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EU draft Directive to tackle “shell entities”: ATAD III or the European “Magnificent Seven”-step approach

31/01/2022

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Belgium

On 22 December 2021, the European Commission published one of its most ambitious and far-reaching draft directives known as the ATAD III directive. This proposal aims to tackle the misuse of entities with limited substance that are interposed in group structures to benefit from EU-reliefs on interests, royalties, and dividends streams.
 
To that end, the draft directive proposes the introduction of an EU-wide minimum substance test, allowing member states to identify entities that are misused for tax purposes (the so-called shell entities) and exclude them from EU directives’ tax reliefs on dividends, royalties, and interests (based on the parent-subsidiary directive and the interest-royalty directive).

Moreover, the draft directive provides for reporting obligations for taxpayers and an extensive exchange of information between member states.

Soon to enter the negotiation phase between member states (unanimity is in principle required), the draft directive's proposed entry into force is 1 January 2024 in all member states. 

As the expected impacts on EU investment structures (e.g. foreign private equity investors investing in Belgium through special purpose vehicles located in the UK or Luxembourg) or multinational groups—including EU holdings—are substantial, it is strongly recommended to rapidly assess whether ATAD III may affect existing group structures and, if needed, act to circumvent potential adverse consequences.  

This Newsflash is based on our article published for MNE Tax.

Shell entities’ identification: a seven-step approach

For any entity that is resident for corporate income tax purposes in a member state and engaged in an economic activity (regardless of its legal form), a seven-step approach is foreseen to identify whether it can qualify as a shell entity. These steps are summarized below.

Step 1: Gateway criteria

To fall within the scope of this new reporting obligation, the entity must (cumulatively):
  • in the last two years, earn passive income (e.g. interests, royalties, dividends, or income from real estate property) for more than 75% of its total income;
  • be engaged in cross-borders activities;
  • outsource administration related to day-to-day operations and the decision-making on significant functions; and
  • not fall into one of the excluded entities exceptions.
Excluded entities are the following: regulated financial entities; securitization entities; entities employing at least five FTEs employees or members of staff; holding entities having the main activity of holding shares in operational business and located in the same member state as their beneficial owners; or holding entities located in the same member state as their shareholders or ultimate parent.

Step 2: Annual reporting requirement

Entities meeting all gateway criteria without being excluded from the scope of ATAD III would be subject to a specific reporting obligation. They would have to report information and “satisfactory documentary evidence” on substance in their annual corporate income tax return.

Reported information would relate to specific substance indicators (corresponding to common indicators used in the relevant international tax case law), e.g. whether the entity has its own premises or bank account(s); whether the entity’s director(s) is(are) tax resident(s) in or close to its state or residence; and whether the entity’s director(s) is(are) qualified and authorised to actively take independent decisions.

Step 3: Rebuttable presumption

Entities that are lacking at least one substance indicator are presumed to qualify as a shell entity for the purposes of the draft directive.

Step 4: Rebuttal of presumption

Entities that are presumed shell entities following step three, may rebut the presumption by providing any additional supporting evidence of the business activities they perform to generate passive income.

At this stage, the additional information should show the following: commercial reasons for setting-up an entity with a low level of substance; employees’ profiles, level of experience, decision-making power, qualifications, etc.; and concrete evidence that the decision-making power is located in the entity’s state of residence.

Step 5: Exemption

Entities that are not meeting the minimum substance test still may be exempt from the shell entity- consequences if they demonstrate that their existence does not reduce the tax liability of the beneficial owner(s) or of the group, they are part of, as a whole.

Local tax authorities can grant this exemption for a maximum of six years (one year extended with a maximum of five years).

Step 6: Tax consequences

Identification as a shell entity may lead to multiple detrimental tax consequences, such as the denial of issuance of certificates of tax residence allowing the shell entity to benefit from income tax treaties or the relevant EU (parent-subsidiary and interest-royalty) directives’ tax reliefs, or taxation of the shell entity’s relevant income at the level of the shareholder (CFC-like rule).

Moreover, the shell entity’s state of residence still would be able to tax this entity accordingly.

It is striking that the draft directive does not include any measures to prevent double taxation, whereas prevention of double taxation was exactly the purpose of the parent-subsidiary and interest-royalty directives.

Member states would apply an additional penalty applicable to infringements of the local implementation of this draft directive that includes an administrative sanction of at least 5% of the shell entity’s turnover.  

Step 7: Exchange of information

All the information that has been collected for entities that have met step one’s gateway criteria (entities at risk) would be automatically exchanged among member states through a centralised exchange facility. This also means that if one member state decides to accept a rebuttal of the presumption of step three, the reasons (and supporting information) of such a rebuttal also would be exchanged with other member states. This peer exchange and monitoring system would probably not lead to a lenient interpretation of the satisfactory character of additional information provided.  

Final consideration

If adopted, the directive would have to be transposed at the national level by 30 June 2023, and would enter into force on 1 January 2024.

As this directive would definitely increase the tax authorities’ attention to the international concept of substance, more than ever, it is crucial for multinational groups to engage in a review of their structure, or, for foreign investors, to rethink their typical investment structures to increase the substance or even relocate their investment vehicles. As the case may be, it is definitely time to take action to prevent any adverse tax consequences resulting from this game-changing European Magnificent Seven-step approach.
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In case of questions, please do not hesitate to contact the Belgian tax team of Fieldfisher.

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