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On 22 December 2021, the European Commission released its 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 “Directive Proposal”).
The Directive Proposal targets companies and legal entities that are not commercially or financially active and which were set up within the EU to secure tax benefits for their beneficial owners or for their group. This is the case, for example, for EU companies without real substance that obtain profits exempted from withholding tax through the Parent-Subsidiary Directive or the Interest and Royalties Directive ([1]), and then in turn transfer such profits to a sister company resident in a low-tax jurisdiction outside of the EU.
The essential features of the Directive Proposal are:
- identifying EU companies that must evidence minimum substance requirements because of their features (ie., receipt of cross-border passive income and outsourcing of administrative functions);
- identifying the minimum substance requirements (the so-called "Substance Test"), absent which such companies will be considered "shell companies";
- hindering such shell companies by denying them the benefits of the double taxation treaties and of the Parent-Subsidiary and Interest and Royalties Directives.
The Directive Proposal should be implemented by Member States on or before 30 June 2023 and be effective as of 1 January 2024.
EU companies under the remits of the Directive Proposal
Subject to certain exclusions (such as those applicable to entities that under the Directive Proposal are "excluded entities"), the Directive Proposal applies to all entities which, regardless of their legal form, carry out trading activities and are resident for tax purposes in a Member State.
The excluded entities include, for example, listed companies, regulated financial entities (eg., financial institutions, insurance companies, pension funds, AIFs, UCITS, securitisation SPVs, etc.), certain holding companies and companies with at least five full-time employees devoted to the passive income generating activities described below (Article 6, paragraph 2 of the Directive Proposal).
Entities that are not excluded entities must be subject to the Substance Test if, cumulatively (Article 6, paragraph 1 of the Directive Proposal):
- more than 75% of the revenues earned in the preceding two tax years is passive income (eg., interest, dividends, capital gains on shares, royalties, real estate income, income from services that the entity has outsourced to related companies, etc.) or, alternatively, more than 75% of the book value of the entity’s assets are shares or immovable property and/or movable property (other than cash, shares or securities) held for private purposes;
- at least 60% of the passive income is generated in the context of cross-border transactions or more than 60% of the book value of the entity’s assets represented by immovable and movable property held for private purposes is located outside the entity’s Member State in the preceding two tax years; and
- in the preceding two tax years, the entity has outsourced the management of day-to-day operations and the decision-making activities of relevant functions.
Given that the national implementing provisions are scheduled to come into force on 1 January 2024, requirements (i), (ii) and (iii) above should already be satisfied during the current fiscal year (2022).
Notwithstanding satisfaction of requirements (i), (ii) and (iii) above, under the Directive Proposal an entity need not satisfy the Substance Test if it can demonstrate that the tax liability of its beneficial owner(s) or of its group is not reduced as a result of the entity's existence (Article 10 of the Directive Proposal).
The minimum substance requirements
Entities that (a) do not fall within the category of excluded entities, (b) meet the requirements under (i), (ii) and (iii) above and (c) are not beneficiaries of an exemption pursuant to Article 10 of the Directive Proposal, must declare in their tax returns that they satisfy certain minimum substance requirements and provide adequate documentary evidence.
The Substance Test will be deemed to be met if, cumulatively (Article 7 of the Directive Proposal):
- the entity has its own premises or premises for its exclusive use in the Member State of residence;
- the entity has at least one active bank account in the EU;
- one or more directors of the entity: (i) are resident for tax purposes in the entity’s Member State of residence or at a distance from that Member State compatible with the proper performance of their duties; (ii) are qualified and authorised to make decisions in relation to the activity that generates passive income or in relation to the assets of the entity; (iii) actively and independently perform their duties; (iv) are not employees and/or directors of a company that is not related to the entity by reason of certain shareholding relationships. As an alternative to the existence of such requirements for one or more directors, it will be sufficient for the majority of the entity's full-time employees to be resident for tax purposes in the entity’s Member State of residence or at a distance from that Member State that is compatible with the proper performance of their duties, and to be qualified to engage in activities that generate the entity’s passive income.
Entities which meet requirements (a), (b) and (c) above shall be presumed not to be shell entities for the relevant financial year; entities which do not meet all or part of such requirements shall be presumed to be shell entities (Article 8 of the Directive Proposal). Such entities, pursuant to Article 9 of the Directive Proposal, can choose to rebut the presumption of being shell companies by demonstrating that they control the activity generating passive income and/or the company’s assets as well as bearing the related risks.
Tax consequences applicable to companies that do not pass the Substance Test
Entities which are presumed to be shell entities and are unable to rebut the above-described presumption are subject to certain tax consequences:
- the Member State of residence will not grant the entity the tax residence certificate intended for use outside the entity’s jurisdiction or, if issued, it shall expressly certify that the entity is not eligible under the double taxation treaties, the Parent-Subsidiary and Interest and Royalties Directives (Article 12 of the Directive Proposal);
- the other Member States do not recognise the application of the double taxation treaties in force with the entity’s Member State of residence or the Parent-Subsidiary and Interest and Royalties Directives (Article 11, paragraph 1 of the Directive Proposal);
- the entity’s shareholders' Member State will tax the passive income of the entity in accordance with its national laws, and will deduct any tax paid on such income in the entity’s Member State itself (Article 11, paragraph 2 of the Directive Proposal);
- the above should not affect the agreements or double taxation treaties (if any) in force between Member States (other than the Member State of residence of the entity) or between a Member State and a third State (ie., the States of the payer of passive income and the entity’s shareholder) (Article 11, paragraph 2 of the Directive Proposal);
- in the event of there being immovable property and/or movable property (other than cash, shares or securities) held for private purposes, the Member State in which the immovable property is located and the Member State of residence of the entity’s shareholder will tax the relevant property as if such property were owned directly by the entity’s shareholder (Article 11, paragraph 3 of the Directive Proposal).
Finally, it should be noted that the Directive Proposal introduces the automatic exchange between Member States of information relating to shell companies, certain cooperation obligations for the purposes of conducting tax audits and the obligation to introduce pecuniary sanctions (no less than 5% of turnover) against entities which do not comply with the reporting obligations pursuant to Article 7 of the Directive Proposal or file false tax return (Articles 13, 14 and 15 of the Directive Proposal).
The Directive Proposal remains to be approved by the Council of the European Union and upon its approval it might be subject to amendments.
[1] Direttive 2003/49/EC e 2011/96/EU.