Insight

ATAD 3: How to come prepared

Shell

On 22 December 2021, the European Commission published a legislative proposal for a Directive – known as ATAD 3 – which sets forth rules to prevent the misuse of shell entities for tax purposes. In this article, we provide an overview of the proposed Directive and the steps that would need be followed for entities tax resident in the European Union.

Globally, economic substance has become more and more important for entities from a legal and tax perspective. It is relevant to the application of national tax laws and double tax treaties and avoids the application of national anti-abuse rules. And substance comes in many forms: taxpayers are required to maintain significant assets, employees and functions, assume risks, and use and enjoy the income received within a jurisdiction in order to be entitled to the benefits of certain double tax treaties and EU tax Directives.

ATAD 3 aims to introduce an EU-wide “substance test,” including a reporting obligation for taxpayers, to assist Member States in identifying entities that are engaged in an economic activity but which do not meet minimum substance requirements and, in the view of the Commission, are misused for the purpose of obtaining tax advantages (referred to as shell companies).

The Commission proposes to attach consequences to the qualification of an entity as a shell company for tax purposes. It also envisages automatic exchange of information by amending the Directive on administrative cooperation in the field of taxation (Directive 2011/16/EU, or DAC).

Seven steps to compliance

With the draft Directive, the Commission has proposed a seven-step approach for companies to follow in order to meet the requirements of ATAD 3. This step plan should be followed for each entity that is resident for corporate income tax purposes in an EU Member State.

Within this process, the Commission proposes that the tax authorities in the Member State where the entity is tax resident shall assess the information provided by the entity.

Expand the following sections to discover what’s involved in each step:

Step 1: Gateway

The first step entails three cumulative “gateway” criteria. An entity passes the gateway if it:

1. Engages in cross-border activities

This criterion contains an asset test and an income test (detailed below). Only one test needs to be met in order to qualify under the gateway criteria.

Asset test – If more than 60% of the book value of certain assets held by the taxpayer (such as immovable property) is located outside the Member State of residence, the asset test is met.

Income test – If more than 60% of the entity’s “relevant income” is derived from abroad, the income test is met. Such relevant income generally consists of passive income such as interest and other financial income including crypto assets, royalties, dividends and other share income, and income from leasing, insurance and immovable property.

2. Which are geographically mobile

This criterion would be generally met if more than 75% of the entity’s income in the preceding two years qualifies as relevant income.

3. Has (partly) outsourced its own administration

The draft Directive does not elaborate the requirements of this criterion. Based on the explanatory memorandum enclosed with the draft Directive it seems this criterion specifically targets entities that have outsourced their administration to professional third party service providers.

The first step includes several carve-outs and exceptions, for example for listed entities, specific regulated financial entities, certain holding entities of operational businesses in the same Member State, and entities with at least five full-time equivalent employees exclusively carrying out the activities generating the relevant income.

If no exception applies and the gateway criteria 1-3 are met, an entity is considered to be at risk for the purposes of ATAD 3 and a reporting obligation arises.

Step 2: Reporting

Each entity considered at risk under Step 1 must report on substance in its tax return. In short, the entity is obliged to confirm whether the following cumulative criteria are met and provide documentation in support of its position:

  • The entity has premises available for its exclusive use
  • The entity has at least one bank account in the EU
  • The entity has at least one director and/or the majority of relevant employees resident close to its activities.

Step 3: Shell company

An entity considered at risk under Step 1 that does not meet the three criteria under Step 2 is considered a “shell company,” in scope of the draft Directive.

Steps 4 and 5: Counter proof qualification

Step 4 provides an entity considered to be a shell company under Step 3 with two opportunities to counter-prove this presumption:

  1. The entity substantiates that it conducts a genuine economic activity and is therefore not a shell company (in spite of it not meeting the criteria under Step 2)
  2. The entity substantiates that it does not create a tax benefit. In such cases, despite the entity having low substance, it is considered out of scope of the draft Directive given ATAD 3’s focus on preventing the granting of tax benefits through the use of low-substance companies.

Step 6: Tax consequences

The Commission proposes a number of tax consequences for a shell company that fails to counter-prove the presumption under Steps 4 and 5. Firstly, the entity’s Member State of residence should either deny it the granting of a tax residency certificate or only provide a tax residency certificate with a warning statement.

Secondly, other Member States should effectively disregard such a shell company in relation to relevant tax treaties between Member States and tax Directives (for example the Interest and Royalty Directive). This means that no benefits should be provided.

What’s more, a “look through” approach is applied, taking into account the beneficial owner of the shell company (which may result in a (partial) reduction of the tax benefit obtained through the shell company, e.g. lower withholding tax on interest or dividends). This approach should also be applied where a Member State is the state of the beneficial owner.

Step 7: Information exchange

As a final step, the Commission proposes that all Member States shall have access to information on any entities considered at risk under Step 1, even if such entities meet any of the exceptions in the subsequent steps. This information will be exchanged automatically. Furthermore, a Member State would be able to request another Member State to audit a tax resident entity if the former suspects that this entity lacks minimal substance.

Penalties

Although the draft Directive leaves it to Member States to establish penalties, a minimum penalty for non-compliance is provided: at least 5% of the entity’s turnover.

What happens next?

The draft Directive will now move to the negotiation phase among Member States with the aim of reaching a final agreement. In the EU, adoption of tax legislation generally requires unanimity between all 27 Member States. The Commission proposes that the Member States shall transpose the Directive into their national laws by 30 June 2023 for the rules to come into effect as of 1 January 2024.

Although the initiative is only aimed at certain low-substance shell companies, implementation of the draft Directive would lead to additional compliance obligations for many structures and taxpayers. The proposal also has significant compliance implications for tax authorities in the EU Member States. Since the current proposal raises numerous questions, we expect that the draft Directive will be subject to change during the negotiation process.

IQ-EQ is here to help

While it is not yet known whether Member States will embrace the Commission’s initiative in full, at IQ-EQ we strive to stay one step ahead and ensure our clients are fully prepared for any potential changes and new compliance requirements.

We will be working closely with our clients in the coming months to conduct entity ‘health checks’ to identify any that may be impacted by ATAD 3. This will be followed by a thorough impact analysis where applicable, and close collaboration with local tax counsel on necessary follow-up actions.

To discuss how IQ-EQ could support you or your clients with ATAD 3 compliance, please don’t hesitate to contact me.

 

This article is provided for information purposes only and does not constitute legal, tax or other professional advice.