Tax updates have been an EU focus for a while now; with ATAD (Anti-tax avoidance directive), DAC (directive on administrative cooperation) and, most recently, the Communication on Business Taxation for the 21st Century. However, there are still issues to be addressed – one of which being ‘shell’ entities, identified as “legal entities with no minimal substance or economic activity”.
While the European Commission (EC) does recognise that these shell entities exist for valid reasons, it has identified a need for action to address tax evasion by shell entities “misusing undertakings that do not perform any actual economic activity”. The EC’s research and the consultation process showed that such entities often involve tax systems of more than one EU Member State, and recognised the need for an overall EU initiative to counter such practices as not all Member States have their own targeted rules to hinder abuse by shell entities.
The EC also identified that “shell entities at risk to be misused are more likely to be identified amongst those engaged with the activity of holding and managing equity or intellectual property or with financing and leasing activity”, with consultation respondents indicating that trusts are at “slightly higher risk” of misuse. Other recognisable features of such entities are listed as not having a bank account and having directors that do not reside in the entity’s jurisdiction.
The EC has now published proposed rules to amend Directive 2011/16/EU to prevent the misuse of shell entities for tax purposes.
The proposal outlines a “substance test” to “help Member States to identify undertakings that are engaged in an economic activity, but which do not have minimal substance and are misused for the purpose of obtaining tax advantages.”
Criteria to assess whether proof of substance is required
Companies meeting the following three cumulative, indicative conditions criteria will be required to report to relevant competent authorities as to their resources in the Member State where they are resident for tax purposes. These reports will be reviewed on a case-by-case basis to assess their substance:
- Companies with more than 75% of revenue in the preceding two tax years is relevant income.
- Companies engaged in cross-border activity where at least 60% of the relevant income is earned or paid out via cross-border transactions, or more than 60% of the book value of the undertaking’s assets (immovable property or movable property held for private purposes and with a book value of more than €1m, other than cash, shares or securities) was located outside the Member State of the undertaking in the previous two tax years.
- Companies that outsourced the administration of day-to-day operations and the decision-making on significant functions in the previous two years.
It is noted, though, that companies “subject to an adequate level of transparency” are exempt from this requirement. This includes:
- companies which have a transferable security admitted to trading or listed on a regulated market or multilateral trading facility;
- regulated financial companies (including: credit institutions, investment firms, alternative investment funds (managed by AIFMs), insurance or reinsurance undertakings, pension institutions, and others, as listed in Article 6.2);
- companies that have the main activity of holding shares in operational businesses in the same Member State while their beneficial owners are also resident for tax purposes in the same Member State;
- companies with holding activities that are resident for tax purposes in the same Member State as the undertaking’s shareholder or the ultimate parent entity;
- companies with at least five own full-time equivalent employees or members of staff exclusively carrying out the activities generating the relevant income.
Minimum substance indicators
The proposal requires that companies meeting the above criteria declare in their annual tax return, for each tax year, whether they meet the following indicators of minimum substance:
- The company has its own premises in the Member State, or premises for its exclusive use
- The company owns at least one active bank account in the EU
- The company has one of the following indicators:
- are resident for tax purposes in the Member State of the company, or at no greater distance from that Member State insofar as such distance is compatible with the proper performance of their duties;
- are qualified and authorised to take decisions in relation to the activities that generate relevant income for the undertaking or in relation to the undertaking’s assets;
- actively and independently use this authorisation on a regular basis;
- are not employees of an enterprise that is not an associated enterprise and do not perform the function of director or equivalent of other enterprises that are not associated enterprises;
- The majority of the full-time employees of the company are resident or live at no greater distance from that Member States insofar as such distance is compatible with the proper performance of their duties, and are qualified to carry out the activities that generate relevant income for the company.
The proposal includes details on how disputes are to be handled, including rebuttals, and provides conditions for exemptions from reporting for a one-year period if certain conditions are met.
The proposal also lists the tax-related consequences for entities that fail this “substance test”, including revocation of the certificate of tax residence, disregard of any double taxation agreements relevant on the income, application of withholding taxes, and possible fines of at least 5% of turnover. It is also permitted for the relevant competent authority to conduct a tax audit.
While the proposal is yet to be adopted as a Directive, a timeline is listed in the report which indicates that any new Directive should be transposed into EU Member States’ national law by 30 June 2023, and come into effect as of 1 January 2024.
We will keep you updated on the status of the proposal, but feel free to contact your Auxadi Team if you have any queries.