The proposed new EU “Unshell” directive

On 22 December 2021, the European Commission published a number of Directives impacting a wide variety of corporate structures and taxpayers. One of these Directives is “laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU’’, commonly referred to as ATAD3 or the Unshell Directive (see here) (hereinafter also “Directive”).

The Unshell Directive has not yet been accepted by all Member States and is therefore still subject to political debate. There is also some doubt about the feasibility of some of its legal principles.  In the current form, however, the Unshell Directive should be implemented into the national legislation of the EU Member States by 30 June 2023, and come into effect by 1 January 2024.

In essence, the Unshell Directive incurs an increased reporting obligation and a number of tax consequences for in-scope entities. If it is implemented, groups with entities within the scope will need to consider the impact on their reporting and corporate group structures.  We will discuss the potential implications of this Directive on investment holding structures and particular EU jurisdictions in a subsequent article on this Directive.

What does the proposed Directive target?

The draft Directive aims to identify and penalise entities that do not maintain sufficient substance within the EU.

Additional reporting requirements would be imposed on entities that do not meet the substance requirements (or one of the exemptions), and such entities would also be denied the benefits of double tax treaties relief and EU Tax Directives (such as the EU Interest and Royalty Directive and the EU Parent-Subsidiary Directive). 

The draft Directive is likely to increase communication between the Member States through the automatic exchange of information on all entities within scope, regardless of whether they are shell entities are not.

When will an entity be within the scope of the Directive?

Potentially in-scope entities will be identified by the use of three “gateway” tests. If an entity “passes through” all the gateways, it will be brought within the scope of the Directive and subject to additional reporting requirements unless it is excluded. The gateway tests are:

• More than 75% of the entity’s revenue is from “relevant income”. Broadly, “relevant income” refers to “passive” income sources, examples include income from insurance, banking, and other financial activities, leasing, real estate, dividends, interest, and royalties, or any other income generated from intellectual or intangible property. The definition also includes income from services that were outsourced by the entity to associated entities.
• The entity is engaged in cross-border activity such that:
  • More than 60% of the book value of the entity’s assets was located outside the member state of the entity; or
  • At least 60% of the entity’s income is earned or paid out via cross-border transactions.
• The entity has outsourced the administration of its day-to-day operations and decision-making on significant functions.

It should be noted that the above tests are applied for the two proceeding years. If the Directive comes into force in 2024, this would result in 2022, and 2023 is considered for the purpose of the tests.

Which entities are excluded?

Certain entities are excluded by derogation from the above gateway tests, these include:

• Companies that have transferable security are admitted to trading or are listed on a regulated EU market or multilateral trading facility.
• Regulated financial undertakings.
• Entities that hold shares in operational businesses where they are resident in the same Member State as the operational business and their beneficial owners.
• Entities with at least five full-time employees who exclusively carry out income-generating activities.
• Entities that qualify as securitisation special purpose entities.

What are the reporting requirements for entities within the scope of the Directive?

Entities that meet the above gateway tests will be required to report via their tax returns whether they meet minimum substance requirements.

Indicators of the minimum substance include:

• Existence of premises for its exclusive use in the Member State.
• At least one active bank account of its own in the EU.
• Either:
• at least one director of the undertaking is qualified, authorised, and close-by to take decisions in relation to the activities generating the relevant income, makes use of its authorisation, is not employed by a non-associated enterprise, and does not perform the function of a director for another non-associated enterprise; or
• the majority of the qualified full-time employees of the undertaking are tax resident in the Member State of the undertaking (or resides sufficiently close to the Member State in order to perform their duties).

Based on this information the tax authorities will then assess whether or not the substance indicators (or domestic similar rules) are met.  Entities that have passed the gateway tests and do not meet the substance requirements will be presumed to be shell entities for the purposes of the Directive.

Can an entity rebut the presumption that it is a shell?

The proposed Directive allows the presumption of lack of substance to be rebutted by entities under certain circumstances. This would require the entity to demonstrate that it either:

• does have substance in the Member State of claimed residence. This would require the provision of evidence of the activities performed by the entity and how these activities are performed. This is expected to include evidence that the key decisions on the value generating activities of the undertaking are made in the Member State of claimed residence, and information on the commercial (non-tax) rationale for setting up the entity; or

• is not being used to obtain a tax advantage. This would require the entity to compare the tax liability of the structure/group of which it is a part, with or without its interposition.

What are the tax consequences for shell entities?

The tax consequences for an entity being deemed a shell entity include the following:

• The Member State in which the shell entity claims tax residence will either not issue a tax resident certificate or will issue a tax resident certificate which includes a warning.
• Advantages conferred by double taxation agreements and EU Directives (such as the EU Interest and Royalty Directive and the EU Parent-Subsidiary Directive) could be disallowed by the other EU Member States.
• New taxing rights over the income allocation of taxing rights to the other Member States, for example:
  • the Member State in which the shell entity’s shareholders are residents are entitled to tax the relevant income of the shell entity (and entitled to take a deduction for any tax paid by the shell entity); and
  • income deriving from an immovable property being taxed by the Member State in which that property is situated.
• If the shell’s shareholders are not resident in the EU, Member States will withhold tax on payments to the shell entity.
• The imposition of penalties if the shell entity does not meet the relevant reporting obligations. The Directive broadly leaves the penalties at the discretion of the individual Member States but proposes a penalty of at least 5% of the shell entity’s turnover.