ATAD III: It is urgent to test this year the substance of holding companies in light of the shell entities directive

Will the decision of the Member State of the holding company on whether it is a shell or nor, be followed by other involved Member States (State of shareholders and State of source of income flowing through the company)?

Responding to a request from the European Parliament following the Panama Papers and Luxleak scandals, the Commission has published a draft directive 2021/0434 or ATAD III, designed to prevent the use of shell companies. If transposed, provisions are due to be applicable from 1 January 2024, with the need to assess certain criteria from this year (i.e. two years in advance).

The primary target of the legislation is financial holding companies that hold intellectual property rights and real estate, with cross-border activity or assets. Regulated banking or financial companies are excluded, as are AIFM funds.

Eligible companies will themselves have to report to the administration whether or not they present a risk of being considered as a shell company, through the application of three criteria. If so, the company would retain the possibility of demonstrating that its interposition has no tax advantage, which would not prevent it from being reported in a dedicated central directory accessible immediately by all Member States. Failing this, the “at-risk company” will have to justify that it is not a shell company through three other criteria of minimum substance (of activity and local management). In the event of failure, the company will be presumed to be a “shell” company and will be neutralised for tax purposes: Shareholders will be taxed on its profits as it were transparent and the shell company will non longer be eligible to treaty benefit and directives benefits as well.. However, the presumption may be rebutted if the presumes shell company demonstrates that it has substance or in any case it is not misused for ta purpose through its management autonomy and effective economic activity generating the earnings.

The directive aims to harmonise the definition of shell companies and the associated sanction by establishing a system of transparency through the exchange of information between Member States. The question of substance usually calls for a flexible response which necessarily differs depending on the activity.

Effective harmonisation through objective criteria would also require harmonising their assessment, which will necessarily need to vary depending on the company’s country of residence. The assessment of the conditions for exemption and reversal of presumption should also be aligned in a context where the Member States of the shareholders and of the source of the income derived from the holding company should rely on the analysis and conclusions of tbe country of residence of the holding company. This should certainly create difficulties and raise questions between the Member States involved.

The Member State where the income originates or the member State of the shareholder are still entitled to apply their own anti-abuse rules in the event of a favourable opinion from the company’at risk s State3. Furthermore, the explanatory memorandum of the directive allow “tax administrations” to refer to their domestic law, other than that drawn from the directive, to assess the company’s minimum substance3. The plural used in reference to the tax administration, along with the reference to domestic law, appears to give other Member States the opportunity to conduct own their analysis. The recognition of the possibility offered to other Member States to invite the Member State of residence of the company to reconsider its position and to initiate a tax audit procedure does not militate for a separate assessment. However, the issue of taxable base and the necessarily variable nature of the concept of substance may lead to arguments between the competent authorities, more often at the expense of the taxpayer.

Application of the directive will, above all, have the effect of disclosing to all Member States through the central directory the company considered as being at risk, unless they have justified that they do not allow the group or the shareholder to obtain a tax advantage. In that context, the risk of an audit cannot be ignored.

Investment groups and funds are therefore encouraged to reassess the robustness of companies likely to be within the scope of ATAD III. Strengthening the company’s local capacity, transferring, moving to The Member States of the shareholder (beneficial owner) and reorganizations are amongst the main options to be favoured.

Finally, a company holding crypto-assets falls within the scope of the directive. Financial services providers dedicated to crypto-assets are excluded however (in anticipation of forthcoming European regulations).

1. When is a company at risk?

A company will be considered “at risk” if it meets the following three criteria:

more than 75% of its income has been passive for the past two years: dividends, interest including crypto-assets, royalties, capital gains, rents including on properties, income from movable assets other than securities (if their book value exceeds €1 million), income from financial activities or income from services outsourced to a related company (particularly at least 25% of the voting rights or capital); and

more than 60% of its income or the book value of the assets held has been or is located outside the entity’s Member State of residence for two years. If real-estate assets (or movable assets other than securities, such as art or a yacht if their value exceeds €1 million) total more than 75% of the value of the assets, the condition is deemed to be met regardless of the level of income;

- the company’s management has been entrusted to a third party (day-to-day management and decision-making process on significant functions), also for at least two years; or if it has less than five full-time employees dedicated to the activities that generate the income.

The scope is broadly defined based on tests, without distinguishing the nature of the activity, subject to excluded companies such as regulated financial entities, UCITS, companies holding shares in active entities in the same Member State, also State of residence of the shareholder, or, without lilitation, companies having 5 or more full time employees devoted to the activity generating the income.

2. At-risk company with no tax advantage for beneficial owners

The justification for the absence of tax advantage(s) for the shareholder or the group from the interposition should remove the company from the scope of the directive and listing. An individual application based on a numerical comparative analysis is required. A favourable response from the administration in the country of residence of the company could be valid for up to six years.

3. At-risk company presumed to be a shell company?

Once considered “at risk”, the company must justify a minimum acceptable substance. The indicators listed are the provision of own premises; the holding of an active bank account in the EU; the existence of at least one qualified senior manager who regularly makes decisions independently relating to the activities generating the income and who is a resident of the company’s Member State without being an employee or manager of non-related companies. This last condition is primarily intended to exclude professionals such as fiduciaries or trustees. If the condition linked to the manager is not met, then the criterion may still be fulfilled by the employment of qualified and full-time employees at least half of whom bing residents of the same Member State as the entity. The company is free to communicate any other documents it deems useful. If all the criteria are met, the company should be considered at risk only without being considered as a “shell”.

The production of satisfactory evidence is not necessarily a guarantee if the “tax authorities” were to consider, for example, that the conditions of domestic law – other than those arising from the directive – are not met. This stipulation is disturbing, as we have seen. It casts doubt on which tax authority is competent. Could it be also those in the other Member States involved? This would not correspond to the objective of harmonisation inherent to the the directive, which calls for the prevailing analysis of the company’s Member State of residence. Nevertheless, even if the national law of the company’s Member State of residence were applicable, this would lead to distortions of analysis depending on the country of residence. Clarifications would be helpful to refrain any attempt of Member States other than the company’s Member State of residence to conduct their own analysis, even if only through their anti-abuse rules.

4. Rebuttable presumption

The entity will be presumed to be a shell company if at least one of the indicators is not completed, unless it can demonstrate (i) the economic justification for the creation of the company; (ii) concrete evidence of the process for making the most important decisions locally; and (iii) the actual activity of the employees and their qualification. A favourable decision may be valid for six years.

5. Sanctions

The tax advantages related to interposition, both in the country where the income originates and in the Member State of its beneficial owner, are neutralised. Domestic law will remain the only applicable law, unless a tax treaty is applied between the country where the income originates and that of the shareholder. No certificate of residence will be issued or, if it is, it will contain an warning statement preventing the application of tax treaty to the shell company, also vis-à-vis third countries.

6. New tax arrangements for cross-border income: tax transparency

Drawing on all the consequences of the failure to take into account the shell company, the shareholder of the company will be taxed transparently on the income and gains of the shell company, with deduction under domestic law of the taxes borne by the shell company in its country of residence and in the country where the income originates (with application, where applicable, of the tax treaty between the originating country and the shareholder’s country).

7. Exchange of information within 30 days: transparency between Member States

A central database (central directory) is planned to hold the information received from companies considered to be at risk, as well as information leading to the removal of the presumption. The information must be communicated within 30 days of receipt of the file associated with the tax return or the individual decision made by the tax administration in the Member State of the company considered to be a shell company. Lastly, each Member State may request the Member State of residence of the company to launch an audit on the basis of information in its possession. The requested country must respond quickly and share its analysis, which will be distributed via the central database, where applicable.

8. Penalty for non-compliance

Member States are free to set the penalties for non-compliance with reporting obligations, with a minimum requirement of 5% of the shell company’s turnover.