On December 22, 2021 the European Commission has published a proposal for a Directive that is laying down rules to prevent the misuse of shell entities for tax purposes (“ATAD3”). The ATAD3 Directive introduces substance requirements for certain tax resident companies of the EU, where not meeting these substance requirements could result in an exposure to (additional) taxation. In this update we provide you with the key features of the ATAD3 Directive.

1. Background, Object and Purpose

In their communication of May 18, 2021 the European Commission announced measures to promote a more robust, efficient and fair business tax system in the European Union, also setting out both a long-term and short-term vision to support Europe’s recovery from the COVID-19 pandemic. The draft ATAD3 Directive should contribute to the short-term objective as a means to improve the current tax system with a focus on ensuring fair and effective taxation.

In light of this objective it has been acknowledged that there is a risk that legal entities with no or minimal substance and economic activity (“shell companies”) are used for improper tax purposes, such as tax evasion and avoidance. While there can be valid reasons to use such entities, the (mis)use of such entities creates an environment of unfair tax competition and unfair tax burden distribution. It has therefore be deemed necessary to introduce rules with the aim of combating tax avoidance and evasion practices through entities with no or minimal substance and economic activity. These rules are laid down in the draft ATAD3 Directive that introduces substance requirements for EU companies and lays down consequences for companies that do not meet these substance requirements.

2. ATAD3 in a nutshell

The ATAD3 Directive introduces a system whereby qualifying EU companies that are receiving relevant income should meet a series of substance requirements. Consequently these EU companies have to demonstrate that these substance requirements are met by providing documentation to the respective tax authorities along with their corporate income tax return proving that the substance requirements have been met. Where these substance requirements are not met additional (withholding) taxes may be due. Where a qualifying EU company has to provide information to the local tax authorities, this information will be exchanged with all other EU Member States. Non-compliance with the measures of ATAD3 will be penalized with administrative pecuniary penalties. In the following sections we will highlight the most important features of the ATAD3 Directive into more detail.

3. Qualifying Entities under ATAD3

Companies that are tax resident of the EU and are eligible to acquire a tax residence certificate from the authorities of the Member State they are residing in, are a Qualifying Entity under ATAD3 if they meet the following three conditions:

  1. More than 75% of their revenues in the preceding two tax years is relevant income (e.g. royalty, dividend, interest, lease income or income from services which the EU company has outsourced to associated entities). This criterion is also deemed met should the book value of the immovable and certain movable assets held for private purposes of the EU company exceed 75% of the total book value of the EU companies assets; and

  2. The EU company is engaged in cross-border activity on any of the following grounds:
    1. more than 60% of the book value of the EU company’s qualifying movable and immovable property was located outside the Member State of the EU company in the preceding two tax years;
    2. at least 60% of the EU company’s relevant income is earned or paid out via cross-border transactions; and
       
  3. In the preceding two tax years, the EU company outsourced the administration of day-to-day operations and the decision-making on significant functions.
     

Where a company is qualifying under the abovementioned three conditions an exemption may still apply if the company is a qualifying exempt entity, or if they can prove that the existence / interposition of the company does not reduces the tax liability of its beneficial owner(s) or of the group as a whole. Examples of exemptions are financial undertakings, undertakings with at least five own full-time equivalent employees exclusively carrying out the activities generating the relevant income, or in case of holding activities whereby the shareholder or ultimate shareholder is resident for tax purposes in the same Member State as the undertaking.

4. Minimum substance requirements

Every Qualifying Entity under ATAD3 should declare in their annual corporate income tax return whether they have met the following minimum substance requirements:

  1. The Qualifying Entity has own premises in the Member State, or premises for its exclusive use;

  2. The Qualifying Entity has at least one own and active bank account in the European Union;

  3. One of the following indicators:
    1. One or more directors of the Qualifying Entity:
      1. Are resident for tax purposes in the Member State of the Qualifying Entity, or are resident at no greater distance from that Member State insofar as such distance is compatible with the proper performance of their duties;
      2. Are qualified and authorized to take decisions in relation to the activities that generate relevant income for the Qualifying Entity or in relation to the Qualifying Entity’s assets;
      3. Actively and independently use the authorization referred to in point ii on a regular basis;
      4. Are not employees of an enterprise that is not an associated enterprise (25% criterium) and do not perform the function of director or equivalent of other enterprises that are not associated enterprises;
    2. The majority of the full-time equivalent employees of the Qualifying Entity are resident for tax purposes in the Member State of the Qualifying Entity, or are resident 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.
       

In addition these Qualifying Entities will be required to provide documentary evidence that these substance requirements are met along with their annual corporate income tax return. This documentary evidence should consists of the following: description of business activities, address and type of premises, type and amount of gross revenue and business expenses, number and qualification of directors, outsourced activities and bank account.

Qualifying Entities that do not meet these minimum substance requirements may still be able to prove that the Qualifying Entity features a minimum level of substance (rebuttal rule), by providing evidence of: a) the commercial rationale behind the establishment of the company, b) information about employees, and c) that the decision-making concerning the relevant income generating activity is taking place in the Member State of the Qualifying Entity.

5. Tax consequences

Where a Qualifying Entity is not meeting the minimum substance requirements and did not successfully rebut this presumption,  various tax consequences may apply. It goes beyond the scope of this tax alert to provide a detailed outline of the tax consequences of all possible scenarios. In general, depending on the situation, the following tax consequences may apply:

  • Tax treaties and EU Directives (PSD & IRD) that provide for the elimination of double taxation may not apply anymore;
  • The relevant income of Qualifying Entities may be included in the taxable income of the EU shareholder of the Qualifying entity, where it will be subject to taxation;
  • The Member State of a Qualifying Entity may be obligated to impose withholding taxes in accordance with their national laws on qualifying payments made by a Qualifying Entity;
  • Income from immovable property may become subject to tax as if the EU shareholder of the Qualifying Entity would own this immovable property directly;
  • The Member State of the Qualifying Entity has the option to not provide a certificate of residence anymore, or to provide a certificate of tax residence that prescribes that the Qualifying Entity is not entitled to the benefits of agreements and tax treaties that provide for the elimination of double taxation of income and part of the PSD and IRD.

Our recommendation

ATAD3 will have a significant impact to Qualifying Entities that have no or minimum substance, which impact could consist of the levying of taxes on transactions that would have normally been exempt from taxation based on an arrangement for the elimination of double taxation or the EU PSD or IRD.

The rules of ATAD3 will in principle enter into force as per January 1, 2024. However, based on the conditions to be a Qualifying Entity under ATAD3 in 2024, the income and outsourcing of administration and day-to-day operations in the “two preceding years” are also relevant to determine whether your company qualifies in 2024 or not. As such, and depending on your business structure and needs, it  might be recommendable to prevent qualifying as a Qualifying Entity by ensuring that in 2022 and/or 2023 these qualifying conditions are not met.

In any case, should the conditions to be a Qualifying Entity be met, still an escape might exist should for example the entity in 2024 employ sufficient fulltime staff or where holding activities are performed in the same member State as the Qualifying Entity’s shareholder, or where an exemption applies, or whereby the minimum substance requirements as outlined in paragraph [4] are met as from 1 January 2024.

This means that ATAD3 may in principle already be relevant to your company as per January 1, 2022. We recommend to assess as soon as possible whether the ATAD3 measures will have adverse consequences for your EU structures and to consequently take adequate measures to mitigate the impact of ATAD3 where such consequences have been identified.