Introduction
Scope
Indicators to determine presence of "real" economic activity
Reporting and presumption
Rebuttal of presumption
Exemption for lack of tax motives
Consequences if undertaking is deemed to be shell
Exchange of information
Penalties
Comment
On 18 May 2021, the European Commission (EC) published a communication that contained the EU Tax Policy Agenda and the actions to be adopted in 2021 and in the coming years to increase transparency and substance requirements. One of the most relevant proposals was the initiative against the misuse of shell companies (ie, companies with no or minimal substantial presence and real economic activity).
On 22 December 2021, the European Commission released a proposal for the directive. The proposed directive sets out indicators of minimum substance for undertakings in member states and aims to increase scrutiny of shell companies within the European Union to prevent them from being used for tax evasion and avoidance. Further, the proposed directive enhances and completes the efforts of previous EU measures including anti-tax avoidance directives (ATADs) and directives on administrative cooperation (DAC) and is, therefore, also referred to as "ATAD 3"".
If adopted, it must be implemented by 30 June 2023 in order to become effective by 1 January 2024.
Currently, there are no specific rules in Luxembourg that relate to shell entities. However, an administrative circular issued by the tax authorities on 27 December 2016 set the level of substance that should be met by companies that carry out intra-group financing activities. Further, it is general market practice to maintain a certain level of substance, regardless of any specific activity, and consider other requirements from a foreign perspective.
This article provides an overview of the main provisions of the proposed directive and considerations for Luxembourg-based holding companies, which will need to monitor the proposal's progress and make preparations to comply with the directive.
The provisions of the proposed directive are applicable to any undertaking that is considered tax resident and is eligible to receive a tax residency certificate in a member state, including Luxembourg, regardless of its legal form. The targets are entities without real economic activities that are used within a scheme to avoid and evade taxes and allow their beneficial owners or group to access a tax advantage. Undertakings that carry out certain activities are explicitly excluded; they include:
- companies listed on a regulated market;
- certain regulated financial undertakings as specifically identified and listed by the directive (eg, alternative investment funds within the meaning of the Alternative Investment Fund Managers Directive); and
- undertakings with at least five full-time employees or members of staff who exclusively carry out the activities that generate the relevant income.
According to the impact assessment carried out in the framework of this initiative, it is expected that less than 0.3% of all EU companies will fall within this scope.
Indicators to determine presence of "real" economic activity
The proposed directive establishes a so-called "substance test" with "gateway" criteria (based on an assessment of the two previous tax years) that comprises three cumulative conditions to determine whether an undertaking is sufficiently at risk to be subject to reporting requirements. The conditions provide that the undertaking:
- derives predominantly passive income;
- is mainly engaged in cross-border activities; and
- has no or inadequate resources to perform core management activities, which are outsourced.
Entities that meet the above three conditions are considered "at risk".
At-risk undertakings should declare in their tax returns information related to their substance, such as:
- premises;
- existence of an active bank account within the European Union;
- place of residence for tax purposes and qualification of the directors and/or employees.
Such undertakings in Luxembourg will have to document this information in order to allow tax authorities to carry out audits. If an undertaking fails to meet one of the substance indicators, it will be presumed to be a shell company (ie, a company that does not have minimum substance for the tax year).
Undertakings deemed to be a shell will have the possibility to rebut such a presumption. In this regard, the taxpayer will be required to produce concrete evidence of the activity it performs and how it proceeds. To this effect, the taxpayer will be expected to provide information on:
- non-tax or commercial reasons for its set-up and maintenance;
- human resources; and
- any element that will allow the nexus to be verified between the undertaking and the member state where it claims to be tax resident for tax purposes (ie, the place where its decisions are taken in relation to value generating activities).
The taxpayer will have to demonstrate that it has continuously exerted control over, and borne the risk related to, its business activities that generate the relevant income (or in the absence of income, its assets). Tax authorities in Luxembourg should, when satisfied, certify the outcome of the rebuttal for the relevant tax year. The validity of the certificate can be extended for another five years (with a total six-year maximum), provided the legal and factual circumstances remain unchanged.
Exemption for lack of tax motives
Undertakings that do not meet a certain level of substance or cross the "gateways" but carry out genuine business activities without creating tax benefits for its beneficial owner or its group will have the possibility to provide evidence and request an exemption from their reporting obligations. These undertakings will be expected to evidence that their interposition does not lead to a tax benefit for their beneficial owner(s) or the group as a whole. Therefore, they will have to provide evidence that allows comparisons of the tax liability of the structure or group to which they belong, with or without their interposition. Similarly, as with the procedure for rebutting presumption, Luxembourg tax authorities should, when satisfied, grant the exemption for the relevant year. The validity of the exemption can be extended for another five years, provided the legal and factual circumstances do not change.
Consequences if undertaking is deemed to be shell
If an entity is presumed to be a shell without any applicable rebuttal or exemption, the undertaking will not be able to access tax relief and the benefits of the national tax treaty network and/or to qualify for the Parent-Subsidiary and Interest and Royalties Directives. Accordingly, the shell company's member state of residence will be compelled to either not issue a tax residence certificate or to issue a certificate with a warning statement that the company is a shell.
It is also expected that there will be an allocation of taxing rights between the source countries and the shareholders of the shell company. Such relationships are possible only between EU member states. The impact on third countries should be closely analysed based on applicable treaties and domestic laws.
Luxembourg, as well as all member states, will have access at any time to information on EU shells, even for the ones that have rebutted the presumption or are exempt. The information will be exchanged automatically. To this effect, the proposed directive will amend DAC.
Under the proposed directive, Luxembourg authorities will be free to impose penalties when reporting obligations are violated. These penalties should be effective, proportionate and dissuasive, and they should include an administrative pecuniary sanction of at least 5% of the entity's turnover.
The proposed directive establishes transparency standards and indicators for minimum substance around the use of EU shell entities so that their misuse can more easily be detected by tax authorities. Transparency is the cornerstone of fair taxation. Further, the directive introduces defensive measures to limit the access to exemption, as well as other tax benefits derived from certain EU tax directives and tax treaties, which in practice create new conditions for certain tax frameworks (eg, participation exemption).
At this stage, although some concepts deserve further clarification, it seems that many Luxembourg companies may fall under the scope of the draft directive. International groups, investment or fund structures with ties to Luxembourg companies will be required to prepare for the impact of the directive if it is adopted, which is very likely. As the gateway criteria will be assessed based on information available from the preceding two years, it is necessary to evaluate structures that are already in place for 2022. In particular, the resources related to the administration of day-to-day operations should be monitored carefully and properly documented.
If the relevant three gateways are met and the minimum substance requirements are not fulfilled, the rebuttal of presumption procedure will be a good option for groups investing via Luxembourg companies with genuine economic reasons for existing, adequate workforce and decision making to mitigate the negative consequences of the draft directive. Similarly, the final exemption procedure (ie, comparing the level of taxation at the level of its beneficial owners and group as a whole) may also be of interest when the choice of Luxembourg company is tax neutral. This may potentially be a valuable option for Luxembourg securitisation vehicle structures.
As a tentative conclusion, it seems that the market practice is moving towards implementing and using own resources as a privileged mechanism to avoid passing the outsourcing gateway and mitigate the impact of the draft directive. Otherwise, taxpayers will have to check whether they are in the scope of subjective exemptions (eg, authorised investment funds), or whether they use the rebuttal of presumption or the referred beneficial owner and group exemption procedures.
For further information on this topic please contact Frédéric Feyten, Alejandro Dominguez and Delphine Danhoui at CMS Luxembourg by telephone (+352 26 27 53-1) or email ([email protected], [email protected] and [email protected]). The CMS Luxembourg website can be accessed at www.cms.law.