entity for purposes of computing AFSI—both for determining Applicable Corporation status as well as for calculating CAMT liability.[4]

• Corporate partners – manner of taking into account partnership AFSI to determine Applicable Corporation status. Section 56(c)(2)(D)(i) contains a “distributive share” rule that provides that, for purposes of calculating AFSI to determine an Applicable Corporation’s CAMT liability, an Applicable Corporation that is a partner in a partnership takes into account only its distributive share of the partnership’s AFSI.[5]  The Notice clarifies that the distributive share rule is disregarded for purposes of determining whether a corporation is an Applicable Corporation regardless of whether the partnership is part of the corporate partner’s controlled group.[6]   The Notice does not provide any guidance regarding how a taxpayer should determine its distributive share.  The IRS and Treasury have requested comments on the application of this distributive share rule.

• Foreign-parented multinational groups. The Notice addresses how the safe harbor applies to entities in a foreign-parented multinational group and also seeks comments in this area.

Although the determination of Applicable Corporation status in the context of investment fund structures involving partnerships and portfolio companies similarly raises significant issues, the Notice does not address any of these issues.[7]

2. Certain M&A and Restructuring Transactions – Combinations and Divisions

The Notice addresses how M&A and restructuring transactions affect the determination of Applicable Corporation status and the computation of CAMT liability.

a. Entirely Tax-free transactions disregarded

The Notice provides that any financial accounting gain or loss resulting from specified tax-free transactions is disregarded for purposes of calculating AFSI — both to determine Applicable Corporation Status and to calculate CAMT liability for the taxable years in which the applicable financial statements take into account the relevant nonrecognition transaction.[8]  This guidance is particularly welcome in clarifying that both spin-offs and split-offs do not affect AFSI if they are otherwise tax-free even though split-offs can result in financial statement gain or loss.  It is important to note that this rule applies only to transactions that are wholly tax-free (i.e., that do not have any “boot”).[9]  The IRS and Treasury have requested comments regarding how to treat transactions that are partially taxable.

In addition, the Notice requires that each component transaction of a larger transaction be examined separately for qualification as a tax-free transaction that is covered by the Notice.  The Notice nonetheless also provides that general step transaction doctrine principles apply.

Taxpayers will need to consider these rules when structuring acquisitions and divestitures.

b. Impact on Applicable Corporation Determination

The Notice provides three sets of rules regarding the determination of AFSI for a party to an applicable M&A transaction for purposes of determining Applicable Corporation status.

• Acquisition of Standalone Target or Entire Target Group. If a corporation acquires a standalone target or entire target group to form a new group, the acquirer group takes into account the AFSI of the acquired target (or target group) for the three-year taxable period ending with the taxable year in which the acquisition takes place (the “Three-Year Period”).   The Applicable Corporation status (if it existed immediately prior to the transaction) of the target or target group terminates.
• Carve-Out. If a corporation acquires only a portion of a target group, the acquiring corporation takes into account only the portion of the AFSI of the target group allocated to the target (based on any reasonable method until proposed regulations are issued that specify a required allocation method) for the Three-Year Period, and the AFSI of the remaining target group is not adjusted.  In other words, the AFSI allocated to the target is included in the AFSI for both the target’s group and the acquiror’s group for the Three-Year Period.  If Applicable Corporation status existed for the target immediately prior to the transaction, it terminates.
• Spin-off or Split-off. If a corporation distributes a controlled corporation to its shareholders, the controlled corporation is allocated a portion of the AFSI of the distributing corporation (or the applicable group of which the distributing corporation is the parent) for the Three-Year Period (based on any reasonable allocation method until proposed regulations are issued that specify a required allocation method).[10]   The AFSI of the distributing corporation (or the applicable group of which the distributing corporation is the parent) is not adjusted.  Rather, as in the carve-out situation, the AFSI allocated to the controlled corporation is included in the AFSI for both the distributing and the controlled groups.  If Applicable Corporation status existed for the controlled entity immediately prior to the transaction, it terminates.

Although the application of the CAMT rules to M&A and restructuring transactions is rife with complexity and ambiguity, the interim guidance provides taxpayers with much needed clarity regarding the application of the CAMT to these transactions and is a very helpful starting point for future regulations.  It is not surprising that this is a key area in which the IRS and Treasury have requested comments.

3. Distressed Situations

The Notice provides relief for certain distressed corporations.  Specifically, the Notice excludes from the calculation of AFSI—for purposes of both determining Applicable Corporation status and calculating CAMT liability—financial accounting gain that is excluded from income for U.S. federal income tax purposes under section 108(a)(1).  The Notice also requires a reduction to the taxpayer’s CAMT tax attributes to the extent of the amount of the excluded cancellation of indebtedness income that results in a reduction of tax attributes under section 108(b) or Treas. Reg. § 1.1508-28.

The IRS and Treasury have requested comments regarding what CAMT attributes should be adjusted and what methodology should be used to adjust the CAMT attributes (and in what order).

4. Depreciable property and new refundable and transferable tax credit rules

The statute provides that tax depreciation deductions, rather than financial statement depreciation expense, are taken into account in computing AFSI for purposes of both determining Applicable Corporation status and calculating CAMT liability.  The Notice includes various rules clarifying the application of this rule to certain tangible property.  For example, the Notice provides that this rule applies only to depreciation deductions allowed under section 167 with respect to property that is in fact depreciated under section 168.[11]  The Notice also makes clear that AFSI is reduced by tax depreciation that is capitalized to inventory under section 263A and recovered as part of cost of goods sold in computing gross income under section 61.

 In addition, the Notice includes guidance regarding the new refundable and transferable tax credit rules for clean energy and advanced manufacturing projects.  Specifically, the Notice provides that AFSI (again, for purposes of both determining Applicable Corporation status and calculating CAMT liability) is determined by taking into account appropriate adjustments to disregard amounts (i) that the taxpayer elects to treat as a payment of tax under section 48D(d) or 6417, (ii) treated as tax-exempt income under sections 48D(d) or 6417), and (iii) received from the transfer of an eligible credit that is not includible in the gross income of the transferring taxpayer under section 6418(b) or is treated as tax-exempt income under section 6418(c).  Although the Notice does not provide color on the meaning of “appropriate adjustments,” the guidance is helpful in clarifying that the imposition of the CAMT is not intended to undermine the new energy incentives enacted last year.

__________________________

[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).

The IRS issued a second notice on December 27, 2022, that provides important initial guidance on the new stock buyback excise tax.  See our January 3, 2022, client alert “IRS and Treasury Issue Interim Guidance on New Stock Buyback Excise Tax,” available at https://www.gibsondunn.com/irs-and-treasury-issue-interim-guidance-on-new-stock-buyback-excise-tax/.

[2] The CAMT increases a taxpayer’s tax only to the extent that the 15 percent minimum tax (computed after taking into account applicable foreign tax credits) exceeds the taxpayer’s regular tax plus the base erosion and anti-abuse tax.

[3] A U.S. corporation is a member of a foreign-parented multinational group if it is included in the applicable financial statements of a group that has a foreign parent.

[4] Importantly, not all AFSI computational rules apply for both purposes.

[5] Unless indicated otherwise, all “section” references are to the Internal Revenue Code of 1986, as amended, and all “Treas. Reg. §” references are to the Treasury regulations promulgated thereunder.

[6] This guidance was necessary because the statute alone does not make clear whether the distributive share rule applies only in circumstances in which the corporate partner and the partnership are aggregated for purposes of calculating AFSI or in all cases.

[7] What is clear is that the typical private equity partnership is not required to take into account the book income of its portfolio companies.  This position was proposed by Senate Democrats before the Act was passed in August of 2022, but Finance Committee member John Thune’s amendment removed that language from the bill.

[8] The list of specified transactions has notable exclusions.  For example, it does not include tax-free capital contributions under section 118, like-kind exchanges under section 1031, involuntary conversions under section 1033, stock-for-stock exchanges under section 1036, or conversions of convertible debt under Revenue Ruling 72-265.

[9] The Notice requires the transaction not “result” in any amount of gain or loss for U.S. federal income tax purposes.  The proposed regulations should clarify that “result” in this context means recognition (and not realization) of gain or loss.

[10] The IRS and Treasury have requested comments on how to allocate AFSI of the distributing group to the controlled corporation.

[11] The precise meaning of the depreciation rule is not entirely clear.

---

This alert was prepared by Anne Devereaux, Pamela Lawrence Endreny, Adam Gregory, Kathryn A. Kelly, Jennifer Sabin, and Eric Sloan.

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

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On 19 December 2022, representatives from 188 countries adopted a new agreement at the United Nations (“UN”) Biodiversity Conference in Montreal, Canada, to guide global action on nature.[1]  The agreement, the Kunming-Montreal Global Biodiversity Framework (“GBF”), is the result of several years of negotiations under the auspices of the UN Convention on Biological Diversity (“CBD” or the “Convention”),[2] the first summit having taken place in Kunming, China, in October 2021.[3]  The GBF aims to “halt and reverse” biodiversity loss through a series of specific goals and targets.[4]  Its cornerstone is the target to conserve 30% of the world’s land and 30% of the world’s oceans by 2030, widely known as the 30×30 pledge. The GBF is one of a handful of CBD agreements[5] but has the potential to become one of the most significant in moving the dial on nature loss and degradation to date.  Described as a “landmark” agreement,[6] a “huge, historic moment,”[7] and a “major win for our planet and for all of humanity”[8], the GBF was signed against a backdrop of global regulatory developments and investor pressure urging action to address climate change and the interconnected biodiversity loss crisis. We share below our insights on the new framework and how it is expected to shape national and international policies and regulations relating to biodiversity, with implications for global organizations and financial firms.

Key Highlights In December 2022 at COP 15, 188 countries adopted a new Global Biodiversity Framework (“GBF”) under the UN Convention for Biological Diversity to “halt and reverse” biodiversity loss. GBF includes four “overarching global” goals and 23 targets for 2030 to protect nature. Seen as a landmark agreement, the GBF aims to conserve 30% of the world’s land and 30% of the world’s oceans by 2030. A number of the GBF target will impact the  private sector-including those related to disclosure and transparency, reduction of pollution risks “from all sources,” reduction of subsidies “harmful to biodiversity” by at least $500 billion per year by 2030, and mobilization of at least $200 billion per year to implement national biodiversity goals. GBF is likely to spur additional actions at the domestic and international levels and lead to enhanced and new voluntary (and eventually mandatory) rules on nature-related issues. A number of initiatives across the financial sector have already expressed support for the GBF and its objectives.  For example, a new coalition of institutional investors (Nature Action 100) was announced at COP 15 and will focus on identifying and supporting critical private sector actors in key sectors.

I. Background to COP15

The meeting of the Conference of the Parties (“COP”) to the CBD takes place every two years with a view to advancing the goals of the Convention.  The CBD, which opened for signature in 1992 at the Earth Summit in Rio de Janeiro[9] and entered into force in 1993, is an international treaty with three objectives—(i) the conservation of biological diversity; (ii) the sustainable use of the components of biodiversity; and (iii) the fair and equitable sharing of the benefits derived from the use of genetic resources.[10]  The CBD has nearly universal participation, with 196 States Parties including Belgium, Brazil, China, France, Germany, Singapore, the UAE, and the United Kingdom. The United States signed the treaty in 1993 but has not ratified it.  (The U.S. nonetheless participates at the COPs and, as we discuss below, COP15 has implications for U.S. entities and other global organizations.)

In 2010, at COP10 in Nagoya, Japan, the Parties adopted a revised and updated Strategic Plan for Biodiversity, including the Aichi Biodiversity Targets for 2011–2020 (“Aichi Targets”), to achieve a goal of “living in harmony with nature” by 2050.[11]

In 2019, however, a report by the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (“IPBES”) concluded that nature was declining globally at rates unprecedented in human history.  In 2020, the Global Biodiversity Outlook 5, a CBD report, found that, despite progress in some areas, governments had failed to meet the Aichi Targets.[12]

These findings set the tone for the next COP—COP15—whose key purpose was to agree on global nature targets for 2030 and 2050.  The meeting opened on 7 December 2022 and, following a “sometimes fractious” two-week meeting[13] and reservations voiced by several States including on the sensitive and critical topic of financing, the GBF was adopted and the updated draft agreement published in the last few hours of COP15.[14]  Alongside the GBF, COP15 adopted a number of other decision texts that spell out more technical details, including monitoring mechanisms, resource mobilization, and areas for future work.[15]

II. Why are COP15 and Biodiversity Important to Organizations and Investors?

In our previous alert, we touched on some of the key reasons why biodiversity loss poses a risk to companies and investors.  Most businesses depend on ecosystem services underpinned by biodiversity.  For example, a 2020 report from the World Economic Forum (“WEF”) found that more than 50% of the world’s GDP ($44 trillion) is moderately or highly dependent on nature and its ecosystems—and is therefore at risk of disruption due to nature loss.[16]

Today, the WEF ranks biodiversity loss as a top three risk to the global economy.[17]

Chart 1.  Examples of Global Biodiversity Risks[18]

Up to $577 billion in annual global crop production is at risk from pollinator loss

Around 40% of the global population is adversely affected by land degradation

100-300 million people are at increased risk of floods and hurricanes due to coastal habitat loss

Collapse of wild pollinator populations, marine fisheries, and timber production alone could reduce global GDP by $2.7 trillion annually by 2030

Wildlife is the source of 70% of novel pathogens and loss of natural habitats substantially increases the risk of global pandemics via human encroachment

Coral reefs alone generate $36 billion per year for the global tourism industry.

60% of coffee varieties are in danger of extinction due to climate change, disease and deforestation.

25% of drugs used in modern medicine are derived from rainforest plants

Companies and investors are increasingly appreciating and focusing on these material, systemic risks posed by biodiversity loss.[19]

With these global risks, however, also come opportunities for both the public and private sectors.  A recent World Bank report estimates that “nature-smart” policies can reduce the risk of ecosystem collapse and are “win-win” policies in terms of biodiversity and economic outcomes.  Meanwhile, the WEF’s Future of Nature and Business Report[20] found that “nature-positive” solutions could create over $10 trillion in business opportunities and provide 395 million more jobs by 2030. Investment in nature can prove to be not just a cost-effective but even a profitable solution for addressing the broader societal objective of biodiversity loss.[21]  This growing awareness is reflected in investment in “nature-based solutions” (“NbS”),[22] which is expected to grow in the light of the GBF’s package of actions relating to resource mobilization, mechanisms for planning, and capacity-building and development, and technical and scientific cooperation, as discussed below.

Against this backdrop of urgency and interest, it was no surprise to many that, for the first time, the conference featured a dedicated Finance Day.  There were a number of initiatives and developments emanating from the financial sector both in the run up to, at, and following the COP15, including:

• The UN Principles of Responsible Investment (“UN PRI”), a UN-supported international network of financial institutions, coordinated a call by 150 global financial institutions with more than $24 trillion in assets under management, on governments to adopt the GBF and committed to work within their own organizations to support the effective alignment of the proposed vision from the CBD of “Living in Harmony with Nature by 2050.”[23]
• The topic of “biodiversity credits” and establishing a voluntary market for these developing financial instruments was keenly debated at the COP, and in parallel the WEF and the Biodiversity Credit Alliance are exploring market options for biodiversity credits.[24]
• A new coalition of institutional investors, Nature Action 100, was announced at COP15. The group will identify most critical private-sector actions and work with companies to address nature loss and degradation, focusing initially on 100 companies in key sectors (i.e., those deemed to be systemically important to the GBF’s goal of reversing nature and biodiversity loss by 2030).
• The World Benchmarking Alliance (“WBA”) published a new Nature Benchmark at COP15—an assessment of 389 companies—which found that just 5% understand their impact on nature and less than 1% know how much their operations depend on nature.

III. The GBF’s Global Roadmap to 2030

The overarching aim of the GBF is for people to “liv[e] in harmony with nature” by 2050.  To achieve this vision, the GBF has set out a “mission” to “halt and reverse” biodiversity loss by 2030.  It adopted four “overarching global” goals and 23 targets for 2030 to protect nature, which are described in more detail below:

(A) The GBF’s Four Goals

The GBF’s four overarching global goals include:

Goal	Goal Summary
Goal A	Halting “human-induced extinction” of known threatened species and reducing the rate and risk of extinction of all species “tenfold” by 2050
Goal B	Sustainable use and management of biodiversity to ensure that “nature’s contributions to people . . . are valued, maintained and enhanced,” for the benefit of present and future generations by 2050
Goal C	Fair and equitable sharing of the “benefits from the utilization of genetic resources, and digital sequence information on genetic resources” and protection of traditional knowledge associated with genetic resources
Goal D	Ensuring that adequate means of implementing the GBF are accessible to all Parties, and in particular the Least Developed Countries and Small Island Developing States

Although Goal D does not specifically mention either the public or the private sector, is it regarded as one of the most relevant goals for the corporate and financial services sector.  Adequate means of implementation, including financial resources, capacity-building, and technical and scientific cooperation are seen as key to ensure the success of the GBF and “progressively clos[e] the biodiversity finance gap of 700 billion dollars per year.”

(B) The GBF’s 23 Targets

The GBF’s targets (of which nine incorporate specific 2030 targets) cover the following areas:

Target	Target Summary
Target 1	Spatial planning to bring the loss to areas of high biodiversity importance to close to zero by 2030
Target 2	Effective restoration of at least 30% of degraded terrestrial, inland water, and coastal/marine ecosystems by 2030
Target 3	Effective conservation of at least 30% of degraded terrestrial, inland water and coastal/marine ecosystems by 2030 (i.e., 30 x 30), recognizing indigenous and traditional territories, where applicable
Target 4	Ensure urgent management actions to stop human-induced extinction of species and restore genetic diversity
Target 5	Ensure that the use, harvesting, and trade of wild species is sustainable, safe, and legal, and reduce the risk of pathogen spill-over
Target 6	Eliminate, reduce, or mitigate impacts of invasive alien species on biodiversity
Target 7	Reduce pollution risks and negative impact of pollution “from all sources” to non-harmful levels by 2030, including reducing excess nutrients lost by at least 50% including through more efficient nutrient cycling and use, reducing the “overall risk from pesticides and highly hazardous chemicals” by at least 50% including through integrated pest management, and working towards “eliminating plastic pollution”
Target 8	Minimize the impact of climate change and ocean acidification on biodiversity
Target 9	Ensure that the management and use of wild species is sustainable, thereby supporting especially those most dependent on biodiversity
Target 10	Ensure that areas under agriculture, aquaculture, fisheries, and forestry are managed sustainably
Target 11	Restore, maintain, and enhance contributions to people, such as regulation of air, water, and climate, soil health, pollination and reduction of disease risk, through nature-based solutions and ecosystem-based approaches
Target 12	Significantly increase the area, quality, and connectivity of access to and benefits from green and blue spaces in urban and densely populated areas, including by ensuring biodiversity-inclusive urban planning, enhancing native biodiversity, ecological connectivity and integrity
Target 13	Take effective legal, policy, administrative, and capacity-building measures to ensure the fair and equitable sharing of benefits from genetic sources
Target 14	Ensure the full integration of biodiversity into policies and regulations, including environmental impact assessments (“EIAs”), across all levels of government and sectors, and progressively align all public and private activities, fiscal and financial flows with the GBF
Target 15*	Take legal, administrative, or policy measures to encourage and enable large and transnational companies and financial institutions to “monitor, assess, and transparently disclose” their biodiversity risks, dependencies, and impacts through their operations, portfolios, supply, and value chains, including by providing more information to consumers and reporting on compliance with regulations
Target 16	Ensure that people are encouraged to make sustainable consumption choices, including by establishing supportive policy, legislative, and regulatory frameworks, and, by 2030, reduce “the global footprint of consumption,” halve global food waste, and reduce waste generation
Target 17	Establish, strengthen capacity for, and implement biosafety measures
Target 18	Eliminate or reform incentives which are “harmful to biodiversity” (e.g. subsidies) by 2050, by progressively reducing them by at least $500 billion per year by 2030, while scaling up positive incentives for biodiversity conservation and sustainable use
Target 19	Increase the level of financial resources to implement national biodiversity strategies and action plans by mobilizing at least $200 billion per year (from public and private sources) and increasing international financial flows from developed to developing countries to at least $20 billion per year by 2025 and $30 billion by 2030
Target 20	Strengthen capacity-building, access to, and transfer of technology and R&D for the conservation and sustainable use of biodiversity
Target 21	Ensure that the best available data, information, and knowledge accessible to decision-makers and the public to guide governance, awareness-raising, education, monitoring, and R&D management
Target 22	Ensure the full, equitable, inclusive gender-responsive representation and participation in decision-making related to biodiversity
Target 23	Ensure gender equality in the implementation of the GBF

* Target 15 is the GBF’s private sector-focused target for businesses and financial institutions.  However, as the WEF has noted in its most recent report, multiple other goals and targets are relevant to the private sector and create both risks and opportunities for global organizations and financial institutions.[25]

(C) The CBD’s Next Steps  

The next UN biodiversity conference will be held in Turkey in 2024.  In the interim, the CBD’s subsidiary bodies will continue to meet and develop the scientific, reporting, and monitoring foundations for the GBF.  Meanwhile, the Global Environment Facility (“GEF”) will create a new biodiversity-specific trust fund, as outlined in the final agreement.[26]

In parallel, at the domestic level, States Parties to the CBD will be expected to revise their National Biodiversity Strategies and Action Plans (“NBSAPs”) to “align” them with the goals and targets set out in the GBF (Art. 34(a)) by COP16—the next biodiversity summit.[27]  COP15 also agreed that the CBD Parties should submit national reports containing agreed headline indicators in 2026 and 2029.[28]

Implementation of the GBF, however, will also likely continue outside of the narrow context of the CBD.  For example, about 60% of the Earth’s ocean surface lies outside national jurisdictions—and beyond the reach of national legislation.  To preserve biodiversity on the high seas (and on the seafloor), States would need to adopt a complementary sets of biodiversity rules and targets.[29]

IV. Broader Implications and Developments of Note for Corporations and Financial Institutions

The GBF is not a legally binding international treaty, but it is nonetheless expected to affect national policies, regulations, and plans globally as governments seek to give effect to their new biodiversity commitments.  As we have seen, global financial institutions are already both supporting and urging such actions.

With its more measurable targets and an “enhanced implementation mechanism,” the GBF is thought to be more robust—and more likely to be successfully implemented—than its predecessor, the 2010 Aichi Targets.[30]  The GBF’s system of reporting, monitoring, and “ratcheting up” of ambition over time is expected to result in more concrete actions.[31]  This approach draws on the implementation framework underpinning the 2015 Paris Agreement on Climate Change (“Paris Agreement”).  The Paris Agreement—which requires countries to regularly submit their national climate plans for review and increase their climate targets over time—has already had significant impact both on domestic legislation (across all levels of government) and voluntary measures by the private sector.  The GBF, already (aspirationally) described as the “Paris Agreement for Nature,” could potentially be as far-reaching.

At the same time, while the GBF contains some specific targets, not all are quantitative.  Quantifying and standardizing national commitments (both in targets and in financial investment) is seen as necessary to ensure implementation.

Depending on the degree of implementation by governments and/or voluntary adoption by the private sector, there are a number of specific aspects of the GBF which could lead to changes in the scope, nature, and increased costs of business and compliance for various organizations as illustrated below.[32]  It will be important for individual businesses, management, and boards to track and proactively consider the potential impact of these developments on their operations, investment decisions, and compliance.  For instance:

• Impact of GBF Substantive Targets – Expansion of Protected Areas: The GBF’s substantive targets could have significant implications for business, in particular those that already enjoy a significant degree of support among governments.[33] Currently, around 17% of land and 8% of marine areas globally are protected.[34]  The GBF commitment in Target 3 to expand protected areas to at least 30% of the world’s land, coastal areas, and oceans by 2030 is likely to have material implications for a number of businesses, including agriculture, fisheries, mining, and logging, which may see a contraction in areas available for their operations, while other sectors, such as tourism, consumer products, cosmetics, and pharmaceuticals, may see growth.  Moreover, it is expected that the 30% target may be revised upwards in the future in view of other scientific assessments suggesting that protecting biodiversity requires 30-50% of Earth’s land and sea to be set aside for nature.[35]
• Finance – Phasing out of Subsidies: The implementation of Target 18 could reshape international financial flows by redirecting $500 billion every year in subsidies that are seen to have a negative impact on biodiversity and putting those funds to a different use. While specific sectors are not named in the GBF, this commitment is expected to target subsidies for agriculture, fisheries, and hydrocarbons.
• Respecting Indigenous Rights – Implications for Land Use and Operations: The GBF incorporates Indigenous Rights into various targets.[36] This will shape how governments and the private sector conduct operations in areas with an Indigenous population and heighten the need for securing their free, prior, and informed consent.
• Respecting Human Rights: The GBF also expressly states that implementation should follow a human rights-based approach and acknowledges the human right to a clean, healthy, and sustainable environment in line with the U.N. General Assembly Resolution 76/300 of 28 July 2022.
• Disclosure, Increased Transparency, and Commitments: Finally, Target 15 calls on large and transnational companies and financial institutions to “monitor, assess, and transparently disclose” their risks and impacts on biodiversity throughout their operations, portfolios, supply, and value chains by 2030. Many Parties, as well as Business for Nature, a corporate coalition, had called on the COP15 delegates to make Target 15 mandatory for all companies.  While the GBF did does not make the target “mandatory” or set concrete benchmarks and does not bind private actors, it may nonetheless have significant impacts and enhance impetus in this area, which has already seen some development.

The disclosure-related Target 15 builds on a growing number of existing regulations and standards and will likely spur additional actions, as summarized below:

• Existing National and Regional Regulations – As noted in our previous alert, a number of regulations already apply to corporates and/or investment funds in Europe (for example in the UK, France, and the EU[37]) and globally that already incorporate specific biodiversity and nature-related disclosures. As with other ESG-related disclosures and standards, alignment across regulatory and industry sectors in the development of further or enhanced biodiversity disclosures will be key for industry generally.  Organizations should, however, be prepared to encounter a host of new and potentially inconsistent rules and regulations across countries.
• Global Standards and Frameworks – Prior to COP15, the Taskforce on Nature-Related Financial Disclosure (“TNFD”) released the third version of its beta framework (v0.3) for nature-related risk management and disclosures, which includes guidance on target-setting developed with the Science Based Targets Network (“SBTN”).[38] Calls on business and financial institutions to assess and disclose their biodiversity impacts and risks have only increased since COP15.  In response, the International Sustainability Standards Board (“ISSB”) announced that it will research “incremental enhancements” to complement the Climate-Related Disclosures Standard (S2) (currently under development), including in relation to “natural ecosystems.”[39]  There are already calls to make the ISSB standard (once completed) mandatory.[40]

While mandatory disclosure may be some years away, in the meantime the GBF may result in the enhancement of existing national and regional regulations and accelerate the development and proliferation of new voluntary (and eventually mandatory) rules on nature-related disclosure across different jurisdictions and regulatory regimes.  This could in turn affect long-term investment decisions and regulatory compliance for businesses across the value chain.

V. Conclusion

There have already been a number of private-sector related developments relating to biodiversity, which indicate that these issues are gaining real momentum and traction in the financial markets.  These include the launch of a number of new biodiversity funds,[41] the expansion and enhancement of biodiversity criteria in sustainable bonds and sustainability-linked loans, and the developments in the voluntary biodiversity credits market.

The Global Biodiversity Framework reflects a further, important milestone in this journey.  The full impact of COP15 may not be visible until COP16, when CBD Parties are called to publish their national biodiversity action plans.  However, the private sector is rightly taking note of the key emerging operational impacts on business (such as respect for Indigenous and human rights, and transparency and reporting of risks and impacts on biodiversity) and its corresponding complexities and costs of implementation alongside the growth and economic opportunities for market participants.

____________________________

[1]      Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.25, Kunming-Montreal Global Biodiversity Framework, Draft Decision Submitted by the President (Dec. 18, 2022) [hereinafter “GBF”].

[2]      Convention on Biological Diversity, opened for signature, June 5, 1992, 1760 U.N.T.S. 79 (entered into force Dec. 29, 1993) [hereinafter “CBD”].

[3]      See Gibson Dunn’s Client Alert on COP 15 (Part I) and related regulatory developments published in October 2021: COP 15 Biodiversity Firmly Back On The Regulatory Agenda.

[4]      See CBD, Nations Adopt Four Goals, 23 Targets for 2030 in Landmark UN Biodiversity Agreement, CBD Press Release (Dec. 19, 2022) [hereinafter “CBD Press Release”].

[5]      See, e.g., Cartagena Protocol on Biosafety to the Convention on Biological Diversity, opened for signature, May 15, 2000, 2226 U.N.T.S. 208 (entered into force Sept. 11, 2003); Nagoya Protocol on Access to Genetic Resources and the Fair and Equitable Sharing of Benefits Arising from their Utilization to the Convention on Biological Diversity, opened for signature Feb. 2, 2011, 3008 U.N.T.S. 3 (entered into force Oct. 12, 2014).

[6]      See CBD Press Release.

[7]      UK International Environment Minister Zac Goldsmith, quoted in CarbonBrief, COP15: Key outcomes agreed at the UN biodiversity conference in Montreal, 20 Dec. 2022 [hereinafter CarbonBrief, COP15: Key outcomes].

[8]   Canadian Environment Minister Steven Guilbeault, quoted in id.

[9]      The other key Rio Summit treaties include the UN Framework Convention on Climate Change (“UNFCCC”) and the UN Convention to Combat Desertification (“UNCCD”).

[10]     CBD, art. 1.

[11]    CBD, Decision X/2, “The Strategic Plan for Biodiversity 2011-2020 and the Aichi Biodiversity Targets,” Doc. No. UNEP/CBD/COP/DEC/X/2, 29 October 2010.

[12]    The Global Biodiversity Outlook 5 found, inter alia, that “[b]iodiversity is declining at an unprecedented rate, and the pressures driving this decline are intensifying. None of the Aichi Biodiversity Targets will be fully met, in turn threatening the achievement of the Sustainable Development Goals and undermining efforts to address climate change.”

[13]    CBD, Nations Adopt Four Goals, 23 Targets for 2030 in Landmark UN Biodiversity Agreement, CBD Press Release, 19 Dec. 2022.

[14]   CarbonBrief, COP15: Key outcomes.

[15]    See, e.g., Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.26, Monitoring framework for the Kunming-Montreal global biodiversity framework, Draft Decision Submitted by the President (Dec. 18, 2022); Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.27, Mechanisms for Planning, Monitoring, Reporting and Review, Draft Decision Submitted by the President (Dec. 18, 2022); Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.29, Resource Mobilization, Draft Decision Submitted by the President (Dec. 18, 2022); Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.34, Long-term strategic approach to mainstreaming biodiversity within and across sectors, Draft Decision Submitted by the Chair of Working Group I (Dec. 19, 2022).

[16]    See World Economic Forum, Nature Risk Rising: Why the Crisis Engulfing Nature Matters for Business and the Economy (2020).

[17]    See World Economic Forum, The Global Risks Report (2022).  The top two global risks over a 10-year horizon are “climate action failure” and “extreme weather.”

[18]    See Global Environment Facility, Land Degradation; Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES), Nature’s Dangerous Decline ‘Unprecedented’; Species Extinction Rates ‘Accelerating’, Media Release (May 5, 2019); OECD, Biodiversity: Finance and the Economic and Business Case for Action (Report prepared by the OECD for the French G7 Presidency and the G7 Environment Ministers’ Meeting, 5-6 May 2019) (2019); World Economic Forum, Nature Risk Rising: Why the Crisis Engulfing Nature Matters for Business and the Economy (2020); World Bank, Protecting Nature Could Avert Global Economic Losses of $2.7 Trillion Per Year, Press Release (July 1, 2021); UK Government Office for Science, COP15 International Science Advisors’ Statement (Dec. 5, 2022).

[19]    For example, a recent assessment (November 2022) conducted by CDP showed almost half the companies covered recognising biodiversity as a risk and considering it in their strategies and circa 31% making public commitments and/or endorsements of biodiversity-related initiatives.

[20]    See World Economic Forum, The Future of Nature and Business, New Nature Economy Report II (2020).  “Nature-positive” refers to the goal that calls for zero net loss of nature from 2020, a net increase by 2030 and full recovery by 2050.

[21] See studies by Verdone and Seidl on the value of investing in restoration and degraded landscapes who estimate that at a global level each US dollar invested in restoring degraded forests gives back between US$7 and US$30 in economic benefits. (Verdone, M., Seidl, A. (2017). Time, space, place, and the Bonn Challenge global forest restoration target Restoration Ecology 25(6): 903–911).

[22]    U.N. Env’t Prog., State of Finance for Nature (2021).

[23]    UNPRI, 150 financial institutions, managing more than $24 trillion, call on world leaders to adopt ambitious Global Biodiversity Framework at COP15, COP 15 Announcement (Dec. 13, 2022).

[24]    A financial instrument which can be used by organizations to help finance activities that deliver absolute positive biodiversity gains.  See also World Economic Forum, How biodiversity credits can deliver benefits for business, nature and local communities (Dec. 9, 2022).

[25]    See World Economic Forum, The Post-2020 Global Biodiversity Framework and What it Means for Business (Dec. 2022) [hereinafter “WEF, The Post-2020 GBF”].

[26]    Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.29, Resource Mobilization, Draft Decision Submitted by the President (Dec. 18, 2022) (requesting the GEF to establish a Special Trust Fund called the Global Biodiversity Framework Fund (“GBF Fund”) “in 2023, and until 2030” to support the framework).

[27]    See Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.27, Mechanisms for Planning, Monitoring, Reporting and Review, Draft Decision Submitted by the President (Dec. 18, 2022), Art. 1(a).

[28]    See id., Art. 1(b).

[29]    This could take the form of a separate treaty instrument, like Biodiversity Beyond National Jurisdictions (“BBNJ”), which is currently being negotiated within the framework of the United Nations Convention on the Law of the Sea (“UNCLOS”), while the exploitation of the seafloor would be governed by the International Seabed Authority.

[30]    CarbonBrief, COP15: Key Outcomes.

[31]    See, e.g., GBF, Sec. J (“Responsibility and Transparency”) (setting out “effective mechanisms for planning, monitoring, reporting and review”).  See also Conf. of the Parties to the Convention on Biological Diversity, U.N. Doc. CBD/COP/15/L.27, Mechanisms for Planning, Monitoring, Reporting and Review, Draft Decision Submitted by the President (Dec. 18, 2022) (adopting an “enhanced multidimensional approach to planning, monitoring, reporting and review” in order to “enhanc[e] implementation” of the CBD and the GBF).

[32]    In particular, the WEF expects that these changes will help level the playing field for businesses that have been proactive in addressing their impacts on nature, while imposing “growing transition risks” on those who have not worked on adopting a nature-positive approach.  Some of the regulator- and business-driven approaches to halting and reversing biodiversity decline include: 1. Deforestation-free supply chains and supply-chain environmental and social due diligence; 2. Net positive impact (NPI) approaches; 3. Financial institutions’ policies to address drivers of biodiversity loss; 4. Extended producer responsibility (EPR) schemes; 5. Payment for ecosystem services (PES); and, 6. Regenerative agriculture.  See WEF, The Post-2020 GBF.

[33]    See, e.g., High Ambition Coalition, More than 100 Countries Now Formally Support the Global Target to Protect at Least 30% of the Planet’s Land and Ocean by 2030, Statement (June 30, 2022).

[34]    See U.N. Env’t Prog. et al., Protected Planet Report 2020 (May 19, 2021).

[35]    This is at the same time seen as key to tackling climate change.  A joint report by the IPBES (referenced above) and the Intergovernmental Panel on Climate Change (“IPCC”) in 2021 emphasized that biodiversity and climate challenges can only be solved in tandem.  See also WEF, The Post-2020 GBF, at 45.

[36]    This includes Goal C, as well as spatial planning (Target 1), conservation (Target 3), customary sustainable use (Target 5 and 9), financial resources (Target 19), data, information, and knowledge (Target 21), access to justice, information, and participation (Target 22).  There are also specific references to “traditional knowledge” (Goal C, & Targets 13, 21, 22).  More generally, implementation of the GBF must ensure Indigenous rights and knowledge, including traditional knowledge associated with biodiversity (GBF, Art. 8 – “Contribution and rights of indigenous peoples and local communities”).

[37]    See, e.g., (i) French Law No. 2019-1147 of 8 November 2019 Regarding Energy and Climate, Art. 29 (Loi n° 2019-1147 du 8 novembre 2019 relative à l’énergie et au climat); (ii) EU Sustainable Finance Disclosure Regulation 2019/2088 (“SFDR”)-required Statement of Principal Adverse Impacts (“PAI”) of investment decisions on sustainability factors, such as PAI 7 (Biodiversity): “Activities negatively affecting biodiversity-sensitive areas”; (iii) EU Taxonomy Regulation 2020/852‘s Environmental Objective 6 (Protection and Restoration of Biodiversity and Ecosystems) and the EU’s Do No Significant Harm (“DNSH”) principle, which is meant to ensure that economic activities are not damaging to any environmental objective, where relevant, within the meaning of Article 17 of Regulation (EU) 2020/852.

[38]    On the COP15 Finance Day, Germany committed new funding of EUR 29 million to the TNFD, to be used to complete the technical design work of the TNFD’s recommendations, encourage global uptake, and aid alignment with emerging sustainability standards and regulations around the world.  The TNFD is based on the format adopted for the Task Force on Climate-Related Financial Disclosures (“TCFD”).

[39]    ISSB has stated that it would build on the work of market-led initiatives grounded in current-best practice and thinking and consider in particular the work of the TNFD and other existing nature-related standards and disclosures (including TNFD’s recent work on the intersection of climate and biodiversity disclosures).

[40]    For example, Mark Carney, Co-Chair of the Glasgow Financial Alliance for Net-Zero (“GFANZ”) and founder of the Taskforce on Scaling Voluntary Carbon Markets, has called on the CBD Parties to establish a mandate within Goal D and Target 15 to align financial flows with nature goals and in particular to use these as a base to “establish credible policies to hold finance and other sectors to account for aligning with the goals of halting and reversing nature loss and scaling nature-based solutions.”  See Mark Carney speech at the COP15 Finance and Biodiversity Day on 13 December 2022.

[41]    Examples include a number of new equity funds launched such as AXA WF ACT Biodiversity Fund, BNP Paribas Easy ESG Eurozone Biodiversity Leaders PAB UCITS ETF and BNP Paribas Ecosystem Restoration fund, Federated Hermes Biodiversity Equity Fund, Fidelity Biodiversity Equity Fund, RobecoSAM Biodiversity Equities, and UBAM Biodiversity Restoration fund.

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The following Gibson Dunn lawyers assisted in the preparation of this client update: Selina Sagayam, Susy Bullock, and Maria L. Banda.

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, any member of the firm’s Environmental, Social and Governance (ESG), Transnational Litigation, or International Arbitration practice groups, or the authors:

Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Selina S. Sagayam – London (+44 (0) 20 7071 4263, [email protected])
Maria L. Banda – Washington, D.C. (+1 202-887-3678, [email protected])

Environmental, Social and Governance (ESG) Group:
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
Perlette M. Jura – Los Angeles (+1 213-229-7121, [email protected])
Ronald Kirk – Dallas (+1 214-698-3295, [email protected])
Michael K. Murphy – Washington, D.C. (+1 202-955-8238, [email protected])
Selina S. Sagayam – London (+44 (0) 20 7071 4263, [email protected])

Transnational Litigation Group:
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Perlette Michèle Jura – Los Angeles (+1 213-229-7121, [email protected])
Andrea E. Neuman – New York (+1 212-351-3883, [email protected])
William E. Thomson – Los Angeles (+1 213-229-7891, [email protected])

International Arbitration Group:
Cyrus Benson – London (+44 (0) 20 7071 4239, [email protected])
Penny Madden KC – London (+44 (0) 20 7071 4226, [email protected])
Jeff Sullivan KC – London (+44 (0) 20 7071 4231, [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.

The legislative and regulatory landscape concerning electric vehicles (EVs) continues to undergo significant changes. EV regulation shares many elements of traditional automobile regulation, but the technologies involved also create new areas of regulatory coverage and manufacturer concern. This alert discusses California’s industry-shaping Advanced Clean Car II regulations, California’s technology-forcing electric truck regulations, NHTSA reporting and recall enforcement risks, other federal regulatory updates, developments in EV supply chain regulations, the developing space of battery recycling regulation, privacy and cybersecurity concerns, and charging infrastructure incentives and regulation.

For vehicle manufacturers, this alert is meant to act as a quick guide to the current EV regulatory landscape and as a map for spotting where regulatory currents are heading. For additional detail on these topics, please contact the attorneys who assisted in preparing this alert.

Read More

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The following Gibson Dunn attorneys assisted in preparing this client update: Gustav Eyler, Abbey Hudson, Vivek Mohan, Arthur Halliday, Raquel Alexa Sghiatti, and Mark Tomaier, with contributions by Stacie Fletcher, Rachel Levick, Thomas Manakides, and Julie Sweeney.

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, the authors, or any of the following leaders and members of the firm’s Environmental Litigation & Mass Tort, Privacy, Cybersecurity & Data Innovation, or White Collar Defense & Investigations practice groups:

Environmental Litigation and Mass Tort Group:
Stacie B. Fletcher – Washington, D.C. (+1 202-887-3627, [email protected])
Abbey Hudson – Los Angeles (+1 213-229-7954, [email protected])
Rachel Levick – Washington, D.C. (+1 202-887-3574, [email protected])
Thomas Manakides – Orange County (+1 949-451-4060, [email protected])

Privacy, Cybersecurity and Data Innovation Group:
Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])

White Collar Defense and Investigations Group:
Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])

On Dec. 14, the Federal Trade Commission hosted an open meeting featuring a staff presentation on cybersecurity.

Alex Gaynor, the FTC’s deputy chief technology officer, discussed the implications of the FTC’s approach to data security enforcement over the past year, specifically highlighting four security best practices.

He noted that the FTC’s latest orders signaled an important new focus on addressing flaws in the nuts and bolts of companies’ cyber programs that leave user and employee data vulnerable in an increasingly digital economy.

The presentation gives important context by reviewing the FTC’s enforcement actions over the course of 2022 and in light of broader federal government trendlines as stipulated in President Joe Biden’s Executive Order No. 14028 on improving the nation’s cybersecurity.

This review indicates the FTC is exerting heightened focus on assessing certain technical security safeguards, the absence of which can create exploitable gaps that undermine appropriate management of data.

The FTC’s emphasis on certain core technical measures is instructive for all companies, regardless of size or industry, in order to minimize cyber risk and regulatory scrutiny.

Read More

Originally published by Law360, © Portfolio Media Inc., January 4, 2023. Reprinted with permission.

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Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any member of the firm’s Privacy, Cybersecurity & Data Innovation practice group:

Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])

Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, [email protected])

Kunal Kanodia – San Francisco (+1 415-393-8207, [email protected])

Apratim Vidyarthi, a recent law graduate in New York not admitted to practice law, also contributed to this article.

Please also feel free to contact the following leaders and members of the firm’s Data Privacy, Cybersecurity and Data Innovation Group:

United States
Matthew Benjamin – New York (+1 212-351-4079, [email protected])
Ryan T. Bergsieker – Denver (+1 303-298-5774, [email protected])
S. Ashlie Beringer – Co-Chair, PCDI Practice, Palo Alto (+1 650-849-5327, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])
Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650-849-5203, [email protected])
Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, [email protected])
Lauren R. Goldman– New York (+1 212-351-2375, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Howard S. Hogan – Washington, D.C. (+1 202-887-3640, [email protected])
Robert K. Hur – Washington, D.C. (+1 202-887-3674, [email protected])
Kristin A. Linsley – San Francisco (+1 415-393-8395, [email protected])
H. Mark Lyon – Palo Alto (+1 650-849-5307, [email protected])
Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])
Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])
Rosemarie T. Ring – San Francisco (+1 415-393-8247, [email protected])
Ashley Rogers – Dallas (+1 214-698-3316, [email protected])
Alexander H. Southwell – Co-Chair, PCDI Practice, New York (+1 212-351-3981, [email protected])
Deborah L. Stein – Los Angeles (+1 213-229-7164, [email protected])
Eric D. Vandevelde – Los Angeles (+1 213-229-7186, [email protected])
Benjamin B. Wagner – Palo Alto (+1 650-849-5395, [email protected])
Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, [email protected])
Debra Wong Yang – Los Angeles (+1 213-229-7472, [email protected])

Europe
Ahmed Baladi – Co-Chair, PCDI Practice, Paris (+33 (0) 1 56 43 13 00, [email protected])
James A. Cox – London (+44 (0) 20 7071 4250, [email protected])
Patrick Doris – London (+44 (0) 20 7071 4276, [email protected])
Kai Gesing – Munich (+49 89 189 33-180, [email protected])
Bernard Grinspan – Paris (+33 (0) 1 56 43 13 00, [email protected])
Joel Harrison – London (+44(0) 20 7071 4289, [email protected])
Vera Lukic – Paris (+33 (0) 1 56 43 13 00, [email protected])
Penny Madden – London (+44 (0) 20 7071 4226, [email protected])
Michael Walther – Munich (+49 89 189 33-180, [email protected])

Asia
Kelly Austin – Hong Kong (+852 2214 3788, [email protected])
Connell O’Neill – Hong Kong (+852 2214 3812, [email protected])
Jai S. Pathak – Singapore (+65 6507 3683, [email protected])

On January 5, 2023, the Federal Trade Commission (FTC) issued a Notice of Proposed Rulemaking (NPRM) to prohibit employers from entering non-compete clauses with workers.[1]  The proposed rule would extend to all workers, whether paid or unpaid, and would require companies to rescind existing non-compete agreements within 180 days of publication of the final rule.[2]  The FTC will soon publish the NPRM in the Federal Register, triggering a 60-day public comment period.‎[3]  The rule could be finalized by the end of the year; court challenges to the final rule are likely to follow.

The rule proposal follows recent FTC settlements with three companies and two individuals for allegedly illegal non-compete agreements imposed on workers – the first time the FTC has claimed that non-compete agreements constitute unfair methods of competition under Section 5 of the FTC Act.‎[4]

The Proposed Rule Would Broadly Ban Non-Compete Agreements

The proposed rule provides:

(a) Unfair methods of competition.  It is an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker; maintain with a worker a non-compete clause; or represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe that the worker is subject to an enforceable non-compete clause.‎[5]

The proposed rule broadly defines non-compete agreements as:  “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.”‎[6]  It proposes a functional test to determine if a clause is a non-compete provision:  to qualify, the provision would have “the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.”‎[7]  The proposed rule identifies two types of agreements that would constitute impermissible “non-competes”:

• A non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer; and
• A contractual term between an employer and a worker that requires the worker to pay the employer or a third-party entity for training costs if the worker’s employment terminates within a specified time period, where the required payment is not reasonably related to the costs the employer incurred for training the worker.‎[8]

While the proposed rule would not expressly prohibit non-disclosure and intellectual property agreements with employees, those agreements could be deemed impermissible non-competes if, pursuant to the provision excerpted above, they are deemed to be written “so broadly” that they “effectively preclude[ ] the worker from working in the same field.”‎[9]  Further, the term “worker” would be defined as “a natural person who works, whether paid or unpaid, for an employer,” but would not include a franchisee in a franchisee/franchisor relationship.‎[10]

Rescission Requirement, Safe Harbors, and Federal Preemption

The proposed rule would require employers to rescind all existing non-compete provisions within 180 days of publication of the final rule, and to provide current and former employees notice of the rescission.‎[11]  If employers comply with these two requirements, the rule would provide a safe harbor from enforcement.‎[12]‎  Further, the proposed rule would exempt from its scope certain non-competes entered in connection with the sale of businesses where “the seller of the business is a substantial owner of . . . the business at the time the person enters into the non-compete clause.”‎[13] For this exception to apply, “substantial owner” is defined as an “owner, member, or partner holding at least a 25% ownership interest in a business entity.”‎[14]  This exception also applies under California law, recognizing the need to protect the goodwill of a business.‎[15]

The proposed rule would preempt all state and local rules inconsistent with its provisions, but not preempt State laws or regulations that provide greater protections.‎[16]  As a practical matter, the proposed rule would override existing non-compete requirements and practices in the vast majority of states.

Concerned Parties Should Submit Public Comments

A sixty-day public comment period will begin once the FTC publishes the NPRM in the Federal Register.  After the notice-and-comment period concludes, the FTC will consider the comments and then publish a final version of the rule.  Enforcement may begin 180 days after publication of the final rule (although, as discussed below, the final rule is likely to be challenged in court).

The final rule’s terms will depend in part on the FTC’s response to comments submitted by interested parties during this notice-and-comment period, including legal and practical objections raised to the rule.  Thus, concerned parties are advised to submit robust comments thoroughly explaining their concerns, including potential costs and adverse effects.

Legal Challenges to the Rule Are Likely Once It Is Finalized

The proposed rule represents a significant expansion of the FTC’s regulatory reach in two respects:  First, the Commission had not previously held non-compete agreements to be unfair methods of competition under the Federal Trade Commission Act, until its recently-announced settlements.  Second, substantial doubt exists that the FTC possesses rulemaking authority in this area.‎[17]  As Gibson Dunn partners have explained and Commissioner Christine S. Wilson notes in her statement dissenting to the Notice of Proposed Rulemaking, any final rule is likely subject to several potentially significant legal challenges.  Commissioner Wilson notes three concerns:

1. Congress did not intend to grant authority to promulgate substantive competition rules under the FTC Act provisions on which the FTC purports to rely to promulgate the proposed rule.‎[18]

2. The rule may exceed the limits imposed by the Supreme Court’s major questions‎ doctrine.[19]

3. The rule may exceed the limits imposed by the Supreme Court’s non-delegation doctrine.‎[20]

Takeaways

This new proposed rule is part of a larger trend toward more vigorous federal regulation of the employment relationship, including by the FTC, National Labor Relations Board, and Department of Labor (DOL), as we have noted in previous Client Alerts addressing the FTC’s approach to no-poach and non-solicit agreements, the DOL’s rulemaking on who qualifies as an independent contractor under the FLSA, and the FTC’s broader vision of its authority to address unfair methods of competition under Section 5.

Gibson Dunn attorneys are closely monitoring these developments and available to discuss these issues as applied to your particular business or assist in preparing a public comment for submission on this proposed rule.

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[1] Non-Compete Clause Rulemaking, Fed. Trade Comm’n (Jan. 5, 2023). The Commission vote to publish the Notice of Proposed Rulemaking was 3-1 along party lines.  Chair Khan and Commissioners Slaughter and Bedoya released a joint statement.  See Joint Statement, Fed. Trade Comm’n (Jan. 5, 2023).  Commissioner Wilson dissented.  See Dissenting Statement of Commissioner Christine S. Wilson, Fed. Trade Comm’n (Jan. 5, 2023) (objecting because the proposed rule fails to consider factual context, the fact that “the need for fact-specific inquiry aligns with hundreds of years of precedent,” and the business justifications for such clauses).

[2] Notice of Proposed Rulemaking, Fed. Trade Comm’n (last visited Jan. 5, 2023) (outlining the text of the rule as will be published in the Federal Register at 16 CFR Part 910). Notably, prior FTC workshops on this subject focused on low-wage employees, but this proposed rule goes beyond that scope.  Workshops, Making Competition Work:  Promoting Competition in Labor Markets, Fed. Trade Comm’n (Dec. 6–7, 2021).

[3] Id. at 1.

[4] Press Release, FTC Cracks Down on Companies That Impose Harmful Noncompete Restrictions on Thousands of Workers, Fed. Trade Comm’n, (Jan. 4, 2023). See also Client Alert, FTC Announces Broader Vision of Its Section 5 Authority to Address Unfair Methods of Competition, Gibson, Dunn & Crutcher LLP (Nov. 14, 2022) (noting that “this development at a minimum adds uncertainty for businesses that heightens the need for vigilance in how they operate”).

[5] Notice of Proposed Rulemaking at 215 (§ 910.2(a)).

[6] Id. at 4.

[7] Id. at 214 (§ 910.1(b)(2)).

[8] Id. (§ 910.1(b)(2)(i)-(ii)).

[9] Id.

[10] Id. at 214–15 (§ 910.1(f)).

[11] Id. at 215–17 (§ 910.2(b)(1)-(2)).

[12] Id. at 217 (§ 910.2(b)(3)).

[13] Id. at 131 (§ 910.3). See also id. at 128–131 (explaining the scope of § 910.3).

[14] Id. at 131.

[15] Cal. Bus. & Prof. Code § 16601.

[16] Notice of Proposed Rulemaking at 217 (§ 910.4).

[17] See Svetlana Gans & Eugene Scalia, The FTC Heads for Legal Trouble, W.S.J. (Aug. 8, 2022) (Gibson Dunn partners explaining why “FTC regulation of employment noncompete agreements would run headlong into the major questions doctrine” and other issues with the FTC’s approach).

[18] Dissenting Statement of Commissioner Christine S. Wilson, Fed. Trade Comm’n, at 10–11 (Jan. 5, 2023) (discussing Sections 5 and 6(g) of the FTC Act and how the FTC’s authority should be interpreted in light of the Magnuson-Moss Act).

[19] Id. at 11–12 (discussing West Virginia v. EPA, 142 S. Ct. 2587 (2022) and its implications).

[20] Id. at 12–13, 12 n.61 (noting recent writing from most of the Supreme Court’s justices that would indicate a willingness to reconsider and broaden the scope of the Supreme Court’s non-delegation doctrine) (citing Gundy v. United States, 139 S. Ct. 2116, 2131 (2019) (Alito, J. concurring) (stating with respect to the nondelegation doctrine that “[i]f a majority of this Court were willing to reconsider the approach we have taken for the past 84 years, I would support that effort”); Gundy, 139 S. Ct. at 2131 (Gorsuch, J., dissenting, joined by Chief Justice Roberts and Justice Thomas) (expressing desire to “revisit” the Court’s approach to the nondelegation doctrine); Paul v. United States, 140 S. Ct. 342, 342 (2019) (statement of Kavanaugh, J, respecting the denial of certiorari); Amy Coney Barrett, Suspension and Delegation, 99 Cornell L. Rev. 251, 318 (2014)).

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The following Gibson Dunn lawyers prepared this client alert:  Rachel Brass, Svetlana Gans, Kristen Limarzi, Ilissa Samplin, Eugene Scalia, Katherine V. A. Smith, Stephen Weissman, Chris Wilson, Jamie France, and Connor Leydecker.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Administrative Law and Regulatory Group, Antitrust and Competition, Labor and Employment, and Trade Secrets practice groups, or the following practice leaders:

Administrative Law and Regulatory Group:
Eugene Scalia – Washington, D.C. (+1 202-955-8673, [email protected])
Helgi C. Walker – Washington, D.C. (+1 202-887-3599, [email protected])

Antitrust and Competition Group:
Rachel S. Brass – San Francisco (+1 415-393-8293, [email protected])
Kristen C. Limarzi – Washington, D.C. (+1 202-887-3518, [email protected])
Stephen Weissman – Washington, D.C. (+1 202-955-8678, [email protected])

Labor and Employment Group:
Jason C. Schwartz – Washington, D.C. (+1 202-955-8242, [email protected])
Katherine V.A. Smith – Los Angeles (+1 213-229-7107, [email protected])

Trade Secrets Group:
Harris M. Mufson – New York (+1 212-351-3805, [email protected])
Ilissa Samplin – Los Angeles (+1 213-229-7354, [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. Please note, prior results do not guarantee a similar outcome.

On December 29, 2022, the Integrity, Notification, and Fairness in Online Retail Marketplaces for Consumers Act (the “INFORM Consumers Act” or the “Act”) was signed into law as a last-minute addition to the Consolidated Appropriations Act of 2023, an omnibus bill that authorizes federal government spending for the upcoming year.[1]  The INFORM Consumers Act applies to online marketplaces – broadly defined to include “consumer-directed” platforms that “facilitate or enable third party sellers to engage in the sale, purchase, payment, storage shipping or delivery of a consumer product” – and requires them to collect, verify, and make available to buyers certain identification information for “high-volume third party sellers” on their platforms (i.e., sellers with more than 200 transactions and $5,000 in revenues in a 12 month period).  The Federal Trade Commission (“FTC”) is responsible for enforcing the INFORM Consumers Act, and state attorneys general are provided with the right to bring civil actions against online marketplaces whose noncompliance with the Act affects residents of their states.  Online marketplaces must implement policies, procedures, and controls to comply with the INFORM Consumers Act’s requirements by June 27, 2023, the date the requirements go into effect.

This alert summarizes the INFORM Consumers Act and discusses its new diligence and disclosure requirements, including the:

• Collection of seller identification and bank account information within ten days of the seller qualifying as a “high-volume third party seller,” verification of the information within ten days of receipt, and collection of seller certifications regarding the accuracy of the information at least annually;
• Maintenance of data security measures to protect seller information that the marketplace collects;
• Disclosure to buyers of identification information for sellers with $20,000 or more in annual revenue from marketplace sales;
• Suspension of seller accounts if requested information, certifications, or disclosures are not provided within ten days of a marketplace’s request; and
• Implementation of a reporting feature on product listing pages for high-volume third party sellers that allows for electronic and telephonic reports.

While some online marketplaces may already comply with some of these requirements, it is likely that many will need to implement new measures to avoid the substantial liability risks that the Act creates for non-compliance.  In particular, requirements to collect and verify bank account and identification information and to obtain annual certifications – and to suspend sellers who fail to comply within 10 days – may present a significant operational lift for online marketplaces.  Covered marketplaces may also need to update their platform agreements, including, for instance, Merchant and Seller Terms of Service, Privacy Policies, Payment Processer Terms, and Purchaser Terms to reflect new requirements under the Act.  Moreover, the Act’s information collection and verification requirements may increase practical risks for online marketplaces by potentially exposing them to red flags of unlawful seller or buyer conduct that may give rise to liability in other contexts.

Gibson Dunn has extensive experience advising online marketplaces and commerce platforms on a wide variety of regulatory, product and commercial counseling, and enforcement matters.  We stand ready to advise companies on compliance with the INFORM Consumers Act.

I. Background on the INFORM Consumers Act

In March 2021, Senators Dick Durbin (D-IL) and Bill Cassidy (R-LA) introduced the INFORM Consumers Act as a bipartisan bill intended “to combat the online sale of stolen, counterfeit, and dangerous consumer products by ensuring transparency of high-volume third party-sellers in online retail marketplaces.”[2]  In recent years, similar bills were also introduced in many states, and several of them have passed into law.  Various online marketplaces and other companies initially opposed the Senate bill based on concerns that it would have a disproportionate impact on individual and small-business sellers.  In October 2021, Rep. Jan Schakowsky (D-IL) and Rep. Gus Bilirakis (R-FL) introduced a new version of the INFORM Consumers Act in the House.[3]  In announcing the bill, Rep. Bilirakis said it would “provide a layer of enhanced protections for consumers from stolen and counterfeit goods without adding undue burdens on small mom-and-pop businesses.”[4]  This version of the INFORM Consumers Act, which is nearly identical to the enacted version, received broader support than the Senate version.  Although the information collection and disclosure requirements generally remained the same, new supporters of the Act welcomed the House version’s decreased burden on individual and small business sellers and anticipated preemption of state laws.

On December 19, 2022, the INFORM Consumers Act was added to the Consolidated Appropriations Act of 2023, which passed Congress on December 23, 2022, and was signed into law by President Biden on December 29, 2022.

II. The INFORM Consumers Act’s Scope

The INFORM Consumers Act applies to “online marketplaces” where third parties sell “consumer products.”  “Online marketplaces” is broadly defined to include any “consumer-directed” platform that—(A) includes features that allow for, facilitate, or enable third party sellers to engage in the sale, purchase, payment, storage, shipping, or delivery of a consumer product in the United States; (B) is used by one or more third party sellers for such purposes; and (C) has a contractual or similar relationship with consumers governing their use of the platform to purchase consumer products.”[5]

Online marketplaces must comply with the Act’s information collection and verification, data security, and reporting requirements for “high-volume third party sellers” on their platforms; whereas, the Act’s disclosure requirements apply only to a subset of those sellers with higher annual revenues.  “High-volume third party sellers” is defined as “third party sellers [that] in any continuous 12-month period during the previous 24 months, ha[ve] entered into 200 or more discrete sales or transactions of new or unused consumer products and an aggregate total of $5,000 or more in gross revenues.”[6]  The Act’s disclosure requirements apply only to high-volume third party sellers that have at least $20,000 in annual gross revenue through the marketplace.[7]

The INFORM Consumers Act adopts, by reference, the Magnuson-Moss Warranty Act’s (“Mag-Moss”) definition of “consumer products,” which is “any tangible personal property which is distributed in commerce and which is normally used for personal, family, or household purposes (including any such property intended to be attached to or installed in any real property without regard to whether it is so attached or installed).”[8]  Notably, this definition has been interpreted as applying only to physical, retail goods, and as not including digital goods or other intangible items, services, or goods purchased for a commercial purpose.

III. The INFORM Consumers Act’s Requirements

The INFORM Consumers Act requires online marketplaces to: (i) collect and verify bank account and identification information for high-volume third party sellers and obtain periodic certifications from those sellers regarding the accuracy of the information; (ii) ensure the disclosure of certain seller information to buyers; (iii) provide clear and conspicuous reporting mechanisms on product listing pages for high-volume third party sellers; and (iv) comply with data privacy and security requirements for information received pursuant to the Act.  Marketplaces are further required to suspend sales activity for sellers that do not provide the required information, certifications, or disclosures within ten days.

These requirements go into effect 180 days after the Act’s enactment – i.e. by June 27, 2023.[9]

The following sections detail each of the Act’s requirements and highlight considerations for implementing measures to comply with those requirements.

a. Diligence Requirements: Collection, Certification, and Verification of High-Volume Third Party Seller Information

i. Information Collection

The INFORM Consumers Act requires an online marketplace to collect:

• A seller’s name, email address, phone number, tax identification number, and banking account information within ten days of the seller meeting the transaction and revenue thresholds to qualify as a “high-volume third party seller.”[10]
• For entity sellers, marketplaces must also obtain either a copy of a valid government-issued identification for an individual acting on the seller’s behalf or a copy of a government-issued record or tax document that includes the business name and physical address of the seller.

The Act provides that the required bank account information may be collected either by the marketplace itself or by a “payment processor or other third party contracted by the online marketplace to maintain such information, provided that the online marketplace ensures that it can obtain such information within 3 business days . . . .”[11]  If a seller does not have a bank account, the Act permits marketplaces to instead collect the “name of the payee for payments issued by the online marketplace to such seller.”[12]  Although the Act requires the collection of bank account information, it does not include language limiting permissible payment methods that an online marketplace may accept.

Importantly, if a seller does not provide the required information within ten days of qualifying as a high-volume third party seller, the marketplace must suspend sales activity by the seller until the information is received.[13]

Although not as arduous, these collection requirements are similar, in some respects, to customer due diligence and know-your-customer requirements imposed on financial institutions under the Bank Secrecy Act (“BSA”), the anti-money laundering regulatory regime applicable to financial services entities.  Lessons learned from that regulatory regime might be informative as to what online marketplaces can expect in implementing these requirements and what factors may be considered in assessing compliance with the requirements.  As seen in the context of the BSA, such information collection requirements can prove quite challenging to implement, particularly to a high volume of existing relationships.  In addition, as discussed below, information collected to comply with these requirements could, in certain cases, create heightened liability risk for marketplaces to the extent that the information raises red flags that the seller may be engaged in, or facilitating, unlawful activities.

Although many marketplaces already have information collection procedures for their sellers, it is likely that the Act’s specific requirements will require changes or additions to processes for nearly all marketplaces.  Many marketplaces that already collect seller information, for example, rely on third party payment processors or other third parties to gather and store at least some of that information.  Although the Act allows marketplaces to rely on third parties for the collection and storage of bank account information, there is not similar language for the records and other information that marketplaces need to collect, suggesting that marketplaces may be expected to collect and store that information themselves.  In addition, marketplaces that would like to rely on payment processors or other third parties for the collection and storage of bank account information should consider whether existing or new agreements have sufficient provisions regarding the collection and prompt accessibility of that data, as required by the Act.  Marketplaces may also need to consider implementing measures to identify efforts by sellers to evade the collection thresholds by seeking to establish multiple seller accounts on the marketplace.

The requirement to collect bank account information from sellers may also require a variety of new processes and controls.  Many marketplaces allow their sellers to receive payments to non-bank online accounts or wallets.  Some marketplaces may not collect information about those accounts and may simply allow sellers to link the accounts via APIs.  Marketplaces may now need to request, either themselves or through a third party, bank account information for high-volume sellers.  Although there is an exception for sellers that “do not have a bank account,” it remains to be seen what level of validation a marketplace would need to engage in to establish that a seller does not have a bank account in order to rely on this exception.

Marketplaces must also consider how and when they will collect the required information for new sellers, as well as how they will upgrade collection and verification for existing sellers.

ii. Seller Certifications

The Act also requires that platforms “periodically, but not less than annually,” notify high-volume third party sellers of their need to update information provided to the marketplace if there are any changes and obtain electronic certifications from those sellers that the information on file is accurate and up-to-date.[14]  If a seller does not provide a certification within ten days of a request for one, the marketplace must suspend the seller’s sales activity pending receipt of a certification.[15]  This requirement could create substantial disruption on marketplaces if seller accounts are frequently suspended and reactivated.

iii. Information Verification

The INFORM Consumers Act requires marketplaces to “verify” information collected from sellers within ten days of receipt.  The Act defines “verify” as “to confirm information provided to an online marketplace pursuant to [the Act], which may include the use of one or more methods that enable the online marketplace to reliably determine that any information and documents provided are valid, corresponding to the seller or an individual acting on the seller’s behalf, not misappropriated, and not falsified.”[16]  There is a presumption of verification for information contained in a “copy of a valid government-issued tax document.”  By providing a presumption of verification, the Act may encourage the collection of those records, even when not required by the Act.  However, the Act does not include a similar presumption of verification for information contained in “government-issued identification,” which is a separate term used within the Act.

In the context of the BSA, which has similar requirements, there are a wide variety of methods that financial institutions use to verify identities, including, among others, running the information through third party identification verification solutions, using taxpayer identification matching tools, requesting copies of supporting records from the other party, and/or searching publicly available information.  It is possible that factors used to assess adequate identification verification under the BSA could be considered to assess compliance with the INFORM Consumers Act.

Notably, the Act provides that marketplaces must obtain a “working phone number” and “working email address” for high-volume sellers, which suggests that marketplaces may also be expected to verify the functionality and accuracy of that information.

As discussed below, these verification requirements could increase practical risks for online marketplaces by potentially exposing them to red flags or knowledge that they will need to act on to avoid liability in other contexts.

b. Disclosure Requirements: Make High-Volume Third Party Seller Information Available to Consumers

Per the Act’s disclosure requirements, marketplaces must require that sellers with $20,000 or more in annual gross revenue provide “clear and conspicuous” information to consumers either on the seller’s product listing pages or in order confirmations and the consumer’s transaction history, including: (i) seller name; (ii) seller’s physical address; (iii) “contact information for the seller, to allow for the direct, unhindered communication with high-volume third party sellers by users of the online marketplace, including…a current working phone number; [] a current working email address; or [] other means of direct electronic messaging (which may be provided to such seller by the online marketplace)…”; and (iv) whether a different seller was used to supply the product purchased, and if so, upon purchaser request, all of the information in (i), (ii), and (iii) for that sub-seller.  Marketplaces must also collect this information from these sellers.  There are limited exceptions to the disclosure requirements where a seller certifies that it has only a personal address and/or phone number.  Marketplaces must suspend sales activity for sellers that do not comply with these disclosure requirements within ten days of receiving notification of the requirement from a marketplace.  As with the Act’s other collection requirements, marketplaces will need to consider when and how to gather necessary information and any needed authorizations from sellers and sub-sellers to share the required information.

c. Mandatory Seller Account Suspensions

As noted above, the Act requires that sellers provide requested information and certifications and disclose required information within ten days of receiving such requests from an online marketplace.  If a seller does not comply within ten days, the marketplace must suspend the seller’s account from any further sales activity pending the seller’s compliance.

d. Reporting Mechanism Requirement for High-Volume Third Party Sellers

Under the Act, marketplaces also must incorporate a “clear and conspicuous” reporting mechanism on each product listing page for a high-volume third party seller.[17]  The mechanism must provide for both electronic and telephonic reports to the marketplace about “suspicious marketplace activity.”  Notably, information acquired through submitted reports may further increase risks under the other laws and regulations, as discussed below.  In response to this requirement, marketplaces should consider whether they have adequate and sufficient processes and resources to investigate and disposition these reports.  Marketplaces may also want to consider whether to implement or enhance policies regarding voluntary notifications to law enforcement upon learning about particularly high-risk conduct on their platforms.

e. Data Privacy and Security Requirements

The Act prohibits marketplaces from using information gathered “solely” to comply with its provisions for any other purpose than compliance with the Act, unless required by law, and it requires marketplaces to implement security measures to protect collected information.[18]  As to the latter, the Act provides that marketplaces “shall implement and maintain reasonable security procedures and practices, including administrative, physical, and technical safeguards, appropriate to the nature of the data and the purposes for which the data will be used, to protect the data collected to comply with the requirements of this section from unauthorized use, disclosure, access, destruction, or modification.”  Violations of this provision can be enforced in the same manner as those for the collection and disclosure of seller information.  This requirement may require significant cybersecurity and data-privacy assessment and enhancement efforts for many marketplaces, particularly those that have not previously collected or stored tax identification numbers, bank account information, or copies of government-issued records.

IV. Enforcement of the INFORM Consumers Act

The INFORM Consumers Act treats violations of its provisions “as a violation of a rule defining an unfair or deceptive act or practice prescribed under section 18(a)(1)(B) of the Federal Trade Commission Act (15 U.S.C. 57a(a)(1)(B)),” with the effect that violations will be subject to a statutory civil penalty of $46,517 per violation.[19]  Online marketplaces can expect that the government will seek to count each alleged failure to collect, verify, protect, or report required information as a violation of the Act, potentially giving rise to substantial civil penalty exposure.  Online marketplaces may also expect an increase in government investigations and potentially third party subpoenas for seller information as a result of the Act.

Because it is likely that the FTC will seek a civil penalty for most violations of the Act, the Act will add to the growing number of actions referred by the FTC to DOJ’s Consumer Protection Branch, which litigates civil penalty actions on behalf of the FTC.  The number of such actions has increased steadily over the last few years, especially following the Supreme Court’s decision in AMG Capital Management, LLC v. FTC.[20]  In addition to seeking civil penalties, the FTC may pursue injunctive relieve[21] and relief “to redress injury to consumers,” including the “rescission or reformation of contracts, the refund of money or return of property, the payment of damages, and public notification.”[22]

The FTC also has authorization to engage in certain types of rulemaking regarding the Act’s requirements.  In particular, the Act provides that “the [FTC] may promulgate regulations…with respect to the collection, verification, or disclosure of information under this [Act], provided that such regulations are limited to what is necessary to collect, verify, and disclose [required] information.”[23]

The INFORM Consumers Act further provides that any state attorney general may bring a civil action in district court against any marketplace where there is reason to believe the marketplace has violated or is violating any of the Act’s requirements and the violation affects one or more residents of that state.[24]  State civil actions may seek to enjoin further violations, enforce compliance with the Act, obtain civil penalties under the Act, obtain other remedies pursuant to state law, and obtain damages, restitution, or other compensation on behalf of the state’s residents.[25]  The FTC may intervene in any action brought by a state, and states may join an action filed by the FTC.[26]  Consequently, we may see more partnerships between the FTC and states seeking to enforce provisions of the Act.

While the INFORM Consumers Act preempts states from enacting or enforcing laws that “conflict[] with the requirements of [the Act],” it continues to allow states to enforce complementary laws, including those that may impose requirements in addition to the Act’s terms.  This may lead to a patchwork regulatory scheme.

V. Additional Enforcement Risks Created by the INFORM Consumers Act

In addition to imposing new compliance burdens and direct enforcement risks, the Act’s collection and verification requirements increase practical risks for online marketplaces by potentially exposing them to red flags or knowledge that they will need to act on to avoid liability in other contexts.

Marketplaces, for instance, could face criminal and civil liability under various consumer protection statutes if they are deemed to have knowingly sold or distributed unlawful drugs or other products based on information they learned about sellers through complying with the Act.  Indeed, regulators already are increasingly focused on online marketplaces for their alleged roles in the sale or distribution of products that are unlawful or used for unlawful purposes.  As FTC Chair Lina Khan recently explained, regulators are “looking upstream at the firms that are enabling and profiting from [unlawful] conduct.”[27]  Recent examples of this trend include agency warnings to, and litigation against, marketplaces for their alleged distribution of unlawful products.[28]  And the trend is largely driven by many of the same factors that motivated passage of the INFORM Consumers Act, including a proliferation of smaller, anonymized, and foreign sellers against whom enforcement actions often are impractical or ineffective.[29]

The Act also could increase marketplaces’ exposure under anti-money laundering statutes if they ignore red flags of transactions involving criminal activity identified through compliance with the Act’s verification requirements.  Generally, anti-money laundering statutes prohibit conducting, attempting to conduct, or otherwise facilitating a financial transaction with knowledge that the proceeds involved are the proceeds of “unlawful activity” if the government can prove that the proceeds were derived from a “specified unlawful activity.”[30]  “Unlawful activity” can be a violation of any federal, state, or foreign law that constitutes a felony; whereas, “specified unlawful activity” includes over 200 types of U.S. crimes and certain foreign crimes, including trafficking in counterfeit goods, sanctions offenses, fraud, and controlled substances offenses.  Courts have found that knowledge for purposes of establishing a money laundering offense can be based on willful blindness or conscious avoidance, which may arise where one turns a blind eye or deliberately avoids gaining positive knowledge when faced with a high likelihood of criminal activity, e.g., ignoring red flags.[31]  If online marketplaces obtain information that raises suspicions that a seller is engaged in criminal activity, there could, in certain circumstances, be increased risk of liability under the anti-money laundering criminal statutes, particularly when they do not conduct additional diligence to resolve those suspicions.

As a result, online marketplaces should thoughtfully approach the design and implementation of systems to comply with the Act’s requirements, including consideration of processes where potentially problematic information is learned about a seller.  Marketplaces should also consider sanctions screening for information received pursuant to the Act, and procedures for parsing false positive results from true matches – particularly given the policy goals leading to the Act.

___________________________

[1] Consolidated Appropriations Act of 2023, H.R. 2617, 117th Cong. Div. BB, Title III, § 301 (2022), https://www.govinfo.gov/content/pkg/BILLS-117hr2617enr/pdf/BILLS-117hr2617enr.pdf (“INFORM Consumers Act”).

[2] Press Release, Committee on the Judiciary, Durbin, Cassidy, Grassley, Hirono, Coons, Tillis Introduce Bill to Ensure Greater Transparency for Third-Party Sellers of Consumer Products Online (Mar. 23, 2021), https://www.judiciary.senate.gov/press/dem/releases/durbin-cassidy-grassley-hirono-coons-tillis-introduce-bill-to-ensure-greater-transparency-for-third-party-sellers-of-consumer-products-online; see also INFORM Consumers Act, S. 936, 117th Cong. (2021).

[3] INFORM Consumers Act, H.R. 5502, 117th Cong. (2021).

[4] Press Release, Congresswoman Jan Schakowsky, Schakowsky Introduces Bill To Protect Consumers Making Online Purchases, (Oct. 5, 2021), https://schakowsky.house.gov/media/press-releases/schakowsky-introduces-bill-protect-consumers-making-online-purchases.

[5] INFORM Consumers Act at (f)(4).

[6] Id. at (f)(3).

[7] The Act does not include a provision providing for automatic adjustments to these thresholds for inflation.

[8] 15 U.S.C. § 2301(1).

[9] INFORM Consumers Act at (f).

[10] Id. at (a).

[11][11] Id. at (a)(1)(A)(i)(II).

[12] Id. at (a)(1)(A)(i)(I).

[13] Id. at (a)(1)(A) and (a)(1)(C).

[14] Id. at (a)(1)(B).

[15] Id. at (a)(1)(C).

[16] Id. at (f)(7).

[17] Id. at (b)(3).

[18] Id. at (a)(3-4).

[19] Id. at (c)(1).

[20] 593 U.S. ___ (2021).

[21] See 15 U.S.C. § 53(b).

[22] 15 U.S.C. § 57b(b).

[23] INFORM Consumers Act at (c)(3).

[24] Id. at (d)(1).

[25] Id. at (h).

[26] Id. at (3).

[27] Oversight of the Enforcement of the Antitrust Laws, Hearing Before the Subcommittee on Antitrust, Competition Policy and Consumer Rights of the S. Comm. on the Judiciary, 117th Cong. (Sept. 20, 2022), https://content.mlex.com/Attachments/2022-12-20_O426MIOT4L28LWDK%2fP210100SenateAntitrustTestimony09202022+(1).pdf.

[28] See, e.g., FDA, Warning Letter – 631751 (Oct. 28, 2022), https://www.fda.gov/inspections-compliance-enforcement-and-criminal-investigations/warning-letters/amazoncom-inc-631751-10282022; FDA, Warning Letter – 631755 (Oct. 28, 2022), https://www.fda.gov/inspections-compliance-enforcement-and-criminal-investigations/warning-letters/walmart-inc-631755-10282022; Order on Motion to Dismiss and Motion for Summary Decision, In the Matter of Amazon, Inc., CPSC No. 21-2 (Jan. 19, 2022), https://www.cpsc.gov/s3fs-public/pdfs/recall/lawsuits/abc/027-Order-on-Motion-to-Dismiss-and-Motion-for-Summary-Judgement.pdf?VersionId=fgW05hge.c7FvPZZOijVWVapvJBQKudZ; Press Release, EPA, EPA Issues Order to eBay to Stop Selling 170 Unregistered, Misbranded Pesticides (June 17, 2021), https://www.epa.gov/newsreleases/epa-issues-order-ebay-stop-selling-170-unregistered-misbranded-pesticide.

[29] See, e.g., https://www.fda.gov/international-programs/global-perspective/fdas-top-cop-adapting-challenges-globalization-and-e-commerce.

[30] See 18 U.S.C. §§ 1956-57.

[31] See, e.g., U.S. v. Nektalov, 461 F.3d 309, 313-14 (2d Cir. 2006).

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The following Gibson Dunn lawyers prepared this client alert: Ryan Bergsieker, Ashlie Beringer, Gustav Eyler, Svetlana Gans, Roscoe Jones, Alexander H. Southwell, Ella Alves Capone, and Amanda Neely.

Gibson Dunn has extensive experience advising online marketplaces on a wide variety of enforcement, regulatory, and compliance matters, and we stand ready to help guide industry players through complex challenges posed by increased regulation, enforcement focus, and technical innovation impacting the space. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s  Privacy, Cybersecurity and Data Innovation, Anti-Money Laundering, FinTech and Digital Assets, Public Policy, and Administrative Law and Regulatory teams, or any of the following:

Ryan T. Bergsieker – Denver (+1 303-298-5774, [email protected])
Ashlie Beringer – Palo Alto (+1 650-849-5327, [email protected])
Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])
Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, [email protected])
Roscoe Jones, Jr. – Washington, D.C. (+1 202-887-3530, [email protected])
Alexander H. Southwell – New York (+1 212-351-3981, [email protected])
Ella Alves Capone – Washington, D.C. (+1 202-887-3511, [email protected])
Amanda H. Neely – Washington, D.C. (+1 202-777-9566, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP

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This edition of Gibson Dunn’s Federal Circuit Update summarizes a petition for certiorari granted by the Supreme Court concerning enablement under 35 U.S.C. § 112.  This Update also discusses recent Federal Circuit decisions concerning claim construction at the Patent Trial and Appeal Board, nonjoinder of a co-inventor under 35 U.S.C. § 102(f), and more Western District of Texas venue issues.

Federal Circuit News

Supreme Court:

The Supreme Court has granted certiorari in the following case:

Amgen Inc. v. Sanofi (U.S. No. 21-757):  The Federal Circuit affirmed the district court’s determination that the specification of the patent-at-issue did not enable preparation of the full scope of the claims without undue experimentation.  The Supreme Court granted certiorari on the following issue:  “Whether enablement is governed by the statutory requirement that the specification teach those skilled in the art to ‘make and use’ the claimed invention, 35 U.S.C. § 112, or whether it must instead enable those skilled in the art ‘to reach the full scope of claimed embodiments’ without undue experimentation—i.e., to cumulatively identify and make all or nearly all embodiments of the invention without substantial ‘time and effort.’”

Noteworthy Petitions for a Writ of Certiorari:

The Supreme Court is currently considering certiorari in a number of potentially impactful cases.

• Juno Therapeutics, Inc. v. Kite Pharma, Inc. (US No. 21-1566): “Is the adequacy of the ‘written description of the invention’ to be measured by the statutory standard of ‘in such full, clear, concise, and exact terms as to enable any person skilled in the art to make and use the same,’ or is it to be evaluated under the Federal Circuit’s test, which demands that the ‘written description of the invention’ demonstrate the inventor’s ‘possession’ of ‘the full scope of the claimed invention,’ including all ‘known and unknown’ variations of each component?”  This petition frames its question similar to the one presented in Amgen, except regarding written description instead of enablement.  It has been scheduled for the January 6, 2023 conference.

• Interactive Wearables, LLC v. Polar Electro Oy (US No. 21-1281) and Tropp v. Travel Sentry, Inc. (US No. 22-22) present questions regarding 35 U.S.C. § 101. Both petitions have been considered in conference by the Court.  The Court has called for the views of the Solicitor General in both cases.

• Apple Inc. v. Cal. Institute of Tech. (US No. 22-203) and Jump Rope Systems, LLC v. Coulter Ventures, LLC (US No. 22-298) present questions regarding estoppel effects of Patent Trial and Appeal Board (“Board”) institution and final written decisions. The Court requested a response in both cases; the briefing in Apple is complete, and the response in Jump Rope is due January 19, 2023.

Other Federal Circuit News:

In the past year, the Federal Circuit has welcomed two new judges:  Judge Tiffany P. Cunningham (who was most recently a partner at Perkins Coie LLP in Chicago) and Judge Leonard P. Stark (who was most recently a district court judge of the District of Delaware).

Federal Circuit Practice Update

On December 1, 2022, the Federal Circuit updated its Rules of Practice.  The update incorporates December 1, 2022 amendments to Federal Rules of Appellate Procedure 25 and 42, which do not impact the Federal Circuit’s local rules or procedures.

Upcoming Oral Argument Calendar

The list of upcoming arguments at the Federal Circuit is available on the court’s website.

Key Case Summaries (November–December 2022)

American National Manufacturing Inc. v. Sleep Number Corp., Nos. 21-1321, 21-1323, 21-1379, 21-1382 (Fed. Cir. Nov. 14, 2022):  American National Manufacturing Inc. filed two inter partes reviews (“IPRs”) against patents owned by Sleep Number Corp. related to adjusting pressure in an air bed.  After the IPRs were instituted, Sleep Number sought to amend the claims to make the claims more consistent and accurate in terminology and phrasing.  American National argued that the amendments were not proper because they were not for the purpose of overcoming the instituted ground.

The Federal Circuit (Stoll, J., joined by Schall and Cunningham, JJ.) affirmed, agreeing with the Board that the patent owner can amend the claims to correct perceived issues, and not just overcome the instituted grounds, so long as the amendment does not enlarge the scope of the claims or introduce new matter.  The petitioner is free to challenge the proposed amended claims on grounds beyond §§ 102 and 103, including § 112.

VLSI Technology LLC v. Intel Corp., Nos. 21-1826, 21-1827, 21-1828 (Fed. Cir. Nov. 15, 2022):  VLSI Technology LLC sued Intel Corp. for allegedly infringing a patent related to integrated circuits.  The district court construed the term “force region” to mean a “region within the integrated circuit in which forces are exerted on the interconnect structure when a die attach is performed.”  Intel filed an IPR, and proposed a construction of “force region” consistent with the construction that the district court adopted.  However, the Board uncovered a disagreement between the parties as to the meaning of “die attach,” and therefore, adopted its own construction.

The Federal Circuit (Bryson, J., joined by Chen and Hughes, JJ.) affirmed-in-part, reversed-in-part, and remanded for further proceedings.  VLSI argued that the Board failed to consider the district court’s claim construction as required under 37 C.F.R. § 42.100(b).  The Court disagreed, however, determining that while the Board did not specifically mention the district court’s claim construction in its Final Written Decision, it was extensively discussed in the parties’ briefing and oral argument.  Moreover, the Board recognized that the true dispute between the parties turned on interpretation of the term “die attach.”  Thus, it was proper for the Board to adopt its own construction rather than the parties’ purported agreed construction.

CUPP Computing AS v. Trend Micro Inc., Nos. 20-2262, 20-2263, 20-2264 (Fed. Cir. Nov. 16, 2022):  CUPP Computing AS appealed three IPR decisions by the Board, concluding that three patents were unpatentable as obvious.  The claims at issue involved a “mobile security system processor” that was “different than” the mobile devices processor.

The Federal Circuit (Dyk, J., joined by Taranto and Stark, JJ.) affirmed the Board’s obviousness finding as adequately explained.  CUPP argued that the Board erred by rejecting its disclaimer arguments during the IPRs.  The Federal Circuit disagreed with CUPP, holding that:  “[t]he Board is not required to accept a patent owner’s arguments as disclaimer when deciding the merits of those arguments.”  In other words, disclaimers in an IPR proceeding are not binding on the Patent Office in the proceeding in which they are made; otherwise, the patent owner could freely modify their claims via argument in an IPR.

Treehouse Avatar LLC v. Valve Corp., No. 22-1171 (Fed. Cir. Nov. 30, 2022): Treehouse Avatar LLC sued Valve Corp. accusing two video games (Dota 2 and Team Fortress 2) of infringing its patent.  The parties adopted the Board’s construction of “character-enabled network sites” from a previous IPR.  However, Treehouse’s infringement expert submitted a report that applied the plain and ordinary meaning for “character-enabled network sites.”  The district court subsequently granted Valve’s motion to strike portions of the infringement expert report that applied the plain and ordinary meaning instead of the parties’ agreed-upon construction.

The Federal Circuit (Reyna, J., joined by Lourie and Stoll, JJ.) affirmed.  The Court held that it was not an abuse of discretion for the district court to strike portions of the infringement expert report that did not rely on the agreed-upon construction.  Even though Treehouse argued that the expert witness relied on a construction that was not materially different from the agreed-upon construction, the Court held that any expert theory relying on a different construction is “suspect.”

Plastipak Packaging, Inc. v. Premium Waters, Inc., No. 21-2244 (Fed. Cir. Dec. 19, 2022): Plastipak Packaging, Inc. sued Premium Waters, Inc. for alleged infringement of two groups of patents directed to plastic bottles.  The district court granted summary judgment to Premium Waters, concluding that all asserted patents were invalid for nonjoinder of a co-inventor (Falzoni) under 35 U.S.C. § 102(f).

The Federal Circuit (Stark, J., joined by Newman and Stoll, JJ.) reversed and remanded.  The Court held that, for both groups of patents, summary judgment was improper because there was a genuine dispute of material fact as to whether Falzoni had sufficiently contributed to the claimed inventions.  The Court determined that Premium Waters presented sufficient evidence that “a reasonable fact-finder may find clear and convincing evidence that Falzoni was a joint inventor.”  However, nothing required that conclusion making summary judgment improper.

Genentech, Inc. v. Sandoz Inc., No. 22-1595 (Fed. Cir. Dec. 22, 2022):  Genentech, Inc. sued Sandoz, Inc., who had submitted two Abbreviated New Drug Applications (“ANDAs”) on a generic version of pirfenidone, asserting that Sandoz’s generic product would induce the infringement of two sets of Genentech’s patents.  The first set of patents (“LFT patents”) claim methods for managing certain side effects when using pirfenidone, which is a drug used to treat idiopathic pulmonary fibrosis (“IPF”).  The second set of patents (“DDI patents”) are directed to methods for avoiding adverse interactions between pirfenidone and fluvoxamine, which is a drug that may inhibit the ability of certain enzymes from metabolizing drugs such as pirfenidone.  The district court determined that the LFT patents would have been obvious over prior art and standard medical practice disclosed in the prior art, and that the DDI patents were not infringed.

The majority (Lourie, J., joined by Prost, J.) affirmed.  The majority agreed that the LFT patents would have been obvious over the prior art and standard medical practices, because the claims “do not represent the invention of a new drug, nor do they recite a novel application of an existing drug.”  Instead, the claims “recite adjusting doses in the presence of side effects,” which the majority reasoned “clinicians routinely do.”  Turning to the DDI patents, the majority determined that the district court did not clearly err in “considering all the evidence, including Sandoz’s proposed label and physician practice” in finding no infringement.  Physicians had testified that in practice they had never prescribed pirfenidone to an IPF patient taking fluvoxamine.  But if they found themselves in that position, they would have chosen a noninfringing response—prescribing nintedanib (another drug that treats IPF) instead.

Judge Newman dissented without opinion.

Venue in the Western District of Texas:

In re Apple Inc. (Fed. Cir. No. 22-162): The Federal Circuit (Reyna, J., joined by Dyk, J. and Taranto, J.) granted Apple’s petition, directing the district court to vacate a scheduling order that would require the parties to complete fact discovery and re-briefing of Apple’s motion to transfer venue.  Under the district court’s scheduling order, by the time the district court considered Apple’s motion to transfer, the motion would have been pending for a year.  The Court explained that consideration of venue motions should be prioritized and requiring the extra effort by the parties would lead to unnecessary expenditure of resources by the parties, the transferring court, and the potential transferee court.

In re Cloudfare, Inc. (Fed. Cir. No. 22-167):  The panel (Reyna, J., joined by Dyk and Taranto, JJ.) denied Cloudfare’s petition, holding no clear abuse of discretion in denying Cloudfare’s motion to transfer.  The Court determined that Cloudfare’s declarant “lacked credibility and admitted to not investigating facts relevant to Cloudfare’s Austin office.”  The Court also determined that the district court had found that Cloudfare’s “employees [in the Western District of Texas] helped research, design, develop, implement, test, and market the accused products,” and the Western District of Texas “had a localized interest and would be convenient for potential sources of proof and party witnesses.”  The Court was not prepared to disturb these findings.

In re Amazon.com, Inc. (Fed. Cir. No. 22-157):  The panel (Hughes, Wallach, and Stoll, JJ.) granted Amazon.com, Inc.’s petition, holding that the district court abused its discretion by denying Amazon’s motion to sever and motion to transfer.  Flygrip Inc. sued Amazon alleging infringement of device cases manufactured by PopSockets LLC and Otter Products LLC.  The panel determined that the district court erred because (1) the addition of Coghlan Family Enterprises LLC (CFE), a small local business based in the Western District of Texas, after Amazon filed its motion to transfer to be “suspect,” (2) the claims against CFE were peripheral to the claims against Amazon, and (3) the transfer factors weigh heavily in favor of transferring to the District of Colorado, where PopSockets and Otter were headquartered and had filed a declaratory judgment of noninfringement.

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Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Federal Circuit.  Please contact the Gibson Dunn lawyer with whom you usually work or the authors of this update:

Blaine H. Evanson – Orange County (+1 949-451-3805, [email protected])
Audrey Yang – Dallas (+1 214-698-3215, [email protected])

Please also feel free to contact any of the following practice group co-chairs or any member of the firm’s Appellate and Constitutional Law or Intellectual Property practice groups:

Appellate and Constitutional Law Group:
Thomas H. Dupree Jr. – Washington, D.C. (+1 202-955-8547, [email protected])
Allyson N. Ho – Dallas (+1 214-698-3233, [email protected])
Julian W. Poon – Los Angeles (+ 213-229-7758, jpoon@gibsondunn.com)

Intellectual Property Group:
Kate Dominguez – New York (+1 212-351-2338, [email protected])
Y. Ernest Hsin – San Francisco (+1 415-393-8224, [email protected])
Josh Krevitt – New York (+1 212-351-4000, [email protected])
Jane M. Love, Ph.D. – New York (+1 212-351-3922, [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.

On December 29, 2022, the IRS and Treasury issued (1) proposed regulations for determining whether a real estate investment trust (a “REIT”) or registered investment company (a “RIC”) qualifies as a “domestically controlled qualified investment entity” (the “Proposed QIE Regulations”); (2) proposed regulations revising the definition of a “controlled commercial entity” for purposes of section 892[1] (the “Proposed Section 892 Regulations”); and (3) final regulations relating to qualified foreign pension funds (“QFPFs” and the “Final QFPF Regulations”) and their exemption from the application of FIRPTA (as defined below).

Proposed QIE Regulations

Background

Subject to certain exceptions discussed below, section 897 and related sections added to the Code by the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) require foreign persons who recognize gain from the sale or disposition of United States real property interests (“USRPIs”) to file U.S. federal income tax returns reporting those gains and pay U.S. federal income tax on those gains at regular graduated rates, even if the gains are not otherwise effectively connected with the conduct of a U.S. trade or business.

The definition of USRPIs is broad.  In addition to including a wide range of interests in U.S. real estate (defined broadly), USRPIs include equity interests in domestic corporations that are United States real property holding corporations (“USRPHCs”) and interests in disregarded entities and certain partnerships that own U.S. real estate.  Generally, a USRPHC is any corporation, including a REIT, if the value of its USRPIs represents at least 50 percent of the aggregate value of its real estate (both U.S. and non-U.S.) and business assets.

Domestically Controlled REIT Exception

Notwithstanding that equity interests in domestic USRPHCs generally are treated as USRPIs, section 897(h)(2) provides that an interest in a domestically controlled qualified investment entity (a “QIE”) is not a USRPI.  A QIE is a REIT or RIC (i.e., mutual fund) that is a USRPHC.[2]  Under section 897(h)(4), a QIE is domestically controlled if less than 50 percent of the value of its stock is held “directly or indirectly” by “foreign persons” at all times during the shorter of (1) the 5-year period ending on the relevant determination date or (2) the period during which the QIE was in existence (the “Testing Period”).  Under these rules, gain recognized by a foreign person on the disposition of an interest in a domestically controlled REIT (a “DREIT”) is not subject to U.S. federal income tax under FIRPTA, even if the DREIT is a USRPHC.

Foreign persons often seek to invest in U.S. real estate through DREITs because, in these structures, foreign persons can exit the investment via a sale of DREIT stock without being subject to U.S. tax on the gain or being required to file a U.S. tax return.

In the 2015 PATH Act,[3] Congress added section 897(h)(4)(E) to the Code, which treats QIE stock held by another, publicly traded, QIE as held by a foreign person unless that publicly traded QIE is domestically controlled, in which case the QIE stock is treated as held by a U.S. person.  Section 897(h)(4)(E) also provides an express look through-rule for QIE stock owned by another, private QIE.  Apart from these narrow exceptions, section 897 does not otherwise clarify when QIE stock owned by one person should be treated as owned “indirectly” by another person for purposes of determining DREIT status.[4]

Notwithstanding the lack of guidance, it is our experience that many taxpayers generally look through domestic partnerships for purposes of determining DREIT status and treat the partners of the domestic partnership as indirectly owning the QIE stock owned by the domestic partnership. In contrast, it is our experience that many taxpayers treat stock of a QIE held by a domestic C corporation as held by the domestic C corporation (and not indirectly by its shareholders) for purposes of determining DREIT status, in part because, unlike a domestic partnership or a REIT, a domestic C corporation is fully subject to U.S. taxation on any gain from disposition of its REIT stock.

This view is consistent with Treasury’s previous guidance on the subject.  Existing regulations provide that, for purposes of determining DREIT status, the actual owners of stock, as determined under Treas. Reg. § 1.857-8, must be taken into account.[5]  Treas. Reg. § 1.857-8(b) provides that the actual owner of stock of a REIT is the person who is required to include the dividends received on the stock in gross income, and that such person generally is the shareholder of record of the REIT.  Although this language suggests that a domestic partnership that owns REIT stock should be treated as the actual owner of the stock, as discussed above most practitioners have been unwilling to take this position, partly on the basis that the partnership’s partners would also be required to take into account their distributive shares of the REIT dividends on their returns.[6]  However, in the case of a domestic C corporation, only the C corporation would take into account the REIT dividends on its return and pay taxes on those dividends.  Relying in part on these regulations, in a 2009 private letter ruling (PLR 200923001), the IRS ruled that REIT stock owned by a foreign person through a domestic C corporation is to be treated as owned by the domestic C corporation, and not as owned “indirectly” by the foreign person, to determine DREIT status.

Proposed QIE Regulations Treat Certain Foreign-Owned Domestic C Corporations as Transparent

The Proposed QIE Regulations depart from the guidance discussed above in significant respects.  The Proposed QIE Regulations provide a broad look-through rule for purposes of determining DREIT status that applies to various types of pass-through entities, including  REITs, partnerships (whether U.S. or non-U.S., other than publicly traded partnerships), S corporations, and RICs, to determine DREIT status (the “Look-Through Rule”).[7]  The Look-Through Rule is implemented by imputing QIE stock to owners of entities that are “look-through persons” on a pro rata basis based on the owners’ proportionate interests in the look-through person.[8]

Surprisingly, the Proposed QIE Regulations further extend the Look-Through Rule to “foreign-owned domestic C corporations.”  A “foreign-owned domestic C corporation” is defined as any non-publicly traded domestic C corporation if foreign persons hold directly or indirectly 25 percent or more of the value of its outstanding stock, after applying look-through rules analogous to the ones that apply to QIEs.[9]

For instance, assume that 51 percent of the stock of a REIT is owned by a non-publicly traded domestic C corporation and that the remaining 49 percent is owned by foreign individuals.  The stock of the non-publicly traded domestic C corporation is owned as follows: 20 percent by a foreign corporation, 5 percent by a foreign individual, and 75 percent by U.S. persons.  In this case, the non-publicly traded domestic C corporation is a “foreign-owned domestic C corporation” because 25 percent of its stock is owned by a foreign corporation or foreign individuals.  One must therefore look through this domestic corporation to its shareholders.  Under these facts, the REIT would not be a DREIT because 61.75 percent of its stock would be treated as owned by foreign persons (10.2 percent by the foreign corporation through the domestic corporation, plus 2.55 percent by the foreign individual through the domestic corporation, plus 49 percent directly by foreign persons).[10]

The preamble to the Proposed QIE Regulations does not mention the contrary view taken by the IRS in the 2009 private letter ruling.[11]  The preamble does acknowledge the existing regulations, which provide that the actual owners of a REIT’s stock, as determined under Treas. Reg. § 1.857-8, must be taken into account to determine DREIT status.  But the preamble explains that, in the government’s view, reliance on those regulations for purposes of determining DREIT status is misplaced because “the determination of actual ownership pursuant to §1.857-8 is only intended to ensure the beneficial owner of stock is taken into account when different from the shareholder of record, and §1.897-1(c)(2)(i) does not state or otherwise suggest that the actual owners of QIE stock as determined under §1.857-8 are the only relevant persons for determining whether a QIE is domestically controlled or provide any guidance on the meaning of ‘held directly or indirectly by foreign persons.’”  In support of that view, the preamble describes an example where foreign persons own REIT stock through a domestic partnership.  The preamble explains that looking through the domestic partnership is necessary because otherwise, foreign persons could “dispose of USRPIs held indirectly through certain intermediate entities, such as domestic partnerships, to avoid taxation under section 897(a).”

As discussed above, many taxpayers were already looking through domestic partnerships in determining DREIT status.  But the example in the preamble is not analogous to a situation where foreign persons own REIT stock through a domestic C corporation that would be subject to tax on a disposition of DREIT shares.  Accordingly the preamble’s reasoning is less persuasive in this context.  Moreover, even if the reference to the “actual owner” of REIT shares in Treas. Reg. § 1.857-8 is merely intended to ensure that beneficial ownership is taken into account where the shareholder of record is not the beneficial owner, and is not meant to imply that the “actual owner” is the sole owner to take into account to determine DREIT status, there is no suggestion in the existing and long-standing regulations regarding DREITs, or anywhere else in the FIRPTA or REIT rules, that one must look through a domestic C corporation that is the beneficial owner of REIT shares.

Further, given that the phrase “directly or indirectly,” has many different meanings under the Code depending on the context, and that Congress declined to explicitly require looking through domestic C corporations despite requiring looking through non-public QIEs, it is far from clear that the preamble’s interpretation is consistent with Congressional intent.

The preamble also does not explain the significance, in the absence of any statutory guidance, of the 25 percent foreign ownership threshold for applying the Look-Through Rule to domestic C corporations.

As discussed above, the Look-Through Rule also applies to foreign partnerships and makes these partnerships “look-through persons.”  Before the release of the Proposed QIE Regulations, many practitioners had been unwilling to look through a foreign partnership to determine DREIT status.  Thus, in this context, the Look-Through Rule provides a welcome clarification for taxpayers.

Proposed QIE Regulations Also Clarify Status of QFPFs

The Proposed QIE Regulations also provide that a QFPF or a QCE (as defined below) will always be treated as a foreign person for purposes of determining DREIT status.  This clarification was in response to a suggestion by some commentators that, because a QFPF or QCE is not treated as a “nonresident alien individual or a foreign corporation” for purposes of being subject to U.S. tax under FIRPTA, it also should not be treated as a foreign person for DREIT purposes.

Effective Date

The Proposed QIE Regulations apply to dispositions of interests in QIEs that occur after the date on which the Proposed QIE Regulations are finalized.  However, the preamble indicates that “the IRS may challenge positions” taken by taxpayers that are contrary to the Proposed QIE Regulations prior to the regulations’ being finalized.

Taxpayers may have limited flexibility to seek to restructure investments to reflect the Proposed QIE Regulations.  The Testing Period for determining DREIT status extends up to 5 years before the relevant determination date, so if an investor were seeking to sell an interest in a DREIT after the regulations are finalized, the investor would need to prove DREIT status using the finalized regulations for the 5 years prior to the date of sale.

Further Takeaways

In light of the issuance of the Proposed QIE Regulations, sponsors of, and investors in, REITs intended to qualify as DREITs should reevaluate whether those REITs would qualify as DREITs under the proposed regulations.  Sponsors should also review the information, representations, and covenants that they request from investors in order to determine whether a REIT will qualify as a DREIT.  In that regard, REIT sponsors should also consider any obligations they may have to cause a REIT to qualify as a DREIT.

Any foreign investors who invested in a REIT assuming that it was a DREIT should re-examine their investment to determine whether their assumptions continue to be valid and whether restructuring is advisable before the date that the Proposed QIE Regulations become effective.

Proposed Section 892 Regulations

Background

Section 892(a)(1) exempts from U.S. federal taxation certain income derived by a foreign government.  However, this exemption does not apply to income that is (1) derived from the conduct of a commercial activity, (2) received by or from a controlled commercial entity of the foreign government, or (3) derived from the disposition of an interest in a controlled commercial entity of the foreign government.

Generally, a controlled commercial entity is an entity that is controlled by the foreign government and is engaged in commercial activities.  Under Temp. Treas. Reg. § 1.892-5T(b)(1), a USRPHC (whether a foreign or domestic corporation) is treated as engaged in commercial activity regardless of its actual activities, and, therefore, any USRPHC that is controlled by a foreign government is treated as a controlled commercial entity.  As a result, under the current regulations, an entity controlled by a foreign government is treated as a controlled commercial entity if 50 percent or more of its assets consist of USRPIs, including interests in USRPHCs.  This aspect of the current regulations can be a trap for the unwary and requires foreign governments that seek section 892 benefits for the entities they control to carefully monitor the value of the USRPIs those entities own.

Proposed Section 892 Regulations Relax the “Per Se” Rule for USRPHCs

The proposed regulations would modify current Temp. Treas. Reg. § 1.892-5T(b)(1).  Under the Proposed Section 892 Regulations, the per se rule that treats a USRPHC as being engaged in commercial activity would be modified to include an exception for any corporation that is a USRPHC solely by reason of its direct or indirect ownership in one or more other corporations not controlled by the relevant foreign government.  As a result, the Proposed Section 892 Regulations would prevent entities from being treated as controlled commercial entities solely because they are USRPHCs as a result of their ownership of minority interests in other USRPHCs.

Prop. Treas. Reg. § 1.892-5(b)(1) also would exempt foreign USRPHCs that are QFPFs or are wholly owned by one or more QFPFs from being treated as engaged in commercial activity solely as a result of their USRPHC status.

The Proposed Section 892 Regulations are proposed to apply to taxable years ending on or after December 29, 2022.  Taxpayers may rely on the Proposed Section 892 Regulations until they are finalized.

Additional Notice on Section 892 Regulations

In addition to releasing the Proposed Section 892 Regulations, the IRS and Treasury published a notice on December 29, 2022 stating that they are considering finalizing regulations proposed under section 892 in 2011 that provide additional guidance on what constitutes commercial activities.  Treasury and the IRS are accordingly reopening the comment period with respect to the 2011 proposed regulations through February 27, 2023.[12]

Final QFPF Regulations

Background

Under section 897(l), QFPFs and their wholly owned subsidiaries are exempt from having to file U.S. federal income tax returns and pay U.S. federal income tax on gain attributable to the disposition of USRPIs, unless that gain is otherwise effectively connected with the conduct of a U.S. trade or business.

In 2019, the IRS and Treasury published proposed regulations containing rules relating to the qualification for the exemption under section 897(l), as well as rules relating to withholding requirements under sections 1441, 1445, and 1446 for dispositions of USRPIs by QFPFs (the “2019 Proposed Regulations”).  The Final QFPF Regulations finalize these 2019 Proposed Regulations with certain changes, some of which are discussed below.

A QCE Must Be a Wholly Owned Subsidiary of a QFPF

The 2019 Proposed Regulations had provided that gain or loss from the disposition of a USRPI by a “qualified holder” is not subject to tax under FIRPTA.  A “qualified holder” is either a QFPF or a qualified controlled entity (“QCE”) that, in each case, satisfies the “qualified holder” rules under Treas. Reg. § 1.897(l)-1(d).  A “QCE” is defined as a trust or corporation that is organized under the laws of a foreign country and all of the interests of which are held directly or indirectly by one or more QFPFs.  The 2019 Proposed Regulations would have required that all of the interests in a QCE be held, directly or indirectly, by one or more QFPFs, with no exceptions.  Commentators had suggested that Treasury include certain de minimis exceptions to this strict requirement, for example an exception for small ownership interests awarded to management of the QCE.

In promulgating the Final QFPF Regulations, the IRS and Treasury rejected those comments.  Accordingly, the Final QFPF Regulations require that, for a trust or corporation to qualify as a QCE, all of the interests in the QCE must be held, directly or indirectly, by one or more QFPFs.  For this purpose, an “interest” is defined as an interest other than an interest solely as a creditor and includes (but is not limited to) stock of a corporation, an interest in a partnership as a partner, an interest in a trust or estate as a beneficiary, and certain option instruments.  The IRS and Treasury declined to provide express guidance as to whether a non-economic interest[13] held by a non-QFPF in an entity that otherwise qualifies as a QCE would cause that entity not to qualify as a QCE.  Instead, in the preamble to the Final QFPF Regulations, the IRS and Treasury indicated that the determination as to whether such a non-economic interest would be an interest in the entity (and thus render that entity a non-QCE) would be made on the facts and circumstances, taking into account general tax principles.

Testing for Qualified Holder Status

Under the Final QFPF Regulations, a QFPF or a QCE must satisfy one of two tests on the relevant determination date to be a qualified holder.  Under the first test, a QFPF or a QCE is a qualified holder if it owned no USRPIs as of the date it became a QFPF or QCE and has remained qualified as a QFPF or QCE since then.  Under the second test, if a QFPF or a QCE held USRPIs when it became a QFPF or QCE, it is a qualified holder if it was a QFPF or QCE during the entire “testing period” applicable to the entity.  This testing period is the shortest of (i) the period beginning on December 18, 2015 and ending on the determination date, (ii) the ten-year period ending on the determination date, and (iii) the period beginning on the date the entity (or its predecessor) was created or organized and ending of the determination date.  Although the Final QFPF Regulations reformulated the description of this test, these requirements generally are substantively unchanged from the 2019 Proposed Regulations.

The Final QFPF Regulations provide a limited transition period safe harbor for determining whether a QFPF or a QCE is a qualified holder: with respect to any period from December 18, 2015 to December 29, 2022 (for a QFPF) or to June 6, 2019 (for a QCE), the QFPF or QCE is deemed to be a qualified holder if the QFPF or QCE satisfies the requirements under section 897(l)(2) (which generally defines and describes a QFPF) based on a reasonable interpretation of those requirements.  The Final QFPF Regulations further provide that, in determining whether a QCE is a qualified holder from December 18, 2015 to February 27, 2023,[14] a QCE is permitted to disregard a 5 percent or smaller interest owned by any person that provides services to the QCE.  This safe harbor does not apply to disregard a 5 percent or smaller interest in the QCE at the time the QCE disposes of a USRPI; instead, the safe harbor only provides that an entity that otherwise would have failed to qualify as a QCE (and therefore as a qualified holder) during the transition period as a result of a 5 percent or smaller interest owned by a service provider will not be treated as having failed to qualify as a QCE if that owner is divested from its ownership in such entity no later than February 27, 2023.  Accordingly, QCEs that have de minimis service provider ownership should consider causing those service providers to dispose of their interests in the QCE before February 27, 2023 and not disposing of any USRPIs in the interim.

Treatment of Eligible Fund as a QFPF

In general, a trust, corporation, or other organization or arrangement that maintains segregated accounts for retirement or pension benefits to participants or certain other beneficiaries (such as current or former employees) is treated as a QFPF (and, therefore, an “eligible fund”) if both (i) all of the benefits that the entity provides are qualified benefits for qualified participants (the “100 percent threshold”) and (ii) at least 85 percent of the present value of the benefits that the eligible fund reasonably expects to provide in the future are retirement or pension benefits (the “85 percent threshold”).

The 2019 Proposed Regulations would have required that an eligible fund must measure the present value of benefits to be provided during each year of the entire period during which the fund is expected to be in existence.  The Final QFPF Regulations retain this requirement but add a taxpayer-friendly alternative 48-month test as another means to meet the 85-percent threshold.  The 48-month alternative calculation test is satisfied if the weighted average of the present values of the retirement and pension benefits that the eligible fund reasonably expects to provide over its life, as determined by the valuations performed over the 48 months preceding (and including) the most recent present valuation, satisfies the 85-percent threshold.  If an eligible fund has been in existence for fewer than 48 months, the 48-month alternative calculation is applied to the period the eligible fund has been in existence.

Withholding Related to Qualified Holders

The Final QFPF Regulations provide that a foreign partnership that is owned solely by qualified holders is not treated as a foreign person for purposes of withholding under section 1445 and, to the extent applicable under FIRPTA, section 1446 (such a foreign partnership, a “withholding qualified holder”).  In addition, even if a qualified holder is a partner in a foreign partnership that is not a withholding qualified holder (because the partnership has partners that are not qualified holders), the qualified holder is still eligible for exemption from taxation on its distributive share of USRPI items.

A withholding qualified holder may submit a certification of non-foreign status to establish withholding qualified holder status.  This certificate must state that the transferor is not a foreign person because it is a withholding qualified holder, and the transferor may provide its foreign taxpayer identification number if it does not have a U.S. taxpayer identification number.  The preamble to the Final QFPF Regulations clarifies that, once a revised IRS Form W-8EXP is released, this revised IRS Form W-8EXP can be used to make this certification by a withholding qualified holder.

Effective Dates

The Final QFPF Regulations generally apply with respect to dispositions of USRPIs occurring on or after December 29, 2022, although certain provisions (including the qualified holder rule) apply as of June 7, 2019 (the date the 2019 Proposed Regulations were published).  An eligible fund may choose to apply the Final QFPF Regulations with respect to dispositions and distributions occurring on or after December 18, 2015 and before the effective date of the Final QFPF Regulations, if the eligible fund and all persons bearing a relationship to the eligible fund described in section 267(b) or 707(b) consistently apply all of the rules in the Final QFPF Regulations for all relevant years.

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[1] Unless indicated otherwise, all “section” references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all “Treas. Reg. §” references are to the Treasury regulations promulgated under the Code.

[2] Even though the rules discussed below apply to both REITs and RICs, our discussion focuses on REITs and DREITs given that foreign persons are more likely to invest in U.S. real estate through REITs than RICs.

[3] Protecting Americans from Tax Hikes Act of 2015, § 133, Pub. L. No. 114-113 (Dec. 18, 2015).

[4] The expression “directly or indirectly,” used to qualify ownership, is used throughout the Code and the regulations with a variety of intended meanings in different contexts.  For example, in subpart F (sections 951-965), “indirectly” does not imply ownership by attribution but rather beneficial ownership. Likewise, sections 318, 544, 881, and 883 provide for attribution rules that apply to stock held “directly or indirectly” by or for a person but, because those sections contain specific attribution provisions, the implication is that “indirect” ownership does not include ownership by attribution other than as a result of the specific attribution rules.  By contrast, under section 447(d)(2)(B) (before repeal in 2017), “indirect” ownership was interpreted to include ownership by attribution, even absent specific attribution rules.

[5] Treas. Reg. § 1.897-1(c)(2)(i).

[6] See § 702(a)(5); Treas. Reg. § 1.702-1(a)(5).

[7] Prop. Treas. Reg. § 1.897-1(c)(3)(ii)(B); Prop. Treas. Reg. § 1.897-1(c)(3)(v)(D).  Note that the Look-Through Rule does not override the 2015 look-through rule for QIEs previously mentioned.

[8] Prop. Treas. Reg. § 1.897-1(c)(3)(ii)(B).

[9] Prop. Treas. Reg. § 1.897-1(c)(3)(v)(D); Prop. Treas. Reg. § 1.897-1(c)(3)(v)(B).

[10] Prop. Treas. Reg. § 1.897-1(c)(3)(vi)(B), Ex. 2.

[11] The IRS and Treasury sometimes acknowledge contrary private letter rulings when issuing regulations. See, e.g., T.D. 9932 (regarding final regulations under section 162(m)), fn. 12 (Dec. 30, 2020) (acknowledging a conflicting private letter ruling).

[12] See 87 FR 80108 (Dec. 29, 2022) (The IRS Notice may be found here: https://www.federalregister.gov/documents/2022/12/29/2022-27969/income-of-foreign-governments-and-international-organizations-comment-period-reopening); REG-146537-06 (Nov. 3, 2011) (The 2011 Proposed Regulations may be found here: https://www.govinfo.gov/content/pkg/FR-2011-11-03/pdf/2011-28531.pdf).

[13] For example, a noneconomic general partner interest in a foreign partnership that elects to be classified as a corporation for U.S. federal income tax purposes.

[14] The Final QFPF Regulations noted that this period concludes 60 days after the date the Final QFPF Regulations were published in the Federal Register.  Because the Final QFPF Regulations were published on December 29, 2022, the 60-day time frame concludes on February 27, 2023.

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This alert was prepared by Josiah Bethards, Emily Brooks, Evan M. Gusler, Brian W. Kniesly, Yara Mansour, James Manzione, Alex Marcellesi, Jeffrey M. Trinklein, and Daniel A. Zygielbaum.

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

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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]

1. 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]

2. 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.

3. 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.

4. 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.

5. 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:

1. 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;

2. 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;

3. De minimis repurchases. Stock repurchased where the total value of the stock repurchased during the taxable year does not exceed $1,000,000;

4. 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;

5. Repurchases by RICs and REITs. Repurchases by a section 851 regulated investment company or a real estate investment trust; and

6. 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.

____________________________

[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.

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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

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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.

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: Fraud cases where the penalty is based on either intended loss or gain, rather than actual loss; Money laundering cases that involve commingled funds; Financial transaction structuring cases involving a “pattern of unlawful activity”; Tax cases involving multiple alleged violations; and Any corporate resolution where a company seeks credit for self-reporting, cooperation, or acceptance of responsibility.

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.

_________________________

[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).

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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.

London of counsel Ceyda Knoebel and associate Stephanie Collins are the authors of “The European Union’s Proposed Amendments to Article 10(1) of the ECT – Advancing or Undermining Its Ambitions for the Green Transition?” [PDF] published in the European Investment Law and Arbitration Review, Volume 7 in January 2023.

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.

***

Table of Contents

A. Domestic developments

I. Key changes in the Autumn Statement

a. Thresholds

b. Energy Profits Levy

c. R&D Relief

II. Consultations

a. Sovereign Immunity

b. VAT on Fund Management Services

III. Transfer Pricing

IV. Retained EU Law Bill

V. QAHC

VI. Proposed Amendments to the Tax Rules for Real Estate Investment Trusts

B. International developments

I.  EU Updates:

a. BEFIT consultation

b. ATAD III Update

c. UK-Brazil Double Tax Treaty

II. BEPS 2.0

a. Update on Pillar 1 and Pillar 2 Consultations

b. UK Implementation and Autumn Statement

c. EU/ROW Implementation

III. Mandatory Disclosure

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:

1. 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.
2. 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.
3. 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:

1. 1. 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.
   2. Next, any “excluded entities” must not be considered part of the consolidated group. Excluded entities include:
      1. 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);
      2. 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);
      3. a governmental entity;
      4. an international organization;
      5. a non-profit organization; and
      6. 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.

   3. 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).
   4. 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.
   5. Once a qualifying multinational group has been determined, the effective tax rate (“ETR”) of the group must be determined as follows:
      1. The adjusted profits (or losses) for each member of the group in the accounting period in question must be determined.
      2. 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.
      3. 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.
      4. 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.
   6. 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:
      1. The ETR of the standard members of the group (as calculated above) should be subtracted from 15%.
      2. 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.
      3. 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).
      4. 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.
   7. 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:

	Reporting obligation	UK status
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.
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.
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.

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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

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

New York partner Joel Cohen and Washington, D.C. partner Michael Diamant are the authors of “Potential liability under the third-party-payment provision – Due diligence a must do” [PDF] published in Global Legal Insights – Bribery & Corruption 2023 in December 2022.

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.

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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.

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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

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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.

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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]
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
2709	Petroleum oils and oils obtained from bituminous minerals, crude. Includes Clean Condensate.
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: trading/commodities brokering financing; shipping; insurance, including reinsurance and protection and indemnity (“P&I”); flagging; and customs brokering services.[21]	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: technical assistance; brokering services; financing; or financial assistance, 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: financial services; funds; or brokering services.[23] 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: any United States citizen or lawful permanent resident, wherever located; any entity organized under the laws of the United States or any jurisdiction within the United States (including foreign branches); or any individual or entity in the United States.[24]	Applies: within the territory of the EU; to EU nationals, wherever located; to companies and organizations incorporated under the law of an EU member state, wherever located; to any company or organization in respect of any business done in whole or in part within the EU; and on board aircrafts or vessels under the jurisdiction of an EU member state.[25]	Applies to: United Kingdom nationals, wherever located;[26] bodies incorporated or constituted under the law of any part of the United Kingdom; and conduct in the United Kingdom or in the United Kingdom’s territorial sea by any person.[27]

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.

	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: commodities brokers and traders; importers; refiners; and other persons acting in their capacity as seller or buyer of Russian oil.	U.S./UK/EU.  Including, but not limited to: financial institutions providing relevant financing; customs brokers; ship/vessel agents; and charterers.	U.S./UK/EU. Including, but not limited to: ship owners; insurance brokers; cargo and HM insurers; P&I clubs; reinsurers; flagging registries; and ship managers.
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.
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.
	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.
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.
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.

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]

___________________________

[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

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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:

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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])
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Europe
Attila Borsos – Brussels (+32 2 554 72 10, [email protected])
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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])
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Michael Walther – Munich (+49 89 189 33 180, [email protected])

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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.

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