Los Angeles partner Bradley Hamburger and associate Jeremy Smith are the authors of “A modest proposal: Amend FRAP to permit reply briefs in support of petitions for permission to appeal” [PDF] published by the Daily Journal on May 26, 2021.

On 21 May 2021, the Hong Kong government published the Consultation Conclusions[1] on legislative proposals to enhance anti-money laundering and counter-terrorist financing (“AML/CTF”) regulations in Hong Kong, including a proposal to introduce a licensing regime for virtual asset services providers (“VASPs”). This client alert discusses the proposed scope of the licensing regime, the proposed regulatory requirements for licence holders, implications for cryptocurrency trading platforms, and opportunities for the future development of such trading platforms in Hong Kong.

Note that the discussions in this alert are based on the Consultation Conclusions. While unlikely, there could still be further changes in the drafting of the legislation before the laws are passed. Importantly there will be further public consultation before the detailed regulatory regime for licence holders, including applicable guidelines, are published, as discussed below.

I. Why introduce a licensing regime for VASPs?

In recent years, the world has seen tremendous growth in the trading of virtual assets (“VAs”) including cryptocurrencies like bitcoin. This drew the attention of the Financial Action Task Force (“FATF”), which expressed concern about the perceived money laundering and terrorist financing (“ML/TF”) risks arising from the growing use of VAs. To address these ML/TF risks, the FATF updated the FATF Standards in February 2019[2] to require jurisdictions to subject VASPs to the same range of AML/CTF obligations as financial institutions. To fulfil its obligations as a member of FATF, the Hong Kong government launched a public consultation on 3 November 2020.[3] Amongst other things, the consultation proposed amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”) to introduce a licensing regime for VASPs. The public consultation period ended on 31 January 2021, and the Consultation Conclusions were published on 21 May 2021.

II. Scope of proposed licensing regime for VASPs

The proposed licensing regime for VASPs would designate the business of operating a VA exchange as a “regulated VA activity”. As such, any person seeking to operate a VA exchange in Hong Kong would be required to apply for a licence[4] from the Hong Kong Securities and Futures Commission (“SFC”) to become a licensed VASP under the AMLO. The granting of the licence would be subject to meeting the SFC’s fit-and-proper test and other regulatory requirements, which we discuss further below.

The proposed definition of a “VA exchange” is any trading platform which:

• Is operated for the purpose of allowing an invitation to be made to buy or sell any VA in exchange for any money or any VA; and
• Comes into custody, control, power or possession of, or over, any money or any VA at any time during the course of its business.

Accordingly, a peer-to-peer trading platform would not fall within the definition of a VA exchange provided that the actual transactions in VAs are conducted outside the platform and the platform is not involved in the underlying transaction by coming into possession of any money or any VA at any point in time (i.e. platforms that only provide a forum for buyers and sellers to post their bids and offers, where the parties themselves transact outside the platform). As such, on the basis of the current drafting, it is possible that decentralised exchanges (“DEXs”) that operate on the basis of non-custodial storage (as opposed to centralised exchanges where users give up custody of their assets to the exchange) and without a centralised entity in charge of the order book, may not ultimately be caught by the definition of a VA exchange.

The proposed definition of “VA” means a digital representation of value that:

• Is expressed as a unit of account or a store of economic value;
• Functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of debt, or for investment purposes; and
• Can be transferred, stored or traded electronically.

The definition of “VA” is therefore likely to include cryptocurrencies such as bitcoin and VAs backed by another asset for the purpose of stabilising its value (i.e. stablecoins). On the other hand, the definition of VA would not cover:

• Digital representations of fiat currencies (such as digital currencies issued by central banks);
• Financial products already regulated under the Securities and Futures Ordinance (“SFO”);
• Closed-loop, limited purpose items that are non-transferable, non-exchangeable and non-fungible (e.g. air miles, credit card rewards, gift cards, customer loyalty points, gaming coins, etc.); and
• Stored value facilities which are regulated under the Payment Systems and Stored Value Facilities Ordinance.

Depending on the final drafting of the legislative amendment to introduce the licensing regime for VASPs, it appears that non-fungible tokens (“NFTs”) may fall outside the definition of “VA”. In that scenario NFT trading platforms would also fall outside the scope of the licensing regime

III. Implications for non-Hong Kong cryptocurrency exchanges

The proposed licensing regime for VASPs would also extend to VA exchanges which operate outside of Hong Kong, but which actively market to the public of Hong Kong. This means that a cryptocurrency exchange that is based outside of Hong Kong will be prohibited from ‘actively marketing’ regulated VA activity (i.e. operating a VA exchange) to the public of Hong Kong unless they are a licensed VASP. This would be similar to existing prohibitions under the SFO[5] on actively marketing regulated activities to the public of Hong Kong (see below). In the context of the SFO, the meaning of actively markets is potentially broad, with some guidance available from the SFC[6] and in case law on its interpretation.

IV. Crypto assets which are securities or futures contracts are already regulated under the SFO

It is important to note that financial products which are already regulated under the SFO would not fall within the definition of “VA”, and therefore trading platforms which enable trading in such products would not fall within the licensing regime for VASPs.  An example of such financial products is bitcoin futures which, depending on its terms and features, would likely either fall within the definition of “securities” or “futures contracts” under the SFO (and therefore would not be considered VAs).[7]

However, such trading platforms may already fall within the SFO regulatory regime for providing automated trading services, if it operates in or from Hong Kong, or actively markets to the public in Hong Kong (even if the platforms are based outside of Hong Kong). In this respect, in November 2019, the SFC published a position paper[8] which outlined the regulatory standards for the licensing of trading platforms that enable trading of crypto assets which have “securities” features.

V. Proposed licensing requirements for licensed VASPs

• Eligibility: applicants must either be incorporated in Hong Kong, or non-Hong Kong incorporated companies which are registered in Hong Kong under the Companies Ordinance.
• Fit-and-proper test: in considering whether or not an applicant is fit-and-proper to be granted a VASP licence, the SFC will take into account, among other matters, whether or not the applicant has been convicted of an ML/TF offence or other offence involving fraud, corruption or dishonesty, their experience and qualifications, their good standing and financial integrity, etc. This fit-and-proper test is likely to be very similar to, if not derived from, the well-established fit-and-proper test which applicants are required to satisfy to be granted a regulated activity licence under the SFO.
• Two responsible officers: as with any firm currently licensed by the SFC, applicants will need to appoint at least two responsible officers to assume the responsibility of ensuring compliance with AML/CTF and other regulatory requirements, who may be held personally accountable in case of non-compliance.

VI. Regulatory requirements for licensed VASPs

Licensed VASPs will be subject to the AML/CTF requirements stipulated in Schedule 2 of the AMLO (i.e. the same as financial institutions), including customer due diligence and record-keeping requirements.

In addition to AML/CTF requirements, licensed VASPs will also be subject to regulatory requirements designed to protect market integrity and investor interests. These requirements will be set out in codes and guidelines to be published by the SFC. Licensed VASPs would be required to comply with these requirements under licensing conditions imposed by the SFC. These requirements are likely to be wide-ranging in scope, with prescribed requirements covering, among other things, financial resources, risk management, segregation and management of client assets, financial reporting, prevention of market manipulative and abusive activities, prevention of conflicts of interest, etc.

Notably, licensed VASPs will only be able to provide services to professional investors, i.e. high net worth and institutional investors. This means that after the commencement of the licensing regime for VASPs, licensed VASPs cannot provide services to retail investors.

VII. Supervisory powers of the SFC over licensed VASPs

The SFC will be given broad powers to supervise the AML/CTF and regulatory compliance of licensed VASPs. This will include powers to enter business premises, to request the production of documents and records, to investigate non-compliance and to impose sanctions (including orders for remedial actions, civil penalties and suspension or revocation licence) for non-compliances. The SFC will also have intervention powers to impose restrictions and prohibitions against the operations of licensed VASPs and their associated entities where the circumstances warrant, such as to prohibit further transactions or restrict the disposal of property. These powers enable the SFC to protect client assets in the event of emergency and to prevent the dissipation of client assets in the case of misconduct by a licensed VASP.

VIII. Timing

The Hong Kong government aims to introduce the AMLO amendment bill into the Legislative Council in the 2021-22 legislative session, which is due to commence in October 2021. The SFC will also prepare and publish for consultation the regulatory requirements for licensed VASPs, before commencement of the licensing regime for VASPs. Considering the above, the licensing regime is unlikely to commence before 2022. In any event there will be a 180-day transitional period from the commencement of the licensing regime to facilitate licence applications by interested parties.

IX. Conclusion

While the primary motivation for introducing the licensing regime for VASPs is to ensure that Hong Kong meets the latest FATF Standards, the Hong Kong authorities are also focused on promoting the protection of market integrity and investor interests, and the regulatory requirements for licensed VASPs extend beyond AML/CTF requirements by seeking to regulate matters including customer type (i.e. professional investors only), prevention of market manipulative and abusive activities, and prevention of conflicts of interest.

As Mr. Christopher Hui, Secretary for Financial Services and the Treasury, recently said in his remarks at a fintech forum,[9] the introduction of the licensing regime for VASPs is intended to facilitate the development of such an industry by providing a clear regulatory framework for the industry to operate within. Notably, the original proposal for the licensing regime has now been amended to allow non-Hong Kong companies to apply for a VASP licence[10] which may help to attract overseas crypto asset trading platforms that wish to develop their business within the Hong Kong regulatory framework.

For current VASPs contemplating applying for a VA licence when the licensing regime commences, we would recommend starting by reviewing their existing AML/CTF policies and systems and controls to identify gaps with the requirements under Schedule 2 of the AMLO. This is because these requirements are unlikely to be significantly modified during the legislative process, and it may take time and resources to design and implement. VASPs should also be alert to future consultations by the SFC on the codes and guidelines for licensed VASPs in order to identify the detailed regulatory requirements which licensed VASPs would need to comply with. Implementing these requirements will likely require preparing written policies and procedures, upgrading systems and controls, and potentially restructuring aspects of their business and operations to address potential conflicts of interest.

__________________________

   [1]   Consultation Conclusions on Public Consultation on Legislative Proposal to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong (May 2021), published by the Financial Services and the Treasury Bureau, available at: https://www.fstb.gov.hk/fsb/en/publication/consult/doc/consult_conclu_amlo_e.pdf

   [2]   Public Statement – Mitigating Risks from Virtual Assets (22 February 2019), published by FATF, available at: https://www.fatf-gafi.org/publications/fatfrecommendations/documents/regulation-virtual-assets-interpretive-note.html

   [3]   Government launches consultation on legislative proposal to enhance anti-money laundering and counter-terrorist financing regulation (3 November 2020), Hong Kong government press release, available at: https://www.info.gov.hk/gia/general/202011/03/P2020110300338.htm

   [4]   There will be an exception for a VA exchange that is already regulated as a licensed corporation in the voluntary opt-in regime supervised by the SFC pursuant to the SFO.

   [5]   Section 115 of the SFO.

   [6]   “Actively markets” under section 115 of the SFO (last updated 17 March 2003), published by the SFC, available at: https://www.sfc.hk/en/faqs/intermediaries/licensing/Actively-markets-under-section-115-of-the-SFO#9CAC2C2643CF41458CEDA9882E56E25B

   [7]   Circular to Licensed Corporations and Registered Institutions on Bitcoin futures contracts and cryptocurrency-related investment products (11 December 2017), published by the SFC, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=17EC79

   [8]   Position paper: Regulation of virtual asset trading platforms (6 November 2019), published by the SFC, available at: https://www.sfc.hk/-/media/EN/files/ER/PDF/20191106-Position-Paper-and-Appendix-1-to-Position-Paper-Eng.pdf

   [9]   Secretary for Financial Services and the Treasury, Mr. Christopher Hui, remarks at StartmeupHK Festival – Virtual FinTech Forum on 27 May 2021, available at: https://www.news.gov.hk/eng/2021/05/20210527/20210527_131949_094.html

  [10]   The non-Hong Kong incorporated company would need to be registered in Hong Kong under the Companies Ordinance.

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Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you would like to discuss further, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Financial Institutions practice group, or the following authors:

Connell O’Neill – Hong Kong (+852 2214 3812, [email protected])
Sébastien Evrard – Hong Kong (+852 2214 3798, [email protected])
Arnold Pun – Hong Kong (+852 2214 3838, [email protected])

Please also feel free to contact any of the following practice leaders and members:

Matthew L. Biben – New York (+1 212-351-6300, [email protected])
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, [email protected])
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
M. Kendall Day – Washington, D.C. (+1 202-955-8220, [email protected])
Mylan L. Denerstein – New York (+1 212-351- 3850, [email protected])
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, [email protected])
Arthur S. Long – New York (+1 212-351-2426, [email protected])
Matthew Nunan – London (+44 (0) 20 7071 4201, [email protected])
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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

As a reaction to the spectacular collapse of Wirecard, a then-DAX-listed financial service provider, in June 2020, an Act on Strengthening the Financial Market Integrity (Finanzmarktintegritätsstärkungsgesetz – FISG) has now been adopted following several months of intense discussions. It enters into effect on 1 July 2021 with a transitional period for certain provisions. The Act establishes new requirements for the corporate governance and the audit of listed companies as well as other public-interest entities.

Corporate Governance

• Mandatory audit committee comprising at least two financial experts

Although German law already now addresses the composition, role and functions of audit committees in several regulations and the recommendations by the German Corporate Governance Code (see D.3 German Corporate Governance Code), it had been, until now, up to the discretion of the supervisory board whether to form an audit committee. The FISG now requires all listed companies and other public-interest entities (PIE), including in particular certain financial institutions and insurance companies as defined in the new § 316a German Commercial Code (Handelsgesetzbuch – HGB), to establish a mandatory audit committee no later than 1 January 2022 (§ 107 (4) Stock Corporation Act (Aktiengesetz -AktG) (new version), § 324 HGB (new version)). In order to ensure compliance with the obligation to form an audit committee, a (periodic) penalty payment of up to € 5,000 can be imposed on each individual member of the supervisory board (§ 407 AktG (new version)). Since the formation of audit committees is already best practice for listed companies, however, the implications of this for the vast majority of the listed companies will be limited.

The FISG further requires that the audit committee (or, if the supervisory board comprises only three members, the supervisory board itself) shall comprise at least two financial experts, with one member having expertise in the fields of accounting and another member in the fields of auditing (§ 100 (5) AktG (new version), 107 (4) AktG (new version)). Previously, the law required only that at least one supervisory board member (who, if an audit committee was formed, must have been also a member of the audit committee) must qualify as a financial expert with expertise in the fields of auditing or (alternatively) accounting. The new qualification requirements shall ensure that both kinds of expertise are represented, and with different board members. The consequences in case the new qualification requirements are not met are not further stipulated by the law and thus remain unclear. According to the prevailing view in legal literature, the election of a supervisory board member which results in a violation of this special requirement for the composition can be challenged in court within the usual one-month period after the election takes place; if no legal action is brought within this term, the election is finally valid.

The new qualification requirements must be met for elections taking place on or after 1 July 2021, but do not apply retroactively.

• Extended information rights and functions for audit committee members

Each audit committee member shall have the right to request information from the heads of the company’s central services that fall within the audit committee’s responsibilities, e.g. the head of risk management, the head of internal audit or the head of the compliance department. Any such requests must be channeled via the chair of the audit committee, who must then provide the requested information to all other audit committee members and must also inform the management board of the information request without undue delay) (§ 107 (4) AktG (new version)). Furthermore, the Act now also explicitly stresses that the responsibilities of the audit committee in relation to the audit also include the quality of the audit (§ 107 (3) AktG (new version)). The new information rights and functions apply starting 1 January 2022.

• Separate meetings with the auditor without the management board

In order to foster the confidentiality of communications between the auditor and the supervisory board or the audit committee, respectively, the law explicitly stipulates that if the auditor is consulted as an expert by the supervisory board or a supervisory board committee, from 1 July 2021 on, the management board shall only participate in such a meeting if the supervisory board or its committees deems its participation necessary (§ 109 (1) AktG (new version)).

• Legal obligation to establish an internal control system and a risk management system

The new law explicitly requires the management board of a listed company to establish an effective internal control system and a risk management system which are appropriate for the size and the risk position of its business (§ 91 (3) AktG (new version)). The implications of this new statutory obligation, which will be applicable immediately starting 1 July 2021, will be limited since most listed companies already have such systems in place (see also principle 4 of the German Corporate Governance Code).

Audit

• Mandatory external auditor rotation after ten (10) years and internal auditor rotation after five (5) years

The maximum duration for an audit engagement of public-interest entities shall be ten (10) years. The currently existing option to extend this period under the exemption of the Member State option of Regulation (EU) /No 537/2014 (hereinafter EU Regulation) will be abolished (elimination of § 318 (1a) HGB). Abolishing this exemption also re-synchronizes the maximum term for listed companies with the maximum ten-year term applicable to CRR institutes and insurance companies.

For a transition period audit engagements may still be renewed after expiry of the ten (10)-year term for the business year beginning after 30 June 2021 and the following business year, provided the requirements for a renewal of the engagement have been fulfilled prior to 30 June 2021. If the business year equals the calendar year this means that the auditor needs to be changed for the business year 2024 at the latest.

Furthermore, the maximum term for the internal rotation of the key audit partner will be reduced from currently seven (7) to five (5) years (§ 43 (6) Public Accountant Act (Wirtschaftsprüferordnung – WPO) (new version)). In the absence of any transitional period the shortened term will be immediately applicable starting 1 July 2021.

• Tightening of the prohibition of non-audit services

In order to further strengthen the independence of auditors, the Member State option of the EU regulation to allow certain tax and valuation services when such services are immaterial or have no direct effect on the audited financial statements (see § 319a HGB) will be rescinded. As a consequence, all black-listed non-audit services of Article 5 (1) sub-paragraph 2 of the EU Regulation will now be prohibited. In addition, the exemption relating to the fee cap (§ 319a (1a) HGB) will also be abolished. In case of noncompliance with the prohibition of non-audit services, shareholders holding five percent (5%) per cent of the voting rights or share capital or shares with a stock market value of at least € 500,000 can request the court to replace the auditor (§ 318 (3) HGB (new version)). The new rules will apply to the audit of business years starting on or after 1 January 2022.

• Increase of the liability caps for auditors and tightened criminal liability

Previously, the civil liability of auditors was capped at one (1) million Euro for listed companies to four (4) million Euro, respectively, for negligence (including gross negligence), and higher damages could only be recovered by the company or its group of companies in case of intent on the auditors’ part. In the future, the civil liability of auditors for negligence will be capped at sixteen (16) million Euro for the audit of listed and other capital market companies, at four (4) million Euro for other PIEs and at one point five (1.5) million Euro for all other companies. In addition, in case of intent or gross negligence no liability cap will apply for listed companies and other capital market-orientated companies. With regard to other PIEs and other companies, the cap for gross negligence will be thirty-two (32) million Euro or twelve (12) million Euro, respectively (§ 323 (2) HGB new version)). The new rules will be applicable for the audit of business years starting on or after 1 January 2022.

One should note, however, that under German law, shareholders, absent any tort, normally do not have liability claims against the statutory auditors of companies. Thus, absent exceptional circumstances, only the company can raise such claims. It remains to be seen whether this will change in the aftermath to the Wirecard accounting fraud.

Furthermore, the FISG also provides for a significant tightening of criminal liability for accounting and auditing offences.

• Election of auditors of insurance companies by the shareholders

The auditors of insurance companies will now be elected by the shareholders and not by the supervisory board (cancellation of § 341k (2) HGB). This shall apply for business years starting on or after 1 January 2022.

Financial Reporting Enforcement

The current two-tier enforcement system will be fundamentally changed. With effects as of 1 January 2022, the private-law Financial Reporting Enforcement Panel (FREP) (Deutsche Prüfstelle für Rechnungslegung – DPR) will be abolished, and financial reporting enforcement will be bundled at the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) (§§ 106 et seq. Securities Trading Act (Wertpapierhandelsgesetz – WpHG) (new version)). In addition, the competences of BaFin will be extended, and will include, amongst others, a right of BaFin to search business and residential premises as well as to confiscate documents and other evidence. The competent court for issuing the required search warrant and confiscation order will be the local court of Frankfurt/Main.

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Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. For further information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the team in Frankfurt or Munich, or the following authors:

Silke Beiter – Munich (+49 89 33371, [email protected])
Ferdinand Fromholzer – Munich (+ 49 89 33270, [email protected])
Johanna Hauser – Munich (+49 89 33272, [email protected])
Finn Zeidler – Frankfurt (+49 69 247411530, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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

Decided June 3, 2021

Van Buren v. United States, No. 19-783

Today, the Supreme Court held 6-3 that the Computer Fraud and Abuse Act does not cover obtaining information for an improper purpose if the user is otherwise authorized to access that information.

Background:
The Computer Fraud and Abuse Act of 1986 (CFAA) creates criminal and civil liability for “[w]hoever . . . intentionally accesses a computer without authorization or exceeds authorized access, and thereby obtains . . . information.” 18 U.S.C. § 1030(a)(2). The phrase “exceeds authorized access” means “to access a computer with authorization and to use such access to obtain or alter information in the computer that the accesser is not entitled so to obtain or alter.” Id. § 1030(e)(6).

Van Buren, a police officer, used his access to a law-enforcement database to run an unauthorized license-plate search in exchange for money, and was charged under the CFAA. The Eleventh Circuit, applying a broad view of the CFAA, held that Van Buren had exceeded his authorized access because he accessed the database for an improper purpose, in violation of his department’s policies.

The Supreme Court granted certiorari to resolve the split between the narrow approach of the Second, Fourth, and Ninth Circuits, which hold that a person “exceeds authorized access” only if he accesses information on a computer that he is prohibited from accessing, and the broader approach of the First, Fifth, Seventh, and Eleventh Circuits, which hold that a person “exceeds authorized access” if he accesses otherwise available information for an unauthorized purpose.

Issue:
Whether a person who is authorized to access information on a computer for certain purposes violates the CFAA if he accesses the same information for an unauthorized purpose.

Court’s Holding:
No. The CFAA proscribes only obtaining information from computers, files, folders, or databases that a person is not authorized to access. It does not create liability for those who, like Van Buren, obtain information otherwise available to them for an unauthorized purpose. 

The CFAA “covers those who obtain information from particular areas in the computer—such as files, folders, or databases—to which their computer access does not extend. It does not cover those who . . . have improper motives for obtaining information that is otherwise available to them.”

Justice Barrett, writing for the Court

What It Means:

• By holding that the CFAA does not prohibit accessing otherwise-available information for an improper purpose, today’s decision clarifies that day-to-day violations of computer-use policies, such as using an employer-provided electronic device for a non-business purpose in violation of workplace rules, or using a pseudonym on a social media website in violation of the site’s terms and conditions, do not in and of themselves give rise to liability under the CFAA.
• The Court explained that section 1030(a)(2)’s “exceeds authorized access” clause targets “inside hackers”—“those who access a computer with permission, but then exceed the parameters of authorized access by entering an area of the computer to which that authorization does not extend,” whereas the “without authorization” clause targets “outside hackers”—those who “access a computer without any permission at all.” The Court held that liability under both clauses turns on “a gates-up-or-down inquiry”—“one either can or cannot access a computer system, and one either can or cannot access certain areas within the system”—rejecting the Government’s view that the “exceeds authorized access” inquiry depends on the facts and circumstances.
• The Court specifically left open the question of whether the scope of authorization turns only on technological or code-based restrictions on access or violations of contractual terms alone may give rise to liability under the CFAA. Nonetheless, the Court’s reasoning suggests that a user violating terms-of-service or other policy restrictions alone likely does not exceed authorized access under the CFAA.

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The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Allyson N. Ho +1 214.698.3233 [email protected]

Mark A. Perry +1 202.887.3667 [email protected]

Lucas C. Townsend +1 202.887.3731 [email protected]

Bradley J. Hamburger +1 213.229.7658 [email protected]

Related Practice: Privacy, Cybersecurity and Data Innovation

Alexander H. Southwell +1 212.351.3981 [email protected]

S. Ashlie Beringer +1 650.849.5327 [email protected]

Ahmed Baladi +33 (0)1 56 43 13 50 [email protected]

Matthew Benjamin +1 212.351.4079 [email protected]

Related Practice: White Collar Defense and Investigations

Stephanie Brooker +1 201.887.3502 [email protected]

Joel M. Cohen +1 212.351.2664 [email protected]

Nicola T. Hanna +1 213.229.7269 [email protected]

Chuck Stevens +1 415.393.8391 [email protected]

F. Joseph Warin +1 202.887.3609 [email protected]

Reed Brodsky +1 212.351.5334 [email protected]

Orange County partner Thomas Manakides and associate Joseph Edmonds are the authors of “Roundup Case Shows State Law Can Top Preemption Defense,” [PDF] published by Law360 on June 1, 2021.

Recent amendments to Mexico’s Hydrocarbon Law (“Hydrocarbon Reform”) and Electricity Industry Law (“Electricity Reform”) may have a significant impact on the operations of foreign investors in the energy sector in Mexico. The recent legislative amendments curtail the market power of private electricity, and oil and gas producers in Mexico and discriminate against foreign investors.

The Hydrocarbon Reform grants the Government broad discretion to suspend or refuse to renew existing permits granted to private companies, with corresponding provisions granting State-owned company Petróleos Mexicanos (“Pemex”) the right to take over the facilities of private companies who no longer have a permit without compensation.[1] At its core, the Hydrocarbon Reform aims to recalibrate the existing regulatory framework to revive the dominance of Pemex and limit the prevalence of privately owned oil and gas companies in Mexico.[2]

Similarly, the Electricity Reform disadvantages private electricity providers by granting dispatch preference to electricity generated by State-owned company Comisión Federal de Electricidad (“CFE”).[3] Prior to this amendment, Mexico’s electrical grid rules prioritized dispatch on the basis of the least expensive generated electricity.[4] The Electricity Reform has been developed to consolidate CFE’s market participation to the detriment of private producers, many of whom generate wind and solar energy.[5]

A judge in Mexico has ordered an indefinite suspension on the implementation of the Reforms pending resolution as to their constitutionality under domestic law.[6] If the suspension is lifted, foreign investors may well have an investment treaty claim as set out further herein.

Mexico’s reforms to the energy sector may violate investment treaty protections

The Hydrocarbon and Electricity Reforms may violate investment treaty protections owed by Mexico to foreign investors who have invested in the State and are protected by an applicable investment treaty. For example, investors from the United States and Canada can arbitrate claims directly against Mexico for breaches of the protections granted by the investment chapter in the Agreement between the United States of America, the United Mexican States, and Canada (“USMCA”) and its predecessor the North American Free Trade Agreement (“NAFTA”).[7] In fact, in response to Mexico’s ongoing discriminatory treatment of foreign investors, three U.S. companies filed claims on 12 May 2021 before the International Centre for Settlement of Investment Disputes (“ICSID”)—Finley Resources Inc, MWS Management Inc and Prize Permanent Holdings LLC—on the basis that Mexico had breached its obligations under Chapter 14 of the USMCA and Chapter 11 of NAFTA.

In addition, investors from Australia, Brunei, Canada, Chile, Japan, Malaysia, New Zealand, Peru, Singapore and Vietnam may also have a claim against Mexico pursuant to the investment chapter in the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (“CPTPP”). Mexico is also party to a number of bilateral investment treaties with more than 20 States that provide for recourse to international arbitration.[8]

The right to national treatment

Investment treaties commonly include a protection that requires the host State to treat investments of foreign investors no less favorably than it treats domestic investors in “like circumstances.”[9] Arbitral tribunals considering the meaning of “like circumstances” have found that this has “a wide connotation” that requires an assessment of whether “a non-national investor complaining of less favourable treatment is in the same ‘sector’ as the national investor. . . . [this] includes the concepts of ‘economic sector’ and ‘business sector.’”[10]

While it is not necessary to prove an intent to discriminate, tribunals have held that a State measure which “on its face, appears to favour its nationals over non-nationals” is a “factor[ that] should be taken into account.”[11] Arbitral tribunals have added that “[d]iscrimination does not cease to be discrimination, nor to attract the international liability stemming therefrom, because it is undertaken to achieve a laudable goal or because the achievement of that goal can be described as necessary.”[12] A previous tribunal found Mexico liable for breach of the national treatment protection where a controversial tax “was enacted for the purpose of protecting the domestic Mexican sugar industry from foreign competitors.”[13] The tribunal awarded the investor in excess of US$ 33.5 million in damages.[14]

Mexico’s Reforms are facially discriminatory to foreign investors operating side-by-side with State-owned operators Pemex and CFE, with the laws being structured in a manner that the adverse impact will be felt almost exclusively by foreign investors. President Andrés Manuel López Obrador and other members of the Government have likewise stated publicly that the purpose of the Reforms is to reestablish State control over the energy sector.[15] As a consequence, it is questionable whether Mexico is complying with its obligation to provide national treatment under various investment treaties to which it is Party.

The right to fair and equitable treatment

Most investment treaties also include a protection granting investors the right to fair and equitable treatment by host States. This includes a right to “protection of [a foreign investor’s] legitimate expectations, protection against arbitrary and discriminatory treatment, transparency and consistency.”[16]

Many of Mexico’s investment treaties require Mexico to treat the investments of a foreign investor fairly and equitably.[17] Arbitral tribunals have held that host States like Mexico cannot exercise legislative power “to act in an arbitrary or discriminatory manner, or to disguise measures targeted against a protected investor under the cloak of general legislation.”[18]

Given the targeted purpose and impact of the Reforms, impacted foreign investors may arguably have a claim that Mexico has breached its fair and equitable treatment obligation by arbitrarily discriminating against foreign investors. The changes in the legislative framework affecting hydrocarbon permitting and electricity distribution may likewise amount to a violation of foreign investors’ legitimate expectations.

* * *

Investment treaties can offer important protections to foreign investors operating in markets that present significant political and legal risks. Gibson Dunn lawyers have extensive experience advising clients in disputes against States for breaches of investment treaties. If you have any questions about how your company can take advantage of such protections, or if you think your company has an investment treaty claim based on Mexico’s Hydrocarbon or Electricity Reforms, we would be pleased to assist you.

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[1] See here.

[2] See here.

[3] See here.

[4] See here.

[5] See here.

[6] See here and here.

[7] Canadian and U.S. investors in Mexico are able to file claims against Mexico before July 1, 2023 pursuant to the investor-State dispute settlement provisions available under the USMCA’s predecessor, NAFTA, provided that the dispute arises out of investments made when NAFTA was still in force and remained “in existence” on July 1, 2020. See USMCA, Annex 14-C. Thereafter, Canadian investors can seek recourse against Mexico under the CPTPP, and U.S. investors can seek recourse under Annex 14-D and Annex 14-E of the USMCA.

[8] See, e.g., Kuwait-Mexico BIT, Article 10; China-Mexico BIT, Article 12; Republic of Korea-Mexico BIT, Article 8.

[9] See, e.g., Bahrain-Mexico BIT, Article 3 (“Each Contracting Party shall accord to investors of the other Contracting Party and their investments, treatment no less favourable than that it accords, in like circumstances, to its own investors”); Belarus-Mexico BIT, Article 3 (“Each Contracting Party shall accord to investors of the other Contracting Party treatment no less favourable than that it accords, in like circumstances, to its own investors”); Mexico-Slovakia BIT, Article 3 (same).

[10] S.D. Myers, Inc. v. Government of Canada, UNCITRAL, Partial Award, 13 November 2000, ¶ 250.

[11] S.D. Myers, Inc. v. Government of Canada, UNCITRAL, Partial Award, 13 November 2000, ¶ 252.

[12] Corn Products International Inc. v. United Mexican States, ICSID Case No. ARB(AF)/04/1, Decision on Responsibility, 15 January 2008, ¶ 142; Quiborax S.A. and Non Metallic Minerals S.A. v. Plurinational State of Bolivia, ICSID Case No. ARB/06/2, Award, 16 September 2015, ¶ 253.

[13] Archer Daniels Midland Co. & Tate Lyle Ingredients Americas, Inc. v. United Mexican States, ICSID Case No. ARB(AF)/04/05, Award, 21 November 2007, ¶ 210.

[14]  Archer Daniels Midland Co. & Tate Lyle Ingredients Americas, Inc. v. United Mexican States, ICSID Case No. ARB(AF)/04/05, Award, 21 November 2007, ¶ 293.

[15] See here and here.

[16] Crystallex International Corporation v Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/11/2, Award, 4 April 2016, ¶ 543.

[17] See, e.g., United Arab Emirates-Mexico BIT, Article 4 (“Each Contracting Party shall accord to investments . . . fair and equitable treatment . . .); Turkey-Mexico BIT, Article 4 (same).

[18] Rusoro Mining Ltd. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/12/5, Award, 22 August 2016, ¶ 525.

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Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s International Arbitration Practice Group, or any of the following:

Penny Madden – London (+44 (0) 20 7071 4226, [email protected])
Cyrus Benson – London (+44 (0) 20 7071 4239, [email protected])
Jeffrey Sullivan – London (+44 (0) 20 7071 4231, [email protected])
Graham Lovett – Dubai (+971 (0) 4 318 4620, [email protected])
Rahim Moloo – New York (+1 212-351-2413, [email protected])
Lindsey D. Schmidt – New York (+1 212-351-5395, [email protected])
Marryum Kahloon – New York (+1 212-351-3867, [email protected])
Maria L. Banda – Washington, D.C. (+1 202-887-3678, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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

Pearl of Wisdom

The DIFC Court of Appeal in Lahelalahela V Lameezlameez [2020] DIFC CA 007 found that the Riyadh Convention[1] is not a part of DIFC Law, and in any event provides a non-exclusive service regime. To the extent Pearl Petroleum[2] found to the contrary, it was wrongly decided. The DIFC Court can therefore order alternative service or dispense with service in respect of a receiving party domiciled in a Riyadh Convention state. This will come as a great relief to DIFC Court practitioners who have been grappling with Pearl Petroleum and the significant hurdles it created for service of DIFC Court documents in the GCC Region. The Court of Appeal also provided welcome clarity on the implementation of international agreements to which the UAE is a party into DIFC Law, finding that obligations in such agreements are not automatically a part of DIFC Law where they relate to civil and commercial matters. This is an important development with wide-ranging implications for the source and content of DIFC Law, as well as for the enforcement of DIFC-seated arbitrations. Gibson, Dunn & Crutcher, with lead Counsel Tom Montagu-Smith-QC, acted for the successful Claimant at first instance and Respondent on appeal.

Background

The Claimant obtained a monetary award in DIFC-seated arbitration proceedings against the Defendant, and later successfully obtained (ex parte) a DIFC Court order recognising and enforcing the award (the “Enforcement Order”). Pursuant to RDC 43.70 and the terms of the Enforcement Order, the Enforcement Order could not be enforced until after it had been served on the Defendant.

The Defendant company is registered in Erbil, in the Republic of Iraq, which, along with the UAE, is a signatory to the Riyadh Convention. Article 6 of the Riyadh Convention sets out a method of service (“Convention Service”), which applies where the sender and recipient are both resident in a signatory state to the Riyadh Convention (a “Convention State”).[3] Unlike diplomatic service, Convention Service operates directly between a sending court (in this case the DIFC Court) and a receiving court (in this case the local Erbil Court).

The Claimant attempted Convention Service. The local court in Erbil refused to serve the Enforcement Order and stated (wrongly) that the Riyadh Convention did not apply.  The Claimant then obtained (ex parte) an order for alternative service from the DIFC Court (the “Service Order”). Upon being served with the Service Order, the Defendant applied for it to be set aside. The principal argument by the Defendant was that Pearl Petroleum correctly found that the Riyadh Convention, where applicable, is part of DIFC law and provides an exclusive and mandatory service regime, and the DIFC Court does not have the power to order alternative service or dispense with service.

The Claimant argued that Pearl Petroleum was distinguishable, and in any event wrongly decided because the Riyadh Convention is not binding on the DIFC Court. At first instance, H.E. Justice Shamlan Al Sawalehi (“Justice Al Sawalehi”) found for the Claimant on both these grounds. As the first instance decision conflicted with Pearl Petroleum, permission to appeal was granted, and a hearing occurred before the Court of Appeal in February 2021, with the Court of Appeal issuing its decision on 9 May 2021.

Pearl Petroleum

In Pearl Petroleum, the DIFC Court set aside an order for alternative service of a recognition and enforcement order. The alternative service order had been initially granted ex parte on the basis that service under the Riyadh Convention would very likely be stymied by the award-debtor, the Kurdistan Regional Government. The DIFC Court held that, by virtue of Article 5 of UAE Federal Law No. 8 of 2004 (“Article 5”)[4], treaties which form part of the law of the UAE are binding in the DIFC.  Importantly, the Court found that, not only was the Riyadh Convention applicable in the DIFC, but the service regime in Article 6 of the Riyadh Convention was mandatory and exclusive. That is, there was no scope to circumvent the terms of the Riyadh Convention by an order for alternative service or to dispense with service altogether so that the Riyadh Convention was not engaged.

The effect of Pearl Petroleum was that, if the Court of a Convention State refuses or fails to serve a DIFC Court recognition and enforcement order pursuant to the Convention Service regime, the recognition and enforcement order will never become enforceable; similarly draconian implications applied to the service of other court documents. The obvious problem that this gave DIFC Court users was exacerbated by the fact that the Riyadh Convention is of broad application throughout the GCC region.

Justice Al Sawalehi’s Decision

At first instance, Justice Al Sawalehi held that Pearl Petroleum was distinguishable, as, unlike in Pearl Petroleum, service had been attempted but failed in the present case. In the alternative, His Honour found that Pearl Petroleum was wrongly decided and the DIFC Court was not bound to follow the Riyadh Convention at all.

The present case distinguished from Pearl Petroleum

In Pearl Petroleum, the claimant had not actually attempted service in accordance with the Riyadh Convention – instead, alternative service had been sought on the basis that interference with service by the Defendant was highly likely. Justice Al Sawalehi considered this to be a critical distinction and confined the ration in Pearl Petroleum accordingly. That is, Pearl Petroleum, properly interpreted, held that where a document in DIFC Court proceedings is required to be served on a defendant in a Convention State, it must first be attempted to be served by Convention Service, but after this attempt, the Court is empowered to order alternative service or dispense with it altogether.

Pearl Petroleum wrongly decided

Justice Al Sawalehi also found that, even if Pearl Petroleum was not distinguishable, it was in any event wrong on a more fundamental basis – i.e. the Riyadh Convention was not binding in the DIFC at all. There are two ‘avenues’ by which the Riyadh Convention could ‘automatically’[5] apply in the DIFC: (1) Article 5; and (2) Article 3(2) of the UAE Federal Law No. 8 of 2004, which provides that financial Free Zones “shall…be subject to all Federal laws, with the exception of Federal civil and commercial laws” (“Article 3(2)”).

Regarding Article 5, His Honour found that it placed an obligation on “financial free zones”, which meant the DIFC executive (i.e. the Ruler, the President of the DIFC and the DIFC Authority), but not the DIFC Courts. To the contrary, Article 30 of the DIFC Court Law[6] provides a mandatory, exhaustive list of the law that can be applied by the DIFC Court. UAE Federal law is not mentioned. Therefore, the DIFC Court shall not apply UAE Federal law unless either: (1) it is agreed by the parties, or (2) it is incorporated into DIFC domestic law by express enactment. There was no such party agreement, and His Honour found that the Riyadh Convention had not been incorporated into DIFC Law, notwithstanding Article 42(1) of the DIFC Arbitration Law[7] and Article 24(2) of the DIFC Court Law[8]. As such, Article 5 was not binding on the DIFC Court.

His Honour also grappled with the slightly different question of whether the Riyadh Convention applied to the DIFC Court, not by virtue of Article 5, but by virtue of Article 3(2). The Riyadh Convention is not only an international treaty to which the UAE is party (thus potentially triggering Article 5, were it to apply), but it is also incorporated directly into UAE Federal law by way of Federal Decree No. 53 of 1999 (the “Decree”). If the Riyadh Convention (as converted to Federal Law by the Decree) was not a civil or commercial law, it would therefore apply to the DIFC by virtue of Article 3(2). The Defendant argued that the Riyadh Convention was procedural law, not civil or commercial law, and thus applied in the DIFC. Justice Al Sawalehi rejected this, finding that Article 6 fell under the rubric of civil and commercial law in Article 3(2), and was thus precluded from application in the DIFC.

The Appeal

The Defendant appealed, and the hearing occurred in February 2021 before Chief Justice Zaki Azmi, Justice Wayne Martin, and Justice Sir Richard Field. The two[9] key issues on appeal were:

1. Do the terms of the Riyadh Convention form part of DIFC Law such that they must be applied by the DIFC Court?
2. If the answer to (1) is yes, is the service regime in the Riyadh Convention exclusive, such that the DIFC Court cannot either order alternative service or dispense with service?

(1)    Is the Riyadh Convention part of DIFC Law?

The Court of Appeal answered this question in the negative, which was sufficient to dismiss the Appeal. Like the Court of First Instance, the focus of the Court of Appeal was on whether the Riyadh Convention was ‘automatically’ a part of DIFC Law (and therefore binding on the DIFC Court), by virtue of Article 5 and/or Article 3(2).

Article 5

Regarding Article 5, the Court of Appeal found:

(a)    Article 5 imposes obligations upon the “Financial Free Zones”. On the proper construction of Article 5, “Financial Free Zones” does not include the DIFC Courts. This was for the following reasons:

i.	A “Financial Free Zone” is defined by Article 1 to be the corporate body created when a Federal Decree is issued in accordance with Article 2[10] of UAE Federal Law No. 8 of 2004. The DIFC Court is not such a corporate entity[11].  Rather, the combined effect of Federal Law No. 8 of 2004 and Federal Decree No. 35 of 2004 was to create a corporate entity known as the Dubai International Financial Centre. It is this entity that is the subject of Article 5.
ii.	There is an important distinction between the obligation of courts to apply the domestic law of the jurisdiction, and the obligation of States to comply with their international agreements. The Defendant/Appellant’s reliance on Article 5 elided this distinction.
iii.	Article 5 is intended to ensure that the relevant corporate body which is delegated executive power by the State exercises such power in a manner which does not put the State in breach of its international agreements. In other words, Article 5 functions as a constraint on the exercise of executive power; it cannot be taken to import all obligations imposed under all treaties to which the UAE is a party into the domestic law of each Financial Free Zone.
iv.	Indeed, Articles 3 and 7(3)[12] of UAE Federal Law No. 8 of 2004 are the provisions concerned with the laws applicable in Financial Free Zones, not Article 5.
v.	The exercise of judicial authority within a Financial Free Zone is left to be dealt with by laws issued by the relevant Emirate pursuant to Article 7(3). It is impossible to construe the reference in Article 5 to the “Financial Free Zones” to include whatever myriad arrangements might be made with respect to the exercise of judicial authority within the various Emirates within which such Zones might be created.

The crux of the above is that Article 5 does not provide that international agreements to which the UAE is party apply automatically within the DIFC. Subject to Article 3(2) (see below), unless and until a relevant Emirate exercises the powers reserved to it by Article 7(3) to issue legislation implementing international agreements into the domestic law of the relevant Financial Free Zone, such obligations will not form part of that domestic law – in the same way as treaty obligations do not form part of the domestic law of any State unless and until implemented by the State.

However, the Court of Appeal was careful to say that, although the Riyadh Convention was not binding law in the DIFC, the DIFC Court was a UAE Court and thus could invoke the provisions of the Riyadh Convention to facilitate service where it was applicable. In such cases, whether service is validly effected as a matter of DIFC Law will turn upon the question of whether service has taken place in accordance with the rules of the Court.

Article 3(2)

As set out above, Article 3 provides that all Financial Free Zones are subject to all Federal Laws “with the exception of Federal civil and commercial laws”. On the assumption that the Riyadh Convention formed part of the UAE Federal Law, the critical question for the Court of Appeal was whether the Riyadh Convention generally, or Article 6 of the Riyadh Convention specifically, were “civil and commercial laws” and therefore excepted from the operation of Article 3(2). The Court of Appeal found as follows:

1. Article 3(2) is properly construed as applying to the specific rule or obligation which it is contended should be applied within the relevant Zone, rather than as a reference to the instrument in which that rule, law or obligation is located. So the question was not whether the Riyadh Convention is a civil and commercial law, but whether the relevant provisions are (e.g. Article 6).
2. The relevant provisions in the Riyadh Convention relate to service of DIFC Court documents. This is a matter of civil procedure. Pursuant to the case of  IGPL v Standard Chartered Bank[13], matters of civil procedure are matters of civil and commercial law, and thus excepted from the operation of Article 3. This is further supported by the application of Article 6, which is expressly said to relate to “civil, commercial and administrative cases and cases of personal status”.

For these reasons Article 3(2) expressly excludes Article 6 of the Riyadh Convention from application within the DIFC. The Judge in Pearl Petroleum was wrong to conclude otherwise.

(2)     Is the service regime in the Riyadh Convention exclusive?

While strictly unnecessary given the finding that the Riyadh Convention did not apply in the DIFC under either Article 5 or Article 3(2), the Court of Appeal also considered whether the Riyadh Convention specified an exclusive service regime. The Court of Appeal answered this in the negative, finding that:

1. The Riyadh Convention does not state that Convention Service is the exclusive means by which service can be validly effected.
2. Any construction of the Riyadh Convention to that effect would be antithetical to its objects and purpose.
3. The proposition that service by alternative methods may only be permitted after service under the Riyadh Convention had been attempted but failed therefore falls away.

(3)     Can the DIFC Court in any event dispense with service so that the Riyadh Convention is not engaged?

The Riyadh Convention also did not prevent the DIFC Court from dispensing with service. Article 6 applies to documents which are “required to be served or notified”. Determining which documents fall within that category is a matter for the Court in which the proceedings are being conducted. If that Court concludes, in accordance with its own rules, that a document is not required to be served, Article 6 has no application.

Take-away points

To recap, the key points from the Judgment are as follows:

1. Article 5 of Federal Law No. 8 of 2004 does not provide that international agreements to which the UAE is party apply automatically within the DIFC. Subject to Article 3(2), unless and until a relevant Emirate expressly implements the international agreement into the domestic law of the relevant Financial Free Zone, such obligations will not form part of that domestic law. The Riyadh Convention is not therefore part of DIFC Law.
2. In any event, the Riyadh Convention does not provide an exclusive service regime.
3. The DIFC Court can, in an appropriate case, order alternative service or dispense with service in respect of a receiving party domiciled in a Convention State.
4. That said, where a receiving party is domiciled in a Convention State, the Riyadh Convention should be considered a ‘tool in the arsenal’ – it can still be used to effect valid service, provided the DIFC Court Rules are satisfied.

Conclusion

The Court of Appeal’s decision will be welcomed by DIFC Court practitioners and users. It provides welcome clarity to an issue that has dogged practitioners since Pearl Petroleum, and confirms flexibility regarding service-out of DIFC Court documents on parties resident in Convention states. No longer are parties bound to attempt Convention Service, and blocked when Convention Service fails. This reaffirms the DIFC Court’s status as a regional dispute resolution hub that is pro-arbitration and committed to enforcement. Further, and perhaps most importantly, the decision has answered the fundamental question of when and how international agreements to which the UAE is a party become part of DIFC law. This will no doubt be relied on in many cases to come.

For further information or advice regarding the Court of Appeal decision, or service and enforcement more generally, please contact the highly experienced team at Gibson Dunn.

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      [1]     The 1983 Riyadh Arab Agreement for Judicial Cooperation (the “Riyadh Convention”). The Riyadh Convention has state signatories from across the Arab world (including the UAE, Jordan, Bahrain, Tunisia, Egypt, Algeria, Djibouti, Saudi Arabia, Sudan, Syria, Somalia, Iraq, Oman, Palestine, Qatar, Kuwait, Lebanon, Libya, Morocco, Mauritania and Yemen).

      [2]     Pearl Petroleum Company Limited & Others v The Kurdistan Regional Government of Iraq [2017] DIFC ARB 003 (“Pearl Petroleum”).

      [3]     A translation of Article 6 of the Riyadh Convention provides (with alternative wording in square brackets): “Legal and non- legal [Judicial and non-judicial] documents and papers relating [pertaining] to civil, commercial and administrative cases and cases of personal status required to be served or notified to [which are to be published or which are to be transmitted to] persons residing in one of the contracting states shall be sent [dispatched] directly by the authority or the competent legal office [from the judicial body or officer concerned] to the court which the person who is required to be served or notified resides in its jurisdiction area [to the court of the district in which the person to be notified resides].”

      [4]     Article 5 provides: “The Financial Free Zones shall not do anything which may lead to contravention of any international agreements to which the state is or shall be a party”.

      [5]     That is to say, apply without express implementation by Dubai or DIFC Law, or the agreement of the parties.

      [6]     Law No. 10 of 2004. Article 30 provides: “Governing Law (1) In exercising its power and functions, the DIFC Court shall apply: (a) the Judicial Authority Law; (b) DIFC Law or any legislation made under it; (c) the Rules of Court; or (d) such law as is agreed by the parties. (2) The DIFC Court may, in determining a matter or proceeding, consider decisions made in other jurisdictions for the purpose of making its decision”.

      [7]     Article 42(1) provides: “For the avoidance of doubt, where the UAE has entered into an applicable treaty for the mutual enforcement of judgments, orders or awards the DIFC Court shall comply with the terms of such treaty”.

      [8]     Article 24(2) provides: “Where the UAE has entered into an applicable treaty for the mutual enforcement of judgments, orders or awards, the Court of First Instance shall comply with the terms of such treaty”. In his additional reasons for granting permission to appeal, Justice Al Sawalehi found that, Article 24(2) was an express exception to the general rule that UAE treaties do not apply directly within the DIFC. The need for this express exception carried with it a negative implication – i.e. that UAE treaties do not have direct effect within the DIFC absent DIFC legislation enacting the treaty as law. This was consistent with the relationship between UAE treaties and the rest of the UAE. This does not mean that DIFC Courts cannot comply with UAE treaties which have not been expressly incorporated into DIFC Law; it simply means that the effectiveness of proceedings will not come down to compliance or non-compliance with them.  This is similar to the approach of the English Courts with respect to UK treaties.

      [9]     The Court also briefly discussed other issues that had been raised by the Parties, including: (1) whether the DIFC Court was precluded from applying Federal Laws generally, absent agreement of the Parties and (2) whether the New York Convention overrode any inconsistent provisions of the Riyadh Convention.  Ultimately the Court found it was unnecessary to decide these issues given its primary finding that the Riyadh Convention was not a part of DIFC law.

      [10]    Article 2 provides: “A Financial Free zone shall be established by a Federal Decree. It shall have a body corporate and shall be represented by the President of its Board. It and no one else shall be responsible for the obligations arising out of the conduct of its activities. The Cabinet will describe its area and location”.

      [11]    The DIFC Courts are a separate (in effect, subsidiary) corporate body established under the Dubai Law No. 9 of 2004, which was made pursuant to the legislative powers specifically reserved to the Emirate of Dubai by Article 7(3) of Federal Law No. 8 of 2004.

      [12]    Article 7(3) provides: “Subject to the provisions of Article 3, the concerned Emirate may, within the limits of the goals of establishing the Financial Free Zone, issue legislation necessary for the conduct of its activities”.

      [13]    [2015] DIFC CA 004.

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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, or the following authors in the firm’s Dubai office:

Graham Lovett (+971 (0) 4 318 4620, [email protected])
Michael Stewart (+971 (0) 4 318 4638, [email protected])
Sophia Cafoor-Camps (+971 (0) 4 318 4629, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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Colorado’s Equal Pay for Equal Work Act (EPEW), as well as the accompanying Rules and guidance, took effect on January 1, 2021. Prior to the new year, however, the Rocky Mountain Association of Recruiters (RMAR) sued the Colorado Department of Labor and Employment (CDLE) in the U.S. District Court for the District of Colorado, challenging the constitutionality of the law’s compensation and promotion posting requirements. On May 27, 2021, after previously ordering supplemental briefs on the posting requirements’ burdens on interstate commerce, Judge William J. Martinez denied the RMAR’s request for a preliminary injunction to suspend enforcement of the posting provisions at issue.

Colorado’s Equal Pay for Equal Work Act Posting Requirements

With a stated goal of aiding in achieving pay equity in Colorado, the EPEW has an expansive reach, covering all public and private employers that employ at least one person in Colorado. The law includes extensive compensation and promotion posting requirements, which employers—particularly multi-jurisdictional employers—have struggled with implementing. In fact, the posting provisions have proved so burdensome in practice that some employers have elected to wholly remove some employment opportunities from Colorado rather than navigate compliance difficulties. See https://www.9news.com/article/news/investigations/job-posting-labor-laws/73-7f2ac237-06fe-4353-8318-00a4b52d80bc.

Under the EPEW’s compensation posting requirements, employers are required to “disclose in each posting for each job the hourly or salary compensation, or a range of the hourly or salary compensation, and a general description of all of the benefits and other compensation to be offered to the hired applicant.” C.R.S. § 8-5-201(2) (2021). In addition to postings for jobs in Colorado, the requirement also reaches postings for all remote positions that could be performed in Colorado. 7 CCR 1103-13 (4.3)(B).

Additionally, the EPEW requires employers to “make reasonable efforts to announce, post, or otherwise make known all opportunities for promotion to all current employees on the same calendar day and prior to making a promotion decision.” C.R.S. § 8-5-201(1) (2021). Under the Rules, a “promotional opportunity” is broadly defined as “when an employer has or anticipates a vacancy in an existing or new position that could be considered a promotion for one or more employee(s) in terms of compensation, benefits, status, duties, or access to further advancement.” 7 CCR 1103-13 (4.2.1). Postings are required even if no one in Colorado is qualified for the promotional opportunities. The promotion requirement applies widely and only allows for a few narrow exceptions, such as when employees are unaware they will be separated from their employers.

Background on Rocky Mountain Association of Recruiters v. Moss

In its initial complaint, the RMAR argued that: (1) the EPEW’s posting requirements constitute unlawfully “compelled speech” in violation of the First Amendment; and (2) the requirements violate the Dormant Commerce Clause due to their excessive burden on interstate commerce and their conflict with other states’ statutory schemes. The RMAR requested from the court a declaration that the posting requirements are unconstitutional, as well as a permanent injunction barring the CDLE’s enforcement of the posting provisions. Additionally, the RMAR filed a motion for a preliminary injunction on December 31, 2020, which would prevent the posting provisions’ enforcement until a decision on their legality is reached.

On April 21, 2021, Judge William J. Martinez held a hearing on the RMAR’s motion for preliminary injunction. The court ordered supplemental briefings from the CDLE and RMAR on the burdens that the EPEW posting requirements place on interstate commerce—hinting that the court was potentially amenable to the RMAR’s Dormant Commerce Clause argument. The supplemental briefs were filed on May 6, 2021, and response briefs were filed on May 17, 2021.

For the RMAR’s supplemental brief, the court directed it to identify the two most burdensome aspects of both the compensation and promotion posting requirements. For the compensation posting requirements, the RMAR identified as most burdensome: (1) the requirement to post compensation for remote jobs or other jobs that “could” be performed in Colorado; and (2) the forced disclosure of confidential information and trade secrets. For the most burdensome aspects of the promotion posting requirements, the RMAR identified: (1) the requirement to notify Colorado employees of “promotional opportunities” anywhere in the world and to pause any hiring or promotions until such notice is provided; and (2) the lack of exceptions for trade secret disclosures, confidential searches, and corporate mergers and reorganizations. In its response brief, the CDLE argued that the RMAR’s identified burdens were “simply operational or logistical burdens” on individual firms, which do not rise to cognizable burdens on interstate commerce under the Dormant Commerce Clause.

From the CDLE, the court requested a supplemental brief on why the operational compliance costs incurred by employers do not matter to Dormant Commerce Clause analysis. In its brief, the CDLE argued that the RMAR failed to show that interstate commerce would be unduly burdened, as individual companies’ increased operational or compliance costs do not equate to a harm to the national market. It also argued that, because the EPEW’s effects are felt primarily in Colorado (or equally inside and outside of Colorado), precedent dictates that the court should not engage in Dormant Commerce Clause balancing analysis at all. Finally, the CDLE contended that, even if the court proceeds with a balancing test, the RMAR’s allegations are too broad and general to use as evidence in such a test. In response, the RMAR reiterated that the posting requirements burden interstate commerce by interfering with “a fundamental part of the process of talent acquisition and mobility nationwide (and worldwide)” and that the burdens on its members are representative of the burdens on interstate commerce.

Injunction Holding & Key Takeaways

On Thursday, May 27, 2021, Judge William J. Martinez denied the RMAR’s motion for preliminary injunction, finding that the RMAR failed to demonstrate a substantial likelihood of success on the merits of its Dormant Commerce Clause or First Amendment claims. Notably, the court categorized the RMAR’s request as a disfavored preliminary injunction and applied a heightened standard, with the RMAR bearing a heavier burden to show likelihood of success on the merits of its claims.

For the RMAR’s Dormant Commerce Clause claim, the court found that the RMAR “failed to put forward the necessary evidence regarding the relative magnitude of the local benefits, as compared to the burdens on interstate commerce.” That is, given the record’s lack of specific evidence regarding the EPEW’s harm to interstate commerce, the court could not effectively engage in the necessary balancing test. As such, the RMAR failed to establish a substantial likelihood of success on its Dormant Commerce Clause claim.

For the RMAR’s First Amendment claim, the court found that the EPEW bears a reasonable relationship to a substantial government interest and that, at this stage, the RMAR failed to show that the posting provisions created an undue burden on employers. Specifically, the court noted that, based on testimony and common sense, the posting requirements rationally related to the law’s goal of reducing the wage pay gap. Further, the court found that the requirements do not drown out employers’ individual messages in job postings, because they can be satisfied “in short statements and by disclosing promotion opportunities available to some employees to current Colorado employees.” The court was similarly unpersuaded by the RMAR’s argument that the provisions chill commercial speech, because “employers are still able to recruit candidates with compensation rates for positions of the employers’ choosing.” Thus, the RMAR failed to show a substantial likelihood of success on its First Amendment claim.

It is worth noting that the RMAR’s Dormant Commerce Clause claim failed due to the record’s lack of evidence at this initial, pre-discovery stage of litigation. This leaves the door open for the record to be developed adequately, as the suit proceeds, with the types of specific evidence the court identified as necessary for determining whether the Dormant Commerce Clause claim has merit. (The court seemed less receptive to the First Amendment claim, as its Order tended to focus on the substantive flaws of the RMAR’s arguments.) Thus, while the court denied the RMAR’s motion for preliminary injunction, the RMAR could still ultimately succeed in the suit and, if so, potentially obtain a permanent injunction that would prevent enforcement of the EPEW’s posting provisions. It will be important for employers to continue to comply with the EPEW’s posting requirements in the meantime.

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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, any member of the firm’s Labor and Employment practice group, or the following authors:

Jessica Brown – Denver (+1 303-298-5944, [email protected])
Marie Zoglo – Denver (+1 303-298-5735, [email protected])

Labor and Employment Group:
Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202-955-8242, [email protected])
Katherine V.A. Smith – Co-Chair, Los Angeles (+1 213-229-7107, [email protected])
Rachel S. Brass – San Francisco (+1 415-393-8293, [email protected])
Jessica Brown – Denver (+1 303-298-5944, [email protected])
Catherine A. Conway – Los Angeles (+1 213-229-7822, [email protected])
Jesse A. Cripps – Los Angeles (+1 213-229-7792, [email protected])
Theane Evangelis – Los Angeles (+1 213-229-7726, [email protected])
Gabrielle Levin – New York (+1 212-351-3901, [email protected])
Michele L. Maryott – Orange County (+1 949-451-3945, [email protected])
Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])
Molly T. Senger – Washington, D.C. (+1 202-955-8571, [email protected])
Greta B. Williams – Washington, D.C. (+1 202-887-3745, [email protected])

© 2021 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 Friday, May 28, 2021, the EEOC updated its technical assistance on vaccinations (the “Guidance”). Among other items summarized below, the Guidance states that employers may mandate vaccines under federal EEO laws, explains how to resolve requests for accommodations from employees who cannot be vaccinated for a protected reason under Title VII of the Civil Rights Act of 1964 (“Title VII”) or the Americans with Disabilities Act (“ADA”), and clarifies that employers may request documentation of vaccination.

Employer-Mandated Vaccination

Although the EEOC’s previous guidance from December 16, 2020, strongly implied that employers could mandate vaccines, this updated Guidance clearly states that nothing in the EEO laws prevents an “employer from requiring all employees physically entering the workplace to be vaccinated for COVID-19, subject to the reasonable accommodation provisions of Title VII and the ADA and other EEO considerations.” This is true whether the employee receives the vaccine from the employer or a third party, although if the employer or its agent provides vaccines pursuant to a mandatory-vaccination policy, the employer may only ask pre-vaccination screening questions if it has “a reasonable belief, based on objective evidence, that an employee who does not answer the questions and, therefore, cannot be vaccinated, will pose a direct threat to the employee’s own health or safety or to the health and safety of others in the workplace.”

Employers may also require confirmation, including documentation, of vaccination, but under the ADA, “documentation or other confirmation of vaccination provided by the employee to the employer is medical information about the employee and must be kept confidential” and maintained in a separate location from the employees’ personnel files. The Guidance does not address state data privacy laws and requirements, which may impose additional obligations.

The Guidance explains that when deciding on and implementing a vaccination policy, employers should be mindful that, “because some individuals or demographic groups may face greater barriers to receiving a COVID-19 vaccination than others, some employees may be more likely to be negatively impacted by a vaccination requirement.” An employer may not adopt a vaccination policy that discriminates on the basis of any protected characteristic.

When introducing a vaccination policy, employers should, “as a best practice,” notify employees that they may request an accommodation if they are unable to be vaccinated due to a disability or religious belief, practice, or observance. Managers and/or supervisors tasked with implementing the vaccination policy should know how to recognize an accommodation request (which does not require employees to use any particular verbiage) and should know to whom any requests should be referred for resolution.

Accommodations Process under the ADA and Title VII

Under the ADA, if an employee cannot be vaccinated due to a disability, the employer may not “require compliance” from the employee unless “the individual would pose a ‘direct threat’ to the health or safety of the employee or others in the workplace.” To determine whether the individual is a direct threat, the employer must “make an individualized assessment of the employee’s present ability to safely perform the essential functions of the job,” based on “(1) the duration of the risk; (2) the nature and severity of the potential harm; (3) the likelihood that the potential harm will occur; and (4) the imminence of the potential harm.”

The direct threat assessment “should be based on a reasonable medical judgment that relies on the most current medical knowledge about COVID-19.” The Guidance identifies the following as relevant to whether an unvaccinated employee would present a direct threat:

• “the level of community spread at the time of the assessment”;
• “the type of work environment,” including:
  • “whether the employee works alone or with others”;
  • whether the employee works inside or outside;
  • available ventilation;
  • “the frequency and duration of direct interaction the employee typically will have with other employees and/or non-employees”;
  • “the number of partially or fully vaccinated individuals already in the workplace”;
  • “whether other employees are wearing masks or undergoing routine screening testing”; and
  • “the space available for social distancing.”

If the employer determines that the unvaccinated employee would present a direct threat to others or themselves, the employer must determine whether there is a reasonable accommodation for the employee. Possible reasonable accommodations include the following:

• Requiring the employee to
  • wear a mask;
  • work a staggered shift;
  • work at a distance from coworkers or non-employees; and/or
  • get periodic tests for COVID-19
• “making changes in the work environment (such as improving ventilation systems or limiting contact with other employees and non-employees )”;
• “permitting telework if feasible”; or
• “reassigning the employee to a vacant position in a different workspace.”

An accommodation request may only be denied if there is no accommodation option that “does not pose an undue hardship, meaning [under the ADA] a significant difficulty or expense.” As with the direct threat assessment, “[e]mployers may rely on CDC recommendations when deciding whether an effective accommodation is available that would not pose an undue hardship.” The undue-hardship assessment should consider the “proportion of employees in the workplace who already are partially or fully vaccinated against COVID-19” and the “extent of employee contact with non-employees, who may be ineligible for a vaccination or whose vaccination status may be unknown.”

The Guidance suggests that the employer’s first option should be an accommodation that would “allow the unvaccinated employee to be physically present to perform his or her current job without posing a direct threat.” If no such option is possible, the employer “must consider if telework is an option for that particular job as an accommodation” and, as a “last resort,” determine “whether reassignment to another position is possible.”

Employers must also provide reasonable accommodations for employees who cannot be vaccinated due to “an employee’s sincerely held religious belief, practice, or observance” and must do so “according to the same standards that apply to other accommodation requests.” The Guidance notes that “the definition of religion is broad and protects beliefs, practices, and observances with which the employer may be unfamiliar” and that “the employer should ordinarily assume that an employee’s request for religious accommodation is based on a sincerely held religious belief, practice, or observance,” unless the employer has an objective basis to question the sincerity or religious nature of an employee’s accommodation request. Under Title VII, employers are not required to accommodate employees who are unable to be vaccinated due to religious beliefs, practices, or observances if doing so would impose “more than minimal cost or burden on the employer,” which “is an easier standard for employers to meet than the ADA’s undue hardship standard.”

Finally, the Guidance explains that employees who “seek job adjustments” or request exemptions from a vaccination requirement due to pregnancy “may be entitled to job modifications, including telework, changes to work schedules or assignments, and leave to the extent such modifications are provided for other employees who are similar in their ability or inability to work.”

Incentives

Employers may “offer an incentive to employees to voluntarily provide documentation or other confirmation that they received a vaccination on their own from a pharmacy, public health department, or other health care provider in the community.” The employer may also offer an incentive for employees to receive a vaccination from the employer or its agent, but only if vaccination is voluntary. This is because of the “pre-vaccination disability-related screening questions” that accompany the vaccine, which employers generally cannot compel their employees to answer. Therefore, if the employer (or its agent) provides the vaccine, the employer may not offer such a large incentive that employees would feel “pressured to disclose protected medical information” to the employer in connection with those  screening questions.

Employers also may not offer incentives for employees’ family members to receive the vaccine from the employer or its agent, again because of the pre-screening questions, which would lead to the employer’s receipt of genetic information in the form of family medical history of the employee. But employers may (1) provide vaccines to employees’ family members without offering any incentive or (2) offer incentives “to employees to provide documentation or other confirmation from a third party not acting on the employer’s behalf, such as a pharmacy or health department, that employees or their family members have been vaccinated.”

Emergency Use Authorization

The Guidance no longer references the obligations of the Food and Drug Administration (“FDA”) with regard to the Emergency Use Authorization (“EUA”) status of the COVID-19 vaccines. Previously, the EEOC had indicated that the FDA had an obligation to ensure recipients of the vaccine received informed consent, but it now states that it “is beyond the EEOC’s jurisdiction to discuss the legal implications of EUA or the FDA approach.”

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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, any member of the firm’s Labor and Employment practice group, or the following authors:

Jessica Brown – Denver (+1 303-298-5944, [email protected])
Hannah Regan-Smith – Denver (+1 303-298-5761, [email protected])

Please also feel free to contact the following practice leaders:

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

© 2021 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 UAE Commercial Companies Law (the “CCL”) has been amended to permit 100% foreign ownership of companies incorporated in the UAE under the CCL, commonly known as “onshore” companies (“Onshore Companies”). The UAE Ministry of Economy announced that the foreign ownership amendment would be effective on 1 June 2021. We previously discussed the amendment in our earlier Client Alert.

The requirement that a minimum of 51% of the shares in an Onshore Company be held by one or more UAE nationals, being natural or legal persons, has been removed from Article 10 of the CCL. Foreign ownership restrictions are a key concern for foreign investors, including private equity and venture capital funds, and cause additional complexity and barriers  to investments in Onshore Companies. Foreign investors may now own and control Onshore Companies without the need to employ nominee or similar structures, thus avoiding cumbersome arrangements, additional costs and legal uncertainty. Furthermore, single-shareholder entities, which previously had to be wholly-owned by UAE national(s), are now eligible to be 100% owned by foreign investors.

The Department of Economic Development (“DED”) of each Emirate will specify business activities open to 100% foreign ownership. The Abu Dhabi DED has issued a list of license activities which may be conducted by a foreign-owned Onshore Company encompassing more than 1,100 activities and covering a range of sectors. While “trading” does not appear on the current list, the Abu Dhabi DED may expand the list of license activities in the future to include this activity. The Dubai DED has announced that its list will include more than 1,000 commercial and industrial license activities. The discretion of each Emirate’s DED in determining which activities may be conducted by a foreign owned-Onshore Company may result in different foreign ownership regimes applying to companies operating in the same sector, depending on which one of the Emirates an entity is incorporated in.

Foreign ownership limitations remain in respect of companies carrying out activities of strategic importance, as determined by the UAE Council of Ministers. Companies carrying out such activities will be subject to local ownership and board participation requirements to be determined by the UAE Council of Ministers.

We expect the amended CCL to strengthen the UAE’s standing as an international investment destination. It remains to be seen whether the UAE’s free-zones will decline in popularity with foreign investors as a result.

We would be happy to help clients consider and review their current ownership and governance arrangements to assess the impact of the amended CCL on their business and also discuss investment opportunities with clients.

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Gibson Dunn’s Middle East practice focuses on regional and global multijurisdictional transactions and disputes whilst also acting on matters relating to financial and investment regulation. Our lawyers, a number of whom have spent many years in the region, have the experience and expertise to handle the most complex and innovative deals and disputes across different sectors, disciplines and jurisdictions throughout the Middle East and Africa.

Our corporate team is a market leader in MENA mergers and acquisitions as well as private equity transactions, having been instructed on many of the region’s highest-profile buy-side and sell-side transactions for corporates, sovereigns and the most active regional private equity funds. In addition, we have a vibrant finance practice, representing both lenders and borrowers, covering the full range of financial products including acquisition finance, structured finance, asset-based finance and Islamic finance. We have the region’s leading fund formation practice, successfully raising capital for our clients in a difficult fundraising environment.

For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors in the firm’s Dubai office, with any questions, thoughts or comments arising from this update.

Hardeep Plahe (+971 (0) 4 318 4611, [email protected])
Fraser Dawson (+971 (0) 4 318 4619, [email protected])
Aly Kassam (+971 (0) 4 318 4641, [email protected])
Hanna Chalhoub (+971 (0) 4 318 4634, [email protected])
Thomas Barker (+971 (0) 4 3184623, [email protected])
Galadia Constantinou (+971 (0) 4 318 4663, [email protected])
Sarah Keryakas (+971 (0) 4 318 4626, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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

Background

On May 28, 2021, the Administration released its fiscal year (FY) 2022 Budget, outlining a plan for $6 trillion of federal spending and $4.1 trillion in revenue for FY 2022 alone. Each year, the White House publishes the President’s Budget request for the upcoming fiscal year, which begins on October 1st. The President’s Budget lays out the Administration’s proposals for discretionary spending, revenue and borrowing and typically marks the opening of a dialog with Congress that culminates in appropriations bills and, on a parallel path, tax expenditure and revenue-raising legislation.

Detailed descriptions of the Administration’s legislative tax proposals have historically been provided in a “Greenbook” that includes revenue estimates generated by economists in Treasury’s Office of Tax Policy.[1] With the December 2017 enactment of sweeping changes to the federal tax law in legislation commonly known as the “Tax Cuts and Jobs Act” (the “TCJA”),[2] the prior administration did not publish a separate document laying out new tax legislative proposals. Thus, for the first time since the Obama Administration’s FY 2017 Budget (released in February 2016), the President’s FY 2022 Budget includes a Greenbook with detailed proposals for changes to the federal tax law, including provisions that would modify, expand or add to existing tax expenditures and revenue-raising measures.

Although the Greenbook is only the opening chapter in the FY 2022 budget and appropriations process, the current unified Democratic control of both the White House and of Congress, albeit each House of Congress by small margins, suggests that at least some of its proposals have a significant, although by no means certain, likelihood of moving forward as part of the Appropriations process or in separate pieces of legislation like an infrastructure bill. Most notably, the narrow Democratic majority in the House and the potential use of “reconciliation” procedures in an evenly divided Senate allow Democratic Senators, if they all agree, to pass legislation in Congress without help from Senate Republicans. The prospect of Democrats enacting legislation into law without Republican buy-in provides a new dynamic this year and makes this the most anticipated set of administration legislative tax proposals in recent memory.

The following summaries focus on tax expenditure and revenue-raising proposals in the Greenbook that affect business taxpayers and their owners, as follows:

Part I: Increased Rates for Corporations and Individuals

Part II: Elimination of Certain Significant Benefits

Part III: Sea Changes for International Tax

Part IV: Changes to Prioritize Clean Energy

Part V: Improve Compliance and Tax Administration

PART I: INCREASED RATES FOR CORPORATIONS AND INDIVIDUALS

Corporate Income Tax Rate Raised to 28%

The Greenbook proposes to increase the federal income tax rate on C corporations from 21 percent to 28 percent, effective for taxable years beginning after the end of 2021 (with a phase-in rule for taxpayers that have a non-calendar taxable year).

Recent comments by President Biden caused many to expect a proposed increase to 25 percent, rather than 28 percent, and it remains possible that the Administration will end up agreeing to a smaller corporate rate increase. An increased corporate income tax rate may incentivize corporations to accelerate income into the 2021 calendar year and to defer deductions until a later calendar year. This proposal may also encourage the use of passthrough entities (although taxpayers must also take into account the proposed increase in individual rates). Moreover, the proposed increase would push the corporate rate well above the 23.51 percent average rate for trading partners in the Organisation for Economic Co-Operation and Development (the “OECD”), raising again the long-standing tension between avoiding a “race to the bottom” on rates and strengthening the global tax competitiveness of U.S.-based companies.

It is noteworthy that in proposing an increase in the corporate rate, the Greenbook makes no reference to repealing or modifying the deduction for qualifying business income of certain passthrough entities (e.g., partnerships and S corporations) under Internal Revenue Code (the “Code”) section 199A. That provision was included in the TCJA late in the legislative drafting process in order to create parity between corporations and business operated in passthrough form, such as partnerships, S corporations, and sole proprietorships. Setting the corporate rate at 28 percent (along with the proposed elimination of lower rates on qualified dividends above stated thresholds) may tend to shift the incentive in the opposite direction, although Code section 199A is scheduled to expire in 2025.

Corporate taxpayers with GAAP-based financial statements will have to consider the impact of any rate increase on the values of their deferred tax assets and liabilities.

New 15 Percent Minimum Tax on Book Earnings of Large Corporations

The Greenbook proposes a 15 percent minimum tax on worldwide pre-tax book income for corporations whose book income exceeds $2 billion annually.

This proposal, taken together with the proposal for disallowing interest deductions, would further integrate income tax treatment with financial statement accounting treatment. Historically, these treatments have operated independently, but began to be integrated for limited purposes with the enactment of Code section 451(b) in 2017. The link to financial statement treatment is one of two proposals in the Greenbook (along with the proposed SHIELD provision discussed below) that would significantly expand reliance on third-party accounting standards to determine federal tax liability, a notable shift from the long-standing assumption, recognized by the Supreme Court in Thor Power Tool Co. v. United States, that there are “differing objectives of tax and financial accounting” and the risks and challenges associated with conforming them. It would also re-introduce the complexity of parallel sets of tax rules that Congress sought to eliminate when it repealed the corporate alternative minimum tax as part of the TCJA.

The proposal would be effective for taxable years beginning after December 31, 2021.

Top Marginal Tax Rate for Individuals Raised to 39.6%

Under current law, the top marginal income tax rate for individuals is 37 percent (before accounting for the additional 3.8 percent tax rate on net investment income), but would revert to 39.6 percent (again, before accounting for the additional 3.8 percent tax rate on net investment income) for taxable years beginning on and after January 1, 2026. In 2021, the top marginal rate applies to taxable income that exceeds $628,300 (for married couples filing jointly) or $523,600 (for single filers).

The Greenbook proposes that, beginning in 2022, the new 39.6 percent (before accounting for the additional 3.8 percent tax rate on net investment income) top marginal income tax rate would apply to taxable income that exceeds $509,300 (for married couples filing jointly) or $452,700 (for single filers); the thresholds would be adjusted for inflation in taxable years after 2022. The proposed increase in individual tax rates was not accompanied by a repeal of the limitation on deductibility of state and local taxes.

Tax Certain Capital Gains at Ordinary Income Rates for High Earners

Currently, individual taxpayers are taxed at preferential rates on their long-term capital gains and qualified dividends as compared to ordinary income—the current highest rate for long-term capital gains and qualified dividends is 20 percent (23.8 percent, including the net investment income tax, if applicable).

The Greenbook proposes to tax individuals’ long-term capital gains and qualified dividends at ordinary income tax rates to the extent that the individual’s adjusted gross income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022. For example, an individual with $200,000 of long-term capital gains and $900,000 of wages would have $100,000 of long-term capital gains taxed at ordinary income rates (the $100,000 excess over $1 million).

Other than a brief period of time after passage of the Tax Reform Act of 1986, capital gains have received preferential federal income tax treatment since the 1920s. The Greenbook proposal will add to the long-standing debate on the merits of this preference and undoubtedly cause taxpayers to consider ways in which they can defer or avoid recognition events.The proposal would also remove a historic tax incentive to hold capital assets for one year, possibly resulting in earlier and more common dispositions of assets held for 10 or 11 months.

The proposal would be effective for gain recognized after the date of the announcement (understood to be April 28, 2021, the date when President Biden announced the proposal as part of the American Families Plan). As with other aspects of the Greenbook proposals, the effective date could change during the Budget reconciliation process.

“Deemed” or “Forced” Realization – New Realization Events for Gifts, at Death and for Certain Partnerships and Trusts

Under general tax principles, taxpayers take into account increases and decreases in the value of their assets only at the time of a realization event, such as a sale. Currently, gifts and transfers upon death are not treated as taxable events. This is the case on transfers on death, even though the heir generally takes a “stepped up” fair market value basis in the decedent’s assets upon death, with no income tax due at that time.

Under the Greenbook proposal, donors and decedents would recognize capital gain upon a transfer to a donee or heir, as applicable, based on the asset’s fair market value at the time of transfer. A decedent would be permitted to use capital losses and carry-forwards to offset such capital gains.

The proposal would require the recognition of unrealized appreciation by partnerships, trusts, and other non-corporate entities that are the owners of the property if that property has not been subject to a recognition event in the prior 90 years. Because the look-back period begins January 1, 1940, this aspect of the proposal would not become operational until December 31, 2030. The operational aspects of this proposal – such as which property would be taxed, who would bear the incidence of tax, and the extent of adjustment to basis – are not addressed by the Greenbook.

The proposal also would treat otherwise tax-deferred contributions to, or distributions from, partnerships, trusts, and other non-corporate entities as taxable events. The description of this aspect of the proposal in the Greenbook is startling in its breadth. That is, if taken literally the proposal would upend the bedrock principles in partnership taxation that contributions to and distributions by partnerships generally are tax free. Presumably, the proposal was intended to address indirect donative transfers, and it is hoped that clarification will be forthcoming in short order.

Exclusions would apply to assets transferred to U.S. spouses and charities. Additionally, there would be a $1 million per-person exclusion (generally $2 million per married couple) that would be indexed for inflation. Payment of tax would be deferred in the case of certain family-owned and -operated businesses (which are not defined but would presumably be modeled on the payment extension provisions for estate taxes in Code section 6166) until the interest in the business is sold or the business ceases to be family-owned and -operated. Additionally, the proposal would allow a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death (excluding certain liquid assets and transfers of businesses for which the deferral election is made). This proposal has the potential to create substantial liquidity issues for closely held businesses. As proposed, no change would be made to the exclusion of certain capital gains under Code section 1202.

The proposal generally would be effective beginning January 1, 2022.

Eliminate Gap in Medicare Taxes for High Earners

The current 3.8 percent “net investment income tax” generally applies to passive income and gains recognized by high-income individuals, including trade or business income earned by taxpayers who do not materially participate in the business. The separate 3.8 percent “SECA” tax currently applies to self-employment earnings of high-income taxpayers—both taxes are intended to fund Medicare and are often colloquially referred to as “Medicare” taxes.

Neither form of Medicare tax currently applies to limited partners (many taxpayers believe that certain members of limited liability companies classified as partnerships for federal income tax purposes are “limited partners” for this purpose) and S corporation shareholders (who are subject to Medicare tax solely on “reasonable compensation” paid in an employee capacity) who are treated as materially participating in a trade or business. The Biden Administration likens this gap to a loophole because certain high-income taxpayers’ distributive share of business income may escape Medicare taxation.

The Greenbook proposal would subject all trade or business income of high-income taxpayers (earned income exceeding $400,000) to the 3.8 percent Medicare tax (either through the net investment income tax or the SECA tax) and would apply to taxable years beginning on or after January 1, 2022. The Greenbook bases this change on fair and efficient tax administration. “Different treatment [for owners of different types of passthrough entities] is unfair, inefficient, distorts choice of organizational form, and provides tax planning opportunities for business owners, particularly those with high income, to avoid paying tax.” Notwithstanding that explanation, the proposal goes to some lengths to ensure that it does not impact taxpayers with less than $400,000 in earned income, although it is noteworthy that the proposal is explicit in saying that this threshold would not be indexed for inflation. It is also noteworthy that the exclusion for these lower income taxpayers is linked to earned income rather than “taxable income (from all sources),” which is used elsewhere in the Greenbook as the trigger for proposed denial of capital gain treatment for carried interest.

PART II: ELIMINATION OF CERTAIN SIGNIFICANT BENEFITS

Tax Carried Interests as Ordinary Income

The Greenbook, following in the footsteps of many previously proposed bills, proposes to tax a partner’s share of profits from, and gain from the disposition of, an “investment services partnership interest” as ordinary income, regardless of the character of the income at the partnership level.

Under current law, partnerships are generally able to issue a partnership interest to a service provider who then holds the interest as a capital asset, with the character of the partner’s share of profits from the partnership being determined by reference to the character of the profits in the hands of the partnership. Thus, if the partnership recognizes capital gain, the service provider’s share of such income would generally likewise be capital gain. These equity grants may take the form of a “profits interest,” which is referred to as a “carried interest” in the private equity context, an “incentive allocation” in the hedge fund context, or a “promote” in the real estate context. The TCJA limited the ability to recognize long-term capital gain with respect to these profits interests by enacting Code section 1061, which generally treats gain recognized with respect to certain partnership interests held for less than three years as short-term capital gain.

The Greenbook proposal would eliminate this benefit, but only for partners whose taxable income (from all sources) exceeds $400,000. Partners whose taxable income does not exceed $400,000 would continue to be subject to Code section 1061, which generally treats gain recognized with respect to certain partnership interests or partnership assets held for less than three years as short-term . The “cliff” effect of this proposal would add considerable complexity to the tax law, requiring a parallel set of rules that may apply differently to different members of the same partnership.

The proposal would apply to profits interests held by persons who provide services to a partnership that is an “investment partnership.” A partnership would be an investment partnership if (i) substantially all of its assets are investment-type assets and (ii) more than half of the partnership’s contributed capital is from partners whose partnership interest is an investment (i.e., partners in whose hands the partnership interest is not held in connection with a trade or business). The proposal would not apply to a partnership interest attributable to any capital contributed by the service provider. The proposal includes certain anti-abuse rules intended to prevent the avoidance of the recharacterization rule through the use of compensatory arrangements other than partnership interests.

It appears that the most significant differences between the proposal in the Greenbook and existing law under Code section 1061 would be (i) unlimited time duration (Code section 1061 applies only to recharacterize long-term capital gain recognized with respect to an asset held for three years or less), (ii) treatment of the recharacterized amount as ordinary income rather than short-term capital gain (there is no rate differential, but there could be sourcing and other differences), and (iii) subjecting the income to SECA.

Given that final Treasury regulations under Code section 1061 were released only this year, the proposal to repeal and replace Code section 1061 in certain cases is somewhat surprising, although similar proposals have recently been introduced in Congress. If enacted, this proposal could meaningfully impact the taxation of individuals in the private equity, hedge fund, and real estate industries, and other service providers receiving a profits interest as a form of compensation. It should be noted that if the proposal ending the preferential treatment of long-term capital gain is also enacted, this carried interest proposal would materially affect only profits interests holders with taxable income below $1 million (the threshold in the long-term capital gain proposal).

The provision would be effective for taxable years beginning after December 31, 2021.

Make Permanent Excess Business Loss Limitation of Noncorporate Taxpayers

The TCJA requires that “excess business losses” be carried forward as net operating losses rather than deducted currently. Very generally, an excess business loss is the amount of losses from a business that exceeds the sum of the gains from business activities and a stated threshold ($524,000 for married couples filing jointly and $262,000 for other taxpayers).

Under current law, the excess business loss provision expires in 2027; the Greenbook would make the provision permanent.

Severely Limit Deferral of Gain from Like-Kind Exchanges

Code section 1031 currently provides for non-recognition of gain on exchanges of real property for other like-kind real property (like-kind exchanges). The Greenbook proposes to limit the applicability of Code section 1031 to exchanges that defer gain of less than $500,000 (or $1 million in the case of married individuals filing a joint return) in a taxable year. The proposal does not index the exclusion amounts to inflation, although it does apply those amounts on an annual basis.

This proposal represents a significant change for the real estate, oil and gas, and mineral industries, which together engage in billions of dollars of like-kind exchanges per year. In particular, the proposal could significantly impact the business of REITs, which must distribute at least 90 percent of their taxable income per year and often use Code section 1031 to reduce the amount of income subject to this distribution requirement in order to keep additional cash on hand to complete other real estate purchases. Further, oil and gas “acreage swaps” and mineral interest exchanges could be severely limited. If enacted, the $500,000 / $1 million exclusion included in the proposal could create an incentive to divide property and make partial, tax-deferred dispositions. It could also create an incentive for taxpayers to use tenant-in-common or other pooled structures, like tax partnerships, to facilitate transactions without triggering taxation.

The proposal would be effective for exchanges completed in taxable years beginning after December 31, 2021.

PART III: SEA CHANGES FOR INTERNATIONAL TAX

The TCJA introduced sweeping reform on international tax matters with the goal of incentivizing multinational companies to remain in the United States. Along these lines, not only did the TCJA lower the U.S. corporate income tax rate and provide a 100 percent dividends-received deduction for certain offshore dividends, but it also introduced new obstacles and penalties to discourage so-called inversions and established the global intangible low-tax income (GILTI) and base erosion anti-avoidance regimes to generally provide a minimum level of tax on certain foreign earnings.

The Greenbook, as described in further detail below, proposes to—again—usher in comprehensive changes and unscramble some of the TCJA complexity. Interestingly, several of these proposals are reminiscent of similar proposals made by the OECD. In fact, the Greenbook mentions the OECD four times (compared to zero mentions in the JCT’s Blue Book for the TCJA), suggesting a willingness to find common ground with the OECD on some principles of international taxation.

The proposed changes to the international tax regime come less than four years after passage of the TCJA and inject a new level of uncertainty and instability into U.S.-based companies’ decisions around the global deployment of capital. Moreover, the IRS is just now beginning to audit many of the returns filed for the 2018 tax year, the first year in which TCJA was in full effect. Beyond the front-end planning challenges for taxpayers, enactment of the Greenbook proposals will raise significant administrability issues for the IRS as it works with taxpayers to sort through several interlocking but materially different regimes for taxing cross-border activities.

Revised Global Minimum Tax Regime                 

The Greenbook proposal would increase the effective tax rate of U.S. multinational companies by overhauling the GILTI regime. Specifically, the so-called “QBAI” (or qualified business asset income) exemption would be eliminated, with the result that a U.S. shareholder’s entire net tested income would be subject to tax (i.e., net tested income would no longer be offset by a deemed 10 percent return on certain depreciable tangible property).

The elimination of the QBAI exemption would remove the last fig leaf of the quasi-territorial tax system that was announced with much fanfare in 2017. If enacted, the United States will stake new ground in the international tax arena by requiring U.S. shareholders to pay tax on all earnings in foreign companies, as compared to most countries that tax analogous shareholders only on certain foreign earnings (e.g., corporate earnings from low-tax countries or passive income). Moreover, since all foreign earnings would now be taxed, the Code section 245A dividend-received exemption would become increasingly irrelevant, since the earnings underlying the dividends would generally have been taxed under subpart F or GILTI at the time the foreign corporation earned the income.

It is also worth noting that QBAI is generally tangible property eligible for depreciation, such as buildings or machinery, but QBAI does not include assets that are not depreciable (such as land) nor intangible assets. As a result, the elimination of QBAI may disproportionately affect companies with more tangible assets, rather than companies whose value is primarily intangible assets (like intellectual property). In addition, the cost-benefit analysis of a potential Code section 338(g) election, which regularly arises in cross-border acquisitions, will change given that the step-up in asset basis will no longer produce a tax benefit in the form of QBAI to reduce future GILTI inclusions, though Code section 338(g) elections still have other benefits.

The proposal would also effectively increase the GILTI rate by reducing the Code section 250 deduction from 50 percent to 25 percent. Under current law, U.S. shareholders are entitled to a 50 percent deduction against a 21 percent tax rate, resulting in an effective 10.5 percent GILTI rate. The Greenbook proposal, however, would reduce the deduction to 25 percent. Taken together with the proposed corporate rate increase to 28 percent, this change would result in an effective GILTI rate of 21 percent. Interestingly, the Greenbook’s proposal does not do away with the Code section 250 deduction. Rather, it achieves the 21 percent rate by changing the percentage of the deduction. This approach suggests a willingness to use the relative percentage deduction as a way to reach a compromise on the overall package.

Consistent with the general increase in corporate tax rates, this change to the effective GILTI rate may encourage taxpayers to accelerate gain recognition transactions and/or defer deductions.

In addition, the Greenbook proposes that U.S. shareholders of a controlled foreign corporation (“CFC”) calculate their global minimum tax on a country-by-country basis. In other words, a U.S. shareholder’s global minimum tax inclusion, and tax on such inclusion, would be determined separately for each country in which it or its CFCs operate, rather than permitting taxes paid to higher-taxed jurisdictions to reduce the residual U.S. tax paid on income earned in lower-taxed foreign jurisdictions. This proposed change results in a separate foreign tax credit limitation for each country.

The Greenbook does not suggest any changes to the 80 percent limitation that currently applies to GILTI foreign tax credits. If the 80 percent limitation still exists, GILTI will be exempt from further U.S. tax only if it is subject to foreign taxation at a rate of at least 26.25 percent, since 20 percent (or 5.25) of the foreign tax credit is disallowed under current law.

Finally, this proposal would also repeal the high tax exemption to subpart F income and repeal the cross-reference to that provision in the global minimum tax rules in Code section 951A. This proposal would end the controversy over the Treasury Regulations that provided a high tax exemption for GILTI.

In a proposal that is remarkable for its potential deference to the OECD, these general rules would be adjusted for foreign-parented multinational groups (consistent with the OECD/G20 Inclusive Framework on BEPS project’s Pillar Two proposal (the “Pillar Two”)).

These rules would be effective for taxable years beginning after December 31, 2021.

Expanded Application of Anti-Inversion Rules    

To backstop the changes to the global minimum tax regime and prevent U.S. companies from moving offshore to avoid the global minimum tax, the Greenbook proposes a dramatic expansion of the anti-inversion regime under Code section 7874. Code section 7874 currently applies to the acquisition of a U.S. corporation by a foreign corporation if, after the transaction, the former shareholders of the U.S. corporation own more than 80 percent, by vote or value, of the foreign corporation and certain other conditions are satisfied. In this case, Code section 7874 applies to treat the foreign acquiring corporation as a domestic corporation for U.S. federal income tax purposes, assuming certain other conditions are satisfied. If the portion of the foreign corporation held by former shareholders of the U.S. corporation (the so-called ownership fraction) is between 60 and 80 percent, current law subjects the foreign corporation to the possibility of increased taxation, but does not treat it as a domestic taxpayer.

The Greenbook proposal would replace the current 80-percent threshold with a 50-percent threshold and would eliminate the current 60-percent test entirely. In addition, the proposal would expand the universe of acquisitions treated as inversions (regardless of ownership fraction) to include acquisitions where (1) immediately prior to the acquisition, the fair market value of the domestic entity is greater than the fair market value of the foreign acquiring corporation, (2) after the acquisition, the expanded affiliated group is primarily managed and controlled in the United States, and (3) the expanded affiliated group does not conduct substantial business activities in the country in which the foreign acquiring corporation is created or organized. The proposal would also broaden Code section 7874 in several important ways, by including certain asset acquisitions and stock distributions, picking up U.S. businesses operated by foreign partnerships, and by considering the spinoff of a foreign subsidiary the equivalent of an inversion under certain circumstances.

Code section 7874 is already exceedingly complex and broad in many respects and is thus a frequent trap for the unwary. These proposals, if enacted, will require careful scrutiny by taxpayers and practitioners to avoid dangerous foot faults. Introduction of the management and control and substantial business activities tests, in particular, would add a new level of subjectivity and uncertainty to the threshold question of whether the rules apply.

These rules would be effective for transactions that are completed after the date of enactment of such rules. The lack of an exception for transactions for which there is a binding contract as of the effective date could chill market activity even before passage.

Repeal of Deduction for Foreign-Derived Intangible Income     

The Greenbook proposes the repeal of the deduction currently available to domestic corporations with respect to 37.5 percent of any foreign-derived intangible income for taxable years beginning after December 31, 2021. This proposal was expected, and is framed by the Greenbook as the elimination of an inefficient subsidy to multinational corporations. Additionally, many commentators viewed the existing provision as violating World Trade Organization principles. The increased tax revenue that is estimated to come from repeal would be “used to encourage R&D” (presumably in the United States), although no details are provided on how the $123 billion would be deployed.

Replace BEAT with Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD) Rule

The Greenbook would replace the “base erosion and anti-abuse tax” (“BEAT”) in Code section 59A with a new rule—the Stopping Harmful Inversions and Ending Low-Tax Developments (“SHIELD”) rule—disallowing deductions by domestic corporations with respect to members in their financial reporting group whose income is subject to (or deemed to be subject to) an effective tax rate that is below either the rate agreed to under OECD Pillar Two or the U.S. global minimum tax rate of 21 percent. Disallowance may be complete or partial, depending on whether the payment is made directly to such low-taxed entities.

The rule would apply to financial reporting groups with greater than $500 million in global annual revenues, although the proposal permits the Treasury Department to exempt from SHIELD (i) certain financial reporting groups, if they meet a minimum effective level of tax (on a jurisdiction-by-jurisdiction basis) and (ii) payments to investment funds, pension funds, international organizations, or non-profit entities. It is unclear whether the exemption would extend to investors that rely on the Code section 892 exemption. As discussed above in connection with the proposed minimum tax on book earnings, the link to financial statement reporting would mark another notable shift to reliance on third-party standards for determining U.S. income tax liability.

This proposal could adversely impact entities that have already “inverted,” or foreign-parented entities with domestic subsidiaries (and which conduct significant business in the United States). Foreign-parented entities that have substantial offshore intellectual property held in lower-tax jurisdictions may be particularly affected by this proposal.

The rule would be effective for taxable years beginning after December 31, 2022.

Limit Foreign Tax Credits from Sales of Hybrid Entities

The Greenbook would require that, for purposes of applying the foreign tax credit rules, the source and character of items of certain hybrid entities resulting from either a disposition of an interest in such a hybrid entity or a change in the U.S. tax classification of such entity that is not recognized for foreign tax purposes be determined as if the recognition event were a sale or exchange of stock.

The rule would be effective for transactions occurring after the date of enactment.

Restrict Interest Deductions for Disproportionate Borrowing in the United States

This proposal potentially disallows deductions for interest paid by an entity that is a member of a multinational group that prepares consolidated financial statements. Such an entity’s interest deductions would be disallowed to the extent they exceed an amount determined by reference to the entity’s proportionate share (based on its proportion of group earnings) of the group’s net interest expense as reported on the group’s consolidated financial statement.

Alternatively, if an entity subject to the proposal fails to substantiate its proportionate share of the group’s net interest expense for financial reporting purposes, or an entity so elects, the entity’s interest deduction would be limited to the entity’s interest income plus ten percent of the entity’s adjusted taxable income (as defined under Code section 163(j)).

The proposal would not apply to financial services entities. The proposal also would not apply to groups that would otherwise report less than $5 million of net interest expense, in the aggregate, on one or more U.S. income tax returns for a taxable year.

The proposal would be effective for taxable years beginning after December 31, 2021.

Tax Incentive for Onshoring Jobs

This proposal would create a new general business credit equal to 10 percent of certain expenses paid or incurred in connection with moving a trade or business located outside the United States to the United States to the extent the action results in an increase in U.S. jobs.

The proposal would also reduce tax benefits associated with U.S. companies moving jobs outside of the United States by disallowing deductions for certain expenses paid or incurred in connection with offshoring a U.S. trade or business to the extent the action results in a loss of U.S. jobs.

The proposal would be effective for expenses paid or incurred after the date of enactment.

Expand Taxation of Foreign Fossil Fuel Income

Under current law, certain non-U.S. oil-and-gas-related income effectively is taxed at a lower rate than similar oil-and-gas-related income from activities within the United States. For example, “foreign oil and gas extraction income” is excluded from a controlled foreign corporation’s “gross tested income” and may be repatriated tax free. In addition, taxpayers may claim a credit against U.S. income tax liability for certain levies paid to non-U.S. governments.

The Greenbook proposes scaling back the beneficial tax treatment afforded to non-U.S. oil-and-gas-related income. Specifically, the proposal would require foreign oil-and-gas-extraction income to be included in a CFC’s gross tested income for purposes of GILTI and would limit the situations in which taxpayers can claim a credit for levies paid to non-U.S. governments.

The proposal would be effective for taxable years beginning after December 31, 2021.

PART IV: CHANGES TO PRIORITIZE CLEAN ENERGY

Extension of Tax Credits for Wind, Solar and Other Renewable Generation Facilities

The production tax credit (“PTC”) and investment tax credit (“ITC”) are long-standing renewable energy incentives. The PTC is a production-based incentive, available as power produced from qualifying renewable resources (e.g., wind, solar) is sold to unrelated parties. The ITC is a cost-based incentive, determined as a percentage of eligible basis, that arises when a qualifying renewable energy facility is placed in service. The credits have historically been subject to a complicated patchwork of rules for different resources (e.g., when construction of a facility needs to begin, when the facility must be placed in service, etc.), the qualification rules have changed frequently and often unpredictably, and the credits have been non-refundable. Taken together, these features have presented challenges in the development and financing of renewable energy projects.

The Greenbook proposes a long-term extension of the rules, with the full PTC and ITC both being available for facilities whose construction begins after December 31, 2021 and before January 1, 2027, followed by a predictable, stepped phase-down period. Moreover, unlike the current PTC and ITC, taxpayers would have the option to elect a cash payment in lieu of the tax credits (the so-called “direct pay” option).

If enacted, these proposals would bring greater predictability to project developers and, through the direct pay option, make it meaningfully easier for taxpayers lacking sufficient tax “appetite” to efficiently participate in renewables transactions, spurring additional investment in renewable energy generation facilities. While not described in detail, this “direct pay” option would appear to effectively make the credits refundable, meaning that funding is available irrespective of whether the taxpayer has positive income tax liability. Although this could reduce the incentive to use partnership structures to utilize the credits, it would also add a new level of complexity to their administration and raise concerns from the IRS about the potential for abuse.

The proposal would be effective for taxable years beginning after December 31, 2021.

Expansion of Tax Credits to Stand-Alone Energy Storage and Energy Transmission Assets

Historically, energy storage assets (such as battery storage projects) have been eligible for the ITC only when paired with certain renewable energy resources, and the ITC has been unavailable with respect to energy transmission property. The Greenbook proposes to make certain stand-alone energy storage assets and energy transmission infrastructure assets eligible for the ITC. Moreover, as with the generation facility credit, taxpayers would be eligible to elect a cash payment in lieu of tax credits.

We expect that these proposals to increase the scope of ITC-eligible assets will provide strong incentives for investment in infrastructure designed to make the nation’s electric grid more reliable and resilient.

The proposal would be effective for taxable years beginning after December 31, 2021.

New Tax Credits for Qualifying Advanced Energy Manufacturing

Existing law authorizes a tax credit for the establishment of certain clean energy manufacturing facilities (e.g., facility to manufacture wind or solar equipment), but the amount of the credit is subject to a relatively low cap, which makes the incentive unavailable to certain otherwise-qualifying credit applicants. The Greenbook would expand the availability of the credit to include various new manufacturing facilities (including those focused on energy storage equipment, electric grid modernization equipment, energy conservation technology, and carbon oxide sequestration equipment) and significantly expand the cap, with a material portion of the credit being specifically allocable to projects in coal communities. Again, taxpayers would be eligible to elect a cash payment in lieu of tax credits. Taken together, the proposal intends to spur the production of domestic manufacturing of clean energy property.

The proposal would be effective for taxable years beginning after December 31, 2021.

Eliminate Fossil Fuel Tax Preferences

Current law provides a number of tax incentives meant to encourage oil and gas production. These incentives were targeted for repeal under the Obama Administration’s Greenbook in each year beginning with the 2011 fiscal year. The Biden Administration’s fiscal year 2022 Greenbook picks up where the Obama Administration left off, proposing to repeal a nearly identical set of fossil fuel-related tax incentives. Specifically, the Greenbook proposes repealing: (1) the enhanced oil recovery credit for eligible costs attributable to a qualified enhanced oil recovery project; (2) the credit for oil and gas produced from marginal wells; (3) the expensing of intangible drilling costs; (4) the deduction for costs paid or incurred for any tertiary injectant used as part of a tertiary recovery method; (5) the exception to passive loss limitations provided to working interests in oil and natural gas properties; (6) the use of percentage depletion with respect to oil and gas wells; (7) two-year amortization of independent producers’ geological and geophysical expenditures, instead allowing amortization over the seven-year period used by integrated oil and gas producers; (8) expensing of exploration and development costs; (9) percentage depletion for hard mineral fossil fuels; (10) capital gains treatment for royalties; (11) the exemption from the corporate income tax for publicly traded partnerships with qualifying income and gains from activities relating to fossil fuels; (12) the Oil Spill Liability Trust Fund excise tax exemption for crude oil derived from bitumen and kerogen-rich rock; and (13) accelerated amortization for air pollution control facilities.

If enacted, the repeal of these incentives would make the production of oil and gas costlier by increasing producers’ effective tax rate. That said, some of these incentives, like the intangible drilling cost deduction, predate the Internal Revenue Code itself and have survived numerous political cycles. Efforts to repeal a nearly identical set of incentives proved difficult for the Obama Administration, even where the revenue generated from repeal was projected to be higher during the Obama Administration.

The proposal generally would be effective for taxable years beginning after December 31, 2021, although the repeal of item 11 above (exception for certain publicly traded partnerships) will only become effective for taxable years beginning after December 31, 2026.

Expand and Enhance the Carbon Oxide Sequestration Credit

Current law provides a tax credit for the capture and sequestration of certain types of carbon oxide captured with carbon-capture equipment placed in service at certain qualifying facilities, with the amount of the credit dependent on when and how the carbon oxide is sequestered.

The Greenbook proposes increasing the value of the sequestration credit by (i) $35 dollars per metric ton for carbon oxide that is more difficult to capture, such as carbon oxide from cement production, steelmaking, or hydrogen production, and (ii) $70 per metric ton for direct air carbon capture projects. Further, the “begin construction” date for qualifying facilities eligible for the credit would be extended five years to January 1, 2031. As is the case for the Greenbook’s other clean energy proposals, taxpayers could elect to receive a direct cash payment in lieu of the credits. The enhanced credits, together with the begin construction date extension and the direct pay option, should spur investment in carbon capture facilities and technologies.

The proposal would be effective for taxable years beginning after December 31, 2021.

Other Clean Energy Proposals

• Establish Tax Credits for Heavy- and Medium-Duty Zero Emissions Vehicles
• Provide Tax Incentives for Sustainable Aviation Fuel
• Provide a Production Tax Credit for Low-Carbon Hydrogen
• Extend and Enhance Energy Efficiency and Electrification Incentives
• Provide Disaster Mitigation Tax Credit
• Extend and Enhance the Electric Vehicle Charging Station Credit
• Reinstate Superfund Excise Taxes and Modify Oil Spill Liability Trust Fund Financing

PART V: IMPROVE COMPLIANCE AND TAX ADMINISTRATION

The Administration has been vocal in recent months in calling for an increase in IRS funding to reverse more than a decade of declining budgets and staff attrition, and to address information technology infrastructure challenges, all of which have driven historically low audit rates. On April 9, 2021, the Office of Management and Budget released an outline of the President’s request for fiscal year 2022 discretionary spending that would provide the IRS with $13.2 billion in funding for next year alone, a $1.2 billion or 10.4 percent increase over enacted IRS funding for 2021.[3] This increase would be used in part to improve taxpayer service but a major focus of the increased funding would be on increasing taxpayer compliance with existing law, reducing the “gap” between what is paid over to Treasury in taxes each year and what is actually owed. The most recent official estimates, covering the 2011 – 2013 tax years, are that this “tax gap” is roughly $441 billion annually (reduced by existing enforcement efforts to roughly $ $281 billion), although IRS Commissioner Charles Rettig recently suggested that a more accurate number may be closer to $1 trillion.

While there are some estimates that the IRS can collect $4 in additional tax for every $1 in increased IRS funding, those estimates cover a broad range of enforcement activity and are likely skewed toward low-cost/high-return functions like automated matching of information returns, rather than audits of complex tax returns. And, in the context of those more complex returns, there is considerably more uncertainty around what tax is actually owed, given ambiguities in the underlying law. Moreover, according to the IRS’s own estimates, over time the voluntary compliance rate has remained remarkably constant at just under 85 percent, even during periods of significantly declining budgets and enforcement activity, raising the question as to whether a material increase in IRS funding will translate into the expected increase in compliance.

Introduce Comprehensive Financial Account Reporting to Improve Tax Compliance

Recognizing that increased funding for the IRS alone will not be sufficient to make the necessary dent in the tax gap, the Greenbook includes several proposals that would equip the IRS with better information to address noncompliance with existing tax laws. The premise for these proposals is that third-party reporting can increase voluntary compliance rates from below 50 percent to as high as 95 percent. From that premise, the Administration proposes to create a “comprehensive financial account reporting regime,” that would require financial institutions to report gross transfers into and out of accounts, including accounts owned by the same taxpayer. This proposal is estimated to raise $8.3 billion in FY 2022 alone and, once fully implemented, to raise over $462 billion over the next 10 years. While increased information reporting will undoubtedly improve voluntary compliance, by how much is an open question. The proposed reporting regime falls several steps short of the Form W-2 reporting that ties directly into taxable income and also falls short of most existing Form 1099 reporting, which ties directly into gross income. Rather, like merchant card reporting under Code section 6050W, the comprehensive reporting regime would provide the IRS with information about fund flows that could lead to uncovering unreported taxable income (or encourage taxpayers to more accurately report taxable income to begin with) but will not do so directly. Whether this helps move compliance from under 50 percent to closer to 95 percent will depend on a number of variables, including the extent to which and how quickly financial institutions can implement a new reporting requirement and whether the IRS has the resources in place to effectively utilize the new information through deployment of artificial intelligence and comprehensive audit follow up. Successful implementation of the program will present additional challenges to the extent that, as proposed, it covers crypto assets, where a longer period of time for implementation could be needed, and unique substantive issues around transfers of “property,” as the IRS has characterized cryptocurrency, are likely to be raised. Even with established financial institutions that have deep experience with reporting information to the IRS, implementation of prior information reporting regimes including broker accounts and FATCA have proven far more complicated and burdensome than first expected.

Oversight of Paid Tax Return Preparers

The Greenbook proposes to provide the Secretary with explicit authority to regulate paid tax return preparers. This proposal has been included in several pieces of introduced legislation and was proposed in a number of prior-year Budget requests. In the past it was met with resistance from some in the tax professional community as well as members of Congress who oppose imposing new regulatory requirements on small businesses.

The proposal would be effective for taxable years beginning after December 31, 2021.

Modifications to Partnership Audit Rules

Under the BBA Centralized Partnership Audit Regime signed into law in 2015 and generally effective for tax years beginning in 2018, partners in the “adjustment” year of a partnership’s return are responsible for any tax payment obligation arising from adjustments going back to the “reporting year” return at issue. The BBA generally permits partnerships undergoing audit for certain tax years to make a “push out” election whereby the reporting year partners, and not the adjustment year partnership, become responsible for payments arising from an audit adjustment. If an adjustment reduces, instead of increases, a partner’s tax liability, the partner can use the decrease to offset its tax liability in the current year, but not below zero, with any reduction in excess of its tax liability in the current year being lost. The proposed change would treat the excess as a tax overpayment, potentially allowing a refund. This proposal reflects the Administration’s priority on increased enforcement for flow-through entities.

The proposal would be effective upon enactment.

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   [1]   The term “Bluebook” has also been used in prior administrations. Greenbook and Bluebook legislative proposals dating back to 1990 are available on the Treasury Department’s website, https://home.treasury.gov/policy-issues/tax-policy/revenue-proposals. The Joint Committee on Taxation (“JCT”) periodically publishes a general explanation of recently enacted tax legislation in a publication that is also known as a “Blue Book.” In December 2018, JCT released a Blue Book that explains the TCJA, which can be found at https://www.jct.gov/publications/2019/jcs-2-19/.

   [2]   TCJA is formally titled “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” Pub. L. No. 115-97, 131 Stat. 2045.

   [3]   https://www.whitehouse.gov/wp-content/uploads/2021/04/FY2022-Discretionary-Request.pdf.

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This alert was prepared by Jennifer Sabin, John-Paul Vojtisek, Dora Arash, Michael D. Bopp, James Chenoweth, Michael J. Desmond, Pamela Lawrence Endreny, Roscoe Jones, Jr., Kathryn Kelly, Brian W. Kniesly, David Sinak, Eric Sloan, Jeffrey M. Trinklein, Edward Wei, Lorna Wilson, Daniel A. Zygielbaum, Michael Cannon, Jennifer Fitzgerald, Evan M. Gusler, Brian Hamano, James Jennings, James Manzione and Collin Metcalf.

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, any member of the firm’s Tax or Public Policy practice groups, or the following authors:

Jennifer Sabin – New York (+1 212-351-5208, [email protected])
John-Paul Vojtisek – New York (+1 212-351-2320, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
James Chenoweth – Houston (+1 346-718-6718, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Pamela Lawrence Endreny – New York (+1 212-351-2474, [email protected])
Kathryn A. Kelly – New York (+1 212-351-3876, [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
David Sinak – Dallas (+1 214-698-3107, [email protected])
Eric B. Sloan – Co-Chair, New York (+1 212-351-2340, [email protected])
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224 /+1 212-351-2344), [email protected])
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])

Public Policy Group:
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, [email protected])
Roscoe Jones, Jr. – Washington, D.C. (+1 202-887-3530, [email protected])

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London partner Michelle Kirschner and New York partner Arthur Long are the authors of “UK independent review of post-financial crisis proprietary trading rules — an opportunity for reform?” [PDF] first published by Thomson Reuters Regulatory Intelligence on May 20, 2021.

Gibson, Dunn & Crutcher LLP is pleased to announce with Global Legal Group the release of the International Comparative Legal Guide to: Anti-Money Laundering 2021. Gibson Dunn partners Stephanie L. Brooker and Joel M. Cohen were again contributing editors to the publication which covers issues including criminal enforcement, regulatory and administrative enforcement and requirements for financial institutions and other designated businesses. The Guide, comprised of 4 expert analysis chapters and 28 jurisdictions, is live and FREE to access HERE.

Ms. Brooker and Gibson Dunn partner M. Kendall Day co-authored “The Anti-Money Laundering Act of 2020’s Corporate Transparency Act.” Senior Associates Ella Alves Capone and Ben Belair provided invaluable assistance with the article.

In addition, Mr. Cohen co-authored with Gibson Dunn Of Counsel Linda Noonan the jurisdiction chapter on “USA: Anti-Money Laundering 2021.”

You can view these informative and comprehensive chapters via the links below:

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About Gibson Dunn’s Anti-Money Laundering Practice: Gibson Dunn’s Anti-Money Laundering practice provides legal and regulatory advice to all types of financial institutions and nonfinancial businesses with respect to compliance with federal and state anti-money laundering laws and regulations, including the U.S. Bank Secrecy Act. We represent clients in criminal and regulatory government investigations and enforcement actions. We also conduct internal investigations involving money laundering and Bank Secrecy Act violations for a wide range of clients in the financial services industry and companies with multinational operations.

For further information, please visit our practice page and feel free to contact Stephanie L. Brooker in Washington, D.C. (+1 202.887.3502, [email protected]), Joel M. Cohen in New York (+1 212.351.2664, [email protected]) or M. Kendall Day in Washington, D.C. (+1 202.955.8220, [email protected]).

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Stephanie Brooker is Co-Chair of Gibson Dunn’s White Collar Defense and Investigations and Financial Institutions Practice Groups. She also co-leads the firm’s Anti-Money Laundering practice. She is the former Director of the Enforcement Division at FinCEN, and previously served as the Chief of the Asset Forfeiture and Money Laundering Section in the U.S. Attorney’s Office for the District of Columbia and as a DOJ trial attorney for several years. Ms. Brooker’s practice focuses on internal investigations, regulatory enforcement defense, white-collar criminal defense, and compliance counseling. She handles a wide range of white collar matters, including representing financial institutions, multi-national companies, and individuals in connection with criminal, regulatory, and civil enforcement actions involving sanctions; anti-corruption; anti-money laundering (AML)/Bank Secrecy Act (BSA); securities, tax, and wire fraud; foreign influence; “me-too;” cryptocurrency; and other legal issues. Ms. Brooker’s practice also includes BSA/AML and FCPA compliance counseling and deal due diligence and asset forfeiture matters. Ms. Brooker has been named a Global Investigations Review “Top 100 Women in Investigations” and National Law Journal White Collar Trailblazer.

Joel M. Cohen, a trial lawyer and former New York federal prosecutor, is Co-Chair of Gibson Dunn’s White Collar Defense and Investigations Practice Group, and a member of its Securities Litigation, Class Actions and Antitrust & Competition Practice Groups. He has been lead or co-lead counsel in 24 civil and criminal trials in federal and state courts, and he is equally comfortable in leading confidential investigations, managing crises or advocating in court proceedings. Mr. Cohen is a top-ranked litigator by Chambers and other leading legal services reviewers. His experience includes all aspects of AML, FCPA/anticorruption issues, securities fraud, insider trading, sanctions, and tax fraud, in addition to financial institution litigation and other international disputes and discovery.

M. Kendall Day is Co-Chair of Gibson Dunn’s Financial Institutions Practice Group, co-leads the firm’s Anti-Money Laundering practice, and is a member of the White Collar Defense and Investigations Practice Group. Prior to joining Gibson Dunn, Kendall was a white collar prosecutor for 15 years, eventually rising to become an Acting Deputy Assistant Attorney General, the highest level of career official in the Criminal Division at DOJ. He represents financial institutions; fintech, crypto-currency, and multi-national companies; and individuals in connection with criminal, regulatory, and civil enforcement actions involving anti-money laundering (AML)/Bank Secrecy Act (BSA), sanctions, FCPA and other anti-corruption, securities, tax, wire and mail fraud, unlicensed money transmitter, false claims act, and sensitive employee matters. Mr. Day’s practice also includes BSA/AML compliance counseling and due diligence, and the defense of forfeiture matters.

Linda Noonan is Of Counsel in the Washington, D.C. office and a member of the firm’s Financial Institutions and White Collar Defense and Investigations Practice Groups. She joined the firm from the U.S. Department of the Treasury, Office of General Counsel, where she had been Senior Counsel for Financial Enforcement.  In that capacity, she was the principal legal advisor to Treasury officials on domestic and international money laundering and related financial enforcement issues. She specializes in BSA/AML enforcement and compliance issues for financial institutions and non-financial businesses.

Ella Alves Capone is a senior associate in the Washington, D.C. office, where she is a member of the White Collar Defense and Investigations and Anti-Money Laundering practice groups. Her practice focuses primarily in the areas of white collar criminal defense, internal investigations, regulatory enforcement defense, and compliance counseling. Ms. Capone regularly conducts internal investigations and advises multinational corporations and financial institutions, including major banks, virtual currency businesses, and casinos, on anti-corruption, Bank Secrecy Act/anti-money laundering, and sanctions compliance.

Ben Belair is an associate in the Washington, D.C. office, where he is a member of the White Collar Defense and Investigations practice group. His practice focuses primarily in the areas of white collar criminal defense, government and internal investigations, and compliance counseling.

© 2021 Gibson, Dunn & Crutcher LLP

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

Private equity firms and their portfolio companies are under ever-increasing scrutiny from federal and state regulators. A veritable “alphabet soup” of government agencies, including DOJ, SEC and FinCEN, have made clear that private equity firms are squarely within their regulatory sights. In this two-part webinar series, we invite you to join Gibson Dunn practitioners experienced in government investigations and related civil litigation to discuss hot topics relevant to private equity firms and their portfolio companies. This is a “must attend” presentation for those in private equity, designed to arm you with the latest information and government enforcement trends applicable to the industry.

View Slides (PDF)

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PART 1 – Tuesday, May 25th

Private Equity and government enforcement in:

• Data security and privacy laws
• The federal and state False Claims Acts
• Covid-19 relief fraud enforcement
• SEC enforcement trends

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PART 2 – Thursday, May 27th

Private Equity and government enforcement in:

• Anti-money laundering issues
• The Foreign Corrupt Practices Act
• Health care enforcement
• Post M&A indemnification and fraud claims

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MODERATOR: 

Nick Hanna, who most recently served as United States Attorney for the Central District of California, is a litigation partner in Gibson Dunn’s Los Angeles office and co-chairs the firm’s global White Collar Defense and Investigations Practice Group. Mr. Hanna’s practice focuses on representing corporations in high-stakes civil litigation, white collar crime, and regulatory and securities enforcement – including internal investigations, False Claims Act cases, special committee representations, compliance counseling and class actions.

PANELISTS:

Michael Celio is a sought-after trial lawyer with more than two decades of experience trying cases in Silicon Valley and beyond. He maintains a wide-ranging trial practice and has tried more than two dozen cases to verdict in state and federal court. He is a recognized expert in the field of securities litigation and is particularly experienced in defending venture capital and private equity funds and their partners as well as their portfolio companies.

Winston Y. Chan is a former federal prosecutor and litigation partner in Gibson, Dunn & Crutcher’s San Francisco office. He has particular experience leading matters involving government enforcement defense, internal investigations and compliance counseling, and regularly represents clients before and in litigation against federal, state and local agencies, including the U.S. Department of Justice, Securities and Exchange Commission and State Attorneys General.

Michael M. Farhang is a former federal prosecutor and a partner in the Los Angeles office of Gibson, Dunn & Crutcher. He is a Chambers-ranked attorney and practices in the White Collar Defense and Investigations and Securities Litigation Practice Groups. Mr. Farhang is an experienced litigator and trial attorney who has earned more than $40 million in recoveries for corporate clients pursuing fraud, contract, and M&A-related claims.

Diana M. Feinstein is a partner in the Los Angeles office of Gibson, Dunn & Crutcher. She is a member of the firm’s Securities Litigation and White Collar Defense and Investigations Practice Groups. Ms. Feinstein’s practice focuses on complex litigation, including securities litigation and high-value commercial litigation. She also focuses on white collar defense and investigations.

John Partridge, a Co-Chair of Gibson Dunn’s FDA and Health Care Practice Group and Chambers-ranked white collar defense and government investigations lawyer, focuses on government and internal investigations, white collar defense, and complex litigation for clients in the life science and health care industries, among others. Mr. Partridge has particular experience with the Anti-Kickback Statute, the False Claims Act, the Foreign Corrupt Practices Act, and the Federal Food, Drug, and Cosmetic Act, including defending major corporations in investigations pursued by the U.S. Department of Justice (DOJ) and the U.S. Securities and Exchange Commission (SEC).

Eric D. Vandevelde is a litigation partner in Gibson Dunn’s Los Angeles office. He is a former federal prosecutor and an experienced trial and appellate attorney. Mr. Vandevelde has been selected by Chambers USA in the area of White-Collar Crime & Government Investigations, has been repeatedly recognized as a “Super Lawyer” by Super Lawyers Magazine, and was named one of the Top 20 Cyber/Artificial Intelligence Lawyers in California by The Daily Journal.

Debra Wong Yang is a partner in Gibson, Dunn & Crutcher’s Los Angeles office. Reflective of her broad practice and comprehensive abilities, Ms. Yang is Chair of the Crisis Management Practice Group, former Chair of the White Collar Defense and Investigations Practice Group, and former Chair of the Information Technology and Data Privacy Practice Group. Drawing on her depth of experience and record of success, Ms. Yang focuses part of her practice on strategic counseling. She leads critical representations, both high profile and highly confidential, involving a wide variety of industries, economic sectors, regulatory bodies, law enforcement agencies, global jurisdictions and all types of proceedings.

James L. Zelenay is a partner in the Los Angeles office of Gibson, Dunn & Crutcher where he practices in the firm’s Litigation Department. Mr. Zelenay has extensive experience in defending clients involved in white collar investigations, assisting clients in responding to government subpoenas, and in government civil fraud litigation. Mr. Zelenay also has substantial experience with the federal and state False Claims Acts and whistleblower litigation.

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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 hours, of which 1.0 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 1.0 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.

New York partner Joel Cohen and Washington, D.C. of counsel Linda Noonan are the authors of “USA,” [PDF] Chapter 32 of the Anti-Money Laundering 2021 published by International Comparative Legal Guides on May 25, 2021.

Washington, D.C. partners Stephanie Brooker and M. Kendall Day are the authors of “The Anti-Money Laundering Act of 2020’s Corporate Transparency Act,” [PDF] Chapter 1 of Anti-Money Laundering 2021 published by International Comparative Legal Guides on May 25, 2021.

Decided May 24, 2021

Guam v. United States, No. 20-382

Yesterday, the Supreme Court held 9-0 that only the resolution of CERCLA-specific liability could give rise to a contribution claim under the Superfund statute. The Court’s decision revives Guam’s cost recovery action against the U.S. Navy for the cleanup of hazardous waste on the island.

Background:
Section 113(f)(3)(B) of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) allows a party to seek contribution from other responsible parties for costs incurred in cleaning up a contaminated site. The provision states that “[a] person who has resolved its liability to the United States … in an administrative or judicially approved settlement” may bring a contribution claim for some or all of the costs of a “response action” under that settlement, no later than threeyears after the settlement is entered. 42 U.S.C. § 9613(f)(3)(B).

Guam sued the United States to recover response costs it spent remediating the Ordot Dump, a landfill containing hazardous waste formerly used by the U.S. Navy. The D.C. Circuit agreed with the United States that Guam’s suit was time-barred under Section 113(f)(3)(B)’s three-year statute of limitations, since Guam’s cleanup around the Ordot Dump was part of its obligations under a 2004 consent decree for Clean Water Act violations. The court reasoned that, although the consent decree did not involve any CERCLA claims and resolved liability only under the Clean Water Act, it still gave rise to, and started the clock for, a contribution claim within the meaning of Section 113(f)(3)(B), which expired in 2007.

Issue:
Whether a non-CERCLA settlement can give rise to a contribution action under Section 113(f)(3)(B).

Court’s Holding:
No.  A settlement must resolve a CERCLA liability to trigger Section 113(f)(3)(B)’s contribution right.

“The most natural reading of [CERCLA] § 113(f)(3)(B) is that a party may seek contribution under CERCLA only after settling a CERCLA-specific liability.”

Justice Thomas, writing for the Court

What It Means:

• Focusing on the statutory text and “interlocking” structure of Section 113(f), the Court explained that the contribution provision is “best understood only with reference to the CERCLA regime.” Slip op. at 5–6. The Court noted that Section 113(f)(3)(B)’s use of the CERCLA-specific term “‘response action,’ express cross-reference to another CERCLA provision, and placement in the statutory scheme” make clear that the provision is not a “free-roving contribution right,” but instead “is concerned only with the distribution of CERCLA liability.” Id. at 4, 5, 8.
• As the Court itself recognized, its decision “provid[es] clarity” on when a settlement gives rise to a Section 113(f)(3)(B) contribution right. Id. at 8 n.4. “Rather than requiring parties … to estimate whether a prior settlement was close enough to CERCLA” that it might trigger contribution, the new, “far simpler approach” asks only “whether the settlement expressly discharged a CERCLA liability.” Id. at 8.
• Because the Court held that the 2004 consent decree did not give rise to a Section 113(f)(3)(B) contribution claim, it found unnecessary to decide whether parties possessing such a claim are prohibited from proceeding under CERCLA Section 107(a) instead. That provision, like Section 113(f), allows a person to recoup some or all of its cleanup costs from other responsible parties, but provides for a more forgiving limitations period—six years after the cleanup effort begins, rather than three years after the qualifying settlement is entered. For its part, the D.C. Circuit concluded that “if a party can assert a contribution claim under § 113(f), it cannot assert a cost-recovery claim under § 107(a).” Id. at 3. The Court declined to reach this question.
• The Court’s decision will allow Guam to proceed with its suit against the Navy for the recovery of cleanup costs associated with the Ordot Dump under Section 107(a), a separate CERCLA provision that permits a person to recoup cleanup costs from other responsible parties within six years after the cleanup begins.

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The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Allyson N. Ho +1 214.698.3233 [email protected]

Mark A. Perry +1 202.887.3667 [email protected]

Lucas C. Townsend +1 202.887.3731 [email protected]

Bradley J. Hamburger +1 213.229.7658 [email protected]

Related Practice: Environmental Litigation and Mass Tort

Daniel W. Nelson +1 202.887.3687 [email protected]

Stacie B. Fletcher +1 202.887.3627 [email protected]

David Fotouhi +1 202.955.8502 [email protected]

Spring 2021 brought two key developments to the UK tax landscape. There was the Budget announcement delivered on 3 March (together with the Finance Bill 2021 published on 11 March), setting out medium-term tax and spending plans as the UK economy emerges from the COVID-19 coronavirus. This was followed by “Tax Day” on 23 March through which more than 30 tax policies and consultations were published with the aim to modernise UK tax administration and policy development.

It is perhaps too early to comment on the long-term effects of the COVID-19 coronavirus, however the UK government appears to be alert to the need for both short-term investment incentives to businesses, as well as longer-term increases in taxes to finance a broadening UK budget deficit. With the Chancellor agreeing to hold the Conservative Party’s 2019 “triple tax lock” manifesto pledge not to increase the rates of income tax, national insurance and VAT, it is not surprising then that UK corporation tax was in the spotlight for this year’s Budget. The main rate is set to increase from April 2023 to 25% on profits over £250,000 (whilst the rate for small profits under £50,000 will remain at 19%, with relief for businesses with profits under £250,000 so that they pay less than the main rate). Interestingly, the threshold rate of tax for meeting the excluded territories exemption under the UK’s controlled foreign company rules would rise from 14.25% to 18.75%. In line with the increase in the main rate, the UK Diverted Profits Tax rate will also rise to 31% from April 2023.

What is more surprising, however, is the absence of broader changes to the UK capital gains tax regime in the Budget this year. In May, the Office of Tax Simplification (“OTS”) published the second report in their two-stage review of the UK capital gains regime. Following publication of the first report in November 2020, in which they recommended significant changes (see our previous Alert), the OTS’ second report considers key practical, technical and administrative issues associated with the current regime. Fourteen recommendations have been made, relating to (i) the treatment of deferred consideration; (ii) the treatment of corporate bonds; and (iii) the current reporting and payment processes. Despite expectations from observers, the government has not yet implemented any recommendations from the first report and so it remains unclear whether (and to what extent) the UK government will adopt the recommendations in the future. The details of the second report will be covered in further detail in the next Quarterly Alert. “Tax Day” also came with an open consultation on the government’s tax administration framework, which sought to explore ways in which the interaction of taxpayers with the tax system (from registration to payment of tax) could be updated and simplified as the UK’s tax system becomes increasingly digital.

At the international level, it remains to be seen whether the OECD’s Inclusive Framework’s aim of reaching consensus on its Pillar I and II initiatives by mid-2021 remains achievable. US treasury secretary Janet Yellen’s speech on 5 April calling for countries to agree on a global minimum corporation tax rate for large companies, and reports earlier this year that she had dropped the former proposal under the Trump administration to allow US companies to opt in to any new system for allocating taxing rights, will however provide fresh impetus for an agreement to be reached. Agreement however among EU nations on proposals for a 21% global minimum corporate tax rate would not be easy. Although higher tax countries such as France and Germany have initially been supportive, corporate tax rates vary significantly across the continent with countries such as Ireland already making it clear it will not amend its current 12.5% corporate tax rate.

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A. UK Budget 2021

1. Amendments to the hybrid and other mismatches regime
2. Loss carry-back extension
3. Capital allowances “super deduction” and extension of the annual investment allowance
4. Off-payroll working rules

B. UK Consultations

1. UK asset holding company regime (second stage consultation)
2. UK funds review consultation
3. Uncertain tax treatment consultation
4. Transfer pricing documentation consultation

C. Other UK Developments

1. Deferral of HMRC’s VAT treatment of compensation and termination payments and VAT grouping consultation update
2. Brexit developments: EU/UK social security co-ordination and repeal of UK’s implementation of the EU Interest and Royalties Directive
3. UK property-rich collective investment vehicles – limited portfolio exemption for offshore CIVs
4. Draft regulations to implement OECD Mandatory Disclosure Rules
5. Possible changes to UK stamp duty procedures

D. International Developments

1. EU consultation on VAT rules for financial and insurance services
2. EU public country-by-country reporting
3. New OECD COVID-19-related guidance

E. Notable Cases

1. Danske Bank A/S v Skatteverket (C‑812/19) and The Commissioners for Her Majesty’s Revenue & Customs v Wellcome Trust Ltd (C-459/19)
2. HMRC v Development Securities PLC and Others [2020] EWCA Civ 1705
3. Odey Asset Management LLP v HMRC [2021] UKFTT 31 (TC)

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A.                 UK Budget 2021

I.             Amendments to the hybrid and other mismatches regime

The Finance Bill 2021 included significant changes to the UK hybrid and other mismatches regime. It addresses many, albeit not all, of the issues raised by respondents during last year’s consultation. It is expected that the new measures will serve to simplify application of the relevant rules. Groups may wish to revisit their existing structures to assess the impact of the changes and to consider whether to elect certain rules to apply retrospectively.

The UK hybrid and other mismatches regime (the “Regime”) was introduced in 2017 to counter arrangements that give rise to hybrid mismatch outcomes and generate a tax mismatch. As discussed in our previous December 2020 Quarterly Alert, HMRC published responses to its consultation on certain aspects of the Regime in November 2020 paving the way for wider reforms and further draft legislation to follow.

The Finance Bill 2021 included key provisions making significant amendments to the Regime addressing many (if not all) of the concerns raised with HMRC by taxpayers, advisers and industry bodies. Most of these provisions reflect the announcements and draft legislation previously published by HMRC in November 2020 (see our previous Alert), although there are some changes. The following elements in particular are worth noting:

Retrospective widening of “dual inclusion income”

The previously proposed widening of the concept of “dual inclusion income” (broadly a single amount of ordinary income that is recognised twice for tax purposes where the relevant entities and jurisdictions involved correspond to those that benefit from a double deduction) which was due to have mandatory retrospective effect from when the Regime was introduced in 2017, will now have effect from Royal Assent of the Finance Bill, although companies will be able to elect to apply the changes retrospectively.

The new dual inclusion income construct widens the existing rules, by capturing income taxed in the hands of a payee in the UK, but for which there is no deduction obtained by the payer in any jurisdiction, and that non-deductibility arises from the hybridity of the UK payee. The new definition introduces the concept of inclusion/no deduction income that may be treated as dual inclusion income when determining to what extent a double deduction mismatch should be counteracted. It will be welcome news for groups that receive income that is brought into account for tax purposes in the UK without generating a tax deduction in any other jurisdiction. This should however be read alongside the extension of the targeted anti-avoidance rule under the Regime to regard steps taken to engineer something to be treated as dual inclusion income as a relevant tax advantage under the rule.

We had previously discussed potential issues with the then current application of the double deduction mismatch rules (where section 259ID did not obviously apply). In particular, an intra-group payment by a US parent company to a UK subsidiary (that is disregarded for US federal income tax purposes) may give rise to a disallowance for an otherwise deductible expense incurred by the UK subsidiary – resulting in taxation on profits it does not economically possess. The above described changes however will now render the intra-group payment as deemed dual inclusion income. Although the wider dual inclusion income concept is to be welcomed, certain groups may continue to face double economic taxation. In particular, where the intra-group payment is instead made by a non-UK sister company to the UK subsidiary (i.e. where sister company is also wholly owned by a US parent and disregarded). As there must be no deduction obtained by the payer in any jurisdiction, the deductibility of the payment by the sister company in the jurisdiction in which it is established will prevent the intra-group payment from being treated as deemed dual inclusion income. This is disappointing given that a number of multinational group structures are arranged in this way and under the proposed rules will continue to be subject to double economic taxation. Restructuring around this issue may be costly and administratively burdensome, at a time when other jurisdictions (notably Ireland) take a more pragmatic approach to their implementation of hybrid mismatch rules by preventing a counteraction in circumstances where economic double taxation can be demonstrated.

Intra-group surrenders of “surplus” dual inclusion income

In addition to the intra-group surrender mechanism stipulated in November 2020 for “surplus” dual inclusion income where there is a shortfall in another group entity, administrative requirements for the making, withdrawing or replacing consent to such claims for “surplus” dual inclusion income to be surrendered, have now been provided. Notably, such claims will need to be submitted to HMRC. The new mechanism will nevertheless help taxpayers whose group structure results in income arising in the “wrong” entity (compared to relevant expenses). The change is effective from 1 January 2021.

Illegitimate overseas deduction

Amendments have been made to the rules regarding illegitimate overseas deductions so that they will only disallow UK tax relief where the relevant double deduction is utilised for overseas tax purposes by an entity other than the UK corporation tax paying company or its investors. The change which takes effect from the date of Royal Assent of the Finance Bill should allow the Regime to operate more proportionately and are likely to assist US groups with disregarded UK subsidiaries.

Acting together threshold

It had been proposed in November 2020 that the definition of “acting together” should be amended to exclude any investor holding less than 10% of a partnership that is a collective investment scheme (subject to certain rules preventing partners from artificially fragmenting their interests to fall below the threshold). Instead, that proposal has been replaced with specific provisions to ensure that counteractions under the Regime are simply disapplied where they arise in respect of participants in transparent funds who hold less than a 10% interest. So although investors in a fund will be treated as acting together, a similar position is reached by ignoring interests of relevant minority investors when calculating the size of any mismatch.

Helpfully, “fund” is defined to include any collective investment scheme or alternative investment fund for UK financial services law purposes, with no requirement that it be widely held. Such funds will be transparent if they are treated as transparent for UK income tax purposes. As such, funds structured as UK limited partnerships, Luxembourg SCSps or Cayman limited partnerships should benefit. The changes will have effect from the date of Royal Assent of the Finance Bill.

In line with the proposals in November, the definition of “acting together” will be amended to exclude cases where a party has a direct or indirect equity stake in a paying entity no greater than 5%, including votes and economic entitlements.

Retrospective changes to definition of “hybrid entity”

Changes to the definition of a “hybrid entity” were originally intended to operate so that it only tests whether an entity is transparent by reference to the laws where it and its opaque investors are established/resident. The status of the potential hybrid entity under UK law would no longer be considered, unless the entity or a relevant entity in its ownership structure is in the UK.

HMRC had explained that the alteration removes the need to make the previously announced changes in relation to US LLCs. That is, where an LLC is seen as transparent under its own tax law and that of all its investors, it will no longer be a hybrid entity, thus removing the risk of counteraction under the current Regime where the UK generally views an LLC as fiscally opaque (subject to the terms of its constitutional documents) and the US regards it as fiscally transparent (unless checked close) causing it to be treated as a hybrid entity. Having made the changes as part of the initial draft of the Finance Bill 2021, the government has since identified the draft legislation as having gone too far, with certain unintended consequences resulting. The government has decided to revisit the draft legislation in order to allow it to operate solely as intended – as a result the envisaged amendments will be postponed until the next Finance Bill. The changes (when they come) will be treated as having retrospective effect from when the Regime was introduced.

The many positive changes to the Regime resolve a number of issues, but not all of the problems experienced in relation to the existing rules. Certain requests from consultation respondents last year also remain unanswered. These include the addition of a tax avoidance motive to the Regime, an exclusion for small and medium-sized enterprises and the treatment of the US global intangible low-taxed income (“GILTI“) rules as an equivalent regime (so as to prevent a UK counteraction where a GILTI charge applies).

Groups may wish to revisit their existing structures to assess the impact of the changes and to consider whether to elect certain rules to apply retrospectively.

II.          Loss carry-back extension

In order to provide further aid for businesses impacted by COVID-19 coronavirus, the UK government has extended the period for which trading losses may be carried back for tax relief purposes for relevant accounting periods ending between 1 April 2020 and 31 March 2022. As a result, taxpayers will be permitted to carry-back relevant losses to set against profits incurred in the three years leading up to the period in which the loss was incurred (rather than the one year currently).

As part of the new measures, there will be a £2 million cap on the amount that may be carried back more than one year for each relevant accounting period in which a loss is made, and the cap will apply on a group basis. As a result, businesses in the two year period that the extended relief is expected to be available may be eligible for a potential cash refund. The £2 million cap will not be pro-rated for short accounting periods and the new measures do not impact the amount of trading losses that may be carried back to the immediately preceding year (which remains unlimited for companies).

Such extended relief will need to be carried back to be offset against profits from the most recent years first. By way of example, a company that incurs a loss in the year to 31 December 2020 would, under the current rules, only be able to carry this loss back to set against profits of the year to 31 December 2019. Under the new rules, after 2019 profits are fully offset, up to £2 million of such losses may be carried back to first be set against profits arising in the previous year ended 31 December 2018 and then, if necessary, 31 December 2017. As the cap applies on a per tax year basis, a separate cap of £2 million would apply on the extended carry-back of losses incurred in accounting periods ending in the period 1 April 2021 to 31 March 2022.

Claims for such carry-back relief will be required to be made on a company tax return unless the losses available to be utilised more than one year before the beginning of the relevant period are below a de minimis of £200,000. Claims up to this amount may be made outside of a return so that the benefit is obtained without waiting to submit a company tax return for the period in which the loss is incurred.

As the £2 million cap applies at group level, groups that have a member making a claim in excess of the de minimis will be required to submit an allocation statement to HMRC showing how the £2 million cap has been allocated between group members. If no group company is able to make a claim in excess of the £200,000 de minimis, then no allocation statement will be needed.

The extension of the carry-back relief rules will be particularly useful for taxpayers in previously profitable sectors that have been heavily affected by COVID-19 coronavirus. Such businesses should consider seeking to utilise this extension as early as possible to help with cash flows, alongside other available reliefs.

III.       Capital allowances “super deduction” and extension of the annual investment allowance

As part of the Spring Budget 2021 the UK government has provided for two temporary first-year capital allowances over the next two years to boost investment and productivity levels as the UK economy recovers from the COVID-19 coronavirus. These are a 130% first year capital allowance for qualifying plant and machinery assets (the “super deduction”) and a 50% first-year allowance for qualifying special rate assets. In addition, the annual investment allowance of £1 million will be extended to 31 December 2021. Although the announcement was headline-grabbing at the time, the measures viewed in light of the planned increase in the rate of corporation tax may be better described as a short-term incentive to bring forward investment spending plans in lieu of longer-term increases in tax.

From 1 April 2021 until 31 March 2023, companies investing in qualifying new plant and machinery assets will be able to claim a deduction against taxable profits at the following rates:

• a 130% first year allowance on qualifying plant and machinery within the main rate pool (which under the current rules attract a writing down allowance of 18% per annum on a reducing balance basis); and
• a 50% first-year allowance for qualifying special rate assets within the special rate pool (which under the current rules attract a writing down allowance of 6% per annum on a reducing balance basis). Special rate expenditure broadly includes integral features (including electrical systems, hot and cold water systems, heating, ventilation, lifts and solar shading) and certain long-life assets.

The £1 million rate of the annual investment allowance will also be extended to 31 December 2021, although it is due to revert to the previous limit of £200,000 as of 1 January 2022. The allowance gives relief for 100% of expenditure qualifying for capital allowances, up to the threshold, in the tax year in which the expenditure is incurred.

The draft rules for the new “super deduction” and 50% allowance specify a number of qualifying conditions in order for a company to be eligible. These include the following:

• relief is only available to companies that are within the charge to UK corporation tax;
• expenditure on qualifying plant and machinery must be new (i.e. not second-hand);
• the expenditure is incurred between 1 April 2021 and 31 March 2023;
• for expenditure incurred that is associated with a contract for plant and machinery, that contract was entered into on or after 3 March 2021; and
• certain existing exclusions for first-year allowances under the current rules will continue to apply, notably this disallows connected party transactions and expenditure on assets for leasing (although following later stage amendments to the draft rules, property lessors would be able to claim the “super deduction” and 50% allowance on investments in background plant and machinery for a building).

Companies using finance to invest in plant and machinery through hire-purchase arrangements should also be able to access the “super deduction”, albeit subject to separate conditions, including that payments are made to actually acquire (rather than purely lease) the asset.

Taxpayers will need to carefully consider the timing of their asset purchases, with the new measures being strictly limited to expenditure incurred on or after 1 April 2021. Under existing rules for first year allowances, capital expenditure is generally incurred “as soon as there is an unconditional obligation to pay it” (rather than deemed to be incurred on the first day a trading activity is carried out). However, the Finance Bill provisions disapply this general rule where the expenditure is incurred pursuant to a contract entered into prior to 3 March 2021 (i.e. even if the unconditional obligation to pay arises after 1 April 2021). As a result certain expenditure incurred over the following two years will not be eligible for the new “super deduction” or the 50% allowance because it was already committed to before 3 March 2021.

At the other side of the two-year window, the “super deduction” for expenditure incurred in a chargeable period ending after 31 March 2023, is proportionately reduced according to the relevant number of days in the chargeable period that extend past 31 March 2023.

As first year allowances are not pooled for capital allowances purposes, disposals of relevant qualifying assets are subject to a “balancing charge” (i.e. treated as immediately taxable income), rather than reducing the balance of the pool. To prevent abuse of the new measures, the Finance Bill  provides that if assets, for which a “super deduction” was previously claimed, is disposed of on or before to 31 March 2023, an additional claw back of relief is obtained by applying a time apportioned factor of 1.3 to the calculation of the balancing charge. Similar rules apply to the 50% allowance.

Without a cap on the amount of relief available under the new “super deduction” and 50% allowance, there are clear incentives for businesses to bring forward their investment plans to take advantage. Taxpayers will be wise however to carefully consider the timing of their investments, the conditions required to qualify and the interaction of these first-year allowances with other tax reliefs.

IV.       Off-payroll working rules

Planned reforms to the off-payroll working rules (IR35) have been introduced with effect from 6 April 2021, after being postponed by 12 months owing to the COVID-19 coronavirus. The new reforms require medium and large size private sector organisations to assess whether individuals falling within the scope of IR35 and employed through an intermediary are “deemed employees”, and if so, to deduct income tax and National Insurance Contributions from any fees paid. This switches the burden of the determination from the intermediary to the client who ultimately receives the services from the individual.

On 6 April 2021, the planned reforms to the off-payroll working rules came into effect. This follows a decision made by the UK government on 17 March 2020 to postpone the introduction of the reforms to the private sector due to the impact of the COVID-19 coronavirus.[1]

The off-payroll working rules ensure that individuals who are employed through their own limited company (“personal service company”) or other intermediary, but who would otherwise be treated as an employee if services were provided directly to the client, are treated as “deemed employees” and will be liable to pay income tax and National Insurance Contributions (“NICs”) as if the individual was an employee.

The former IR35 regime required the intermediary to determine whether the individual would be a “deemed employee”. Making a determination of whether an individual is a “deemed employee” requires a consideration of the terms of the contract between the client and the intermediary and the working arrangements in practice. If the individual is within the scope of IR35 and a “deemed employee”, the intermediary was required to operate payroll, make deductions for income tax and NICs and make employer contributions for NICs on fees received for the services.

In April 2017, similar reforms were introduced in the public sector which switched the requirement to determine whether an individual providing services through an intermediary is a “deemed employee” from the intermediary to the client.[2] The factors used to make this determination have not changed. Following the 2017 reforms, if the individual’s contract fell within the scope of IR35 and a public sector organisation regarded the individual as a “deemed employee”, it would then be responsible for deducting income tax and NICs.

The changes in effect from 6 April 2021 have extended the 2017 reforms to clients in medium or large size private sector organisations. Accordingly, medium or large private sector organisations that employ individuals through a limited company or other intermediary must now determine if the individual should be regarded as a “deemed employee”, issuing a “Status Determination Statement” to set out and explain their decision where the rules are found to apply. There is no change for contractors working for small, private sector clients, who will still be required to make the determination themselves. If the contracted individual falls within the scope of IR35, the medium or large size private sector client will retain the obligation to account to HMRC for any employment taxes associated with the contractor’s services fee (i.e. as if it was a salary payment).

Contractors engaged through an agency or umbrella company (which itself engages the contractor as its employee and pays them subject to employment taxes) should not be subject to the new rules. That is, such an agency or umbrella company should not be treated as an “intermediary” under the IR35 rules according to a clarificatory statement issued by HMRC on 15 October 2020.

Whilst applying a decision to a group of off-payroll workers with the same role, working conditions and contractual terms may be appropriate in some circumstances, HMRC guidance stresses the importance to end-clients of making determinations on a factual case-by-case basis.[3]

B.                  UK Consultations

I.             UK asset holding company regime (second stage consultation)

In December 2020, the government published its second stage consultation on the tax treatment of asset holding companies in alternative investment funds. Interestingly, the government has opted for a new standalone regime for eligible asset holding companies (rather than individual changes to existing rules). Responding positively to many of the concerns respondents raised during the first stage last year, the proposals will be welcome news for investors and asset managers.

We previously reported on the UK government’s initial stage consultation on the tax treatment of asset holding companies (“AHCs”) in alternative investment funds, including some of the issues inherent under the existing rules, as part of our April 2020 Quarterly Alert (see here). In December 2020, HM Treasury published its response to that consultation and, recognising there is a strong case for change in this area, sought views on more detailed design features for a more internationally competitive tax regime for AHCs. The consultation response, although positive, is the first in a number of expected consultations on potential changes to the tax treatment of UK funds and fund structures.

Most respondents to the March 2020 consultation agreed that a key aim of such funds is to ensure that its investors do not achieve a significantly worse tax outcome (including timing and administrative requirements) than if they had invested in the underlying investment directly. Identifying that a closely defined concept of an AHC would, in any event, be required if individual changes to existing rules were implemented, the government has instead opted for a new standalone tax regime for AHCs. The key features of the proposed regime are described below:

Eligibility

According to the response paper, the bespoke regime is intended to apply to the use of AHCs “in structures where capital from diverse or institutional investors is pooled and managed by an independent, regulated or authorised asset manager in which the AHC plays an intermediate, facilitative role”. Accordingly, eligibility criteria will need to identify: (i) criteria for investors making investments via an AHC, (ii) how investors should be identified, (iii) criteria to identify the asset manager, and (iv) the character and activities of the AHC, with the government seeking feedback on how best to achieve the relevant aims. In respect of criteria (iv) above, the government wants to restrict the regime to entities that serve to facilitate flows of capital, income and gains between investors and investment assets. It should not apply to funds that otherwise meet the above criteria but carries on activities that form part of the trade of a portfolio company.

It is anticipated that a company would need to elect into the AHC regime as part of its company tax return.

AHC taxation

The government has proposed that any taxable profit of an AHC should be proportionate to its intermediary role. The proposed AHC regime does not propose a fully tax exempt AHC, which may be helpful to funds seeking to access benefits under the UK’s double tax treaty network.

In respect of deductions against taxable profits at the AHC level, provided the AHC practices the return of its profits to its investors, it is proposed that the AHC should be able to obtain relief against its taxable income (albeit, limited in accordance with transfer pricing principles). On the other hand, given the additional deductions available to an AHC under the regime, it is proposed that an AHC should not be able to surrender or claim losses as group relief.

The response paper provides little in the way of detail in respect of transfer pricing approaches, instead requesting feedback from respondents. Given the need of funds to accurately predict their taxable margins, this will be an important development.

Disposals of investment assets by an AHC would be subject to a new relief (instead of the existing substantial shareholding exemption) from taxation at the AHC level. An exception to the relief would be for UK land and assets that derive 75% or more of their value from UK land in accordance with existing rules. The government anticipates that gains not reinvested will be taxed when returned to UK investors (or on those investors when they dispose of their interest in the AHC), with the intention that the AHC regime should not be used to artificially defer tax on capital gains.

The government is also considering a specific exemption under the AHC regime from withholding tax on interest paid by an AHC to its investors, unusually, by reference to a purpose test to disapply the exemption where a main purpose is the escaping of tax imposed by any jurisdiction.

Taxation of investors

Under the proposals, the AHC rules should operate so that for investors within the scope of UK tax:

• amounts deductible from taxable income of an AHC and paid to investors are treated as taxable income in the hands of those investors; and
• amounts returned to investors that are attributable to capital gains realised by an AHC are treated as gains in the hands of those investors.

For income purposes, UK investors would be taxed on returns as if they were of the form from which the AHC had itself derived such income from its investments (e.g. interest income received from a portfolio company that is then distributed to the UK investor).

For capital gains purposes, the proposal is for amounts returned to investors that are attributable to capital gains realised by an AHC to be treated as capital gains in the hands of the investors. Given the complexity of certain funds and the variety of ways in which an AHC might return gains to investors, complex rules may follow to allow for the tracking of gains through fund structures. The government has also made clear this is an area where anti-avoidance rules will be needed.

More broadly, there will also be consideration of whether there is scope for a more simplified exemption from stamp duty and stamp duty reserve tax on some or all transfers of shares and loan capital in an AHC.

Real estate considerations

Under existing UK rules, investors are required to pay tax on rental income and capital gains on UK real estate even if those investors are resident outside the UK. The response paper is therefore careful to explain that any new AHC regime should not create risks of loss of UK tax on UK property income and gains for the government.

The initial proposed solution to this however is somewhat disappointing: that AHCs under the regime be prevented from owning UK land or UK property-rich assets. Helpfully, this approach is subject to further consultation, and the response paper also considers situations where an AHC would be permitted to hold UK real estate indirectly through a separate corporate vehicle.

The government received feedback on a number of areas where the UK real estate investment trust (“REIT”) regime could be improved. In particular, a relaxation of the current listing requirements for certain investors, as well as providing increased flexibility under the balance of business eligibility criteria, are currently being considered by the UK government. Whilst a more fulsome review of the REIT regime is intended to form part of a separate funds review, the government is considering a number of changes that could be made alongside the AHC rules that would make the UK a more competitive location for holding real estate assets.

The second stage consultation on a new AHC regime will be welcomed by investors and asset managers alike. A key comment from respondents however is that any new UK AHC regime will necessarily be compared to other domestic investment structures (such as those with AHCs in Luxembourg), and it is not clear to what extent (if any) a UK regime would need to provide benefits above and beyond those in other jurisdictions. Any such benefits would also need to be considered carefully, in light of the value attributed by investors to tax regimes that provide certainty and rules that are straightforward to follow.

II.          UK funds review consultation

In January 2021, the government published a call for tax, regulatory and other input as part of its broader review of the UK funds regime. The paper sets out the scope and objectives of the review, and invites stakeholders to provide views on which reforms should be prioritised and taken forward. The wider aim being to make the UK a more attractive location to establish, administer and manage funds, and to support a wider range of more efficient investment vehicles better suited to investor needs.

The call for input follows last year’s Spring Budget announcement (see our April 2020 Alert here) and sits alongside other areas of consultation (see second stage AHC consultation section above). It covers the areas that will be particularly relevant to UK asset managers and fund administrators, including tax, regulatory and other aspects of the regime. The government appears to have taken on the message that any new UK funds regime will need to compete directly with existing preferential regimes within established hubs (such as those in Ireland and Luxembourg). In addition to enhancing the UK’s reputation as a location for new funds, any new regime should also consider the incentives provided for existing funds to move to the UK given the costs of re-domiciliation and speculated changes to the UK’s capital gains tax and carried interest rules.

From a tax perspective, the call for input covers the following areas:

• Tax neutrality principle (that is, to ensure investors achieve a tax neutral treatment irrespective of whether they invest in an asset directly or through a fund vehicle) – recognising that as a practical matter the existing regime does not always achieve such tax neutrality for investors in funds (e.g. certain balanced funds that invest in both equity and debt instruments are not always entitled to tax deductions for distributions at the fund level giving rise to tax leakage), the consultation seeks views on ways in which the regime may be improved.
• Barriers within the existing REIT rules – recognising that the rules for REITs can be complex, the government will consider simplifying measures including the relaxation of the listing requirement, changes to how the close company test is applied, the application of the holders of excessive rights rules and how the “balance of business” test should operate.
• Issues with the UK approach to VAT on fund management services – the review paper only seeks initial responses to the issues at this stage (with separate actions to follow later this year). Nevertheless, the recoverability of VAT on management fee costs at fund level, and that the position of asset managers is not adversely affected by their incurring of irrecoverable VAT that would not arise had they provided management services to a fund established outside the UK, will be important to the success of any UK funds regime.
• Declining use of UK limited partnerships and tax-elected funds – the call for evidence seeks views as to why the use of UK limited partnerships has declined in recent years and take up of the tax-elected fund regime, introduced to facilitate onshore multi-asset funds, has been so limited. The perceived complexity of each of the regimes compared to those in other jurisdictions which adopt more straightforward tax exemption models will likely be a factor. If so, the wider funds review provides an opportunity for more substantive (rather than incremental) changes to the taxation of these vehicles.

The consultation closed on 20 April 2021. The British Private Equity and Venture Capital Association (“BVCA”) published its response on the same date, noting the importance of the UK limited partnership regime (English and Scottish) to the UK private funds industry and the relative ease with which legal and tax enhancements may be made without the need for an entirely new regime for unauthorised fund structures. The BVCA response also reiterated the importance of preserving the UK’s capital gains tax and carried interest rules in an increasingly competitive global marketplace and in order to attract asset managers to the UK.

The scope of the review and range of proposals will be welcome news. Given the trend within the funds industry to accumulate holding vehicles in a single jurisdiction (in order to satisfy even more stringent international substance requirements for tax purposes), it is helpful that the UK funds review comes alongside coordinated consultations on the UK asset holding company regime. More details of the proposals and the ways in which they would operate are to follow, however funds and asset managers will be keen to assess whether any new UK funds regime is straightforward to access and is competitive with those of other key EU and non-EU fund domiciles.

III.       Uncertain tax treatment consultation

On 23 March 2021, the government published its second consultation on proposals to require large businesses to notify HMRC in advance if they have taken a tax position contrary to HMRC’s. Whilst certain aspects of the proposal have changed for the better (such as a series of more objective triggers for when an uncertain tax treatment occurs), the requirement and administrative burden for large businesses to provide HMRC with information to help them identify and resolve potential disagreements at an earlier stage remains.

We previously reported on the delay (until April 2022) of a new obligation for businesses to notify HMRC of uncertain tax positions taken in their tax returns (see our see our previous Alert). As part of its Tax Day announcements in March this year, the government has published its second consultation on uncertain tax treatment that will broadly require large businesses to notify HMRC in advance if they have taken a tax position contrary to HMRC’s.

The first consultation last year received widespread criticism from respondents that the proposal was too subjective and difficult for businesses to assess. HMRC appears to have taken note, with the new consultation aiming to obtain feedback on a series of more objective triggers for determining when an uncertain tax treatment occurs. It is proposed that these will be scenarios where the tax treatment:

• results from an interpretation that is different from HMRC’s known position;
• was arrived at other than in accordance with known and established industry practice;
• differs from how an equivalent transaction was treated in a previous return;
• is in some way novel, so that it cannot reasonably be regarded as certain;
• is the subject of a provision in the company’s accounts;
• results in a deduction greater than the related economic loss; or
• has been the subject of professional advice that either contradicts other advice received or has not been followed.

Whilst more helpful than the proposal as part of the first consultation, a number of the new triggers are still likely to be viewed as too subjective (with significant scope for further HMRC guidance). The second consultation requests views from stakeholders on the threshold for notification, exclusions from the requirement to notify and input on a new penalty regime. Helpfully, the second consultation provides that the new measure would only apply to VAT, income tax (including PAYE) and corporation tax (rather than all taxes envisaged under the first consultation). The previous materiality threshold of £1 million has instead been replaced with a figure of £5 million, as a means of reducing the administrative burden for businesses. In addition, there will now only be one penalty for failure to notify a tax uncertainty, which would fall on the entity rather than on any individual (with slightly different rules applying to large partnerships). Despite these positive changes, the underlying policy rationale for the new regime has still not been fully explained. As a result, taxpayers may be concerned that the proposals are a disproportionate response to the issues HMRC has identified and hopes to solve.

Other aspects are yet to be explained, such as the position of taxpayers that do not have a HMRC Customer Compliance Manager, and the expected actions where a tax position becomes uncertain after a report has been made (e.g. following subsequent updates to HMRC manuals). Whilst certain aspects of the proposal have changed for the better, the requirement for large businesses to provide HMRC with information to help them identify and resolve potential disagreements at an earlier stage remains.

IV.       Transfer pricing documentation consultation

On 23 March 2021, the government published a new consultation to seek views on the clarifying and strengthening of UK transfer pricing documentation requirements. The consultation aims to explore potential changes to: (i) transfer pricing record keeping requirements for the largest businesses, and (ii) the introduction of a new tax filing requirement for all businesses affected by transfer pricing regulations.

The current transfer pricing documentation requirements are governed by relatively generic record keeping requirements for businesses to keep sufficient records to deliver complete and accurate tax returns. The new proposals as part of the consultation may require certain businesses to keep additional transfer pricing information in a standardised format in order to be promptly provided to HMRC upon request, and to provide further details in their annual tax return about material cross border transactions with associated entities.

The government is seeking feedback on the introduction of a new requirement for multinational enterprises within country-by-country reporting groups to provide HMRC with a copy of the master file and local file within 30 days of request. In addition, the benefits of requiring the local file to be supported by some form of evidence log is being explored

The consultation also seeks to align the UK with the approach taken by a number of other jurisdictions, which require businesses to file an annual schedule reporting data about intra-group cross-border transactions. Such an international dealings schedule is proposed to be in addition to any requirement for a master and local file. It would apply to those businesses within the scope of the UK transfer pricing rules (that is, other than small and medium sized businesses that are generally exempt), and UK-to-UK transactions would be excluded.

C.                 Other UK Developments

I.             Deferral of HMRC’s VAT treatment of compensation and termination payments and VAT grouping consultation update

VAT Treatment of Compensation and Termination Payments

HMRC has updated its guidance on the VAT treatment of compensation payments and termination charges by withdrawing previously published amendments stipulating that such payments will generally be subject to VAT having retrospective application. Instead, the revised VAT treatment will take effect from a “future date” (still to be determined at the time of writing), and HMRC will issue revised guidance to assist businesses with the new approach.

In our previous Alert, we discussed Revenue and Customs Brief 12/20 which concluded that, in HMRC’s view, payments by a customer for early termination or cancellation of a contract constitutes consideration for the original supply that the customer had contracted for. That is, such payments will generally be subject to VAT including with retrospective effect. Previously, payments, including compensation or early termination payments, were regarded as outside the scope of VAT.

When Revenue and Customs Brief 12/20 was first published in September 2020, the amendments were not well received by industry, which raised concerns about the negative effects to the principle of legal certainty arising from the retrospective application.

On 25 January 2021, HMRC decided that the VAT treatment set out in Brief 12/20 would no longer have retrospective application, but that it would apply from a “future date”.[4] Although the particular date is currently unclear, HMRC has provided welcome clarification that businesses have two choices about how to treat payments until further guidance is issued. This includes: (i) treating payments as consideration for a supply and therefore liable to VAT, or (ii) regard the payments as outside the scope of VAT (if that is how they were treated before the HMRC Brief) until further guidance is published. Until this time, it may be prudent for taxpayers to review any termination and compensation payments within new or existing contracts that may fall within the scope of the revised guidance, to enable swift action once further guidance is published.

VAT Grouping

Following last year’s call for evidence to review VAT grouping provisions in the UK, the UK government announced plans within the Spring Consultation to publish the responses in summer 2021, although the government would not take the issue any further.

In August 2020, HMRC issued a call for evidence to examine the operation of VAT grouping provisions in the UK, and determine how the provisions impact businesses and the wider business environment in order to inform future policy.[5] The call for evidence sought information on the establishment provisions; compulsory VAT grouping; and the eligibility criteria for limited partnerships who are not within the current legislation, which is discussed further in our previous Alert.

In the 2021 Spring Consultation, it was announced that whilst the responses to the call for evidence would be published by summer 2021, the government would not take the issue further.

As discussed further in our previous Alert, we identified concerns raised in relation to the additional administrative burden of the “establishment only” approach, the inflexibility of compulsory VAT grouping and an increase in compliance costs for funds that may not be recoverable. Given that the proposals in the call for evidence may have increased VAT costs for UK taxpayers, the decision by the government to take no further action may be welcomed, particularly by fund structures and financial services groups.

II.          Brexit developments: EU/UK social security co-ordination and repeal of UK’s implementation of the EU Interest and Royalties Directive

EU / UK Social Security Coordination

Following the UK’s exit from the European Union on 31 December 2020, the EU-UK Trade and Cooperation Agreement has introduced a Social Security Protocol which seeks to replicate the former social security coordination between the UK and the EU under the EU’s Social Security Regulations.

Prior to 1 January 2021, the EU’s Social Security Regulations[6] provided that an individual is only subject to the social security rules of one member state at any time, and typically contributions will be payable to the state where the work is done. Limited exceptions to the basic principle included: (i) individuals working in two or more member states, and (ii) those who worked in the UK on a short term assignment. In effect, the Social Security Regulations prevented an individual from paying social security contributions in multiple member states and protected against the risk of double taxation.

The EU–UK Trade and Cooperation Agreement includes a Social Security Protocol, which has largely replicated the existing social security coordination between the UK and EU. As before, an individual to whom the Social Security Protocol applies shall be subject to the legislation of one state only – namely, the state where the employment activities are performed. Two exceptions however remain for: (i) detached workers; and (ii) employees working in two or more member states.

Detached workers who are seconded by UK employers to work in an EU member state on a temporary basis for a maximum period of 24 months will remain within the scope of UK National Insurance contributions. Unlike under the Social Security Regulations, there will be no prospect to extend the 24 month period. Notably, and in contrast to the Social Security Regulations, this was an “opt in” provision, but by 1 February 2021, all EU member states had opted in, and agreed to apply the provisions. However, each EU member state can opt out of the rules in the future with only one month’s notice.

The Social Security Protocol maintains that where an employee works in the UK, as well as one or more EU jurisdictions, the employee will be subject to contributions in the jurisdiction where the employee resides, provided that at least 25% of their working time or remuneration is pursued there. Otherwise, a number of tests (depending in part on how many employers the employee has) is applied to determine whether contributions are payable in the UK or the EU.

The Social Security Protocol is applicable to both UK and EU nationals, and to third-country nationals who are or have been subject to the social security system of either the UK or an EU country, but not to individuals working in EEA countries (Iceland, Norway, Lichtenstein or Switzerland) who may be required to obtain further documentation to permit payment of National Insurance contributions in the UK.[7] It will cover new assignments, or employees starting work in multiple locations on or after 1 January 2021. Any arrangements in effect prior to this date will continue to be governed by the Social Security Regulations for so long as the existing arrangements continue unchanged and without interruption.

Repeal of the Interest and Royalties Directive

The Finance Bill 2021 has repealed UK law that gave effect to the EU Interest and Royalties Directive, effective from 1 June 2021. As a result, UK companies will no longer be able to rely on the withholding tax reliefs for interest and royalty payments between connected companies. Such companies are instead advised to deduct tax at the respective double tax treaty rate, which may be nil, although not necessarily in all cases.

The EU Interest and Royalties Directive[8] was implemented into UK law in 2004. It ensured that intra-group interest and royalty payments between connected companies in different EU member states were not treated less favourably than such payments between connected companies within the same member state.

Where each of the following conditions were satisfied: (i) the payee is a company resident in an EU member state other than the UK; (ii) the payer is a UK tax resident company or a UK permanent establishment of an EU company; and (iii) the payer owns at least 25% of the payee (or vice versa) or a third company owns at least 25% each of the payer and payee, the EU Interest and Royalties Directive aimed to remove, wherever possible, withholding taxes on payments of interest and royalties between such connected companies.

When the Brexit transition period ended on 31 December 2020, the EU Interest and Royalties Directive was no longer applicable to the UK. The UK implementing laws were however still in force and so its provisions still apply to payments of interest and royalties paid from the UK to EU member states. The Finance Bill 2021 repealed the UK implementing laws, with effect from 1 June 2021. The effect of this is that interest and royalty payments made from UK resident companies to eligible connected companies resident in the EU will no longer be exempt from withholding tax.

• Instead, from 1 June 2021, withholding tax obligations will be governed “solely by the reciprocal obligations in double taxation agreements”.[9] In many cases, the double taxation agreements may, subject to relief application to HMRC, reduce or eliminate withholding tax obligations, reducing the impact on tax liabilities . However, UK resident companies should carefully consider the applicable rate and conditions under the relevant double taxation agreement between the UK and relevant EU member state where a connected company is expected to receive such interest or royalty payments.

III.       UK property-rich collective investment vehicles – limited portfolio exemption for offshore CIVs

In 2020, the UK government consulted on new legislation relating to “UK property-rich” collective investment vehicles (“CIVs”) and their investors for UK capital gains tax purposes. New legislation has been introduced so that specified investors in UK property-rich CIVs are (provided certain conditions are satisfied) treated as not having a substantial indirect interest in UK land at the time of a relevant disposal for capital gains tax purposes.

New UK regulations came into effect on 24 March 2021 amending the tax treatment of non-UK investors in UK property-rich CIVs. This follows consultations that took place late in 2020.[10]

The Finance Bill 2019 first introduced the ability to tax gains made by non-UK residents on UK property, including specific rules for ‘UK property-rich’ CIVs and their investors. The effect of the legislation was that offshore CIVs that are not partnerships were by default treated as companies for the purpose of chargeable gains, and disposals of interests in offshore CIVs by non-UK resident investors would also be subject to UK tax.

Under the 2019 rules, CIVs were treated separately to the treatment of UK property-rich assets (i.e. assets that derive at least 75% of their value from UK land). Non-UK resident investors were liable to pay tax on any gain arising from a disposal of a UK property-rich asset where they owned at least a 25% interest (directly or indirectly) in that entity (a substantial indirect interest). Non-UK resident investors in CIVs however did not have the benefit of the substantial indirect investment test and did not have to satisfy the 25% ownership threshold before tax was payable.

The new CIV regulations seek to redress this imbalance. Under the new rules, an offshore CIV disposing of a UK property-rich company will be deemed not to have a substantial indirect interest if the CIV:

• meets the non-UK real estate and genuine diversity of ownership conditions;
• is not a UK feeder vehicle (i.e. where at least 85% of the market value of the assets of the vehicle at that time derives from units in a single CIV that is UK property-rich) immediately before the disposal; and
• immediately before disposal, the offshore CIV did not have a 10% interest in the UK property-rich company.

The effect of this is that non-UK resident investors in offshore CIVs that dispose of an interest in a UK property-rich company will not be treated as having a substantial indirect interest in UK land at the time of the relevant disposal. Accordingly, non-UK resident investors will not be liable to pay capital gains tax on the disposal, provided that the conditions listed above are met. This will be welcome news to non-UK resident investors in UK land and helps to prevent potential situations of double taxation where non-UK resident investors dispose of their interests in a CIV vehicle.

IV.       Draft regulations to implement OECD Mandatory Disclosure Rules

The UK government plans to begin consultations to implement the OECD Mandatory Disclosure Rules after the scope of mandatory reporting under DAC 6 was significantly narrowed shortly before the end of the Brexit transition period.

As noted in our January DAC 6 update, the UK government narrowed the scope of mandatory reporting under the EU Mandatory Disclosure Regime, (“DAC 6”), in the UK with effect from 11 pm on 31 December 2020. As a result, only cross-border arrangements (i.e. those concerning the UK or an EU member state) falling within the Category D hallmark of DAC 6 (broadly, those that (a) have the effect of circumventing the OECD’s Common Reporting Standard, or (b) obscure beneficial ownership) will be reportable.

As part of the Finance Bill 2021, the UK government confirmed that it will begin consultations on, and the implementation of, mandatory reporting under the OECD Mandatory Disclosure Rules. No specified time frame has been provided for the consultation, but HMRC explained that it will be “as soon as practicable” in order to transition from European to international rules. It is also likely that the existing legislation which implements DAC 6 in the UK will be repealed.

V.          Possible changes to UK stamp duty procedures

During the COVID-19 pandemic, HMRC relaxed procedures for the stamping of instruments subject to UK stamp duty. Updates to HMRC’s guidance suggest that these processes may be permanent.

The “stamping” of instruments subject to UK stamp duty is an analogue process: it requires the instrument of transfer to be posted to HMRC, a physical stamp affixed to the instrument (once HMRC is satisfied that the duty had been paid), and the stamped instrument posted back to the taxpayer or its advisers. The process typically takes approximately 6 to 8 weeks. Procedures were, however, relaxed as a result of the COVID-19 pandemic. Since March 2020, HMRC has: (a) accepted, via email, pdf copies of instruments of transfer and instruments signed electronically; and (b) instead of physically stamping the instrument, (once satisfied that stamp duty has been paid) provided taxpayers with a letter of acknowledgment directing registrars that the register of the company transferred can be updated to reflect the change of shareholder. While the process still generally takes 4 to 6 weeks, the changes have been widely welcomed, and HMRC issued a consultation in the summer of 2020 about modernising the stamping process. In April 2021, guidance (first published in March 2020) to explain the above-mentioned changes was updated, to remove references to “temporary measures” in place “during the pandemic”, and instead refer to “new measures”. While HMRC has yet to make an announcement, the updates suggest that the processes currently in place may be permanent.

D.                 International Developments

I.             EU consultation on VAT rules for financial and insurance services

On 8 February, the European Commission (“EC”) launched a public consultation on the VAT rules applying to the supply of financial and insurance services, with a view to updating and rationalising existing rules. The consultation closes on 3 May, with the EC proposing to introduce a new directive in the last quarter of 2021.

Supplies of financial and insurance services are generally exempt for VAT purposes. While this makes the cost of the supplies more competitive to customers, it restricts the ability of financial and insurance businesses to recover their input VAT. The consultation identifies a number of concerns about the VAT rules in this area:

• The law has developed over the years through fact-specific case-law, rather than coherent policy decisions. Supplies of fund management services to defined benefit pension schemes are taxable, for example, while those provided to defined contribution pension schemes are generally exempt.
• The rules are often applied inconsistently across member states, jeopardising neutrality and creating uncertainty.
• The exemption for financial services may not adequately address the increasingly sophisticated types of financial and insurance services developed in the interim.

A number of alternatives for addressing the above concerns have been put forward – each involving a trade-off between the benefit of greater simplicity, and policy concerns about increasing costs for consumers. Proposals include the possibility of: (a) removing the VAT exemption entirely for financial and insurance supplies, with VAT charged at the standard rate, or alternatively, reduced rates; (b) limiting the scope of exempt financial and insurance supplies; (c) granting businesses the option to tax financial and insurance supplies and (d) reinstating financial and insurance businesses’ flexibility to address irrecoverability through VAT group and cost-sharing groups (mechanisms which have, in recent years, been curtailed[11] or removed for financial services providers[12], respectively).

The consultation comes at an interesting time. Since the end of the Brexit transitional period, UK suppliers of financial and insurance services have been able to recover input VAT on exempt supplies made to recipients in the EU. The potential competitive advantage for the UK financial industry may serve as a catalyst for EU reform. Further, with the end of the Brexit transitional period last year, the UK is no longer obliged to keep in step with EU VAT developments. The UK Treasury’s own consultation on the VAT treatment of financial services (which was widely expected to open on Tax Day) has yet to be published. If there is clarity on the proposed changes to EU VAT rules by the time the UK consultation concludes, this delay may prove wise: a consultation on the future of UK VAT rules is likely to produce the most considered outcomes when it is informed by the wider VAT landscape in which those rules sit.

II.          EU public country-by-country reporting

EU proposals for so-called “public country-by-country reporting”, first mooted in 2016, are gaining traction. Broadly, EU jurisdictions (and many others) currently require parent companies of large multinational groups to annually report (generally to their home tax authority) key financial information for each jurisdiction in which the group operates. New EU proposals would, if implemented, require large groups with EU operations to publicise such information.

BEPS Action 13 standards (which have been adopted in over 90 jurisdictions) require parent companies  of multinational businesses with annual global revenues of over €750 million to provide tax authorities with an annual breakdown, for each jurisdiction in which the group operates, of revenue, (pre-tax) profits/losses and tax paid and accrued. In February, 16 EU member states (the minimum necessary for the proposal to advance) agreed to support a draft directive for public reporting of (broadly similar) information – albeit on a slightly less granular basis (with information on non-EU jurisdictions generally being aggregated).

The draft directive currently contemplates that the reporting obligation would apply to groups meeting the above-mentioned €750 million threshold whose parent company is incorporated in an EU member state, while those with an EU subsidiary or branch (other than a small-sized enterprise) would also need to “comply or explain”. Businesses subject to the EU’s Capital Requirements Directive IV would be exempt.

The EC will now negotiate with the European Parliament (who favour more onerous requirements) on the draft directive, with a view to reaching agreement by the end of June. If the proposals are implemented, it would likely be a watershed moment for tax transparency. However, the costs are likely to be felt not only in the form of additional compliance burdens, but also in the potential chilling effect on legitimate tax planning (which non-tax professionals may view with suspicion).

III.       New OECD COVID-19-related guidance

The OECD has published specific guidance on the application of: (i) transfer pricing principles[13]; and (ii) double tax treaties[14], in the context of the COVID-19 pandemic.

As discussed in our April and July 2020 Quarterly Alerts, there has been uncertainty over the last year as to how transfer pricing principles and double tax treaties should be applied in the novel context of the COVID-19 pandemic. The OECD has now published new guidance on these subjects, which (while expressly not intended to displace existing OECD guidance) is intended to provide greater clarity.

Transfer pricing guidance: The new transfer pricing guidance addresses: (i) comparability analysis; (ii) losses and the allocation of COVID-19-specific costs; (iii) government assistance programmes; and (iv) advance pricing agreements. Highlights include practical suggestions for addressing the absence of contemporaneous comparability data, such as providing flexibility in related party contracts for terms to be retrospectively updated to reflect contemporaneous comparability data when it becomes available). The guidance also confirms that (while each advance pricing agreement should be assessed on a case-by-case basis) changes in economic and market conditions arising from the COVID-19 pandemic are likely to qualify as a breach of the critical assumptions under the OECD’s advance pricing agreement guidelines.[15]As discussed in our April and July 2020 Quarterly Alerts, there has been uncertainty over the last year as to how transfer pricing principles and double tax treaties should be applied in the novel context of the COVID-19 pandemic. The OECD has now published new guidance on these subjects, which (while expressly not intended to displace existing OECD guidance) is intended to provide greater clarity.

Tax treaty guidance: The guidance addresses (amongst other things) concerns relating to: (i) residence and the creation of permanent establishments; (ii) agency and construction site permanent establishments; (iii) changes to an individual’s residence status; and (iv) income from employment. In particular, the guidance confirms that (in the OECD’s view): (A) neither “the exceptional and temporary change of the location where employees exercise their employment” nor “the temporary  conclusion  of  contracts  in  the  home  of employees  or  agents  because  of  the  COVID-19 pandemic” should create a permanent establishment for businesses; and (B) “a temporary  change  in  location  of  board  members  or  other  senior  executives is  an extraordinary and temporary situation due to the COVID-19 pandemic and such change of location should not trigger a change in treaty residence.” In an employment tax context, however, the guidance notes that “an exceptional  level  of  coordination  between  jurisdictions is needed to mitigate  the compliance  and  administrative  costs  for  employees  and  employers  associated  with  an involuntary  and  temporary  change  of  the  place  where  employment  is  performed”, and (where relevant) recommends recourse to mutual agreement procedures.

The decision as to how these topics will be dealt with ultimately rests with local tax authorities. Unfortunately, (unless the tax authority has issued guidance on its intentions), whether they will choose to follow the OECD’s pragmatic approach is only like to become apparent once the crisis has abated.

E.                  Notable Cases

I.             Danske Bank A/S v Skatteverket (C‑812/19) and The Commissioners for Her Majesty’s Revenue & Customs v Wellcome Trust Ltd (C-459/19)

Two key VAT decisions were handed down by the Court of Justice of the European Union (“CJEU”) in March 2021: Danske Bank[16] and Wellcome Trust.[17]

Danske Bank A/S v Skatteverket (C‑812/19)

Background

Danske Bank’s head office was located in Denmark and was part of a Denmark VAT group. The company carried on activities in Sweden through a branch which did not form part of any VAT group. The head office provided a computer platform to the branch for the purposes of its activities in Sweden and re-charged a portion of the costs to the branch. A question arose as to whether the supply of the platform by the head office to the branch was a supply for VAT purposes and subject to a VAT reverse charge in Sweden.

Drawing on the principle set out in Skandia, the CJEU found in favour of the Swedish authorities, and held that by joining the Danish VAT group, the head office became a taxable person for VAT purposes, separate from the branch. Accordingly, VAT applied under the reverse charge mechanism on the services provided to the Swedish branch.

Observations

The Danske decision is likely to have implications for cross-border businesses operating through branches in the EU and third countries. Not only will this decision increase VAT compliance and administrative obligations for these businesses, exempt or partially exempt groups that had previously relied on the decision in FCE Bank[18] (which held that services between a head office and a branch could be ignored for VAT purposes) will now be subject to VAT, such VAT being, in whole, or in part, irrecoverable – representing an actual cost. For those solely making taxable supplies, any input VAT incurred in connection with those supplies will be recoverable – albeit that there may be a cash flow impact if periods of account are not aligned.

While financial institutions are hopeful that the EC’s review of the VAT rules[19] (currently subject to public consultation (as noted above)), will lead to the removal of the VAT exemption on supplies of financial and insurance services (allowing recovery of any input VAT incurred on the relevant supplies) it is not yet clear whether this indeed will be the outcome, or when a new VAT directive would take effect. Accordingly, the Danske decision will likely force businesses to review their intra-group supplies, in the interim.

The CJEU noted that EU VAT grouping rules should be limited territorially, meaning that overseas branches should not belong to a domestic VAT group (i.e. supporting an ‘establishment only’ approach). It will be interesting to see whether member states that apply a ‘whole establishment’[20] approach to VAT grouping, like Ireland and the Netherlands, will be forced to revise their rules as a result.

As the decision in Dankse was delivered following the end of the transition period, the UK is not bound by this decision. The UK currently applies a ‘whole establishment’ approach to VAT grouping, accordingly, UK VAT groups are not subject to this territorial limit and overseas branches may be treated as part of a UK VAT group (subject to the treatment of the branch under the VAT grouping rules in the other jurisdiction).

Wellcome Trust Ltd (C-459/19)

Background

The CJEU upheld the Attorney-General’s decision[21] (reported in our July 2020 Quarterly Alert) determining that a UK trustee receiving services from an overseas supplier in connection with its non-economic activities must account for VAT under the reverse charge mechanism (with potential irrecoverable VAT suffered) where those services are used in a business, and not a private capacity.

Observations

The CJEU rejected the argument that a taxable person receiving services in connection with its non-economic activities was not a ‘taxable person acting as such’ for the purposes of Article 44. The CJEU distinguished between a taxable person carrying out non-economic activities in a business capacity and non-economic activities in a private capacity, noting that the latter would not fall to be treated as a “taxable person acting as such” under Article 44. Consequently, the Court noted that for the purposes of determining the place of supply for VAT purposes in this instance, the purpose of the non-economic activities should be clearly documented.

II.          HMRC v Development Securities PLC and Others [2020] EWCA Civ 1705

The Court of Appeal (“CoA”) allowed HMRC’s appeal that certain Jersey-incorporated subsidiaries of a UK parent were centrally managed and controlled in the UK by the directors of the UK parent, and consequently, UK tax resident. Whilst the judgement expressed ‘considerable reservations’ about the First Tier Tribunal’s (“FTT”) conclusions on residency, the CoA ultimately overturned the Upper Tribunal’s (“UT”) subsequent decision on technical grounds.

Background

Jersey resident subsidiaries (“Jersey Companies”) of a UK-resident company (“DS Plc”) purchased UK real estate (the “Assets”), above value (the “Acquisition”). Immediately following the Acquisition, the Jersey Companies migrated to the UK (by replacing Jersey directors with UK resident directors) and transferred the Assets to other UK group members with an aim to maximise capital losses available to the UK group. Following advice from DS Plc regarding the arrangement, the directors of the Jersey Companies met in Jersey to approve the arrangement.

To maximise the capital loss position, the Jersey Companies had to be Jersey tax resident at the time of the Acquisition. This was contested by HMRC.

A company is resident in the UK if it is either (i) incorporated in the UK; or (ii) centrally managed and controlled in the UK. The latter is ultimately a question of fact. De Beers Consolidated Mines Ltd v Howe[22] is the leading authority on (ii), establishing the principle that a company resides where its real business is carried on and where decisions are in substance made.

The CoA decision

The CoA upheld the FTT’s decision that central management and control had been exercised by the directors of DS Plc. The FTT determined that, while the directors of the Jersey Companies met in person, were made aware and had understood the arrangement, they were merely agreeing to implement transactions on the instruction of the directors of DS Plc, “without any engagement with the substantive decision albeit having checked (in tandem with DS Plc) that there was no legal bar to them carrying out the instruction“.[23]

The CoA had restored the FTT’s decision on the basis that the reasons for the UT overturning the FTT’s decision, were flawed. It is interesting to note that the CoA did not necessarily agree with the FTT’s decision. Lord Justice Nugee noted that he had ‘considerable reservations’ about the FTT’s conclusions on residency and agreed with the taxpayers comment that “the [First-Tier Tax Tribunal’s] decision was the first time in any case where the local board of directors of a company had actually met, had understood what they were being asked to do, had understood why they were being asked to do it, had decided it was lawful, had reviewed for itself the transactional documents, had been found not to have acted mindlessly, but had nevertheless been found not to have exercised [central management and control].”[24]

Observations

The CoA’s decision is yet another example of the difficulties faced in applying the corporate residency test in practice. The CoA reiterates the importance of documentation and note-taking at board meetings however, falls short of clarifying the application of the residency test where an offshore company acts on instruction from a parent. It remains to be seen whether DS Plc will rely on Lord Nugee’s reservations as support for an appeal to the Supreme Court.

III.       Odey Asset Management LLP v HMRC [2021] UKFTT 31 (TC)

The FTT found that profits allocated to a corporate member as part of a deferral mechanism were subject to income tax (as miscellaneous income)[25] in the year amounts were ultimately received by the individual members.

Background

Odey Asset Management Limited (“Odey”) was a UK partnership carrying on an investment fund management business. Under a special capital arrangement, individual members’ right to receive partnership profits (an “Individual Share”) were deferred until certain performance conditions were satisfied. Each year, Odey paid the Individual Shares to a corporate member of Odey (“PSCL”) (the “year of allocation”). PSCL would contribute these amounts to Odey subsequently reallocate these profits (subject to the satisfaction of certain conditions) at which time, the individuals could withdraw their Individual Share (the “year of receipt”).  Odey held that the individual members were not subject to income tax on their Individual Share in the year of allocation or of receipt.

HMRC disagreed, arguing that each individual member is subject to tax:

• on their Individual Share in the year of allocation under section 850 of the Income Tax (Trading and Other Income) Act 2005 (“ITTOIA”);
• in the alternative, in the year of receipt under section 687 of ITTOIA (relating to miscellaneous income), or
• if section 687 ITTOIA did not apply, under sections 773 to 778 of chapter 4 of part 13 of the Income Tax Act 2007 (“ITA”) (relating to the sale of occupation income).

HMRC lost on (1) but won on (2). The FTT noted that (3) would not apply in this case.

(1)        Section 850 of ITTOIA

Section 850 provides that the share of partnership’s trading profits treated as arising to a partner is by reference to the current “profit-sharing arrangements” defined as, “rights of the partners to share in the profits of the trade and the liabilities of the partners to share in the losses of the trade”. The FTT held that a “right” referred to an immediate legal entitlement to receive profits. While the profits had been ‘ear-marked’ for particular individuals in the year of allocation, receipt of those amounts was conditional on meeting certain performance criteria. The FTT accordingly held that the Members had no such “right” in the year of allocation and that section 850 did not apply.

(2)        Section 687 of ITTOIA

The FTT held that the amounts received in the year of receipt were subject to tax under section 687 – which operates as a ‘sweep up’ provision, applying to income ‘from any source’. The FTT held that:

• sums received were analogous to employment income (in effect, as a deferred bonus);
• the “source” of the amounts is the individual members employment; and
• drawing on the Upper Tier Tribunal’s decision in Spritebeam[26], there was a ‘sufficient connection’ between the individuals employment and the amounts received, notwithstanding the absence of any contractual obligation on Odey to pay these amounts.

(3)        Section 773 to 778 of chapter 4 of part 13 of ITA

Broadly, a tax arises under these provisions where: (i) an individual carries on an occupation; (ii) an individuals earning capacity is exploited by putting another person in a position to enjoy all or part of the income derived from the individuals activities; and (iii) a capital amount is received by the individual in connection with (ii).

The FTT determined that condition (ii) was not met as PSCL was not put ‘in a position to enjoy all or part of the income derived from the individuals activities’ – it received those amounts in its own right. Interestingly, the FTT reached a different conclusion in HFFX LLP & Ors v HMRC[27] finding that amounts allocated to the corporate member (in lieu of being paid to individual members) were subject to tax under these provisions.

Observations

It is interesting that HMRC relied on the operative income tax provisions and did not bring a claim under the targeted anti-avoidance rules despite, as the FTT noted, the clear tax motives behind the arrangement. Given the broad scope of section 687 of ITTOIA, we may see HMRC increasingly seek to tax individual members receiving ‘capital’ amounts (calculated with reference to employment activities), as income. Over the years, HMRC has introduced a myriad of rules (for example, the disguised investment management fee rules and the income-based carried interest rules) that tax investment managers’ performance-based fees, as income, and the Odey decision arguably now provides HMRC with yet another avenue through which this could be achieved.

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   [1]   https://www.gov.uk/government/publications/off-payroll-working-rules-communication-resources/know-the-facts-for-contractors-off-payroll-working-rules-ir35

   [2]   https://www.gov.uk/government/publications/off-payroll-working-in-the-public-sector-changes-to-the-intermediaries-legislation/off-payroll-working-in-the-public-sector-changes-to-the-intermediaries-legislation

   [3]   https://www.gov.uk/government/publications/off-payroll-working-rules-communication-resources/know-the-facts-for-contractors-off-payroll-working-rules-ir35

   [4]   https://www.gov.uk/government/publications/revenue-and-customs-brief-12-2020-vat-early-termination-fees-and-compensation-payments

   [5]   https://www.gov.uk/government/publications/vat-grouping-establishment-eligibility-and-registration-call-for-evidence

   [6]   Comprised of Regulation (EC) 883/2004 on the co-ordination of social security systems and Regulation (EC) 987/2009, the implementing regulations.

   [7]   https://www.gov.uk/guidance/national-insurance-for-workers-from-the-uk-working-in-the-eea-or-switzerland

[8]   EU Council Directive 2003/49/EC.

[9]   https://www.gov.uk/government/publications/repeal-of-provisions-relating-to-the-interest-and-royalties-directive/repeal-of-provisions-relating-to-the-interest-and-royalties-directive

[10]   https://www.gov.uk/government/consultations/draft-regulations-the-uk-property-rich-collective-investment-vehicles-amendment-of-the-taxation-of-chargeable-gains-act-1992-regulations-2021

[11]   See for example, Skandia (Case C‑7/13) and Danske Bank (Case C‑812/19), discussed in section E below.

[12]   As to which, see DNB Bank (Case C-326/15), Minister Finansów v Aviva (Case C-605/15) and EC v Germany (Case C-616/15).

[13]   Guidance on the transfer pricing implications of the COVID-19 pandemic: https://www.oecd-ilibrary.org/social-issues-migration-health/guidance-on-the-transfer-pricing-implications-of-the-covid-19-pandemic_731a59b0-en

[14]   Updated guidance on tax treaties and the impact of the COVID-19 pandemic, OECD, 21 January: https://www.oecd.org/coronavirus/policy-responses/updated-guidance-on-tax-treaties-and-the-impact-of-the-covid-19-pandemic-df42be07/

[15]   Guidelines for Conducting Advance Pricing Arrangements under the Mutual Agreement Procedure, 2017: https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2017/annex-ii-to-chapter-iv-guidelines-for-conducting-advance-pricing-arrangements-under-the-mutual-agreement-procedure-map-apas_tpg-2017-20-en#page1

[16]  Danske Bank A/S, Danmark, Sverige Filial v Skatteverket (Case C‑812/19) EU:C:2021:196 (11 March 2021) (Advocate General: E. Tanchev).

[17]  The Commissioners for Her Majesty’s Revenue & Customs v Wellcome Trust Ltd (C-459/19) EU:C:2021:209 (17 March 2021) (Advocate General: G. Hogan).

[18]   Ministero dell’Economia e delle Finanze and Agenzia delle Entrate v FCE Bank plc (C-210/04) EU:C:2006:196 (23 March 2006) (Advocate General: P. Léger).

[19]   Launched as part of the EU’s tax action plan for fair and simple taxation to support the EU’s recovery (published 15 July 2020).

[20]   This means that overseas branches of eligible persons, can be treated as part of a domestic VAT group.

[21]   Wellcome Trust Ltd (C-459/19) (25 June 2020).

[22]   (1906) 5 TC 198.

[23]   Development Securities (No. 9) Ltd & Ors [2017] TC 0600 [430].

[24]   HMRC v Development Securities PLC and Others [2020] EWCA Civ 1705 [101].

[25]   Section 687, Income Tax (Trading and Other Income) Act 2005.

[26]   Spritebeam v HMRC [2015] STC 1222.

[27]   HFFX LLP & Ors v HMRC [2021] TC8023.

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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])
Fareed Muhammed (+44 (0) 20 7071 4230, [email protected])
Avi Kaye (+44 (0) 20 7071 4210, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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

Mass arbitration is a recent phenomenon in which thousands of plaintiffs—often consumers, employees, or independent contractors—bring arbitration demands against a company at the same time. Many mass arbitrations are the product of sophisticated advertising campaigns in which a plaintiffs’ firm uses social media to generate a list of thousands of individual “clients.” Other mass arbitrations arise after a court has enforced a class-action waiver in an arbitration agreement—instead of filing a single arbitration on behalf of the named plaintiff only, the plaintiffs’ firm tries to replicate the failed class action by bringing thousands of arbitrations on behalf of would-be class members.

Mass arbitrations can impose significant, even crippling, costs on companies, particularly in light of the hefty filing fees that many arbitration providers charge. For example, if a company’s filing-fee obligation is $2,000 per arbitration, a mass arbitration of 5,000 individuals could result in the arbitration provider invoicing the company for $10 million in nonrefundable filing fees. Equally large invoices—for case management fees and arbitrators’ fees—can quickly follow.

Because mass-arbitration plaintiffs are often recruited on social media, with little-to-no vetting, a mass arbitration might include hundreds of plaintiffs who never had any relationship or dealings with the company. Nonetheless, it is often difficult to identify and eliminate those frivolous claims before the arbitrations commence, and many arbitration providers insist on the company paying nonrefundable filing fees regardless of whether the claims have merits. A recent California law (SB 707) raises the stakes even further by requiring companies to pay arbitration fees within 30 days, and failure to do so can lead to default judgments and liability for the plaintiffs’ attorneys’ fees.

Many companies, however, have deployed successful strategies for deterring and defending against mass arbitrations, primarily through the careful drafting of their arbitration agreements. Below, we identify a few of the strategies that have been deployed. This list is not exhaustive, not all strategies are right for each company, and mass arbitration tactics are evolving and changing rapidly.

1. Informal dispute resolution clauses. Companies can often reduce mass-arbitration costs by requiring the parties to engage in a mediation or informal dispute resolution conference before either side serves an arbitration demand. Those conferences can often result in the settlement or dismissal of many claims, and also deter the filing of frivolous claims, saving the company costly arbitration filing fees.
2. Require individualized arbitration demands. Plaintiffs’ firms often try to initiate mass arbitrations by sending the company a single arbitration demand and appending a list of their purported clients. This tactic often fails to give companies sufficient information about the claimants bringing the arbitration demands, and also increases companies’ nonrefundable filing fees. To deter this tactic, some companies have required claimants to serve individualized arbitration demands, each of which must clearly identify the claimant, their legal claims, the requested relief, and an express authorization by the claimant to bring the arbitration demand.
3. Cost-splitting provisions. Courts generally permit companies to require consumers, employees or independent contractors to bear some of the costs of arbitration, including the amount it would cost a claimant to file a lawsuit in a local court. Requiring claimants to pay for some arbitration fees can reduce the cost of a mass arbitration and deter the filing of frivolous claims.
4. Fee-shifting for frivolous claims. Companies may also consider inserting clauses in their arbitration agreements that allow the arbitrator to award fees and costs to the prevailing party if the arbitrator finds that the losing party filed a frivolous claim. This can be another useful tool for deterring frivolous mass arbitrations and, at a minimum, it incentivizes plaintiffs’ counsel to vet claimants before bringing claims on their behalf.
5. Offers of judgment. In many jurisdictions, an offer of judgment shifts costs to the plaintiff if they recover less money at trial than the settlement offer. A company may be able to reduce its costs and exposure by making offers of judgment at the outset of a mass arbitration. While most jurisdictions automatically enforce offers of judgment in arbitration, companies may consider including provisions in their arbitration agreements that expressly permit offers of judgment, with cost-shifting.
6. Selecting the arbitration provider. Arbitration providers charge filing fees and other fees that vary widely. Some arbitration providers have dedicated fee schedules and other protocols for mass arbitrations. Companies should research and compare providers’ fee schedules and mass-arbitration protocols before selecting a provider for their arbitration agreement. It is also advisable to include a provision in the arbitration agreement that allows either side to negotiate lower fees with the provider—without such a provision, the provider may be unwilling to enter into such negotiations.
7. Reserve the right to settle claims on a class-wide basis. A company facing a mass arbitration may wish to obtain global peace by entering into a class settlement that extinguishes all claims. No clause in an arbitration agreement should be necessary to allow a company to settle a class action. Indeed, for years, companies have settled class actions despite having arbitration agreements with class-action waivers. However, some plaintiffs’ lawyers have argued that class-action waivers preclude companies from settling a class action. Therefore, in an abundance of caution, companies might consider adding a clause to their arbitration agreements that allows any party to settle claims on a class-wide basis.
8. Establish a protocol for adjudicating a mass arbitration. Some companies have inserted specific protocols in their arbitration agreements to help reduce the cost of a potential mass arbitration. For example, some arbitration agreements state that, in the event more than 100 similar arbitrations are filed at the same time, they will be “batched” into groups of 100, with each batch assigned to a single arbitrator and triggering a single filing fee. In this particular example, the batching protocol could potentially cut the company’s arbitration costs by up to 99%. However, having arbitrators assigned to multiple arbitrations could create additional risk for the company. In addition to batching, there are other mass-arbitration protocols that offer different risk/cost profiles.

Conclusion

Mass arbitrations can create significant cost and risk for a company. Being proactive and drafting an arbitration agreement with an eye toward mass arbitration can help reduce that cost and risk.

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We will continue to monitor closely and develop new strategies and approaches to mass arbitration. If you have any questions or would like additional information about these or other developments, please reach out to any of your contacts at Gibson Dunn, any member of the firm’s Class Actions practice group, or the author of this alert:

Michael Holecek – Los Angeles (+1 213-220-6285, [email protected])

The following Gibson Dunn attorneys also are available to assist in addressing any questions you may have regarding this alert:

Christopher Chorba – Los Angeles (+1 213-229-7396, [email protected])
Theane Evangelis – Los Angeles (+1 213-229-7726, [email protected])
Joshua S. Lipshutz – Washington, D.C. (+1 202-955-8217, [email protected])
Dhananjay S. Manthripragada – Los Angeles (+1 213-229-7366, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

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

In May 2021, Gibson Dunn attorneys won a landmark case before the General Court of the European Union (case T-561/18, ITD and Danske Fragtmænd v European Commission).

Gibson Dunn represented ITD (a Danish trade association of international companies operating parcel and logistics services) and Danske Fragtmænd (a company operating in this sector in Denmark) in a case concerning state subsidies in the Danish post and courier market. The EU General Court partially annulled a European Commission decision of 28 May 2018 authorising certain aid measures granted by the Danish and Swedish States to Post Danmark, the Danish postal incumbent and former monopolist owned by PostNord AB, a holding company in turn owned by the Danish and Swedish States. In its decision the Commission had rejected claims that a capital injection from Post Danmark’s parent company and a tax exemption in favour of Post Danmark involved unlawful State aid, but the General Court overturned this decision.

With the rapid decline in letter volumes across the EU, ex monopolists in the postal sector have been struggling to remain viable and have become more actively engaged in the booming parcel freight transport market based on e-commerce transactions. The problem is that ex monopolists still receive funding from their owners, i.e., the State, and while that funding may lawfully be granted for providing a universal letter service in remote areas, it is not justified to use it to gain a competitive advantage in markets such as parcel transport. The EU courts have therefore intensified its scrutiny of Member States which transfer funding to their State owned ex monopolists in various sectors, including in the postal sector. While Member States are allowed to invest in their own companies, capital contributions to loss making entities with no prospect of a reasonable return constitute prohibited State aid. Similarly tax exemptions granted selectively to State owned companies are illegal.

Post Danmark, the ex monopolist for letter services in Denmark, has experienced a 80% decline in letter volumes and has been unable to generate a profit even in the parcel transport market. The company has been incurring catastrophic losses for a decade (or more).

On 5 May 2021, the General Court of the European Union annulled the Commission’s finding that a capital injection to Post Danmark of EUR 135 million in 2017 did not involve State aid as well as a finding that a VAT exemption (with an annual value of approx. EUR 37 million) benefitting Post Danmark for at least 10 years did not constitute State aid. The Danish State and PostNord AB (the Danish-Swedish owned parent company of Post Danmark) intervened in the case to support the European Commission while two freight transport companies, Jørgen Jensen Distribution and Dansk Distribution, intervened in support of ITD and Danske Fragtmænd.

This judgment is the latest in a series by EU Courts setting out requirements regarding Member States’ capital injections in loss making State owned companies in the EU. Specifically, the General Court makes clear that State aid granted in the form of capital injections must be capable of producing a reasonable rate of return in order to avoid being classified as prohibited State aid.

Indeed, while the European Commission had concluded that the capital injection of EUR 135 million granted to loss making Post Danmark would make it possible to restore Post Danmark’s viability, the General Court found that the Commission had no basis for coming to this conclusion. There was no evidence that the company could be brought back to profitability nor that it would have prospects of generating a reasonable return. In the same vein, while the Commission had accepted their arguments that Denmark and Sweden were not involved in the capital injection (as it had been contributed by the parent company to Post Danmark) and were merely ‘passive spectators’ to this payment, the General Court held that the Commission cannot just rely on States’ own arguments whilst ignoring conflicting information submitted by the complainants. Instead the Commission must diligently investigate the matter especially in view of the Commission’s obligation to conduct an impartial examination of the complaint.

The judgment also finds that the VAT exemption (with an annual value of approx. EUR 37 million) benefiting Post Danmark, which allowed e-commerce companies not to  charge their customers VAT if they used Post Danmark as their freight company, also benefits Post Danmark and thus involves illegal State aid. The General Court specifically pointed out that this VAT exemption is not covered by the existing permissible VAT exemption covering the provision of Universal Service Obligations based on the VAT Directive 2006/112/EC of 28 November 2006.

As a result of the judgment, the Commission must now reopen the case and will probably be forced to consider that the capital injection of EUR 135 million and the VAT exemption involve incompatible, and therefore unlawful, State aid that must be recovered from Post Danmark. In view of its catastrophic financial situation, this may mean that Post Danmark will  unable to survive, at least in its current form.

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The following Gibson Dunn lawyers assisted in preparing this client update: Lena Sandberg, Yannis Ioannidis and Pilar Pérez-D’Ocon.

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 member of the firm’s Antitrust and Competition practice group:

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