Draft Un-shell directive is published

On 22 December 2021, the European Commission published a proposal for a directive laying down rules to prevent the misuse of shell entities for tax purposes, also known as Anti-Tax Avoidance Directive - ATAD 3, (Draft Directive).

The Draft Directive is a new tool of the EU anti-tax avoidance package, having the following main features:

• It provides for a substance test to identify undertakings lacking sufficient substance, the so-called shell undertakings.
• It provides for the tax consequences applicable to these shell undertakings: mainly the denial of treaty benefits and/or EU Directives' provisions (eg Parent-Subsidiary Directive, Interest Royalty Directive).
• It contemplates a new layer of EU automatic exchange of information and the possibility for EU Member States to request tax audits on that matter to other Member States.

In a nutshell, some players may have to revisit their current set-up to increase the substance of their undertakings. The fund industry may also be impacted. Although the Draft Directive foresees certain welcome exclusions, for AIFs and UCITS for example, the holding companies within a fund structure are not excluded from the scope of ATAD 3.

Undertakings managed by external local service providers may also face more issues to comply with substance requirements as a consequence of ATAD 3.

On a positive note, undertakings will only be caught by the rules if their daily management and decision-making process on significant functions is outsourced. The precise meaning of these conditions will be key to assess the impact of ATAD 3 in Luxembourg.

The Draft Directive, once adopted, will have to be transposed into national law by 30 June 2023 and ATAD 3 would apply as from 1 January 2024.

In that respect, we recommend that players start now to assess the substance level of their EU tax resident entities in light of the provisions of the Draft Directive in order to be able to monitor any improvements that could be relevant to implement in your structures (eg board composition and operating guidelines, employment strategy, etc.).

Qualification as shell undertakings

Step 1 - Identification of at risk undertakings

Undertakings regardless of their legal form (including partnerships) which are tax resident in a Member State and that meet the following cumulative conditions (gateways) are considered as at-risk undertakings:

• more than 75% of their income derived during the two past tax years is of mainly passive source, eg interest income (including from crypto assets), royalties or assimilated IP income, dividends and gains derived from the disposal of shares, rental income, leasing income, etc. Under conditions, this criteria should be as well met where the income has not actually accrued from the holding of specific assets;
• the undertaking is engaged in cross-border activity, eg more than 60% of their income is realised via cross-border transactions; and
• the day-to-day operations and the decision-making process on significant functions of the undertaking have been outsourced during the preceding two tax years.

The interpretation of the notion of outsourcing would be of particular importance to understand exactly the undertakings which will be caught by these new rules. 

The Draft Directive clearly provides for an exclusion for certain undertakings, such as: (i) regulated financial undertakings (eg credit institutions, alternative investment funds, UCITS, pension institutions, EU securitization vehicles, etc.); (ii) undertakings operating solely in a domestic context and (iii) undertakings with at least five full-time employees or members of staff exclusively carrying out activities generating the relevant income.

Step 2 - Reporting obligation of minimum substance indicators

Undertakings fulfilling all the above gateways would have to report and evidence in their tax returns the following three indicators of minimum substance:

• the existence of own premises or premises for their exclusive use;
• having at least one own and active bank account in a Member State;
• having at least one qualified, authorised and independent director that is resident for tax purposes close to the undertaking and dedicated to its activity or that the majority of the employees carrying out core income generating activity are resident for tax purposes close to the undertaking.

However, an undertaking that demonstrates that its use does not create a tax benefit could request an exemption from these reporting obligations.

Step 3 - Presumption of absence of minimum substance

If an at risk undertaking fails to evidence that at least one of the above substance indicators is met, the undertaking is presumed not to have sufficient minimum substance and therefore qualifies as a shell undertaking for the purposes of ATAD 3.

Possible challenge of the shell undertaking qualification

An undertaking which is presumed to be 'shell' could still challenge the presumption:

• if it can ascertain the commercial rationale behind its establishment;
• if it provides information about the employee profile; and
• if it concretely evidences that decision-making concerning the activity generating the relevant income is taking place in the Member State of the undertaking.

Put another way, the presumption of absence of minimum substance could be rebutted if the undertaking demonstrates as a whole that it continuously had control over and borne the risks of the activities that generated the passive income (or the control over the undertaking's assets in the absence of income).

We note that the tax authorities would in any case preserve a discretionary power to have a different view after analysing the justifications provided by the undertaking to rebut this presumption.

Tax consequences

Undertakings which qualify as shell undertakings for ATAD 3 purposes would not be entitled to the benefit of the double tax treaties and EU directives' provisions.

In order to achieve this outcome, the Draft Directive states that:

• the Member State of the shell undertaking would either (i) not issue a certificate of residence or (ii) issue a certificate of residence with a reservation or warning statement; and
• there would be a re-allocation of taxing rights within the structure as if the shell undertaking was not interposed between other EU/third party undertakings.  

Exchange of information

All data gathered as a result of the reporting obligations of the undertakings under scrutiny will be subject to the automatic exchange of information between the Member States. In addition, the Draft Directive allows Member States at any time to request another Member State to carry out a tax audit.

Penalties

The Member States should lay down the rules regarding penalties for non-compliance. Nevertheless, an administrative pecuniary sanction of at least 5% of the undertaking’s turnover should be introduced by the Member States.

Source: Proposal for Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU