As we near the final review of the Draft ATAD III (Anti-Tax Avoidance Directive) (or “Unshell Directive”) by Member States – officially known as the Proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU as presented by the European Commission on 22 December 2021 – we are starting to discern the outlines of what it could look like in practice.
The Draft Directive adds to the growing trend towards more control of the substance of certain entities (“enterprises”) across the EU. In a way, this project is a continuation of the Base Erosion Profit Shifting (BEPS) Initiative championed by the OECD and builds on several of its action plans. It effectively draws on the national legislation of some EU member states who had beefed up their substance requirements in the last few years, such as Germany.
One of the main features of the Draft Directive would be to test whether the target entity meets 3 cumulative gateways (making it an entity at risk) as explained in the paragraph below: the entity would then have to justify that it has sufficient (minimum) substance by establishing that it has i. its own premises or premises for its own (exclusive or shared) use, ii. at least one active bank account in the EU, and iii. one or more local directors who make decisions in relation to the relevant income. Should the entity fail to meet the criteria contained within this second step, it would be deemed a shell entity, which would result in the entity being denied a certificate of tax residence. As a consequence, the entity would be denied double tax treaty benefits and lose access to EU directives such as the Parent-Subsidiary Directive and the Interest and Royalty Directive, which allow to reduce significantly or exempt dividends, interest and royalties from withholding tax.
The three gateways that would indicate an entity is at risk are as follows: 1) more than 65% of the entity’s revenue in the last 2 years was passive, 2) cross-border activities representing at least 55% of assets (book value) and/or income, and 3) outsourcing of day-to-day administration and decision-making in relation to significant functions (also in the preceding 2 years). It is to be noticed that passive income not only encompasses dividends and interest, but also income from immovable property and disposal of shares. It should be further noted that intragroup provision of director services would not be regarded as outsourcing. An entity that would meet the 3 gateways would be at risk of being considered a shell company. Some of the initial thresholds were lowered in the last version approved by the EU Parliament. It would consequently have to disclose and justify its substance in its annual tax returns. It can be expected that the exchange of information will guide tax authorities to decide where it might be worth investigating. In addition, the Draft Directive could be a prelude to joint audits. It should also allow tax authorities to issue audit requests to their foreign counterparts in relation to entities that would not meet minimal substance requirements.
The Draft Directive is mostly not expected to impact entities which have not outsourced their decision-making functions, which has arguably already been the best practice in Luxembourg following the BEPS Initiative. The shell entity qualification remains rebuttable and entities would be able to demonstrate the absence of a tax motive in their activities to be granted an exemption (that would be limited in time). The Draft Directive also contains several carve-outs. A “safe harbour” had initially been included in the first draft of the Directive to exclude entities with at least 5 full-time employees solely involved in generating income, but it was subsequently removed. In a way, this initiative is a welcome clarification of what constitutes substance and brings some harmonisation at an EU level that had been characterised by a certain degree of cacophony due to different definitions in various member states. It could soon be followed by a similar initiative in the UK.
There remain doubts around the timing of issue of the Unshell Directive and its implementation into national law, although it is expected to be imminent with effect on 1 January 2024, which would mean the period of 2 years under the contemplated gateways would start from 1 January 2022. The EU Council must still approve it unanimously. As a result, Luxembourg entities are encouraged to consider the impact on their structure. JW Partner routinely provides tax advice to its clients and is well-positioned to help you prepare for these changes, please reach out to us, we would be delighted to assist.