Susan MeierThe EU has significantly ramped up its commitments to effectively combat money laundering and tax evasion across the Union. in a previous article, we looked at initiatives proposed by the EU (such as the Commission's Action Plan for a single EU rulebook on money laundering and terrorist financing, and the creation of a decentralised EU regulatory agency).
In this article, we look at the proposed Directive "laying down rules to prevent the misuse of shell entities for tax purposes" – amending Directive 2011/16/EU. This new legislation is colloquially referred to as the "Shell Company Directive" (or ATAD 3).
In principle, the use of shell companies established in the EU solely for tax purposes is being actively discouraged. The need for a Directive to protect the Community was deemed necessary, particularly "following continued scandals regarding the misuse of shell companies worldwide" – a nod to the Panama Papers era.
Scope and Rationale
The primary objective of this Directive is to combat "tax avoidance and evasion practices which directly affect the functioning of the internal market". Furthermore, under Article 2, the scope applies to all "undertakings that are considered tax resident and are eligible to receive a certificate of tax residence in a Member State".
The planned measures do not go beyond ensuring the minimum protection required for the internal market. In line with the principle of proportionality, the Directive is carefully designed to prescribe a "minimum level of protection" for Member States rather than enforcing full harmonisation.
What are Shell Companies?
The Directive repeatedly notes the difficulty in defining exactly what constitutes a shell company, acknowledging that assessing a lack of substance depends on the specific facts and circumstances of each entity. ACAMS classifies a shell company as "an entity without active business operations or significant assets". Shell companies are legal, but are sometimes misused to, for example, disguise business ownership.
The proposed Directive aims to identify shell companies and prevent their misuse across the Community by targeting "the setting up of undertakings in the EU which are presumably engaged in an economic activity but which, in reality, do not conduct any such activity".
Threats and Vulnerabilities
While "shell companies" are not illegal per se, part of the problem lies in the inherent risks associated with these structures. There is a growing consensus at EU level that the absence of a dedicated bank account (common with shell companies) creates an unacceptable risk. Another relevant issue concerns directors; in many cases, the majority are not resident in the country where the company is based. In practice, the highest potential for misuse has been identified in shell companies that hold and manage equity, intellectual property, or real estate.
Applicability
Given the above, this Directive aims to capture all undertakings (companies) that can be considered tax resident in any EU Member State, regardless of their legal form (e.g. limited liability companies, PLCs, and/or partnerships). This is enshrined in Article 2 of the Directive.
Furthermore, all tax rights and considerations apply only to Member States. The content of this Directive should not be interpreted as applying to "third countries". [This does not alter the fact that situations involving third countries may arise, particularly if a shell company owns assets in a non-EU jurisdiction.] Shell companies resident outside the EU also fall outside the scope.
However, national rules, including those transposing EU law, must still be applied to identify shell companies not covered by this specific Directive.
The Substance Test
Recognising that some companies are used intentionally to bypass tax treaties and obligations, the Directive introduces a "test" designed to help EU countries identify companies that, while engaged in some form of economic activity, lack minimal substance and are consequently being misused to obtain tax advantages. If such companies are classified as "shells", immediate tax consequences follow.
These consequences may vary, but the Member State must (at a minimum) either refuse to issue a tax residence certificate or issue one with a warning (preventing the company from obtaining any benefits).
This document serves as an administrative tool to inform the source country that it should not grant the benefits of its Double Tax Treaty with the shell company's Member State – as provided for in Article 12.
If a tax benefit is denied in any form, the Member State should still determine how income flows through and out of the company, and examine any assets "held" by the company to determine whether they should be taxed.
Conversely, companies that declare they meet all minimum substance elements and "provide the necessary supporting evidence" are presumed to have minimum substance for tax purposes. Companies presumed to lack substance have the right to rebut this presumption (under Article 9).
The "Gateway Criteria"
As mentioned, the Directive aims to capture and identify companies "without minimal substance" that are likely to facilitate tax avoidance and/or evasion. These are classified as companies at risk of lacking substance, as opposed to low-risk entities.
However, structures whose main purpose is not to obtain a tax advantage can use a mechanism to apply for an upfront exemption. The Directive also makes allowances for companies that meet the "Gateway Criteria" but whose involvement has "no genuine beneficial impact on the overall tax position of the corporate structure" or the Ultimate Beneficial Owner(s).
These "Gateway Criteria" are introduced to determine "which undertakings are sufficiently at risk of being classified as shell companies". The test is based on three (3) criteria that indicate which companies pose a risk and warrant reporting.
According to Article 6 of Chapter II, the conditions are:
- More than 75% of the company's revenue in the two preceding tax years does not come from the company's trading activity (i.e., it is passive income);
- The company is engaged in cross-border activity based on one of the following: more than 60% of the book value of its assets (primarily generating income from movable and/or immovable property) was located outside the company's Member State in the preceding two tax years, OR at least 60% of the relevant income is earned or remitted through cross-border transactions;
- In the preceding two tax years, the company outsourced the administration of day-to-day operations and the decision-making on significant functions.
Point (3) is interpreted to apply to companies that literally have insufficient "own resources".
Measures Following Classification
"Low-risk" cases that do not cross the threshold (e.g., meeting none or only some of the criteria) are considered "irrelevant" for the purposes of this Directive.
Conversely, companies classified as reportable (higher risk) under Article 6(1) – as discussed above – must, under Article 7(1), "declare in their annual tax return for each tax year whether they meet the following indicators of minimum substance":
- Whether the company has its own premises in the Member State, or premises for its exclusive use; and
- Whether the company has at least one (1) own and active bank account in the EU.
Additionally, one of several other indicators must be selected, including details regarding the company's directors (e.g., tax residence status) and/or whether the majority of full-time employees are tax resident in the Member State.
Where no director is resident, the Directive recommends that the company demonstrate an adequate "nexus" to the Member State of tax residence – specifically if most of its employees performing day-to-day functions are tax resident in that EU Member State.
All declarations in the annual tax return must be accompanied by sufficient supporting evidence (e.g., business address, revenue details, nature of activities, number of directors, etc.).
These details are known as "substance indicators". If a company fails to meet at least one of these substance indicators, it will be classified as a "shell company".
Exemptions
Under Article 6(2), the following entities are exempt from the reporting obligation: regulated entities, companies with shares listed on a regulated market in the EU, and companies with at least five (5) own full-time employees.
A Member State may grant an exemption for a tax year provided all necessary evidence is gathered and submitted to the competent authority. Furthermore, after the initial tax year, the State may extend the validity of the exemption for a further five (5) years, provided the factual and legal circumstances regarding the company and the UBO(s) remain unchanged during this extended period.
Exchange of Information
A crucial element is the exchange of information and the speed of enquiries between Member States. Countries may request critical information, such as copies of tax audits, to deter abuse. Under the Directive, information must be exchanged whenever a company is classified as "at risk". This sharing of data should occur even if a company exercises its right to rebut the presumption of being a shell or applies for an exemption. (Member States should also be informed of the reasons why such an assessment – exemption/rebuttal – is being conducted).
To ensure all interested Member States have "timely" access to all findings and information, dissemination is to take place via the Common Communication Network ("CCN") established by the EU.
Penalties
Article 14 in Chapter 5, dealing with "Enforcement", requires Member States to lay down penalties for infringements of this Directive. These penalties include, for example, an administrative fine of at least 5% of the company's turnover in the relevant tax year if the company fails to comply with the requirements of Article 6 (i.e., reporting).
Conclusion
The EU proposal stipulates that once adopted, the Directive must be transposed into national law by Member States by 30 June 2023 at the latest, with the Directive entering into force on 1 January 2024.
The expertise of DW&P Dr. Werner & Partners (particularly in corporate law and tax) can help address the concerns and questions of directors and potential clients in this regard. To fully assess the impact of the proposed Directive (especially for companies with cross-border elements), we recommend contacting one of our advisors as soon as possible.
Disclaimer: The above article is based on independent research by Dr. Werner & Partners and does not constitute legal advice. Furthermore, the article contains only excerpts from the proposed Directive and cannot be interpreted or construed as a complete and comprehensive analysis of all relevant rules and provisions. If you would like to meet with one of our representatives for further information, please book an appointment with us.
