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Proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU (the “ATAD3”) The new challenge ahead

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The European Commission has proposed a directive for laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU (the “Proposal”). Furthermore, the Proposal will allow Member States to accurately describe and quantify the extent of shell entity tax abuse in the EU. Ultimately, the Proposal should further discourage the creation of entities that do not perform any actual economic activity in the EU, also referred to as “shell entities”.

The said Proposal lays down indicators of minimum substance for undertakings in Member States and rules regarding the treatment for tax purposes of those undertakings that do not meet the indicators. The Proposal is aimed at legal entities, irrespective of their legal form, who are tax residents in the European Union and are involved in cross-border activities and may claim benefits under double tax treaties and other Directives issued by the European Commission.

In this Article we provide a brief summary of the proposed directive and the requirements of the identification of an undertaking that does not meet indicators of minimum substance for tax purposes along with the tax treatment adopted for such undertaking.

To ease the reader, we are quoting directly from the Proposal the following definitions in order to have a better understanding of the technical terms used:

“Undertaking” means any entity engaged in an economic activity, regardless of its legal form, that is a tax resident in a Member State;

“Undertaking’s shareholders” means the individuals or entities directly holding shares, interest, stakes, participations, membership rights, entitlement to benefits or any equivalent rights or entitlements in the undertaking and in the case of indirect holdings, those individuals or entities holding interest in the undertaking through one or a chain of undertakings none of which fulfils the indicators of minimum substance as further shown below;

“Relevant Income” shall mean income falling under any of the following categories:

(a)    interest or any other income generated from financial assets, including crypto assets;

(b)    royalties or any other income generated from intellectual or intangible property or tradable permits;

(c)    dividends and income from the disposal of shares;

(d)    income from financial leasing;

(e)    income from immovable property;

(f)     income from movable property, other than cash, shares or securities, held for private purposes and with a book value of more than One Million Euros;

(g)    income from insurance, banking and other financial activities;

(h)    income from services which the undertaking has outsourced to other associated enterprises.

  1. The Reporting Undertakings

1.1. Member States shall require that undertakings meeting the following criteria report to the competent authorities of Member States in accordance with the indicators of minimum substance for tax purposes as mentioned further below:

(a)    More than 75% of the revenues accruing to the undertaking in the preceding two tax years is Relevant Income;

(b)    The undertaking is engaged in cross-border activity on any of the following grounds:

                                               i.      more than 60% of the book value of the undertaking’s assets that fall within the scope of Relevant Income points (e) and (f), was located outside the Member State of the undertaking in the preceding two tax years;

                                                ii.      at least 60% of the undertaking’s Relevant Income is earned or paid out via cross-border transactions;

(c)     In the preceding two tax years, the undertaking outsourced the administration of day-to-day operations and the decision-making on significant functions.

An undertaking which holds assets that can generate income falling within the scope of Relevant Income, points (e) and (f), shall also be deemed to meet the criterion set out in point 1.1 (a), irrespective of whether income from these assets has accrued to the undertaking in the preceding two tax years, if the book value of these assets is more than 75% of the total book value of the undertaking’s assets.

An undertaking which holds assets that can generate income falling within the scope of Relevant Income, point (c), shall also be deemed to meet the criterion set out in point 1.1(a), irrespective of whether income from these assets has accrued to the undertaking in the preceding two tax years, if the book value of these assets is more than 75% of the total book value of the assets of the undertaking.

1.2. The Proposal provides a derogation from the above paragraph where the following categories are not subject to minimum substance for tax purposes:

(a)    companies which have a transferable security admitted to trading or listed on a regulated market or multilateral trading facility as defined under Directive 2014/65/EU of the European Parliament and of the Council;

(b)    regulated financial undertakings;

(c)   undertakings that have the main activity of holding shares in operational businesses in the same Member State while their beneficial owners are also resident for tax purposes in the same Member State;

(d)    undertakings with holding activities that are resident for tax purposes in the same Member State as the undertaking’s shareholder(s) or the ultimate parent entity;

(e)   undertakings with at least five own full-time equivalent employees or members of staff exclusively carrying out the activities generating the Relevant Income.

  1. Indicators of minimum substance for tax purposes

2.1. Member States shall require that undertakings meeting the criteria laid down in the Reporting Undertakings mentioned above declare in their annual tax return, for each tax year, whether they meet the following indicators of Minimum Substance:

(a)    the undertaking has its own premises in the Member State, or premises for its exclusive use;

(b)    the undertaking has at least one own and active bank account in the Union;

(c)    one of the following indicators:

  1. One or more directors of the undertaking:
  2. 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;
  3. 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;
  4. actively and independently use the authorisation referred to in point (2) on a regular basis;
  5. are not employees of an enterprise that is not an associated enterprise and do not perform the function of director or equivalent in 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.

2.2. Undertakings referred to in paragraph 2.1 shall accompany their tax return declaration with documentary evidence. The documentary evidence shall include the following information:

(a)    address and type of premises;

(b)    amount of gross revenue and type thereof;

(c)    amount of business expenses and type thereof;

(d)    type of business activities performed to generate the relevant income;

(e)   the number of directors, their qualifications, authorisations and place of residence for tax purposes or the number of full-time equivalent employees performing the business activities that generate the Relevant Income and their qualifications, their place of residence for tax purposes;

(f)     outsourced business activities;

(g)    bank account number, any mandates granted to access the bank account and to use or issue payment instructions and evidence of the account’s activity.

  1. Tax consequences of not having Minimum Substance for tax purposes in Member States other than the Member State of the undertaking

3.1. Member States other than the Member State of the undertaking shall disregard any agreements and conventions that provide for the elimination of double taxation of income, and where applicable, capital, in force with the Member State of the undertaking as well as Articles 4, 5 and 6 of Directive 2011/96/EU and Article 1 of Directive 2003/49/EC, to the extent that those Directives apply due to the undertaking being deemed to be resident for tax purposes in a Member State, where the following conditions are met:

(a)    an undertaking is presumed not to have Minimum Substance;

(b)    an undertaking does not rebut the presumption referred to in point (a) for a tax year.

3.2. The Member State of the undertaking’s shareholder(s) shall tax the relevant income of the undertaking in accordance with its national law as if it had directly accrued to the undertaking’s shareholder(s) and deduct any tax paid on such income at the Member State of the undertaking, where the following conditions are met:

(a)    the relevant income accrues to an undertaking that is presumed not to have Minimum Substance;

(b)    the undertaking does not rebut the presumption referred to in point (a);

(c)     both the undertaking’s shareholders and the payer are resident for tax purposes in a Member State.

The first subparagraph shall apply notwithstanding any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force within another Member State.

Where the payer is not resident for tax purposes in a Member State, the Member State of the undertaking’s shareholder(s) shall tax the relevant income accruing to the undertaking in accordance with its national law as if it had directly accrued to the undertaking’s shareholder(s), without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force between the Member State of the undertaking’s shareholders and the third country jurisdiction of the payer.

Where the undertaking’s shareholder(s) is not resident for tax purposes in a Member State, the Member State of the payer of this income shall apply withholding tax in accordance with its national law, without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force within the third country jurisdiction of the undertaking’s shareholder(s).

3.3. Where property is owned by an undertaking that is presumed not to have Minimum Substance and does not rebut this presumption:

(a)    the Member State where property is situated shall tax such property according to its national law, as if such property was owned directly by the undertaking’s shareholder(s), without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force within the jurisdiction of the undertaking’s shareholder(s);

(b)    the Member State of the undertaking’s shareholder(s) shall tax such property in accordance with its national law as if the undertaking’s shareholder(s) owned it directly, without prejudice to any agreement or convention that provides for the elimination of double taxation of income, and where applicable, capital, in force within the jurisdiction where the property is situated.

  1. Tax consequences of not having Minimum Substance for tax purposes in the Member State of the undertaking

4.1. Where an undertaking does not have Minimum Substance for tax purposes in the Member State where it is resident for tax purposes, that Member State shall take any of the following decisions:

(a)    deny a request for a certificate of tax residence to the undertaking for use outside the jurisdiction of this Member State;

(b)   grant a certificate of tax residence which prescribes that the undertaking is not entitled to the benefits of agreements and conventions that provide for the elimination of double taxation of income, and where applicable, capital, and of international agreements with a similar purpose or effect and of Articles 4, 5 and 6 of Directive 2011/96/EU and Article 1 of Directive 2003/49/EC.

If the proposed directive is implemented in its current form it could significantly affect Administration Service Providers (“ASPs”) as they will not be able to provide multiple directorship services. As per the provisions of the Proposal, to show Minimum Substance, independent directors must hold only one directorship and must be residents close to the undertaking. This raises concerns as it could be argued that the Proposal is contrary to the Companies’ Law CAP 113 which permits directors to be appointed and perform their functions and exercise their duties to more than one entity.

The proposed directive will be entered into force on 1st January 2024, but it is worth noting that there is a two years reference period (1st January 2022 – 31st December 2023). Therefore, undertakings operating legitimately at this point could already be inadvertently falling within the scope of the proposed directive when/if it is implemented in 2024.

The content of this article is valid as at the date of its first publication. It is intended to provide a general guide to the subject matter and does not constitute legal advice. We recommend that you seek professional advice on your specific matter before acting on any information provided. For further information or advice, please contact Stephanos Ayiomamitis, Senior Associate at the Limassol Office, Tel +357 25363685 or email stephanos.ayiomamitis@kyprianou.com