EU Commission proposes Directive on Shell Entities (ATAD3)

EU Commission proposes Directive to end the misuse of shell entities

On 22nd December 2021, the EU Commission has issued a proposal for a Directive aimed at fighting the use of shell entities and other arrangements aimed at benefiting from tax advantages. The proposal comes in the form of amendments to Council Directive 2016/1164/EU – the EU Anti-Tax Avoidance Directive (ATAD) and to Council Directive 2016/16 on administrative cooperation in the field of taxation (DAC).

The European Commission ‘’shell entities’’ proposal
The Directive sets out a seven-step process aimed at identifying entities that lack economic substance with the aim of obtaining economic substance.

Step 1: Determine if the entity needs to report on economic substance
This step is focused on identifying those entities that lack substance in the country in which they are incorporated. The features on which an entity is assessed are referred to as gateways and assess:

- How the revenue of the entity is generated i.e. either (i) more than 75% of the overall revenue from the previous two years is generated from the entity’s business activity, or (ii) 75% of the assets consist of real estate or valuable private property;
- Cross-border element i.e. whether the majority of the entity’s revenue is generated from cross border transactions, or the income is passed on to foreign entities;
- Whether the company is managed by in-house personnel, as opposed to outsourcing the management function.
An entity that falls within the parameters of all three gateways is considered as a high-risk entity and would be required to report about its economic substance in the particular country with the exception of companies listed on a regulated stock exchange, regulated financial undertakings, holding companies with no/limited cross border elements and entities that have at least five-full time employees engaged exclusively in the activity generating the income.
Entities which do not satisfy all three of the gateways are considered low-risk and are not required to report on their substance.

Step 2: Reporting on economic substance
Entities which satisfy all three gateways and do not fall within any of the carve-outs are required to include information on substance indicators in their annual tax return. In particular, entities are required to report about:
i. Whether they have premises available for their exclusive use;
ii. Whether they own an active bank account in the EU;
iii. Provide proof of adequate connections with the Member States of claimed tax residence. This can be demonstrated through relevant personnel being resident close to the entity, at least one dedicated director or a sufficient number of employees engaged in its core activity.
The tax return declaration should be accompanied by supporting documentation which shall serve as proof to the information contained in relation to the above.

Step 3: Presumption of lack of minimal substance and tax abuse
An entity that is considered as a high-risk entity in step 1 and that has provided sufficient evidence in support of its declaration that it meets all indicators of minimum substance in Step 2, should be presumed to have minimum substance for the particular tax year. Nonetheless, tax authorities may conclude that the entity:
- Is a ‘shell’ under the Directive, if the evidence produced does not uphold the information reported; or
- Is a ‘shell’ or lacks substantial economic activity under domestic rules; or
- Is not the beneficial owner of any stream of income paid to it.

Step 4: Rebuttal
An entity which is considered as a ‘shell’ company under Step 3 by the Tax Authorities of the Member State where it is incorporated, may provide additional supporting evidence to rebut the Authorities’ conclusion. The additional supporting evidence provided under this step depends on the circumstances of the entity and may include commercial reasons (not tax related) for setting up and maintaining the entity in that Member State, and reasons why the entity does not need to have a bank account, management and/or employees in that State.

The evidence provided shall then be assessed by the Tax Authority of the Member State and when the tax administration is satisfied with the information provided and agrees that the entity is not a ‘shell’ for the purposes of this directive, it will certify the outcome of the rebuttal process for the relevant tax year. If the factual circumstances of the entity do not change, it is possible to extend the validity of the rebuttal for another five years (i.e. for a total period of six years). After the six year period, the entity would have to go through the process under Step 4 for the rebuttal of the presumption that it is a shell company again.

Step 5: Exemption for lack of tax motives
An entity that satisfies the gateways in step 1 and fails to satisfy the minimum requirements under step 2 can apply for the exemption from the scope of the Directive if they can prove that the incorporation of the entity does not create a tax benefit for the group of companies of which it forms part or its ultimate beneficial owner(s).
If the tax authority is satisfied that no tax benefit is created, it should certify that the entity is not a ‘shell’ for the scope of the Directive. The exemption can be extended for a further five years.

Step 6: Tax consequences
An entity considered as a shell entity and that does not rebut this presumption or gets the exemption under step 5, shall be denied the benefits otherwise available to it under double tax treaties or the Parent-Subsidiary Directive and Interest and Royalties Directive. In practice, this means that the Member State where the shell is resident shall either deny the issuance of a tax residency certificate to the ‘shell’ entity, or issue it with a tax residency certificate with a warning stating that the tax authority of the country where it is resident considers the entity as a ‘shell’ and thus the advantages of the double taxation agreements and the above mentioned EU Directives shall not apply for the entity.

Step 7: Exchange of information
Under this step, all information collected by the tax authority under Step 2 would be subject to automatic exchange of information between Member States. Furthermore, Member States will be allowed to ask the tax authority where the entity is incorporated to perform tax audits on the entity, provided they have sufficient grounds to suspect a lack of minimum substance. This will bring along amendments to Directive 2011/16/EU on administrative cooperation between Member States, setting out deadlines and information to be communicated by tax authorities.

Other aspects
Member States are allowed to lay down penalties for non-compliance however the Directive notes that an administrative penalty of at least five percent of the entity’s turnover should be introduced by each Member State.

The Commission proposes that each Member State should transpose the rules into domestic legislation by 30 June 2023 and that the provisions of the Directive should apply as of 1 January 2024.