The last year has been intensive for the European Commission (“EU Commission”) on the aggressive tax planning front. In 2021, particular focus was placed on the use of undertakings lacking commercial and economic substance put in place for the purposes of obtaining tax benefits, such undertakings are commonly referred to as shell entities. In its first communication, dated the 18th of May, 2021, the EU Commission announced a tax reform project, aiming at a transformation of the EU tax environment, in consistency with the international tax initiatives of the Organization for Economic Cooperation and Development’s (“OECD”). The prevention of the misuse of shell entities for improper tax purposes was part of this project.
As a next step towards this transformation, on the 22nd of December 2021 the EU Commission published a proposal for the third Anti-Tax Avoidance Directive (“ATAD III Directive”). This new Directive introduces criteria for a rebuttable presumption for considering an undertaking a shell entity, new reporting obligations and even penalties in case of non-compliance. The Directive will ultimately need unanimous approval from all 27 EU Member States and is now just moving into the negotiation phase.
With this newsletter, Grant Thornton Luxembourg would like to draw your attention to the current draft of the new ATAD III Directive, which, if entered into force, should be implemented into the Member States’ national legislations by the 30th of June 2023 and come into effect by the 1st of January 2024. This Directive will ultimately mandate the Member States’ competent authorities to exchange information on all undertakings in scope, regardless of whether these are considered as shell entities or not. It should be noted that undertakings would be considered in-scope of the Directive in accordance with their position two years back. Therefore, the 1st of January 2022 may already be a reference point for some undertakings, which should already consider taking appropriate measures to ensure adequate substance.
ATAD III in Detail
As stated in the explanatory memorandum to the Directive, the proposed rules “are part of the central EU strategy on direct corporate taxation with a view to ensuring that everybody pays their fair share”. The proposed measures fit into the broader patchwork of EU direct tax rules by aiming to curb the use of shell entities for abusive tax purposes.
2. Scope and Applicable Rules
The ATAD III Directive applies to all undertakings that are considered tax resident and are eligible to receive a tax residence certificate in a Member State. Where an entity is in scope of the Directive, it will be subject to a five-part assessment procedure:
- Consideration of whether the entity should report based on its risk level;
- Subsequent reporting on substance requirements;
- The establishment of a presumption of ‘shell’ status;
- The rebuttal of the presumption and, finally;
- Whether the entity should be exempt despite otherwise being considered a shell entity.
2.1. Undertakings that meet the following cumulative criteria are subject to reporting obligations, unless they fall outside of the Directive’s scope:
- More than 75% of an entity's overall revenue in the preceding two tax years is a “relevant income” (i.e. typically, mobile or passive income, such as income from immovable property, interest income, royalties and dividends);
- Over the course of the preceding two tax years, at least 60% of the entity’s relevant income is earned or paid out via cross-border transactions, or more than 60% of the book value of immovable property or movable property with a book value exceeding EUR 1 million is located outside the residence Member State of the entity; and
- The administration of day-to-day operations and the decision-making on significant functions was outsourced in the preceding two tax years.
2.2. Reporting obligation
If an entity crosses all three gateways above, it will be required to report certain information in its tax return in order to determine whether it will be presumed to be a shell entity or not. The reported information should be accompanied by supporting documentary evidence proving that the entity meets the following criteria:
- Has its own premises or premises available for exclusive use;
- Has at least one own and active bank account in the EU;
- Has at least one director that is:
- Resident geographically close to the entity,
- Qualified, i.e. active in the decision-making process, which should take place in the entity’s Member State,
- Authorized, i.e. with formal powers vested in him/her, and
- Actually participating in the day-to-day management of the entity
Or, alternatively, shows that most of its employees performing day-to-day functions in its core income generating activities are resident geographically close to the entity.
These three criteria are also known as ‘substance indicators’.
2.3. Presumption of (lack of) minimum substance for tax purposes
An undertaking that fails to meet one or more of these substance indicators is presumed to be a shell entity for the purposes of the ATAD III Directive.
Conversely, if the reporting demonstrates that the undertaking meets all of the substance indicators, it is presumed not to be a shell entity for the purposes of the Directive.
2.4. Rebuttal of the presumption
An undertaking can rebut the presumption of lack of substance if it provides additional information with respect to the business activities that generated the “relevant income” (or in the absence of income, the undertaking’s assets), which proves that:
- The undertaking has, and continues to exercise, control over the business activities, and;
- The undertaking bears the risks of the business activities.
Exclusions and general exemption
There are a number of specific exclusions from the scope of the ATAD III Directive, including some regulated financial entities explicitly listed in the Directive (e.g. credit institutions, investment firms, AIFMs, UCITS), companies with transferable securities admitted to trading or listed on a regulated market, and companies with at least five own full-time equivalent employees or members of staff exclusively carrying out the activities which generate the “relevant income”.
Moreover, the Directive provides a general exemption where a shell entity exists but does not create a tax benefit. An undertaking found to be “at-risk”, as per the above, can request an exemption from its reporting obligation if it can provide evidence that its existence does not reduce the tax liability of the beneficial owner(s) or of its group. This exemption is granted for 1 year and can be extended up to 5 years.
3. Tax treatment of entities not in compliance with the minimum substance for tax purposes
3.1. Tax consequences
The EU Commission has proposed tax consequences, which, in order to amount to proportional measure to neutralize the inappropriately tax benefit gained, effectively constitute the denial of tax benefits. Specifically, Member States other than the entity’s place of residence should disallow the application of double tax treaties and other tax agreements in place, as well as the application of the Parent-Subsidiary and Interest Royalty Directives, in relation to transactions with the reporting entity. If the entity has shareholder(s) within the EU, the Member State(s) of the shareholder(s) should tax the “relevant income” as though it accrued at the level of the shareholder(s) following the relevant national rules. Accordingly, tax credit would be applied with respect to the income tax already paid at the level of the reporting entity.
In addition, the Member State of the shell entity should take special consideration with regards to the issuance of tax residence certificates requested by the entity. Specifically, the Member State may take one of the following approaches:
- Deny a request for a tax residence certificate made by the entity;
- Provide a certificate which prescribes that the entity is not entitled to double tax treaty benefits and where applicable, benefits of the Parent-Subsidiary and the Interest Royalty Directives.
The reason why this is an effective measure is that providing a valid tax residence certificate is typically necessary to gain access to tax benefits deriving from international tax agreements. Consequently, it has the effect of denying favorable tax treatment gained through the shell entity.
3.2. Information exchange
Given that aggressive tax planning arrangements frequently have a cross-border nature, Member States’ authorities will now automatically exchange information on all entities falling in the scope of the ATAD III Directive. This exchange will be conducted regardless of whether these undertakings are considered shell entities or not. This will result in creating a new EU central database on administrative cooperation in the field of taxation. The database will contain information on all EU entities, which are considered reporting entities. In this context, the Member States’ competent authorities will also be under strictly defined deadlines to provide the outcome of their assessments in a timely manner.
Furthermore, an important aspect of the ATAD III Directive is that a Member State may request another Member State to conduct a tax audit of any entity, which reports for tax purposes in the latter State and which is suspected to lack sufficient substance therein. The auditing Member State would need to communicate the outcome of the audit to the requesting Member State within a reasonable time frame.
While the ATAD III Directive grants discretion to the Member States to lay down rules regarding penalties for non-compliance with the domestic rules implementing the Directive (i.e. failure to report or incorrect reporting), these penalties should amount to at least 5% of the entity’s turnover.
As mentioned before, the ATAD III Directive is just the latest development in a growing body of direct tax legislation in the EU legal order, and while it has yet to receive final approval, it could have important implications for the day-to-day operations of corporate taxpayers. The Directive takes aim at the use of shell entities and could ultimately establish a harmonized standard of minimum substance and add a number of compliance burdens.
In trying to set a workable concept of shell entities, the ATAD III Directive provides a more cohesive standard of substance requirements at the EU level. As discussed, these rules relate in particular to an entity’s directors, decision-making processes and employees. Legislation that targets undertakings that lack sufficient substance for tax purposes has notably been missing at the EU level and the misuse of shell entities remained a way in which the corporate taxpayers engaged in tax avoiding behavior. Navigating substance requirements can also be a complicated process and should be considered on a case-by-case basis. The ATAD III Directive provides a clearer test and some harmonization in this respect, while acknowledging that a prima facie analysis is not sufficient, and that ‘shell’ entities may still have valid commercial reasons for existing.
While the ATAD III Directive appears to provide some added legal certainty, it does also add new compliance burdens. Many common financing structures are likely to be impacted by the new rules. While that is not to say that existing structures will no longer remain valid, they may be likely to at least trigger the reporting requirements, if not establish a presumption of a lack of substance. This will mean that many Luxembourg-based businesses should undertake a check to verify if they will have any ‘at-risk’ entities and should report on their substance. In addition, the Directive introduces a number of additional complexities for non-compliant businesses, such as further barriers to obtaining a tax residence certificate. It should be monitored whether the above measures will remain intact during the negotiation phase of the legislation process at EU level.
How Grant Thornton Luxembourg can assist
- Provide a check of your corporate structure and entities to determine your risk level in consideration of the new rules;
- Undertake a critical and detailed analysis of your entities’ substance and the implications of our findings;
- Keep you informed on the developments at the EU and Luxembourg levels to ensure that you are up-to-date on the legislation that will affect your business.
For further guidance regarding the new Anti-Tax Avoidance Directive (ATAD III), please contact Jean-Nicolas Bourtembourg.