On 22 December 2021, the European Commission published an anti-tax-avoidance directive intended to neutralise the misuse of shell entities for tax purposes says Sanjeev Jewootah, Director at Crestbridge Luxembourg. 

Known as ATAD III, the draft Directive is aimed at EU-resident entities, including SMEs, partnerships, trusts, and other legal arrangements which claim benefits under double tax treaties and other EU Directives, but which lack a minimum level of economic substance. 

This directive is one of the initiatives to improve the current tax system with a focus on ensuring fair and effective taxation. ATAD III follows two previous iterations of EU-wide anti-tax avoidance legislation. In January 2016, the Commission proposed the Anti-Tax Avoidance Directive ("ATAD"), in order to "create a level playing field for all businesses in the EU and to implement the OECD's base erosion profit shifting ("BEPS") measures across Europe. 

The directive lays down indicators of minimum substance for entities and rules regarding tax treatments for those that do not meet the indicators and "at risk" of being a shell company.

The directive applies to entities that are considered tax residents and eligible to a tax residency certificate.

Certain undertakings are excluded, as they are already subject to significant scrutiny. These include companies listed on regulated markets, regulated financial undertakings, and undertakings with at least five of their own full-time equivalent employees or members of staff carrying out relevant income-generating activities. .

An entity will be considered "at-risk", and subject to further reporting requirements if it meets the "Gateway test":
•    More than 75% of revenue in the preceding two tax years is relevant income including Interest, assets from financial assets, royalties, dividends, capital gains, and income from properties). In the absence of income, the book value of the assets is taken into consideration.
•    The entity is mainly engaged in cross-border activity
•    The administration of day-to-day operations and decision-making on significant function are outsourced.
"At-risk" entities must then report whether they meet one or more of the following indicators of "minimum substance" on their yearly tax return:
•    Individual premises in a Member State
•    At least one own and active bank account in the EU
•    At least one local director, who is qualified and authorized to take exclusive active and independent decisions or full-time local employees

Entities with minimum substance for tax purposes will be required to accompany their tax return declaration with the following evidence:
(a) address and type of premises; 
(b) amount of gross revenue and type thereof; 
(c) amount of business expenses and type thereof; 
(d) type of business activities performed to generate the relevant income; 
(e) the number of directors, their qualifications, authorisations, and place of residence for tax purposes or the number of full-time equivalent employees performing the business activities that generate the relevant income and their qualifications, their place of residence for tax purposes; 
(f) outsourced business activities; 
(g) bank account number, any mandates granted to access the bank account and to use or issue payment instructions, and evidence of the account's activity.
An entity considered at-risk that does not meet the three criteria for minimum substance is considered a "shell company," in the scope of the Directive.

The directive provides for an entity considered to be a shell company with two opportunities to counter-prove this presumption:
a)    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). b) 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 the scope of the draft Directive given ATAD 3's focus on preventing the granting of tax benefits through the use of low-substance companies.

There are a number of tax consequences for a shell company that fails to counter-prove the presumption.

Firstly, the entity will be denied the granting of a tax residency certificate, or provided one 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.

The directive requires Member States to publish rules on penalties applicable to infringements of national provisions ensuring they're effective, proportionate, and dissuasive. Penalties include an administrative sanction of at least 5% of turnover.

The current timeline suggests the Directive should be implemented into Member States' national laws by 30 June 2023, and come into effect from 1 January 2024.

However, the ATAD III substance test also includes a look-back period of the preceding two tax years, meaning that should the Directive be implemented, it will come into effect in 2024. An undertaking's compliance as of January 2022 may be taken into consideration, it is therefore imperative that action is taken now to avoid any unforeseen compliance issues.

By Sanjeev Jewootah, director at Crestbridge Luxembourg