On 22 December 2021, the European Commission published a proposal for a Directive (ATAD_3) to target the misuse of shell companies for tax purposes. EU Member States need to transpose the Directive into their national legislations by 30th June 2023, with its provisions coming into effect on 1st January 2024. The Directive targets entities tax resident in the EU that are engaged in cross-border economic activities but have little or no economic substance. Such entities will run the risk of being classified as shell entities and, if classified as such, could face a number of tax consequences.
Targets of Directive:
The basic target of the Directive is to introduce a uniform set of criteria (‘gateways’) for identification of entities that are engaged in such economic activities, but do not have minimum economic substance, and may thus be misused for tax purposes.
If an undertaking cumulatively meets all of the gateways (for which there is a 2-year lookback period), and if it does not fall within any of the carve-out categories provided for in the Directive, it will be considered to be ‘at-risk’ of being classified as a shell entity.
Entities at-risk shall need to report whether they cumulatively meet a series of substance indicators. Entities that do not cumulatively meet all of these indicators will be presumed not to have minimum economic substance and will in principle qualify as shell entities.
Such entities will have the opportunity to either rebut this presumption by providing additional supporting evidence of the business activities that they perform to generate their revenues, or to request for an exemption, on the grounds that their existence does not create a tax benefit. Failing to either rebut the presumption or to obtain an exemption, such entities will be classified as shells and will face a number of tax consequences, including denial of access to the benefits of double tax treaties or EU Directives, increased transparency via automatic exchange of information, and possible tax audits. Moreover, penalties will apply for infringement of the proposed rules.
Once adopted, the Directive is expected to have a major impact on corporate groups with international activities that make use of EU-established entities. Even though the Directive is primarily targeted towards the misuse of shell entities for tax purposes, it nevertheless goes beyond the improper tax use of shell entities. Vehicles such as companies, partnerships, trusts etc with little substance are at risk to come within the scope of the Directive, even though the majority of them are set up for perfectly valid business and/or investment reasons.
What to do:
Provided that the Directive comes into effect as planned (January 2024), and given the two (2) year look-back period, international corporate groups involving holding entities would do well to start considering, sooner rather than later, whether they may fall within the scope of the Directive, so they should consider actions such as:
– Changing the status of the entity in order not to cross the gateways, or
– Meeting the substance requirements of the Directive to the best possible extend, in an effort to avoid the ‘shell entity’ status (in any case, increasing local substance generally strengthens any international vehicle used), or
– Determining whether it is possible to rebut the ‘shell entity’ presumption or to request for an exemption.
Application of Directive:
The Directive applies to undertakings, irrespective of legal form (including, for instance, partnerships and Trusts) that are tax resident and are eligible to receive a tax residency certificate in an EU Member State, and are involved in cross-border activities. The methodology proposed by the Directive is outlined as follows:
- Identification of entities being at risk to be classified as shell companies (‘gateway criteria’)
- Substance indicators.
- Presumption of being classified as a shell entity for tax purposes.
- Rebuttal of presumption or obtaining of exemption.
- Tax consequences of being classified as a shell entity.
- Exchange of information, tax audits, penalties.
The Directive provides for three criteria, commonly referred to as ‘gateways’. An entity cumulatively meeting all three of them will be ‘at risk’ of being considered a shell entity. Entities which do not meet any of the gateways or only meet some of them will be considered to be low-risk and thus will fall outside the scope of the Directive. The gateways are as follows:
- More than 65% of the revenues accruing to the undertaking in the preceding two tax years is relevant income (see NOTE 1).
- The undertaking is engaged in cross-border activities on any of the following grounds:
- More than 55% of the book value of certain assets of the undertaking (immovable property, and movable property other than cash, shares or securities, held for private purposes and with a book value of more than €1 million) was located outside the Member State of the undertaking in the preceding two years.
- More than 55% of the undertaking’s relevant income is earned or paid out via cross border transactions.
- In the preceding two tax years, the undertaking outsourced the administration of day-to-day operations and the decision-making on significant functions to a third party.
The term ‘relevant income’ shall mean income falling under any of the following:
- interest or any other income generated from financial assets (including cryptos).
- royalties or any other income generated from intellectual or intangible property or tradable permits.
- dividends and income from the disposal of shares.
- income from financial leasing.
- income from immovable property.
- income from movable property, other than cash, shares or securities, held for private purposes and with a book value of more than €1 million.
- income from insurance, banking and other financial activities.
- income from services which the undertaking has outsourced to other associated enterprises.
The proposal makes it clear that the outsourcing gateway focuses on undertakings that do not have adequate own resources and thus tend to engage third party providers of administration, management, correspondence and legal compliance services. The outsourcing of certain ancillary services only, such as bookkeeping services alone, whilst keeping the core activities within the undertaking, would not in itself suffice for the undertaking to meet this condition.
Steps of Establishing Substance:
An undertaking cumulatively meeting all of the gateways (and thus considered ‘at risk’ of being a shell entity) will need to demonstrate, on an annual basis, that it has sufficient minimum substance in order to carry out the activities that it performs. This will be done via declaring information related to its substance (the so-called ‘substance indicators’) in its annual tax return.
The undertaking needs to declare that it has cumulatively fulfilled all of the substance indicators, otherwise it shall be presumed not to have minimum substance for the tax year in question.
The substance indicators are as follows:
- Use of own premises, or premises for its exclusive use, or premises shared with entities of the same group (the original draft Directive made reference to premises for exclusive use only; the revised draft also makes allowance for shared premises)
- Evidence of at least one own and active bank account or e-money account within the EU, through which the relevant income is received (the original draft Directive did not provide for the option of an e-money account; now provided in the revised draft).
- One of the following two criteria is met:
- One or more directors of the company are:
- tax resident in the Member State of the company, or reside no further away from that country that the distance involved would still allow for the proper performance of their duties.
- authorised to take decisions in relation to the activities generating the relevant income of the company, or in respect of the company’s assets (noting that the original draft Directive required that the directors be both ‘authorised’ as well as ‘qualified’. The reference to ‘qualified’ has been deleted in the revised draft).
The original draft contained two additional conditions which have been removed in this revised draft; namely that one or more directors should: (a) exercise their authority actively and independently on a regular basis, and (b) should not hold any other employment or directorship positions, except in other affiliated companies within the group.
- The majority of the company’s full-time employees have their habitual residence in the Member State of the company or reside no further away from that country than a distance which would allow them to perform their duties adequately, and the said employees are qualified to carry the activities that generate relevant income for the company.
The above substance indicators will need to be supported by documentary evidence that will accompany the tax returns, and shall include the following information:
- address and type of premises.
- amount of gross revenue and type thereof.
- amount of business expenses and type thereof.
- type of business activities performed to generate the relevant income.
- the number of directors, their qualifications, authorisations and place of residence for tax purposes or the number of full-time equivalent employees performing the business activities that generate the relevant income and their qualifications, their place of tax residence.
- outsourced business activities.
- bank account number, any mandates granted to access the bank account and to use or issue payment instructions and evidence of the account’s activity.
- an overview of the structure of the undertaking and associated enterprises and any significant outsourcing arrangements, including the rationale behind the structure, described in the context of a standardised format.
- a summary report of the documentary evidence submitted, containing (i) a brief description of the nature of the activities of the undertaking; (ii) the number of employees on a full-time equivalent basis; (iii) the amount of profit or loss before and after taxes.
Tax consequences when a company is considered a shell entity:
If an undertaking qualifies as a shell entity, it shall face a number of consequences which in effect will aim to neutralise the shell entity’s tax impact, i.e. disallowing any tax advantages that have been (or could be) obtained through the entity in accordance with double tax treaties and/ or EU Directives.
Specifically, the EU Member State of the shell entity shall deny any request for the issue of a tax residency certificate for use outside its jurisdiction.
This will ensure that the shell entity shall not be eligible for the tax benefits of the network of double tax treaties of its Member State of residence, or for the application of relevant EU Directives. Despite this, the shell entity will continue to be resident for tax purposes in the respective Member State and will have to continue fulfilling its relevant tax obligations.
In case where the shell entity’s shareholders are tax resident in an EU Member State, then that Member State shall have the right to tax the relevant income of the shell entity in accordance with its national law, as if it had accrued directly to the shareholders (effectively adopting a ‘look-through’ approach).
Moreover, any relevant income of a shell entity which is sourced in an EU country will be subject to withholding tax (where applicable) in that country, disregarding any exemptions afforded by double tax treaties or EU Directives.