The last 10 years have seen the evolution of tax policies and practices at a global level in response to the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) action points, the increasing public demand to improve transparency following data leaks such as LuxLeaks, the Panama Papers and the Paradise Papers, as well as the desire of tax authorities to minimize tax arbitrage.
Responding to Action 12 of the OECD BEPS, the Council Directive (EU) 2018/822 of May 25, 2018, known as Directive on Administrative Cooperation (DAC 6), represents the newest and one of the many tools in the hands of the European tax authorities to minimize base erosion and profit shifting and increase transparency in the internal market.
DAC 6 aims to increase transparency on transactions that cross EU borders, reduce the scope for harmful tax competition by establishing a set of uniform and common rules in the EU and deter taxpayers from entering into a particular scheme if it has to be disclosed.
To achieve this, DAC 6 imposes a primary disclosure obligation on intermediaries in the EU, being widely defined as anyone who designs, markets, organizes, makes available or manages the implementation of a reportable cross-border arrangement (i.e. one that meets at least one of the five hallmarks underpinning the new rules) with a secondary reporting obligation on taxpayers.
The scope of DAC 6 is very wide-reaching and, while some of the hallmarks target arrangements that provide a tax advantage as the main benefit, there are other hallmarks not linked to this “main benefit test” meaning that there may not be a safe harbor for commercial arrangements.
This article questions the necessity of DAC 6, by considering the co-ordination of the new rules with other disclosure and compliance tools of the U.K. and European legislative armory and considers its implications for the asset management and private equity (PE) industry. As there is extensive literature that analyzes the generic and specific hallmarks and the transactions in scope, this article makes no further analysis of these aspects.
What’s New Under DAC 6?
The focus on tax transparency on cross-border activities is not something new. Most, if not all, of the objectives of DAC 6 have already been addressed to an extent by legislative measures at a global, EU or domestic level.
In 2019, in response to concerns raised by the EU Code of Conduct Group, substantial steps were taken globally to prevent multinational enterprises (MNEs) from taking advantage of abusive cross-border tax arrangements, such as allocating profits to offshore corporations in low tax jurisdictions in which they are established but to which they have no economic nexus.
The need to address territorial substance in order to achieve a more level playing field across all jurisdictions is something that countries have already recognized. To date, several offshore jurisdictions commonly known as “tax havens” have been encouraged, via the threat of a blacklist, to enact legislation reinforcing the substance requirements for companies operating in their territories.
DAC 6 is based on certain indicators (hallmarks), most of which are targeting arrangements that have the characteristics of aggressive tax planning. In our view, the tax arrangements in scope have already been addressed by domestic or EU anti-tax avoidance provisions. At domestic level countries have made significant progress in implementing the main BEPS measures in the area of direct taxes. The prevention of the artificial avoidance of permanent establishment and tax treaty abuse, the interest deductibility limitations and the strengthening of Controlled Foreign Company (CFC) rules sit at the top of most countries’ anti-tax avoidance agenda.
Protection against corporate tax avoidance has been further reinforced through the EU Anti-Tax Avoidance Directives (ATAD I and II) that introduced a comprehensive framework of anti-abuse measures to complement existing domestic rules and/or to ensure that domestic rules were harmonized at the EU level.
These rules focus on deterring profit shifting to a low/no tax country, preventing double non-taxation, preventing companies from avoiding tax when relocating assets and discouraging artificial debt arrangements designed to minimize taxes.
In addition, a mandatory General Anti Abuse Rule (GAAR) was introduced to counteract aggressive tax planning when other rules do not apply. The above rules are mandatory for all member states as from January 1, 2019, largely eliminating the potential for tax arbitrage that existed previously.
Does DAC 6 therefore add anything new? It arguably does not add new anti-tax avoidance provisions, but it instead summarizes the abusive tax schemes already known to the tax authorities in order to increase deterrence for aggressive tax planning. It also provides the tax authorities with the opportunity to receive more timely information regarding new schemes, thereby decreasing any potential tax gap and increasing transparency. It is therefore aimed at influencing the behavior of promoters, advisers and intermediaries as well as taxpayers. It is worth noting that information sharing is not new to taxpayers, as mandatory disclosure schemes already exist at global, EU or domestic level.
At the EU level, information exchange mechanisms have been in place since the late 1970s with the milestone being the enactment of DAC 1 in 2013 that extended and enhanced the administrative cooperation between member states and made the automatic exchange (i.e. without prior request) of certain types of information mandatory.
In 2015, the scope of automatic exchange of information was further broadened with the introduction of the OECD Common Reporting Standard (CRS), which replicated the U.S. Foreign Account Tax Compliance Act (FATCA) and made it mandatory for financial institutions around the globe to report certain information about overseas beneficiaries to local tax authorities.
The year 2016 marked the introduction of country-by-country reporting under which MNEs were required to provide the tax authorities of the parent’s jurisdiction with information about global activities, profits and taxes. This was another major step towards combating tax evasion.
In addition, many EU jurisdictions have already established disclosure facilities at domestic level, such as the Disclosure of Tax Avoidance Schemes (DOTAS) regime in the U.K., targeting specifically tax avoidance schemes. While these facilities produce similar outcomes, they do not fulfil the same objectives because they have a slightly narrower scope compared to DAC 6. The DAC 6 hallmarks target also arrangements that serve a commercial purpose, but which have a “potentially aggressive tax planning” motive, thereby broadening the definition of reportable transactions. The reporting obligations are however limited under DAC 6 to those arrangements with an EU cross-border element.
Therefore, what DAC 6 effectively does is increase the reportable arrangements by bringing a greater range of transactions into scope, as well as increase the number of reportable persons for each transaction, thereby increasing visibility. The effect of this will be an increased administrative burden and hence costs for intermediaries and ultimately the taxpayers who will have to carefully identify and track reportable transactions. It may however also mean that this is an opportunity for legitimate business schemes to rid themselves of the stigma associated with international investments.
Assessing the Impact for Fund Structures
The impact of DAC 6 on fund structures will depend on whether an arrangement has a cross-border dimension that makes it reportable and whether the fund manager/and or the fund qualifies as an intermediary or simply as a taxpayer.
A cross-border arrangement is one that “concerns” multiple EU jurisdictions or an EU jurisdiction and a third country. Whether an arrangement concerns multiple jurisdictions will be a question of fact and degree. HM Revenue & Customs (HMRC) is of the view that in order for the arrangement to “concern” multiple jurisdictions, those jurisdictions must be of some material relevance to the arrangement. An arrangement is reportable if it meets one of the five hallmarks.
A fund manager or a fund with U.K. nexus is likely to be viewed as an intermediary on the basis that it designs, organizes and implements cross-border arrangements on behalf of the fund investors. If, however, this is not the case, for example because the manager and/or the fund are resident outside the EU, then they will only have reporting obligations under DAC 6 where there is no intermediary able to fulfill this obligation.
In any case, some of the transactions undertaken by both private equity and hedge fund structures are likely to trigger a reporting obligation given their frequency and the likelihood of crossing EU borders. This means that regardless of whether the primary reporting obligation rests with the fund manager, when cross-border transactions take place, fund managers will need to ensure that sufficient information is made available to the reporting parties, being tax advisers, lawyers or the bank.
Indicative Arrangements within Scope of DAC 6 for Hedge Fund Structures
- Arrangements with nonresident LLP members (where the asset manager is a U.K. LLP) will potentially be under scope especially where the residence of the partners was of material relevance to the design, promotion or implementation of the arrangement (i.e. provides tax benefit).
- Arrangements which involve non-transparent legal or beneficial ownership chains which use persons (whether legal or real), arrangements or structures:
- that do not carry on a substantial economic activity supported by adequate staff, equipment, assets and premises;
- that are incorporated, managed, resident, controlled or established in any jurisdiction other than the jurisdiction of residence of one or more of the beneficial owners of the assets held by such persons, legal arrangements or structures; and
- where the beneficial owners of such persons, legal arrangements or structures are made unidentifiable.
- Arrangements whereby funds (i.e. cash) are routed via an offshore jurisdiction, despite having a domestic origin, in order to benefit from preferential tax treaty terms or other similar benefits. The round tripping of the funds serves little or no commercial purpose and is done primarily to achieve the beneficial treatment that may be available. A proper analysis will be required to establish whether the main benefit test is satisfied.
Indicative Arrangements within Scope of DAC 6 for Private Equity Structures
- Arrangements that involve the payment of tax-deductible interest by a U.K. resident company to a 25% related pass through entity incorporated in the U.S. (LLC or Partnership) will be reportable because the recipient being a U.S. transparent entity is not a tax resident in any tax jurisdiction.
- Where there are investments in EU entities financed by debt and the fund making the investment is in an offshore low or zero-tax jurisdiction, any tax-deductible interest payments to the offshore fund will be reportable by a U.K. asset manager because of the tax-exempt status of the recipient.
What Should Fund Managers do to Prepare for the New Rules?
All U.K. fund managers should take the following steps in preparation for the new legislation coming in December 2019:
- Review all cross-border transactions that have taken place from June 25, 2018.
- Consider which arrangements may give rise to a reporting obligation by identifying the potentially applicable hallmark(s). Professional assistance may be required at this stage to understand the level of scrutiny required as the scope of the legislation is very wide and does not only include situations where a tax advantage is obtained.
- Identify the intermediaries involved in the potentially reportable cross-border transactions, liaise with the relevant intermediaries and seek confirmation that they will meet their reporting obligations. This may require reaching a commercial agreement by updating the terms and conditions of the business engagement.
- Identify who and what will be reported, especially when the reporting obligation falls on the taxpayer (where a fund manager is regarded as the taxpayer). This would be the case if there is no intermediary, or because the intermediary does not have to report certain information due to legal professional privilege. Ensure that the reporting obligations and timings are clear to those responsible in the organization.
- Where the business enters into cross-border arrangements on an ongoing basis, set up a suitable system to monitor arrangements and collect the relevant data.
Conclusion and Final Thoughts
DAC 6 introduces a new wave of transparency in the way businesses transact by introducing mandatory reporting on external parties, the intermediaries, who, despite having a primary obligation to report, in some cases have limited information or even knowledge of the commercial reasons underpinning a cross-border transaction.
Any cross-border transaction giving rise to a multiple reporting obligation will, at its minimum, involve four intermediaries; a lawyer, a tax adviser, an accountant and a bank. These parties will have equal obligation to report unless they have evidence that another party to the arrangement has fulfilled this obligation.
The role of banks has been criticized as creating enhanced risks and uncertainty for the taxpayers as banks operate in a strict regulatory environment that, in our experience, encourages reporting for all cross-border arrangements without distinction and often in the absence of complete information. The legislator acknowledges that banks might lack knowledge of the wider arrangements, and crucially whether the arrangement triggered any hallmarks and has on this basis introduced a defense for these institutions. However, it is to be seen whether banks will exercise their right not to report and if they do report whether they will disclose this to the taxpayer.
It is therefore critical that the relevant taxpayers proactively encourage all parties to the arrangement to discuss obligations and agree on the requirement to disclose or not disclose. Effective communication between the parties will be necessary in order to prevent contestation.
The successful implementation of DAC 6 depends on the commitment of the intermediaries to identify and disclose the reportable arrangements and the taxpayers’ willingness to cooperate and provide the reportable information. Although the reportable persons face penalties for non-compliance, the DAC 6 reporting is not linked to payments of tax upfront such in the case of DOTAS, which renders the success of this new disclosure scheme less certain at least in the short term. It will be important to keep a watchful eye on how the member states and the EU Commission will use the information provided in the long term.
Theodora Mavromati is an Analyst, International Tax Advisory and Andy Murray is Managing Director, International Tax Advisory, Duff & Phelps, U.K.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.