On 22 December 2021, the European Commission released a legislative proposal for a Council Directive (“Draft Directive” or “Draft ATAD 3”) laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU on administrative cooperation in the field of taxation.
The European Commission proposes that Member States transpose the Draft Directive into their national law by 30 June 2023 with a targeted date of 1 January 2024 for its entry into force.
The Draft ATAD 3 is a response to the Communication on Business Taxation for the 21st Century released on 18 May 2021 by the European Commission presenting a plan of action to pursue the implementation of the Base Erosion and Profit Shifting project and to enhance Europe's recovery from the COVID-19 pandemic. The main objective of the Draft Directive is to address tax avoidance in the area of direct taxation conducted through the use of so-called “shell companies”. To do so, the Draft Directive aims at introducing a “substance test” through new reporting obligations on EU taxpayers (i.e., so-called “undertakings” within the meaning of the Draft ATAD 3) upon filing of their tax returns. Such a substance test has been designed in accordance with a number of objective standards to be assessed towards undertakings (such as their respective level of turnover, existence of staff and presence of premises). The Draft Directive foresees additional provisions on the field of automatic exchange of information by amending Directive 2011/16/EU on administrative cooperation in the field of taxation.
More importantly, the Draft Directive requires Member States to levy minimum penalties applicable against the violation of the reporting obligations amounting to at least 5% of the undertaking’s turnover.
Scope of application
Undertakings that meet the following cumulative criteria are subject to reporting obligations, unless they fall outside of the scope of the Draft Directive’s:
- deriving 75% of their income from “relevant income” (i.e., to be broadly understood as passive income) in the preceding two fiscal years such as interest, royalties and dividends;
- mainly engaging in cross-border activities or passing on revenues to foreign shareholders (more than 60% of the book value of the undertaking’s assets was located outside the Member State of the undertaking in the preceding two tax years OR at least 60% of the undertaking’s relevant income is earned or paid out via cross-border transaction); and
- outsourcing day-to-day administration and decision-making for significant functions in the preceding two tax years.
An undertaking that meets the aforementioned cumulative criteria may, however, request an exemption from its reporting obligation, if it can provide evidence that its existence does not reduce the tax liability of the beneficial owner(s) or of its group. This exemption is granted for one year and can be extended up to five years.
Furthermore, the Draft Directive includes several carveouts and exceptions, for example for listed entities, specific regulated financial entities (e.g. AIF, UCITS, AIFM); certain holding entities located within the same Member State of their respective operational businesses; or entities deemed with sufficient recourses (i.e. with at least five own full-time equivalent employees exclusively carrying out the activities generating the relevant income).
Reporting obligations for in-scope undertakings
An undertaking within scope of the Draft Directive is obliged to report its substance level in its tax return (and through additional documentary evidence) by indicating whether the following cumulative criteria (the “Gateways”) are met : (i) the entity has premises available for its exclusive use, (ii) the entity has at least one bank account in the EU and (iii) the entity has at least one exclusive local director dedicated to the group OR full-time employees (the director and the majority of the employees should be residing close to the undertaking).
Presumption of lack of minimum substance and tax abuse
An entity is to be considered at risk when it does not meet the three aforementioned Gateways and is therefore to be treated as a shell company for the purposes of the Draft Directive.
Should an entity’s reporting reveal that all Gateways are passed, the undertaking should be presumed not to be a shell company. However, this presumption does not exclude that the tax administrations still find that such undertaking:
- is a shell for the purposes of the Draft Directive because the documentary evidence produced does not confirm the information reported; or
- is a shell or lacks substantial economic activity under domestic rules other than the Draft Directive, taking into account the documentary evidence produced and/or additional elements; or
- is not the beneficial owner of any stream of income paid to it.
The undertaking which is presumed to be a shell within the meaning of the Draft Directive has the right to provide that it has substance or in any case it is not misused for tax purposes. To rebut the presumption of shell entity the taxpayers should produce concrete evidence of the activities they perform and how they realize them (commercial reasons; information on the entity’s resources; assessment of key decisions on the value generating activities; etc.).
Practical tax consequences for shell entities failing at the minimum substance test
Tax consequences arising in the Member State other than the undertaking’s Member State:
- Member States shall deny the application of any tax treaties, Articles 4, 5 and 6 of Directive 2011/96/EU on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States and Article 1 of Directive 2033/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States;
- The Member State of the undertaking’s shareholders shall tax the relevant income of the undertaking in accordance with its national law as if it had directly accrued to the said shareholder (but still without prejudice to any tax treaty provisions if applicable). This should apply regardless of the undertaking’s country of residence for tax purposes;
- When the undertaking’s shareholder is not resident for tax purposes in a Member State, the Member State of the payer of the relevant income shall apply withholding tax in accordance with its national law (but still without prejudice to tax treaty provisions if applicable).
Tax consequences arising in the Member State of the shell entity:
The Member State of residence of the shell entity either shall deny the granting of a tax residency certificate to the shell company or shall grant a certificate which prescribes that the shell entity is not entitled to the benefits of tax treaties.
Exchange of information between Member States
All Member States will have access to information on EU shells (which shall be exchanged automatically), at any time and without a need for recourse to request for information. Moreover, a Member State would be able to request the Member State of the entity to conduct an audit on an entity, if it suspects that this entity lacks the minimal substance.
The adoption at EU level of ATAD 3 is to be expected for the first quarter of 2022.