If adopted, the “Directive laying down rules to prevent the misuse of shell entities for tax purposes”, aka “ATAD 3” or the “Unshell Directive”, will deny the benefits of European directives and also the benefit of double tax treaties to EU-based holding companies which fail to meet minimum substance requirements from 2024. Per the draft directive, this applies not just to equity holding companies, but to holding companies for all forms of passive income including income from debt, IP and real estate.

Access to treaties or directives is generally important for holding companies because it is likely that this will ensure that withholding taxes, and in some cases capital gains, will be applied predictably and at the lowest achievable rate applied by the relevant jurisdiction.

The “indicators” of minimum substance are, briefly summarised, that the company has local premises for its exclusive use, a bank account somewhere in the EU, and either at least one suitably qualified local director who is exclusive to the company and its affiliates, or a majority of local FTE employees who are suitably qualified.

These indicators are likely to be achievable for those private equity managers which have established master holding companies in the EU, though they may need to look carefully at details such as exactly which entity employs their staff. For those managers that set up EU holding companies on a deal-by-deal basis the requirement for exclusive premises is likely to be challenging - we could see increased demand for very small offices in Luxembourg! It could also be difficult for such companies to evidence sufficient activity on the part of the local director or to meet the hurdles for FTE employees.

It is very common to see a string of holding companies in the same jurisdiction, for example a master holdco and subsidiaries established in the same jurisdiction for the purposes of a particular deal. Often these lower tier companies are the ones that hold the relevant assets and so will be the ones claiming the treaty/ directive benefits. It is rather unclear how the directive would apply to these companies.

They are themselves unlikely to meet the substance indicators, but it looks as though they may be exempted, assuming (though this is not clear either) they have a parent company in the same jurisdiction which does meet the criteria. It is even less clear how this would operate if the parent company’s ownership is less than 100%. If majority-owned subsidiaries don’t benefit, there could be a significant issue for coinvestment structures where it is fairly common for coinvestors to take a minority stake in these lower-tier holding companies.

Other exemptions that may apply are for regulated entities, including AIFs and certain securitisation companies, for companies with listed securities, and for companies with at least five FTE employees engaged in the business. Some companies may also take the view that they do not meet the outsourcing condition which is one of the gateways to the legislation - this requires that the company has outsourced both the administration of day-to-day operations and the decision making on significant functions. Exemption or falling outside the scope of the rules is likely to be preferable to falling within them but meeting the substance requirements, because entities in the latter position will still need to report and have their information exchanged.

It may turn out that those private equity managers that have already devoted time and resource to establishing an EU platform for holding investments could find the new rules helpful because, for the first time in the long-running debate on substance and holding companies, there would be a bright line test and companies on the right side of that line may gain a level of certainty that has been missing so far.

It does, however, remain to be seen how these rules will interact with rules that are already in place in this area. If a holding company meets these substance requirements or is exempt, might the underlying jurisdiction still look to other anti-avoidance provisions to deny treaty or directive entitlement? Technically the Directive supplements rather than replaces those other rules.

On the other hand, some managers are likely to be deterred from EU holding companies altogether by the minimum requirements of the directive, for example UK or US-based managers that may not yet have established an EU holding platform. Those managers are likely to consider instead non-EU alternatives, with the UK, and in particular the new UK asset holding company, likely to feature prominently in their thoughts.

Care will be needed as the Commission has already announced that it plans to follow up ATAD 3 with a further proposal aimed at non-EU shell companies. In any case, existing anti-avoidance provisions mean that it is unlikely in practice that a non-EU holding company with a lower level of substance that that prescribed for ATAD 3 will fare better for EU investments than an EU holding company in the same position.

Managers need to approach the holding company question from the starting point of where the key decision makers for the holding company are, or will be, located rather than which jurisdiction gives the best tax result.

The draft directive is currently open for consultation and hopefully some of the uncertainties mentioned above will be resolved.