The European Commission on 22 December 2021 published a proposed EU directive that would introduce rules to prevent the misuse of shell entities for tax purposes and expand the scope of the EU Council Directive on administrative cooperation. Combined, these two measures are referred to as “ATAD3” or the shell entities directive. The proposal introduces an information disclosure regime that may lead to the disallowance of any tax advantages for EU companies that are deemed to have no or minimal economic activity.
If adopted, the directive would enter into force in all EU member states on 1 January 2024.
The proposed directive targets entities within the EU that are purportedly engaged in an economic activity but that, in reality, do not conduct any economic activities and do not have minimal substance. The reason these companies are in place is to enable certain tax advantages to flow to their beneficial owner or to the group to which they belong, as a whole. In the EC’s view, these entities are typically misused for the purpose of obtaining tax advantages.
If an entity is presumed to be a shell company for purposes of ATAD3, tax advantages based on a tax treaty or an EU directive, such as the parent-subsidiary directive and the interest and royalties directive, may be disallowed.
In essence, disallowance would mean that tax treaties and directives must be applied as if the shell entity had not been interposed. To that end, the EU member state of which the shell entity is a resident must either refuse to issue a tax residency certificate to that entity or issue a “warning” certificate (a statement indicating that the shell company cannot avail itself of EU directive and treaty benefits). This does not affect the member state’s ability to tax the shell entity as resident under its domestic law.
ATAD3 describes the process for denying tax benefits under different scenarios when payments are made to a shell entity and when either the payer or the shareholder of the entity is resident in another EU member state or in a third country.
ATAD3 sets out a seven-step approach for identifying entities that lack minimum substance and are being improperly used to obtain tax benefits, i.e., shell entities. The ATAD3 provisions apply to all entities, regardless of their legal form, that are engaged in an economic activity and that are considered to be tax resident and eligible to receive a tax residency certificate in an EU member state. The directive also captures legal arrangements, such as partnerships, that are deemed resident for tax purposes in an EU member state. The proposal does not apply to entities in third countries.
Step 1: Entities that should report
The first step is to identify entities lacking substance by checking three “gateways”:
If an entity crosses all three gateways, it will be deemed to be “at risk” and will be required to report on its substance in its tax return to assess whether it will be presumed to be a shell entity.
An entity does not have to report if:
Step 2: Reporting on economic substance
Entities that cross all three gateways in Step 1 are “at risk” and must report information in their annual tax return regarding “substance indicators.” The minimum substance indicators can be summarized as follows:
The reporting must be accompanied by satisfactory documentary evidence, which should be attached to the tax return as well, if not already included. Non-compliance will result in a penalty of at least 5% of the companies’ turnover for the relevant tax year.
If at least one indicator is not met, the entity will be presumed to be a shell entity. Regardless of whether the entity qualifies as a shell, the information reported will be automatically exchanged.
Step 3: Presumption of lack of minimal substance and tax abuse
An entity that declares it has not met one or more of the minimum substance indicators in Step 2 or does not provide satisfactory supporting documentary evidence will be presumed not to have minimum substance.
Step 4: Rebuttal
An entity that is presumed to be a shell company may rebut this presumption by providing any additional supporting evidence of the business income activities it performs to generate relevant income.
Step 5: Exemption for lack of tax motives
Alternatively, an entity can request an exemption from its obligations under ATAD3 if the entity provides sufficient and objective evidence that its existence/interposition does not lead to a tax benefit for its beneficial owner(s) or the group as a whole. That evidence will allow a comparison of the amount of overall tax due by the group as a whole, having regard to the interposition of the entity, with the amount that would be due under the same circumstances in the absence of the entity.
Step 6: Tax consequences for shell entities
The consequences for entities that are deemed to be shell entities are twofold:
Further, ATAD3 indicates that the member state of a shell entity remains free to continue to consider a shell entity as a resident for tax purposes in its territory and levy tax on the relevant income flows and/or assets under its domestic law.
Step 7: Exchange of information
All data collected under Step 2 will be automatically exchanged between member states through a central database within 30 days of the tax administration obtaining this information, that is, within 30 days of receiving the returns or within 30 days of a tax administration declaring that an entity has rebutted a presumption or is exempt.
Because ATAD3 is expected to enter into force on 1 January 2024, and given the fact that two preceding tax years are reviewed under Step 1, it may be advisable for taxpayers to review the proposed directive now.