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European Commission Introduces Minimum Substance Test Directive
On 22 December 2021, the European Commission presented an initiative to fight against the misuse of shell entities for harmful tax purposes – the Proposal for the Directive Laying Down Rules to Prevent the Misuse of Shell Entities for Tax Purposes (the Unshell Proposal). It promotes the principle that entities in the European Union that have no or minimal economic activity should not benefit from any tax advantages. This will lessen the financial burden on taxpayers and ensure equal opportunities for European businesses.
Shell companies are often used for tax evasion. Businesses can direct financial flows through shell entities towards jurisdictions that have no or very low taxes, or where taxes can be circumvented. Similarly, some individuals can use shells to shield assets, such as real estate, from taxes. The proposed new measures will help tax authorities to detect such entities and their activities.
Criteria for Shell Company Identification
The proposal introduces a filtering system for the entities in scope, which have to comply with a number of indicators (“gateways”).
Companies will be inspected for meeting three criteria:
- whether the bigger part of the company’s income (dividends, interest on bonds, etc) is passive. The gateway is met if more than 75% of an entity’s overall revenue in the previous two tax years does not derive from the entity’s trading activity or if more than 75% of its assets are real estate property or other private property of particularly high value;
- whether a majority of transactions are cross-border. This means that the company receives the majority of its relevant income (at least 65% in the preceding two tax years) through transactions linked to another jurisdiction or transfers this income to other companies situated abroad.
- whether management and administration are outsourced or performed in-house.
If the company meets all three parameters, it will be required to provide more detailed information in its tax return about so-called “substance indicators”:
⇒ premises of the company (these must be available for the exclusive use by the company);
⇒ bank accounts (the company must have at least one active account in the EU);
⇒ tax residency of directors and employees (which must be close to the company).
If an entity fails at least one of the substance indicators, it will be presumed to be a “shell”.
Consequences for Companies Defined as Shells
1) A company deemed to be a shell one will not be able to access tax relief and the benefits of the tax treaties of its Member State and/or to qualify for the treatment under the Parent-Subsidiary and Interest and Royalties Directives. The Member State of residence of the company will either deny the shell company a tax residence certificate, or the certificate will specify that the company is a shell.
2) Moreover, payments to third countries will not be treated as flowing through the shell entity and will be subject to withholding tax at the level of the entity that paid to the shell.
3) Assets of wealthy individuals using shells and which, as a result, have no income flows will be taxed by the state where the asset is located as if it were owned by the individual directly.
Nevertheless, entities that do not meet all substance indicators will still have the opportunity to prove they are not shells by providing documentary evidence: information about the commercial, non-tax reason of their establishment; profiles of their employees, and the proof that decision-making takes place in the Member State of their tax residence.
Exclusions from the Scope of the Directive
There are several categories of enterprises which do not meet the risk of being defined as those with minimal substance:
→ companies which have a transferable security admitted to trading or listed on a regulated market or multilateral trading facility as defined under Directive 2014/65/EU;
→ 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;
→ undertakings with at least five own full-time equivalent employees or members of staff exclusively carrying out the activities generating the relevant income.
Information Exchange Obligations for Member States
Member States’ authorities will automatically exchange information on all entities in scope of the Directive, regardless of whether these are shell entities or not. The proposal will amend the Directive 2011/16/EU on Administrative Cooperation in the Field of Taxation (DAC) to this effect. Furthermore, Member States will be able to perform tax audit of such entities and exchange their findings between themselves.
It is expected the Directive shall come into effect on 1 January 2024 after being approved by Member States.