On 22 December 2021, the European Commission issued the draft Anti-Tax Avoidance Directive (ATAD 3), the latest regulatory tool in the fight against tax evasion.
ATAD 3, which targets companies that are tax resident in an EU member state, proposes changes specifically aimed at countering the misuse of shell entities. The directive targets companies that have mainly passive income and have outsourced many of their operations and functions. Under the directive, qualifying entities which do not meet minimum substance requirements would be subject to additional reporting obligations and a variety of tax penalties.
The directive specifies that target companies that are tax resident in an EU member state must satisfy the following conditions:
• 75% or more of the entity’s income over the two preceding tax years is made up of passive income. Passive income includes income deriving from passive investments, such as interest income and dividends, but now also includes income from financial assets (including cryptoassets) such as insurance, banking and financial activities and real estate;
• has shareholders residing in other jurisdictions;
• the company engages mainly in cross-border activities (defined as 60% based on the book value of certain assets or of the income deriving from cross-border transactions); and
• the entity has outsourced its day-to-day administration and decision-making relating to significant functions in the two preceding tax periods.
Excluded entities
If the company falls into all three categories above, it will be subject to the reporting rules of ATAD 3. The new directive however does set out a number of exclusions including:
• companies with at least 5 full time employees managing the assets producing passive income;
• listed entities – companies can avail of this exemption with any kind of transferable securities listed on an MTF or regulated market;
• companies regulated in accordance with EU directives and regulations, for example an AIF managed by an AIFM, UCITS and their management companies, investment firms and pension institutions (please note, however, that holding companies held by otherwise exempted regulated institutions are not themselves automatically exempt); and
• holding entities held by shareholders or an ultimate parent company located in the same country.
Minimum substance requirements
Where an entity is subject to the reporting obligations, it will be required to specify whether it meets each of the following three minimum substance requirements in its annual tax return, namely having:
• a dedicated premises to conduct business within the EU;
• a bank account held in the EU; and
• its own appropriately qualified resident personnel.
Critically, the directive outlines that a manager or director should be able to take decisions independently and must not have the same functions at the level of other unrelated companies.
Various supporting information evidence regarding the substance should be provided with the tax return, as required.
If the company is deemed to not meet the substance tests, it is therefore considered a shell entity.
What are the consequences and sanctions for shell companies?
The most significant consequence of an entity failing to demonstrate any of the minimal substance indicators is that it will be denied the right to a certificate of residence in the relevant member state and denied the tax benefits of EU tax directives and tax treaties by other member states involved. Instead, taxing rights will be ascribed to the shareholders of the shell company. This could mean that the company may now be subject to applying withholding taxes. In addition to this, fines may also be imposed on the company.
Next steps
Although we await clarification on the exact implementation and application of ATAD 3, it is highly likely that the directive will be adopted. Member states are expected to introduce the directive to domestic legislation in mid-2023, with the rules likely to be effective from 1 January 2024.
The introduction of ATAD 3 will have significant consequences for payors making payments to qualified shell entities and for the shareholders. It is important for organisations to carefully examine their current structures and holdings to assess their exposure.
