On the 22nd December 2021, the European Commission proposed a Directive laying down rules to prevent the misuse of shell entities for tax purposes. This initiative is intended to ensure that entities in the European Union that have no or minimal economic activity are unable to benefit from any tax advantages. The proposed new measures will establish transparency around the use of shell entities, so that their abuse can be more easily detected and tackled by tax authorities. Using a number of objective indicators related to income, staff and premises, the proposal will help national tax authorities to detect entities that exist merely on paper.
Entities that do not fulfil basic economic substance indicators, would then be prevented from receiving a tax residence certificate, and other tax relief and tax advantages designed to support actual businesses performing real economic activity. Importantly, given the cross-border nature of aggressive tax planning, this proposal will enhance cooperation amongst Member States’ tax authorities and ensure that information on shell entities is shared among them.
What are the standards and indicators used to determine if a company has real economic activity?
The proposal introduces a filtering system for the entities in scope, which have to comply with a number of indicators. These levels of indicators constitute a type of “gateway”. The proposal sets out three gateways. If a company crosses all three gateways, it will be required to annually report additional information to the tax authorities through its tax return.
How do these gateways work in practice?
The first level of indicators looks at the activities of the entities based on the income they receive. The gateway is met (meaning the first carve out from the scope of Directive is lost) if more than 75% of an entity’s overall revenue in the previous two tax years does not derive from the entity’s trading activity or if more than 75% of its assets are real estate property or other private property of particularly high value.
The second gateway requires a cross-border element. If the company receives the majority of its relevant income through transactions linked to another jurisdiction or passes this relevant income on to other companies situated abroad, the company meets the second gateway and crosses to the next gateway. The third gateway focuses on whether corporate management and administration services are performed in-house or are outsourced.
What happens if an entity crosses all gateways?
An entity crossing all three gateways will be required to report information in its tax return related, for example, to the premises of the company, its bank accounts, the tax residency of its directors and that of its employees. These are known as “minimum substance indicators.” All declarations need to be accompanied by supporting evidence. If an entity fails at least one of the minimum substance indicators, it will be presumed to be a ‘shell’.
Which entities are exempt under the directive?
An entity that meets any of the following criteria will not be subject to any additional assessment, even if the entity satisfies all the three gateways. Consequently, such entity will not be subject to the requirements set out in relation to the Minimum Substance Test:
- A company with its transferable securities listed on a regulated market or multilateral trading facility;
- An entity that is a regulated financial undertaking (as defined in the proposed Directive);
- Undertakings that hold shares in operational businesses located in the same Member State as the undertaking’s shareholders or ultimate parent entity, or
- An undertaking that has at least five full-time employees exclusively carrying out the income-generating activities of the undertaking.
What happens if a company is deemed to be a shell?
If a company is deemed a shell company, it will not be able to access tax relief and the benefits of the tax treaty network of its Member State and/or to qualify for the treatment under the Parent-Subsidiary and Interest and Royalties Directives. To facilitate the implementation of these consequences, the Member State of residence of the company will either deny the shell company a tax residence certificate or the certificate will specify that the company is a shell.
Moreover, payments to third countries will not be treated as flowing through the shell entity and will be subject to withholding tax at the level of the entity that paid to the shell. Accordingly, inbound payments will be taxed in the state of the shell’s shareholder. Relevant consequences will apply to shell companies owning real estate assets for the private use of wealthy individuals and which as a result have no income flows. Such assets will be taxed by the state where the asset is located as if it were owned by the individual directly. Once adopted by Member States, the proposal should come into force as of 1 January 2024.
However, in terms of the proposed directive when assessing whether an entity is a shell or otherwise, reference has to be made to the two preceding fiscal years. This means that if the proposed Directive indeed becomes effective as from 1st January 2024, the present fiscal year 2022 would need to be assessed for the purpose of the gateway and minimum substance tests.
Given the wide scope of this proposed Directive, this will likely have a large impact on both commercial and personal undertakings that are in scope. Where an undertaking does not meet the minimum substance requirements and cannot demonstrate its genuine business purpose, this may lead to a limitation to the current benefits that the undertaking and/or its shareholders enjoy under the Parent-Subsidiary Directive or the Interest and Royalties Directive and any relevant double tax treaty upon which it may presently be relying in addition to the additional reporting obligations required in the annual tax return on indicators related to substance.
In short, while this proposed Directive may work well in limiting the use of shell entities for tax avoidance and evasion, it will create an added layer of complexity that entities will need to consider. Given that the proposed Directive will cover the two years preceding 2024, that is 2022 and 2023, it is imperative that entities assess whether the proposed Directive could potentially affect them, so that any needed remedial action is taken as from now.
Our team of dedicated tax advisors can assist with analysing the potential impacts and where required recommend possible measures to alleviate or remove the impact of the proposed Directive.