Newsletter November 2019

Convention for the avoidance of Double Taxation between Spain and the USA.

Smart contracts.

Incentive Plans for Startups.

Convention for the avoidance of Double Taxation between Spain and the USA.

The new protocol that amends the Convention for the avoidance of Double Taxation between Spain and the USA will come into effect on November 27.

The new protocol updates the Convention signed in 1990 in order to to comply with the new OECD directives, to improve the taxation of certain income and also to extend its application to some types American of companies which were not covered in the previous agreement. Furthermore, new systems of dispute settlement and improvements in the information exchange system have now bee added.

The main new elements in the new convention are the following:

  1. The Convention regulates for the first time the application of the benefits arising from it to transparent entities and its participants. This is of great significance mainly in view of the large number of transparent entities in the USA.

  2. It now includes a definition of “pension funds”.

  3. The lapse of time necessary to consider a company as permanent has been amended so that now extends from 6 to 12 months.

  4. The withholding tax rate on certain dividends in reduced as follows:

• In the case of dividend paying societies in which the direct interest held by the other society is more than 10%, the retention rate will be 5% . When this interest is 80% or more in the social capital, the dividends will be exempt from withholding tax.
• 15% in the rest of the cases.

  1. Taxation of interest and fees is eliminated when the direct beneficiary is a resident in the other country.

  2. Capital gains derived from the alienation of stock or shares will be exempt from taxation, except when they grant the right to enjoyment of property.

  3. A limitation on benefits clause is now included, which will define the scope of application of the Convention. As opposed to other conventions signed by Spain, the Convention with the USA regulates the subjective scope of application by introducing the concept of “qualified person”. A person will be considered “qualified” to benefit from the Convention when the taxable person, apart from being a resident, meets a series of requisites which allow to understand that there is a strong enough link to the country of residence or when there are valid commercial reasons to obtain the yields subject to taxation through this country.

  4. Mutual agreement procedures for dispute resolution are improved under the convention between these two countries, and they now include the possibility of requiring arbitration.

  5. The information exchange and administrative assistance clauses are regulated in light of the new standards of the OECD model tax convention.

The amendments introduced by the new protocol will enter into force on the following dates:

• Regarding taxes withheld at source, November 27, 2019. In view of this, and taking into account the reduction in taxation at source of the income specifically regulated by the new protocol, it is advisable to delay accrual to the date when the protocol comes into force.
• As to taxes covering a given tax period, they will be applicable for fiscal years starting from November 27, 2019 onwards.
• In the rest of the cases, from the time of its entry into force, that is, from November 27, 2019 onwards.

Smart contracts.

When we talk about contracts the first thing that comes to mind is the traditional contract, which is defined as an agreement signed by two or more parties and whose main object is to establish, regulate or extinguish a patrimonial legal relationship.

However, these days, even when the traditional contract is still the most widely used all over the world, new types of contracts have been developed, such as (i) digitally signed contracts when users registers on a website, (ii) contracts requiring voice confirmation (these contracts are used by companies which offer services through telecommunications) and (iii) smart contracts.

The concept of smart contract was defined in 1993 by the cryptographer and legal scholar Nick Szabo in a work titled “Formalizing and Securing Relationships on Public Networks”. However, back then this was purely theoretical given that the technological infrastructure needed to develop it, that is, blockchain technology, was not available at the time. The advent of Blockchain brought with it the possibility of executing a series of actions programmed on a ledger which is in turn shared with and validated by users to ensure security.

Smart contracts are software programs which are programmed to automatically execute agreements reached by two or more parties who will remain anonymous given that the information is encrypted. In this regard, smart contracts are subject to the meeting of a term, for example a deadline, or a condition.

As opposed to traditional contracts, smart contracts can be autorun, which eliminates paperwork, and they also have the advantage of being integrated to Blockchain, which allows for information to be recorded, unchanged, secure, and available.

Nonetheless, in the same way as traditional contracts, smart contracts need to meet the basic requirements of any contract in order to be legally binding and enforceable before the courts. That is:

(i) consent needs to be provided by the parties involved in the contract, who will identify themselves through an algorithm, code, or wallet, depending on the object of the contract. In order to confirm consent, the parties will make a “double deposit” as stated in the smart contract; and

(ii) a lawful purpose of the contract which refers to an obligation with digital support and that can be fulfilled in the digital environment is required. This real-world limitation is now being solved by, among others, the tokenization of assets.

Smart contracts offer endless possibilities and they are changing the traditional way of doing business by making available many different possibilities so that companies can enjoy all their advantages. Some of the blockchain platforms currently using smart contracts are Bitcoin, Side chains, NXT and Ethereum.

Yet, even with the growing use of technology, lawyers will still need to be involved, and they will have to specialize in the area of coding, as it will be impossible to avoid the need to interpret the content of the smart contracts in view of the difficulty involved in translating the ambiguity and flexibility of legal provisions into a formal language that can be interpreted by a machine.

Incentive Plans for Startups.

When it comes to analyzing incentive plans for startups (ESOP in the financial jargon), the first thing to bear in mind, even if it sounds like a truism, is precisely the fact that they are aimed at startups. In this regard, this type of companies have a series of particularities, two of which are worth highlighting here: (i) they are companies in which one invests with the purpose of making a subsequent sale (the so called Exit); and, (ii) they are companies which operate in a sector with high staff turnover in which talent scouting and retention is a growing concern for the HHRR departments in these companies.

In terms of types of incentive plans, there are two big categories: (i) Stock Options Plans, which are falling into disuse in view of their operational problems; and (ii) Phantom Shares Plan, which have been consistently used for many years.

The difference between these two plans is widely known: while Stock Option Plans grant recipients (Beneficiaries) the status of company shareholders ( though momentarily in most cases), in the case of Phantom Shares Plan, the shares are virtual or fictitious, that is, its use amounts to mere fiction in order to act as reference point to calculate the incentive, which, when appropriate, can be derived to the Plan Beneficiaries for their participation.

Regarding the way Incentive Plans work, the first aspect to take into account is the virtual inexistent regulation given that they are developed on the basis of the principle of free will as set out in article 1255 of the Civil Code. Therefore, they are contracts between the Startup and the Plan Beneficiary. As to the way they function, the following characteristics are worth highlighting:

  1. Design of the Plan itself: a plan is designed which operates as a framework document which will comprehensively regulate (virtually) all its functioning particularities. As to who should design and approve the plan, this should be in accordance with the provisions in the partners agreement or the Articles of Association. Should regulation be inexistent, in principle, given it is a matter of compensation, the management body would be fully empowered to adopt it. However, to the extent possible, it is advisable for the board to approve it and especially in the case of stock option plans, whereas the acquisition of partnership has to be authorized by the board, or in those cases when the incentive is in favour of a member of the board of directors, by applying the provisions in the corporation law in relation to managers’ compensation

  2. Invitation to the Plan Document: this is the document which communicates Beneficiaries that they have been invited to participate in the Plan, a faculty which is generally established in favour of the management board as this is the body which will manage the Plan. In relation to the Invitation to the Plan Document, it includes the number of phantom shares which the Beneficiary opts for; the “strike price” (explained below), and, when applicable, the specific characteristics of each Beneficiary, which could differ in relation to the general regulations set out in the Plan.

  3. Vesting Period: Once a number of phantom shares have been awarded in accordance with the Invitation to the Plan Document (although sometimes a suspension of the limitation period is established through the so called “cliff”) the consolidation period starts, during which the Beneficiary will gradually acquire the shares. This, combined with the Good Leaver and Bad Leaver clauses which will be explained below, aims at dealing with the above-mentioned issue of talent retention.

Thus, a consolidation period is established for all the shares, which is usually fractioned in sub-periods. Once the Beneficiary completes each sub-period by staying in the company, they consolidate the proportional part of their shares. Let me explain with an example: through the Invitation to the Plan Document, 100 shares are awarded with a four-year consolidation period at 25% per year. Therefore, 25 shares are consolidated at the end of each calendar year and after the four years are completed, the Beneficiary’s 100 shares are consolidated.

Clarification: once the shares are consolidated, the Beneficiary does not receive the financial Incentive but rather a right to perceive it arises as long as the Trigger Event takes place, more on this later.

  1. Good Leaver and Bad Leaver Clauses: Good Leaver and Bad Leaver Clauses regulate the Beneficiary’s treatment in those cases when the Trigger Event takes place after the Beneficiary has finished its relationship with the startup. Defining what is Good Leaver and what is Bad Leaver and the consequences of both circumstances is a matter inherent to the principle of free will. The sector’s standards are generally set out in the following way:

(i) Good Leaver: death, retirement, permanent sick leave, unlawful dismissal with final decision declared by judge or jury, voluntary resignation due to breach of corporate responsibility as set out in article 50 of the Statute of Workers Rights or, in the case of a commercial relationship, breach of contract without cause (or unjustified cause) on the part of the company, or serious and essential infringement on the part of the company when the resolution is urged by the service provider.
(ii) Bad Leaver: anything other than Good Leaver, that is, voluntary resignation, lawful dismissal, etc.

Where dismissals on objectives grounds should be included is usually a matter of debate.

In terms of consequences:
(i) In the case of Good Leaver, the Beneficiary retains the consolidated shares until the completion date so that if a Trigger Event occurs, they will be able to (or will certainly have to) participate in it.
(ii) In the case of Bad Leaver, the shares are cancelled, the Beneficiary ceases to have said status, and consequently, will have nothing to demand or claim from the society as a result of his participation in the Plan.

  1. Strike Price: this will be the reference price for the purposes of Incentive calculation
    The strike price is a reference, therefore, except for stock options, it will not in any way be paid. A common standard is the price by share derived from the pre-money valuation of the society in the last round, although in the very early stages it is not unusual for the nominal value to be fixed as strike price.

  2. Trigger Event: event whose occurrence involves the settlement of the Plan and the Incentives calculation (if any). Different types:

(i) General trigger event: identified with the company exit, whether through the sale of the society, of the total (or virtual total) of its assets, or through society operations with a similar result ( mergers or integrations resulting in 50% of the voting rights being transferred to a third party). It is therefore the prime example of a Trigger Event in view of the purpose of startups mentioned before. If it occurs, the Plan is settled in such a way that participation is mandatory.
(ii) Voluntary Trigger Event: rarely used, though it can be a useful instrument in the case of company solvency and the will to attempt to empty the Plan pool. Sometimes the Beneficiary is forced to sale at the request of the management board, though this clause is arbitrary and thus poses serious legal reserve doubts ex. article 1256 of the Civil Code.
(iii) Partial Trigger Event: investment in the society resulting in a sufficient amount to give a predetermined return in the Plan to its Beneficiaries. It is increasingly falling into disuse and it is a clear Red Flag for VCs in the Due Diligences executed in the framework of a round. The reason is obvious: investing in a company in which, precisely as a consequence of the investment, part of the invested capital is destined to pay the Plan Beneficiaries and not to develop the Society Business Plan constitutes an important disincentive.

  1. Market Value Price ( MVP). Price fixed in the framework of the Plan Trigger Event in order to calculate the Incentive. The MVP varies according to the type of Trigger Event, but also according to who it is applied to. Thus, the MVP in a General Trigger Event can be different in those cases in which the Beneficiaries keep providing services in favour of the Society, in which case the MVP would correspond to the price of ordinary Shares paid in the framework of this General Trigger Event. On the contrary, the MVP calculated in the General Trigger Event for those Beneficiaries who do not provide services in favour of the society but whose exit is considered Good Leaver can coincide, for example, with the share price paid in the framework of the round previous to the termination of service in favour of the society.

  2. Incentive: positive difference between the strike price and the corresponding MVP.

  3. Price Correction Clauses:

In the case of a Phantom Share Plan, it is important to put on record the following aspects:

(i) virtual shares used as reference are reference in relation to the startup ordinary shares, so the liquidation preference clauses set out in favour of the Preferred Shareholders in the Partners Agreement and/ or the Articles of Association of the Society will not be applicable.
(ii) When the contracts inherent to the operation which leads to a General Trigger Event include clauses setting a variable price, total or partial deferral of price, indemnity regimes, etc., these clauses will be applied mutatis mutandi to the Incentive payment.
In the case of a Stock Options Plan, the Plan should establish an obligation on the part of the Beneficiary to sign the partner agreement of the Society as Ordinary Shareholder prior to acquire partner status and to sign the SPA (or documents that might be signed in the framework of the Trigger Event) under the same condition.

  1. Duration of the Plan: the common market standard is that shares in the Incentive Plans last ten years so that if a Trigger Event does not take place within this period, the Beneficiary shall lose all entitlement in relation to the Plan.