Amendments to the draft EU Directive on the minimum requirements for the economic substance of entities (undertakings) established in the EU (the “Directive”), which were approved by the European Parliament in a modified version on 17 January 2023, were published in January 2023. The Directive is intended to set the rules to prevent the use of shell companies, i.e. entities without sufficient economic substance, to obtain a more favorable tax regime for certain types of income.
We outlined the main features and principles of the Directive in detail in last year’s article. As a brief reminder, if a legal entity is assessed as lacking sufficient economic substance, it will be denied the benefits from bilateral double taxation treaties and it will not have an access to the tax exemptions of dividends, interest, and royalties under the relevant EU directives (Parent-Subsidiary Directive, Interest and Royalties Directive).
Of the amendments adopted in the draft Directive, let’s take a closer look at the changes to the three entry criteria (“gateways”) that lead to the triggering of the reporting obligation in relation to the minimum economic substance requirements. These cumulative criteria have been reformulated in terms of their parameters (de facto tightened) as follows:
I. more than 65% (initially 75%) of the revenues accruing to the undertaking in the preceding two tax years is “relevant income”. This primarily includes passive income in the form of dividends, interest, royalties, rental income, income from insurance, etc.;
II. more than 55% (initially 60%) of the undertaking’s relevant income is earned or paid out via cross-border transactions, or more than 55% (initially 60%) of the book value of the undertaking’s assets that generate relevant income was located outside the Member State of the undertaking in the preceding two tax years; and
III. in the preceding two tax years, the undertaking outsourced the administration of day-to-day operations and the decision-making on significant functions to a third party (initially only “outsourced”).
Other noteworthy changes include the removal of the safe harbor exemption, according to which companies with at least five own full-time equivalent employees or with members of staff exclusively carrying out the activities generating relevant income were to be excluded from the scope of the Directive.
The penalty system envisioned by the Directive has also been modified. Instead of the originally proposed pecuniary sanction of at least 5% of the undertaking’s turnover in the relevant tax year, which would be imposed in case of failure to comply with the reporting obligation or the provision of false information, the penalties have been newly differentiated as follows:
- A penalty of at least 2% of the revenue in the relevant tax year will be imposed on the entity if it fails to comply with the requirement to report within the prescribed time limit.
- If it makes a false declaration in the tax return, it will be liable to a penalty of at least 4% of its revenue for the period in question.
Under the amended draft Directive, the sanctioning system also takes into account entities with low or zero revenue, for which the penalty for the above-mentioned non-compliance would be based on the total book value of their assets.
There have been no changes in terms of the planned effective date. According to the previously announced target date, the new rules should be applied from 1 January 2024. However, the fulfilment of the target date requires first the unanimous approval of the proposed Directive by the European Council (i.e. representatives/finance ministers of all EU Member States) and its subsequent implementation into the legal system of EU Member States. Based on the information available so far, the unanimous position of all Member States on the parameters of the Directive and their implementation in practice is uncertain. In this context, the declared effective date seems somewhat ambitious. Despite the unclear situation regarding the approval of the Directive, we recommend paying close attention to this matter now and considering the potential impacts.