Introduction
On 22 December 2021, the European Commission published a legislative proposal for a Directive setting forth rules to increase scrutiny on and prevent the misuse of shell entities for tax purposes (known as ATAD III)[1]. The draft Directive aims to introduce a “substance test”, including a reporting obligation for taxpayers, to assist the Member States in identifying undertakings engaged in economic activity which do not have minimal substance and could be misused to obtain tax advantages (shell entities).
Moreover, under the Commission proposal, the qualification of an entity as a shell entity for tax purposes will entail consequences. It also enhances and completes the efforts of previous EU measures, including anti-tax avoidance directives (ATAD), and it envisages promoting automatic exchange of information both in the context of the Directive on administrative cooperation in the field of taxation (DAC[2]), which it amends, or as a response to a request by one Member State to another for tax audits.
Why has the Commission put forward this proposal, what does it entail and what are the next steps?
Context
On the 18th of May 2021, the Commission released the Communication on Business Taxation for the 21st century setting out its vision to provide a fair and sustainable EU business tax system and support the recovery. Among the corporate tax reforms proposed in the Communication, the Commission announced its plans to table a legislative proposal in 2021, setting out EU rules to “neutralize the misuse of shell entities for tax purposes.”
According to the explanatory memorandum to the draft Directive, despite the recent EU anti-tax avoidance measures, the problem of tax avoidance and evasion persists, including through the misuse of shell entities.
This Directive is not the first EU initiative directed against abusive tax practices. On the one hand, one can find soft law instruments, such as the work of the Code of Conduct Group on Business taxation on “substance of legal entities”. On the other hand, there are several examples of hard law instruments, namely several directives which include (or were amended to include) anti-abuse provisions, but, more importantly ATAD I and ATAD II which intend to create a level playing field for all businesses in the EU[3], coordinate the implementation of some Base Erosion and Profit Shifting (BEPS) recommendations and, subsequently, tackle the issue of hybrid mismatches and provide protection against mismatches outcomes[4].
However, shell entities, commonly known for their lack of “substance” or “economic activity”, continue to pose a risk of being used for improper tax purposes, such as tax evasion and avoidance, as evidenced recently by scandals such as Lux Leaks, Panama Papers and Open Lux investigation, which, understandably, have also been a trigger for the Commission proposal.
The main problem this initiative seeks to overcome is the absence of specific scrutiny, instruments and actions towards situations involving the foregoing lack of “substance” or “economic activity”. This is so because it is easier said than done. “Substance” is a complex concept, difficult to grasp and subject to multiple interpretations. With a high degree of subjectivity, there is hardly a commonly shared criterion that allows defining substance and its content, even more in Law and Tax Law.
In the construction of the concept of substance, given the difficulties in defining it, the Commission opted for a singular approach. Instead of determining the essence behind the concept of substance – hence, consequently, of shell entity -, the Commission focused on determining the facts, signs and elements often repeatable in behaviours and cases of tax avoidance. Based on these, presumptions of tax avoidance can be built, allowing to identify indicators of “business presence” and “economic activity” that enable the conceptualization of “substance” and, thus, the characterization of shell entities. With this approach, the Commission aims to create an interpretative tool for the concept of “substance” and “shell entity”.
The source of inspiration for this proposal and approach can be traced back to the Court of Justice of the European Union (CJEU)’s judgement in the case C-196/04 Cadbury Schweppes,and the concept of “wholly artificial arrangements”, which do not reflect economic reality and are aimed at circumventing the tax normally due on the profits generated as a result of the activities carried out. In the Cadbury Schweppes case, the CJEU indicates that it is necessary to examine the behaviour of a taxpayer who incorporates a company in another Member State, under the right of freedom of establishment, in order to assess whether (the behaviour at stake) it is a mere and legitimate exercise of freedom of establishment or legal abuse.
Moreover, another conclusion of this case should be noted, which could constitute a safeguard on possible challenges of Tax Administration’s decisions based on this Directive: the CJEU considered that a legitimate exercise of the right of freedom of establishment requires a stable and continuing basis in the economic life of a Member State other than the state of origin. Therefore, a company cannot invoke freedom of establishment in another Member-State for the sole purpose of benefiting from more advantageous legislation, unless the establishment in the other Member State is intended to carry out genuine economic activity.
The Draft Directive
The provisions of the proposed Directive shall apply to any undertaking that is considered tax resident and is eligible to receive a tax residency certificate in a Member State, regardless of its legal form and without any materiality threshold. It also captures legal arrangements, such as partnerships, that are deemed residents for tax purposes in a Member State.
The purpose of this Directive is to address tax avoidance, in the area of direct taxation, conducted through the use of low-substance entities. The targets are entities without real economic activity used within a scheme to avoid and evade taxes and with the purpose of allowing their beneficial owners or group to access a tax advantage.
In short, the draft Directive does not contain measures linked to a minimum level of taxation, rather it establishes a minimum level of substance for undertakings.
To reach that goal, the draft Directive proposes what can be seen as a step-by-step process, where each undertaking is assessed to verify whether it is at risk of falling under the scope of the draft Directive. This process entails a self-assessment approach.
Step 1 – Substance test
The proposed Directive establishes a so-called “substance test” with a “gateway” criterion (to be assessed on the basis of the two previous tax years) of three structured cumulative conditions to determine whether an undertaking is sufficiently at risk to be subject to reporting requirements, and, possibly, to be deemed a shell entity along with the implications of such classification.
An entity passes the gateway if:
- The undertaking derives predominantly passive income (broadly, royalties, dividends and income from assets);
- The undertaking is mainly engaged in cross-border activities; and
- The undertaking has no or inadequate resources to perform core management activities which are outsourced to professional third party service providers, or equivalents thereof.
This proposal establishes several carve-outs and exceptions. Undertakings performing certain activities are explicitly carved out. These include, without limitation, companies listed on a regulated market, certain regulated financial undertakings as specifically identified and listed by the Directive (as they are already subject to significant scrutiny), and undertakings with at least five own full-time equivalent employees or members of staff exclusively carrying out the activities generating the relevant income.
On the other hand, undertakings which do not meet a certain level of substance or cross the “gateways”, but carry out genuine business activities without creating tax benefits for its beneficial owner or its group (i.e. it is not misused for tax purposes), will have the possibility to request, upon evidence, an exemption from their reporting obligations. Such entities can request the certification of exemption from the obligations of this proposal at any stage of this process.
Tax authorities of the jurisdiction where the undertaking is resident should, if satisfied with the evidence received, grant the certification exemption for the relevant year. Validity of the exemption can be extended for another 5 years (to a 6-year maximum), provided the legal and factual circumstances remain unchanged.
If no carve-out and exception apply and the gateway criteria are met, an entity is considered to be at risk for purposes of the draft Directive and a reporting obligation arises.
Step 2: Reporting
Undertakings deemed “at risk” under Step 1 have to report in their tax returns information related to their substance. The entity is obliged to confirm whether the following cumulative criteria are met and to provide supporting documentation:
- The undertaking has either own premises available or premises for its exclusive use;
- The entity has at least one active bank account in the EU; and
- The entity has at least one director and/or the majority of relevant employees being resident close to its undertaking.
This reporting should be duly documented in order to allow tax authorities to perform any audit.
Step 3: Shell entity
An undertaking considered at risk under Step 1 and which does not meet one or more of the criteria under Step 2, will be presumed to be a shell entity (hence not having minimum substance for the tax year). Even when the undertaking declares to meet all the required indicators, it can still be deemed a “shell” for the purposes of the Directive if the accompanying documentary evidence does not support the stated position. As Caesar’s wife, this declaration must be above suspicion.
Step 4: Rebuttal of presumption
The draft Directive also includes a right to contest the conclusion that an undertaking is a “shell”, based on the aforementioned exercise. In fact, this conclusion constitutes a presumption which should not be considered irrebuttable. On the one hand, there is the absence of a universally accepted notion of what constitutes a shell entity or transaction. On the other hand, and more importantly since harmonization might solve the first, avoidance and evasion for EU law requires more than just the mere existence of a shell entity or transaction: it also requires the intention of adopting said arrangement to pursue an unintended use of legislation and tax benefit. Therefore, a case-by-case analysis is necessary.
Under this Step, the burden of proof is on the undertaking that has been presumed as a shell to prove that it has minimum substance. In this regard, the entity will be required to produce concrete evidence on how the entity actually performs its activity and how it proceeds (to prove it had control over and born the risk of the business activity), such as information on (i) non-tax or commercial reasons for its setting up and maintenance, on (ii) its resource and on (iii) any element that allows to verify the nexus between the undertaking and the member State where it claims to be resident.
Tax authorities of the jurisdiction where the undertaking is resident should, when satisfied, certify the outcome of the rebuttal for the relevant year. The validity of the certificate can be extended for another period of 5 years (to a total 6-year maximum) on the condition that legal and factual circumstances remain unchanged.
Step 5: Tax consequences
The draft Directive proposes a number of tax consequences for a shell entity which fails either to rebut the presumption or request an exemption.
Firstly, the Member State of residence of the shell company should either deny the granting of a tax residency certificate to the shell company or only provide a tax residency certificate with a warning statement, to prevent its use or the purposes of obtaining advantages under relevant agreements and EU Directives.
Secondly, other Member States should effectively disregard such a shell entity for the granting of benefits under the relevant tax Directives (for example the Parent-Subsidiary and Interest and Royalties Directives) or tax treaties between Member States.
This means that no benefits should be provided as a consequence of the interposition of such a shell entity.
The draft Directive also sets out rules on how the tax advantages available to those shell entities can be disallowed in various scenarios involving payments to a shell entity where either the payer or the shell entity’s shareholder are resident in another EU Member State or third country.
As third countries would not be bound by the provisions of the Directive, the Explanatory Memorandum accompanying the Directive includes suggestions on the treatment that third countries that are either source or recipient countries in a structure involving a shell may wish to apply.
Step 6: Information exchange
As a final step, the draft Directive proposes that all Member States shall have access to information on any entities considered at risk, even if such entities meet any of the exceptions. This information will be subject to the automatic exchange of information between member States. To this effect, the proposed Directive will amend DAC accordingly, setting out the deadlines and information to be communicate by tax Authorities.
Furthermore, a Member State would be able to request to the Member State where the shell entity is based to conduct tax audits, provided they have sufficient grounds to suspect the shell entity has not met its obligations under this Directive, more than a suspicion about the lack of minimum substance.
Step 7: Penalties
Although the draft Directive allows Member States to establish penalties against the violation of the reporting obligations, a minimum penalty for non-compliance is provided consisting of at least 5% of the entity’s turnover.
Next steps and considerations
The draft Directive is a proposal and has not yet been adopted by the Council. It is now moving to the negotiation phase between Member States with the aim of reaching a final agreement. In the EU, adoption of tax legislation generally requires unanimity between all 27 Member States. Should this happen, the current timeline suggests that the proposed Directive should be implemented into Member States’ national laws by 30 June 2023, and come into effect from 1 January 2024.
It is worth noting that the proposed substance test includes a look-back period of the preceding two tax years, meaning that should the Directive come into effect in 2024, an undertaking’s compliance as of January 2022 may be taken into consideration.
The adoption of the proposed Directive would mark a significant evolution in the area of direct taxation within the EU. It would represent the first harmonization of minimum substance criteria for tax purposes within the Union.
Although the Commission’s initiative is only aimed at fighting certain low-substance shell entities, implementation of the draft Directive could lead to additional compliance obligations and implications for tax authorities in the Member States and many taxpayers.
As always, in this kind of negotiation processes, the draft Directive may be subject to changes during the process.
[1] Available at https://ec.europa.eu/taxation_customs/system/files/2021-12/COM_2021_565_1_EN_ACT_part1_v7.pdf
[2] Council Directive 2011/16/EU of 15 February 2011 on administrative cooperation in the field of taxation.
[3] European Commission, Taxation and Customs Union “Anti-Tax Avoidance Package”, January 2016.
[4] Proposal for a Council Directive amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries, February 2017.
Gonçalo Grade