The EU's unwaving commitments towards effectively curbing money laundering and tax evasion throughout the community just increased tenfold! In a previous article, we delved into the EU's proposed initiatives (such as the Commission's Action Plan to create a single EU Rulebook on AML/CFT and the setting-up of a decentralized EU Regulatory agency).

In this article, we will explore 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 being colloquially marketed as the ‘Shell Companies' Directive.

As a principle, shell entities established in the EU with the sole aim for tax purposes should be discouraged. The need for a directive to protect the community was particularly felt ‘in the aftermath of continuous scandals on the misuse of shell entities worldwide' – hearkening back to the days of the Panama Papers scandal.

  • Scope & rational 

The main aim of this Directive is primarily to combat ‘ tax avoidance and evasion practices which directly affect the functioning of the EU's Internal Market' . Moreover, as per Article 2 of the Directive, the scope applies to all ‘undertakings that are considered tax resident and are eligible to receive a tax residency certificate in a Member State'.

Furthermore, the envisaged measures do not go beyond ensuring the minimum necessary level of protection for the internal market. As per the Principle of Proportionality , the Directive is carefully constructed as imposing ‘minimum protection' for Member States in lieu of full harmonization.

  • What are Shell Companies?

Throughout the directive, one notices that ‘defining what is a shell entity is challenging and that assessing lack of substance depends on the facts and circumstances of each specific entity'. In fact, ACAMS classifies a Shell Company as ‘ an entity without active business or significant assets. Shell companies are legal, but people sometimes use them illegitimately—for instance, to disguise business ownership'.

The overall gist of the proposed Directive is that the scheme (aimed towards identifying Shell companies and precluding their abuse across the community) ‘targets the setting up of undertakings within the EU which are presumably engaged with an economic activity but, in reality, do not conduct any of such activities'.

  • Threats & Vulnerabilities

Despite ‘Shell Companies' not being illegal, part of the problem when dealing with these structures relates to the inherent risks posed – particularly a general consensus (reinforced at EU level) that absence of an own bank account (as is often the case with Shell Companies) leads to an unacceptable risk . There is also another pertinent point insofar as directors are concerned, whereby in some cases, most might not be residing in the country where the entity is located. More crucially, industry practice has shown that shell entities with the greatest potential for misuse include those holding and managing equity, intellectual property, or real estate.

  • Applicability

In view of the aforementioned, this Directive seeks to include and capture all undertakings (companies) that can be considered resident in any Member State of the EU for tax purposes, regardless of the legal form (eg, Limited Liability Companies, PLCs, and/ or partnerships). This is enshrined in Article 2 of the Directive.

Furthermore, any taxing rights and considerations affect only Member States – and the substance of this directive should not be interpreted and constructed as being applicable to ‘third countries'. [This does not detract from the fact that situations involving third countries could arise particularly if a shell owns assets in a third countries ]. Any shell undertakings resident outside the EU also fall outside of scope.

National rules, including those rules transposing EU law, shall nevertheless apply to identify shell companies which are not captured by this Directive.

  • Substance testing

Considering that some companies may be purposefully used to by-pass tax treaties and obligations , the Directive introduces a ‘test' that will help countries within the EU identify entities that whilst being engaged in some form of economic activity – do not have minimal substance and are consequently misused for the purposes of obtaining tax advantages. In the event that such companies are classified as ‘shells', tax consequences will immediately apply .

Said consequences may vary but the Member State must (at a minimum) either not issue a tax residence certificate or will issue a certificate with a warning statement (to prevent the entity from obtaining any advantage). The latter document will merely serve as an ‘administrative practice' to inform the source country not to grant benefits of its tax treaty with the Shell Company's member state – as per Article 12 of the Directive.

In the event that any form of tax advantage is disallowed, the Member State should nevertheless determine how income will flow through and out of the company as well as consider any of the assets ‘held' by the entity – to determine whether or not these would be taxed.

On the other hand, undertakings that declare to possess all the elements of the minimum level of substance and ‘provide the required supporting documentation' are presumed to have minimal substance insofar as ‘tax purposes' are concerned. Those companies presumed not to have substance are afforded the right of rebuttal accordingly (as governed by the provision/s of Article 9 of the Directive).

  • The ‘Gateway Criterion'.

As previously stated, the Directive is aimed at capturing and identifying undertakings ‘without minimal substance' – which would likely leading to tax avoidance and/or evasion. These would be classified as entities which are ‘at risk for lacking substance' as opposed to those that are ‘low risk'.

However, structures that are not designed with the main purpose of obtaining a tax advantage may avail themselves of a mechanism to request an upfront exemption. Moreover, the Directive also considers those companies which satisfy ‘the gateway criterion' yet their ‘interposition has no actual advantageous impact on the overall tax position of the entity's structure' or the Ultimate Beneficial Owner/s.'

Said ‘Gateway criterion' are introduced in order ‘ to conclude which undertakings are sufficiently at risk as being classified as Shell Companies' . The test is based on three (3) conditions – wherein said conditions will ‘conclude which undertakings are at risk and justify reporting'.

As per Article 6 of Chapter II of the Directive, the conditions are as follows:

  1. more than 75% of revenues accruing to the undertaking in the preceding two tax years are not derived from the company's trading activity;
  2. the undertaking is engaged in cross-border activity on any of the following grounds (more than 60% of the book value of the assets that are primarily income from movable and/or immovable property were 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 via cross-border transactions);
  3. in the preceding two tax years, the company outsourced the administration of its day-to-day operations and the decision making on significant functions.

Point (3) is to be interpreted for those companies which literally have inadequate ‘own resources'.

  • Actions following classification.

‘Low-risk' cases that do not cross the gateway (eg those that present none or some of the criteria) are ‘irrelevant' insofar as this directive is concerned.

On the contrary, entities classified as necessitating reporting (posing higher risk) in terms of Article 6(1)– as discussed above – will, as per Article 7(1), be required to declare ‘in their annual tax return, for each tax year, whether they meet the following indicators of minimum substance': –

  1. Whether the undertaking has its own premises in the Member State or premises for its exclusive use and
  2. Whether the undertaking has at least one (1) own and active bank account in the EU;

Moreover, one of a number of other indicators will need to be selected including inter alia details concerning company directors (such as tax residency status) and/or whether the majority of the full-time employees are resident for tax purposes within the Member State.

In the event that no director is resident, the Directive recommends that the company would have adequate linkages (‘nexus'), to the Member State of claimed tax residence – particularly if most of its employees that perform day-to-day functions are tax residents in that EU Member State.

Any information included in the annual tax return must be accompanied by sufficient documentary evidence (such as business address, details pertaining to revenue, type of activities, number of directors etc.)

These are all known as ‘Substance Indicators'. If an entity fails at least one of the substance indicators, it will be considered as a ‘Shell Company.'

  • exemptions

Exemptions from reporting, as per Article 6(2) of the Directive include: regulated companies, companies with shares listed on a stock exchange in the EU and companies with at least five (5) own full-time employees.

A Member State may grant an exemption for one tax year provided all required evidence is both collated and submitted to the relevant authority. Furthermore, following the first tax year, the State may extend the validity of the exemption for a further five (5) years provided that the factual and legal circumstances insofar as the Company and UBO/s are concerned remain unchanged throughout this extended period.

  • Exchange of Information

An essential element also pertains to exchange of information and expediency of requests among Member States. In this respect, countries might require critical information such as copies of tax audits to discourage abuse/s. As per the Directive, whenever an undertaking is classified as being ‘at risk' – information must be exchanged accordingly. Dissemination should also occur in circumstances where an entity also exercises its right to rebut the assumption of being a shell or request an exemption from said directive. (Member States should also be afforded information as to the reasons why such an assessment – exemption/rebuttal – is being carried out).

In order to ensure that all interested Member States have ‘timely access' to all findings and information, such dissemination is to be shared through the common communication network (‘CCN') formulated by the EU itself.

  • penalties

Article 14 within Chapter 5 dealing with ‘Enforcement' prescribes Member States to lay down penalties applicable to infringements of this directive. Such penalties are to, for instance, include an administrative sanction of 5% of the company's turnover in the relevant tax year if the company does not comply with the requirements emanating from Article 6 (ie, dealing with reporting).

Conclusion

Once adopted as a Directive, the EU mandates that it be transposed into Member States' national law by not later than the 30th of June 2023 – with the Directive coming into effect as of the 1st of January 2024 .

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.