The Shell Company Directive: demystifying the misuse of shell entities for improper tax purposes and implementing the substance test
Executive Vice President for an Economy that Works for People, Valdis Dombrovskis, said, “Shell companies continue to provide an easy opportunity for criminals to abuse tax obligations. We have seen too many scandals resulting from shell company abuse over the years.
On 22 December 2021, the European Commission presented a proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and other crimes such as money laundering or terrorist financing . The directive aims to curb the misuse of front or letterbox companies. The Directive has defined a number of objective indicators related to revenue, staff and premises, as well as other substantive requirements. The proposal will help national tax authorities to detect entities that only exist on paper.
The Directive lists certain derogations regarding the inapplicability of certain reporting requirements to certain regulated financial undertakings, such as insurance companies, credit institutions and fund managers.
The proposed substance test has three substance indicators.
– The first indicator relates to the activities of the entities according to the revenues they receive. The gateway is satisfied if more than 75% of an entity’s aggregate income in the two previous tax years is not derived from the entity’s business activity or if more than 75% of its assets are real estate or other private property of particularly high value. assess.
– The second indicator requires a cross-border element. If the company derives the majority of its relevant income through transactions related to another jurisdiction or transfers such relevant income to other companies located overseas, the company moves on to the next indicator.
– The third indicator focuses on whether the management and administration services of the business are provided in-house or outsourced.
An entity meeting all three indicators will be required to report information in its tax return relating to, for example, business premises, bank accounts, the tax residency of its directors and that of its employees. All declarations must be accompanied by supporting documents.
The directive sets the following indicators for the minimum substance:
1. The entity has its own premises in the Member State or premises for its exclusive use;
2. The entity has at least one own and active bank account in the Union;
3. One of the following indicators:
(i) One or more company directors:
– have their tax residence in the Member State of the company, or are not further from this Member State insofar as this distance is compatible with the proper performance of their duties;
– are qualified and empowered to make decisions in relation to activities that generate relevant income for the company or in relation to the assets of the company;
– make active and independent use of the authorization referred to in point 2 above on a regular basis;
– are not employees of a company that is not an associated company and do not exercise the function of director or similar of other companies that are not associated companies;
(ii) the majority of full-time equivalent employees of the company are domiciled for tax purposes in the Member State of the company, or at a maximum distance from this Member State insofar as this distance is compatible with the proper exercise of their functions, and these employees are qualified to carry out the activities which generate relevant income for the company.
If an entity fails at least one of the substance indicators, it will be presumed to be a “shell”, but the presumption is rebuttable.
If a company is considered a shell company, it will not be able to access the tax relief and benefits of its Member State’s tax treaty network and/or benefit from the treatment provided by the Parent-Subsidiary and Interest and Royalty Directives. In addition, either the company’s Member State of residence will refuse the fictitious company a certificate of tax residence, or the certificate will specify that the company is a fictitious company.
In addition, payments to third countries will not be treated as passing through the fictional entity and will be subject to withholding tax at the level of the entity that paid to the fictional entity. Accordingly, incoming payments will be taxed in the state of the shell shareholder.
The Directive grants exemptions to a Member State to allow a business that meets the criteria to claim an exemption from its obligations under the Directive if the existence of the business does not reduce the tax liability of its beneficiary(ies) workforce or of the group as a whole of which the company is a part.
Once adopted by member states, the directive is expected to enter into force on January 1, 2024.
This article was written by Dr. Franklin Cachia, Senior Director of Tax and Regulated Industries at CSB Group. For more details and information, he can be contacted at [email protected]
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