On 22 December 2021, the European Commission released a proposed directive which lays down rules to prevent the misuse of so-called “shell” entities for tax purposes in the EU. This is often referred to as the “Unshell initiative."

Its objective is to target cases involving “the setting up of undertakings within the EU which are presumably engaged with an economic activity but that, in reality, do not conduct any economic activities”. Its aim is capturing all undertakings and legal arrangements that can be considered or deemed to be considered as tax resident in a member state and are eligible to receive a tax residency certificate in a member state. This is done by outlining a “substance test” (not quite “boots on the ground” but not a million miles away either), imposing additional tax compliance obligations on taxpayers, providing for sanctions, and extending the scope of automatic exchange of information between member states. So not an inconsequential list of consequences right there. The directive talks about “undertakings” which is any entity engaged in an economic activity, but I’ll just refer to companies here.

The draft, once unanimously adopted by member states as a directive, would be required to be transposed into domestic legislation by 30 June 2023 and applying 1 January 2024.

This draft directive adopts three “gateway” criteria and where a company trespasses all three then it will be required to annually report certain information to the tax authorities in its tax return. The first gateway is met if more than 75% of the company’s revenue in the preceding two tax years is “relevant income”. That new-fangled term includes certain interest, royalties, dividends, rental income, income from financial leasing, income from certain property, other than cash, shares, or securities, held for private purposes and with a book value exceeding €1 million, income from insurance, banking, and other financial activities; and income from services outsourced by the undertaking to other associated enterprises.

The second gateway requires a cross-border element. If the company receives the majority of its relevant income through transactions with another country or passes this relevant income on to other companies situated abroad, the company would trespass this gateway.

The third gateway focuses on whether corporate management and administration services are performed in-house or are outsourced. This gateway would be trespassed if in the preceding two tax years, the undertaking outsourced the administration of day-to-day operations and the decision-making on significant functions. Like “relevant income”, the lookback period is important given that if the directive were to get off the ground in 2024 then that lookback period may have already started.

Certain types of undertaking are explicitly excluded from the reporting obligations e.g. certain listed companies, certain regulated financial undertakings as well as companies with at least five own full-time equivalent staff exclusively carrying out the activities generating the relevant income.

An undertaking trespassing all three gateways (and not covered by the exclusions) would be required to report certain information in its annual tax return on whether it meets the minimum substance requirements. These are detailed in the draft directive and include whether the company has either exclusive use of premises in the member state; the company has at least one own and active bank account in the EU together with certain criteria for its directors and employees.

Companies required to report would have to substantiate the minimum substance indicators with certain documentary evidence. Where all the substance requirements are met, the reporting company is presumed to have sufficient substance for the relevant year otherwise, it’s presumed not to have sufficient substance. However, this presumption can be rebutted by providing certain specified additional supporting evidence of the business activities which the company performs to generate relevant income, including detailed information about the commercial, non-tax reason for establishing the company, profiles of employees, and proof that decision-making takes place in the member state of tax residence.

A member state must allow a company trespassing the gateway test to request an exemption from its obligations under the draft directive if the existence of the undertaking does not reduce the tax liability of its beneficial owners or of the group as a whole.

Where a company is presumed not to have minimum substance and is unable successfully to rebut the presumption, the company’s member state of residence would be required to (1) Deny any request by the undertaking for a certificate of residence for use outside the jurisdiction of the member state; or (2) Grant a certificate of residence which specifies that the undertaking is not entitled to the benefits of double tax agreements or conventions and certain aspects of the parent-subsidiary directive and the interest and royalties directive). These agreements generally provide detail on where the income is to be taxed and reduce certain withholding tax rates.

Further, member states other than the company’s state of residence would be required to disregard any double tax agreements with the member state of the undertaking as well as the parent-subsidiary and interest and royalties directives (to the extent that those directives apply owing to the company being resident for tax purposes in a member state).

The member state of the company’s shareholders would tax the company’s relevant income in accordance with its laws and deduct any tax paid on such income in the company’s member state. Where the payer is not resident in a member state, the member state of the company’s shareholders would tax the relevant income in accordance with its domestic law without prejudice to any agreement or convention in force between the member state of the shareholders and the third country jurisdiction.

Where the company’s shareholders are not resident for tax purposes in an EU member state, the income payer’s member state would apply withholding tax in accordance with its domestic law, without prejudice to any agreement or convention in force between the member state of the payer and the third country jurisdiction of the shareholders.

Besides the tax consequences, the information on all entities in scope of the reporting obligation under the directive would be exchanged automatically between EU member states' tax authorities, regardless of whether or not these entities were able to rebut the presumption and whether or not they benefit from the exemption. So staying on the right side of this directive is important.

Please note this article first featured in the Business Post on 13 February 2022 and was re-published kindly with their permission on our website.