Navigating the EU mandatory disclosure rules

The European Union (the EU) has introduced an additional level of disclosure designed to detect potentially aggressive tax planning with an EU cross-border element.

The requirements come from the colloquially known “DAC6” European Directive (DAC6), which needs to be implemented in UK legislation by 1 July 2020. However, DAC6 provides for implementation with retrospective effect from 25 June 2018. These rules therefore catch arrangements which are being used now.

The purpose of DAC6 is to enable tax authorities to obtain early knowledge of such arrangements so that they can take prompt action where appropriate to counteract them.

This increasing trend of transparency is also targeted at changing behaviour more generally and to deter intermediaries and their clients from promoting or using such arrangements.

This note provides an overview of DAC6, focusing on the “hallmarks” concerning the Common Reporting Standard (the CRS) and beneficial ownership, which will arguably have the greatest impact on private clients and the intermediaries advising them.

See our note here on the impact of DAC6 more generally.

Mandatory disclosure of cross-border arrangements

DAC6 provides for mandatory disclosure of certain cross-border arrangements by intermediaries, or taxpayers, to the tax authorities and mandates automatic exchange of this information amongst Member States within the EU.

Member States must adopt and publish the laws, regulations and administrative provisions necessary to comply with DAC6 by 31 December 2019. Indeed, some Member States such as Poland have already introduced rules much earlier and broader than expected. Other jurisdictions, such as Italy, Lithuania, Sweden, Cyprus and the Netherlands have also already submitted draft legislation for consultation.

In the UK, HMRC is consulting with the private sector and more widely when the draft rules are prepared to determine how DAC6 will be implemented in the UK.

Despite not knowing yet how DAC6 will be implemented in the UK, intermediaries and clients need to be aware that there are transitional rules that require disclosure of reportable transactions which are entered into after 25 June 2018, with 31 August 2020 being the final date for disclosure of reportable arrangements from this transitional period.

It is also possible that HMRC may go above and beyond the minimum threshold of DAC6 and implement the DAC6 rules with a longer retrospective period in line with the Organisation for Economic Cooperation and Development’s (the OECD) “Model Mandatory Disclosure Rules for Addressing CRS Avoidance Arrangements and Opaque Offshore Structures” (the MMDRs). The MMDRs require retrospective disclosure of arrangements implemented on or after 29 October 2014.

Which arrangements will be caught?

Arrangements need to satisfy the following two conditions to be disclosable under DAC6:

1. It must be a cross-border arrangement

In other words, it must be an arrangement concerning either more than one EU Member State, or an EU Member State and a third country where at least one of the following conditions is met:

• not all participants in the arrangement are tax resident in the same jurisdiction;
• at least one of the participants has dual residency for tax purposes;
• at least one of the participants in the arrangement carries on a business in another jurisdiction through a permanent establishment and the arrangement forms part of the business of that permanent establishment; or
• at least one of the participants in the arrangement carries on activities in another jurisdiction without being resident for tax purposes or creating a permanent establishment situated in that jurisdiction.

Whilst purely domestic arrangements are therefore not caught by these rules, there is nothing preventing Member States from extending the regime to cover purely domestic arrangements.

2. It must contain at least one of the 18 “hallmarks”

In other words, it must have a specified characteristic or feature that presents an indication of a potential risk of tax avoidance.

DAC6 expressly states that in implementing the parts addressing CRS avoidance arrangements and beneficial ownership, Member States can use the work of the OECD, and specifically the MMDRs and its commentary (the Commentary), as a source of illustration or interpretation. The next section therefore draws on the MMDRs and the Commentary to illustrate the type of arrangements that may be caught by DAC6.

As noted above, the most relevant hallmark for private clients and the intermediaries advising them is likely to be the specific hallmarks concerning automatic exchange of information and beneficial ownership, which we will look at in more detail below.

Automatic exchange of information

A cross-border arrangement will be caught if it may have the effect of undermining the CRS reporting obligations or if it takes advantage of the absence of such legislation or agreements.

DAC6 states that such arrangements include at least the following elements.

• The use of financial investments that are not caught by the CRS but have features that are substantially similar to those that are caught (for example, the use of certain types of e-money and derivative contracts).
• The transfer of funds to a jurisdiction which is outside the scope of the CRS.
• The reclassification, transfer or conversion of assets into those that are outside the scope of the CRS.
• Arrangements that purport to eliminate reporting, such as back-to-back investment arrangements.
• Arrangements that undermine or exploit weaknesses in due diligence procedures used by financial institutions, including the use of jurisdictions with inadequate or weak enforcement or transparency requirements.

Further guidance is required to understand where the bar will be set when it comes to arrangements which reduce CRS reporting but where there is no intention to avoid reporting.

The Commentary notes that the arrangement does not have the effect of circumventing the CRS solely because it results in non-reporting under the relevant CRS legislation, provided that it is reasonable to conclude that such non-reporting does not undermine the policy intent of such CRS legislation.

For example, it is not uncommon for a US citizen who is resident in a Member State to establish a trust in Delaware for US estate planning purposes.

The US is one of the few jurisdictions that have not implemented the CRS. The Commentary states that if the relevant information is exchanged under FATCA (the US equivalent of CRS) with the jurisdiction of tax residence of the reportable taxpayer, it will not have the effect of circumventing CRS.

It gives an example of a reportable taxpayer that is tax resident in jurisdiction X who transfers assets to the US, and notes that that transfer would not have the effect of circumventing the CRS legislation provided the account information is exchanged by the competent authority of the US with jurisdiction X.

In many cases, however, the US is not currently exchanging information. On the face of it, this example would therefore seem be caught by these rules.

Another example is if a client sets up a discretionary trust for the benefit of his/her children and descendants and the trust instrument defines the beneficiaries by referring to them as a class rather than by name. In some countries, where the beneficiaries are defined as a class, it is only beneficiaries who receive distributions who are reportable under the CRS.

It seems unlikely that this amounts to circumventing CRS since this is specifically provided for in the CRS guidance. However, until we have further guidance in relation to DAC6, the position is unclear.

Beneficial ownership

A cross-border arrangement will also be caught if it satisfies a second hallmark.

This is where the arrangement involves a non-transparent legal or beneficial ownership chain with the use of persons, legal arrangements or structures:

• that do not carry on a substantive 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.

It is not yet clear what this hallmark is intended to capture. Many (if not all) of the arrangements that will satisfy the three conditions set out above will already be caught by the automatic exchange of information hallmark described above.

It is possible that it is aimed at those who deliberately and illegally obscure beneficial ownership rather than those entering into arrangements that have a potential for tax avoidance. In other words, it may be intended to capture those who should be disclosed under normal anti-money laundering legislation but are nevertheless not disclosed by the intermediary and/or the taxpayer.

The Commentary suggests that this hallmark is aimed at:

• the use of nominee shareholders with undisclosed nominators;
• indirect control beyond formal ownership;
• arrangements that provide a person with access to assets or income without being identified as the beneficial owner; and
• legal or formal arrangements that have the effect of depriving the legal owner of the economic benefit of the asset or income in favour of a third party such that the third party has the benefit of the asset without being recognised as the beneficial owner.

One example given is where a person provides funds to a non-affiliated company in exchange for an option to acquire all or substantially all of the assets of that company for a nominal sum.

Another example given is where a trustee of a trust habitually acts under the instructions of another person even though the person is not recognised as a trustee or a protector under the trust deed.

The scope of this hallmark is therefore potentially very wide. Further guidance will be required to understand how the hallmark will apply in practice.

The three conditions that need to be satisfied also give rise to a number of additional uncertainties.

Many offshore financial centres have recently implemented new economic substance rules. If the entity in question satisfies the new substance requirements, will this be considered “adequate” for these purposes?

It will also be necessary to monitor changes in residence status of those involved to determine whether the second condition may be satisfied at a later date.

The final condition raises the question of what is meant by “unidentifiable”. It is not clear, for example, whether this will capture those who hold properties through nominees provided by third parties, the purpose of which may be to provide privacy. Whilst “undisclosed” on the public land registry, this nominee arrangement does not prevent the beneficial owner from being disclosed to the relevant tax authority if there is any tax liability in respect of the property.

There may therefore be many arrangements that could satisfy this hallmark simply as an outcome of a commercial transaction or as part of standard estate planning undertaken by internationally mobile families.

Who reports?

The primary reporting obligation falls on the “intermediary”.

An “intermediary” is any person that designs, markets, organises, makes available for implementation or manages the implementation of a reportable cross-border arrangement.

Examples include: tax advisers, accountants and lawyers advising clients on reportable cross-border arrangements. There is no exclusion for in-house advisers.

An intermediary also includes any person who provides (directly or indirectly) services in relation to a reportable cross-border arrangement if it is reasonable for the service provider to know that the arrangement is reportable.

This is a wide definition that is likely to catch many service providers such as banks, family offices, trustees, corporate service providers, and notaries, who may assist with such arrangements.

However, it may not catch situations where the intermediary’s role is limited, for example, if it is solely one of administration or compliance. This is because it depends on the circumstances, information available and expertise of the person in question. It may be unreasonable to expect the service provider to know that the arrangement is reportable if, for example, they are simply dealing with the necessary filing formalities as part of a transaction or carrying out routine banking transactions.

For an intermediary to have a reporting obligation, they must also be resident for tax purposes or provide the relevant services in a Member State.

For example, a non-EU law firm would be within the scope of the DAC6 regime if it was providing services in an EU Member State.

Where there is more than one intermediary, the obligation to report lies with all the intermediaries involved in the arrangements.

An intermediary may, however, be exempt from filing information to the extent that it has proof that this information has already been filed by another intermediary.

Where there is no EU intermediary or the EU intermediary is a lawyer whose advice benefits from legal privilege, the obligation to report the cross-border arrangement then passes to the taxpayer, if resident in the EU.

Where there is more than one taxpayer who must report (such as a husband and wife), the primary obligation is on the taxpayer who agreed the arrangement with the intermediary.

When to report?

The first reportable transactions will be those that have had the first implementation step between 25 June 2018 and 1 July 2020, with 31 August 2020 being the final date for disclosure from this transitional period.

From 1 July 2020, the arrangements become reportable within 30 days from (whichever comes first):

• the day after the reportable cross-border arrangement is made available for implementation;
• the day after the reportable cross-border arrangement is ready for implementation; or
• when the first step in the implementation of the reportable cross-border arrangement has been made.

What to report?

The following information must be disclosed to the tax authorities:

• The identification of the intermediaries and the relevant taxpayers - including their name, date and place of birth (in the case of an individual), residence for tax purposes, and tax identification number.
• The hallmarks - details of the hallmarks that make the cross-border arrangement reportable.
• A summary of the reportable cross-border arrangement - including the value of the assets involved.
• The timing - the date on which the first step in implementing the reportable cross-border arrangement has been, or will be, made.
• The relevant member states - the identification of the Member State of the relevant taxpayer(s) and any other Member State(s) which are likely to be concerned with the reportable cross-border arrangement.
• Other persons affected - the identification of any other person(s) in Member State(s) likely to be affected by the reportable cross-border arrangement – indicating to which member state such person is linked.
• A reference number for the arrangement - so that if more than one intermediary or taxpayer is obliged to file the information, one single reference number should feature on all the exchanges so that they can be linked to a single arrangement.

Member States will exchange this information quarterly by entering reports they receive in a central EU database, which can then be assessed by every other Member State. This information will not be available for public use.

Practical implications

Whilst DAC6 may have been targeted primarily at large corporate transactions, this new mandatory disclosure regime increases the transparency of private wealth holding structures as well.

Aside from the potential for financial penalties, the reputational damage for intermediaries and taxpayers could be significant if they fail to comply with this regime.

Intermediaries should therefore now review any advice or services given to clients within the EU and with cross-border arrangements to ensure that they do not trigger a notification requirement under the new disclosure regime, bearing in mind that disclosure is required if the arrangement has the effect of circumventing CRS reporting or obscuring beneficiary ownership, whether or not that was intended.

Where clients implement transactions without external advice, or seek advice and services from a non-EU intermediary or from EU intermediaries that benefit from legal privilege, then the obligation will fall on them to capture and report the relevant information.

The immediate practical steps to consider include:

• understanding which transactions may be impacted by the disclosure regime;
• identifying transactions undertaken during the transition period that must be reported by 31 August 2020;
• collating, analysing and storing the data that will be needed for submission; and
• agreeing an approach with client teams and other intermediaries to ensure consistent reporting.

If you would like further information or specific advice, please contact us.