The European Commission on December 22, 2021, presented a key initiative to fight against the misuse of shell entities for improper tax purposes – Proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU, a.k.a. “ATAD 3” or the “Unshell Directive”.
The aim of ATAD 3 is to lay down a common framework, in order to strengthen Member States’ resilience against practices of tax avoidance and evasion linked to the use of undertakings that do not perform an economic activity even if presumably they are engaged with economic activity and therefore do not have any or have only minimal substance for tax purposes. As those undertakings may be established in one Member State but may be used with the effect of eroding the tax base of another Member State, the ATAD 3 prescribes a common set of rules for determining what should be considered as the insufficient substance for tax purposes in the internal market as well as for delineating specific tax consequences linked to such insufficient substance. Where an undertaking has been found to have sufficient substance under this Directive, the ATAD 3 shall not prevent the Member States from continuing to operate anti-tax avoidance and evasion rules.
The ATAD 3 lays down a test that will help the Member States to identify undertakings that are engaged in economic activity, but which do not have minimal substance and are misused for the purpose of obtaining tax advantages. This test can be commonly referred to as a “substance test”. In addition, the Directive attaches tax consequences to the undertakings that do not have minimal substance (shells). It also envisages automatic exchange of information as well as potential requests by one Member State to another for tax audits for a broader group of undertakings that are treated as being at risk (as they fulfill certain conditions) but are not necessarily deficient in substance for the purposes of this Directive.
The ATAD 3 will apply to all undertakings that are considered to be tax residents in any EU member state. Any entity engaged in economic activity, in any legal form, is in the scope of the Directive and there is no minimum threshold for applying. This Proposal, once adopted as a Directive, should be transposed into Member States’ national law by 30 June 2023 and come into effect as of 1 January 2024.
The Directive is structured so as to essentially reflect the logical sequence of each step of the aforementioned substance test. There are 7 steps: undertakings that should report (due to being found to be ‘at risk’); reporting; possibility of gaining exemption from reporting for lack of tax motives; presumption of lack of minimal substance; the possibility of rebuttal; tax consequences; exchange of information automatically via making data available on a Central Directory as well as potential request for the performance of a tax audit.
Undertakings that should report
The first step divides the various types of undertakings in those at risk for lacking substance and be misused for tax purposes vs. those at low risk. Risk cases are those that present simultaneously a number of features usually identified in undertakings that lack substance. These criteria are commonly referred to as ‘gateway’. Low-risk cases are those that present none or only some of these criteria, i.e. those that do not pass the gateways.
The relevant criteria that set up the gateways aim to distinguish at-risk those undertakings that seemingly engage with cross-border activities which are geographically mobile and in addition rely on other undertakings for their own administration, in particular professional third-party service providers or equivalents.
Low-risk cases that do not cross the gateway are irrelevant for the purposes of the Directive. Resources can therefore focus on the riskiest cases, i.e. those that present all relevant features and hence cross the gateway.
For tax certainty, undertakings performing certain activities are carved out explicitly and are therefore considered from the outset as being low-risk and irrelevant for the purposes of the Directive. These include undertakings that would either not cross the gateway or, if they did, they would be found irrelevant for the purposes of the Directive at a later step of the test. Undertakings that fall in the scope of any of the carve-outs do not need to consider whether or not they cross the gateway.
Reporting
Only the undertakings considered at risk at the first step proceed to the second step, which is the core of the substance test itself. Due to the fact that they are at risk, these undertakings are asked to report on their substance in their tax return.
Reporting on substance means providing specific information, normally already arising from the undertaking’s tax return, in a way that facilitates the assessment of the activity performed by the undertaking. The focus is on specific circumstances that are normally present in an undertaking that performs a substantial economic activity.
Three elements are considered important: first, premises available for the exclusive use of the undertaking; second, at least one own and active bank account in the Union; and third at least one director resident close to the undertaking and dedicated to its activities or, alternatively, a sufficient number of the undertaking’s employees that are engaged with its core income-generating activities being resident close to the undertaking. A director’s dedication to the activities of the undertaking may be demonstrated in his qualifications, which should be such as to allow the director to have an active role in the decision-making processes, the formal powers that he/she is vested and the director’s actual participation in the day-to-day management of the undertaking. Where no director with the necessary qualifications is resident close to the undertaking, alternatively it would be expected that the undertaking has adequate nexus to the Member State of claimed tax residence if most of its employees that perform day-to-day functions are resident for tax purposes close to that Member State. Decision-making should also take place within the Member State of the undertaking. These specific elements have been selected drawing on the international standard on substantial economic activity for tax purposes.
It must be kept in mind that these elements are set with regard to undertakings with cross-border activities that are geographically mobile and which do not have their own resources for their own administration.
Furthermore, the reporting must be accompanied by satisfactory documentary evidence, which should be attached to the tax return as well, if not already included. The evidence required is aimed at allowing the tax administrations to verify directly the truth of the reported information as well as to form a general overview of the situation of the undertaking so as to consider whether to initiate a tax audit.
Presumption of lack of minimal substance and tax abuse
The third step of the test prescribes the appropriate assessment of the information that the undertaking reported in the second step in terms of substance. It sets out how the outcome of the reporting, i.e. the declaration of the undertaking that it has or does not have the relevant elements, should be qualified, at least at first sight.
An undertaking that is a risk case, since it has crossed the gateway, and whose reporting also leads to the finding that it lacks at least one of the relevant elements on substance, should be presumed to be a ‘shell’ for the purposes of the Directive, i.e. lacking substance and being misused for tax purposes.
An undertaking that is a risk case but whose reporting reveals that it has all relevant elements of substance should be presumed not to be a ‘shell’ for the purposes of the Directive. However, this presumption does not exclude that the tax administrations still find that such undertaking:
- is a shell for the purposes of the 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 this 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.
Rebuttal
The fourth step involves the right of the undertaking which is presumed to be a shell and misused for tax purposes, for the purposes of the Directive, to prove otherwise, i.e. to prove that it has substance or in any case, it is not misused for tax purposes. This opportunity is very important because the substance test is based on indicators and as such, may fail to capture the specific facts and circumstances of each individual case. Taxpayers will therefore have an effective right to make the claim that they are not a shell in the sense of the Directive.
To claim a rebuttal of a presumption of shell the taxpayers should produce concrete evidence of the activities they perform and how. The evidence produced is expected to include information on the commercial (i.e. non-tax) reasons for setting up and maintaining the undertaking which does not need own premises and/or bank account and/or dedicated management or employees. It is also expected to include information on the resources that such undertaking uses to actually perform its activity. It is also expected to include information allowing to verify the nexus between the undertaking and the Member State where it claims to be resident for tax purposes, i.e. to verify that the key decisions on the value-generating activities of the undertaking are taken there.
While the above information is essential and required to be produced by the rebutting undertaking, the undertaking is free to produce additional information to make its case. This information should then be assessed by the tax administration of the undertaking’s State of tax residence. Where the tax administration is satisfied that an undertaking rebuts the presumption that it is a shell for the purposes of the Directive, it should be able to certify the outcome of the rebuttal process for the relevant tax year. As the rebuttal process is likely to create a burden for both the undertaking and the tax administration while leading to the conclusion that there is a minimum substance for tax purposes, it will be possible to extend the validity of the rebuttal for another 5 years (i.e. for a total maximum of 6 years), after the relevant tax year, provided that the legal and factual circumstances evidenced by the undertaking do not change. After this period, the undertaking will need to renew the process of rebuttal if it wishes to do so.
Exemption for lack of tax motives
An undertaking that might cross the gateway and/or does not fulfill the minimum substance could be used for genuine business activities without creating a tax benefit for itself, the group of companies of which it is part, or for the ultimate beneficial owner. Such an undertaking should have an opportunity to evidence this, at any time, and to request an exemption from the obligations of this Directive.
To claim such an exemption, the undertaking is expected to produce elements allowing to compare the tax liability of the structure or the group to which it is part with and without its interposition. This is similar to the exercise recommended to be undertaken in order to assess any type of aggressive tax planning schemes (Commission Recommendation of 6 December 2012 on aggressive tax planning[1].
As is the case with the rebuttal of the presumption, the tax administration of the place of claimed tax residence of the undertaking may be considered best placed to assess the relevant evidence produced by the undertaking. Where the tax administration is satisfied that the interposition of a specific undertaking within the group does not impact on the tax liability of the group, it should be able to certify that the undertaking is not at risk of being found a ‘shell’ under this Directive for a tax year. As the process for obtaining an exemption could create a burden for both the undertaking and the tax administration while leading to the conclusion that there is no tax avoidance or evasion purpose, it will be possible to extend the validity of the exemption for another 5 years (i.e. for a total maximum of 6 years), provided that the legal and factual circumstances evidenced by the undertaking do not change. After this period, the undertaking will need to repeat the process of requesting an exemption if it wishes to continue being exempt and can substantiate that it remains entitled to.
Consequences
Once an undertaking is presumed to be a shell for the purposes of the Directive and does not rebut such presumption, tax consequences should kick in. These consequences should be proportionate and aim at neutralizing its tax impact, i.e. disallowing any tax advantages which have been obtained, or could be obtained, through the undertaking in accordance with agreements or conventions in force in the Member State of the undertaking or relevant EU directives, in particular, Council Directives 2011/96/EU on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States and 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. These advantages would be in effect disallowed if the relevant agreements, conventions, and EU directives were disregarded with regard to the undertaking that was found not to have minimum substance and did not prove the contrary.
Given that to obtain these advantages, an undertaking normally needs to provide a certificate of residence for tax purposes, in order to accommodate for an efficient process, the Member State of tax residence of the shell will either not issue a tax residence certificate at all or will issue a certificate with a warning statement, i.e. including an explicit statement to prevent its use for the purposes of obtaining the above advantages. Not issuing a tax residence certificate or issuing a special certificate, including the warning described above, does not set aside the national rules of the Member State where the shell is tax resident with regard to any tax obligations linked to the shell. It will only serve as an administrative practice to inform the source country that it should not grant the benefits of its tax treaty with the Member State of the shell (or of applicable EU directives) to payments towards the shell.
If tax advantages accorded to the undertaking are disallowed, it should be determined how income flows to and from the undertaking, as well as any assets owned by the undertaking, should actually be taxed. In particular, it should be determined which jurisdiction should have a right to tax such income flows and/ or assets. Such determination should not affect any tax that may apply at the level of the shell itself; the Member State of the shell would thus remain free to continue to consider the shell as a resident for tax purposes in its territory and apply tax on the relevant income flows and/or assets as per its national law.
The allocation of taxing rights should take into account all jurisdictions that may be affected by transactions involving the shell. Such jurisdictions, except for the Member State of the shell, are:
(i) In the case of income flows: on the one hand, the source jurisdiction or jurisdiction where the payer of the income is located and on the other, the jurisdiction of the final destination of the flow, i.e. the jurisdiction of the shareholder of the undertaking;
(ii) In case of real estate assets: on the one hand, the source jurisdiction or jurisdiction where the assets are situated and on the other, the jurisdiction where the owner resides, i.e. the jurisdiction of the shareholder of the undertaking;
(iii) In case of valuable movable assets, such as art collections, yachts, etc.: the jurisdiction of the owner, i.e. of the shareholder of the undertaking.
The allocation of taxing rights necessarily affects the only Member States, which are bound by this Directive, i.e. it does not and cannot affect third countries. However, situations involving third countries are indeed likely to arise, e.g. where income from a third country flows to the shell or where the shareholder(s) of the shell are in a third country or where the shell owns assets situated in a third country. In these cases, agreements for the avoidance of double taxation between a Member State and a third country should be duly respected as regards allocation of taxing rights. In absence of such agreements, the Member State involved will apply its national law.
In detail, four scenarios can be envisaged:
(1) Third-country source jurisdiction of the payer – EU shell jurisdiction – EU shareholder(s) jurisdiction
In this case, the source jurisdiction is not bound by the Directive, while the jurisdictions of the shell and of the shareholder fall in scope.
- Third country source / payer: may apply domestic tax on the outbound payment or may decide to apply the treaty in effect with EU shareholder jurisdiction
- EU shell: it will continue to be resident for tax purposes in the respective Member State and will have to fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment
- EU shareholder(s): shall include the payment received by the shell undertaking in its taxable income, as per the national law and may be able to claim relief for any tax paid at source, in accordance with the applicable treaty with third country source jurisdiction. It will also take into account and deduct any tax paid by the shell.
(2) EU source jurisdiction of the payer– EU shell jurisdiction – EU shareholder(s) jurisdiction
In this case, all jurisdictions fall in the scope of the Directive and are therefore bound by it.
- EU source / payer: it will not have a right to tax the payment but may apply domestic tax on the outbound payment to the extent it cannot identify whether the undertaking’s shareholder(s) are in the EU
- EU shell: it will continue to be resident for tax purposes in the respective Member State and will have to fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment
- EU shareholder(s): will include the payment received by the shell undertaking in its taxable income, as per the national law and may be able to claim relief for any tax paid at source, including by virtue of EU directives. It will also take into account and deduct any tax paid by the shell.
(3) EU source jurisdiction of the payer – EU shell jurisdiction – third country shareholder(s) jurisdiction
In this case, only the source and the shell jurisdiction are bound by the Directive while the shareholder jurisdiction is not.
- EU source / payer: will tax the outbound payment according to treaty in effect with the third country jurisdiction of the shareholder(s) or in the absence of such a treaty in accordance with its national law.
- EU shell: will continue to be resident for tax purposes in a Member State and will have to fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment.
- Third country shareholder(s): while the third country jurisdiction of the shareholder(s) is not compelled to apply any consequences, it may be asked to apply a tax treaty in force with the source Member State in order to provide relief.
(4) Third-country source jurisdiction of the payer – EU shell jurisdiction – third country shareholder(s) jurisdiction
- Third country source / payer: may apply domestic tax on the outbound payment or may decide to apply tax according to the tax treaty in effect with the third country jurisdiction of the shareholder(s) if it wishes to look through the EU shell entity as well.
- EU shell: will continue to be resident for tax purposes in a Member State and fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment
- Third country shareholder(s): while the third country shareholder jurisdiction is not compelled to apply any consequences, it may consider applying a treaty in force with the source jurisdiction in order to provide relief.
Scenarios where shell undertakings are resident outside the EU fall outside the scope of the Directive.
Exchange of information
All Member States will have access to information on EU shells, at any time and without a need for recourse to request for information. To this effect, information will be exchanged among the Member States from the first step, when an undertaking is classified as being at risk for the purposes of this Directive. The exchange will also apply where the tax administration of a Member State makes an assessment based on facts and circumstances of individual cases and decides to certify that a certain undertaking has rebutted the presumption of being a shell or should be exempt from the obligations under the Directive. This will ensure that all Member States are in a position to become aware, in a timely manner, of the discretion exercised and the reasons behind each assessment. Member States will also be able to request the Member State of the undertaking to perform tax audits where they have grounds to suspect that the undertaking might be lacking minimal substance for the purposes of the Directive.
To achieve that the information is available to all Member States that may have an interest in it in a timely manner, the information will be exchanged automatically through a central directory by deploying the existing mechanism of administrative cooperation in tax matters. Member States will exchange the information in all above scenarios without delay and in any case within 30 days from the time the administration has such information. This means within 30 days from receiving tax returns or within 30 days from when the administration issues a decision to certify that an undertaking rebutted a presumption or should be exempt. An automatic exchange will also take place within 30 days from the conclusion of an audit to an undertaking at risk for the purposes of the Directive, if the outcome of such audit has an impact on the information already exchanged or that should have been exchanged for this undertaking. The information to be exchanged is prescribed in Article 13 of this Directive. The principle is that such information should allow all Member States to receive the information reported by undertakings at risk for the purposes of this Directive. In addition, where a Member State’s administration assesses a rebuttal of presumption or an exemption from the obligations of the Directive, the information exchanged should allow the other Member States to understand the reasons for this assessment. The other Member States should always be able to request from another Member State a tax audit on any undertaking that passes the gateway of this Directive if they have doubts on whether or not it has the minimal substance required. The requested Member State should perform the tax audit within a reasonable timeframe and share the outcome with the requesting Member State. If there is a finding of a ‘shell’ entity, the exchange of information should be automatic in accordance with Article 13 of this Directive.
Penalties
The proposed legislation leaves it to the Member States to lay down penalties applicable against the violation of the reporting obligations provided by this Directive as transposed into the national legal order. The penalties shall be effective, proportionate, and dissuasive. A minimum level of coordination should be achieved amongst the Member States through the set of a minimum monetary penalty as per existing provisions in the financial sector. Penalties should include an administrative pecuniary sanction of at least 5% of the undertaking’s turnover. Such a minimum amount should take into account the circumstances of the specific reporting entity.
The ATAD 3 is one initiative in the Commission’s toolbox of measures aimed at fighting abusive tax practices. In December 2021, the Commission tabled a very swift transposition of the international agreement on minimum taxation of multinational enterprises. In 2022 the Commission will put forward another transparency proposal, requiring certain large multinationals to publish their effective tax rates, and the 8th Directive on Administrative Cooperation, equipping tax administrations with the information needed to cover crypto assets. In addition, while this initiative addresses the situation inside the EU, the Commission will present in 2022 a new initiative to respond to the challenges linked to non-EU shell entities[1].
[1] OJ L 338, 12.12.2012, p. 41.
Find more information on EU official website: https://ec.europa.eu/commission/presscorner/detail/en/ip_21_7027
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