The European Commission proposes a new directive to prevent misuse of shell entities in the EU

Entities in scope: The proposed rules will apply to all entities engaged in economic activity, in any legal form, that are deemed to be tax resident in an EU member state. No minimum threshold in terms of turnover exists.

Gateway: An entity that crosses a gateway without being covered by an explicit exclusion is considered a “risk case”. The assessment is based on three indicative substance conditions usually identified in companies that lack substance, including i.a. whether the entity has a certain share of passive income earned or paid via cross border transactions. The criteria are cumulative, implying that if at least one of the conditions is not met the company will be deemed a low-risk entity.

Risk cases: A company deemed as a risk case is obliged to include certain information on substance indicators in its annual tax return. An entity that fails to report this within the prescribed deadline or provides incorrect information risks an administrative pecuniary sanction of at least 5% of the company’s turnover in the relevant tax year.

Low-risk cases: No reporting obligation exists for entities that do not cross the gateway.

Substance indicators: A company deemed as a risk case must include information on certain substance indicators in its tax return, i.a. whether the company has its own premises or premises for exclusive use in the member state, if it has at least one own and active bank account in the EU and details concerning the tax residency of its directors and (if applicable) its employees. Documentary evidence supporting the information provided must be enclosed with the tax return. If all substance requirements are met, the entity will be presumed to have sufficient substance for the relevant year. If not, the company will be presumed to be a shell entity.

Rebuttal: An entity deemed as a shell company has the right to rebut the presumption by providing sufficient evidence for e.g. the commercial rationale behind the establishment of the structure.

Exemption: A company that can prove that the establishment of a structure does not lead to a tax benefit for its beneficial owner(s) or the group as a whole, i.e. does not reduce the effective tax liability, can request an exemption from the reporting obligation from the tax authority in the member state where it is tax resident. This exemption may be granted for one year, with a possibly of extension to five years. Entities listed on a regulated market, certain financial companies and entities having at least five full-time employees or its beneficial owner being tax resident in the same member state (“domestic” holding companies) are also excluded from the reporting obligation.

Consequences for shell entities: A company deemed as a shell entity that is unable to rebut the presumption will be denied tax benefits according to tax treaties between EU member states as well as the parent-subsidiary and interest and royalties directives.

Consequences for EU shareholders of shell entities: If the shell company has an EU shareholder, the EU jurisdiction of the shareholder will tax the relevant income of the shell entity as if it had accrued to the shareholder directly, according to its national rules, with a deduction for any taxes paid at the level of the shell entity.

Next steps: Member states will need to unanimously agree on the draft text of the proposed directive in the Council of Europe under the special legislative procedure. Once the text of the directive has been agreed, member states will be required to implement the directive into their domestic legislations by 30 June 2023 and to apply the directive as from 1 January 2024. The proposed directive is a minimum directive, meaning that Sweden as well as other member states, can introduce stricter rules.

Looking at the gateway to determine if a company is required to report, circumstances in the preceding two tax years is of relevance. This means that circumstances from 1 January 2022 and onwards can affect the potential reporting obligation.

Our view: The directive is expected to prevent the misuse of shell entities within the EU. The cost for this will, however, be an increased administrative burden and complexity for European taxpayers in general and an associated risk for high administrative fees in case of non-compliance with the reporting obligations. In our view, it can be questioned whether it is reasonable to levy administrative penalties for a failure to report mere risk cases that are not deemed shell entities in the end.

In addition to the administrative burden, is there a risk that the directive will lead to double taxation? An individual is for example a resident in Sweden. The individual owns a Cypriot company deemed as a shell entity according to the directive. The Cypriot company owns shares in an underlying investment in a UK company. If the individual is taxed for dividends from the UK company to the Cypriot company as if it had accrued to the shareholder directly, will the shareholder still be taxed for dividends from Cypriot company to the individual and how will the double taxation in such case be mitigated? The income can in some situations e.g., be deemed as another type of income and the transactions can also take place in different years.

If an entity can prove that the establishment of a structure does not lead to a tax benefit, the proposed directive states that an exemption from the reporting may be granted by the relevant tax authority. It is however not stated that an exemption shall be granted if the entity can prove that no tax benefit is obtained. Given the suggested wording it may be difficult for entities to rely on this exemption, which may in practice lead to an increased reporting obligation also for entities fulfilling this exemption.

It remains to be seen how the final rules will be phrased and how they will apply in practice, but there is certainly a need for clarification of some parts. Deloitte follows the development and the continued discussions among the member states.

Please get in touch with one of us if you would like to discuss what this development might mean for you.

For further information please also refer to this article provided by Deloitte Luxembourg.