Anti-Tax Avoidance Directive (ATAD 3): Planned mandatory reporting of EU shell entities to tax authorities from 2024

Shortly before the end of 2021, the European Commission (EC) presented a proposal for an Anti-Tax Avoidance Directive (so-called “ATAD 3”) to prevent the misuse of shell (or letterbox) entities. The planned directive envisages extensive reporting obligations for shell entities, which may potentially lead to a loss of tax benefits (e.g. arising from application of the Parent-Subsidiary Directive, or the Interest and Royalties Directive). The Directive enables tax authorities to require (potential) foreign letterbox firms to undergo substance checks by foreign authorities. The proposed regulations would mean that multinational groups would have to quickly review their structures to recognise possible impacts early.

Background

On 22 December 2021, the EC presented a draft of an amendment to the Administrative Cooperation Directive (2011/16/EU), which sets outs measures for the prevention of the misuse of shell entities for tax purposes. The EC recognises that entities without economic substance or with low economic substance may also serve legitimate business purposes. However, as such entities are still associated with the risk of pursuing aggressive tax practices, despite various measures in recent years (ATAD, extension of Administrative Cooperation Directive, etc.), the Commission now proposes the introduction of a multi-stage substance test, which is intended to deter businesses from misusing shell entities and thus contribute to fair and effective taxation as well as ensuring the functioning of the internal market. For further details, please also see our Tax Policy Alert.

Scope

The Directive covers all entities that are tax resident in an EU Member State and eligible to receive a tax residency certificate. The Minimum Substance Test will therefore apply irrespective of the chosen legal form or the amount of revenues of an entity. Nevertheless, to promote legal certainty the Directive exempts certain entities, which are associated with very low risk of being misused, from the Minimum Substance Test. These include:

• • • listed companies
    • regulated financial undertakings
    • undertakings that mainly hold shares in operational businesses, where the operational business and its beneficial owners are tax resident in the same Member State as the intermediary holding company
    • undertakings with at least five full-time employees, exclusively carrying out relevant income-generating activities (see below).

Minimum Substance Test

1. Undertakings required to report

In a first step, the Directive stipulates under which circumstances a “high risk” of misuse of entities exists (so-called gateway test). This is given if the following three criteria are cumulatively fulfilled:

• • • Entities that are engaged in cross-border activities
    • that are geographically mobile and
    • outsource their own administration to third parties.

Cross-border activities exist if more than 60% of the book value of specific assets was located outside of the entity’s state of tax residence in the last two years, or if more than 60% of the entity’s “relevant income” is earned or paid out via cross-border transactions.

Entities are geographically mobile if 75% of their revenue in the preceding two years is “relevant income” (income types including, in particular, interest, crypto assets, royalties, rental/leasing income, insurance income, dividends and capital gains). This criterion is also met if particular types of asset (e.g. shareholdings) make up more than 75% of the total book assets of the entity.

2. Reporting of substance indicators

If a company is associated with a high risk according to the test described above, it is required to make certain disclosures about its substance as part of the annual tax return. It has to confirm:

• • • whether it has its own premises or premises available for exclusive use by the company,
    • whether it has its own and active bank account within the EU, and
    • whether at least one qualified director of the company is resident close to the company who is professionally dedicated to its activities or, alternatively, whether the majority of the company’s full-time employees (who are engaged in the company’s qualified income-generating activities) are located close to the company.

Documentation must be appended to the annual tax return to provide various pieces of information (e.g. location and type of premises, amount and type of gross earnings, amount and type of business expenses, business activities leading to generation of the relevant income listed above, number of managing directors and their qualifications, tax residence of the directors, information on the bank accounts used, including ability to access them, etc.).

3. Assessment of substance and possible tax abuse

In step 3, the tax authorities must use the confirmations and information submitted to determine whether the company in question has a minimum of substance. In the event that the substance criteria listed above are not all fulfilled, or if their fulfilment cannot be satisfactorily proven by the submission of the relevant documents, a shell entity will be deemed to exist within the meaning of the Directive.

Note: The above classification does not prevent tax authorities from making an alternative assessment under domestic law, or a finding that the company is not the beneficial owner of the income paid to it.

4. Rebuttal of the presumption that a shell entity is misused

If the tax authorities come to the conclusion that the entity is (potentially) a misused shell entity that lacks substance, the taxpayer has the option of providing evidence to the contrary (so-called “rebuttal of the presumption”). In particular, the entity must provide information on the business reasons for setting up and maintaining the entity, information on the resources that it uses to actually perform its activity (premises, employee roles and skills, etc.), as well as verifications that the key decision-making actually takes place in the country of tax residence of the entity.

A positive rebuttal will be valid for a one-year period and can be extended for another five years if the factual and legal circumstances of the entity do not change.

5. Exemption from reporting obligations due to lack of tax benefit

Each entity also has the option of applying for an exemption from the reporting obligation, provided that the existence of the entity or its “intermediary” has a genuine business purpose and does not lead to a reduction of the tax liability of its beneficial owner or of the group of companies to which the entity belongs. This also applies to (shell) entities that otherwise lack substance within the meaning of the Directive.

The exemption will be granted for a one-year period, although a Member State may extend the exemption for another five years if the factual and legal circumstances of the entity do not change.

Consequences

The following tax consequences are associated with the presumption that a shell entity which lacks substance is being used for tax purposes:

• • • The Member State of the entity in question will either not issue a tax residency certificate at all, or will issue the certificate with a warning statement to prevent its use for the purposes of claiming relief from double taxation. However, this does not restrict the right to tax of the country of tax residence.
    • Any obtained or existing tax benefits that are not used will be denied or not granted (this includes in particular tax treaty benefits, or withholding tax exemptions under the Parent-Subsidiary Directive or the Interest and Royalties Directive).
    • In addition, the income of the shell entity will be taxed at the level of its shareholders, with the tax paid by the shell entity being deducted. If the shareholders are not tax resident in an EU Member State, the payer’s country of residence, provided that it is an EU Member State, must withhold tax in accordance with their domestic law.

The information obtained in the context of the above measures will be shared between EU tax authorities via a database (automatic exchange of information).

The Member States are also required to provide for effective, proportionate and dissuasive penalties, which should include an administrative pecuniary sanction in the amount of at least 5% of the turnover of the entity concerned.

Tax audit of foreign entities

In addition to the new “hurdles” for obtaining an (unrestricted) tax residency certificate mentioned above, the proposed Directive also grants national tax administrations the option of requesting foreign tax administrations to carry out tax audits of foreign-resident entities from the perspective of the Directive. The foreign tax administration should initiate the audit within one month of receiving the request and communicate the results without delay after completion (within one month) to the tax administration that made the request.

Timeline / required actions

Once (unanimously) adopted, this proposed Directive should be transposed into domestic law by the Member States before 30 June 2023 and enter into force from 1 January 2024.

Given the broad scope – assuming the proposed Directive remains largely unchanged – significant impacts can be anticipated. In the absence of evidence of a genuine business purpose for the existence of an entity, the entity will cease to enjoy various tax benefits. Against this background, international groups in particular are recommended to carry out a timely and detailed analysis of the planned new regulations in order to be able to assess whether they have entities / business units that may potentially be impacted and, under certain circumstances, to take steps towards optimisation (e.g. expanding substance) in good time. We would be happy to support you and keep you updated on the latest developments.

Author: Sophie Schönhart