On December 22, 2021, the European Commission published a proposal for a Directive “laying down rules to prevent the misuse of shell entities for improper tax purposes and amending Directive 2011/16/EU.” This Directive is also referred to as the ATAD 3 Directive.
The Directive introduces reporting requirements for EU tax-resident companies – irrespective of their legal form – with certain mobile and passive income streams and inadequate operational substance. In certain cases of inadequate substance, the benefits of tax treaties and EU Directives may be denied, resulting in an increased withholding tax burden as well as potential penalties for failure to report or incorrect reporting.
Once the rules are adopted, EU Member States will need to implement the proposed measures into their domestic tax legislation by June 30, 2023 and apply them by January 1, 2024. It is important to note that, in order to determine if a company falls within the scope of the Directive, a two-year look-back rule shall be applied. Therefore, the company’s position as of January 1, 2022 may already be a reference point, and entities may want to consider appropriate actions on a current basis. Moreover, companies may need to anticipate necessary operational changes.
We expect that, in particular, companies that have engaged third-party service providers to act as external directors for their EU tax-resident companies may be impacted by these new rules. The investment funds industry may be especially affected, despite the specific carveout available, which does not apply to intermediate holding companies held directly or indirectly by an investment fund. Other multinationals may also fall within the scope of these newly proposed rules.
Prudent companies will review their corporate structure in the EU to align their operations with these new substance requirements ahead of time.
The reporting process and accompanying implications are outlined below:
Step 1: Determine if a company in the EU is required to report
A company in the EU is required to report in case:
- More than 75 percent of the revenues of the company in the preceding two tax years is relevant income (defined in the Directive as, typically, mobile or passive income)
- The company is engaged in cross-border activity and
- In the preceding two tax years, the company outsourced the administration of day-to-day operations and decision-making on significant functions.
There is a number of specific exclusions to the above rule, most notably (i) certain regulated financial companies (including the aforementioned investment funds’ carveout), (ii) companies with transferable securities listed on a regulated market and (iii) companies with at least five full-time employees carrying out the activities which generate the relevant income.
A company that meets the above criteria may, however, request an exemption from its reporting obligation if it can provide evidence that its existence does not reduce the tax liability of the beneficial owner(s) or of its group. This exemption is granted for one year and can be extended up to five years.
Step 2: Reporting requirement
Companies in the EU that are required to report must declare in their tax return (ie, self-assessment) whether they meet certain minimum substance requirements:
- The company has an office space or exclusive use of an office space
- The company has at least one active bank account in the EU and
- The company meets one of the following two indicators:
- At least one director of the company:
- Is resident of or lives close to the jurisdiction of the company
- Is qualified and authorized to make relevant decisions
- Actively, independently and on a regular basis, takes use of their authorization and
- Is not an employee of an unrelated party and is not a director of any other unrelated company.
- The majority of the company’s employees are resident or live close to the jurisdiction of the company, and those employees are qualified to carry out the income-generating activities.
- At least one director of the company:
A company may still rebut the presumption of inadequate substance based on substantiating the business rationale of its activities within the Member State. The burden of proof in the rebuttal process is with the company and subject to an assessment by the tax authorities.
Step 3: Consequences of not meeting the substance requirements
If an EU tax-resident company is presumed to have inadequate substance based on its self-assessed reporting or a failed rebuttal process, the following consequences shall kick in:
- Other Member States will disregard application of tax treaties and disregard the application of the Parent-Subsidiary and Interest and Royalties Directives in relation to transactions with the reporting company. The relevant Member State may nonetheless allow benefits under domestic law or tax treaties to apply in relation to the shareholder of the reporting company (ie, look-through treatment)
- If the reporting company has an EU shareholder, the EU jurisdiction of the shareholder will tax the relevant income of the reporting company as if it had accrued to them directly, according to its national rules, with a credit for taxes paid at the level of the reporting company, and
- The reporting company will, in principle, no longer receive a certificate of tax residency, or the respective tax authority will issue an amended tax residency certificate indicating that the reporting company is no longer entitled to benefits of treaty or relevant EU Directives.
Step 4: Exchange of information, penalties and tax audits
There will be a central databank accessible to all Member States with information related to all EU companies that are considered reporting companies and which are required to report in their tax return.
Member States may introduce penalties up to five percent of the annual revenues for companies that fail to report or file incorrect reports (ie, self-assessment).
Finally, Member States may request other Member States to initiate a tax audit if they suspect an EU company to be uncompliant with the provisions of the Directive.