Background
Gradually, economic substance has become a key element in an international context and is relevant for the application of national tax laws and double tax treaties and avoid the application of national anti-abuse rules. Accordingly, taxpayers are required to maintain a significant level of assets, employees, functions, assume risks and use and enjoy the income received to be entitled to the benefits of certain double tax treaties and EU tax Directives. The business substance is a combination of many elements which include human and material resources.
The Court of Justice of the EU addressed this issue in the so-called Danish cases.[1] According to the Court, the fact that the sole aim of the creation of financial arrangements is to benefit from certain tax advantages (such as withholding tax exemption), is not acceptable to circumvent taxation because it is a purely artificial economic arrangement. The Court also highlighted the relevant factors which should be considered to analyze the actual economic substance of a company. These include the management of a company, its balance sheet, the structure of its costs, the expenditure incurred, the staff it employs, the premises and the equipment it has.
Besides having relevant local presence, it is also necessary to justify the business rationale underpinning the existence of the investment company and its role within the group. There must be business reasons driving the establishment and functions of a corporation and ideally one should be able to justify why an investment activity is carried out through one particular jurisdiction and why the investments are not made directly.
While several actions at EU and international level provide instruments to tackle the use of abusive tax structures, legal entities with only minimal substance and economic activity continue to pose a risk of being used for improper purposes, such as aggressive tax planning. This issue has been specifically addressed by the EU Commission in its communication on business taxation for the 21st century which proposes a tax agenda with a series of measures to ensure fair and effective taxation within the EU.
EU wider substance agenda
Following the EU Action Plan of 2020 and the issues linked to the globalization and digitalization of the economy, the European Commission has recently published a communication[2] which contains the EU Tax Policy Agenda and the actions to adopt in 2021 and the coming years to increase transparency and substance requirement. One of the most relevant proposals is the initiative on fight against the abusive use of shell companies meaning companies with no or minimal substantial presence and real economic activity. Consequently:
- The EU Commission wants to tackle abusive tax structures and entities created for the main purpose of reducing the tax liability of a group while such entity has no or limited presence in the jurisdictions where they are established. However, if there is a real and valid economic activity, the company will likely fall out of the scope of these measures. Accordingly, legal entities without significant business and economic presence would be further denied from tax advantages derived from EU law.
- It is anticipated that the proposal will also contain certain reporting obligations to allow the tax administrations to evaluate the substance of the shell companies and (dis)allow the tax benefits.
- This proposal of directive is expected to be adopted by the beginning of 2022.
- This proposal, if adopted, will reinforce the pressure regarding the use of intermediate holding companies. To mitigate costs, multinational groups will probably have to select one single jurisdiction to establish their holding companies and build up the necessary level of substance.
How is this relevant to your investment or fund structure?
In order to manage the tax risks arising from lack of substance, investment or fund structures involving the use of blockers/holding companies will require to anticipate ATAD 3 measures. Certain holding companies held by funds do not maintain an adequate workforce, assets and functions with certain activities are decentralized and said companies potentially do not meet all substance requirements. In consequence, an evaluation of your structure may be advised in the future.
Our tax team is at your disposal for any question.
Article co-authored by Vicente Chapa.
[1] Joined Cases C‑115/16, C‑118/16, C‑119/16 and C‑299/16 dated 26 February 2019.
[2] COM (2021) 251 final.
