Anti-Tax Avoidance Directive (ATAD 3) – The End Of Shell Entities - Tax Authorities

The European Commission on 22^nd December 2021 has issued a proposal to prevent the misuse of shell entities for tax purposes (as a proposed EU directive – "ATAD 3").

The timeline for ATAD 3 was to be adopted early in 2022 by the Council and to be implemented by the Member States by 30^th June 2023 at the latest. The provisions of the Directive should be effective by all Member States as from 1^st January 2024.

On 17^th of January 2023, the European Union Parliament approved a revised version of the proposed directive and suggested various amendments on the initial draft.

In effect, a Company's position as of January 1, 2022 should actually be a reference point, and for entities are is good to consider appropriate actions on a current basis.

Under consideration are entities that are residing in the EU, that mainly generating passive income, holding real estate, operating cross border, and engaging third-party service providers to act as external directors for their EU tax-resident companies.

The Directive is providing a uniform test to help Member States identifying undertakings engaged in economic activities, but not having the minimal substance and which are actually misused for obtaining tax advantages.

The undertaking will be classified as 'shell entity', if the minimum substance requirements are not met. The result is that the entity will sustain certain adverse tax consequences.

Definitions

For the purposes of this Directive the following definitions shall apply:

'Undertaking' means any entity engaged in an economic activity, regardless of its legal form, that is a tax resident in a Member State
'Tax year' means a tax year, calendar year or any other appropriate period for tax purposes
'Member State of the undertaking' means the Member State where the undertaking is resident for tax purposes
Cyprus International Trusts, that are not classified as tax resident undertakings, do not covered under the provisions of the Proposed Directive
'Relevant income' shall mean income falling under any of the following categories:

a. Interest or any other income generated from financial assets, including crypto assets,

b. Royalties or any other income generated from intellectual or intangible property or tradable permits;

c. Dividends and income from the disposal of shares;

d. Income from financial leasing;

e. Income from immovable property;

f. Income from movable property, other than cash, shares or securities, held for private purposes and with a book value of more than one million euro.

g. Income from insurance, banking and other financial activities;

h. Income from services which the undertaking has outsourced to other associated enterprises.

The proposed directive by incorporating the EU Parliament's recommendations is providing a 7 step criteria, in order to identify the shell entities:

Determination of undertakings being at risk for their classification as shell entities
Reporting requirements for substance
Undertakings that are exempted from reporting
Classification as a shell entity or not, for being misused for tax purposes
Rebuttal of the classification as a shell entity and available exemptions
Setting the tax consequences for not meeting the substance requirements
Exchange of the relevant information, tax audits requests and provided penalties.

Determination of undertakings being at risk for their classification as shell entities (step 1)

By reference to given features common in such entities, the undertakings meeting all the following criteria are considered as being at risk for classification as shell entities and that they were misused to obtain tax advantages:

a. more than 65% of the revenues accruing to the undertaking in the preceding two tax years is relevant income or if the undertaking holds assets which are generating income of dividends and income from the disposal of shares, and the book value of those assets is more than 75% of the total book value of the undertaking's assets or if the assets of the undertaking are consisting of immovable property and valuable private property specifically identified and the book value of those assets is more than 75% of the total book value of the undertaking's assets; and

b. engaging by the undertaking in cross-border activity, on any one of the following ways:

i. more than 55% of the book value of the undertaking's assets that fall within the scope points (e) and (f), was located outside the Member State of the undertaking in the preceding two tax years and/or

ii. more than 55% of the undertaking's relevant income is earned or paid out via cross-border transactions and

c. 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.

Once those undertaking are at risk to for classification as shell entities, they should be asked to report on their substance, inside their yearly tax return, which leads to the 2^nd step.

Reporting requirements for substance (step 2)

Undertakings that were considered at risk on step 1 above, have to declare in their annual tax returns, for each year, whether they meet the following minimum substance indicators.
In case when the undertaking falls under the exempted undertakings as explained further below, then the undertaking is excluded from the requested reporting.

The substance requirements

existence of own premises in the Member State for the exclusive use by the undertaking or shared use of the premises with entities of the same group; and
undertaking operates at least one active bank account or e-money account in the EU, through which any relevant income is received; and
one of the two following indicators are being met by the undertaking:
i) One or more directors of the undertaking:
1. are resident for tax purposes in the Member State of the undertaking, or at no greater distance from that Member State insofar as such distance is compatible with the proper performance of their duties; and,
2. are authorised to take decisions in relation to the activities that generate relevant income for the undertaking or in relation to the undertaking's assets; and,

ii) the majority of the full-time equivalent employees of the undertaking are resident for tax purposes in the Member State of the undertaking, or at no greater distance from that Member States insofar as such distance is compatible with the proper performance of their duties, and such employees are qualified to carry out the activities that generate relevant income for the undertaking.

The undertakings having the obligation to report their substance as above, shall accompany their tax return declaration with documentary evidence.

The documentary evidence shall include the following information:

address and type of premises;
amount of gross revenue and type thereof;
amount of business expenses and type thereof;
type of business activities performed to generate the relevant income;
the number of directors, their qualifications, authorisations and place of residence for tax purposes or the number of full-time equivalent employees performing the business activities that generate the relevant income and their qualifications, their place of residence for tax purposes;
outsourced business activities;
bank account number, any mandates granted to access the bank account and to use or issue payment instructions and evidence of the account's activity.
an overview of the structure of the undertaking and associated enterprises and any significant outsourcing arrangements, including the rationale behind the structure, described in the context of a standardised format;
a summary report of the documentary evidence submitted under this paragraph, containing in particular:
- a brief description of the nature of the activities of the undertaking;
- the number of employees on a fulltime equivalent basis;
- the amount of profit or loss before and after taxes.

Undertakings that are exempted from reporting (step 3)

The following undertakings are not subject to requirements of:

companies which have a transferable security admitted to trading or listed on a regulated market or multilateral trading facility;
regulated financial undertakings;
undertakings 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;
undertakings with holding activities that are resident for tax purposes in the same Member State as the undertaking's shareholder(s) or the ultimate parent entity;

Classification as a shell entity or not, for being misused for tax purposes (step 4)

An undertaking that is a risk case, since it has crossed the criterias, and whose reporting also leads to the finding that it lacks at least one of the relevant elements on substance, should be presumed to be a 'shell' for the purposes of the Directive, i.e. lacking substance and being misused for tax purposes.

An undertaking that is a risk case but whose reporting reveals that it has all relevant elements of substance and provides the required supporting documentary evidence should be presumed not to be a 'shell' for the purposes of the Directive.

Rebuttal of the classification as a shell entity and available exemptions (step 5)

Rebuttal

Member States shall take the necessary measures to allow undertakings that are presumed not to have minimum substance, to rebut this presumption, without undue delay and excessive administrative costs, by providing any additional supporting evidence of the business activities which they perform to generate relevant income.
For the purposes of paragraph 1, undertakings shall provide the following additional evidence:

(a) a document allowing to ascertain the business rationale behind the establishment of the undertaking in the Member State where the activity is performed;

(b) information about the full-time, part time, and freelance employee profiles, namely the level of their experience, their decision-making power in the overall organisation, role and position in the organisation chart, the type of their employment contract, their qualifications and duration of employment, safeguarding high levels of data protection and privacy;

(c) concrete evidence that decision-making concerning the activity generating the relevant income is taking place in the Member State of the undertaking.

A Member State shall treat an undertaking as having rebutted the presumption if the evidence that the undertaking has provided under paragraph 2 proves that the undertaking has performed and continuously had control over, and borne the risks of, the business activities that generated the relevant income or, in the absence of income, the undertaking's assets.

(a). The Member State shall consider a request for the rebuttal of the presumption within a period of nine months after the introduction of the request and it shall be considered to be accepted in the absence of an answer from the Member State after the expiry of that nine-month period.

After the end of the tax year for which the undertaking rebutted the presumption successfully, in accordance with paragraph 3, a Member State may consider for a period of five years that the undertaking has rebutted the presumption on the condition that the factual and legal circumstances of the undertaking remain unchanged during this period.

Exemptions

A Member State shall take the necessary measures to allow an undertaking that meets the criteria to request, without undue delay and excessive administrative costs, an exemption from its obligations under this Directive if the existence of the undertaking does not reduce the tax liability of its beneficial owner(s) or of the group, as a whole, of which the undertaking is a member.
A Member State may grant that exemption for one tax year if the undertaking provides sufficient and objective evidence that its interposition does not lead to a tax benefit for its beneficial owner(s) or the group as a whole, as the case may be. That evidence shall include information about the structure of the group and its activities, including a list of its employees working on full-time equivalence. That evidence shall allow to compare the amount of overall tax due by the beneficial owner(s) or the group as a whole, as the case may be, having regard to the interposition of the undertaking, with the amount that would be due under the same circumstances in the absence of the undertaking.
After the end of the tax year for which an exemption was granted in accordance with paragraph 2, a Member State may extend the validity of the exemption for five years on the condition that the factual and legal circumstances of the undertaking, including of the beneficial owner(s) and the group, as the case may be, remain unchanged in the relevant period.

(a). A Member State shall consider the exemption request within a period of nine months after the introduction of the request and it shall be considered to be accepted in the absence of an answer from the Member State after the expiry of the nine-month period.

Setting the tax consequences for not meeting the substance requirements (step 6)

Tax consequences of not having minimum substance for tax purposes in Member States other than the Member State of the undertaking

Member States other than the Member State of the undertaking shall disregard any agreements and conventions that provide for the elimination of double taxation of income, and where applicable, capital, in force with the Member State of the undertaking, as well as the application of proposed Directives for Parent-Subsidiary and Interest and Royalties related transactions with the reporting undertaking, to the extent that those Directives apply due to the undertaking being deemed to be resident for tax purposes in a Member State.
The Member State of the undertaking's shareholder(s) shall tax the relevant income of the undertaking in accordance with its national law as if it had directly accrued to the undertaking's shareholder(s) and deduct any tax paid on such income at the Member State of the undertaking. Where the payer is not resident for tax purposes in a Member State, the Member State of the undertaking's shareholder(s) shall tax the relevant income accruing to the undertaking in accordance with its national law as if it had directly accrued to the undertaking's shareholder(s), without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force between the Member State of the undertaking's shareholders and the third country jurisdiction of the payer; Where the undertaking's shareholder(s) is not resident for tax purposes in a Member State, the Member State of the payer of this income shall apply withholding tax in accordance with its national law, without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force with the third country jurisdiction of the undertaking's shareholder(s).
Where property referred to under 'Relevant income' in Definitions section above, is owned by an undertaking that is presumed not to have minimum substance and does not rebut this presumption:

a. the Member State where property referred to in point (e) of relevant income in Definitions section above, is situated shall tax such property according to its national law, as if such property was owned directly by the undertaking's shareholder(s), without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force with the jurisdiction of the undertaking's shareholder(s);

b. the Member State of the undertaking's shareholder(s) shall tax such property in accordance with its national law as if the undertaking's shareholder(s) owned it directly, without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force with the jurisdiction where the property is situated.

Tax consequences

Where an undertaking does not have minimum substance for tax purposes in the Member State where it is resident for tax purposes, that Member State shall deny any request for a certificate of tax residence to the undertaking for use outside the jurisdiction of that Member State.

When denying a request for such certificate, the Member State shall issue an official statement duly justifying such decision and prescribing that the undertaking is not entitled to the benefits of agreements and conventions that provide for the elimination of double taxation of income, and, where applicable, capital, or of international agreements with a similar purpose or effect and of Articles 4, 5 and 6 of Directive 2011/96/EU and Article 1 of Directive 2003/49/EC.

In cooperation with Member States, the Commission shall ensure that those tax consequences are well articulated in relation to existing bilateral tax agreements with third countries so that they receive the information on the presumed shell companies.

Exchange of the relevant information, tax audits requests and provided penalties (step 7)

Exchange of information

Τhe Commission suggests that all Member States must have access to information on any undertakings considered at risk at step 1, despite if such undertakings is meeting any of the exceptions in subsequent steps. The information should be exchanged automatically.

Where the competent authority of a Member State identifies other Member States likely to be concerned by the reporting of the undertaking, the communication shall include a specific alert to those Member States deemed to be concerned.

Penalties

Member States shall ensure that those penalties include an administrative pecuniary sanction of at least 2% of the undertaking's revenue in the relevant tax year, if the undertaking that is required to report pursuant to Article 6 does not comply with such requirement for a tax year within the prescribed deadline and an administrative pecuniary sanction of at least 4 % of the undertaking's revenue if the undertaking that is required to report pursuant to Article 6 makes a false declaration in the tax return under Article 7. In case of an undertaking with zero or low revenue, defined as being below a threshold determined by the national tax authority and not falling below a minimum threshold set by the Commission in an implementing act, the penalty should be based on the total assets of the undertaking.

Tax audit

Where the competent authority of one Member State has reason to believe that an undertaking which is resident for tax purposes in another Member State has not met its obligations under this Directive, the former Member State may, specifying such reasons, request the competent authority of the latter to conduct a joint tax audit of the undertaking following the relevant procedures.

If the requesting competent authority is not able to conduct a joint tax audit due to legal reasons, the competent authority of the requested Member State shall initiate a national audit within one month from the date of receipt of the request and conduct it, in accordance with the rules governing tax audits in the requested Member State.

Sources

Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU
European Parliament legislative resolution of 17 January 2023 on 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

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

European Union: Anti-Tax Avoidance Directive (ATAD 3) – The End Of Shell Entities