Walking on egg shells – exploring the impact of ATAD3

Draft Shell Entities Directive / ATAD 3

On 22 December 2021, the European Commission published a proposal for a directive laying down rules to identify undertakings resident in the EU without substance (Shell Entities) and to subject them to certain tax rules and restrictions.

Implications

This draft Directive could have a significant impact on your current operations and structures. You need to act now as the review period may have already started if the directive is adopted by the proposed 1 January 2024 time frame.

Under the draft Directive:

• Undertakings which identify as Shell Entities will not be entitled to the benefit of any double tax treaties, the Parent-Subsidiary Directive or the Interest & Royalty Directive.
  The draft Directive proposes to deny access also to double tax treaties which have been negotiated individually by Member States with countries outside the EU. The Multi-lateral Instrument (MLI), agreed by the members of the OECD, now ensures all tax treaties have a principal purpose test which addresses treaty shopping and abuse. This raises the question as to what type of abuse the Commission intends to target with this draft Directive.
• All Member States will have access to information on Shell Entities at any time and without a need for recourse to request for information. Individual Members States will also be able to request that the particular Member State of the Shell Entity perform tax audits where they have grounds to suspect that the undertaking might be lacking minimal substance for the purposes of the draft Directive.
• Penalties for not reporting include an administrative pecuniary sanction of at least 5% of the entity’s turnover in the relevant tax year.

Who does the draft Directive affect?

The draft Directive does not apply to quoted companies, regulated financial undertakings (as defined in the draft Directive), same Member State groups or where the undertaking has at least five full-time employees.

Subject to these exceptions though, the draft Directive applies to all undertakings regardless of their legal form (including partnerships) that are considered tax resident in a Member State, and consequently are eligible to receive a tax residence certificate. It uses a substance test to identify undertakings that are engaged in an economic activity, but which do not meet the draft Directive’s requirement for minimal substance and are misused for the purpose of obtaining tax advantages. At risk undertakings are those:

• where more than 75% of their income derived during the past two years is mainly passive income 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.);
• which are 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 decision-making processes on significant functions of the undertaking have been outsourced during the preceding two years.

Notwithstanding the exceptions, this means that the draft Directive could catch a significant number of entities that are currently sitting in a group structure, even a group structure where some members of that group may qualify for an exception.

Further, undertakings that exist now, and operate within market practice, could already be within the scope of the draft Directive when/if it is implemented. As undertakings could be judged, in two years’ time, on their activities today it is extremely important that you are aware of the substance criteria and take appropriate action now.

Any at risk undertakings (meeting the three criteria above) would have to report and evidence in their tax returns the following three indicators of minimum substance:

1. the existence of own premises or premises for their exclusive use;

2. having at least one owned and active bank account in a Member State;

3. having either

a) at least one qualified, authorised and independent director that is resident for tax purposes close to the undertaking and dedicated to its activity, or

b) the majority of the employees, carrying out core income generating activity, resident for tax purposes close to the undertaking.

Corporate Service Providers could be significantly affected by the third point above if the draft Directive is implemented in its current form. To count towards showing minimum substance independent directors must hold only one directorship and must be resident close to the undertaking. This could pose a problem for many EU Member States. It also seems contrary to the fundamental freedoms of the European Union – free movement of people and capital and freedom of establishment.

Presumption of guilt

If an undertaking can demonstrate that its use does not create a tax benefit it could request an exemption from the reporting obligations set out above. However, at the outset, there is a presumption of a lack of minimal substance and tax abuse.

An undertaking that is at risk and whose reporting also leads to the finding that it lacks even one of the relevant elements on substance, will be presumed to be a Shell Entity that is being misused for tax purposes.

The relevant undertaking has a right, under the draft Directive, to rebut the presumption if it can prove that it has substance or in any case it is not misused for tax purposes. Challenges to the presumption can include:

• its commercial rationale for establishment;
• information about the employee profile; and
• concrete evidence that decision-making concerning the activity generating the relevant income is taking place in the Member State of the undertaking.

A Member State shall treat an undertaking as having rebutted the presumption if the evidence provided, as set out above, proves that the undertaking has performed and continuously had control over, and bore the risk of, the business activities that generated the relevant income or, in the absence of income, the undertaking’s assets.

Is this draft Directive actually needed?

The draft Directive purports that tax compliance costs for businesses are expected to increase in a limited manner only on the basis that the number of companies within the scope of the initiative is expect to be less than 0.3% of all EU companies. It would be interesting to see how the Commission evidenced this assessment and more globally to identify the cumulative impact of all additional compliance costs that result from the recent increased reporting and filing measures.

With all of the anti-avoidance legislation which has recently been, and is in line to be, implemented, we would question whether this draft Directive is required. The draft Directive does not specify exactly what tax avoidance and evasion practices are targeted which are not already covered by existing EU and local tax legislation.

Has the European Commission over-stepped its remit?

The legal basis for the draft Directive is stated to be Article 115 of the Treaty on the Functioning of the European Union (TFEU) which states that “…the Council shall…issue directives for the approximation of such laws, regulations or administrative provisions of the Member States as directly affect the establishment or functioning of the internal market.”

We would question whether this draft Directive could be said to directly affect the establishment or functioning of the internal market or is required to repair any perceived malfunctioning of the internal market. It would be helpful to know the Commission’s rationale for using Article 115 TFEU as its legal basis for introducing the draft Directive.

What about the rest of the world?

Debate among Member States concerning this type of policy initiative from the Commission and a determination on what the policy initiatives actually achieve could be of interest as the volume of anti-avoidance measures and increased reporting compliance obligations could in the end make the EU less attractive for locating business when compared with the rest of world.

Accelerated timeline

The draft Directive aims to take effect from 1 January 2024 with a two year look back period. Therefore undertakings operating legitimately right now could already be inadvertently coming within the scope of the draft Directive when/if it is implemented in 2024.

January 2024 could be too soon for implementation of the draft Directive, especially given that another draft directive has been proposed for implementation on 1 January 2023 on the global minimum effective tax rate (the so-called undertaxed payment rule included therein is proposed to enter into effect on 1 January 2024 as well).

One should be careful not to “act in haste and repent at leisure!”.