The Shell Companies Directive: Un-shelling misuse of shell entities for improper tax purposes and implementing the Substance Test
Executive Vice-President for an Economy that Works for People, Valdis Dombrovskis, stated: “Shell companies continue to offer criminals an easy opportunity to abuse tax obligations. We have seen too many scandals arising from misuses of shell companies over the years.”
On December 22, 2021, the European Commission presented a proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and other crimes such as money laundering or financing of terrorism. The directive intends to curb the misuse of shell or letterbox companies. The directive outlined a number of objective indicators related to income, staff and premises, and other substance requirements the proposal will help national tax authorities detect entities that exist merely on paper.
The directive lists down certain derogations on the inapplicability of certain reporting requirements, to certain regulated financial undertakings, such as insurance companies, credit institutions and fund managers.
The Substance Test proposed has three substance indicators.
– The first indicator looks at the activities of the entities based on the income they receive. The gateway is met if more than 75 per cent of an entity’s overall revenue in the previous two tax years does not derive from the entity’s trading activity or if more than 75 per cent of its assets are real estate property or other private property of particularly high value.
– The second indicator requires a cross-border element. If the company receives the majority of its relevant income through transactions linked to another jurisdiction or passes this relevant income on to other companies situated abroad, the company crosses to the next indicator.
– The third indicator focuses on whether corporate management and administration services are performed in-house or are outsourced.
An entity reaching the three indicators will be required to report information in its tax return related, for example, to the premises of the company, its bank accounts, the tax residency of its directors and that of its employees. All declarations need to be accompanied by supporting evidence.
The directive lays down the following indicators for minimum substance:
1. The entity has own premises in the Member State, or premises for its exclusive use;
2. The entity has at least one own and active bank account in the Union;
3. One of the followingindicators:
(i) One or more directors of the undertaking:
- are resident for tax purposes in the Member State of the undertaking, or at no greater distance from that Member State insofar as such distance is compatible with the proper performance of their duties;
- are qualified and authorised to take decisions in relation to the activities that generate relevant income for the undertaking or in relation to the undertaking’s assets;
- actively and independently use the authorisation referred to in point 2 above on a regular basis;
- are not employees of an enterprise that is not an associated enterprise and do not perform the function of director or equivalent of other enterprises that are not associated enterprises;
(ii) the majority of the full-time equivalent employees of the undertaking are resident for tax purposes in the Member State of the undertaking, or at no greater distance from that Member States insofar as such distance is compatible with the proper performance of their duties, and such employees are qualified to carry out the activities that generate relevant income for the undertaking.
If an entity fails at least one of the substance indicators, it will be presumed to be a ‘shell’ however the presumption is rebuttable.
If a company is deemed a shell company, it will not be able to access tax relief and the benefits of the tax treaty network of its Member State and/or to qualify for the treatment under the Parent-Subsidiary and Interest and Royalties Directives. Moreover, the Member State of residence of the company will either deny the shell company a tax residence certificate or the certificate will specify that the company is a shell.
Moreover, payments to third countries will not be treated as flowing through the shell entity and will be subject to withholding tax at the level of the entity that paid to the shell. Accordingly, inbound payments will be taxed in the state of the shell’s shareholder.
The directive allows exemptions to a Member State to allow an undertaking that meets the criteria to request an exemption from its obligations under the directive if the existence of the undertaking does not reduce the tax liability of its beneficial owner(s) or of the group, as a whole, of which the undertaking is a member.
Once adopted by the member states, the Directive should come into effect on January 1, 2024.
This article has been authored by Dr Franklin Cachia, CSB Group Senior Manager Tax & Regulated Industries. For further details and information he may be contacted at info@csbgroup.com.