On 22 December 2021, The European Commission published a proposal for a new directive laying down rules to prevent the misuse of so called “shell” entities (empty shells without economic substance) for tax purposes. The proposal also contains amendments to the Directive on administrative cooperation in the field of taxation (DAC) allowing for automatic exchange of information about entities at risk. The new rules should be implemented into national law by 30 June 2023 and should come into effect on 1 January 2024.
The main goal of the proposed directive is to prevent the misuse of shell entities – i.e. empty shells without sufficient economic substance that do not perform any actual economic activities – as tools of harmful tax planning. The proposal thus introduces minimum substance requirements that, if not met, would result in the denial of benefits of treaties for the avoidance of double taxation (double tax treaties) and the inability to apply tax exemptions to dividends, interest and royalties under the relevant EU directives (see below).
The current proposal only deals with entities within the EU. However, according to the statement of the European Commission, a follow-up directive dealing with this issue with respect to third countries should also be introduced this year.
After finishing the legislative process at the EU level, the final directive should be implemented into national law of member states by 30 June 2023, and the new rules should apply from 1 January 2024.
The proposed directive imposes on certain entities at risk, so-called reporting undertakings, a new reporting obligation towards the tax authorities in their country of residence regarding minimum substance requirements, if three criteria are met simultaneously:
- More than 75% of the revenues accruing to the undertaking in the preceding two tax years is “relevant income” (this mainly includes passive income in the form of dividends, interest, royalties, income from certain leases, income from insurance etc.).
- More than 60% of the undertaking’s relevant income is earned or paid out via cross-border transactions, or more than 60% of the undertaking’s assets, from which relevant income is derived, was located abroad in the preceding two tax years.
- The administration of day-to-day operations and decision-making was outsourced in the preceding two tax years.
On the other hand, low risk entities that meet only some or none of these criteria are not affected by the directive in any way.
According to the proposal, certain entities are automatically considered low risk, such as companies with securities traded or listed on a regulated market, regulated financial entities, certain holding entities with shareholders and/or subsidiaries in the same member state and entities with at least five own full-time employees carrying out the activities generating the relevant income.
Reporting undertakings meeting all three criteria will declare in their annual tax return if (and how) they meet the following three minimum substance requirements:
- The undertaking has its own premises in the member state, or premises for its exclusive use.
- The undertaking has at least one own and active bank account in the EU.
- One or more directors (or other members of the statutory body) of the undertaking take decisions or the majority of qualified full-time employees of the undertaking are residents for tax purposes in the member state of the undertaking (or at no such distance that would be incompatible with the proper performance of their duties).
Reporting undertakings must also accompany their tax return with additional information and documentary evidence regarding their substance, relevant income, outsourced activities etc.
According to the proposal, an undertaking that fails to comply with the reporting obligation or makes a false declaration in its tax return may be fined up to 5% of its turnover in the relevant tax year.
Evaluation of a reporting undertaking’s substance
If a reporting undertaking meets all three minimum requirements (see above), it is presumed that the undertaking has sufficient substance for the relevant tax year.
Even if the reporting entity does not meet some of the minimum requirements, it is still possible to rebut the tax authorities’ doubts about its substance by presenting additional information, especially documents supporting the commercial rationale behind the establishment of the undertaking, information about employees (including their qualifications and decision-making powers), organisational structure, and concrete evidence proving that the decision-making concerning the activities generating the relevant income is taking place in the member state.
Reporting undertakings that provide sufficient evidence that their establishment (and introduction to the group structure) does not lead to a tax benefit for the group or its beneficial owners may, according to the proposal, apply for an exemption from the obligations arising from this directive. The decision should apply for the relevant tax year with and may be extended for up to five tax years on the condition that the factual or legal circumstances of the undertaking, the beneficial owners and the group remain unchanged.
Consequences of not having minimum substance
If the reporting undertaking fails to meet the minimum substance requirements and does not rebut the presumptions about its lack of substance using additional documentary evidence, it should be denied the benefits of treaties for the avoidance of double taxation and should not be entitled to the exemption of dividends, interest, and royalties under the directives 2011/96/EU (parent subsidiary directive) and 2003/49/EC (interest and royalty directive).
The tax authority in the undertaking’ state of tax residence may either not issue a certificate of tax residence for use outside the member state at all or may issue a certificate prescribing that the undertaking is not entitled to the above-mentioned benefits. For the purposes of local taxation, the entity shall continue to be considered a tax resident.
Automatic exchange of information and request to conduct a tax audit
The proposal also includes amendments to Directive 2011/16/EU on administrative cooperation in the field of taxation (DAC), that should facilitate mandatory automatic exchange of information on reporting undertakings within the EU.
Information on reporting undertakings and their substance should in practice be exchanged between tax authorities via a central directory established by the European Commission. The exchange should occur no later than 30 days from obtaining relevant information (typically receiving a report from a reporting undertaking, evaluating that a given undertaking is exempt from the reporting obligation or concluding a tax audit regarding minimum substance requirements). The exchanged information should, among others, include the identification of other member states and foreign entities likely to be concerned by this information.
Where doubts exist about the substance of a foreign entity, a tax authority of one member state may request the tax authority of the member state where the entity is resident for tax purposes to conduct a tax audit. The audit must be initiated within one month from the date of the receipt of the request and feedback on the outcome of the audit must be provided to the requesting tax authority no later than one month after the audit is concluded (and, where relevant, also shared via the automatic exchange mechanism – see above).
We will keep you informed on any new developments regarding this proposal.