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Advisers’ fees non-deductible where management decisions made by parent company

The UK’s First-tier tax tribunal (FTT) has just released an interesting decision considering whether or not expenses incurred by a parent company on advisers’ fees that related to a proposed disposal by a group subsidiary and were charged on to its subsidiary were deductible as expenses of management of the subsidiary under section 1219 of the Corporation Tax Act 2009 because the decisions in respect of the disposals had been taken by the parent and not the subsidiary.

The decision provides cautionary advice on how groups should make sure that they operate and document as clearly as possible the different activities and decision-making process of their individual group members.

In the case (Centrica Overseas Holdings Limited v HMRC), the FTT held that the relevant advisers’ fees were not deductible for the subsidiary because the management decisions on the disposals were taken by the parent company rather than by the subsidiary. This highlights the importance of considering carefully, and documenting, the reasons why particular companies in a group incur their costs.

Facts

The case involved the Centrica group and the disposal of certain assets. Strategic decisions for the Centrica group were made by the parent company (Centrica plc). It decided to dispose of an investment held by Centrica Overseas Holdings Limited (COHL), one of its indirect subsidiaries. Various advisers were engaged to work on the disposal with Centrica plc paying the advisers’ fees and then charging them to COHL by means of book entries. The transaction that was actually entered into involved COHL’s subsidiary (Oxxio) hiving certain of its investments into a newly formed subsidiary and selling that subsidiary, so the actual disposal was made by a subsidiary of COHL.

As mentioned above, strategic decisions for the group were made by Centrica plc. This was facilitated by various central teams within the group. A distinction was drawn between investment decisions, which were made by Centrica plc, and operational decisions regarding how investments were to be run, financed and managed, which were made by cross-company teams within the group. COHL had no employees of its own and its directors were employees of Centrica plc. There was a lack of clear delineation between the various roles in which the individuals who were the directors of COHL were acting. Directors of COHL would be aware of how the disposal was progressing in their group capacities as opposed to specifically in their capacity as COHL directors. This meant that there was no need to brief the directors of COHL or inform them about how any transaction was progressing as they would already know these things in their respective group capacities. Significantly, there would not always be a formal COHL board meeting considering any particular transaction and there were no COHL board minutes regarding the disposal in question.

Decision

Was the expenditure incurred in respect of COHL’s investment business?

HMRC rejected COHL’s claim to deduct the advisers’ fees from its profits as expenses of management. The FTT, in dismissing COHL’s appeal, held that the fees were not the expenses of management of COHL as the management decisions were made by Centrica plc.

The FTT held that the fact that COHL itself did not dispose of anything was not, of itself, a bar to the disputed expenditure being an expense of management of COHL’s investment business. The FTT also held that the fact that a subsidiary paid for services provided or procured by its holding company did not automatically bar the expenditure from being tax deductible for the subsidiary.

However, the FTT affirmed that deductibility required the relevant expenses to be “in respect of” so much of the company’s investment business as consisted of making investments and that there had to be a link between the expenses and the investment business. As outlined above, the lack of delineation in function between individuals acting as directors of Centrica plc and COHL meant that those individuals did not consider the strategic decisions specifically in their capacity as directors of COHL as the investment company claiming deductions for the expenses. The FTT stated in this regard that “the real difficulty … is that COHL was not actually managing anything. Taking a realistic view of the facts it was [Centrica plc] which made all the decisions, strategic and otherwise. The various group functions did not think of themselves as providing services to COHL, they were working to give effect to [Centrica plc’s] strategic decision to divest itself of the Oxxio businesses”.

Were the advisers’ fees “expenses of management”?

The FTT also considered whether the advisers’ fees would have been deductible if it was wrong on the “lack of management” by COHL discussed above. Acknowledging the breadth of the term “expenses of management”, it drew the distinction between expenses which are essentially part of the costs of buying or selling investments (these being the capital costs of implementation and not deductible) and expenses which are severable from the sale or purchase itself (which are expenses of management and deductible unless they are part of the general expenses of the company or capital in nature).

The FTT reviewed applicable case law and considered that, broadly, once a decision to go ahead with a specific transaction with a specific purchaser on specific terms is made then the expenditure moves from management to costs of sale so that the decision to buy or sell marks the boundary between deductible management expenses and non-deductible implementation expenses. Applying this delineation to the facts, the FTT considered that the fees of the accountants would have been management expenses but that the lawyers’ fees would have been implementation costs.

The FTT also went on to look at whether the advisers’ fees were revenue or capital. Capital expenditure is not tax deductible. The FTT held that the tests applied in relation to trading expenditure and the requirement for recurrence were not readily applicable to an investment company and that rather “the line between income and capital management expenses is to be drawn between expenses which are incurred in connection with an investment company’s consideration of and decisions about managing its investments and expenses incurred in connection with an actual or potential capital transaction”, acknowledging that such a line may not always be easy to draw.

The process of deciding whether and how to make a disposal could be revenue in nature whereas the disposal itself was a capital transaction. Therefore the timing of the expenditure is relevant with regards to the capital/revenue distinction but is secondary to the purpose of the expenditure with regards to the distinction between management expenses and implementation costs.

Key takeaways

The case highlights the requirements for groups to consider carefully the basis on which it might be seeking deductions for expenditure and to make sure that the correct corporate steps are taken, and that there is documentary evidence of the manner in which they are taken, to ensure that the transactions actually entered into satisfy the requirements of the relevant tax provisions. So, while a group might consider itself operating as a unified whole for certain purposes (such as strategic decision making in this case), the fact that the UK tax system operates at a company by company basis means that it is important that each company does what is required to claim deductions for expenses. In this case, that means that COHL should have considered the strategic advice provided by Centrica plc and its directors should have considered and decided on it as directors of COHL notwithstanding that they might have already been in possession of all of the knowledge that they required as employees of Centrica plc (or other group companies) involved in considering the strategic decisions.

So, to ensure that management expenses are deductible from a company’s profits under section 1219, those expenses must be expenses incurred in respect of the management of that company’s investment business. Therefore there should be clear delineation as far as possible of (a) the function of each company in a group and (b) in what capacity directors with multiple directorships in the group are acting with regards to particular management decisions. Appropriate documentation by way, for example, of board minutes and the following of applicable company procedures should provide evidence of such delineation for the purposes of linking expenses with the investment business.

In addition, the purpose and timing of expenditure should also be considered in relation to whether expenses are management expenses and whether such expenses are revenue or capital in nature. Therefore decision-making should be clearly documented as to both purpose and timing to maximise the ability to claim deductions for the expenses.

IR35 extension to private sector – Finance Bill 2020 amendment on territorial scope

There has been much discussion over the past year or so about the UK government’s proposal to make changes to the application of the off-payroll working (or IR35) tax rules to private sector end clients so as to shift certain employment status assessment and, depending on the circumstances, employment tax payment obligations from the worker’s intermediary entity (or personal service company) to the private sector end client. These rules were due to come into effect on 6 April this year but, as a result of the COVID-19 crisis, have now been delayed until 6 April 2021.

One of the consequences of the concerns raised when the proposed rules were published was that HMRC announced in March that the new rules would not apply to private sector clients with “no UK presence”.

On 19 May 2020, the government tabled “New Clause 1 and New Schedule 1: Workers’ services provided through intermediaries” for the Public Bill Committee of Finance Bill 2020. This includes proposed amendments to be made to the new private sector off-payroll working rules.

The proposed amendments provide the statutory definition for the “no UK presence” exemption announced by HMRC in March. If enacted as proposed, the change to the rules will mean that private sector clients will only be subject to the new obligations (rather than leaving all obligations with the worker’s intermediary as is the case now) if the end client is either UK resident or has a UK permanent establishment. This means that non-UK resident clients with no UK permanent establishment that engage UK-based workers through intermediaries to carry out work for them should not be subject to the new rules.

This provides useful clarity to such businesses and will allow multi-national businesses using off-payroll workers to plan more effectively for what is likely to be, in any event, relatively onerous internal compliance and management arrangements to comply with the new rules when they are introduced next year.

 

COVID-19: DAC 6 reporting delayed

In light of COVID-19, and in response to requests from European trade associations, the European Commission has published its proposal to amend Directive 2011/16/EU which deals with various strands of administrative co-operation in the field of taxation. Significantly, the proposal includes an extension to the time limit for reporting information under the new rules on cross-border tax arrangements know as DAC 6 (implemented by Council Directive 2018/822/EU).

Many member states have already implemented DAC 6 in domestic legislation. However, a lack of detailed guidance, the potential for differences in interpretation of key terms in DAC 6 between member states and the first reporting deadline looming at the end of August were causing considerable concern, exacerbated by the current COVID-19 crisis. Accordingly, the European Commission has published its proposal to defer certain reporting deadlines. In doing so it acknowledges that the COVID-19 disruption will hamper compliance with reporting obligations and the ability of tax authorities to collect such data. However, the Commission also cautions that the deferral is of limited duration and is proportionate to the practical difficulties of the temporary lockdown.

The Commission’s proposal covers three elements of reporting under DAC 6. It changes:

  • the date for reporting ‘historical’ cross-border arrangements (these are, broadly, arrangements that were implemented or made available for implementation between 25 June 2018 and 30 June 2020) to local tax authorities from 31 August 2020 to 30 November 2020;
  • the start of the 30-day period for cross-border arrangements which become reportable after 30 June 2020 from 1 July 2020 to 1 October 2020; and
  • the date for the first mandatory exchange of information about reportable cross-border arrangements between member states from 31 October 2020 to 31 January 2021.

Member states must approve the above changes and update their domestic filing deadlines accordingly. The amendments will enter into force on the day after their publication in the Official Journal of the European Union.

The Commission has not ruled out a further extension. However, the deferral of reporting does not change the fundamental requirement for organisations to comply with DAC 6. Therefore financial institutions and organisations subject to DAC 6 should continue to introduce and implement procedures and systems to ensure compliance with the new deadlines.

The UK’s tax authority (HMRC) has stated that it will consider its response to the proposal once it is adopted.

 

Coronavirus: House Democrats Introduce the HEROES Act

On May 12, 2020, House Democrats introduced the Health and Economic Recovery Omnibus Emergency Solutions Act (the “HEROES Act”) (H.R. ___), a $3 trillion stimulus bill that would provide additional relief in response to the COVID-19 pandemic and resulting economic downturn.  The HEROES Act would eliminate the limitation on the deduction for state and local taxes for 2020 and 2021 and enhance and expand the earlier Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) (H.R. 748) and the Families First Coronavirus Response Act (the “FFCRA”) (H.R. 6201). However, the HEROES Act would also reverse some of the changes in the CARES Act by paring back the ability of a corporate taxpayer to carry back net operating losses and restoring the limitations on excess business losses for a noncorporate taxpayer. Republicans have dismissed many provisions in the HEROES Act, and there are no immediate plans for it to be considered by the Senate.[1] This blog summarizes some of the most important tax provisions in the bill.[2]

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New Guidance Allows Publicly-Offered REITs and RICs to Issue up to 90% of Qualifying Dividends in the REIT or RIC’s Own Stock Through the End of the Year.

On May 4, 2020, the IRS issued Revenue Procedure 2020-19, which temporarily allows a publicly-offered REIT or RIC to pay as much as 90% of a distribution in its own stock (rather than cash or other property) and still have the entire amount treated as a dividend for US federal income tax purposes. As a result, the distribution will qualify for purposes of the REIT or RIC’s dividend distribution requirement and the dividend paid deduction, so long as certain requirements are satisfied.  Revenue Procedure 2020-19 closely follows the format of similar guidance issued during the 2008 financial crisis and applies to distributions declared on or after April 1, 2020, and on or before December 31, 2020.

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COVID-19 Impact on Executive Compensation – Amending Performance Goals under Equity and Other Incentive Awards

We continue our blog series on COVID-19 implications on executive compensation matters with a post that addresses considerations relating to amending performance goals under equity and other incentive awards.

Setting meaningful and effective performance goals often requires significant focus and analysis by compensation committees with the assistance of their advisors and management.  In light of current economic challenges, stock price volatility and business uncertainty surrounding COVID-19, performance goals and the corresponding targets governing annual and multi-year cash and equity-based incentive awards established in early 2020 or prior will likely not be achieved for many companies.  Accordingly, companies that sponsor these arrangements should consider whether to amend or substitute such plans, programs and practices, as well as the underlying awards, including whether to modify pre-established performance goals.

Companies considering taking such actions should review their current arrangements and analyze how current business conditions have affected existing arrangements, performance goals and stock prices.  In addition to this review and analysis, companies should consider other issues, including Section 409A of the Internal Revenue Code (the “Code”), and if the company is publicly traded, securities laws and limitations under Section 162(m) of the Code.  Set forth below are certain specific questions and limitations to be evaluated in connection with a review of performance goals and potential modifications or other adjustments.

  • Review, outstanding compensation arrangements to
    • Determine if outstanding compensation arrangements contain performance goals;
    • Determine upcoming compensation committee meetings to grant short- or long-term incentive compensation;
    • Determine upcoming award cycles based on historical grant practices; and
    • Determine upcoming compensation committee meetings to certify the level of achievement of performance goals related to different award cycles (i.e., prior awards).
  • Identify
    • Whether established absolute performance goals can realistically be met in light of recent economic developments and whether relative performance goals would be similarly impacted;
    • Whether arrangements, policies or guarantees exist that require recurring incentive compensation grants and how the size of such grants is determined;
    • Whether current arrangements appropriately incentivize and encourage retention of employees and other service providers;
    • Whether current equity plan share limitations are sufficient to satisfy upcoming equity awards;
    • Whether the company has discretion to make amendments and modifications under the terms of the plan and in accordance with the company’s past practices; and
    • Whether liquidity is sufficient to satisfy upcoming incentive compensation payouts.
  • Act, after reviewing the risks and limitations associated with such actions (described in further detail below), to determine appropriate changes or modifications to performance-based and/or equity compensation plans, programs or practices. Including:
    • Modifying or adjusting performance goals, including moving from absolute performance goals to relative performance goals (i.e., absolute total shareholder return versus relative total shareholder return or other peer-based performance goals);
    • Including non-financial performance goals (i.e., operational goals like enhanced supply chain management, process improvements, increased employee and public engagement and/or ESG-based performance goals) or individual performance goals;
    • Extending equity awards or bonuses during periods of furlough or leave of absence;
    • Pausing vesting of equity awards while employees are on furlough or leave of absence;
    • Delaying establishment of annual performance bonuses;
    • Granting special incentive awards;
    • Cancelling, repricing or exchanging options; or
    • Modifying or delaying any contractual commitments to make future equity awards, including for public companies, changing grant practices based on a fixed cash value on a given date to an average value of a fixed number of days or a variable commitment based on a formula taking into account the number of shares to be granted and the share price on the date of grant.

In determining whether to amend or substitute performance goals or equity awards, companies should consider: document limitations, award windfalls, stockholder approval requirements, Securities and Exchange Commission (“SEC”) disclosure considerations, views of institutional investors and proxy advisory firms, Section 409A of the Code, tax deductibility and accounting considerations. We address these considerations in further detail below.

Document Limitations.  Prior to taking any actions with respect to their incentive compensation plans, companies should review the terms of the plans to understand the compensation committee’s rights under the plan to amend performance metrics or target compensation levels.  Plan provisions that could be problematic include provisions that prohibit amendments to outstanding awards or that do not provide sufficient authority to the compensation committee to exercise discretion in adjusting performance metrics, interpreting performance metrics or determining award payouts.  Similarly, plans (or the underlying award agreements) may not provide sufficient discretion for compensation committees to adjust results in order to disregard the effects of COVID-19.  However, even if plans permit adjustments, adjustments for COVID-19’s widespread impact may not be determinable or may be so significant that any possible determination of financial results excluding COVID-19 would be impracticable or may not be consistent with other provisions of the plan (e.g., provisions governing minimum vesting).  Companies should also consider whether actions that they take could be deemed to reduce or materially and adversely affect award holders, in which case, award holder consent may be required.

Award Windfalls.  Companies that maintain arrangements with employees that guarantee a fixed cash value of an equity award may have to grant their employees a larger number of shares than originally anticipated due to falling stock prices.  Larger awards, not only increase the equity plan’s burn rate (e.g., the number of shares issued under the equity plan in relation to the total number of outstanding shares), but may create a windfall and deliver more value than intended to employees if stock prices rebound in a short period of time.  In those circumstances, employees may realize outsized compensation as a result of a short-term downturn in the market instead of in recognition of extraordinary performance, which may subject the compensation committee to criticism from institutional investors and proxy advisory firms.  Similarly, for companies that grant profits interests, if a company receives a low valuation as a result of the current landscape and grants profits interests with a low threshold, if the company’s value rebounds quickly, award holders will be eligible to participate in the company’s profits more quickly than the company planned.  Ultimately, companies will need to evaluate what makes sense in order to properly incentivize and retain key talent while meeting other business needs and considerations.

Stockholder Approval Requirements.  With respect to equity-based incentive compensation plans, prior to taking any actions that would grant new equity awards, companies should confirm that the equity plan has sufficient shares reserved.  If new shares are requested, such amendments, along with certain other amendments and modifications to outstanding equity awards, will require stockholder approval (i.e., for publicly traded companies – option repricings) under the equity plan and stock exchange rules.

SEC Disclosure Considerations. Publicly traded companies may be required to publicly disclose and explain amendments or modifications to existing incentive compensation programs and the adoption of any new arrangements, particularly to the extent they relate to executive officers, directors or equity compensation plans.  These disclosures will generally need to be made in current, quarterly and/or annual reports filed with the SEC (e.g., Forms 8-K, 10-Q and 10-K) and the compensation discussion and analysis and other executive compensation disclosures in proxy statements.

Views of Institutional Investors and Proxy Advisory Firms. In addition to the news media’s potentially negative reaction to companies seemingly easing performance metrics associated with incentive compensation plans, public companies may also be subject to heightened scrutiny by institutional investors and proxy advisory firms, such as Institutional Shareholder Services (“ISS”) and Glass Lewis.  For example, ISS recently released guidance related to the COVID-19 pandemic on performance metrics in incentive compensation plans, which provides that:

(1) companies that modify short-term performance goals, which were previously approved for 2020, should provide contemporaneous public disclosure describing the rationale for the changes to the performance metrics;

(2) ISS discourages changing performance goals mid-cycle because such awards cover multiple years and mid-cycle changes will be reviewed on a case-by-case basis; and

(3) future plans will be reviewed under ISS’s existing benchmarking policy frameworks.

Further, ISS confirmed that it will continue to view option repricing without shareholder approval/ratification as a “problematic pay practice” and if repricing approval/ratification is requested at this year’s annual stockholders meeting, ISS has provided that it will generally recommend against repricing if it occurs within one year following a significant share price drop, but will review on a case by case basis taking into account the following factors: (1) whether repricing was a value-for-value exchange, (2) whether surrendered options were added back to a plan’s reserve, (3) whether replacement awards are subject vesting conditions, and (4) whether the repricing excluded executive officers and directors.   Negative reviews from institutional shareholders could, in turn, lead to an unfavorable vote on the company’s “Say on Pay” vote or a “no” vote on the election of company directors at the next stockholders meeting.

Section 409A of the Code.  Companies should also confirm that any modifications to incentive compensation arrangements do not violate the complex non-qualified deferred compensation rules of Section 409A of the Code.  Modifications to incentive compensation plans that do not comply with the requirements of Section 409A of the Code may cause the full value of the awards, even if not yet vested, to be subject to immediate ordinary income taxation, an additional 20% income tax and penalties and interest.

Tax Deductibility. The amendment or modification of incentive compensation plans may also impact the tax deductibility of those awards.  Publicly traded companies (including certain publicly traded partnerships and private companies with publicly traded subsidiaries) are subject to Section 162(m) of the Code, which imposes a $1 million compensation deduction limitation on compensation paid to their chief executive officer, chief financial officer and the next three most highly compensated executive officers.  The passage of the Tax Cuts and Jobs Act in 2017 obviated the qualified performance-based compensation exemption to the non-deductibility rules of Section 162(m) of the Code, and proposed regulations published in 2019 remove certain other exemptions intended to provide transition relief for newly public companies.  However (i) qualified performance-based compensation arrangements that were in effect on or before November 2, 2017 and (ii) transition relief-qualifying compensation arrangements of newly-public companies that became public prior to December 20, 2019, in each case, may be grandfathered – but would not be eligible for grandfathering if they were to be materially modified.  Companies that have grandfathered incentive compensation arrangements should closely consider whether such modifications will lead to the loss of grandfathering under Section 162(m) of the Code and whether the benefits of the modification are greater than the loss of the grandfathering.

Accounting Considerations. Finally, companies considering modifying their incentive compensation plans or the related awards, should discuss such modifications with their accounting firms, as such changes could lead to liability accounting or treatment of modifications as the grant of new awards.

For more information please refer to Proskauer’s Tax Talks Blog.  Proskauer’s cross-disciplinary, cross-jurisdictional Coronavirus Response Team is focused on supporting and addressing client concerns.  Visit our Coronavirus Resource Center for guidance on risk management measures, practical steps businesses can take and resources to help manage ongoing operations.

Coronavirus: Congress Introduces New COVID-19 Tax Bills

On May 6, 2020, Senators Chuck Grassley (R. Iowa) and Ron Wyden (D. Ore.), the Chair and Ranking Member of the Senate Finance Committee, introduced the Small Business Expense Protection Act of 2020 (S. ___),[1] which would reverse a recent Internal Revenue Service (“IRS”) Notice and permit deductions for expenses that relate to loan forgiveness under the Small Business Administration’s Paycheck Protection Program (the “PPP”). On May 8, 2020, a bipartisan group of Representatives introduced the Jumpstarting Our Businesses’ Success Credit Act (the “JOBS Credit Act”) (H.R. ___), which would expand the employee retention tax credit available under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) (H.R. 748). [2]  This blog summarizes these bills.

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